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By Toby Baxendale, on 2 February 12
In yesterday’s article I emphasised that it is profit that is beneficial, not revenue.
I’ve just read an excellent article (H/T Sean Corrigan) by Jerry L. Jordan, past president of the Federal Reserve Bank of Cleveland. He makes the same point, with particular reference to government “investment” and national accounting.
He opens with an analogy to warm the hearts of American readers:
It is tempting to think that the Soviets perfected negative-value-added investment — the stuff produced is worth less than the value of the resources to produce it. However, most families have experienced this first hand.
It usually surfaces with an entrepreneurial adolescent deciding it would be a good idea to sell lemonade at the curbside to passersby
Parents, wanting to encourage the idea that working and making money is a good idea, drive around to buy the lemon, sugar, designer bottled water, cups, spoons, napkins, a sign or two, and probably a paper table cloth.
Aside from time and gas, the outing adds up to something north of $10. At the opening of business the next day, the kids find business is slow to nonexistent at $1 per cup. So, they start to learn about market demand and find that business becomes so brisk at only 10 cents per cup that they are sold out by noon, having served 70 cups of lemonade and hauled in $7.
The excited lunch-time conversation is about expanding the business. A stand across the street to catch traffic going the opposite direction; maybe one around the corner for the cross-street traffic. The kids see growing revenue; the “investors” see mounting losses.
There is a strand of economics, we’ll call it the K-brand, that sees all this as worthwhile. They add together the $10 spent by the parents to back the venture and the $7 spent by the customers and conclude that an additional $17 of spending is clearly a good thing. Surely, the neighborhood economy has been stimulated.
To the family it is a loss, chalked up as a form of consumption. If this were a business enterprise it would be a write-off. In classical economics it is a “mal-investment.”
But of course the government “invests” on a much larger scale:
To K-brand economics, such “investing” is better done by the government because there never has to be a write-down for bad ideas. So, Japan spent a couple of decades “investing” in airports few people fly to, highways few people drive on and bullet trains that not enough people ride on. All the expenditures were recorded as investment and were additions to national output, never recognizing that the value of what was produced is less than the value of the resources needed to produce it — negative-value-added. Surely it is clear that Japan was made poorer by lots of bad “investments.”
The U.S. recorded a great amount of “residential investment spending” in the central valleys of California that added to national output, only to have the houses bulldozed because there were no buyers. Subsequently, the homebuilders incurred losses, reducing business income, thus shrinking national output.
Nevertheless, the national accounts will never be revised to reflect that the “investment spending” of a few years earlier was all “mal-investment” and should have been recorded as a form of business consumption. Such “investment” actually made us poorer.
The irony of this example is the expenditures incurred to bulldoze the vacant houses is recorded as “stimulus” to the economy. Thanks for that to K-brand economics. They now want California to “invest” in a Japanese-style bullet train that is negative-value-added economics.
I recommend the whole article.
By Detlev Schlichter, on 5 November 11
Reproduced by kind permission of Jacob Wolinsky at ValueWalk.com
Can you tell us a little bit about your background?
I studied economics in my home country, Germany, and joined J.P. Morgan as a trader in Frankfurt in 1990. By 1996 I had become a portfolio manager in J.P. Morgan’s asset management division and moved to London, which I still call my home. I specialized in European and global bond portfolios. From 1998 to 2001 I worked at Merrill Lynch Investment Managers, which has since become part of BlackRock, and in 2001 I joined Western Asset Management, the Pasadena-based bond specialist. For Western I oversaw their London-based investment team and was lead portfolio-manager for all their global strategies. When I left Western in 2009 my team there oversaw roughly $65 billion in assets under management for institutional clients from around the world. I look back on my years in the business with many fond memories. I worked with some interesting people and had some fascinating clients. But by 2009 I had become very pessimistic on our financial system as a result of my study of Austrian School economics and my own experience after almost two decades in the business. The two perspectives combined to form a rather unpleasant outlook. I wanted to step outside the industry, think things through, and write a book about it.
What investing style do you subscribe to?
I am not sure I subscribe to any identifiable style, or that I even consider it particularly desirable to do so. Let me explain. I spent almost 20 years in the institutional asset management business. There is very limited room to develop your own style to begin with. These companies are asset-gathering companies. They need to constantly grow and attract new clients. In order to do that they not only try to establish a decent track record but also a specific house style and a clear and distinguishable process that they can market. They try to create a brand. As a portfolio manager you have to play along and do things in a way that fits the process. Incidentally, that was something I was actually quite good at. Now it so happens that certain styles work for some time and then stop working. Markets constantly change. In the industry, however, whenever somebody has good numbers for a while and a good story about how those numbers have been generated, he is usually in a sweet spot. New clients come rushing in. But I have become very cynical in this regard. That is usually the moment you should sell these firms or money mangers. I accept that my take on the style-question is unusual. But that is how I see it.
The truth is I tried many different things over the years. Only now, that I am out on my own, outside the mainstream industry, can I look at things with an entirely open mind, which is refreshing. I like Doug Casey’s distinction between traders, investors and speculators. Many people call themselves investors when what they really do is trading. This is certainly true of many ‘investors’ in the asset management industry. I would now call myself a speculator. Most of the time you do nothing. Until you spot a major dislocation, or a major event or an opportunity, something that you have a completely different view on from most other people. That’s when you go in and take risk. Example: I am convinced this crisis is misunderstood by most. We are witnessing the failure of our fiat money system. This will get much worse. I try to position myself for it.
What attracted you to the Austrian school of thought?
I came across some writings by F.A. Hayek by chance more than twenty years ago. I can honestly say that I felt immediately that I was reading something special, something that made sense, that was true. I found it exceptionally convincing, and it made a huge impression on me. For the next four years I read everything Hayek wrote. Then, I discovered the other Austrians, Mises, Rothbard, Menger. To sum it up, I would say that it is the methodology that makes the Austrian School so special. Ludwig von Mises, for me, is the unsurpassed master of the Austrian School. He understood better than anybody what economics is about, what it can do and what it cannot do, and how it should go about it. Austrian School Economics starts with the individual actor. Purposeful individual action and human cooperation on markets is the driving force behind all economic phenomena. From the starting point of the individual, the Austrians reconstruct and explain all institutions of the market – from the bottom up, so to speak. By contrast, most modern economists approach economics as if it was a natural science, where we must collect observations, statistical data, and look for patterns. This is the right approach for natural sciences because in nature we can’t perceive of purposeful action. But we do understand the actions of humans in the economy. The approach can be and has to be different. Furthermore, macroeconomists implicitly assume that the statistical aggregates and the large wholes that they work with in their models (consumption, investment, retail spending, aggregate demand, and so forth) are what really interact with one another in the real world. This is a tremendous intellectual error. The economy is ultimately driven by countless individual decision-makers. The Austrians do not lose sight of that.
It is no surprise to me that the Austrian School has such a strong appeal for real-life entrepreneurs and risk-takers. No other school of thought understands entrepreneurship, risk-taking, capital accumulation and capital maintenance, relative prices and the real-life elements of time and error, like the Austrian School does. Of course, politicians, central bankers and state bureaucrats are, by contrast, drawn towards mainstream macroeconomics. It gives them the illusion that the economy can be planned and manipulated from the top down.
What inspired you to write a book?
When you begin to understand Austrian monetary theory you realize that our financial system is built on quicksand – elastic, constantly expanding fiat money to be produced without limit and at full discretion by the central banks. I realized that the growing instabilities and dislocations that I observed in my work-life as a portfolio manager over the past two decades were the inevitable consequence of our monetary infrastructure. What amazed me was that nobody around me saw it that way. Whenever a credit boom threatened to turn into a credit bust – as it sooner or later must – everybody was calling for a monetary stimulus, for lower rates and for policy accommodation to extend the credit boom further. Such a policy may indeed prevent a correction now, but only at the cost of making an even bigger correction necessary in the future. But everybody in financial markets is so indoctrinated with a specific and narrow subset of modern macroeconomics – I would say the most toxic aspects of Keynesianism and Monetarism – that everybody believes any policy to be a good one if it only creates some near-term GDP boost. There is no perception of long-term dislocations and market imbalances, of what the consequences of such a policy of artificially cheap credit must ultimately be. I think a gigantic intellectual bubble exists in which most financial market participants operate. That bubble will probably only get pricked by real events, i.e. the massive crisis that is now unfolding. But I wanted to try and give people a different perspective, to debunk some of the erroneous common wisdom that is readily accepted by so many people in the business.
