A specter is haunting the world, the specter of two percent inflationism. Whether pronounced by the U.S. Federal Reserve or the European Central Bank, or from the Bank of Japan, many monetary central planners have declared their determination to impose a certain minimum of rising prices on their societies and economies.
One of the oldest of economic fallacies continues to dominate and guide the thinking of monetary policy makers: that printing money is the magic elixir for the creating of sustainable prosperity.
In the eyes of those with their hands on the handle of the monetary printing press the economic system is like a balloon that, if not “fully inflated” at a desired level of output and employment, should be simply “pumped up” with the hot air of monetary “stimulus.”
The Fallacy of Keynesian Macro-Aggregates
The fallacy is the continuing legacy of the British economist, John Maynard Keynes, and his conception of “aggregate demand failures.” Keynes argued that the economy should be looked at in terms of series of macroeconomic aggregates: total demand for all output as a whole, total supply of all resources and goods as a whole, and the average general levels of all prices and wages for goods and services and resources potentially bought and sold on the overall market.
If at the prevailing general level of wages, there is not enough “aggregate demand” for output as a whole to profitably employ all those interested and willing to work, then it is the task of the government and its central bank to assure that sufficient money spending is injected into the economy. The idea being that at rising prices for final goods and services relative to the general wage level, it again becomes profitable for businesses employ the unemployed until “full employment” is restored.
Over the decades since Keynes first formulated this idea in his 1936 book, The General Theory of Employment, Interest, and Money, both his supporters and apparent critics have revised and reformulated parts of his argument and assumptions. But the general macro-aggregate framework and worldview used by economists in the context of which problems of less than full employment continue to be analyzed, nonetheless, still tends to focus on and formulate government policy in terms of the levels of and changes in output and employment for the economy as a whole.
In fact, however, there are no such things as “aggregate demand,” or “aggregate supply,” or output and employment “as a whole.” These are statistical creations constructed by economists and statisticians, out of what really exists: the demands and supplies of multitudes of individual and distinct goods and services produced, and bought and sold on the various distinct markets that comprise the economic system of society.
The Market’s Many Demands and Supplies
There are specific consumer demands for different kinds and types of hats, shoes, shirts, reading glasses, apples, and books or movies. But none of us just demands “output,” any more than there is just a creation of “employment.”
When we go into the marketplace we are interested in buying the specific goods and services for which we have particular and distinct demands. And businessmen and entrepreneurs find it profitable to hire and employ particular workers with specific skills to assist in the manufacture, production, marketing and sale of the distinct goods that we as individual consumers are interested in purchasing.
In turn, each of these individual and distinct goods and services has its own particular price in the market place, established by the interaction of the individual demanders with the individual suppliers offering them for sale.
The profitable opportunities to bring desired goods to market results in the demand for different resources and raw materials, specific types of machinery and equipment, and different categories of skilled and lesser skilled individual workers to participate in the production processes that bring those desired goods into existence.
The interactions between the individual businessmen and the individual suppliers of these factors of production generate the prices for their purchase, hire or employment on, again, multitudes of individual markets in the economic system.
The “macro” economist and his statistician collaborator then proceed to add up, sum and averages all these different individual outputs, employments and specific prices and wages into a series of economy-wide measured aggregates.
But it should be fairly clear that in doing so all the real economic relationships in the market, the actual structure of relative prices and wages, and all the multitude of distinct and interconnected patterns of actual demands and supplies are submerged and lost in the macro-economic aggregates and totals.
Balanced Markets Assure Full Employment
Balanced production and sustainable employments in the economy as a whole clearly requires coordination and balance between the demands and supplies of all the particular goods and services in each of the specific markets on which they are bought and sold. And parallel to this there must be comparable coordination and balance between the businessmen’s demands for resources, capital equipment and different types of labor in each production sector of the market and those supplying them.
Such coordination, balance, and sustainable employment requires adaptation to the every-changing circumstance of market conditions through adjustment of prices and wages, and to shifts in supplies and demands in and between the various parts and sectors of the economy.
In other words, it is these rightly balanced and coordinated patterns between supplies and demands and their accompanying structures of relative prices and wages that assure “full employment” and efficient and effective use of available resources and capital, so entrepreneurs and businessmen are constantly and continuously tending to produce the goods we, the consumers, want and desire, and at prices that are covering competitive costs of production.
All this is lost from view when reduced to that handful of macro-aggregates of “total demand” and “total supply” and a statistical average price level for all goods relative to a statistical average wage level for all workers in the economy.
The Keynesian Government “Big Spender”
In this simplified and, indeed, simplistic view Keynesian-type view of things all that needs to be done from the government’s policy perspective is to run budget deficits or create money through the banking system to push up “aggregate demand” to assure a targeted rise in the general price level so profit-margins “in general” are widened relative to the general wage level so employment “in general” will be expanded.
We can think of government as a “big spender” who comes into a town and proceeds to increase “aggregate demand” in this community by buying goods. Prices for final output rise, profit margins are widened relative to the general wage level and other general cost-prices. Private businesses, in general, employ more workers, purchase or hire other inputs, and “aggregate supply” expands to a point of desired “full employment.”
The presumption on the part of the center bankers in targeting a rate of an average annual price inflation of two percent is that while selling prices are to be pushed up at this average annual rate through monetary expansion, the average level of cost prices (including money wages in general) will not rise or not by the same percentage increase as the average increase in the “price level.”
If cost prices in general (including money wages) were to rise at the same rate as the price level, there would be no margin of additional profits to stimulate greater aggregate output and employment.
Market Anticipations Undermine Keynes’ Assumptions
The fallacy in thinking that cost-prices in general will permanently lag behind the rate of increase in the price level of final goods and services was pointed out long ago, in 1898, by the famous Swedish economist, Knut Wicksell:
“If a gradual rise in prices, in accordance with an approximately known schedule, could be reckoned on with certainty, it would be taken into account in all current business contracts; with the result that its supposed beneficial influence would necessarily be reduced to a minimum.
“Those people who prefer a continually upward moving to a stationary price level forcibly remind one of those who purposely keep their watches a little fast so as to be more certain of catching their train. But to achieve their purpose they must not be conscious or remain conscious of the fact that their watches are fast; otherwise they become accustomed to take the extra few minutes into account, and so after all, in spite of their artfulness, arrive too late . . .”
The Government “Big Spender” Unbalances Markets
But the more fundamental error and misconception in the macro-aggregate approach is its failure to appreciate and focus on the real impact of changes in the money supply that by necessity result in an unsustainable deviation of prices, profits, and resources and labor uses from a properly balanced coordination, the end result of which is more of the very unemployment that the monetary “stimulus” was meant to cure.
Let’s revert to our example of the “big spender” who comes into a town. The townspeople discover that our big spender introduces a greater demand into the community, but not for “goods in general.” Instead, he announces his intention of building a new factory on the outskirts of the town.
He leases a particular piece of land and pays for the first few months rent. He hires a particular construction company to build the factory, and the construction company in turn increases its demand not only for workers to do the work, but orders new equipment, that, in turn, results in the equipment manufacturers adding to their workforce to fulfill the new demand for construction machinery.
Our big spender, trumpeting the wonders for the community from his new spending, starts hiring clerical staff and sales personal in anticipation of fulfilling orders once the factory is completed and producing its new output.
The new and higher incomes earned by the construction and machinery workers, as well as the newly employed clerical and sales workers raise the demand for various and specific consumer and other goods upon which these people want to spend their new and increased wages.
The businesses in the town catering to these particular increased consumer demands now attempt to expand their supplies and, perhaps, hire more retail store employees.
Over time the prices of all of these goods and services will start to rise, but not at the same time or to the same degree. They will go up in a temporal sequence that more or less tends to match the pattern and sequence of the changed demands for those goods and services resulting from the new money injected by the “big spender” into this community.
Inflationary Spending Has to Continue and Increase
Now, whether some of the individual workers drawn into this specific pattern of new employments were previously unemployed or whether they had to be attracted away from existing jobs they already held in other parts of the market, the fact remains that their continued employments in these particular jobs is dependent on the “big spender” continuing to inject and spend his new money, period-after-period of time, in the same way and in sufficient amounts of dollar spending to assure that the workers he has drawn into his factory project are not attracted to other employments due to the rise in all of these alternative or other demands, as well.
