“On October 15, the mark’s rate against the pound passed 18 milliards. On October 21, after the mark had moved in three days from 24 milliards to 80 milliards to the pound, Lord D’Abernon noted with some statistical glee that (at 60 milliards) this was ‘approximately equal to one mark for every second which has elapsed since the birth of Christ’. At the end of the month the banknote circulation amounted to 2,496,822,909,038,000,000 marks, and still everybody called for more.”
- From ‘When money dies: the nightmare of the Weimar hyperinflation’ by Adam Fergusson.
The internet has been nicely described by Lars Nelson of the New York Daily News as “a vanity press for the demented”.
Notwithstanding the bitter accuracy of this statement, we flit from time to time to sites like Twitter to attempt quixotically to redress the balance of popular opinion away from wrong-headed nonsense with regard to the financial world in favour of rational (perhaps even moral?) analysis. Last week we engaged in the following conversation:
Anonymized Tweeter: “are u a conspiracy theorist?”
Us: “No, I just believe in sound money and small government. And not in central bankers – who caused this depression too.”
AT: “we aren’t and never hv been in a depression. I’d also argue without current radical policy action from Bernanke we’d be MUCH worse off.”
Us: “If this ends in currency collapse, which I think it might, will we all be better off? Fed to blame in any case.”
AT: “Perhaps ud have preferred a much deeper recession / depression and full banking collapse Japanese style deflation over QE?”
Us: “I think I would rather have a nasty short term recession and bank nationalisations over a perma-depression.”
Admittedly, it’s not exactly War and Peace, but there you go.
The conventional reaction to the extraordinary economic and policy events of the last five years has been to accept an alphabet soup of trillions of dollars’ worth of taxpayer-funded inflationary monetary stimulus directed exclusively at banks as averting what would otherwise have been a nasty though perhaps relatively short-lived deflationary bust. As with the 1930s there is no counter-factual, so we will never know for sure. But we incline more towards Michael Lewis’s take on things. In this summary, our favourite brokerage firm and definitive non-bank Goldman Sachs can serve as the representative of broader banking interests:
Stop and think once more about what has just happened on Wall Street: its most admired firm conspired to flood the financial system with worthless securities, then set itself up to profit from betting against those very same securities, and in the bargain helped to precipitate a world historic financial crisis that cost millions of people their jobs and convulsed our political system. In other places, or at other times, the firm would be put out of business, and its leaders shamed and jailed and strung from lampposts. (I am not advocating the latter.)
Instead Goldman Sachs, like the other too-big-to-fail firms, has been handed tens of billions in government subsidies, on the theory that we cannot live without them. They were then permitted to pay politicians to prevent laws being passed to change their business, and bribe public officials (with the implicit promise of future employment) to neuter the laws that were passed — so that they might continue to behave in more or less the same way that brought ruin on us all.
Like Michael Lewis, this commentator also once worked as a bond salesman – nobody’s perfect – so we claim a modest degree of informedness when it comes to the workings of the banking and investment banking business. So our take on things can perhaps best be summarised as follows. We are living through the tail end of a 40-year credit bubble that has reached the terminal phase of its expansion. As Herbert Stein rightly observed, if something cannot go on forever, it will stop. But bankers don’t want the music to stop, and they are perfectly willing to steal from taxpayers in order to pay the orchestra. Politicians cravenly obeying the unfit-for-purpose four- or five-year electoral cycle are now displaying the biggest tin ear in history to the ever-louder complaints of constituents of what remains of the real, productive economy as opposed to narrowly self-interested Big Finance.
The popular debate, if any, runs out of road once we start to discuss money itself – a critical component within the debate, but insufficiently understood by just about everybody. Why have the untold trillions of central bank ex nihilo base money not already triggered eye-watering levels of inflation? 1) Because they mostly sit inert (so far) as commercial bank reserves. 2) Because commercial banks’ balance sheets remain mostly upside down (i.e. the banks are still pretty much insolvent), so the last thing these firms are going to do is actually lend it out to anyone. 3) There is already uncomfortable inflationary leakage feeding into the prices of many financial assets, including the obvious usual suspects, stocks and bonds.
And so the economy, like that of Weimar Germany, remains moribund even as more and more money gets printed. At some point, which may be fast approaching, the marginal user of money is going to get fed up at this constant devaluation of their purchasing power, and the rush into hard assets will begin. As longstanding readers and our clients are well aware, we love hard assets. As one highly successful fund manager recently wrote to us, hard assets rock.
In the meantime, the financial media continue to prattle on about this mythical ‘Great Rotation’, whereby a polarised constituency of bond investors is mysteriously going to get religion and an overnight mandate change and pile into overpriced stocks instead. This theory is so absurd we won’t waste much more time on it. Suffice to say, if stocks are “attractive” primarily because of their valuation relative to bonds, their “attractiveness” breaks down when bond prices do, as they surely will at some point in the near to medium term. And bond prices are only where they are because of extraordinary monetary stimulus in the form of money which is being devalued on a daily basis. Did we mention hard assets?
Unfortunately, debate is useless because only politicians have sufficient clout to bang heads in the banking (and central banking) sector, and most politicians don’t appear to understand money creation (or destruction) either.
Back to Adam Fergusson:
What really broke Germany was the constant taking of the soft political option in respect of money. The take-off point therefore was not a financial but a moral one; and the political excuse was despicable, for no imaginable political circumstances could have been more unsuited to the imposition of a new financial order than those pertaining in November 1923, when inflation was no longer an option. The Rentenmark was itself hardly more than an expedient then, and could scarcely have been introduced successfully had not the mark lost its entire meaning. Stability came only when the abyss had been plumbed, when the credible mark could fall no more, when everything that four years of financial cowardice, wrong-headedness and mismanagement had been fashioned to avoid had in fact taken place, when the inconceivable had ineluctably arrived.
Money is no more than a medium of exchange. Only when it has a value acknowledged by more than one person can it be so used. The more general the acknowledgement, the more useful it is. Once no one acknowledged it, the Germans learnt, their paper money had no value or use – save for papering walls or making darts. The discovery which shattered their society was that the traditional repository of purchasing power had disappeared, and that there was no means left of measuring the worth of anything. For many, life became an obsessional search for Sachverte, things of ‘real’, constant value: Stinnes bought his factories, mines, newspapers. The meanest railway worker bought gewgaws. For most, degree of necessity became the sole criterion of value, the basis of everything from barter to behaviour. Man’s values became animal values. Contrary to any philosophic assumption, it was not a salutary experience.
What is precious is that which sustains life. When life is secure, society acknowledges the value of luxuries, those objects, materials, services or enjoyments, civilised or merely extravagant, without which life can proceed perfectly well but which make it much pleasanter notwithstanding. When life is insecure, or conditions are harsh, values change. Without warmth, without a roof, without adequate clothes, it may be difficult to sustain life for more than a few weeks. Without food, life can be shorter still. At the top of the scale, the most valuable commodities are perhaps water and, most precious of all, air, in whose absence life will last only a matter of minutes. For the destitute in Germany and Austria whose money had no exchange value left existence came very near these metaphysical conceptions. It had been so in the war. In All Quiet on the Western Front, Müller died ‘and bequeathed me his boots – the same that he once inherited from Kemmerick. I wear them, for they fit me quite well. After me Tjaden will get them: I have promised them to him.’
In war, boots; in flight, a place in a boat or a seat on a lorry may be the most vital thing in the world, more desirable than untold millions. In hyperinflation, a kilo of potatoes was worth, to some, more than the family silver; a side of pork more than the grand piano. A prostitute in the family was better than an infant corpse; theft was preferable to starvation; warmth was finer than honour, clothing more essential than democracy, food more needed than freedom.
We have been warned. And we have been here before. What really broke [Germany] was the constant taking of the soft political option in respect of money. Are our politicians, journalists and central bankers even listening? There are none so deaf as those who will not hear.
This article was previously published at The price of everything.
Every Monday morning the readers of the UK’s Daily Telegraph are treated to a sermon on the benefits of Keynesian stimulus economics, the dangers of belt-tightening and the unnecessary cruelty of ‘austerity’ imposed on Europe by the evil Hun. To this effect, the newspaper gives a whole page in its ‘Business’ section to Roger Bootle and Ambrose Evans-Pritchard, who explain that growth comes from government deficits and from the central bank printing money, and why can’t those stupid Europeans get it? The reader is left with the impression that, if only the European states could each have their little currencies back and merrily devalue and run some proper deficits again, Greece could be the economic powerhouse it was before the Germans took over.
Ambrose Evans-Pritchard (AEP) increasingly faces the risk of running out of hyperbolic war-analogies sooner than the euro collapses. For months he has been numbing his readership with references to the Second World War or the First World War, or to ‘1930s-style policies’ so that not even the most casual reader on his way to the sports pages can be left in any doubt as to how bad this whole thing in Europe is, and how bad it will get, and importantly, who is responsible. From declining car sales in France to high youth-unemployment in Spain, everything is, according to AEP, the fault of Germany, a ‘foolish’ Germany. Apparently these nations had previously well-managed and dynamic economies but have now sadly fallen under the spell of Angela Merkel’s Thatcherite belief in balancing the books and her particularly Teutonic brand of fiscal sadism.
Blame it on ze Germans
The pending bankruptcy of France’s already semi-nationalized car industry is, of course, not to be blamed on high French taxes, strangling French labour market regulation, increasingly uncompetitive French wages, and grave business errors – French car companies have been falling behind their German rivals for years – but the result of French ‘austerity’, which hasn’t even started yet and will culminate in – quote AEP, and drum roll please! – a ‘shock therapy’ next year of 2 percent. Mind you, France’s state has a 57% share in GDP, and the economy deserves the label socialist more than capitalist. Does France really need more state spending, or even unchanged state spending? Another government stimulus? I bet you could cut the French state by 10 percent instantly, and in a year or two you’d have faster growth, not slower growth!
However, Monsieur Hollande is eager to live up to his socialist promises, all the egalité he was voted for, and does not shrink the state but instead raises taxes further, lowers the pension age and raises minimum wages, none of this a demand from Rosa Klebb in Berlin, as far as I know, but AEP doesn’t quibble over such detail. It is all ‘austerity’ to him and ‘austerity’ is always imposed by Germany, and to make really sure that you get that this is a bad idea, and a bad idea coming from Germany, he now calls it the ‘contractionary holocaust’.
Nice touch. There is no place for subtlety, I guess.
Bootle does not stoop quite so low but his pieces are equally filled with the Keynesian myth that there is no economic problem that cannot be solved by more debt and easy money and the occasional devaluation. The fallacy here is the standard Keynesian one: there is no limit to debt, the market doesn’t matter, people can be fooled forever.
The real issue
The reality is different: the markets are slowly waking up to the fact that the social-democratic welfare-state that dominated the West since the First World War is going bust. Everywhere. Faster in some places (Greece, the UK), more slowly in others (Germany), but the direction and the endpoint are the same. This is not a specifically European problem, or even one that is particularly linked to the single currency project; it is pretty much a global phenomenon, and it will shape politics for years to come. It is naïve, dangerous and even irresponsible to dress this up as a design-fault of the euro and thus imply that the problem would be smaller or more easily manageable, or even non-existent, if countries could only issue their own currencies, print money, keep running deficits and devalue to their hearts’ content. The false impression that is being conveyed by Bootle and AEP is that Spain, Greece, Portugal and Italy could somehow simply turn back the clock and, in the more open, more competitive world of the 21st century still run the cosy big state, high inflation, frequent debasement policies of the 1970s.
Bootle and AEP represent the naïve Keynesianism that still believes deficits just pop up in recessions as a ‘natural corrective’ – in fact, AEP exactly describes it that way. The truth is, countries like Greece have been running big deficits in good times and now run bigger deficits in bad times, and they are far from being alone in this. Since the introduction of unconstrained fiat money, most states see no need to balance the books but operate blissfully under the assumption that they can keep accumulating debt forever. Since Greece joined the euro and thereby benefitted from lower borrowing costs, the country’s average wage bill went up 60%, compared to 15% in Germany over the same period. Present Greek structures are simply unsustainable. An economy that has been stifled for decades by the persistent political rent-seeking of its powerful, connected and self-serving interest groups, by an overgrown public sector and uncompetitive wages, simply will not be reinvigorated by yet more debt. And in any case, the bond market has now had enough and won’t fund the Greek state any more anyway. Letting deficits rise, as AEP suggests, is no longer even an option. Not now in Greece, and soon elsewhere. Austerity is, increasingly, not a policy choice but an unavoidable necessity.
So what about devaluation? — It is a bad idea. It must mean inflation, the confiscation of wealth from savers – and savers are the backbone of any functioning economy, even though Bootle and AEP apparently believe it is the state and the central bank that make the economy tick – it must lead to persistent capital flight and hinder the build-up of a productive capital stock. And once you have accumulated a certain level of debt, devaluing the currency could undermine confidence completely and end in hyperinflation, default and total economic destruction.
No country has ever become prosperous by having a soft currency and devaluing repeatedly, yet many have become poor. A hundred years ago, Argentina was among the 8 richest nations in the world and has since managed to decline from first world status to third world status through persistent currency debasement. Since the end of Bretton Woods, Britain has consistently debased its currency, more rapidly than Germany or even the United States, a policy that has undoubtedly contributed to the country’s de-industrialization over this period, its high debt-load, low savings rate and its dependence on cheap money that lasts to this day.
True and lasting prosperity – as opposed to make-believe bubble wealth – has the same sources everywhere and at all times: true savings, proper capital accumulation, and as a result, rising labour productivity. Hard money is the best foundation for these powerful drivers of wealth creation to do their work.
Default instead of devaluation
It is not my goal to defend the policy of the German government or of Chancellor Merkel here. The present policy is wrong in many ways and will fail. But the reasons and my conclusions are different from those advanced by AEP and Bootle. Merkel is desperately trying to pretend that these governments are not bankrupt, that the debt will be repaid, and in so doing she throws good money – that of the German taxpayer – after bad. Most of the governments in Europe, plus the US, the UK and Japan, are unlikely to ever repay their debt, and the big risk is that, once the 40-year fiat money boom that facilitated this bizarre debt extravaganza has ended for good, and the illusion of living forever beyond your means has evaporated, a lot of that debt will have to be restructured, which means it will be defaulted on. That is not the end of the world, albeit the end of the type of government largesse that has defined politics in the West for generations, and it will be the end of the modern welfare state, and herald an era of proper austerity, imposed by the reality of the market and not the Germans. The question is only if policymakers will desperately try and postpone the inevitable and in the process also destroy their fiat monies.