Can you explain to people what your definition of money is?
Money is the medium of exchange. It is the most fungible good in the economy and therefore most readily facilitates exchange of property. It is neither a consumption good nor an investment good. We hold it not to satisfy any of our consumption needs, nor to generate a return. We have demand for it because it gives us flexibility. To hold money balances means to hold purchasing power in its most readily tradable form.
Capitalism developed on the basis of inelastic, inflexible and apolitical commodity money, such as gold and silver – inelastic in its supply and outside political control. Today we live in a world of entirely elastic paper money under discretion of the state, and for the first time in history, such a system spans the entire globe. Remember also, that today’s fiat money system only came into full bloom on August 15, 1971.
Today, most mainstream economists maintain that the perfect elasticity of the money supply is a plus. My book argues that this is wrong. The relative inelasticity of gold makes gold a superior form of money. Elastic money systems must ultimately collapse. Throughout history they always have.
Can you tell us about the US system pre-Fed era?
I should stress first that I am not a monetary historian, although there is a short chapter on the history of paper money systems in my book – all of these systems collapsed by the way. Understanding monetary systems requires theory. History can illuminate concepts or raise new questions. Only theory can explain.
Prior to the founding of a central bank, the Federal Reserve, in 1913 and the subsequent abandonment of a gold anchor in 1933 (domestically) and 1971 (internationally), the US used, for the most part, commodity money. I say ‘for the most part’ as America conducted some interesting experiments with paper money as well, all of them complete disasters. In fact, one of the first historic examples of a paper money system outside Medieval China, was Massachusetts, which, in 1690 when still a British colony, issued paper money to fund military excursions into French Quebec. Then there were the famous continentals, a paper money issued by the Continental Congress in 1775 to fund the Revolutionary War. These early experiments with paper money ended like they always do – with worthless paper tickets. Then in the early part of the 19th century the dollar was defined as a specific amount of gold. This was proper commodity money, a gold standard. There was no central bank. Gold was money. Commercial banks had to redeem their banknotes in specie, which set tight limits on bank credit creation. But the government couldn’t stop interfering, in particular whenever it needed cheap credit, usually to fund wars. Requirements to redeem in physical gold were lifted on a couple of occasions, so in the wake of the War of 1812, when the US was fighting Britain again, and most famously during the Civil War, when the greenbacks were issued and soon inflated into worthlessness. In 1879, the US joined Britain, and in fact most of the then industrialized world, in what became known as the Classical Gold Standard. After the inflation of the greenback era, a corrective deflation was allowed to unfold (but strong economic growth continued nevertheless), and from 1879 to 1914 there was no meaningful deflation or inflation in the system at all. This was a time of hard, inflexible and stable money. This was a period– in the US and globally – of solid economic growth, rising living standards and growing international trade, and of harmonious economic relationships between countries. The Classical Gold Standard was not perfect but probably the best monetary system we have had so far.
Many people have proposed going back to the gold standard? We had many depressions and recessions while on the gold standard, do you think it would be a good idea?
Yes, we should definitely return to a gold standard — not one that is “managed” by the government, but a proper gold standard with no involvement of the state. I wouldn’t hold my breath, however. As we have seen, governments love fiat money. It gives them control over the economy. We will eventually return to some form of gold standard but only after the complete collapse of the present system in a major crisis.
The elasticity of money – which means periods of money expansion and credit booms followed by periods of monetary stagnation or contraction – is the main cause of business cycles. How did this occur under a gold standard? Answer: the spread of deposit banking and fractional-reserve banking, in particular in the late 19th century. These banking practices introduced an element of elasticity into the money supply. They can be profitable for the banks but they are risky and are destabilizing for the broader economy, even under gold standard conditions. That is why many Austrians argue for a 100-percent gold standard, for 100 percent reserve banking. I am not in that camp. I think fractional-reserve banking should not be banned, cannot be banned, and ultimately does not need to be banned. Many of these issues can be solved in a free market. We may have the occasional recession but the system can cope with that.
However, the Fed was founded in a joined effort by politicians and bankers in order not to restrict and contain fractional-reserve banking but, to the contrary, in order to encourage and subsidize it. Money has since not become less elastic but much more elastic. Of course, credit cycles still occur. They now only get much, much bigger. We had a thirty-year credit boom. We will now get a major credit bust. Compared to what we are facing now, the recessions of the gold standard era will look like a walk in the park.
Why do most policy makers seem to be in the Keynesian school and not the Austrian school of thought?
Please remember my answer to the question above about the appeal of the Austrian School. The methodology of the Austrians is superior, but the methodology of mainstream macroeconomics, and Keynesianism in particular, is appealing to politicians. These schools perceive the economy as an organism that sometimes performs below potential, which then provides a convenient excuse for the politicians to get involved. Keynesianism has popularized the concept of ‘aggregate demand’. A recession is now seen simply as a lack of aggregate demand. So politicians have a pseudo-scientific excuse to run deficits and spend money they don’t have. Strangely, the fact that “lack of aggregate demand” can at best be a symptom but hardly an explanation of the recession does not appear to bother too many people.
Truth is, the recession is the result of imbalances that the economy accumulated during the previous artificial credit boom. Once these dislocations (such as excessive levels of debt, overextended banks and inflated asset markets) exist, the cleansing of a recession is needed and unavoidable. That is not a popular message among politicians.
Greece was forced to implement austerity and the budget deficit as % of GDP went up and unemployment skyrocketed. What are your thoughts on the reason why this occurred?
That is not surprising at all. You have to remember that in today’s world GDP is a very poor measure of economic health. In the EU, 50 percent of recorded economic activity is conducted by the public sector. In my adopted home country, the UK, it is 53 percent. The public sector spends more money than all private individuals and corporations put together. This is more socialism than capitalism.
We don’t have to assume that everything the state does is pure waste. For some of these things there would be a proper demand even in a state-less free market. However, we – and in fact the state bureaucrats as well – have no means of telling what is truly demanded by the buying public and what is of marginal or of no productivity, and what is thus complete waste, because the public sector operates outside of market prices and without the guidance of profit and loss. But whatever the state does enters the GDP statistic just the same.
So whenever the state is being cut back – which hardly ever happens, only in cases of default, which is why I am a big advocate of government defaults – a lot of things drop out of the GDP statistics and unemployment goes up because public sector employees are laid off. This drop in GDP is not a lasting problem. We know that a lot of state activity was at least suboptimal to begin with. Now resources (including labor) are being redirected to the private sector, where they will eventually be employed again, and this will enhance wealth and prosperity in the long run. In my view, Greece should stop paying anything to her creditors, declare full default, and shrink the state drastically. For a short while, the statistics would look dreadful. Then Greece would have a massive and lasting recovery. With no debt, a small state and a free economy it could, after some time, outperform everybody else in Europe.
Taxes went up in the Clinton era and the economy still boomed, do you think slightly increasing taxes will be detrimental to the economy?
I object to taxes for moral and ethical reasons (which are subjective) and economic considerations (which are objective). Taxes are always detrimental to the economy. They were so, too, under Clinton. It so happened that other things outweighed their negative impact. Remember, the mega credit boom that started in the early 80s was still in full swing, the Greenspan put was still operable, the NASDAQ bubble was still being inflated. Some of the growth of those years was genuine, that is, based on entrepreneurship, capital creation and innovation, but a lot of it was also the result of easy money. Under these circumstances the tax hikes were not felt that much, that is all.
Today’s environment is very different. The credit boom has ended, and has ended for good. The state and the financial sector have benefitted most from decades of cheap credit and are now severely overstretched. The economy overall is much weaker. Higher taxes would be detrimental. Also, the idea that the gigantic government deficits could be closed with higher taxes is idiotic. To the US I would give the same advice as I just gave to Greece: default, shrink the state massively, go back to hard money. Alas, they won’t do it.
I am curious what you think about the major currencies; Dollar, Euro, Yen, some of the emerging countries?
They are all locked in a deadly race to the bottom. All these currency-areas face the same problems, which are the typical problems of a fiat money system reaching its endgame: massive public debt, uncontrollable deficits, weak banks, addiction to cheap credit and constant asset price inflation. None of these governments want to face up to the reality that they are broke and that what the economy needs is for the market to be allowed to liquidate unsustainable levels of debt and other economic imbalances. As that is deemed politically unacceptable, they will continue to try and buy time by producing ever more currency units and injecting them into financial markets. Inflation and currency destruction will be the endgame. I would stay away from paper money as much as I can. Buy gold and silver instead, and certain other real assets. To guess which of these paper currencies will hit the bottom first is a mug’s game, in my view.