If the interdependent patterns of demands and supplies, and the structure of interconnected relative prices and wages generated by the big spender’s spending are to be maintained, his injection of new money into the community must continue, and at an increasing rate of spending if they are not be fall apart.
An alternative imagery might be the dropping of a pebble or stone into a pond of water. From the epicenter where the stone has hit the surface of the water a sequence of ripples will be sent out which will be reversed when the ripples finally hit the surrounding shore, and will then finally come to rest when there is no longer any new disturbances affecting the surface of the pond.
But if the pattern of ripples created are to be sustained, new pebbles or stones must be continuously dropped into the pond and with increasing force if the resulting counter-waves coming back from the shore are not to disrupt and overwhelm the ripple pattern moving out from the original epicenter.
The “Austrian” Analysis of Inflation
It is no doubt that this way of analyzing and understanding the dynamics of how monetary expansion affects market activities is more complex and complicated than the simplistic Keynesian-style of macro-aggregate analysis. But as the famous Austrian-born economist, Joseph A. Schumpeter emphasized:
“The Austrian way of emphasizing the behavior or decisions of individuals and of defining the exchange value of money with respect to individual commodities rather than with respect to a price level of one kind or another has its merits, particularly in the analysis of an inflationary process; it tends to replace a simple but inadequate picture by one which is less clear-cut but more realistic and richer in results.”
And, indeed, it is this “Austrian” analysis of monetary expansion and its resulting impact on prices, employment and production, especially as developed in the 20th century by Ludwig von Mises and Friedrich A. Hayek, that explains why the Keynesian-originated macro-aggregate approach is fundamentally flawed.
As Hayek once explained the logic of the monetary inflationary process:
“The influx of the additional money into the [economic] system always takes place at some particular points. There will always be some people who have more money to spend before the others. Who these people are will depend on the particular manner in which the increase in the money stream is being brought about . . .
“It may be spent in the first instance by government on public works or increased salaries, or it may be first spent by investors mobilizing cash balances for borrowing for that purpose; it may be spent in the first instance on securities, or investment goods, on wages or on consumers’ goods . . .
“The process will take very different forms according to the initial source or sources of the additional money stream . . . But one thing all these different forms of the process will have in common: that the different prices will rise, not at the same time but in succession, and that so long as the process continues some prices will always be ahead of others and the whole structure of relative prices therefore will be very different from what the pure theorist describes as an equilibrium position.”
An inflationary process, in other words, brings about distortions, mismatches, and imbalanced relationships between different supplies and demands, and the relationships between the structure of relative prices and wages that only last for as long as the inflationary process continues, and often only at an accelerating rate.
Or as Hayek expressed it on a different occasion:
“Any attempt to create full employment by drawing labor into occupations where they will remain employed only so long as the [monetary and] credit expansion continues creates the dilemma that either credit expansion must continue indefinitely (which means inflation), or that, when it stops unemployment will be greater than it would be if the temporary increase in employment had never taken place.”
The Inflationary “Cure” Creates More Market Problems
Once the inflationary monetary expansion ends or is slowed down, it is discovered that the artificially created supply and demand patterns and relative price and wage structure are inconsistent with non-inflationary market conditions.
In our example of the “big spender,” one day the townsfolk discover that he was really a con artist who had only phony counterfeit money to spend, and whose deceptive promises and temporary spending drew them into in all of those specific and particular activities and employments. They now find out that the construction projects began cannot be completed, the employments created cannot be maintained, and the investments started in response to the phony money the big spender injected into this community cannot be completed or continued.
Many of the townspeople now have to stop what they had been doing, and try to discover other demanders, other employers and other possible investment opportunities in the face of the truth of the big spenders false incentives to do things they should not have been doing from the start.
The unemployment and under utilization of resources that “activist” monetary policy by governments are supposed to reduce, in fact, set the stage for an inescapable readjustment period of more unemployment and temporary idle resources, when many of the affected supplies and demands have to be rebalanced at newly established market-based prices if employments and productions are to be sustainable and consistent with actual consumer demands and the availability of scarce resources in the post-inflationary environment.
Thus, recessions are the inevitable result from prior and unsustainable inflationary booms. And even the claimed “modest” and “controlled” rate of two percent annual price inflation that has become the new panacea for economic stability and growth in the minds of central bankers, brings in its wake a “wrong twist” to many of the micro-economic supply and demand and price-wage relationships that are the substance of the real economy beneath the superficial macro-aggregates.
Governments and their monetary central planners, therefore, are the cause and not the solution to the instabilities and hardships of inflations and recessions. To end them, political control and manipulation of the money and banking systems will have to be abolished.
[This piece first appeared here: http://www.epictimes.com/richardebeling/2014/12/the-false-promises-of-two-percent-price-inflation/]
Each commodity market has its own story to tell: oil prices are falling because OPEC can’t agree production cuts, steel faces a glut from overcapacity, and even the price of maize has fallen, presumably because of good harvests.
In local currencies this is not so much the case. Of course, the difference between prices in local currencies and prices in US dollars is reflected in the weakness of most currencies against the dollar in the foreign exchange markets. This tells us that whatever is happening in each individual commodity and in each individual currency the common factor is the US dollar.
This is obvious perhaps, but the fall in commodity prices and the rise in the US dollar have to be seen in context. We should note that for most of the global population, the concern that we are facing global deflation (by which is commonly meant falling prices) is not yet true. Nor is a conclusion that the fall in the oil price indicates a sudden collapse in demand for energy. When the dollar price of oil began to slide, so did the exchange rates for all the other major currencies, confirming a significant part of oil’s price move came from dollar strength, which would have also been true of commodity prices generally.
All we can say is that on average there has been a shift of preferences towards holding dollars and away from holding commodities. Looked at in this light we can see that a trend of destocking can develop solely for financial rather than business reasons, because businesses which account in dollars face financial losses on excess inventory. It is the function of speculators to anticipate these decisions, which is what we have seen in recent months.
Macro-economists, who are Keynesian or monetarist by definition, are beginning to interpret falling commodity prices and a rising dollar as evidence of insufficient aggregate demand, which left unchecked will lead to deflation, increasing unemployment, bankruptcies, falling asset prices, and bank insolvencies. It is, they say, an outcome to be avoided at all costs by ensuring that aggregate demand is stimulated so that none of this happens.
Whether or not they are right in this assessment is not the point. They neglect to allow that some of the move in commodity prices is due to the currency itself as the numéraire of all prices.
For evidence of this we need look no further than the attitude of the Fed and every other central bank that targets price inflation as part of their monetary policy. In forming monetary policy there is no allowance for the possibility, nay likelihood, that in future there will be a change in preferences against the dollar, or any other currency for that matter, and in favour of anything else. The tragedy of this lack of market comprehension is that it’s a fair bet that monetary policy will not only succeed in limiting the rise of the dollar as it is designed to do, but end up undermining it when preferences shift the other way.
The moral of the story is that the Fed may be able to fool some of the people all of the time and all of the people some of the time, but worst of all they are fooling themselves. And we should bear in mind that dollar strength is only a trend which can easily reverse at any time.
[Editor’s Note; this interview, with Cobden Centre contributor Jesus Huerta de Soto, was by Malte Fischer of Handelsblatt]
Professor Huerta de Soto, the inflation rate in the euro zone is now only 0.4 percent. Is deflation threatening us, as many experts maintain?
Deflation means that the money supply is shrinking. This is not the case in the euro zone. The M3, the broadly defined supply of money, is growing by about two percent, while the more narrowly defined money supply, M1, by more than six percent. Although the inflation rate in the euro zone is below the European Central Bank’s target of barely two percent, that’s no reason to stir up fears of deflation like some central bankers are doing.
By doing so, they are suggesting that lowering prices is something bad. That is wrong. Price deflation is not a catastrophe, but rather a blessing.
You’ll have to explain that.
Take my homeland, Spain. At the moment, the consumer prices there are decreasing. At the same time, the economy is growing by around two percent on a yearly basis. Some 275,000 new jobs were created in 2013 and unemployment fell from 26 to 23 percent. The facts contradict the horror scenarios of deflation.
Does that mean we should be happy about deflation?
Certainly. It is particularly beneficial when it results from an interplay of a stable money supply and increasing productivity. A fine example is the gold standard in the 19th century. Back then, the money supply only grew by one to two percent per year. At the same time, industrial societies generated the greatest increase in prosperity in history. That is why the ECB should use the gold standard as an example and lower the target for the growth of the M3 money supply from 4.5 to around 2.0 percent.