In the case of Greece and Portugal and other countries, default should simply be allowed to occur, a proper default, not the type of managed default that Greece went through and that left the country with more debt as a result of more official aid – all in the vain attempt to pretend the country is somehow still solvent and creditworthy. Whether any issuer is solvent or not, is not decided by a bunch of Eurocrats in Brussels but by the market. The market is not lending to Greece, ergo Greece is bankrupt. Period. It would be better for everybody to admit it.
Germany is far from healthy. It, too, is travelling on the road to fiscal Armageddon, just at a slower speed. Merkel’s policy of bailing out her ‘European partners’ – a policy for which she gets little credit from AEP, Bootle and the rest of Europe – will only hasten that process.
Proper defaults on government debt would also teach bond investors a lesson, namely that they should not engage in the socially destructive practice of channelling scarce savings through the government bond market into the hands of politicians and bureaucrats with the aim of obtaining a ‘safe’ income stream out of the state’s future tax receipts (i.e. stolen goods) but to instead invest savings in capitalist enterprise and thus fund the creation and maintenance of a productive, wealth-enhancing capital stock. Losing their money in allegedly ‘safe’ government bonds is, quite frankly, what they deserve.
In defence of a common currency
None of this means that defaulting nations should be forced to leave the single currency. There is, in most cases, simply no need for leaving, and staying in a widely shared common currency does indeed have many benefits.
The idea that numerous countries – even countries with very diverse economic characteristics – should share the same money is entirely sensible and highly recommendable. Money is a medium of exchange that helps people interact on markets and cooperate via trade, and this cooperation does not stop at political borders. Money is valuable because it connects people via trade, and the more people money can connect (the more widely accepted and widely used any form of money is), the more valuable it is, and the more beneficial its services are to society overall. Yes, the best money would be universal money, global money, such as a global gold standard. It is nonsense to have money tied to the nation state. This type of thinking is a relic of the 19th century when the myth could still be maintained that a ‘national economy’ – somehow magically congruous with the political nation state – existed, and that the national government should manipulate the national money according to national objectives. That is the type of thinking that Bootle and AEP epitomize. Although, already by the late 19th century, this myth of the national economy was dying, as the Classical Gold Standard began to provide a stable global monetary framework that allowed peaceful cooperation across borders by vastly different states, and heralded a period of unprecedented globalization, harmonious economic relations and relative economic stability.
Every form of money is more valuable the wider its use. Currency competition is deceptively appealing to many free marketeers, and as an advocate of pure capitalism, I would never stop anybody from introducing a new form of money. But the economic good ‘money’ conveys enormous network benefits. Because of its very nature as a facilitator of trade, there will always be an extremely powerful tendency for the trading public to adopt a uniform medium of exchange, that is, for everybody to adopt the same money.
There is a persistent fallacy out there, and Bootle and AVP are among its numerous victims: the fallacy is that countries can do better economically by cleverly manipulating their own domestic monies. This is erroneous on a very fundamental level. Any easing of financial conditions through extra money creation, through an extra bit of inflation or a bit of devaluation, can never bestow lasting benefits. Such manipulations of money can only ever result in short-lived growth blips, at the most, and these growth blips always come at the price of severe economic costs in the medium to long run. Monetary manipulation is never a free lunch. It is always damaging in the final analysis.
Being part of a currency-union means the end of national monetary policy, and that is, on principle, to be welcome. The main problem with monetary policy today is that there is such a thing as monetary policy. Money should be hard, inflexible, apolitical and universally accepted to best deliver whatever services money can deliver to society. The problem with the euro is not that it encapsulates so many diverse countries but that it is not hard, not inflexible, and not apolitical. The euro is a paper currency, and like any state fiat money it is a political tool, constantly manipulated to achieve certain ends, and over which ends to pursue there is, quite naturally, almost constant conflict.
If only the euro was golden!
Some people say that the euro is like a gold standard and that its failure demonstrates the undesirability of a return to gold. This is nonsense. To the contrary, the euro would work better if it operated more like the gold standard and if it was as hard, as inflexible and as non-political as gold. Then, interest rates could not have been kept artificially low back in the early 2000s, for the benefit of Germany and France, a policy that laid the foundation for the real estate and debt bubbles in the EMU-periphery. Then banks could not have ballooned their balance sheets quite as much as they did with the help of the ECB and not have dragged us all into a major banking crisis, and once the banks had self-destructed, they could not have been bailed out with unlimited ECB loans and artificially low and even lower rates so that they might continue in their merry reckless ways. Today’s major imbalances, from over-extended and weak banks to excessive levels of debt, are inconceivable in a hard money system. But even now that these imbalances have been allowed to accumulate, it would still be preferable to go back to hard and inflexible money. Under a hard money system politicians and bureaucrats cannot lie and cheat and pretend, at least not as much as they can today. Hard money has a tendency to expose illusions.
This is not a defence of the EU, which is a wretched project, and increasingly morphs into a meddling, arrogant super-state, an ever more potent threat to our liberty and our prosperity. I am not particularly keen on the fiat-euro either. But still, the idea of many countries sharing the same currency is a good one. No question.
If Bootle and AEP were right that weaker nations should opt for weaker currencies, for the monetary quick-fixes of devaluation and inflation, what would that mean for so-called national currencies? By that logic, shouldn’t Italy not only exit the euro and return to the lira, but instead adopt a number of different local liras? Should Italy’s Mezzogiorno not issue its own super-soft currency and devalue against the hard lira of the north? Why should these two diverse regions be tied together under the same currency? Should Scotland have its own currency and happily devalue versus more prosperous South East England? And wouldn’t Liverpool and Manchester not benefit from their own monies, conveniently manipulated to stimulate and reinvigorate their local economies? The absurdity of the whole idea becomes quickly apparent.
But AEP is quite happy with his little island nation state. The extent to which he hopelessly underestimates the challenges facing his home nation – and by extension, the world – becomes apparent when he assures the reader that he, AEP, too, supports modest austerity, namely the present coalitions’ pathetic and entirely insufficient attempt of trimming spending by ‘1 pc of GDP each year’, ‘thankfully’ (AEP) flanked by generous debt monetization from the Bank of England and constantly checked by the Labour Party’s opportunistic clamouring for more deficit spending. Well, last I checked, the UK was running 8 pc deficits per annum. Next to Japan, Britain is the most highly geared society on the planet (private and public debt combined), and when the markets pull the plug on this island nation, the fallout might make Greece look like a walk in the park.
But then, AEP won’t be able to blame it on the Germans.
In the meantime, the debasement of paper money continues.
This article was previously published at DetlevSchlichter.com.
It might seem like yesterday to some but it was already in 2009 that politicians in Europe began to talk about ‘austerity’, a concept that quickly became the new black in European political fashion. In brief, austerity in Europe is based on the idea that the accumulated sovereign debts are now dangerously large and need to be reduced by some combination of temporary (so they claim) tax increases and spending cuts. Once the debt is reduced to a more manageable level, so the thinking goes, taxes can be cut and spending restored to the previous level.
Sounds oh-so reasonable now, doesn’t it? The problem is, however, it isn’t working. As we approach the end of 2012, in every instance of austerity being applied, economic growth is weaker and government deficits higher than projected, the result being that the accumulated debt burdens continue to grow. Indeed, they are growing more rapidly than prior to the onset of austerity!
Now one key reason for this is that, concerned about the dire state of the economies in question, the financial markets have dramatically driven up their governments’ borrowing costs. Private sector investors seem unwilling to underwrite the risk that austerity might not work. To a small extent, the European Central Bank (ECB) has stepped in to fill the funding gap, purchasing selective clips of bonds from distressed euro-area governments, but this provides only temporary support.
The simple math of the matter is that unless borrowing costs fall substantially, austerity will fail. But how to bring down borrowing costs when private investors are not convinced austerity is going to work? Why, have the ECB take a much larger role. Hence the showdown between the German Bundesbank, opposed to open-ended bank and sovereign bail-outs, and, well, just about every euro-area politician, policy maker and Eurocrat involved. Let’s briefly explore this important tangent.
AUFTRITT DER UNBEUGSAME WEIDMANN
(ENTER THE UNYIELDING WEIDMANN)
To outside observers, this situation may seem rather odd. Following the introduction of the euro, the Bundesbank ceded power over German monetary policy and, by extension of the German mark’s previous role as anchor currency, over euro-area monetary policy as well. (The Bundesbank retains an important regulatory and supervisory role with respect to German financial institutions.) So how is it, exactly, that the Bundesbank is somehow in a position to resist what has now become a near universal euro-area march toward some form of debt monetisation?
Well, as it happens, the German public hold the Bundesbank in rather high regard. Most Germans recall how the Bundesbank long presided over Europe’s largest economy, maintaining price stability and fostering a sustained relative economic outperformance. Many Germans probably recall how, on multiple occasions, the Bundesbank successfully resisted inflationary government policy initiatives. Older Germans recall how the Bundesbank contributed to the Wirtschaftswunder (economic miracle) of the 1950s and 1960s. And Germans know that the ECB was supposedly modelled on the Bundesbank and the euro on the German mark.
So when the Bundesbank speaks, Germans listen. And when the Bundesbank voices concern over ECB or German government policy, Germans become concerned. And so it is today. It has been widely reported in the German press that Bundesbank President Jens Weidmann has threatened to resign at least once in protest over potential German government participation in inflationary bail outs of distressed euro-area banks and governments. Apparently Chancellor Merkel has pleaded for Weidmann to remain at the helm and so far she has succeeded. 
But what if she should fail? What if Weidmann does indeed resign in protest at some point? His former colleagues Axel Weber and Juergen Stark have already done so (In Stark’s case, from the ECB, not the Bundesbank). What if some of his Bundesbank board colleagues join him?
I can’t emphasise this point enough: The institution of the Bundesbank is held in such high regard among the German public that should Weidmann and any portion of his colleagues resign in formal protest of bailouts in whatever form, it may well bring down the German government, throw any bailout arrangement into complete chaos, spark a huge rout in distressed euro-area sovereign and bank debt and quite possibly result in a partial or even complete breakup of the euro-area. The Bundesbank thus represents the normally unseen foundation on which the entire euro project rests. Should it remove its support, it may all come crashing down.
But why would the Bundesbank ever do such a thing? Isn’t it just a bureaucracy like any other, expected to serve the government? Well, no. Consider the unique role of the Bundesbank under German Law. It is not answerable to the government. It is its own regulator. Its board members are appointed by the president—the head of state—not the chancellor, the head of the government. Its employees are sworn to secrecy during both their active service and in retirement. The Bundesbank alone determines whether its employees have infringed its code of conduct and determines what disciplinary actions, if any, should be taken.
Weidmann’s intransigence is thus entirely in line with German law and tradition. The Bundesbank, by design, will confront the government if it believes that such action is necessary to carry out its mandate. And what is that mandate? As per the original Bundesbank Act, “The preservation of the value of German currency.” Previously the mark, the euro is now the German currency and the Bundesbank’s mandate is to preserve its value. Needless to say, open-ended bailouts of euro-area banks and sovereign countries would, without question, threaten that value.
You can be certain that when President Weidmann said earlier this year that what was being proposed by the ECB “violated its mandate,” he chose his words very, very carefully. In a subsequent speech on the same topic, he quoted from Goethe’s Faust, arguably the most famous play in German literature and a classic warning against hubris and temptation. You don’t do that if you are not deadly serious. The implication, no doubt, is that Weidmann is sending a message that the Bundesbank is independent of the ECB with respect to determining whether or not ECB policies are consistent with “the preservation of the value of German currency,” which now happens to be the euro. The Bundesbank has thus re-assumed this dormant but ultimate power over German monetary policy. Under just what circumstances it will choose to exercise it, I don’t know, but if the German and other euro-area governments continue along the road to bailouts, it will almost certainly happen at some point, presenting the greatest challenge yet to the sustainability of EMU in its current form.
WHY ‘AUSTERITY’ DOESN’T WORK
As mentioned earlier, austerity isn’t working, in many countries largely because borrowing costs are not declining. But if austerity were credible, they would. What is it about austerity as implemented that is failing to win over bond investors?
I have some ideas. First, note that, so far at least, austerity in practice is more about tax increases than spending cuts. However, the countries in question are already among the most highly taxed in the world. As Arthur Laffer and others have suggested in theory and has often been observed in practice, beyond a certain point, tax increases not only fail to generate additional revenue but actually reduce it. (It so happens that the Scandinavian debt crisis of the early 1990s was addressed not with tax increases but with tax cuts, as well as spending cuts. Rapid growth followed, although for a variety of reasons including substantial currency devaluation.)
Second, consider that the countries in question have enormous accumulated debt burdens, in some cases previously disguised and underreported. Cooking the books does not instill investor confidence. Yet paying down such a large debt mountain is going to take a long, long time. Today’s investors need to trust not only today’s politicians, but their successors down the road, to make good on promises that will remain subject to political opportunism and expedience for many years.
Third, governments may talk a good game but can they walk the walk? A close look at European ‘austerity’ legislation reveals that actual spending cuts are few and far between. What is being proposed in most cases is that the rate of spending increases declines. But an increase is still an increase and absent healthy economic growth needs to be financed with, you guessed it, more debt. Investors may want to see real rather than ‘faux’ austerity before accepting lower debt yields.
Fourth, let’s consider the possibility that what investors are really interested in is not some accounting plan that looks nice on paper, assuming governments can rein in runaway spending, but rather a more comprehensive plan that fundamentally reforms economies, making them more flexible and competitive. If growth is not to be provided by deficit spending—the traditional welfare state model—it must be provided by an unsubsidised private sector. If an economy lacks capital or skilled workers, or taxes either labour or capital at too high a rate, it is not going to be able to grow and pay down debt. Such fundamental reform remains essentially off the table in the austerity plans discussed to date.