Is inflation or deflation a bigger threat right now?
Inflation and deflation are both unpleasant but it is wrong to call them both an equal threat right now. Allowing deflation now would have a clear advantage, namely it would bring the economy back to a state of balance and toward more proportionate and sustainable structures. A deflationary correction that would allow the liquidation of market dislocations would be painful but it would ultimately restore the economy to health.
If all market interventions, including cheap money from the Fed, would cease now, we would indeed face a sharp economic contraction and most likely a period of deflation. But this is ultimately unavoidable anyway. Current economic structures are simply unsustainable, and the market has a way of dealing with what is unsustainable: liquidate it. The market is craving a cleansing recession, including drops in certain prices. As I said before, this is deemed politically unacceptable. That is why we will get ever more aggressive monetary policy and ever more money printing. This will not solve our problems but it will lead to inflation and most likely complete currency collapse. My outlook for the coming years is inflation, much higher inflation, not deflation. The reason for that is policy.
Hopefully you won’t consider the following analogy tasteless but to ask what is the bigger threat, inflation or deflation, is a bit like asking a cancer patient what is the bigger threat, death or chemotherapy. Nobody will readily embrace either. But it appears to me that in constantly telling us that we need to avoid deflation at all cost, today’s policy establishment is telling us that we should avoid chemotherapy and accept death by hyperinflation.
What are your opinions on Gold?
Gold is the essential self-defense asset. Whenever fiat money systems enter their endgame and are about to collapse, gold comes back. It is the eternal form of money. As Greenspan once said (and he said it when he was already the head the world’s foremost paper money central bank): In extremis, nobody accepts paper money. Gold will always be accepted.
At its current price of $1,720 an ounce I still consider it cheap. Much more fiat money will be created in coming months and years. You want to own something that is not simultaneously somebody else’s liability (such “money in the bank” on your deposit or savings account) and that cannot be created for political purposes at will and without limit, such as paper dollars.
Don’t trade gold, accumulate it.
QEII, Operation Twist, thoughts?
These operations get ever more extreme. It is just part of the logic of the system. We are in a mess because of the trillions that were created out of thin air in the past. To keep the system going a bit longer, the central banks now have to produce ever more money ever faster. Will it stimulate the economy? Yeah, right.
Like a little hamster in his wheel, Bernanke will have to run ever faster to keep the printing press humming and keep the system from correcting. We will get QE 3 and QE 4, no question. By the way, Operation Twist could already be QE3 in disguise. On the face of it, the Fed is just selling short duration Treasuries and buying long duration Treasuries. But the Fed also promised to keep interbank rates near zero for a long time (meaning: forever), and to achieve that they may be buying back short-term Treasuries pretty soon. Listen, there are no exit strategies. The Fed’s balance sheet will continue to grow. It is already bigger than M1. We will get more and more money……
Flashback to September 2008, what do you think the Government should have done?
Nothing. I like Jim Grant’s term: “constructive inaction”. If you believe that the Fed and the government saved us from another Great Depression with all their bailouts and quantitative easing, think again. All they did was postpone the depression – and to make the final disaster worse. All these imbalances are still with us, many of them are larger and have been moved to the state’s balance sheet. Nothing is fixed.
But if you think that this advice – do nothing – is unrealistic and that the government, after having actively supported the build-up of this credit edifice for decades, cannot simply walk away from it once the house of cards finally unravels, then I would suggest the following: Any actions by the government should have been directed toward sustaining the payment infrastructure and maybe to minimize the fallout for bank depositors, who for a long time have actively be lured into entrusting their savings to an increasingly leveraged, government-supported banking system, which has now checkmated itself. I am not suggesting a debt-funded bailout of the deposit base. But the US government allegedly sits on 260 million ounces of gold, some of it confiscated from its own population. Current market value: $450 billion. That could have been handed back to the banks as a backstop against their deposits. This could have been the first step towards abolishing the Fed and returning the country to a gold standard.
If you were Ben Bernanke what would you do now?
Abdicate. His mandate is contradictory and impossible. He is supposed to provide a stable medium of exchange for the American public, and at the same time provide an unlimited backstop for Wall Street and Washington. Well, it is one or the other. We already know which one he chose.
Same question, Barack Obama?
Abdicate is again a good option.
I am not an American so I am looking at this from a distance. It strikes me that the presidencies of George W. Bush and Barrack Obama were both unmitigated disasters for their country. I don’t even think the two as men are necessarily bad or evil. As individuals they may be decent and have good intentions. But the politics are just shockingly bad. The growth of the state, of government involvement in the economy and in all walks of life, the budget deficits, the ever-growing debt pile, the aggressive monetization of debt and the dependency on cheap credit and ongoing market manipulation – this is a complete shipwreck by any standard but, if I may say so, particularly shameful for a country that for freedom-loving people around the world was once a beacon of liberty, opportunity and capitalism. As a generally pro-American libertarian, I can’t tell you how much it hurts to see this once great country go to bits like this.
What needs to be done? Stop printing money, return the country to a gold standard, default on the debt (it will never be repaid anyway!), shrink the state aggressively, stop all foreign wars – the military is the government’s biggest single expenditure item at close to $1 trillion a year.
If you think this is unrealistic then let me tell you that I think all of this will ultimately happen – but not by choice but by necessity, as a result of a massive crisis.
If you were Angela Merkel or Jean-Claude Trichet?
I think that what I said about Bernanke and Obama broadly applies to Merkel and Trichet as well. At the core, the problems are the same. Europe’s problem is not that many different countries share the same currency. Many more and much more different countries did the same between 1879 and 1914 under the gold standard, and it worked very well. The problem is precisely that they do not share an international, apolitical and inelastic commodity money, but a fully elastic and politicized fiat money that comes with built-in expectations of government and bank bailouts. Stop printing money, return to hard and de-politicized money, preferably a gold standard, and shrink the state – the advice is the same.
Who are you endorsing for US President? Ron Paul?
I think the entire political process, not only in the US, but in all modern mass democracies, has become a most degrading and dispiriting spectacle. I agree with P.J. O’Rourke: Don’t vote. It only encourages the bastards. Politics needs to be thoroughly delegitimized as a problem-solving device. It creates more problems than it solves. So I am not endorsing anybody.
Having said this, Ron Paul is, of course, by far the best choice from my point of view. I don’t think that this will surprise you considering what I said above. He is right about ending the wars, abolishing the Fed, returning to a gold standard, shrinking the state. But I fear that he doesn’t have a snowball’s chance in hell to win the presidency. So the crisis will continue. Don’t bet on politics. Trust your own reason. Be prepared.
By Sean Corrigan, on 2 November 11
In a recent op-ed in the Globe & Mail, Davos Man’s indefatigable mouthpiece for failed, mainstream thinking, Martin Wolf, passed the following verdict on the UK authorities:-
What Mr. Cameron recommends is even nigh on impossible. Why is that? Is it not common sense that if one has borrowed too much, one must pay it back? Alas, what makes sense for individuals does not make sense for an economy, because one person’s spending is another person’s income. Consider a closed economy. Income and spending must match. If the private sector decided to spend less than its income, to pay down debt and if the government also decided to stop borrowing, aggregate incomes would fall until they could no longer achieve what they wanted. All they would obtain, by following Mr. Cameron’s advice, is a race to the economic bottom
Were it not that their own confused thrashings about in the wellsprings of knowledge so muddy the waters that laymen—above all those most dangerous of laymen who have their hands on the levers of power—quickly lose all faith in their own ability to deliver a sensible analysis of the world around them, this would almost be funny.
Never ones to be overnice about maintaining a rigorous distinction between ‘money’ and wealth’; always eager to present the results of their own serial befuddlement and blind-alley reasoning as examples of ‘paradox’ or ‘fallacies of composition’; so entirely ignorant of the role of time or capital in the system that it condemns them to live in a kind of economic Flatland—they truly should be greeted with nothing more than a vitriolic, Swiftian scorn whenever they dare to start pontificating, rather than being according the hushed respect which so many confer upon their profound-sounding inanities.