If the euro economy were to grow by about three percent – which it is capable of doing if it were freed from the shackles of state regulations – prices would decrease by about one percent per annum.
If deflation is so beneficial, why are people afraid of it?
I don’t believe that the average person is frightened by falling prices. It is the representatives of mainstream economics fomenting a deflation phobia. They argue that deflation allows the actual debt burden to increase, and thus strangles the overall economic demand. The deflation alarmists fail to mention that creditors benefit from deflation, which stimulates demand.
Isn’t there a danger consumers will roll back their spending if everything is cheaper tomorrow?
That is an abstruse argument you hear again and again. Look at how fast the latest smartphones sell, although consumers know that the phones will be sold at a lower cost a few months afterwards. America was dominated by deflation for decades after the Civil War. In spite of that, consumption increased. If people were to put off buying because of lower prices, they ultimately would starve to death.
But lowering prices drives down sales figures and lessens the willingness of companies to invest. Do you want to ignore that?
Sales figures are not crucial for companies, but rather their earnings, meaning the difference between revenues and costs. Sinking sales prices increase pressure to reduce costs. The companies, therefore, replace manpower with machines. That means more machines need to be produced, which increases the demand for manpower in the capital goods sector. In this way, workers who lost their jobs in the wake of price deflation find new work in the capital goods sector. The capital stock grows without resulting in mass unemployment.
Aren’t you making that too easy for yourself ? In reality, the gap between the qualifications of the unemployed and the needs of companies is, at times, quite large.
I’m not claiming the market is perfect. That means it’s crucial that the labor market is flexible enough to offer incentives for creative employers to hire new workers.
What role does politics play?
The problem is that politicians have a short time horizon. That is why we need a monetary policy framework that holds both politicians and unions in check. The euro has this job in Europe. The common currency has removed the option of governments to devalue the currency to cover for their misguided economic policies. Economic policy mistakes are seen directly in the affected country’s loss of competitiveness, which forces politicians to make harsh reforms. Two governments in Spain within one and half years have implemented reforms that I hadn’t even dared to dream of. Now, the economic situation is improving and Spain is reaping the harvest of the reforms.
You may be right in the matter of Spain, but there have been no signs of fundamental reforms in Italy and France…
Which is why conditions there will first have to get worse before reforms come. We have learned from experience that the more miserable the economic situation, the stronger the pressure to reform. The reform successes that Spain and other euro countries have achieved increase the pressure on Paris and Rome. High unemployment in Spain had pushed down labor costs. At an average of €20, or $24.90, per hour, they are now half the rate as in France. That is why the French cannot avoid a drastic economic policy cure, even if the people oppose it. Germany should hold to its budgetary consolidation to keep up pressure on France and Italy.
The ECB is coming under increasing pressure to open the monetary floodgates and devalue the euro. The pressure is coming from academics, financial markets and politicians.
The economic mainstream of Keynesianism and monetarism explains the Great Depression of the 1930s with a shortage of money, which allowed an anti-deflation mentality to develop among academics. Politicians use the academic sounding board to pressure the ECB to reinflate the economy. Governments love inflation because it gives them the opportunity to live beyond their means and pile up huge mountains of debt that the central bank devaluates through inflation. It is no wonder it just happens to be the opponents of austerity policies who warn about deflation and demonize the euro’s set of stability policy regulations. They are afraid of presenting the true costs of the welfare state to the electorate.
The head of the ECB, Mario Draghi, succumbed to the pressure with his promise to save the euro if needs be by firing up the money printing presses. A mistake?
Careful. Until now, Mr. Draghi has been mainly making promises, but has barely acted. Although the ECB has initiated generous money lending transactions, and lowered the prime lending rate, the actual yield for 10-year government bonds of ailing euro zone members is above those in America. Measured on the balance sheet totals, the ECB has done less than other Western central banks. As long as the guardians of the euro are only talking but not acting, the pressure will remain on Italy and France to reform. That is why it is crucial the ECB resists the pressure of the governments and the Anglo-Saxon financial world and buys no state bonds.
What role do the Anglo-Saxon financial markets play?
The Anglo-Saxon press and the financial markets are ostentatiously conducting a crusade against the euro and the austerity policy in continental Europe necessitated by it. I am really no believer in conspiracy theories, but the out-and-out attacks against the euro by Washington and London suggest a hidden agenda. The Americans are afraid that the days of the dollar as a global currency are numbered if the euro survives as a hard currency.
Can the euro survive without political union?
A political union will not draw majority support in the population. It also isn’t desirable because it reduces the pressure for fiscal austerity. The best monetary regime for a free society is the gold standard, with all deposits covered by full reserves and without state central banks. As long as we don’t have that, we should defend the euro because it deprives governments of access to the money printing presses and forces them to consolidate their budgets and make reforms. In a certain way, it has the effect of the gold standard.
[Editor’s Note: this piece, by Lewis E. Lehrman And John D. Mueller, first appeared in the Wall Street Journal http://online.wsj.com/articles/how-the-reserve-dollar-harms-america-1416527644. It was kindly brought to our attention by Cobden Centre contributor Ralph Benko.]
For more than three decades we have called attention on this page to what we called the “reserve-currency curse.” Since some politicians and economists have recently insisted that the dollar’s official role as the world’s reserve currency is instead a great blessing, it is time to revisit the issue.
The 1922 Genoa conference, which was intended to supervise Europe’s post-World War I financial reconstruction, recommended “some means of economizing the use of gold by maintaining reserves in the form of foreign balances”—initially pound-sterling and dollar IOUs. This established the interwar “gold exchange standard.”
A decade later Jacques Rueff, an influential French economist, explained the result of this profound change from the classical gold standard. When a foreign monetary authority accepts claims denominated in dollars to settle its balance-of-payments deficits instead of gold, purchasing power “has simply been duplicated.” If the Banque de France counts among its reserves dollar claims (and not just gold and French francs)—for example a Banque de France deposit in a New York bank—this increases the money supply in France but without reducing the money supply of the U.S. So both countries can use these dollar assets to grant credit. “As a result,” Rueff said, “the gold-exchange standard was one of the major causes of the wave of speculation that culminated in the September 1929 crisis.” A vast expansion of dollar reserves had inflated the prices of stocks and commodities; their contraction deflated both.
The gold-exchange standard’s demand-duplicating feature, based on the dollar’s reserve-currency role, was again enshrined in the 1944 Bretton Woods agreement. What ensued was an unprecedented expansion of official dollar reserves, and the consumer price level in the U.S. and elsewhere roughly doubled. Foreign governments holding dollars increasingly demanded gold before the U.S. finally suspended gold payments in 1971.
The economic crisis of 2008-09 was similar to the crisis that triggered the Great Depression. This time, foreign monetary authorities had purchased trillions of dollars in U.S. public debt, including nearly $1 trillion in mortgage-backed securities issued by two government-sponsored enterprises, Fannie Mae and Freddie Mac. The foreign holdings of dollars were promptly returned to the dollar market, an example of demand duplication. This helped fuel a boom-and-bust in foreign markets and U.S. housing prices. The global excess credit creation also spilled over to commodity markets, in particular causing the world price of crude oil (which is denominated in dollars) to spike to $150 a barrel.
Perhaps surprisingly, given Keynes ’s central role in authoring the reserve-currency system, some American Keynesians such as Kenneth Austin, a monetary economist at the U.S. Treasury; Jared Bernstein, an economic adviser to Vice President Joe Biden ; and Michael Pettis, a Beijing-based economist at the Carnegie Endowment, have expressed concern about the growing burden of the dollar’s status as the world’s reserve currency. For example, Mr. Bernstein argued in a New York Times op-ed article that “what was once a privilege is now a burden, undermining job growth, pumping up budget and trade deficits and inflating financial bubbles.” He urged that, “To get the American economy on track, the government needs to drop its commitment to maintaining the dollar’s reserve-currency status.”
Meanwhile, a number of conservatives, such as Bryan Riley and William Wilson at the Heritage Foundation, James Pethokoukis at the American Enterprise Institute and Ramesh Ponnuru at National Review are fiercely defending the dollar’s reserve-currency role. Messrs. Riley and Wilson claim that “The largest benefit has been ‘seignorage,’ which means that foreigners must sell real goods and services or ownership of the real capital stock to add to their dollar reserve holdings.”