Finally, let’s turn to a technical but extremely important point, namely, how austerity as observed in practice adds further evidence to the already substantial pile demonstrating that the dominant neo-Keynesian paradigm held by the economic policy mainstream is itself deeply flawed.
INCONVENIENT MULTIPLIER MATHS
The difficulties with austerity go beyond merely placating the bond markets. The fact is, a large debt burden is a huge economic problem. Sure it is preferable to be able to finance the debt at low rates, but if you want to pay it down you must divert resources from elsewhere. That is going to be painful at any interest rate. But such are the political pressures on the modern welfare state that the accumulation of an excessive, unserviceable debt over time is a near certainty.
Why should this be so? Well, back in the days before the modern welfare, or ‘nanny’ state, politicians didn’t pretend to have solutions for everything. If you were overweight, it was your problem. If your kids didn’t learn basic reading, writing and numeracy, at home or at school, it was their problem. With the growth of the welfare state, however, more of your problems become politicians’ problems and, by extension, those of the taxpayers who must provide the funds for the ‘solutions’.
As the tax burden grows over time, however, taxpayers gradually begin to resist tax increases. In practice, this has resulted in the welfare states steadily accumulating debt, as taxpayers have repeatedly refused to pay the high rates of tax up front to finance the welfare policies in question.
In many welfare states, the average taxpayer is a major receiver of benefits, including publicly provided heathcare and education. Taxpayers in welfare states are suffering a collective ‘tragedy of the commons’, in which each tries to extract maximum benefit for minimum cost. The result is a steadily accumulating debt, representing that portion of welfare not covered by current tax revenues.
The dangers of an accumulating debt can be disguised, however, as long as economic growth appears healthy enough to service the debt. This is where the so-called ‘multiplier’ comes in. As the debt grows, it adds to GDP growth via the multiplier effect: for each unit of deficit spending, the economy will in fact grow by some multiple of that. (This is because deficit spending creates money through borrowing that would not otherwise have been created and this new money flows out into the economy where it stimulates growth generally). This process can go on for many years, as we have seen.
The neo-Keynesian economic mainstream doesn’t see anything wrong with this in principle, as long as debts don’t become excessive relative to GDP. But welfare politics being what they are, they do. (It is a rare welfare state indeed that can rein itself in as debts swell. Indeed, the exceptions that prove the rule here are few and far between and are explained primarily by natural economic advantages.) When a welfare state finally reaches the limits of debt accumulation, as the bond markets refuse to finance any further increase in debt at serviceable rates, some form of austerity would seem to be required.
No so fast. In its most recent World Economic Outlook, the International Monetary Fund (IMF) surveys the evidence of austerity in practice and does not like what it finds. In particularly, the IMF notes that the multiplier associated with fiscal tightening seems to be rather larger than they had previously assumed. That is, for each unit of fiscal tightening, there is a greater economic contraction than anticipated. This results in a larger shrinkage of the economy and has the unfortunate result of pushing up the government debt/GDP ratio, the exact opposite of what was expected and desired.
While the IMF might not prefer to use the term, what I have just described above is a ‘debt trap’. Beyond a certain point an economy has simply accumulated more debt than it can pay back without resort to currency devaluation. (In the event that a country has borrowed in a foreign currency, even devaluation won’t work and some form of restructuring or default will be required to liquidate the debt.)
The IMF is thus tacitly admitting that those economies in the euro-area struggling, and so far failing, to implement austerity are in debt traps. Austerity, as previously recommended by the IMF, is just not going to work. The question that naturally follows is, what will work?
Well, the IMF isn’t exactly sure. The paper does not draw such conclusions. But no matter. If austerity doesn’t work because the negative fiscal multiplier is larger than previously assumed, well then for now, just ease off austerity while policymakers consider other options. In other words, buy time. Kick the can. And hope that the bond markets don’t notice.
Speaking of not noticing, one could be forgiven for wondering whether this IMF paper was not in fact written with precisely this agenda, that is, to provide an expedient justification for easing off the austerity brakes for awhile. Why? Well as it happens, the IMF’s analysis is not particularly robust. First, they use a data set with a rather short history. Second, their claim to have generated robust statistical results seems questionable. How so? Well, have a look at the following chart:
Now the slope of the line through the data is meant to show the forecast error based on the old multiplier assumptions, in other words, the extent to which the IMF has got things wrong. Note Greece in the lower right corner, representing the unanticipated negative effects of a rather extreme fiscal tightening, and Germany in the upper left, representing the forecast error associated with a moderate fiscal expansion. But if you eliminate these two extreme observations from the sample—something any good statistician would do as a reality check—guess what? You are left with a statistically insignificant ‘blot’ of observations from which you can’t really conclude anything. In other words, the IMF is jumping to conclusions. Now why might that be?
I have an idea. Consider: some of the more outspoken Keynesians wasted no time touting these findings as ‘proof’ that austerity can’t work; that what is really needed is more stimulus, not less; that their arch-Keynesian views have now been vindicated!
Among this group are Paul Krugman, who never saw a stimulus he didn’t like; and former Fed economist Richard Koo of Nomura, who shows a bit more discretion in his views. But in this case they are on the same page: the IMF data are clear, unambiguous evidence, in their view, that the problems created by excessive debt are best addressed with more debt, rather than less. Logic, apparently, is mere inconvenience for those with a PhD in Keynesian economics, as are questionable, cursory statistical analyses, normally referred to pejoratively as ‘data-mining’.
MULTIPLIER REALITY CHECK
Now that we have seen how two prominent Keynesians have responded with applause to an unabashedly Keynesian-inspired IMF study, let’s step back and consider the broader implications for a moment. As is the case with many policy papers, this one is perhaps more notable for what it doesn’t say than for what it does.
Consider: even if the IMF paper is correct in its questionable statistical observations, why, exactly, might the multiplier be larger on the downside than on the upside? Could it be that the net economic benefits of borrowing and consuming through the years are more than outweighed by the eventual requirement that the accumulated debts are paid down? Could it be that borrowing and consuming your way to prosperity doesn’t actually work? Or, conversely, that good, old-fashioned saving and investing your way to prosperity does?
The IMF does not ask and thus does not even begin to answer these common-sense questions. If it did, it might come to some rather common-sense conclusions. That they just perform a data-mining exercise, apparently to serve an agenda, rather than ask and answer the real questions, is yet more evidence that the dominant neo-Keynesian paradigm is being exploited by self-serving policymakers seeking any excuse they need to keep borrowing, spending and consuming, so that the inevitable, unavoidable hard choices need not be made on their watch. Leave it rather to their successors or, better yet, the next generation, or the generation after. After all, isn’t it just human nature for parents and grandparents to expect their children and grandchildren to take care of them in their old, infirm age? In any case, it takes hard work and some sacrifice to actually provide for the next generation to have a higher standard of living. But hey, we’re rich enough as it is, aren’t we? Isn’t poverty a thing of the past? And don’t we aspire to higher things these days like economic equality, political correctness, or ‘nanny’ rules and regulations to keep us from smoking, or drinking, or gambling, or whatever other immoral, reprehensible, irresponsible behaviours? Worrying about debts and budgets is just so passé!
Well, ask the Greeks or the Spanish how they feel about political correctness these days. Or ‘nannystate’ rules on personal behaviour. Something tells me they might be rather more concerned with putting food on the table. And something tells me that the theoretical future of the welfare state, long predicted by von Hayek, von Mises, Friedman, Buchanan and other notable, non-Keynesian economists, is rapidly colliding with the actual present, in a list of countries that continues to grow.
Before we move to the next topic, some readers might be asking themselves, if neither ‘austerity’ nor stimulus is the answer, what on earth is? My answer to this question is that the ‘faux austerity’ I mentioned earlier isn’t really austerity at all. Tightening the screws on a failing welfare state without fundamental reform is not going to convince investors to hold additional debt. Corporations that are fundamentally uneconomic need to do more than cut a few costs here and there if they want to rollover their debts. They need to engage in some ‘creative destruction’ of their operations. Anything less, and bond investors will walk away and leave them to their fate.
Unfortunately, the political processes of the modern welfare state, entrenched as they are in administering entitlements of various kinds, do not lend themselves to fundamental economic reform. Thatcher’s near-bankrupt Britain is a rare exception, in which a highly charismatic politician, against all political odds, took a principled stance against the relentless growth of the welfare state and managed to slow its growth for a time. She didn’t stop it, however, something that the present British government, soon to face near-bankruptcy yet again, no doubt regrets.
While Keynesians prefer to ignore relevant examples, the fact is, real austerity is possible. Look at the Baltic States of Estonia, Latvia and Lithuania. Look at Bulgaria, or Slovakia, or Iceland. Look at South Korea, Thailand, Malaysia and other Asian countries hit hard by their collective debt crisis in the late 1990s. It can be done. But it implies real economic hardship for a period of time and it goes right to the heart of the government, which must shrink relative to the private sector. Many career politicians and bureaucrats will simply find that they are out of work and that they must seek private sector jobs, without guaranteed state pensions and other benefits, like most ordinary folks.
THE IMF RESURRECTS THE ‘CHICAGO PLAN’
The reality of contemporary welfare state politics being what it is, I would argue that there is essentially zero chance that the Keynesians in charge are going to do an about-face. Sure, they might have realised that their policies are not working, but this just means that they are going to raise the stakes. As some are now beginning to argue, there is in fact no reason to worry. Austerity might not work once you are stuck in a debt trap, but so what? What if you could just wave a magic wand and make the debt disappear? Now that would solve all our problems, wouldn’t it?
We know intuitively that this is nonsense. But just because something is nonsense doesn’t stop policymakers from spouting it when expedient. As I wrote in an Amphora Report back in 2010, as the euro-area debt crisis was escalating:
Just as there is no free lunch in economics generally, there is no magic wand in economic policy. Policymakers who claim otherwise are like magicians distracting their audience. As is the case in the physical world, in which there is conservation of energy–the first law of thermodynamics–there is also conservation of economic risk. It cannot be eliminated by waving a magic wand. It can, however, be transformed from one type of risk to another.
As it happens, such sleight-of-hand risk transfer forms the core of the sophistic argument put forth in a superficially scholarly paper published recently by the IMF. The authors, Jaromir Benes and Michael Kumhof, resurrect the long-forgotten ‘Chicago Plan’ of the 1930s, first proposed by Irving Fisher, an early exponent of the Monetarist economic school associated with the University of Chicago. In brief, the Chicago Plan proposes changing the nature of money and money creation in the economy from a nominally private-sector affair, in which commercial banks serve as the engines of money growth, to an exclusively public sector one. Somehow, replacing private sector assets and liabilities with public sector ones is supposed to reduce or eliminate the various problems associated with the current system, in which money creation is supposedly a ‘private’ affair.
While I could have a go at pointing out in detail just how hideously flawed this paper is, fortunately I don’t need to. My friend and fellow financial writer Detlev Schlichter recently penned a devastating critique and I highly recommend reading it in its entirety. For our purposes here, a few particularly relevant quotes follow:
[T]he paper sets up an entirely new and I believe bogus problem based on the premise that in our monetary system money is supposedly provided ‘privately’, that is, by ‘private’ banks, and ‘state-issued’ money only plays a minor role. From this rather confused observation, the paper derives its key allegation that ‘state-issued money’ ensures stability, while ‘privately-issued money’ leads to instability. This claim is not supported by economic theory… Monetary theory does not distinguish between ‘state-controlled money’ and ‘privately produced’ money, it is a nonsensical distinction for any monetary theorist. An attempt to give credence to this distinction and its alleged importance is made in a later chapter in the Benes/Kumhof paper but, tellingly, this attempt is not based on monetary theory but on an ambitious, if not to say bizarre, re-writing of the historical record.
Detlev then goes on to point out precisely why this ‘public’ vs ‘private’ money distinction is all but meaningless not only in theory but in practice:
In recent decades, the global banking system found itself on numerous occasions in a position in which it felt that it had taken on too much financial risk and that a deleveraging and a shrinking of its balance sheet was advisable. I would suggest that this was the case in 1987, 1992/3, 1998, 2001/2, and certainly 2007/8. Yet, on each of these occasions, the broader economic fallout from such a de-risking strategy was deemed unwanted or even unacceptable for political reasons, and the central banks offered ample new bank reserves at very low cost in order to discourage money contraction and encourage further money expansion, i.e. additional fractional-reserve banking. It is any wonder that banks continued to produce vast amounts of deposit money – profitably, of course? Can the result really be blamed on ‘private’ initiative?
To answer Detlev’s rhetorical question: of course not! Just because commercial banks are legally private entities does not in any way imply that they are not de facto agencies of the government. Fannie Mae and Freddie Mac were private sector entities too, prior to being placed into official government ‘conservatorship’, albeit ones engaged in even narrower, more heavily regulated activities than ordinary commercial banks.
Perhaps the best way to think about how banking institutions have operated in recent decades is as private utility companies, with their activities heavily regulated and subsidised by the central bank and a handful of government agencies. Or, to use another industry as an example, consider defence contractors. Sure, they might be private firms in the legal sense, but the business in which they are engaged—defence—is so intertwined with the activities of government that it is essentially impossible to distinguish just where the public role ends and the private role begins.
No doubt the legal grey area that exists between public and private activities in any industry is fertile ground for corruption and abuse. In finance, however, this grey area reaches right into the heart of the money and credit creation process and, thereby, has an insidious if largely unseen impact on the entire economy. To blame ‘private sector’ money and credit growth for the mess we are in, as Messrs Benes and Kumhof do in their paper, demonstrates either colossal ignorance or disingenuousness. I leave it to the reader to decide which.
MONETISATION BY ANY OTHER NAME
If while reading the above you thought that what in effect is being proposed is a massive monetisation of debt, you are right. That is exactly what it is. All but the most radical of Keynesian economists, however, refrain from using the ‘m’ word. They prefer wonkish terms like ‘quantitative easing’ for example. Or, when there is natural downward pressure on prices, they say extreme measures are called for due to ‘inflation targeting’. When they get really desperate, they do occasionally refer to things like the ‘printing press’ or even ‘helicopters’, but somehow the ‘m’ word is something only ever contemplated by two-bit dictators, be they fascist, communist or some combination of the two. After all, monetisation is blatant, in-your-face wealth confiscation from private sector savers to public and financial sector borrowers. Modern, enlightened welfare state democracies would never contemplate such a thing now, would they?