In taking the latest outpouring from Mr. Wolf as an example, the first thing we should notice is that Keynesians are entirely happy to dismiss our Austrian idea of a ‘structure of production’ (of which their hallowed GDP components are only one, subjectively-selected subset), yet, when they start to espouse (as Wolf is doing here) their tautologous ‘circular flow of money’ argument, much less their insupportable ‘multiplier effect’, they are suddenly willing to rely upon the actual existence of a larger, ‘subsurface’, Hayekian component to the lesser, above-water, final sales part of the iceberg of spending and making upon which they are so fixated.
Moreover, even if we accept the lack of a deeper appreciation of the role of higher order activity which categorises these economic Neanderthals, this childish simplification of only considering the various ‘sectors’ as if such a statistically-compliant, but monstrous aggregation had any real world validity is really an intolerable reduction to the absurd of the workings of a vastly complex, ever-changing, economic network.
To say that ‘if the household sector doesn’t borrow, then government must’ is to roll the very different tastes, circumstances, and capabilities of – let’s take the case of the US – 300-odd million individuals, living in 100-odd million households, into one, indistinguishable blob of clay and then to throw it into the scales against the only true monolith in existence – Leviathan. Likewise, they do this when they talk about the ‘company sector’ as if the innumerably rich range of business enterprises, all eagerly beavering away to try to generate their various interested parties an income, is nothing but a mass of mindless automatons, marching monotonically to the same beat, as if they were part of a birthday parade for Kim Jong-Il.
They make a similar – but possibly even greater – error when they say that ‘if no-one at home will borrow, then someone abroad must do so’ and then fret that if that uncountable, planet-girdling, to-them-utterly-homogenous, ‘offshore sector’ does not wish to run the trade deficit which is that net borrowing’s usual counterpart (the crude mercantile implication being, of course, that ‘it’ will not wish to do so), then we’re all doomed. This is now to lump the 6.7 BILLION people outside our current exemplar of the US into a single, unthinking ant hill of identical preferences and possibilities!!!!
An extension of this approach is the constant appeal to the shibboleth that ‘we can’t ALL export our way out of difficulties’ – in direct contradiction of the truth that this is exactly what we each attempt to do, every single day of our working lives!
I try to export my skills to you and those like you endeavour to do the same – sometimes to me, but often to a group which does not (and, moreover, NEED not) actually include me at all. As we each expand our ability to produce those goods and services of economic value which we constantly seek to ‘export’ across our interpersonal boundaries – so as to profit from our comparative advantage of talents – and irrespective of whether these boundaries coincide with the artificial divisions which a ‘territorial monopoly of violence’ lays down (i.e., of whether they synch with political borders) – the chances are that we will all become richer in the process.
This is no less the case when—as is well-nigh inevitable— we find the odd, residual imbalance between A and B (and even the less common one between C and everyone else from D through Z) on that single instant when we take the misleading, if regular, snapshot upon which we depend for accounting and tax-related purposes of the inconceivably extended, thrummingly dynamic matrix of global interchange in which we cannot help but be participants.
Yes, to sustain spending above one’s means may lead one into difficulties, especially when that spending is not being directed to wealth-creation or future income generation and even more particularly when it is being financed (rather than savings-funded) by an inflationary increase in money and credit. Hence the present difficulties of US mortgagees, Chinese property speculators, and the many European sucklers at the fast-drying teat of the tutelary Provider State.
But, otherwise, such exercises in five-finger arithmetic are, at best, a travesty of economic reality and, at worst, a breeding ground for ill-judged macro-intervention and invidious, nationalistic finger-pointing.
A similar distortion comes about when it is argued that if present policies reduce spending and if, therefore, prices begin to fall, profits will evaporate and set in train a feedback of even lower incomes and outlays in the future.
Again, this is true only insofar as it goes and, typically, the Keynesian propounders of this deflationary doom do not go anywhere near far enough.
The key to resolving this supposed conundrum lies in those last two items—incomes and outlays. Profit is the difference between income and outgo (less such legal deductibles as depreciation, etc). So, even if most prices were to fall for the reasons the likes of Mr. Wolf often suggest they should, there is nothing to say that a given entrepreneur’s unit costs may not go down faster than his selling prices—particularly if the difficult climate induces him to maximise his efficiency, eliminate all sub-marginal activities, and focus narrowly on what is his most remunerative unertaking. In this case, it is impossible to argue that he will not be left with a profit.
Moreover, even if the monetary count of whatever profit that left him with turns out to be lower than it was before, there is nothing to say that this will not now allow him to buy just as many – and possibly more – goods and services as was his wont (including the direct purchase of labour services) since, as was first postulated, prices have meanwhile fallen, boosting the real or effective value of his net income!
Granted, this does require the unstinting exercise of an unsentimental flexibility on the part of all counterparties involved and it may even require the renegotiation of any monetarily-fixed obligations, such as debt contracts. It also presumes that, at root, whatever credit contraction there may be underway is not allowed simultaneously to shrink the core money supply, else that latter’s real value has no chance of re-equilibrating itself.
To say that none of this is easy to achieve under today’s political and institutional framework is, alas, a truism, but neither is that admission one of finally accepting defeat. Certainly it does not mean that, instead of seeking to apply a judicious dose of social and legal lubricant to the state-stiffened joints of the exchange mechanism, we should douse the whole structure in gasoline and set light to it, as recommended by the sort of economists who are accorded the greatest number of column inches in our most prestigious national newspapers.
Truly, there is no hope for the world while we allow our self-serving political elite to derive post hoc justification for its members’ depredations from dilettantes such as Wolf – ‘second-hand dealers in ideas’ all – who are irredeemably prey to the many logical fallacies and faults of truncated reasoning which allow them to persist in propagating such errant nonsense with such unshakable conviction.
By Alasdair Macleod, on 26 October 11
Speech to the Committee for Monetary Research and Education
At the Fall Meeting, 20th October 2011.
Before addressing the consequences of today’s macro-economic policies I want to tell you my philosophy. I support sound money for two very good reasons:
1. Firstly, it is a basic human right to choose to save, without our savings being debased by the tax of monetary inflation. Those that are worst affected by this inflation tax are not the rich (they benefit), but the poor and the barely well-off, which is why monetary inflation undermines society and why the right to sound money should be respected. If government gives itself a monopoly over money, it has a duty to protect the property rights vested in it.
2. Secondly, it is a basic right for us to own our own money rather than have it owned by the banks. For them to take our money and expand credit on the back of it debases it. It is an abuse of an individual’s property rights and a banking licence is a government licence to do so. If anyone else was to do this, they would be guilty of fraud. Banks should be custodians of our money, and it should not appear on their balance sheets as their property.
If we had stuck to these sound money principles, several benefits automatically follow, some of which I will briefly summarise for you, and I will have a little more to say about them in a moment:
1. With sound money, governments cannot print money to fund their activities, so the true cost of government becomes apparent to the electorate. The result is that in a democracy the electorate votes for small government because profligate politicians simply do not get elected. Indeed, we need sound money for democracy to work.
2. With sound money, governments are unable to go to war without taxpayers being conscious of the true cost. This is a great incentive for peace and an electorate that accepts the benefits of free markets, and therefore peaceful trade, is less belligerent.
3. With sound money, savings are protected. Prices tend to fall gradually over time, reflecting improved efficiencies in production and of economic progress generally. So the purchasing power of savings increases over the years. For a pensioner, the purchasing power of his savings grows. He can then afford the healthcare he increasingly requires as he ages, and he can afford to leave something for his family when he dies. His savings work with his needs, which is the opposite of the situation in our inflation-ridden economies. In a sound money economy, our pensioners look after themselves and need not be a burden on the state.
4. With sound money, business cycles do not occur. The business cycles we are familiar with are in fact credit-driven cycles, the result of central banks expanding money and overseeing bank credit. They are the result of the misconception that monetary expansion leads to growth. It doesn’t: it merely distorts the economy by favouring a select few at the expense of the many.
These are just some of the benefits of sound money; benefits we can only dream about today. So long as we have unsound money we will have difficulties that will always end in a crisis. Today, we have sunk to the point where the answer to everything is found in more money and bank credit instead of the genuine production of goods and services.