This was exactly what Keynes and other British monetary experts promoted in the 1922 Genoa agreement: a means by which to finance systemic balance-of-payments deficits, forestall their settlement or repayment and put off demands for repayment in gold of Britain’s enormous debts resulting from financing World War I on central bank and foreign credit. Similarly, the dollar’s “exorbitant privilege” enabled the U.S. to finance government deficit spending more cheaply.
But we have since learned a great deal that Keynes did not take into consideration. As Robert Mundell noted in “Monetary Theory” (1971), “The Keynesian model is a short run model of a closed economy, dominated by pessimisticexpectations and rigid wages,” a model not relevant to modern economies. In working out a “more general theory of interest, inflation, and growth of the world economy,” Mr. Mundell and others learned a great deal from Rueff, who was the master and professor of the monetary approach to the balance of payments.
Those lessons are reflected in the recent writings of Keynesians such as Mr. Austin, who has outlined what he calls the “iron identities” of international payments, which flow from the fact that global “current accounts, global capital accounts, and global net reserve sales, must (and do) sum to zero.” This means that a trillion-dollar purchase, say, of U.S. public debt by the People’s Bank of China entails an equal, simultaneous increase in U.S. combined deficits in the current and capital accounts. The iron identities necessarily link official dollar-reserve expansion to the declining U.S. investment position.
The total U.S. international investment position declined from net foreign assets worth about 10% of gross domestic product in 1976 to minus-30% of GDP in 2013—while the books of U.S. private residents went from 10% of U.S. GDP in 1976 down to balance with the rest of the world in 2013. The entire decline in the U.S. net international investment position was due to federal borrowing from foreign monetary authorities—i.e., government deficit-financing through the dollar’s official reserve-currency role.
Ending the dollar’s reserve-currency role will limit deficit financing, increase net national savings and release resources to U.S. companies and their employees in order to remain competitive with the rest of the world.
Messrs. Riley and Wilson argue that “no other global currency is ready to replace the U.S. dollar.” That is true of other paper and credit currencies, but the world’s monetary authorities still hold nearly 900 million ounces of gold, which is enough to restore, at the appropriate parity, the classical gold standard: the least imperfect monetary system of history.
Messrs. Lehrman and Mueller are principals of LBMC LLC, an economic and financial market consulting firm. Mr. Lehrman is the author of “The True Gold Standard: A Monetary Reform Plan Without Official Reserve Currencies” (TLI Books, 2012). Mr. Mueller is the author of “Redeeming Economics: Rediscovering the Missing Element” (ISI Books, 2014).
The hypothesis that follows, if carried through, is certain to have a significant effect on gold and the relationship between gold and all government-issued currencies.
The successful remonetisation of gold by a major power such as Russia would draw attention to the fault-lines between fiat currencies issued by governments unable or unwilling to do the same and those that can follow in due course. It would be a schism in the world’s dollar-based monetary order.
Russia has made plain her overriding monetary objective: to do away with the US dollar for all her trade, an ambition she shares with China and their Asian partners. Furthermore, in the short-term the rouble’s weakness is undermining the Russian economy by forcing the Central Bank of Russia (CBR) to impose high interest rates to defend the currency and by increasing the burden of foreign currency debt. There is little doubt that one objective of NATO’s economic sanctions is to harm the Russian economy by undermining the currency, and this policy is working with the rouble having fallen 30% against the US dollar this year so far with the prospect of further falls to come.
Russia faces the reality that pricing the rouble in US dollars through the foreign exchanges leaves her a certain loser in a currency war against America and her NATO allies. There is a solution which was suggested in a recent paper by John Butler of Atom Capital, and that is for Russia to link the rouble to gold, or more correctly put it on a gold exchange standard*. The proposal at first sight is so left-field that it takes a lateral thinker such as Butler to think of it. Separately, Professor Steve Hanke of John Hopkins University has alternatively proposed that Russia sets up a currency board to stabilise the rouble. Professor Hanke points out that Northern Russia tied the rouble to the British pound with great success in 1918 after the Bolshevik revolution when Britain and other allied nations invaded and briefly controlled the region. What he didn’t say is that sterling would most likely have been accepted as a gold substitute in the region at that time, so running a currency board was the equivalent of putting the rouble in Russia’s occupied lands onto a gold exchange standard.
Professor Hanke has successfully advised several governments to introduce currency boards over the years, but we can probably rule it out as an option for Russia because of her desire to ditch US dollar relationships. However, on further examination Butler’s idea of fixing the rouble to gold is certainly feasible. Russia’s public sector external debt is the equivalent of only $378bn in a $2 trillion economy, her foreign exchange reserves total $429bn of which over $45bn is in physical gold, and the budget deficit this year is likely to be roughly $10bn, considerably less than 1% of GDP. These relationships suggest that a rouble to gold exchange standard could work so long as fiscal discipline is maintained and credit expansion moderated.
Once a rate is set, the Russians would not be restricted to just buying and selling gold to maintain the rate of gold exchange. The CBR has the power to manage rouble liquidity as well, and as John Butler points out, it can issue coupon-bearing bonds to the public which would be attractive compared with holding cash roubles. By issuing these bonds, the public is in effect offered a yield linked to gold, but higher than gold’s interest rate indicated by the gold lease rates in the London market. Therefore, as the sound-money environment becomes established the public will adjust its financial affairs around a considerably lower interest rate than the current 9.5%-10% level, but in the context of sound money it must always be repaid. Obviously the CBR would have to monitor bank credit expansion to ensure that lower interest rates do not result in a dangerous increase in bank lending and jeopardise the arrangement.
In short, the central bank could easily counter any tendency for roubles to be cashed in for gold by withdrawing roubles from circulation and by restricting credit. Consideration would also have to be given to roubles in foreign ownership, but the current situation for foreign-owned roubles is favourable as well. Speculators in foreign exchange markets are likely to have sold the rouble against dollars and euros, because of the Ukrainian situation and as a play on lower oil prices. The announcement of a gold exchange standard can therefore be expected to lead to foreign demand for the rouble from foreign exchange markets because these positions would almost certainly be closed. Since there is currently a low appetite for physical gold in western capital markets, longer-term foreign holders of roubles are unlikely to swap them for gold, preferring to sell them for other fiat currencies. So now could be a good time to introduce a gold-exchange standard.
The greatest threat to a rouble-gold parity would probably arise from bullion banks in London and New York buying roubles to submit to the CBR in return for bullion to cover their short positions in the gold market. This would be eliminated by regulations restricting gold for rouble exchanges to legitimate import-export business, but also permitting the issue of roubles against bullion for non-trade related deals and not the other way round.
So we can see that the management of a gold-exchange standard is certainly possible. That being the case, the rate of exchange could be set at close to current prices, say 60,000 roubles per ounce. Instead of intervention in currency markets, the CBR should use its foreign currency reserves to build and maintain sufficient gold to comfortably manage the rouble-gold exchange rate.
As the rate becomes established, it is likely that the gold price itself will stabilise against other currencies, and probably rise as it becomes remonetised. After all, Russia has some $380bn in foreign currency reserves, the bulk of which can be deployed by buying gold. This equates to almost 10,000 tonnes of gold at current prices, to which can be added future foreign exchange revenues from energy exports. And if other countries begin to follow Russia by setting up their own gold exchange standards they likewise will be sellers of dollars for gold.
The rate of increase in the cost of living for the Russian population should begin to drop as the rouble stabilises, particularly for life’s essentials. This has powerfully positive political implications compared with the current pain of food price inflation of 11.5%. Over time domestic savings would grow, spurred on by low welfare provision by the state, long-term monetary stability and low taxes. This is the ideal environment for developing a strong manufacturing base, as Germany’s post-war experience clearly demonstrated, but without her high welfare costs and associated taxation.
Western economists schooled in demand management will think it madness for the central bank to impose a gold exchange standard and to give up the facility to expand the quantity of fiat currency at will, but they are ignoring the empirical evidence of a highly successful Britain which similarly imposed a gold standard in 1844. They simply don’t understand that monetary inflation creates uncertainty for capital investment, and destroys the genuine savings necessary to fund it. Instead they have bought into the fallacy that economic progress can be managed by debauching the currency and ignoring the destruction of savings.