Perhaps this is one reason why the German Weimar hyperinflation is regarded with such horror in the modern economics profession, even though it is but one of many fiat money hyperinflations of the past century. How could a reasonably free and open democracy—indeed, the one in which the idea for the modern welfare state originated—possibly resort to monetisation to solve its excessive debt problem, a legacy of WWI? How irresponsible! Had they just done as Krugman, Koo or other modern Keynesians recommend, and stuck to QE and double-digit fiscal deficits, why, they would have been just fine!
Yes, I’m being faceitious yet again. But come on folks, the idea that somehow, by calling ‘monetisation’ something else makes it so, is just another example of the intellectual sophistry being practiced at the IMF and elsewhere in Keynesian policy circles. They are playing a semantics game while trying desperately to get governments the world over to get on with outright debt monetisation, assuming that this would never morph into a hyperinflation or other such economic calamity.
Ah, but it might. Sorry to sound alarmist, but at some point it might. Reality is a harsh mistress. The future has a way of arriving now and again, sometimes when you least expect it. Responsible folks need to take a sober look at the road we are on. Ignore the can being kicked along the road and focus instead on where the road leads. In this case, it leads to some combination of currency debasement, devaluation and debt default (with the latter substantially less likely, in my opinion, although I would not rule it out in certain cases). It might, just might, lead to a hyperinflation.
So what is a defensive investor, interested primarily in wealth preservation, to do? My advice in this matter has changed little since the first Amphora Report went out in early 2010. Diversify out of financial and into real assets that cannot be debased, devalued or defaulted on. Within financial assets, overweight income-generating stocks in industries with pricing power, that is, those more easily able to pass cost increases through to consumers. Within real assets, acquire some physical, allocated gold and silver but note that these are already trading somewhat expensive relative to most other commodities.
One important lesson of the Great Depression and other periods of severe economic deleveraging is that the prices of less fashionable commodities such as agricultural products can become extremely depressed from time to time and that they tend to outperform precious metals once they cheapen (in relative terms) to a certain point. I would argue that we are at or near that point already.
The Amphora mantra has always been and remains to diversify. Diversification is the only ‘free-lunch’ in economics, frequent Keynesian claims to the contrary notwithstanding, and it is the best form of financial insurance there is. Better than gold. Better than silver, or any single commodity. Better than any one stock, or stock market for that matter. Better than any one bond market, or any one currency. In a world of not just known unknowns, but even unknown unknowns, it would be imprudent to place any number of eggs in just one basket. Even golden ones.
 ECB President Mario Draghi affirmed this policy at today’s monthly ECB press conference and also suggested strongly that the ECB is likely to purchase substantially more debt in future.
 Among other German publications, Der Spiegel reported on this. The link to the article is here.
 Weidmann’s specific words, in German, for those interested, were the following: “Die Bundesbank steht hinter dem Euro. Und gerade deshalb setzen wir uns mit Verve dafür ein, dass der Euro eine stabile Währung bleibt und die Währungsunion eine Stabilitätsunion. Es gibt verschiedene Wege, dieses Ziel zu erreichen. Sicherlich nicht erreichen werden wir dieses Ziel aber, wenn die europäische Geldpolitik in zunehmendem Maße für Zwecke eingespannt wird, die ihrem Mandat nicht entsprechen. The link to this speech is here. His reference in a subsequent speech to Goethe’s Faust can be found at the link here.
 Those welfare states with manageable debt burdens tend to be endowed with plentiful natural resources, such as Norway, Sweden Finland, or Canada, for example. This makes them natural exporters and enables them to finance a certain degree of domestic welfare without resorting to chronic debt accumulation.
 The IMF World Economic Outlook can be found here.
 For more on the concept of a ‘debt trap’, please see “Caught in a Debt Trap”, Amphora Report vol 3 (July 2012). The link is here.
 I have written at length about the critical yet commonly overlooked role that Schumpeterian ‘creative destruction’ plays in a healthy economy. For a recent example, please see “Why Banktuptcy is the New Black,” Amphora Report vol. 3 (April 2012). The link is here.
 “There May Be No Free Lunch, but Is There a Magic Wand?” Amphora Report vol. 1 (September 2010). The link is here.
 The entire paper, The Chicago Plan Revisited, can be found on the IMF’s website here.
 Detlev’s paper is posted to his blog, linked here. I also highly recommend Detlev’s book, Paper Money Collapse, details of which you can also find on his blog.
 For those curious, German chancellor Bismarck introduced the first European pay-as-you-go state pension in the 19th century. It has served as the original model for state pensions subsequently introduced in most of Europe and North America. Germany was also an early adopter of compulsory public education.
 You can find the inaugural Amphora Report here.
This article was previously published in The Amphora Report, Vol 3, 8 November 2012.
If central banking were a stock, you’d go short.
Blue-chip mystique still clings to it but you can feel the reputational parabola slowly gathering momentum on the downside. Its projects are too large and diffuse, the resources to achieve them too crude and there are mounting signs of unhappiness and confusion at the top.
Given their long-standing rock star status, pity the central banker; the fall from grace may be vertiginous.
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The Governor of the Old Lady seems more attuned to this unfolding trend than most. On my reading, he metaphorically ran up the white flag in a recent speech. It was the oddest mixture of explanations, implicit apologies and rationalisations imaginable from such an august perch. Do have a look; it’s not long.
King finished with an amusing touch: “As for the MPC [Monetary Policy Committee], you can be sure we shall be looking for as much guidance as we can find, divine or otherwise. What better inspiration than the memory of those children on Rhossili beach singing Cwm Rhondda.”
Perhaps the South Wales Chamber of Commerce seemed a forgiving place to lay out some of central banking’s many puzzles.
Put simply, his message was: I know what we’re doing seems a bit crazy, and I know all the fundamental problems are still out there waiting to be solved, but what else can we do?
What’s even scarier is that I understand what he means. After all, most of the really important stuff, like correcting the monstrous accumulated imbalances of recent decades and setting a more sensible course for the future, isn’t within the Bank of England’s remit. And yet, because the magic wand is in their hands, everyone looks to them to do something. Anything.
Which, as we know, they did. Cumulative QE (so far) of £375 billion, or 25% of GDP, enough for top spot amongst its Western institutional colleagues. As King suggested, the market is well and truly sated:
During the crisis central banks have provided liquidity to banks on a truly extraordinary scale, so much so that there were no takers for additional liquidity in our latest auction. It is still useful to keep their auction facility as an insurance policy. But banks are now overflowing with liquid assets.
Insurance policy indeed. Any more QE would seem in danger of plunging the whole business into farce.
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King, as he often does, got to the nub of the matter early on in his speech:
In the long run, we will need to rebalance our economy away from domestic spending and towards exports, to reduce the trade deficit, to repay our debts, and to raise the rate of national saving and investment. So you are probably puzzled by the fact that we seem to be doing exactly the opposite of that today. Almost 4 years ago now, I called this the “paradox of policy” – policy measures that are desirable in the short term appear diametrically opposite to those needed in the long term. Although we cannot avoid long-term adjustment to our economy, we can try to slow the pace of the adjustment in order to limit the immediate damage to output and employment.
He’d be only too aware, I’m sure, that our current intolerable mess is the result of giving in to a long succession of apparently desirable short-term policy measures. In each of the would-be and actual recessions of recent decades, politicians and central bankers strove to “limit the immediate damage to output and employment.” And, for the most part, succeeded. Trouble is, of course, in doing so earlier excesses were never allowed to sort themselves out; instead, they were carried forward with compound interest and then added to afresh.
How does one ever decide that now, finally, is the moment to pay the piper?
Thing is, even if King thought the time was now (or, quite possibly, a few years ago), it’s out of his hands. He can advise, plead, cajole, threaten to resign, but he can’t decide. So too with his compatriots elsewhere, many of whom have also been delicately (and sometimes not so delicately) pointing out the limits of of monetary policy and pleading for deeper structural reform.
As King said immediately after his comment about banks now overflowing with liquid assets:
Their problem remains insufficient capital. Just as in 2008, there is a deep reluctance to admit the extent of the undercapitalisation of the banking system in many parts of the industrialised world. The verdict of the market is clear – without central banks support banks still find it expensive to borrow.
What’s true of the banking system is no less true for the economy more generally. There’s way too much debt and not enough equity. Until that imbalance is dealt with (together with all the real world distortions it fostered) there’s no chance of organic growth, just the hyped up, artificial variant produced by great bouts of fiscal and monetary stimulus.
Central bankers are burdened with a kind of original sin. After all, without their unfailing support and encouragement (together with the very nature of the fiat fractional reserve banking systems over which they preside), the credit excesses of recent decades would have been quite impossible. Can any of them coolly and dispassionately disentangle and measure the system in which they’re so deeply embedded?
I don’t know, but it’s not hard to imagine King lying awake in the early hours of the morning.
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So what’s the endgame?
With overall debt levels rising (still), rates pinned to the floor and vast amounts of excess liquidity sloshing about (thank you Mervyn, Ben, Mario et al), a private sector busily trying to repair its collective balance sheet and economies everywhere in the doldrums because of massive imbalances, anyone who says they know the answer is dreaming.
What we can say is that policy is distinctly, perhaps even irretrievably, assymmetrical. Central bankers are conditioned to leap into action at the merest hint of renewed weakness, much less deflation. As with both fiscal and monetary stimulus in recent decades, the political incentives all run one way. In the absence of sustained, reassuring economic growth, it’s hard to see what might change this bias.
Right now, all the resulting excess liquidity is mostly languishing in reserves at various central banks, collecting a paltry return and seemingly doing no harm. There’s a bit of fresh lending going on here and there, but demand is low and the banks, generally, remain relatively cautious. Fact is, central bankers are tearing their hair out because of the financial system’s lack of responsiveness.
Careful what you wish for, perhaps? According to Ashwin Parameswaran, the market’s current willingness to hold unusually large quantities of money because of the crisis induced desire for safety and liquidity may not hold if “real rates turn significantly negative”:
Once real rates become sufficiently negative, credit growth explodes and the positive feedback loop of ever higher inflation fuelled not just by currency repudiation but by active exploitation of the banking and central bank discount window to access essentially free loans is set in motion. In other words, hyperinflation in modern capitalist economies is characterised not just by a collapse in the demand for deposits but an explosion in demand for loans at the free lunch level of nominal interest rates enforced by the central bank.
Whether these huge reserves might one day wreak unexpected havoc is something I’ve long wondered about too. What I hadn’t realised until I read Ashwin’s links was how critically important explosive private credit growth has often been in earlier hyperinflations.
It makes perfect sense, of course. Once the incentives are strong enough (and what could be stronger than seriously negative real rates?) the whole machinery of credit and money creation is unleashed. One shudders to think how silly things could get.
Could it really happen today, in the US, the UK, or Japan? Could central bankers miscalculate or lose control so badly as to set this particular doomsday machine in motion?
Cassandra though I often am in these matters, I struggle to see it. After all, there’s no shortage of historical horror stories at hand. Still, like armies, central bankers are inclined to fight the last war, and after the 1930s they’re understandably paranoid about letting debt deflation get the upper hand. As Bernanke said at a conference honouring Milton Friedman on his 90th birthday: “Regarding the great depression. You’re right, we [the Fed] did it. We’re very sorry. But thanks to you, we won’t do it again.”
So it’s not inconceivable. It just needs inflation to get away enough to generate juicy negative real rates. With so much dry tinder already around and central banks all leaning one way, that’s not inconceivable either. Remember too that while individual banks can get rid of reserves through making loans or purchasing investments, overall, banks can’t. What one loses, another gains. One can therefore imagine an accelerating rush by individual banks to deploy reserves, all of it, at a systemic level, entirely fruitless and on the other side newly hungry demand intent on exploiting negative real rates. While the notion of hyperinflation still seems . . . well, a bit hyper, it doesn’t strike me as an easy beast to rein in if it bolts.
To bring it under control, central banks would either have to vaporise sufficient reserves through sales from their portfolio to give banks pause, or, raise the rate they pay on reserves high enough to discourage the process. Neither seems attractive. Brave indeed would be the central banker who embarked on the former in these bone china delicate times. As for the latter, with reserves so high (and still growing) it sure wouldn’t be cheap.
Tricky business, central banking.
At its most fundamental level, economic activity is no more than an exchange between strangers. It depends, therefore, on a degree of trust between strangers. Since money is the agent of exchange, it is the agent of trust. Debasing money therefore debases trust. History is replete with Great Disorders in which social cohesion has been undermined by currency debasements. The multi-decade credit inflation can now be seen to have had similarly corrosive effects. Yet central banks continue down the same route. The writing is on the wall. Further debasement of money will cause further debasement of society. I fear a Great Disorder.
I am more worried than I have ever been about the clouds gathering today. I hope they pass without breaking, but I fear the defining feature of coming decades will be a Great Disorder of the sort which has defined past epochs and scarred whole generations.
“Next to language, money is the most important medium through which modern societies communicate,” writes Bernd Widdig in his masterful analysis of Germany’s inflation crisis, Culture and Inflation in Weimar Germany (2001). His may be an abstract observation, but it has the commendable merit of being true… all economic activity requires the cooperation of strangers and therefore, a degree of trust between cooperating strangers. Since money is the agent of such mutual trust, debasing money implies debasing the trust upon which social cohesion rests.
So I keep wondering to myself, do our money-printing central banks and their cheerleaders understand the full consequences of the monetary debasement they continue to engineer? Inflation of the CPI might be a consequence both seen and measurable. A broad inflation of asset prices might be a consequence seen, though not measurable. But what about the consequences that are unseen and unmeasurable—and are all the more destructive for it? I feel queasy about the enthusiasm with which our wise economists play games with something about which we have such a poor understanding.
If you take a look around you, any artefact you see will only be there thanks to the cooperative behaviour of lots of people you don’t know. You will probably never know them, nor they you. The screen you watch on your terminal, the content you read, the orders which make the prices flicker… the coffee you drink, the cup you hold, the bin you throw it in afterwards… all your clothes, all your accessories, all the buildings you’ve been in, all the cars… you get the idea. Without exception, everything you own, everything you want to own, everything you need, and everything you think you need embodies the different skills and talents of a mind-boggling number of complete strangers. In a very real sense we constantly trust in strangers to a degree, as strangers trust us. Such cooperative activity is to everyone’s great benefit and I find it is a marvellous thing to behold.