The long-term consequence of monetary inflation is that voters now believe that a government always has the money to provide everything they need. So they naturally vote for more government. They do not question the source of government’s money. They have also been encouraged to believe that the freedom for everyone to do what they want with their own money only enriches the few, when the opposite is the case. People have become genuinely frightened by the thought of free markets. For this reason, governments regulate most of the private sector. Between government spending and government regulation, the private sector is now dominated by government interference. A minimal amount of capitalism is tolerated in economies that are otherwise socialistic; yet our ills are blamed on the only part of the economy that actually works.
The most effective curb on political ambition is sound money. But we don’t have sound money. So government abuses its monopoly power over the currency to pay for its ambitions. Fiat money gives a free rein to the ambitious politician. The First World War was made possible by German economists, led by George Knapp, the Keynes of his day. He showed the Kaiser the way to finance a war without increasing taxes. In the four years from 1913 the Reichsbank increased paper money in circulation to pay for 85% of Germany’s war expenditure for those years. Of course, after that the script did not go to plan, and as we all know it ended with the total collapse of the currency in 1923.
Collapse the currency, and you collapse savings. Savings today are continually devalued by the expansion of money and credit. Only a fool lends his money for an interest return, and savers are therefore forced to speculate to protect themselves. The result is that there is now a separate destabilising pool of foot-loose capital. It is used by the financial engineers of Wall Street and the City of London to offer higher speculative returns. It has become the feedstock for spendthrift borrowers, particularly governments, who have no intention of ever repaying it.
The damage of unsound money to business has been acute. Business cycles are actually credit cycles, the result of the central banks’ monetary policies. It is easy to understand why the expansion of money and credit drives us into cycles of boom and bust – the exact opposite of what it is meant to achieve.
Take the example of businesses operating with sound money. A business developing a new product or improving an existing one has to invest its own funds, or find a lender with savings. In either case, this takes money away from consumption, money that is reallocated into savings and from there into the proposed investment. And because this money is not spent on consumption, the labour and raw materials required for any new project become available. There is a shift of resources from consumption into savings, from savings into investment, and from there into capital goods. A balance is maintained within the economy and there is no boom and bust. It is a non-cyclical process, driven only by peoples’ economic needs. Business activity is inherently stable.
Now look at the situation when business investment is financed by newly created money and bank credit instead of savings. The process starts with the central bank lowering interest rates. Cheap credit makes investment appear attractive, so the businessman borrows to invest in his business. But many other businessmen are encouraged by the same cheap credit to do the same thing at the same time.
Businesses start investing simultaneously. The randomness has gone. But it gets worse: cheap money also supports consumption, because saving money is less attractive due to lower interest rates.
So our businessman has to bid up for labour, because it hasn’t been released by lower consumption, and he is in competition with the other businesses also taking advantage of cheap credit. He has to pay up for raw materials, for the same reasons. The combination of industry and consumers responding to cheap finance, in the short-term will drive the economy better. But with no extra resources available, prices rise due to bunched demand. And since the quantity of money in the economy has increased, its purchasing-power also falls; exacerbating price inflation even more.
And with prices now rising strongly, interest rates also now rise from artificially low levels. Our businessman’s plans are totally screwed. He got the cost of labour and raw materials completely wrong, and because interest rates have shot up, his Return-On-Investment calculations turn out to be far too optimistic. And to make matters worse, the deteriorating economic conditions that follow, as surely as night follows day, force him to accept that his sales projections were also too optimistic.
His fellow entrepreneurs are in the same boat. Businesses start cutting back. They act as a crowd on the way up and on the way down.
The essential point is fake money has created a business cycle which didn’t exist before. It is never just a question of central banks getting their timing wrong, as many suppose.
The central bank then compounds the problems it has created by again lowering interest rates with the downturn. More than anything else it is scared of a fall in GDP, so it cannot allow the distortions and false investments of the earlier round of monetary stimulation to unwind properly.
But next time round, the businessman is not so easily tricked. He builds greater margins into his investment calculations. So the economy becomes slower to respond to a new, deeper round of interest rate cuts. The central bank has to act more aggressively to create yet more fake money, to get a result.
These credit expansions work like a ratchet, becoming more destabilising over each credit cycle.
The businessman eventually wises up, overcomes his patriotic instincts and moves his manufacturing to somewhere where at least some of the factors of production are available. He needs to plan for ten, fifteen, twenty years. He cannot afford to ride destructive credit-driven cycles of three or four years. It is cheaper for him to build a factory in the jungle and train up hard-working natives. It is unsound money that has driven him abroad more than any other factor. Over a number of these credit cycles, the economy in countries with falling savings, like the US and UK, becomes more and more dependent on consumption, and less and less on manufacturing.
And eventually, to encourage GDP growth, consumers are encouraged to actually borrow to spend and abandon saving altogether. So on every credit cycle, savings diminish and debt increases, finally accelerating to unsustainable levels of debt. And that is where we arrived in 2008. That marked the end of the road for the post-war Keynesian experiment.
So understanding our economic condition from a sound money perspective gives us a unique viewpoint. It makes it easier to see through the fog of weak money. It also allows us to see through the problems posed by reconciling contrary statistics. And it is here that the establishment deludes itself as well as the rest of us.
The abuse of the GDP statistic is the most important delusion of all, because all economic policy is directed at ensuring it grows. But we must stop and think what it actually represents. GDP is not economic output, it is its money-value, which is a very different thing. It gives us no information about the relative values of the goods and services that constitute the economy.
It is crucial to appreciate this distinction, so by way of explanation let us again assume sound money. This is like an economy operating with gold as money and without credit expansion. To keep it simple, assume that trade is in balance, and there are no net capital flows to or from other countries. Therefore, at the end of the year, there is exactly the same amount of money, or gold, as there was at the start of the year.
What does this mean for GDP? It is exactly the same of course, irrespective of actual economic activity. It doesn’t matter how much people save, because those savings are reapplied into the production of capital goods. The rest goes on consumption. It really doesn’t matter what proportion is private sector and how much is government. But if you start with a million ounces of gold, after a year you still have a million ounces of gold. The only difference is what a million ounces buys. The reconciliation between the start and the end of the year is obviously a combination of prices and how efficiently the available gold is deployed.
In practice, human nature constantly strives for improvement, so over a period of time in a free market the purchasing power of sound money increases. This was borne out by the experience of Britain, which went on the gold standard in 1821 and only went off it before the First World War. During that time, Britain freed up her economy by dropping tariffs and other restrictions on free trade, and we became the most powerful nation on earth. The purchasing power of the gold sovereign increased substantially over those ninety-odd years.
So if we look at how an economy operates in a sound-money environment, we see that the benefits of free-markets flow to consumers, savers and businesses. We can see that any attempt to measure these benefits by changes in GDP are simply absurd. It therefore follows that any change in GDP represents a change in the quantity of money in an economy and not of the level of production.
Now, for some of us this is quite a discovery. We are so used to thinking that GDP is the economy that government policies are now entirely focused on boosting it, mistaking it for the economy itself. It justifies mainstream macro-economic theory, because within that money identity, there is no differentiation between good and bad deployment of economic resources. This, in the minds of most economists, is why badly targeted government spending is no different from the productive private sector’s use of economic resources. It persuades Keynesians and Monetarists that injecting government spending into an economy or expanding the quantity of money in the economy is a valid route to recovery.
Understand this error and you understand why unemployment in the United States is already at depression levels, but according to the GDP statistic you have only just arrived at the brink of a possible economic downturn. Understand this error, and you understand the frantic attempts to get more money and credit into the economy rather than address the real issues. Understand the error of confusing the condition of an economy with its accounting identity and understand the policy mistakes yet to be made.
So we can see that governments are doing just about everything wrong. They have completely failed to understand the productive difference between free markets and government intervention. They have no knowledge of the real cost of diminishing the productive private sector to pay for the unproductive public sector. The activities of central banks have encouraged boom-bust cycles that have led to the accumulation of debt in both private and public sectors to the point where it has finally become unsustainable. In the process, they have destroyed savings, which are the necessary pre-requisite, the bed-rock for any sustainable recovery.
This is the background to today’s crisis. Governments everywhere are now trying to borrow the largest amounts of money in history, all at the same time. And to those who say that global savings are high, I say those savings are in the hands of the Chinese and Indian workers, who wisely are more likely to buy gold and silver than our government debt.
Governments are now waking up to the fact that real economic growth is disappearing far into the future and taking their hoped-for tax revenues with it. The debt-trap has snapped firmly shut. Some countries, such as the Eurozone members, who cannot print money to finance themselves, are simply the first victims of the imbalance between the financing requirements of governments and the available capital. Others, such as the UK and US, who can print money, do so to defer funding problems and keep their borrowing costs low; but it is only a matter of time before they are found out.