They commonly assume that Russia needs to devalue her costs to make energy and mineral extraction profitable. Again, this is a fallacy exposed by the experience of the 1800s, when all British overseas interests, which supplied the Empire’s raw materials, operated under a gold-based sterling regime. Instead, by not being burdened with unmanageable debt and welfare costs, by maintaining lightly-regulated and flexible labour markets, and by running a balanced budget, Russia can easily lay the foundation for a lasting Eurasian empire by embracing a gold exchange standard, because like Britain after the Napoleonic Wars Russia’s future is about new opportunities and not preserving legacy industries and institutions.
That in a nutshell is the domestic case for Russia to consider such a step; but if Russia takes this window of opportunity to establish a gold exchange standard there will be ramifications for her economic relationships with the rest of the world, as well as geopolitical considerations to take into account.
An important advantage of adopting a gold exchange standard is that it will be difficult for western nations to accuse Russia of a desire to undermine the dollar-based global monetary system. After all, President Putin was more or less told at the Brisbane G20 meeting, from which he departed early, that Russia was not welcome as a participant in international affairs, and the official Fed line is that gold no longer plays a role in monetary policy.
However, by adopting a gold exchange standard Russia is almost certain to raise fundamental questions about the other G20 nations’ approach to gold, and to set back western central banks’ long-standing attempts to demonetise it. It could mark the beginning of the end of the dollar-based international monetary system by driving currencies into two camps: those that can follow Russia onto a gold standard and those that cannot or will not. The likely determinant would be the level of government spending and long-term welfare liabilities, because governments that leech too much wealth from their populations and face escalating welfare costs will be unable to meet the conditions required to anchor their currencies to gold. Into this category we can put nearly all the advanced nations, whose currencies are predominantly the dollar, yen, euro and pound. Other nations without these burdens and enjoying low tax rates have the flexibility to set their own gold exchange standards should they wish to insulate themselves from a future fiat currency crisis.
It is beyond the scope of this article to examine the case for other countries, but likely candidates would include China, which is working towards a similar objective. Of course, Russia might not be actively contemplating a gold standard, but Vladimir Putin is showing every sign of rapidly consolidating Russia’s political and economic control over the Eurasian region, while turning away from America and Western Europe. The fast-track establishment of the Eurasian Economic Union, domination of Asia in partnership with China through the Shanghai Cooperation Organisation, and plans to set up an alternative to the SWIFT banking payments network are all testaments to this. It would therefore be negligent to rule out the one step that would put a stop to foreign attempts to undermine the rouble and the Russian economy: by moving the currency war away from the foreign exchanges and into the physical gold market were Russia and China hold all the aces.
*Technically a gold standard is a commodity money standard in which the commodity is gold, deposits and notes are fully backed by gold and gold coins circulate. A gold exchange standard permits other metals to be used in coins and for currency and credit to be issued without the full backing of gold, so long as they can be redeemed for gold from the central bank on demand.
“Sir, Martin Wolf in his article “Radical cures for unusual economic ills” suggests an abandonment of free market capitalism, as it has been practised these past couple of hundred years, and instead wants some kind of witch-doctoring economic quackery to take its place. Savings are the capital that forms the basis of capitalism. You can’t have capitalism without capital. And without interest rates pegged at levels that encourage savings, you won’t generate the quantities of savings necessary to sustain a capitalist economy.
“We need to stop the insanity. For example, savings rates in the US fluctuate around zero per cent along with interest rates set by the Fed. To hide this stab in the back to savers, the Federal Reserve simulates savings with ersatz monetary hokum like quantitative easing designed to create the illusion of a solvent economy that can run fine without actually having any savings.
“Despite the evidence proving the failure of this approach, Mr Wolf continues to recommend attacking savers, including the so-called “savings glut” held by countries in the east that hold large cash reserves as protection against the reckless policies like those suggested by Mr Wolf, who appears ignorant of the history of why these reserves exist in the first place: to protect these countries and currencies from the unorthodox (read “failed”) policy suggestions of pundits and academics who would do us all a great favour by simply admitting that their prescriptions for global growth have completely, unequivocally, failed.”
– Letter to the Financial Times from Mr Max Keiser, London W1, 28 November 2014.
So the Swiss have decided not to force their central bank into underpinning its reserves with harder assets than increasingly worthless euros. At least they had the chance to vote. But in the bigger picture, the rejection of the “Save Our Swiss Gold” initiative flies in the face of a broader trend towards repatriation and consolidation of sovereign bullion holdings – following on the heels of similar attempts by the Bundesbank, the Dutch central bank, for example, recently announced that it had moved a fifth of its total gold reserves from New York to Amsterdam. And the physical metal continues its inexorable exodus eastwards, into stronger hands that are unlikely to relinquish it any time soon.
The Swiss vote was preceded by some fairly extraordinary black propaganda, most notoriously by Willem Buiter of the banking organisation that now styles itself ‘Citi’. Once again we were treated to the intriguing claim that gold is nothing more than “a six thousand year-old bubble”, and a “fiat commodity currency” (whatever that might mean) that has “insignificant intrinsic value”. Izabella Kaminska for the FT’s Alphaville republished much of Buiter’s ‘research’; the resultant to-and-fro between FT readers on the paper’s website makes for a fascinating scrap between goldbugs and paperbugs. Among the highlights was Vlady, who wrote:
“When a social construct (gold as money) survives for 6,000 years I would expect curious people to inquire as to whether it is tied to some immutable underlying law, or otherwise investigate if there is something more here than meets the eye. Not so curiously inclined, our court economists prefer to write this off as a 6,000 year old delusion. That says a lot about the sorry state of the economics discipline today.”
Another was the artfully named ‘Financially Repressed by Central Banks’, who wrote:
“I think that the reason bankers and governments dislike gold backed hard currencies is that it limits their ability to devalue their fiat currency and redistribute wealth in order to stay in power.
The governmental solution to all the debt in the world is to try to inflate it away and slowly take money away from the people via currency depreciation and manipulating interest rates such savers and forced owners of government debt (such as pension schemes) make a negative return.
I think this is robbery – Pure and simple. The market is not free, it is controlled.
A move away from fiat currency and back to using gold backed currency would remove the ability of governments to print money and this in turn would remove their ability constantly try to avoid facing the consequences of building up huge debts, which in term means they would have to face the music and actually have a plan to repay it.
It is the central banks and private banks who are complicit in this government sponsored process of stealing and their rewards are their ability themselves big bonuses and the occasional tax payer funded rescue..
Mr Buiter works for a bank. What a surprise that he dislikes Gold and is presumably very concerned when a central bank (Switzerland) looks like it might do something silly like buying some gold. Don’t they realize that in acknowledging the concerns of holders of fiat currency (the people of Switzerland) that their actions might encourage others to think that maybe just maybe fiat currency is not quite as useful as gold?
/ rant on / I am not a gold bug, but I am a hard working tax payer who is getting pretty fed up with having my savings earning no interest and possibly being devalued (see Japan) and of not being able to find any sensible place to invest my hard earned due to central bank policies making it impossible to make any return anywhere without taking crazy risks. / rant off /” [Emphasis ours.]
The financial markets feel increasingly unhinged. All-time low bond yields co-exist with all-time high stock markets. Oil has collapsed along with much of the commodities complex. Emerging market currencies have been hit for six. China threatens the West with another strong deflationary impulse. Speaking of matters Chinese, Doug Nolandwrites:
“With global “hot money” now on the move in major fashion, it’s time to start paying close attention to happenings in China. It’s also time for U.S. equities bulls to wake up from their dream world. There are trillions of problematic debts in the world, including some in the U.S. energy patch. There are surely trillions more engaged in leveraged securities speculation. Our markets are not immune to a full-fledged global “risk off” dynamic. And this week saw fragility at the global bubble’s periphery attain some significant momentum. Global currency and commodities markets are dislocating, portending global instability in prices, financial flows, credit and economies.”
Gold is difficult to value at the best of times, in large part because it’s not a productive asset, and partly because it’s conventionally priced in a currency (the dollar) that, like all others, is destined to lose its purchasing power over time. Viewed purely through the prism of price, gold increasingly feels like something close to a ‘value’ investment, given that ‘value’ investing is essentially about picking up dollar bills for something closer to fifty cents. We’re currently reading Christopher Risso-Gill’s biography of the legendary ‘value’ investor Peter Cundill, and some of Cundill’s diary entries seem to be peculiarly relevant to this strange, dysfunctional environment in which we are all trapped. One in particular stands out, which Cundill himself wrote in upper case to make his point:
“THE MOST IMPORTANT ATTRIBUTE FOR SUCCESS IN VALUE INVESTING IS PATIENCE, PATIENCE, AND MORE PATIENCE. THE MAJORITY OF INVESTORS DO NOT POSSESS THIS CHARACTERISTIC.”