The value strangers put on each other’s contributions manifests itself in prices, and prices require money. So it is through money that we express the extent of our appreciation for the many different talents embedded in each thing we consume, and through money that our skills are in turn valued by others. Money, in other words, is the agent of this anonymous exchange, and therefore money is also the agent of the hidden trust on which it depends. Thus, as Bernd Widdig reflects in his book, money “is more than simply a tool for economic exchange; its different qualities shape the way modern people think, how they make sense of their reality, how they communicate, and ultimately how they find their place and identity in a modern environment.”
Debasing money might be expected to have effects beyond the merely financial domain. Of course, there are many ways to debase money. Coin can be clipped, paper money can be printed, credit can be created on the basis of demand deposits which aren’t there… The effects are ultimately the same, though: the implied trust that money communicates through society is eroded.
To see how, consider the example of money printing by authorities. We know that such an exercise raises revenues since the authorities now have a very real increase in purchasing power. But we also know that revenue cannot be raised by one party without another party paying. So who pays?
If the authorities raise taxes explicitly and openly, voters know exactly why they have less spending power. They also know how much less spending power they have. But if the authorities instead raise money by simply printing it, they raise the revenue by stealth. No one knows upon whom the burden falls. People notice only that they can’t afford the things they used to be able to afford, or they can’t afford the things which everyone else can afford. They know that something is wrong, but they just don’t know what, why, or who is to blame. So inevitably they look for someone to blame.
The dynamic is similar to that found in the wellworn plot line in which a group of strangers are initially brought together in happier circumstances, such as a cruise, a long train journey or a weekend away. In the beginning, spirits are high. The strangers exchange jokes and get to know one another as the journey begins. Then some crime is committed. They know it must be one of them, but they don’t know who. A great suspicion ensues. All trust between them is broken down and the infighting begins…
So it is with monetary debasement, as Keynes understood deeply (so deeply, in fact, that it’s ironic so many of today’s crude Keynesians support QE so enthusiastically). In his 1919 book The Economic Consequences of the Peace, he wrote:
By a continuing process of inflation, Governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. … Those to whom the system brings windfalls … become “profiteers,” who are the object of the hatred…. the process of wealth-getting degenerates into a gamble and a lottery. … Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.
Lessons from history
History is replete with Great Disorders in which currency debasement has coincided with social infighting and scapegoating. I have written in the past about the Roman inflation of the Third Century AD. During what is known as the Third Century Crisis, turnover of emperors reached an alarming rate: The second half of the century witnessed the succession of 31 emperors, more than twice that of the previous 50 years. As trade declined, crops failed and the military suffered what must have seemed like constant defeat, it wasn’t difficult for a successful or even popular general to convince the rest of the empire that he’d make a better fist of governing.
But this political turnover was accompanied by what may be history’s first recorded instance of systematic currency debasement. With the empire no longer expanding and barbarians being forced westwards by the migrations of the Steppe peoples, Rome’s borders were under threat. But the money required to fund defense wasn’t there. Successive emperors therefore reached the same conclusions that kings, princes, tyrants and democratically elected governments would later reach down the ages when faced with a perceived “shortage of money”: they created more by debasing the existing stock. In the second half of the third century, the silver content of a denarius shrunk from over 40% to zero. Copper coins disappeared altogether.
So the Romans turned on their Christians with a great violence which lasted throughout the period of the currency debasement but peaked with Diocletian’s edict of 303 AD. The edict decreed, among other things, that Christian meeting places be destroyed, Christians holding office be stripped of that office, Christian freedmen be made slaves once more and all scriptures be destroyed. Diocletian’s earlier edict, of 301 AD, sought to regulate prices and set out punishments for “profiteers” whose prices deviated from those set out in the edict.
A similar dynamic seems evident during Europe’s medieval inflations, only now, the confused and vain effort to make sense of the enveloping turmoil saw the blame focus on suspected witches. Charting the UK price index over the period with the incidence of witchcraft trials reveals that the peak of trials coincided with the peak of the price revolution.
Were the same dynamics at work during the French Revolution of 1789? The narrative of Madame Guillotine and her bloody role is well known. However, the execution of royalty by the Paris Commune didn’t begin until 1792, and the Reign of Terror in which Robespierre’s Orwellian-sounding “Committee of Public Safety” slaughtered 17,000 nobles and counter–revolutionaries didn’t start until well into 1793. In the words of guillotined revolutionary Georges Danton, this is when the French revolution “ate itself.” But the coincidence of these events to the monetary debasement is striking.
The political violence was justified in part by blaming nobles and counter-revolutionaries for galloping inflation in food prices. It saw “speculators” banned from trading gold, and prices for firewood, coal and grain became subject to strict controls. According to Andrew Dickson White, author of Fiat Money Inflation in France (1896), “economic calculation gave way to feverish speculation across the country.”
However, the most tragic of all the inflations in my opinion, and certainly the starkest example of a society turning on itself was the German hyperinflation. Its causes are well known. Morally and financially bankrupt by the First World War, the reparation demands of the Allies (which Keynes argued vociferously against) followed by the French occupation of the Ruhr served to humiliate a once-mighty nation, already on its knees.
And it really was on its knees. Germany simply had no way to pay. The revolution following the flight of the Kaiser was incomplete. Concern was widespread that Germany would follow the path blazed by Moscow’s Bolsheviks only a year earlier. A de facto civil war was being fought on the streets of major cities between extremist mobs of the left and right. Six million veterans newly demobilized, demoralized, dazed and without work were unable to support their families. The great political need was to pay off the “internal debts” of pensions, life insurance and welfare support in any way possible. The risk of printing whatever was required was well understood. Bernhard Dernberg, vice chancellor in 1919, found himself overwhelmed with promises to pay for the war disabled, food subsidies, unemployment insurance, etc., but everyone knew where the money was coming from:
A decision of the National Assembly is made. On its basis, Reich Treasury bills are printed and on the basis of the Reich Treasury bills, notes are printed. That is our money. The result is that we have a pure assignat economy.
But print they did. Prices would rise by a factor of one trillion. At the end of the war, Germany owed 154 billion Reichmarks to its creditors. By November 1923, that sum measured in 1914 purchasing power was worth only 15 pfennigs.
It is difficult to comprehend the psychological trauma inflicted by this episode. Inflation inverted the efficacy of correct behaviour. It turned the ethics of thrift, frugality and notions such as working hard today to bring benefit tomorrow completely on their heads. Why work today when your rewards would mean nothing tomorrow? What use thrift and saving? Why not just borrow in depreciating currency? Those who had worked and saved all their lives, done everything correctly and invested what they had been told was safe, were mercilessly punished for their trust in established principles and their inability to see the danger coming. Those with no such faith who had seen the danger coming had benefited handsomely.
Everything, in other words, was dependent on one’s ability to speculate, recalling what Dickson White observed of the French Revolution and Keynes’s reflections more generally. Erich Remarque is best known for his anti-war novel All Quiet on the Western Front (1929) but perhaps his best work was the The Black Obelisk (1956) set in the early Weimar period, a penetrating meditation on the upside-down world of inflation. The protagonist Georg poignantly captures this speculative imperative when he sits down and lets out a long sigh: “Thank God that it’s Sunday tomorrow… there are no rates of exchange for the dollar. Inflation stops for one day of the week. That was surely not God’s intention when he created Sunday.”
Perhaps the most eloquent chronicler of the Weimar hyperinflation was Elias Canetti, whose mother moved him from the security of Zurich to Frankfurt in 1921 to take advantage of cheaper living. Canetti never forgave her, and his life’s work shows what a lasting impression the move from heaven to hell made: “A man who has been accustomed to rely on [the monetary value of the mark] cannot help feeling its degradation as his own. He has identified himself with it for too long, and his confidence in it has been like his confidence in himself… Whatever he is or was, like the million he always wanted, he becomes nothing.”
More tragic still was what German society became during the inflation. Like other Axis countries on the wrong side of the War and now in the grip of hyperinflation, Germany turned viciously on its Jews. It blamed them for the surrounding evil as Romans had blamed Christians, medieval Europeans had suspected witches, and French revolutionaries had blamed the nobility during previous inflations. In his classic Crowds and Power (1960), Canetti attributed the horror of National Socialism directly to a “morbid re-enaction impulse”:
No one ever forgets a sudden depreciation of himself, for it is too painful. … The natural tendency afterwards is to find something which is worth even less than oneself, which one can despise as one was despised oneself. It is not enough to take over an old contempt and to maintain it at the same level. What is wanted is a dynamic process of humiliation. Something must be treated in such a way that it becomes worth less and less, as the unit of money did during the inflation. And this process must be continued until its object is reduced to a state of utter worthlessness. … In its treatment of the Jews National Socialism repeated the process of inflation with great precision. First they were attacked as wicked and dangerous, as enemies; then, there not being enough in Germany itself, those in the conquered territories were gathered in; and finally they were treated literally as vermin, to be destroyed with impunity by the million.
All this is very disturbing stuff, but testament to a relationship between currency devaluation and social devaluation. Mine is not a complete or in any way rigorous analysis, I know. I emphasize that it’s not in any way meant as some sort of crude mapping on to today’s environment. My point is to show that money operates in many social domains beyond the financial, and that tying currency devaluation to social devaluation might have some merit.
Consider some recent and less extreme currency inflations. The 1970s bear market in equities saw relatively mild inflation which was also characterized by relatively mild but nevertheless real fractionalization of society. An ideological left-vs-right battle played out between labour and capital, unions and non-unions and perhaps most bizarrely, between rock and disco. As already stated, money implies a trust in the future. It implies that today’s money can be used in the future. So in the era of punk, did the Sex Pistols’ cry of “No future” provide the most concise commentary of the malaise?
Credit inflation in recent decades
Despite the CPI inflation of the 1970s receding, our central banks have continued to play games with money. We’ve since lived through what might be the largest credit inflation in financial history, a credit hyperinflation. Where has it left us? Median US household incomes have been stagnant for the best part of twenty years.
Yet inequality has surged. While a record number of Americans are on food stamps, the top 1% of income earners are taking a larger share of total income than since the peak of the 1920s credit inflation. Moreover, the growth in that share has coincided almost exactly with the more recent credit inflation.
These phenomena are inflation’s hallmarks. In the Keynes quote above, he alludes to the “artificial and iniquitous redistribution of wealth” inflation imposes on society without being specific. What actually happens is that artificially created money redistributes wealth towards those closest to it, to the detriment of those furthest away.
Richard Cantillon, writing decades before Adam Smith, was the first to observe this effect (hence the “Cantillon effect”). By thinking through the effects in Spain and Portugal of the influx of gold from the new world, he showed how those closest to the money source benefited unfairly at the expense of others:
If the increase of actual money comes from mines of gold or silver… the owner of these mines, the adventurers, the smelters, refiners, and all the other workers will increase their expenditures in proportion to their gains. … All this increase of expense in meat, wine, wool, etc. diminishes of necessity the share of the other inhabitants of the state who do not participate at first in the wealth of the mines in question. The altercations of the market, or the demand for meat, wine, wool, etc. being more intense than usual, will not fail to raise their prices. … Those then who will suffer from this dearness… will be first of all the landowners, during the term of their leases, then their domestic servants and all the workmen or fixed wage-earners … All these must diminish their expenditure in proportion to the new consumption.
In other words, the beneficiaries of newly created money spend that money and bid up the price of goods with their higher demand. Those who suffer are those who have to pay newly higher prices but did not benefit from the newly created money.
The credit inflation analog to the Cantillon effect has played out perfectly in recent decades. Central banks provided cheap money to banks, the cheap money artificially inflated asset prices, artificially inflated asset prices made anyone connected to those assets rich as we became a nation of speculators, those riches were achieved at everyone else’s expense, and “everyone else” has now realized what has happened and is understandable enraged. As Keynes explained, “Those to whom the system brings windfalls… are the object of the hatred.”
And now the social debasement is clear for all to see. The 99% blame the 1%, the 1% blame the 47%, the private sector blames the public sector, the public sector returns the sentiment… the young blame the old, everyone blames the rich… yet few question the ideas behind government or central banks.
I’d feel a whole lot better if central banks stopped playing games with money. But I can’t see that happening anytime soon. The ECB has thrown the towel in, following the Swiss National Bank last year in committing effectively to print unlimited amounts of money for the greater good. The Bank of England and the Fed have long since made a virtue of what was once considered a necessity, with what was once the unconventional conventional. As James Bullard told everyone a few weeks before the last Fed meeting, lest there be any doubt: “Markets have this idea that, there’s QE1 and QE2, so QE3 must be the same as those previous ones. It’s not that clear to me that this is the way this is going … it would just be to do balance sheet policy as the exact analogue of interest rate policy.” In other words, the central banks’ balance sheets are the new policy tool. As interest rates embarked on a multi-year decline from the 1980s on, central bank balance sheets are set to embark on a multi-year climb.
So as Nobel Prize winning experts in economics punch the air because inflation expectations have been rising since the policy was announced, “It’s the whole point of the exercise” (Duh!), the Bank of England admits that QE has mainly benefited the rich, but vows to continue anyway.
All I see is more of the same — more money debasement, more unintended consequences and more social disorder. Since I worry that it will be a Great Disorder, I remain very bullish on safe havens.
This essay was originally published on 2 October 2012. It was featured in the 17 October edition of the Edelweiss Journal (Issue 9), and is reproduced here with the author’s permission. Copyright The Societe Generale Group 2012.
“But there is no inflation!” – This is a statement I hear quite often, sometimes from people who are, in principle, sympathetic to my arguments, sometimes from people who are less so. In either case, those who state “but there is no inflation” consider it to be a statement of fact and one that they assume must pose a challenge for me. Should the man who argues that we are heading for the collapse of paper money, for some kind of hyperinflationary endgame, not be concerned that all this money printing by central banks around the world has not led to much higher inflation yet? Do present inflation statistics not provide comfort to those who believe in the practicability and even superiority of central-bank-managed fiat money, and do these statistics not allow them to discard my analysis as paranoid?
The short answer is, no.