Price inflation will put an end to these artificially low bond yields, if markets don’t first: it has always been this way in the past and now is no different. We already see prices measured in paper currencies rising everywhere. Commodity prices are reflecting the increased quantities of paper money and credit. Prices of essentials, such as food and energy, have been rising sharply. But there are still people who think that the risk is deflation not inflation. Presumably the Fed thinks so, since it has stated that it expects interest rates to stay at close to zero until mid-2013. They will be in for a shock, and here’s why.
They are about to learn the difference between sound money and their fiat money. Real money cannot be issued by central banks. Fiat money is an undated interest-free claim on a government whose central bank merely tells us that it is money. The difference is important, because in a depression, the purchasing power of real money, measured in goods, increases. In the same depression the purchasing power of fake money falls with the financial condition of the issuing government and with its accelerating supply. This is the dynamic behind the rise in the price of gold over the last decade.
The rising inflation I’ve talked about is measured in fiat money. The rise will accelerate because when you are in a debt trap the only way bills get paid is to issue increasing quantities of fiat money and to borrow. And remember, in a depression tax revenues collapse, while social security costs escalate. To defer the “Grecian moment” we have become unhappily familiar with, both the US and the UK will require more fiat money and bank credit than we can imagine.
So what those who worry about a depression haven’t noticed, is that we have been in one for some time. That comes of confusing GDP with real goods and services. Produce enough fake money and GDP looks good. What doesn’t is the level of unemployment. Doubtless George Knapp – remember him? The German predecessor to Keynes? – Knapp would have felt good that German GDP from 1920 to 1923 looked fantastic. But then there was the small matter of a collapse in the fiat money of the day, and GDP hadn’t yet been invented anyway.
Today people are stumbling towards an awareness of some of these problems. Most visible to everyone so far is the parlous state of the banks. While it would be foolish to completely discount systemic risk, we should bear in mind two things. Firstly, the central banks are now very aware of this risk, which is different from the time of the Bear Sterns and Lehman collapses. So you can reasonably bet that every scenario that frightens us has been anticipated. The banks themselves are now acutely aware of counterparty risk. Secondly, the evolution of banking over the years has given central banks enormous control over their banking systems. It is wrong to think that you can compare the situation today to that of the banking crisis triggered by the collapse of Kredit Anstalt in 1931. The ECB in Europe only has to stand by with unlimited funds when necessary. Indeed, there has been a run on the Greek banks for at least the last eighteen months without systemic failure. All that is required is for the ECB to make its fiat money available in sufficient quantities.
In a few months we will enter 2012. The immediate stresses of today will probably diminish when enough fiat money has been thrown at them. So to my mind the two biggest headaches for next year will be increasing price inflation, the result of too much paper money chasing too few goods if you like, and rising interest rates. I do not expect the Fed to keep its promise of zero rates into 2013. I do expect them to blame unexpected stagflation.
And finally, we must understand that when it comes to resolving our current difficulties, the order of events is bound to be crisis first, solution second. I wish it could be the other way round, but that is the political reality. What we must do meanwhile is get the message home why the establishment has got its macroeconomics so wrong, and why the only solution is to progress towards sound money.
Today I have only focused on two aspects of the problem: the destabilising effects of credit-driven business cycles, and the misapplication of a statistic, GDP, which should have no importance whatsoever. There is much, much more in this sorry tale. I have touched on the role of savings, without going into how their destruction through monetary inflation is now bankrupting governments. I have not gone into the fallacies surrounding trade imbalances, which are always the result of unsound money. I have not asked how we are to feed our elderly and poor, who have become reliant on government pensions and hand-outs, which governments can increasingly ill-afford.
Please just accept, even if you don’t follow my analysis, that sound money guarantees a stable yet progressive economy where people are truly equal. It allows people to save properly for their retirement so that they will not become a burden on the state. It leads to democracy voting for small governments. It encourages peaceful trade and discourages war. It is the only path, after this mess, that leads us to long-lasting and peaceful prosperity. We really need everyone to understand this for the sake of our future.
Thank you.
This speech was previously published at FinanceAndEconomics.org.
By Sean Corrigan, on 22 October 11
Despite the general relief which greeted the release of China’s GDP data for the third quarter, as well as the still resilient industrial production data, we could not quite bring ourselves to join in the cheers.
As we all know, the mainstream is all too ready to treat such numbers as an end in themselves, without paying sufficient attention to the informational content involved in lumping together the sprawling, multifarious, activities of millions of people and boiling it down to one, single number — and that according to a methodology which subjectively combines the raw data in order to fit a pre-conceived concept of how an economy actually functions.
Hayek himself took pains to warn of the limitations of this approach in 1963, when he was discussing the great Methodenstreit of thirty years before:-
…it seems as if this whole effort… to ‘scientificize’ economics… were due to a mistaken effort to make the statistically observable magnitude the main object of theoretical explanation.
But the fact that we can statistically ascertain certain magnitudes does not make them causally significant, and there seems to me no justification whatever in the widely held conviction that there must be discoverable regularities in the relation between those magnitudes on which we have statistical information.
Economists seem to have come to believe that since statistics represent the only quantitative data which they can obtain, it is these statistical data which are the real facts with which they deal and that their theories must be given such a form that they explain what is statistically ascertainable.
There are of course a few fields, such as the problems of the relation between the quantity of money and the price level, where we can obtain useful approximations to such simple relations – though I am still not quite persuaded that the price level is a very useful concept. But when it comes to the mechanism of change, the chain of cause and effect which we have to trace in order to be able to understand the general character of the changes to be expected, I do not see that the objectively measurable aggregates are of much help…
Not only is GDP itself, far too overaggregated – and far too Keynesian—in its construction, but in China’s case the problem is not only compounded by the suspicion that the numbers are made to tell the story the Party wishes to tell, but also by the fact that where they are not actually incomplete, they are highly inconsistent.
So, for example, we are told that the year-on-year rate of real GDP slowed slightly to 9.1% from the previous quarter’s 9.5%, yet the nominal figures—so far as we can recast them - seem to have accelerated from 17.9% to 20.6%. Indeed, this last figure would not be inconsistent with the simultaneously reported 23.6% rise in SOE business revenues over the first nine months (of which more in a moment)
If true, this would not only have represented the fastest gain since before the GFC itself intruded, but it would imply a price inflationary component which had accelerated to 10.5% – also the highest in nearly four years and significantly above, and moving in opposition to, the supposedly slowing, 6.1% pace of CPI increase!
In looking for further clues, one finds that, over the spring and summer, nationwide rail freight slowed from its usual 9.5-10% annual rate to a relatively languid level of 6.5%. Electricity usage, too—though more subject to the vagaries of the weather—has been rising at less than 11.5% over the past two quarters, rather than at the more typical 14.0-14.5% registered during recent periods of full-blooded expansion.
But more telling still—and yet another good illustration why the burn-the-furniture-to keep-warm inadequacy of GDP accounting is such a poor gauge of economic well-being—those same SOEs whose revenues we mentioned above have seen an unbroken run of consecutive monthly declines in profit, so far in the second half.
Given that these mighty bastions of the one-party state represent the favoured few, upon whom the available credit is showered, upon whom the best tax breaks and greatest subsidies—as well as the most advantageous resource pricing—is lavished, that is surely a telling statistic, as is the fact that their reported return on equity—of 5.8% – lay below even the official rate of price rises.
So, even as these behemoths have squeezed out their SME competitors—up to four-fifths of whom are reputedly losing money—they have been unable to parlay growing revenues into growing profits, much less yield a positive real return on capital.
On top of this, there have been any number of warnings from among the Party high-ups about the dire state of the export market — sufficient alarm, indeed, having been generated that Premier Wen pledged an ‘essentially stable renminbi’ from now on: in effect, therefore, signalling the end of an appreciation which has led to all sorts of extended currency gambles in places as diverse as Hong Kong’s Dim-sum bond market and the copper warehousing, L/C-manipulating tricks of the shadow importers.
Finally, it should be noted that not only has the stock market closed at its lowest level since the global asset markets began to recover in March 2009, but an accelerated liquidation of industrial commodities is well underway, with materials as diverse as steel, copper, zinc, rubber, cotton, polyethylene, and terephthalic acid all losing 30-40% from their highs, and all setting new multi-month—even multi-quarter—lows in the process.