And there’s another, originally from Horace, that was also used by the godfather of ‘value’ investing, Ben Graham himself:
“Many shall be restored that now are fallen, and many shall fall that are now held in honour.”
“Finally, as expectations of rapid inflation evaporate, I want to contribute to the debate about the November 15, 2010 letter signed by 23 US academics, economists and money managers warning on the Fed’s QE strategy. Bloomberg News did what I would call a hatchet job on the signatories essentially saying how wrong they have been and seeking their current views. It certainly made for an entertaining read. Needless to say, shortly afterwards Paul Krugman waded in with his typically understated style to twist the knife in still deeper. Cliff Asness, one of the signatories of the original letter, despite observing that “responding to Krugman is as productive as smacking a skunk with a tennis racket. But, sometimes, like many unpleasant tasks, it’s necessary”, penned a rather wittyresponse. Do read these articles at your leisure. But having been one of the few to accurately predict the deflation quagmire into which we have now sunk, I believe I am more entitled than many to have a view on this subject. Had I been asked I would certainly have signed the letter and would still sign it now. The unfolding deflationary quagmire into which we are sinking will get worse and there will be more Fed QE. But do I think QE will solve our problems? I certainly do not. I think ultimately it will make things far, far worse.”
– SocGen’s Albert Edwards, ‘Is the next (and last) phase of the Ice Age now upon us ?’ (20 November 2014)
On Monday 15th November 2010, the following open letter to Ben Bernanke was published:
“We believe the Federal Reserve’s large-scale asset purchase plan (so-called “quantitative easing”) should be reconsidered and discontinued. We do not believe such a plan is necessary or advisable under current circumstances. The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment.
“We subscribe to your statement in the Washington Post on November 4 that “the Federal Reserve cannot solve all the economy’s problems on its own.” In this case, we think improvements in tax, spending and regulatory policies must take precedence in a national growth program, not further monetary stimulus.
“We disagree with the view that inflation needs to be pushed higher, and worry that another round of asset purchases, with interest rates still near zero over a year into the recovery, will distort financial markets and greatly complicate future Fed efforts to normalize monetary policy.
“The Fed’s purchase program has also met broad opposition from other central banks and we share their concerns that quantitative easing by the Fed is neither warranted nor helpful in addressing either U.S. or global economic problems.”
Among the 23 signatories to the letter were Cliff Asness of AQR Capital, Jim Chanos of Kynikos Associates, Niall Ferguson of Harvard University, James Grant of Grant’s Interest Rate Observer, and Seth Klarman of Baupost Group.
Words matter. Their meanings matter. Since we have a high degree of respect for the so-called Austrian economic school, we will use Mises’ own definition of inflation:
“..an increase in the quantity of money.. that is not offset by a corresponding increase in the need for money.”
In other words, inflation has already occurred, inasmuch as the Federal Reserve has increased the US monetary base from roughly $800 billion, pre-Lehman Crisis, to roughly $3.9 trillion today.
What the signatories likely meant when they referred to inflation in their original open letter to Bernanke was the popular interpretation of the word – that second-order rise in the prices of goods and services that typically follows aggressive base money inflation. Note, as many of them observed when prodded by Bloomberg’s yellow journalists, that their original warning carried no specific date on which their inflation might arise. To put it in terms which Ben Bernanke himself might struggle to understand, just because something has not happened during the course of four years does not mean it will never happen. We say this advisedly, given that the former central bank governor himself made the following observation in response to a question about the US housing market in July 2005:
“INTERVIEWER: Tell me, what is the worst-case scenario? Sir, we have so many economists coming on our air and saying, “Oh, this is a bubble, and it’s going to burst, and this is going to be a real issue for the economy.” Some say it could even cause a recession at some point. What is the worst-case scenario, if in fact we were to see prices come down substantially across the country?
“BERNANKE: Well, I guess I don’t buy your premise. It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis. So what I think is more likely is that house prices will slow, maybe stabilize: might slow consumption spending a bit. I don’t think it’s going to drive the economy too far from its full employment path, though.” [Emphasis ours.]
To paraphrase Ben Bernanke, “We’ve never had a decline in house prices on a nationwide basis – therefore we never will.”
One more quote from Mises is relevant here, when he warns about the essential characteristic of inflation being its creation by the State:
“The most important thing to remember is that inflation is not an act of God, that inflation is not a catastrophe of the elements or a disease that comes like the plague.Inflation is a policy.”
Many observers of today’s financial situation are scouring the markets for evidence of second-order inflation (specifically, CPI inflation) whilst either losing sight of, or not even being aware of, the primary inflation, per the Austrian school definition.
James Grant, responding to Bloomberg, commented:
“People say, you guys are all wrong because you predicted inflation and it hasn’t happened. I think there’s plenty of inflation – not at the checkout counter, necessarily, but on Wall Street.”
“The S&P 500 might be covering its fixed charges better, it might be earning more Ebitda, but that’s at the expense of other things, including the people who saved all their lives and are now earning nothing on their savings.”
“That to me is the principal distortion, is the distortion of the credit markets. The central bankers have in deeds, if not exactly in words – although I think there have been some words as well – have prodded people into riskier assets than they would have had to purchase in the absence of these great gusts of credit creation from the central banks. It’s the question of suitability.”
And from the vantage point of November 2014, only an academic could deny that the signatories were wholly correct to warn of the financial market distortion that ensues from aggressive money printing.
Ever since Lehman Brothers failed and the Second Great Depression began, like every other investor on the planet we have wrestled with the arguments over inflation (as commonly understood) versus deflation. Now some of the fog has lifted from the battlefield. Despite the creation of trillions of dollars (and pounds and yen) in base money, the forces of deflation – a.k.a. the financial markets – are in the ascendancy, testimony to the scale of private sector deleveraging that has occurred even as government money and debt issuance have gone into overdrive. And Albert Edwards is surely right that as the forces of deflation worsen, they will be met with ever more aggressive QE from the Fed and from representatives of other heavily indebted governments. This is not a recipe for stability. This is the precursor to absolute financial chaos.
Because the price of every tradeable financial asset is now subject to the whim and caprice of government, rational macro-economic analysis (i.e. top-down investing and asset allocation) has become impossible. Only bottom-up analysis now offers any real potential for adding value at the portfolio level. We discount the relevance of debt instruments almost entirely, but we continue to see merit in listed businesses run by principled and shareholder-friendly management, where the shares of those businesses trade at a significant discount to any fair assessment of their underlying intrinsic value. A word of caution is warranted – these sort of value opportunities are vanishingly scarce in the US markets, precisely because of the distorting market effects of which the signatories to the November 2010 letter warned; today, value investors must venture much further afield. The safe havens may be all gone, but we still believe that pockets of inherent value are out there for those with the tenacity, conviction and patience to seek them out.
As noted in my previous column, AEI’s James Pethokoukis and National Review‘s Ramesh Ponnuru — among many others — appear to have fallen victim to what I have called the “Eichengreen Fallacy.” This refers to the demonstrably incorrect proposition that the gold standard caused the Great Depression.
Pethokoukis proves exactly right in observing that “Benko is a gold-standard advocate and apparently doesn’t much like the words ‘Hitler’ or ‘Nazi’ to be in the same area code of any discussion of once again linking the dollar to the shiny yellow metal.” “Doesn’t much like” being falsely linked with Hitler? Perhaps an apology is more in order than an apologia.
My objecting to a demonstrably false implication of the (true) gold standard in the rise of Nazism does not constitute a display of ill will but rather righteous indignation. To give Pethokoukis due credit he thereupon generously devoted anAEIdea blog to reciting Peter Thiel’s praise for the gold standard, praise which triggered a hysterical reaction from the Washington Post‘s Matt O’Brien.
Pethokoukis’s earlier (and repeated) vilification of gold was followed by a column in the Washington Times by a director of the venerable Committee for Monetary Research and Education Daniel Oliver, Jr., Liberty and wealth require sound money. In it, Oliver states:
What if liberty and riches at times diverge, though? A shibboleth of mainstream economists, repeated recently in The National Review, of all places, is that countries recovered from the Great Depression in the order that they abandoned the gold standard. … No doubt, money printing — the modern equivalent of leaving the gold standard — can plug the holes in banks’ balance sheets when the demand deposits at the base of the credit structure are withdrawn. This is the policy recommended by National Review Senior Editor Ramesh Ponnuru and other “market monetarists” such as the American Enterprise Institute’s James Pethokoukis ….