The long answer I will provide below.
First of all, there is, of course, inflation, and quite a bit of it. In all major industrial countries official inflation is positive, and in some countries inflation has for years been persistently above the official inflation target (UK, Euro Zone). As I keep saying, the debasement of paper money continues. This is meaningful. Also, this inflation is harmful, even if it is not hyperinflation yet. That this inflation is nothing to worry about, or that it is even beneficial is a complete misconception.
Furthermore, I do expect inflation to get worse, if only marginally at first. Even more importantly, I do think that the risk of an inflationary endgame to our fiat money system has been increasing in recent years and is still increasing today, thanks to present policies and the future policies that seem presently most likely. I will explain this in more detail in a minute. Present inflation rates pose no problem for my analysis and my forecast. To see why, I need to first repeat my key premise.
Inflation in the context of the crisis
Please remember that my key statement in Paper Money Collapse is this: A monetary system like ours, which is a system of entirely elastic, unconstrained fiat money under central bank control, designed to constantly expand the supply of this fiat money so that its purchasing power keeps diminishing (controlled inflation), and that will be used periodically to ‘stimulate’ growth, is not, as the mainstream would have it, a guarantor of economic stability but, to the contrary, suboptimal compared to hard money, inherently unstable and indeed unsustainable. Such a system is fundamentally incompatible with functioning capitalism and a danger to economic stability and prosperity. If taken to its logical conclusion – which is what central banks seem determined to do at present – such a system must end in chaos.
Ongoing monetary expansion must cause the economy to accumulate imbalances over time and these imbalances will be an ever more powerful hindrance to proper growth. As I show in detail in Paper Money Collapse, money injections ALWAYS create dislocations, misallocations of capital, that will have to be liquidated in the future. Such imbalances are now abundant and certainly include excessive levels of debt, overstretched banks and inflated asset prices, i.e. distorted relative prices. As long as the mainstream maintains that ‘easy money’ is a necessary antidote to recession and as long as central banks continue to fight the present crisis with low interest rates and ongoing monetary expansion, these imbalances – that are the root cause of the current malaise and that logically have their origin in previous interludes of ‘necessary monetary stimulus’ – will not be allowed to dissolve or get liquidated but will instead be maintained, and new imbalances will get added to the old ones. The economic system moves further and further away from balance. The crisis is not ended but sustained.
Policy makers claim that without their intervention the crisis would be worse, which only means the liquidation of certain imbalances would now have occurred. Their policies have taken us further away from a proper solution of the crisis and have given us a fleeting but false impression of stability, for which we pay with yet more imbalances.
At this point, one of the reasons for the still ‘moderate’ headline inflation today in spite of the massive monetary stimulus from central banks already becomes apparent: As the imbalances – such as excessive levels of debt, overstretched banks and inflated asset prices – get bigger, the (market) forces that work towards their liquidation become stronger. These forces are deflationary in nature. Sustaining the imbalances – in order to keep the illusion of stability alive – requires ever more aggressive money printing on the part of the central banks, which is what we are seeing around the world today. New ‘base money’ – the type of money that central banks issue and that functions as the monetary system’s raw material – does at the moment not lead to higher headline inflation as quickly as it did in the past. Balance sheets are stretched, overall debt levels are high, and asset markets are distorted – all of this a result of previous monetary expansion. Consequently, banks are reluctant to lend, and the private sector is reluctant to borrow. Ongoing monetary accommodation is blunting its own effectiveness. There are other reasons for the presently still contained headline inflation figure, to which I will come soon.
But remember, in our system of entirely unconstrained fiat money, ever more money can be injected ever faster – and in fact ever more money will have to be injected ever faster for the central banks to keep achieving their near-term policy goals, which are to obstruct any liquidation of capital misallocations and excess debt, and to keep debasing money’s purchasing power. The tipping point – and the trigger for much higher inflation – will be reached when the public loses confidence in this charade. When the public reduces its money balances out of fear of future inflation, money’s velocity will shoot up and inflation will accelerate. Persistent moderate inflation or even slightly accelerating inflation could play a role in taking us to this tipping point. In this respect, current inflation developments are not unimportant. But we have to analyse them in the context of the theory here presented.
For those who have read Paper Money Collapse carefully and fully understood it, none of this is new, and I do apologize for the repetition. But let me stress again, my forecast in recent years has not been that by 2012 or 2013 we will already have much higher inflation or even hyperinflation. Of course, I would not and could not have excluded the possibility that we had much higher inflation or even hyperinflation by now. Nobody can. If and when confidence wanes, the inflation dynamic changes quickly. The system is on thin ice, and central banks are betting every day that this ice will not break. But it was not and still is not my central forecast, at least for the immediate future. My forecast has been and continues to be this, which flows directly from the analysis above: The present super-easy monetary policy does not solve the crisis. This policy does not lead to self-sustaining growth of the kind that would allow central banks to withdraw ‘stimulus’ and normalize interest rates and other policy parameters – something that has been promised in recent years but never happened, nowhere in the world. There is no end to ‘quantitative easing’. It will have to continue forever. QE-policies will even have to be expanded and intensified. There is no ‘exit strategy’. The central banks are digging themselves – and all of us – an ever deeper hole.
These forecasts have been accurate so far and they continue to be my forecast for the future. And here is another forecast: The present measures will over time be seconded with others that in my book I label ‘nationalization of money and credit’, that is, institutional investors will be coerced via legislation and regulation to remain invested in certain asset classes, the war on cash and the war on off-shore will continue and intensify, ultimately we will see capital controls.
Back to inflation
I also expect inflation to remain elevated and even increase over time. Despite the massive imbalances which increasingly clutter the normal transmission mechanisms of easy money, enough of the new money will find its way into the wider monetary aggregates and the wider economy, and this will make sure that our paper money continues to lose purchasing power as is indeed one of the main goals of the central banks. Remember, central banks now de facto fund the public sector through money printing. The central banks are the lenders of last resort and the public sector is the borrower of last resort (the private sector is reluctant, for good reasons, as I explained above). In the US, almost 80 percent of new government debt goes straight to the central bank. The ECB is ready to buy government debt directly, rather than fund European governments indirectly as the ECB has done for years and on a large scale by funding all European banks generously against the collateral of government debt. The Bank of England is, of course, the Queen of QE.
Investors will not accept negative real interest rates forever – not even with the ‘encouragement’ of repression through the state and its agencies – and they will demand higher yields at some point. Again, when the public ‘gets it’, when the public realizes that this charade will have to go on forever and on an ever larger scale, that there is no ‘natural’ end point to this policy of continuous debasement, and that this policy involves ever more fiat money creation and indeed substantial debt accumulation, the public will ditch bonds and paper money. At that point inflation will go up, and it won’t go up just a bit.
Today’s inflation is already harmful
Last week, it was reported that official consumer price inflation in the UK had receded and was now closer, although still above, the Bank of England’s target. One newspaper commented that this was good news for British families, and I fully agree. In particular at difficult times for the economy, when many people are unemployed and have to rely on their savings or on reduced income, it is helpful when stuff gets more expensive at least at a somewhat slower pace, which is what is presently happening in the UK. But would it not even be more helpful if stuff actually got cheaper? What if prices would not rise by about 2.6 percent on average but would fall by 2.6 percent? What if every pound in your pocket got you that much further? Would that not even be better news for the British family?
But ironically, that would be that dreadful deflation that mainstream economists never tire of warning us about. We are constantly told that, although incomes hardly rise and many people have to spend some of their savings to make ends meet, we should still be thanking the central bankers for making sure that our money’s purchasing power keeps dwindling.
It used to be the case that the inflationary boom was followed by the deflationary bust. The tendency for prices to fall in a recession was an important factor in stabilizing things again and doing so quite naturally. Lower prices supported those on lower income, and at some stage lower prices lured those with money on the sidelines back into the economy and back to spending and investing it.
Today, policymakers also try to entice people to spend their money balances by artificially depressing interest rates to zero and by debasing money’s purchasing power. Inflationist policies are, in their view, a tool to encourage spending and investing. Money is supposed to become an unwanted asset. They ignore that what is required to keep lowering money’s purchasing power, namely super-low interest rates and injections of new money, simultaneously props up asset prices artificially and obstructs the deleveraging of the economy. This is a persistent disincentive to invest. Those who have money to spend are reluctant to do as long as asset prices are inflated through easy money and cheap credit. They know, of course, that these are not true market prices. Nobody wants to invest in a manipulated market.
It would undoubtedly be much better to stop printing new money, stop manipulating interest rates and stop debasing money, that is, to end inflationary policies. The market would then go through a much needed cleansing, a liquidation of imbalances. The clear advantage would be that interest rates would reflect the availability of true savings again, and prices would reflect true demand for assets. Prices would be lower but would once again be real market prices. Those with money to spend would feel more comfortable investing their funds. This would truly kick-start the economy.
The beneficiaries of inflationism
But those who defend present inflationist policies maintain we cannot allow the market to trade ‘proper’ prices and certainly not to cleanse anything. Falling prices now would lead to a dreadful debt deflation, a deflationary spiral that would cause substantial collateral damage. I do believe that fears of a deflationary spiral are overblown. As the purchasing power of money increases in a deflation, the opportunity costs of holding wealth in the form of money increase and incentives rise to spend money again. The notion that nobody who expects prices to fall in the future would spend money today is nonsense. It ignores entirely the concept of time preference, and we can see that this is not the case every day in the market for computers or smart phones. These products get cheaper and better every year, yet demand for them is strong and people spend considerable amounts of money on them today.
Allowing the market to correct and to liquidate imbalances and excess debt would not mean the end of borrowing and lending. However, it would certainly hurt those who overreached during the previous boom. Those who borrowed excessively and leveraged their balance sheets too much during the last period of easy money are the ones that would struggle in a deflationary correction, and they are now to be saved by means of a policy of ever easier money. Among them are, importantly, the banks and the states, both are, of course, systematic beneficiaries of the privilege to issue unconstrained fiat money, and both were certainly beneficiaries of the cheap credit boom that led us into this crisis. They are now the chief beneficiaries of the present policy of ongoing inflationism. Those who were most reckless in the boom are to be bailed out with easy money, while those who were prudent, who were not lured by cheap credit into dangerous balance sheet extension and who saved are now the victims of this policy, as present policies prohibit them from buying assets at depressed prices (i.e. true market prices) and in fact secretly confiscate their savings via ongoing money debasement.
Those who defend this policy will argue that collapsing banks and a bankrupt state are also not in the interest of the average British family. That may be so, but it only shows how far all of society has now been contaminated by the consequences of persistently easy money. On some level we have all been made addicts to the crack cocaine of endless cheap cash. But what is the alternative to liquidation? Is it really feasible to declare many prices to be free of the risk of decline and large sections of the economy to be free of the risk of default – regardless of the extent to which these entities issued claims against themselves during the good times? How much money do we have to print to make this anti-capitalist fantasy come true?
The fact that this policy has a targeted group of beneficiaries is also one of the reasons why inflation is not higher yet. Central banks create base money, that is, deposit money that sits on account at the central bank. This money functions as bank reserves. Since 2008, central banks around the world have flooded their banking systems with such bank reserves but this has not led to a similar expansion in broader monetary aggregates (although it has certainly encouraged further expansion of wider aggregates and is thus responsible for ongoing, harmful inflation, just not on the scale that the massive expansion of base money would normally suggest). As I said, a lot of this is due to the vast imbalances: banks are too scared to lend (and rather hold excess reserves) and the private sector too scared to borrow – and for good reason as pretty much all prices around us are distorted. However, the central banks have not really targeted the wider aggregates, yet. The US Federal Reserves even pays the banks interest on their risk-fee deposits at the Fed. It thus encourages them to keep excess reserves and not increase lending.
Remember, QE1 was designed to save the banks. The Fed gave the banks more than $1 trillion in new reserves and did so by taking one of the most toxic asset classes off their balance sheets in exchange for the new cash: mortgages. QE2 was designed to manipulate asset prices as Bernanke admitted here. Again, the main objective was not to have banks go out and create vast amounts of new deposit money via fractional-reserve banking and thus give a stronger boost to M2 (and to inflation) but to prop up the prices of ‘risk assets’.
But the economy has not entered a self-sustained recovery thanks to these measures – Surprise! Surprise! Of course, it has not. I explained this in detail above. These policies are simply geared towards avoiding the much-needed liquidation of imbalances. But QE3 is already an indication that patience with the pseudo-recovery among policymakers is running out. QE3 is, more than its predecessors, targeted at ‘lowering unemployment’ or ‘boosting aggregate demand’.
The newspapers are now full of ever more harebrained schemes of how to push more newly printed fiat money down the throat of the economy. Here are some more predictions from me:
Pretty soon, the Fed will stop paying interest on bank reserves. Interest rates will be taken to zero everywhere. We will, at some point, see negative interest rates everywhere. Cash holdings will ultimately get taxed. ‘Hoarders’ of cash will face the death penalty. (As to the last point, I am only half joking.)
I conclude: Still contained inflation readings at present are no reason to relax. It is no surprise that at the current stage of the crisis CPI inflation is not higher. More importantly, there is no reason to assume that present policy is without consequences. Present policy is making it ever more difficult to stop printing fiat money in the future, or to even stop accelerating the creation of fiat money in the future. That is why, if we keep pursuing current policies, we are heading towards paper money collapse. Present inflation readings do not change that.
If you are still wondering when inflation will go up, the answer is: when more people realize where policymakers are taking us.
This will end badly.
This article was previously published at DetlevSchlichter.com.
UK Chancellor George Osborne and Bank of England Governor Mervin King last week announced another round of fiscal and monetary stimulus measures, including steps to ease the funding for banks and allow them to extend more loans.
If these measures were hoped to instil confidence they must be classified as a failure. We have lived through quite a few years of unprecedented and fairly persistent monetary accommodation and occasional rounds of QE by now, and I doubt that yet another dose of the same medicine will cause great excitement. Furthermore, observers must get confused as to what our most pressing problems really are. Have we not had a real banking crisis in the UK in 2008 because banks were over-extended and in desperate need of balance sheet repair? Is a period of deleveraging and a rebuilding of capital ratios not urgently required and unavoidable? Let’s not forget that the government is still a majority-owner of RBS and holds a large chunk of Lloyds-TSB. If banks are still on life-support from the taxpayer and the central bank, is it wise to already prod them to expand their balance sheets again and create more credit to ‘stimulate’ growth?