Far from being ‘ruled out’ by the numbers — as the most credulous of mainstream macromancers have been claiming — China’s hard landing may actually be unfolding as we write, hidden from wider apprehension by the gaudy veil of that one, damnable, statistical fiction which is the stage prop of charlatans and the false comfort of the biddable alike.
China is a prime exemplar of everything we Austrians deprecate, whether in terms of its heavy-handed pretence of knowledge; the fatal conceits of its central planners; its multitudinous suppressions and perversions of the pricing system; or the endemic corruption and influence-peddling which, absent an economically impartial means of allocating means, is the only way to ration scarce resources between competing ends there.
As such, we cannot assume other than it will one day to be revealed to be a heroic disaster; that its attempt to maintain the privileged superstructure of the Party while seeking out a more effective way of marshalling the matériel needed to sustain its all-pervading apparatus will prove to have been the cause of a vast waste of human effort and earthly treasure, even if it has been infinitely preferable to the Maoist horrors which preceded this, the latest grand experiment in socialist Utopianism.
The only professional problem we have with this analysis is the rather crucial one that to be convinced of such an outcome from a grand historical perspective is of precious little use in knowing what or when to buy or sell in the hurly-burly of the fibre-optically fast marketplace in which we operate.
There will undoubtedly prove to be just as much ruin in the Middle Kingdom as there was in Adam Smith’s Britain of the 18th century. Economic law cannot be repealed, but its verdict can often be long suspended, if usually at the cost of a harsher sentence when ingenuity finally fails those seeking to deny its implacable judgement. If the extended nonsense of our own, last four years of swimming against the tide of inevitability proves anything, it surely proves this.
Thus, while we are convinced that the hard landing in China will be more of an asteroid impact than a mere bender of the undercarriage when it eventually arrives, we cannot honestly say that this will be the inescapable result of the nation’s present constellation of difficulties.
In seeking to avoid such a shattering return to earth, the authorities there may yet hit upon new ruses to hide the losses, to defer the final reckoning, and so to sway production patterns and alter input pricing in any manner of unforeseeable ways before they tangle their ankles in a Gordian knot of their own ravelling and measure their mighty length in the dust of human vanity.
Here and now, however, all we are prepared to say is that this COULD be the Big One, but it might also be a lesser, pre-cataclysmic tremblor—much more severe than many of those constructing investment portfolios out of the straw of China’s invincibility can hope to withstand—but, nevertheless, only an ominous reminder of a mighty upheaval yet to come.
What goes for China, goes for its neighbours around the Pacific, of course, so we should not be surprised to see regional air freight falling into the negative column, or US West Coast container imports dropping markedly short of 2010 levels, nor at Taiwan export orders moving decisively below their pre– and post-Crash levels.
In Europe, all of this is playing second fiddle to the ongoing farce of the EFSF negotiations while, in the US, the fiscal arithmetic remains parlous and the arena for a round of vituperative, but ultimately sterile, infighting.
If the burdens of the first region remain yet unalleviated, at least the impasse shows that there are still those who recognise — albeit dimly — that to earmark trillions of euros of the citizens’ money so as to reward both gross irresponsibility on the part of the member states and the cynical exploitation of moral hazard by the barons of the banking boardrooms is as ethically dubious as it is economically suspect. While all the bien pensants may flood the airwaves and stuff their column inches by decrying this as the fault of the characteristically stiff-necked Germans, we can only sigh that a few more of our glorious leaders do not also disport a suitably Teutonic fusion of the cervical vertebrae.
Meanwhile, the situation in America goes from bad to worse. Indeed, the US deficit now seems almost pre-ordained to grow at $1.3 trillion or so each and every year—around 2 1/2 times the concurrent increase in private sector GDP (that number again!) and unfunded to the tune of a dangerous, potentially intractable and thus highly inflationary 35-40% of expenditures.
Whether or not the Fed is successful in its misguided quest to de-emphasise the so-called price stability part of its mandate in favour of the wild goose chase of trying to reduce unemployment on a permanent basis by monetary means, the lack of continence it has encouraged among an intellectually-vacant political elite—as well as the dire budgetary consequences of any reversal in bond yields from their post-War nominal lows on a full GDP-scale debt mountain—argue against any easy reversal of their joint stance.
It might not go unnoticed that the simplistic, but nonetheless illustrative, measure of the ‘misery index’ — unemployment plus consumer price inflation — currently stands at a 19-year high (even under what many darkly mutter are today much less exacting standards than heretofore prevailed) and is, moreover, pushing resolutely onward into territory only visited in the post-WII era during the dreadful spell between 1973-83 when it seemed as if we had finally driven a stake through the heart of the bloodsucker of Bloomsbury.
This is not just a matter of passing interest, since rising prices amid chronic joblessness is a mix which often widens the split between input costs and output prices—a phenomenon which also tends to go hand in hand with higher levels of CPI itself. Such a combination is usually disastrous for equity multiples, which are themselves the main determinants of stock returns, so — even by his own rather dimmed lights — Chairman Bernanke is again on track to achieve exactly the opposite effect of the one at which he is aiming.
Anyone requiring a further explanation of how this arose should go and read Ron Paul’s cogent rehearsal of the ills that afflict the nation in his recent WSJ editorial, a well-justified Philippic in which he also adopts a view about just what it is that is forestalling the recovery which will be familiar to readers of these pages:-
What exactly the Fed will do is anyone’s guess, and it is no surprise that markets continue to founder as anticipation mounts. If the Fed would stop intervening and distorting the market, and would allow the functioning of a truly free market that deals with profit and loss, our economy could recover. The continued existence of an organization that can create trillions of dollars out of thin air to purchase financial assets and prop up a fundamentally insolvent banking system is a black mark on an economy that professes to be free.
Hear! Hear!
Commodity Corner
Around about this time last year, the market began to shake off its angst and buy anything and everything in sight in an increasingly indiscriminate move which would see commodities, stocks, junk—and just about anything else with the word ‘Risk’ attached—rise for the better part of seven months.
But last year’s rally, however ephemeral its impact either as a prop to asset prices or as a fillip to the real economy, was at least based on something tangible. The Fed was actively monetizing a sizeable fraction of the US budget deficit through its QE-II programme; Chinese real money supply growth—while undoubtedly slowing—was still swirling along in the high teens, in contrast to today’s sluggishly low single digits; the RBI was only a third of the way through its (unfinished?) tightening phase; likewise, the Banco do Brasil had seemingly paused, half way through its eventual schedule of higher rates; and the European debt crisis was still only a cloud on the horizon — and a cloud which lowered only over the periphery, at that.
In other words, however futile the attempt to print the world back to prosperity, something tangible was afoot and the newly-created monies were flooding into their most immediately accessible outlets in financial markets, en route to effecting their more malign consequence of raising the price of necessaries for the common man.
This time around, the rally was built more on hope and fear than on anything more concrete: hope that the Fed’s Operation Twist would actually mean something other than just the latest act of vandalism committed upon the price mechanism; hope that Europe would issue itself a large blank cheque and have it delivered in wheel barrows to finance ministries and banking headquarters all across the Zone; and the fear of being caught short of benchmark and mired in the slough of negative returns if the year somehow ended in a sustainable relief rally.
Two weeks of that may have been enough to goose the DAX by almost 20% and the S&P and Emerging Markets by close to 15%; it may have jolted base metals 10% and Brent Crude 17% higher; it may have reversed 140bps of the prior steep rise in junk credit spreads, but it does not look like it changed either the fundamental backdrop or the fact that new sources of central bank jungle juice are so far proving very hard to identify.
So, with a nod to the fact that everyone underwater is currently desperate to locate some last remaining, no-brain trade onto which to bandwagon, in order to dress up another year of lacklustre performance and to avoid one more career-endangering embarrassment of charging fees as a reward for losing clients’ money, we must start from the assumption that the rally has run its course, having achieved what all bear market rallies do — to magnify the pain while recharging the powder magazine — and that there is a risk that the current probe lower is met with a further, irresistible wave of panicky liquidation.