I am not in complete accord with all of Oliver’s propositions therein. Ponnuru is on solid ground in contradicting Oliver’s imputation of sentiments to him he does not hold and does not believe. Yet Ponnuru weakens his defense by citing, among other things, a
recent summary of the history of gold standards in the United States that George Selgin wrote for the Cato Institute. It is a very gold-friendly account, but it ‘concludes that the conditions that led to the gold standard’s original establishment and its successful performance are unlikely to be replicated in the future.’
“Unlikely to be replicated in the future?” Prof Selgin is a brilliant economist, especially in the elite field of monetary economics. Yet as Niels Bohr reportedly once said, “Prediction is very difficult, especially about the future.” This citation in no way advances Ponnuru’s self-defense.
Let it be noted that Cato Institute recently announced a stunning coup in recruiting Prof. Selgin to head its impressive new Center For Monetary and Financial Alternatives. As stated in its press release, “George Selgin, a Professor Emeritus of Economics at the University of Georgia and one of the foremost authorities on banking and monetary theory and history, gave up his academic tenure to join Cato as director of the new center.” Cato’s recruitment, from the Mercatus Institute, of a key former House subcommittee aide, the formidable Lydia Mashburn, to serve as the Center’s Manager also shows great sophistication and purpose.
Prof. Selgin hardly would give up a prestigious university post to engage in a quixotic enterprise. I, among many, expect Selgin rapidly to emerge as a potent thought leader in changing the calculus of what is, or can be made, policy-likely. Also notable are the Center’s sterling Council of Economic Advisors, including such luminaries as Charles Calomiris; its Executive Advisory Council; Senior Fellows; and Adjunct Scholars. It is, as Prof. Selgin noted in a comment to the previous column, “a rather … diverse bunch.”
The Center presents as an array of talent metaphorically reminiscent of the 1927 Yankees. These columns do not imply Cato to be a uniform phalanx of gold standard advocates but rather a sophisticated group of thought leaders committed to monetary and financial alternatives, of which the classical gold standard is one, respectable, offering. Prof. Selgin’s own position frankly acknowledging the past efficacy of the true gold standard represents argument from the highest degree of sophistication.
Ponnuru is on the weakest possible ground in citing the “commonplace observation that countries recovered from the Great Depression in the order they left gold.” This is as misleading as it is commonplace. Ponnuru, too, would do well to break free of the Eichengreen Fallacy and assimilate the crucial fact that a defective simulacrum, not the true gold standard, led to and prolonged the Great Depression.
The perverse effects of the interwar “gold” standard led to a significant rise in commodities prices … and the ensuing wreckage of a world monetary system by the, under the circumstances, atavistic definition of the dollar at $20.67/oz of gold. The breakdown of the system meticulously is documented in a narrative history by Liaquat Ahamed, Lords of Finance: The Bankers Who Broke The World, which received the Pulitzer Prize in history. That road to Hell tidily was summed up in a recent piece in The Economist, Breaking the Rules: “The short-lived interwar gold standard … was a mess.” As EPPC’s John Mueller recently observed, in Forbes.com, “the official reserve currencies which Keynes advocated fed the 1920s boom and 1930s deflationary bust in the stock market and commodity prices.”
The predicament — caused by the gold-exchange standard adopted in Genoa in 1922 — required a revaluation of the dollar to $35/oz, duly if eccentrically performed by FDR under the direction of commodities price expert economistGeorge Warren. That revaluation led to a dramatic and rapid lifting of the Great Depression. Thereafter, as Calomiris, et. al, observe in a publication by the Federal Reserve Bank of St. Louis, the Treasury sterilized gold inflows. That sterilization, together with tax hikes, most likely played a major role in leading to the double dip back into Depression.
The classical gold standard — an early casualty of the First World War — was not, indeed could not have been, the culprit. There is a subtle yet crucial distinction between the gold-exchange standard, which indeed precipitated the Great Depression, and the classical gold standard, which played no role.There is much to be said for the classical gold standard as a policy conducive to equitable prosperity. It commands respect, even by good faith opponents.
For the discourse to proceed we first must lay to rest the Eichengreen Fallacy (and all that is attendant thereon). Once having dispelled that toxic fallacy let the games begin and let the best monetary policy prescription win.
Originating at Forbes.com: http://www.forbes.com/sites/ralphbenko/2014/11/04/the-eichengreen-fallacy-misleads-some-market-monetarists-part-2/
China first delegated the management of gold policy to the People’s Bank by regulations in 1983.
This development was central to China’s emergence as a free-market economy following the post-Mao reforms in 1979/82. At that time the west was doing its best to suppress gold to enhance confidence in paper currencies, releasing large quantities of bullion for others to buy. This is why the timing is important: it was an opportunity for China, a one-billion population country in the throes of rapid economic modernisation, to diversify growing trade surpluses from the dollar.
To my knowledge this subject has not been properly addressed by any private-sector analysts, which might explain why it is commonly thought that China’s gold policy is a more recent development, and why even industry specialists show so little understanding of the true position. But in the thirty-one years since China’s gold regulations were enacted, global mine production has increased above-ground stocks from an estimated 92,000 tonnes to 163,000 tonnes today, or 71,000 tonnes* ; and while the west was also reducing its stocks in a prolonged bear market all that gold was hoarded somewhere.
The period I shall focus on is between 1983 and 2002, when gold ownership in China was finally liberated and the Shanghai Gold Exchange was formed. The fact that the Chinese authorities permitted private ownership of gold suggests that they had by then acquired sufficient gold for monetary and strategic purposes, and were content to add to them from domestic mine production and Chinese scrap thereafter rather than through market purchases. This raises the question as to how much gold China might have secretly accumulated by the end of 2002 for this to be the case.
China’s 1983 gold regulations coincided with the start of a western bear market in gold, when Swiss private bankers managing the largest western depositories reduced their clients’ holdings over the following fifteen years ultimately to very low levels. In the mid-eighties the London bullion market developed to enable future mine and scrap supplies to be secured and sold for immediate delivery. The bullion delivered was leased or swapped from central banks to be replaced at later dates. A respected American analyst, Frank Veneroso, in a 2002 speech in Lima estimated total central bank leases and swaps to be between 10,000 and 16,000 tonnes at that time. This amount has to be subtracted from official reserves and added to the enormous increase in mine supply, along with western portfolio liquidation. No one actually knows how much gold was supplied through the markets, but this must not stop us making reasonable estimates.
Between 1983 and 2002, mine production, scrap supplies, portfolio sales and central bank leasing absorbed by new Asian and Middle Eastern buyers probably exceeded 75,000 tonnes. It is easy to be blasé about such large amounts, but at today’s prices this is the equivalent of $3 trillion. The Arabs had surplus dollars and Asia was rapidly industrialising. Both camps were not much influenced by western central bank propaganda aimed at side-lining gold in the new era of floating exchange rates, though Arab enthusiasm will have been diminished somewhat by the severe bear market as the 1980s progressed. The table below summarises the likely distribution of this gold.
Today, many believe that India is the largest private sector market, but in the 12 years following the repeal of the Gold Control Act in 1990, an estimated 5,426 tonnes only were imported (Source: Indian Gold Book 2002), and between 1983 and 1990 perhaps a further 1,500 tonnes were smuggled into India, giving total Indian purchases of about 7,000 tonnes between 1983 and 2002. That leaves the rest of Asia including the Middle East, China, Turkey and South-East Asia. Of the latter two, Turkey probably took in about 4,000 tonnes, and we can pencil in 5,000 tonnes for South-East Asia, bearing in mind the tiger economies’ boom-and-bust in the 1990s. This leaves approximately 55,000 tonnes split between the Middle East and China, assuming 4,850 tonnes satisfied other unclassified demand.
The Middle East began to accumulate gold in the mid-1970s, storing much of it in the vaults of the Swiss private banks. Income from oil continued to rise, so despite the severe bear market in gold from 1980 onwards, Middle-Eastern investors continued to buy. In the 1990s, a new generation of Swiss portfolio managers less committed to gold was advising clients, including those in the Middle East, to sell. At the same time, discouraged by gold’s bear market, a western-educated generation of Arabs started to diversify into equities, infrastructure spending and other investment media. Gold stocks owned by Arab investors remain a well-kept secret to this day, but probably still represents the largest quantity of vaulted gold, given the scale of petro-dollar surpluses in the 1980s. However, because of the change in the Arabs’ financial culture, from the 1990s onwards the pace of their acquisition waned.