The same confusion exists on fiscal policy. Is the Greece crisis not a stark warning to all other sovereign borrowers out there, which are equally and without exception on a slippery slope toward fiscal Armageddon, that it is high time for drastic reduction in spending and fundamental fiscal reform? If the Bank of England or the government assume any of the risk of the latest additional credit measures, then the taxpayer is on the hook.
None of this will instil confidence, not in the economy and not in the banks, and certainly not in politics. UK newspaper ‘The Independent’ headlined: “King pushes the panic button”, which I consider a pretty apt description.
Banks are parastatal dinosaurs
One thing is now clear to even the most casual observer: banks are not capitalist businesses. In their present incarnation they have little to do with the free market and no place in it. They are constantly oscillating between two positions: One moment, they are a state protectorate, in desperate need of support from the state printing press or unlimited taxpayer funds, as, in the absence of such support, we are supposedly faced with the dreaded social fallout of complete financial collapse; the next moment they are a convenient tool for state policy, simply to be fed with ample bank reserves and enticed with low interest rates to create yet more cheap credit and help manufacture some artificial growth spurt. Either the banks are the permanent welfare queens of the fiat money systems, or convenient policy levers for the macro-economic central planners. In any case, capitalist businesses look different.
Central banks and modern fiat money banks are quite simply a blot on the capitalist system. In order for capitalism to operate smoothly they will ultimately have to be removed. I believe that the underlying logic of capitalism will work in that direction. Personally, I believe that trying to ‘reform’ the present system is a waste of time and energy. It is particularly unbecoming for libertarians as they run the risk of getting infected with the strains of statism that run through the system. Let’s replace this system with something better. With a market-based monetary system.
When and how exactly the present system will end, nobody can say. I believe we are in the final inning. Around the world, all major central banks have now established zero or near-zero interest rates and are using their own balance sheets in a desperate attempt to avoid their highly geared banking systems from contracting or potentially collapsing. If you think that this is all just temporary and that it will be smoothly unwound when the economy finally ‘recovers’, then you are probably on some strong medication, or have been listening for too long to the mainstream economists who are, in the majority, happy to function as apologists for the present system.
I still believe that chances are we will, at some point, get the full throttle, foot-on-the pedal monetary overkill, the ultimate uber-QE that will push the system over the edge. This will be the moment when central bankers discover – and discover the hard way – that their ability to print their fiat money may well be unlimited but that the public’s confidence in this fiat money certainly is not. The whole system will blow up in some hyperinflationary fireball, which has been the end of most previous experiments with complete fiat money systems, all others having ended with a voluntary return to commodity money before the public had lost complete faith in the system. And the prospect for a voluntary and official return to a gold standard seems slim at present. However, this is not the topic of this essay.
The future of money
I am often asked what will come next after the present system collapsed? Will we have to go back to barter? – No. Obviously, a modern capitalist economy needs a functioning monetary system. My hope is that from the ashes of the current system a new monetary system arises that is entirely private and not run by states – and that does not have the unholy state-bank alliance at its core, an alliance that exists in opposition to everything that the free market stands for. Nobody can say what this new system will look like precisely. Its shape and features will ultimately be decided by the market. In this field, as in others, there are few limits to human inventiveness and ingenuity. But we can already make a few conceptual points about such a system, and we should contemplate working on such a system now while the old system is in its death throes.
A private gold ‘standard’…
Free market monetary systems, in which the supply of money is outside political control, are likely to be systems in which money proper is a commodity of limited and fairly inelastic supply. It seems improbable that a completely free market would grant any private entity the right to produce (paper or electronic) money at will and without limit. The present system is unusual in this respect and it is evidently not a free market solution. Neither is it sustainable.
The obvious candidates are gold and silver, which have functioned as money for thousands of years. We could envision a modern system at whose centre are private companies that offer gold and silver storage, probably in a variety of jurisdictions (Zurich, London, Hong Kong, Vancouver). Around this core of stored monetary metal a financial system is built that uses the latest information and payment technology to facilitate the easy, secure and cheap transfer of ownership in this base money between whoever chooses to participate in this system (Yes, there would be credit cards and wire transfers, and internet or mobile phone payments. There would, however, be no FOMC meetings, no Bank of England governor writing letters to the Chancellor, and no monetary policy!).
Are these gold and silver storage companies banks? — Well, they could become banks. In fact, this is how our present banking system started out. But there are important differences about which I will say a few things later. In any case this would be hard, international, private and apolitical money. This would be capitalist money.
Another solution would be private virtual money, such as Bitcoin.
Bitcoin is immaterial money, internet money. It is software.
Bitcoin can be thought of as a cryptographic commodity. Individual Bitcoins can be created through a process that is called ‘mining’. It involves considerable computing power, and the complex algorithm at the core of Bitcoin makes the creation of additional Bitcons more difficult (and thus more expensive) the more Bitcoins are already in existence. The overall supply of Bitcoins is limited to 21 million units. Again, this is fixed by the algorithm at the core of it, which cannot be altered.
Thus, creating Bitcoin money is entirely private but not costless and not unlimited. Most people will, of course, never ‘mine’ Bitcoins, just as under the gold standard most people didn’t mine gold. People will acquire Bitcoins through trade, by exchanging goods and services for Bitcoins, then using the Bitcoins for other transactions.
Bitcoin is hard money. Its supply is inelastic and not under the control of any issuing authority. It is international and truly capitalist ‘money’ – of course this assumes that the public is willing to use it as money.
There are naturally a number of questions surrounding Bitcoin that cannot be covered in this essay: is it safe? Can the algorithm be changed or corrupted and Bitcoins thus be counterfeited? Are the virtual “wallets” in which the Bitcoins are stored safe? – These are questions for the computer security expert or cryptographer, and I am neither. My argument is conceptual. My goal is not to analyze Bitcoin as such but to speculate on the consequences of a virtual commodity currency, which I consider feasible in principle, and I simply assume – for the sake of the argument – that Bitcoin is already the solution. Whether that is indeed the case, I cannot say. And it is – again – for the market to decide.
There is one question for the economist, however: could Bitcoin become widely accepted as money? Would this not contradict Mises’ regression theorem, which states that no form of money can come into existence as a ready medium of exchange; that whatever the monetary substance (or non-substance), it must have had some other commodity-use prior to its first use as money. My counterargument here is the following: the analogy is to the banknote, which started life not as a commodity but as a payment device, i.e. a claim on money proper which was gold or silver at the time. Banknotes were initially used as a more convenient way to transfer ownership in gold or silver. Once banknotes circulated widely and were generally accepted as media of exchange in trade, the gold-backing could be dropped and banknotes still circulated as money. They had become money in their own right.
Similarly, Bitcoin can be thought of, initially, as payment technology, as a cheap and convenient device to transfer ownership in state paper money. (Bitcoins can presently be exchanged for paper money at various exchanges.) But as the supply of Bitcoins is restricted while the supply of state paper money constantly expands, the exchange-value of Bitcoins is bound to go up. And at some stage, Bitcoin could begin to trade as money proper.
A monetary system built on hard, international and apolitical money, whether in the form of a private gold system or Bitcoin, would be a truly capitalist system, a system that facilitates the free and voluntary exchange between private individuals and corporations within and across borders, a system that is stable and outside of political control. It would have many advantages for the money user but there would be little role for present-day banks, which goes to show to what extent banks have become a creature of the present state-fiat money system and all its inconsistencies.
Banks profit from money creation
Banks conduct fractional-reserve banking (FRB), which means they take deposits that are supposed to be safe and liquid and therefore pay the depositor little interest, and use them to fund loans that are illiquid and risky and thus pay the bank high interest. Through the process of fractional-reserve banking, banks expand the supply of money in the economy; they become money producers, which is, of course, profitable. Many mainstream economists welcome FRB as a way to expand money and credit and ‘stimulate’ extra growth but as the Currency School in Britain in the 19th century and in particular the Austrian School under Mises and Hayek in the early 20th century have argued convincingly (and as I explain in detail in Paper Money Collapse) this process is not only risky for the individual banks, it is destabilizing for the overall economy. It must cause boom-bust cycles.
It cannot be excluded that banks could conduct FRB even on the basis of a private system of gold-money or Bitcoin. However, in the absence of a backstop by way of a central bank that functions as a lender-of-last resort, the scope for FRB would be very limited indeed. It would be too dangerous for banks to lower their reserve ratios (at least to fairly low levels) as that would increase the risk of a bank-run.
I am sometimes told that I am too critical of the central banks and the state, and that I should direct my ire toward the ‘greedy’ ‘private’ banks, for it is the ‘private’ banks that create all the money out there through FRB. Of course they do. But FRB is only possible on the scale it has been conducted over recent decades because the banks are supported – and even actively encouraged – in their FRB activities by a lender-of-last resort central bank, in particular as the central bank today has full and unlimited control over fiat money bank reserves. Under a system of hard money (gold or Bitcoin), even if the banks themselves started their own lender-of-last resort central bank, that entity could not create more gold reserves or Bitcoin reserves and thus provide unlimited support to the banks.
FRB is particularly unlikely to develop in a Bitcoin economy, as there is no need for a depository, for safe-keeping and storage services, and for any services that involve the transfer of the monetary system’s raw material (be it gold or state paper tickets) into other, more convenient forms of media of exchange, such as electronic money that can facilitate transactions over great distances. The owner of Bitcoin has an account that is similar to his email account. He manages it himself and he stores his Bitcoin himself. And Bitcoin is money that is already readily usable for any transaction, anywhere in the world, simply via the internet. The bank as intermediary is being bypassed. The Bitcoin user takes direct control of his money. He can access his Bitcoins everywhere, simply via the SIM card in his smartphone.
The tremendous growth in FRB was made possible by the difficulty of transacting securely over long distances with physical gold or physical paper tickets. This created a powerful incentive to place the physical money with banks, and once the physical money was in the banks it became ‘reserves’ to be used for the creation of additional monetary assets.
Channelling true savings into investment is very important, but remember that FRB is something entirely different. It involves the creation of money and credit without any real, voluntary saving to back it. FRB is not only not needed, it is destabilizing for the overall economy. Under gold standard conditions, it created business cycles. Under the system of unlimited fiat money and lender-of-last-resort central banks, it created the super-cycle, which is now in its painful endgame.
Banks make money from payment systems
When I recently made arrangements for a trip to Africa I dealt directly with local tour operators there, which, today, can be done easily and cheaply with the help of email, websites, and Skype. Yet, when it came to paying the African tour operators I had to go through a process that has not changed much from the 1950s. Not only were British and African banks involved, but also correspondence banks in New York. This took time and, of course, cost money in form of additional fees.
Imagine if we could have used gold or Bitcoin! The payment would have been as easy and fast as all the email-communication that preceded it. There would have been no exchange rates and little fees (maybe in the case of gold) or no fees (in the case of Bitcoin).
Another example: Last year I gave a webinar at the Ludwig von Mises Institute (LvMI). The LvMI is located in Auburn, Alabama, I did the seminar from my home in London, the LvMI’s technology officer sat in Taiwan, and the seminar attendants were spread all over the world. All of this is now possible – cheaply, quickly and conveniently – thanks to technology. Yet, when the LvMI paid me a fee it had to go through a few banks – again, correspondence banks in New York – it took quite some time and it incurred additional costs. And the fee from LvMI was paid in a currency that I cannot use directly in my home country.
Banks make money from monetary nationalism
Future economic historians will pity us for having worked under a strange and inefficient global patchwork of local paper currencies – and for having naively believed that this represented the pinnacle of modern capitalism. Today, every government wants to have its own local paper money and its own local central bank, and run its own monetary policy (of course, on the basis of perfectly elastic local fiat money). This is naturally a great impediment to international trade and the free flow of capital.
If I want to spend the money I got from the LvMI where I live (in Britain), I have to exchange the LvMI’s dollars for pounds. I can only do that if I find someone who is willing to take the opposite side of that transaction, someone who is willing to sell pounds for dollars. The existence of numerous monies necessarily re-introduces an element of partial barter into money-based commerce. Sure, the 24-hour, multi-trillion-dollar a day fx market can accommodate me, and do so quickly and cheaply, but this market is only a second-best solution, a highly developed make-shift to cope as best as possible with the inefficiencies of monetary nationalism. The better, most efficient and capitalist solution would be to use the same medium of exchange around the world. The gold standard was a much superior monetary system in this respect. Moving from the international gold standard to a system of a multitude of state-managed paper currencies meant economic regression, not progress.
One hundred years ago, you could take the train from London to Moscow and use the same gold coins all along the way for payment. There was no need to change your money even once. (Incidentally, neither did you need a passport!)
The notion of the ‘national economy’ that needs a ‘national currency’ was always a fiction. So was the idea that economies work better if money, interest rates and exchange rates are carefully manipulated by local bureaucrats. (This fiction is still spread by many economists who make a living off this system.) The biggest problem with monetary policy is that there is such a thing as monetary policy. But in today’s increasingly globalized world, these fictions are entirely untenable. Capitalism transcends borders, and what it needs to flourish is simply hard, apolitical and thus international money. Money that is a proper tool for voluntary human interaction and cooperation and not a tool for politics.
Banks benefit from the present monetary segregation. They profit from constantly exchanging one paper money for another and from foreign exchange trading. Non-financial companies that operate internationally are inevitably forced to speculate in currency markets or to pay for expensive hedging strategies (again paying the banks for providing them).
Banks make money from speculation
There is, of course, nothing wrong with speculation in a free market. However, in a truly free market there would be few opportunities for speculation. Today the heavy involvement of the state in financial markets, the existence of numerous paper currencies, all managed for domestic political purposes, and the constant volatility that is generated by monetary and fiscal policy create outsized opportunities for speculation. Additionally, the easy money that central banks provide so generously to prop up their over-extended FRB-industry is used by many banks to speculate in financial assets themselves, often by anticipating and front-running the next move of the monetary authorities with which these banks have such close relationships. And to a considerable degree, banks pass the cheap money from the central banks on to their hedge fund clients.