By Tim Lucas, on 23 March 11
Loose US monetary policy has had its echoes all around the world. The US dollar, once thought to be “as good as gold”, has now been shown be nothing of the kind. Gold bugs the world over have been proven right. Countries scattered all over the world have either dollarised, or run very tight pegs. In either case, this has meant largely adopting US monetary policy in countries as far flung as humble Ecuador (dollarised in 2002 following its own runaway inflationary disaster, which resulted in the emigration of 10% of the population) to the collection of Asian nations, China, Hong Kong, Malaysia, Taiwan, Indonesia, all of whom adopt some sort of peg to the US dollar. Without exception, each of these countries has experienced extreme property appreciation these last two years.
This documentary explores the Chinese experience.
The mechanism through which expansionary policies are communicated through China appear to follow the following pattern:
- Central government requires GDP growth/employment creation and so instructs the state-owned banks to lend.
- State-owned banks lend principally to state-owned companies as these are good credit-risks, backed – as they are – by the state.
- State-owned companies buy land from local governments for property development in accordance with a master plan for development of a new business district.
- Local governments spend the proceeds on who-knows-what…here the trail goes cold. However, land sales actually account for the vast majority of local governments’ income so one can be sure that they put plenty of pressure back on the central government to keep the cash coming! Once the local government has it, this cash leaks out into the real economy somehow. Some of it presumably gets recycled into new deposits on property.
- Individuals buy units using mortgages from private and state-owned banks, often using equity released from the appreciation of property bought in previous transactions. Ultra-low interest rates, fixed by the central bank, help them keep up with their repayments.
In short, this process is little different in essence from the credit-fuel property booms that have occurred the world over and it will have at its heart cronyism, corruption and waste.
The stories of the booms and busts of each country carry a different twist as the setup of institutions in each country is different, with the common flavour being that of credit growth aided by monetary expansion.
To the requisite ingredients of loose money and credit growth, China has added the explosive ingredient of it being a command economy, which has served to amplify the misallocation of capital. The results are spectacular. The most populous nation on earth does most things on an epic scale, and property boom and bust is seemingly no exception. Enjoy.
Related articles
By Toby Baxendale, on 21 December 09
Sean Corrigan of Diapason Commodities Management packs more sound applied economics into this report than ever: Toby Baxendale provides a commentary. This is a great Christmas read for us all: download the report here.
 Bastiat's Iceberg On the Errors of GDP Accounting
- For the USA economy, Corrigan shows the utter futility of using the conventional GDP measure. The same applies for any of the OECD countries who use the same measure.
- Business spending in 2006 in the USA was $31 trillion vs a GDP of $13.4 trillion.
- Businesses were spending $4.30 for every $1 spend on personal consumption.
- Policy makers from around the world, if any of you are reading this article, please take note of the significance of this fact!
- This focuses on something that all Austrian economists know: the desire by the mainstream economists is not to double-count. In the end, they do not count much at all!
- As a catering fish monger myself, I buy fish off farms, boats and auctions around the world. I cut and prepare the fish and send it to my customers, the hotels and restaurants of the UK. Yet none of my spending exists in the GDP figures! My wealth and that of my suppliers does not exist as far as the authorities are concerned. I only wish that I could get the tax man to take this view like his economist colleagues in the Revenue Department!
- I had this discussion with a member of the MPC some months ago: how if my salmon was bought at the fish farm for £1 per kg and we put a £1 mark-up on after cutting it up and the end user put a £1 mark up on, it is double counting as far as he was concerned. He reasoned that to count all of the stages of production when it only finally gets sold for £3 would be an overstatement as the price of the inputs is in the final price of £3. They miss out the significance that I and my supplier have our profit to the spend in the wider economy after we have spent our companies’ resources on continuing investment and consumption. This is all real activity! This is the danger of having statisticians running the economy.
- All that matters, we are told, is that GDP is composed of 70% of final consumption expenditure. In reality, the final consumption element is more like a quarter of real GDP, once the production sector is included.
- As I have always said, the health of the production sector is driven by its ability to invest in replacement capital to make more efficient production techniques, to supply more goods and services to people at better prices and with better service levels. This is the essence of entrepreneurship, the essence of wealth creation and the essence of the recovery: magic tricks perpetrated by the economic witch doctors, who wish to pursue a policy of QE or similar, will only consume capital and not replace it with some better means of production.
Continue reading “Bastiat’s Iceberg: A Sean Corrigan Masterpiece for Christmas”
By Toby Baxendale, on 26 November 09
Our good friend of the Cobden Centre, Sean Corrigan, is a wealth of fresh economic insight. Here in this small piece, he shows us that, if you strip out Government from GDP figures, you actually see what the private, productive sector of the economy is doing.
Sean does this for Japan. It shows that the current GDP recovery that has been reported widely in the press for this country, when you strip out the Government part of the economy, has actually gone backwards for 6 successive quarters. It has retuned to a level not seen since the early 80’s.
Sean is of course quite right to strip out government, as doing a bit of QE here and a bit there will inflate GDP figures for sure, but do little to grow the economy as we have previously explained before in this article . Now government can spend your money as a taxpayer on things that it views to be priority, i.e. transfer payments to the worthy and not so worthy and building cap ex projects such as railways, providing services such as justice etc, but this just redistributes what you as a taxpayer has earned and moves it form A to B.
To be clear nothing new is created from a wealth perspective, as it was already created by you, the taxpayer, to be given to someone else, directed by the government. More than ever, we need to be looking at how the productive sector is performing in all economies and not how the transfer, sector i.e. government, is doing. This is the engine of recovery and not the government side of the economy for the reasons stated.
I hope Sean or one of our readers would like to prepare this data for the UK. I suspect it would show a similar dismal story. In fact, when we hear of all these nations lifting out of the recession, I have a nagging doubt in my mind that this is the case.
The other interesting measure Sean uses is Debt to Private GDP. In Japan it has risen a staggering 28% in 18 months and is now sitting at 237%. In the UK we are told we now have a Debt to GDP ratio of 59%. What do we think it is in the UK? Without doing the numbers myself, I would suspect for us the Debt to Private GDP is over 100% as government is well into the high 40% + range of the economy.
A third insight is the Japanese MI money measure which is 31% up YOY and that correlated, with a time lag to inflation, so beware Japan for the inflationary Tsunami!
By Steven Baker MP, on 23 October 09
Via The Times Online, we learn that many economists ”revolt over surprise recession data”:
Economists today cast doubt on official data showing that British gross domestic product (GDP) contracted by 0.4 per cent between July and September, claiming the surprise fall is far worse than economic reality.
The shock figures from the Office for National Statistics (ONS) revealed that the country remained mired in recession during the third quarter — the sixth consecutive quarter of contraction, signalling the country’s longest downturn since records began in 1955.
Economists had widely expected that the country had emerged from recession between July and September.
Well, yes, many economists had expected that but as I have explained before, most economists allow themselves to be misled by a superficial reading of numbers distorted by central bank action.
We can and must do better.
By Ewen Stewart, on 16 October 09
 UK Household Savings Ratio (click to enlarge) Equity Strategist Ewen Stewart makes the case that the national debt will within 5 years be over £150,000 per family of 4 with debt repayments of twice the present defence budget, up from £31 billion in 2008/9 to £70 billion in 2013/14. He explains the root causes of our difficulties and indicates a route to recovery.
It’s all over. What a fuss about nothing. The economy will soon be growing again and, look, the FTSE100 is up almost 50% since the March low. Even house prices, according to the Halifax, have risen 6 months in a row. The doom mongers were wrong. Central Banks and Keynesian public spending programmes, together with QE, have worked. Brown indeed has saved the world!
Well that would be one interpretation and a very short sighted one too, for this recovery shows all the hallmarks of a drug addict who claims to be going straight injecting a further mighty dose of the substance that has caused such decay in the first place to prolong the party.
The problem is that the underlying fault lines in the UK economy remain and, thanks to the Government’s response, are even more pronounced.
The underlying problem is, in my view, an addiction to debt, a banking system which is over-leveraged, and now government finances that are out of control. This country that has been living considerably beyond its means for a very long time. Artificial efforts to prop this up, through printing money or inappropriately low interest rates, at best are a short term delaying tactic and at worst risk stoking a loss of confidence and ultimately inflation.
It is my central conjecture that much of the economic growth over the last decade was less the result of genuine private wealth creation but more the result of a number of unique factors which were both unsustainable in their nature and damaging to long term growth. If this view is correct the scale of the over-leverage and the action required to alleviate the problem become even more pronounced.
Continue reading “Happy days are here again? Another view from the City”
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