Remember that immediately after the Lehman collapse, investment banks Goldman Sachs and Morgan Stanley, which previously had shunned deposit and retail banking but have always been heavily involved in securities trading, quickly obtained banking licenses in order to benefit from the safety-net the state provides its own fiat-money-deposit banks.
Banks channel savings into investment
Yes, to some degree they still do this, and this is indeed an important function of financial intermediaries. However, asset managers can do the same thing, and they do it without mixing this services with FRB and money-creation. In general, the asset management industry is much more transparent about how it allocates its clients’ assets, it has a clear fiduciary responsibility for these assets, and it cannot use them as ‘reserves’. In the gold or Bitcoin economy of the future, you will, of course, be free to allocate some of your money to asset managers who mange investments for you.
Have I been too harsh on the banks? – Maybe. The bankers, in their defence, will say that they are not the source of all these inefficiencies, that they simply help their clients deal with the inefficiencies of a state-designed and politicized monetary system – and that they reap legitimate rewards for the help they provide. – Fair enough. To some degree that may be true. But it is very clear that the size, the business models, the sources of profitability, and the problems of modern banks are uniquely and intimately linked to the present, fully elastic paper money system. As I tried to show, even if the paper money system was meant to last – and it certainly is not – the forces of capitalism, the constant search for better, more efficient and durable solutions, coupled with technological progress, would put enormous market pressures on the present banking industry in the years to come. But given that our present system is not the outcome of market forces to begin with, that a system of fully elastic, local state monies is not necessary, that it is suboptimal, inefficient, unstable, and unsustainable, and that it is already in its endgame, I have little doubt that modern banks will go the way of the dodo. They are to the next few decades what the steel and coal industries were to the decades from 1960 to 1990. They are parastatal dinosaurs, joined at the hip with the bureaucracy and politics, bloated and dependent on cheap money and state subsidy for survival. They are ripe for the taking.
The demise of the paper money system will offer great opportunities for a new breed of money entrepreneurs. In that role, I could see gold storage companies, payment technology companies, Bitcoin service providers and asset management companies. If some of these join forces, the opportunities should be great. The world is ready for an alternative monetary system, and when the present system collapses under the weight of its own inconsistencies, there would be something there to take its place.
The present fiat money economy is ripe for some Schumpeterian ‘creative destruction’.
In the meantime, the debasement of paper money continues.
This article was previously published at Paper Money Collapse.
The reason we accept paper money as a store of value is habit. This habit has its origins in history, when banks took our gold as deposit and issued paper receipts for it. The gold has gone, but the paper with its habitual value remains, and we accept it without question. The only backing is a vague government promise.
There is no sound theoretical basis for why unbacked government-issued money should retain a store of value: it depends for its value on a market-based acceptance of financial credibility. So it follows that if a government loses all financial credibility in markets, its paper becomes worthless. This is confirmed by experience in all paper money collapses.
The fact it can and has happened elsewhere confirms that all faith can theoretically disappear from the dollar, pound, euro or yen. This is a very different understanding about currency values compared with what is commonly accepted. Instead, we assume that any change in purchasing power is tied firmly to price inflation, and we factor out any reliance upon faith. But this is a cop-out, a way of not addressing the basic assumptions that uplift the value of government-issued money from zero to what it will actually purchase.
It is vital to understand that price inflation and maintenance of fiat currency premiums are only loosely related. In a sound money economy, an economy where the medium of exchange is backed by gold, changes in the available quantity of money will affect the prices of goods and services exchanged for it. This is because sound money is itself a commodity, whose function happens to be to act as a medium of exchange. However, you cannot say this of fiat money, where the link with value is based entirely on faith. It is a mistake to assume that supply and demand factors that give sound money its value as a means of exchange also apply to unbacked government money. The value of fiat currencies is purely subjective.
In the case of fiat money, additional quantities in circulation increases demand for goods, whose prices rise driven by this extra demand: the rise in prices comes from the goods themselves, and not a change in the value of the money. In stagflation, where there is no extra demand, price rises emanate from changing values in the paper money itself, usually tied to foreign exchange movements.
The implications are profound. To state that in hyperinflations fiat money loses purchasing power because of massive issuance of money is a misunderstanding. The collapse in purchasing power is due to loss of faith in fiat money, and not from its extra supply: if it was otherwise, you would have to establish it had an objective value in the first place.
It is entirely possible, even increasingly likely in these times of growing systemic risk, that a collapse of paper-money values will happen not as a result of rising consumer prices, but of its own subjective value. If this happens there will be little or no warning and it could be substantial if not total.
So the argument in favour of a flight into sound money, best exemplified by precious metals, is getting stronger by the day.
This article was previously published at GoldMoney.com.
“Under the circumstances, discussions with Greece and the official sector are paused for reflection on the benefits of a voluntary approach.” Debt talks “have not produced a constructive response.”
- The Institute of International Finance, January 13 2012.
“The war situation has developed not necessarily to Japan’s advantage..”
- Japanese Emperor Hirohito after the atomic bombing of Hiroshima and Nagasaki, announcing Japan’s surrender to the Allies.
There is a terrible hubris at the heart of mankind. Like every other living thing on the planet we are products of nature, but we consider ourselves to be well above it. We are beset by regular reminders of our vulnerability, but quickly dismiss them off-handedly to a spiritual plane, calling them ‘acts of God’ as if to show that we could never have prevented them. In a significant essay for Foreign Affairs, ‘The Black Swan of Cairo’ (PDF), Nassim Taleb shows how the efforts of our authorities to suppress volatility actually end up making the world less predictable and more dangerous:
Although the stated intention of political leaders and economic policymakers is to stabilize the system by inhibiting fluctuations, the result tends to be the opposite. These artificially constrained systems become prone to “Black Swans” – that is, they become extremely vulnerable to large- scale events that lie far from the statistical norm and were largely unpredictable to a given set of observers.
There is an analogy from the natural world. In the 1960s and 1970s, mid-western American states fell victim to scores of wildfires. Constant interventions by the US Forest Service appeared to have little positive impact – if anything, the problems seemed to worsen. Over time, foresters came to appreciate that fires were a normal and healthy element of the forest ecosystem. By continually suppressing small fires, they were unwittingly creating the conditions for larger and less containable wildfires in the future. Naturally occurring fires are necessary to remove old forest cover, underbrush and debris. If they are suppressed, the inevitable fire to come has a far greater store of latent fuel at its disposal.
Economist Murray Rothbard jangled the sensibilities of the Keynesians when he wrote his classic study, ‘America’s Great Depression’:
If government wishes to see a depression ended as quickly as possible, and the economy returned to normal prosperity, what course should it adopt ? The first and clearest injunction is: don’t interfere with the market’s adjustment process. The more the government intervenes to delay the market’s adjustment, the longer and more gruelling the depression will be, and the more difficult will be the road to complete recovery.
But politicians must be seen to be doing something – like encouraging the construction of a £33 billion white elephant rail link in the middle of an austerity recession.
Not interfering with the market’s adjustment process is simply allowing Schumpeterian ‘creative destruction’ to operate, and cleanse the forest. But that process is anathema to well-compensated entrenched interests that suckle from the teat of the State. Banks, for example. So while ‘laissez faire’ would accelerate any banking crisis and shorten the resultant economic contraction, it would reveal the identity of too many naked swimmers when the tide retreats. Instead, courtesy of highly paid lobbyists, we get a long drawn out depression. The example of Japan’s zombie banks from the 1990s is still fresh, but ignored in the west.
Rothbard identified the ways in which government can hobble the adjustment process:
- Prevent or delay liquidation. Lend money to shaky businesses, call on banks to lend further.
- Inflate further. Further inflation blocks the necessary fall in prices, thus delaying adjustment and prolonging depression. Further credit expansion creates more malinvestments which, in their turn, will have to be liquidated in some later depression. A government’s “easy money” policy prevents the market’s return to the necessary high interest rates.
- Keep wage rates up.
- Keep prices up.
- Stimulate consumption and discourage saving. More saving and less consumption would speed recovery; more consumption and less saving aggravate the shortage of saved capital even further.
- Subsidize unemployment. Any subsidization of unemployment (via unemployment “insurance”, relief, etc.) will prolong unemployment indefinitely, and delay the shift of workers to the fields where jobs are available.
An iatrogenic illness is one caused by the doctor himself. The economies of the west now face policy measures of the sort highlighted by Rothbard that are stated to be in our interests, but which are more likely to do harm to the patient and prolong the recession.
Taleb uses the example of the turkey before Thanksgiving. The turkey is fed for 1,000 days and every days seems to reaffirm the farmer’s generosity of spirit. Until the last day, when the turkey’s confidence and contentment is at its maximum. The “turkey problem” occurs when “a naive analysis of stability is derived from the absence of past variations”. To put it another way, the US property market cannot decline because it hasn’t declined in living memory. As Taleb puts it, as humans we inhabit two systems simultaneously: the linear and the complex. The linear is predictable and permits the use of mathematical tools of high predictive value. Complex systems, on the other hand, are marked by an absence of visible causal links between their elements, “masking a high degree of interdependence and extremely low predictability”. They also incorporate non-linear elements often called “tipping points”. One reason for the severity of the financial crisis, and the losses incurred by banks, is that bankers and financial analysts were using linear tools in a non-linear, highly complex environment otherwise known as the financial markets. The models didn’t work.
The problem we face now as investors will end up being existential for some banking institutions and sovereigns. Our (uncontentious) core thesis is that throughout the west, more debt has been accumulated over the past four decades than can ever be paid back. The question, effectively to be determined on a case-by-case basis, is whether bondholders are handed outright default (which looks increasingly like the case to come in Greece) or whether the authorities, in their understandable but misguided attempts to keep the show on the road, resort to a policy of inflation that could at some point easily spiral out of control. As Rothbard wrote,
The longer the inflationary boom continues, the more painful and severe will be the necessary adjustment process.. the boom cannot continue indefinitely, because eventually the public awakens to the governmental policy of permanent inflation, and flees from money into goods, making its purchases while [the currency] is worth more than it will be in future. The result will be a “runaway” or hyperinflation, so familiar to history, and particularly to the modern world. Hyperinflation, on any count, is far worse than any depression: it destroys the currency – the lifeblood of the economy; it ruins and shatters the middle class and all “fixed income groups”; it wreaks havoc unbounded.. To avoid such a calamity, then, credit expansion must stop sometime, and this will bring a depression into being.
It may be a new year, but we are beset by the same problems that have been recurring since the crisis began. In most cases, those problems have worsened. One of the few improvements has been in the recapitalisation of Anglo-Saxon banks, but continental European banks seem acutely vulnerable to the potential outcome of a disorderly sovereign default. Since the problems are the same, so are our preferred solutions: a specific focus on only the most creditworthy sovereign and quasi-sovereign debt (where it offers a positive real return); a specific focus on only the most defensive and internationally diversified equities; genuinely uncorrelated investments; and exposure to objectively the highest quality currencies, namely precious metals.
Euro zone politicians and policy makers have had plenty of time to come to terms with the continent’s problems, and continue to show no willingness to grasp admittedly difficult nettles. It is symptomatic of the balkanised and adversarial nature of politics in the euro zone (a unified body that exists in theory but barely in fact) that Christian Noyer, chairman of the French central bank, anticipated France’s credit downgrade by suggesting that Britain should be downgraded first. As the Hildebrand scandal also revealed, most of Europe’s central bankers are not fit to sweep the streets. And still time is running out. Readers of a certain age will recall a late 1980s ‘big hair’ rock anthem called ‘The Final Countdown’. It was released by essentially a one-hit wonder band. Its name was Europe.
This article was previously published at The price of everything.
I recently posted an article for GoldMoney showing how US True Money Supply (TMS) appeared to be growing at a hyperbolic rate, and that gold was also on a hyperbolic course. The difference between hyperbolic and exponential is a hyperbola’s rate of growth increases with time, while exponential growth does not. Hyperbolic growth in the quantity of money ends with hyperinflation, while exponential growth can go on for ever. Both TMS and the dollar price of gold are pointing to a hyperinflationary outcome. This article explains why this might be so.
There are five apocalyptic engines pushing the growth in US money supply: they are the government’s budget deficit, its debt trap, the financial condition of the banks, the delusion of Keynesian solutions, and lastly simple compounding arithmetic.
- The US government collects only 55c in taxes for every dollar spent. It is relying on economic recovery to reduce welfare payments and increase tax revenue to close the gap. This prospect is receding and establishment economists advise against cutting government spending.
- The US government’s debt trap is concealed by the exceptionally low interest cost of funding. The only reason this cost is not higher is the Fed maintains a zero interest rate policy. However, as surely as night follows day, price inflation will start rising as monetary inflation feeds through, forcing the Fed to allow interest rates to rise long before any economic recovery occurs. The rise in interest costs will escalate the budget deficit, which will be financed, directly or indirectly by further monetary expansion.
- The banks’ balance sheets are considerably weaker than stated, because of unrealised losses on assets, loan collateral and write-downs on their own debt. Real estate collateral write-downs alone probably exceed bank equity of $1,400bn. On an honest analysis the US commercial banks are collectively bankrupt. To simply survive the banks have no alternative other than to reduce loan exposure while requiring continuing monetary support from the Fed.
- Keynesian economists, aware of the banks’ difficulties are terrified of bank credit contraction. For this reason, the macroeconomic establishment strongly promotes the expansion of narrow money to buy off a deflationary depression.
- As the purchasing power of the dollar falls, the result of past monetary expansion, yet more dollars have to be issued to cover increased government costs. Past inflation becomes a compounding factor behind price rises.
Essentially, money will be printed at an accelerating rate to buy time rather than face the three realities of government default, an over-indebted private sector, and a bankrupt banking system. The Keynesians are belatedly aware of the dangers and see no alternative to printing as much money as is required to defer these problems. The monetarists in the central banks are hesitant, torn between Keynesian fears of outright deflation and worries about the rate of monetary expansion so far.
However, the history of monetary inflation confirms that once it enters a hyperbolic phase, it is almost impossible to stop. Armchair critics have derided the stupidity of central banks and economists in past hyperinflations, such as in Weimar Germany, Argentina and Zimbabwe. The truth is that when hyperinflation has become visible at the price level, it has already gone past the point of no return at the monetary level.
This article was previously published at GoldMoney.com.