By elimination this leaves China as the only other significant buyer during that era. Given that Arab enthusiasm for gold diminished for over half the 1983-2002 period, the Chinese government being price-insensitive to a western-generated bear market could have easily accumulated in excess of 20,000 tonnes by the end of 2002.
China’s reasons for accumulating gold
We now know that China had the resources from its trade surpluses as well as the opportunity to buy bullion. Heap-leaching techniques boosted mine output and western investors sold down their bullion, so there was ample supply available; but what was China’s motive?
Initially China probably sought to diversify from US dollars, which was the only trade currency it received in the days before the euro. Furthermore, it would have seemed nonsensical to export goods in return for someone else’s paper specifically inflated to pay them, which is how it must have appeared to China at the time. It became obvious from European and American attitudes to China’s emergence as an economic power that these export markets could not be wholly relied upon in the long term. So following Russia’s recovery from its 1998 financial crisis, China set about developing an Asian trading bloc in partnership with Russia as an eventual replacement for western export markets, and in 2001 the Shanghai Cooperation Organisation was born. In the following year, her gold policy also changed radically, when Chinese citizens were allowed for the first time to buy gold and the Shanghai Gold Exchange was set up to satisfy anticipated demand.
The fact that China permitted its citizens to buy physical gold suggests that it had already acquired a satisfactory holding. Since 2002, it will have continued to add to gold through mine and scrap supplies, which is confirmed by the apparent absence of Chinese-refined 1 kilo bars in the global vaulting system. Furthermore China takes in gold doré from Asian and African mines, which it also refines and probably adds to government stockpiles.
Since 2002, the Chinese state has almost certainly acquired by these means a further 5,000 tonnes or more. Allowing the public to buy gold, as well as satisfying the public’s desire for owning it, also reduces the need for currency intervention to stop the renminbi rising. Therefore the Chinese state has probably accumulated between 20,000 and 30,000 tonnes since 1983, and has no need to acquire any more through market purchases given her own refineries are supplying over 500 tonnes per annum.
All other members of the Shanghai Cooperation Organisation** are gold-friendly or have increased their gold reserves. So the west having ditched gold for its own paper will now find that gold has a new role as Asia’s ultimate money for over 3 billion people, or over 4 billion if you include the South-East Asian and Pacific Rim countries for which the SCO will be the dominant trading partner.
*See GoldMoney’s estimates of the aboveground gold stock by James Turk and Juan Castaneda.
**Tajikistan, Kazakhstan, Kyrgyzstan, Uzbekistan, India, Iran, Pakistan, and Mongolia. Turkey and Afghanistan are to join in due course.
Janet Yellen gave a widely noted speech, Perspectives on Inequality and Opportunity from the Survey of Consumer Finances, at the Conference on Economic Opportunity and Inequality held by the Federal Reserve Bank of Boston on October 17th.
The speech presented as a if ghostwritten for her by Quincy Magoo, that beloved cartoon character described by Wikipedia as “a wealthy, short-statured retiree who gets into a series of comical situations as a result of his nearsightedness compounded by his stubborn refusal to admit the problem.” What was most interesting was how political was the speech… and what Madame Yellen didn’t say.
Her omission even raised an eyebrow of one of the commentariat’s most astute Fed sympathizers, The Washington Post‘s Ylan Q. Mui. Mui: “Yellen did not address in her prepared text whether the Fed has contributed to inequality. Nor did she weigh in on whether it may actually be slowing down economic growth, an idea that is gaining traction among economists but which remains controversial.”
Yellen’s speech drew a public comment from the Hon. Steve Lonegan, director of monetary policy for American Principles Project and project director of its sister organization’s grass roots FixTheDollar.com campaign (which I professionally advise):
There is a strong correlation between the post-war equitable prosperity to which Madam Yellen alluded and the post-war Bretton Woods gold-exchange standard. And there is a strong correlation between the increase in inequality under the Federal Reserve Note standard put into effect by President Richard Nixon to supplant Bretton Woods.
The monetary policy of the United States has a profound impact on wage growth and prices, both domestically and internationally. Hence the importance of a thorough, objective, and empirical look at its policies — from Bretton Woods through the era of stagflation, the Great Moderation, and the “Little Dark Age” of the past decade.
That is why the Brady-Cornyn Centennial Monetary Commission, and the Federal Reserve Transparency Act which recently passed the House with a massive bipartisan majority, are critical steps forward to ending wage stagnation and helping workers and median income families begin to rise again. As President Kennedy once said, “Rising tide lifts all boats.”
Madam Yellen addresses four factors in what she calls “income and wealth inequality.” Madame Yellen stipulates that “Some degree of inequality in income and wealth, of course, would occur even with completely equal opportunity because variations in effort, skill, and luck will produce variations in outcomes. Indeed, some variation in outcomes arguably contributes to economic growth because it creates incentives to work hard, get an education, save, invest, and undertake risk.”
Even with that ostentatious stipulation, the Fed Chair’s speech is amplifying one of the Democratic Party’s foremost election themes, “income inequality.” The New York Times‘s Neil Irwin observed of this speech: “Nothing about those statements would seem unusual coming from a left-leaning politician or any number of professional commentators. What makes them unusual is hearing them from the nation’s economist-in-chief, who generally tries to steer as far away from contentious political debates as possible.”
Her speech could be read as an Amen Corner to Elizabeth Warren’s stump speech, on behalf of Sen. Al Franken’s reelection effort, that “The game is rigged, and the Republicans rigged it.” Her speech could be read as a little election-season kiss blown to Sen. Franken (D-Mn), who voted for her confirmation and then glowed on Madame Yellen very publicly.
One cringes at the thought that the Fed even might be giving the appearance of playing politics. To align the Fed, even subtly, with either party’s election themes during an election season would seem a deeply impolitic, and unwise, violation of the Fed’s existential principle of political independence. House Financial Services Committee chair Jeb Hensarling and Sen. Mike Crapo (R-Id), should he accede to the chairmanship of the Senate Banking Committee, might just wish to call up Madam Yellen for a public conversation about avoiding even the appearance of impropriety.
The Fed’s independence is as critical as it is delicate. To preserve it demands as much delicacy by the officials of the Federal Reserve System as by the Congress. As Barack Obama might say, here is a “teachable moment” for our new Fed chair.
Also troubling is the decision by the Chair to focus her mental energy, and remarks, on four areas entirely outside the Fed’s jurisdiction: resources available for children; higher education that families can afford; opportunities to build wealth through business ownership; and inheritances. These might be splendid areas for a president’s Council of Economic Advisors (which Madame Yellen chaired, commendably, under President Clinton). Good topics for a professor emerita at the University of California, Berkeley, Haas School of Business, as is Madam Yellen.
They are, however, at best mere homilies from the leader of the world’s most powerful central bank. We would like to hear Madam Yellen talk about monetary policy and its possible role in the diminishing of economic mobility. It does not seem like too much to ask.
Since Madame Yellen, rightly, is considered an eminent Keynesian (or Neo-Keynesian), why not begin with Keynes? In The Economic Consequences of the Peace, Chapter VI, Keynes addressed this very point. The brilliant young Keynes was addressing the insidious power of inflation, not now in evidence and not portended by the data. Yet let it be noted that there is more than one way to debauch a currency:
Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. … By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become ‘profiteers,’ who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. …
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.
America and the world needs, and rightly expects, the chair of the Federal Reserve to be that one in a million able to diagnose. Madame Yellen is called upon to step up her game and pivot from pious homilies to the heart of the matter. If Keynes could call out how bad monetary policy can strike “at confidence in the equity of the existing distribution of wealth,” perhaps so too ought his followers.
What is to be done? Wikipedia also observes of Mr. Magoo that “through uncanny streaks of luck, the situation always seems to work itself out for him, leaving him no worse than before.” We devoutly hope that Madame Yellen — and, thus, the economy — will be the beneficiary of “uncanny streaks of luck.” Hope is not a strategy. Relying on luck tautologically is a dicey way of bringing America, and the world, to a renewed state of equitable prosperity.
Rely on luck? It really is time to shift gears. An obvious place for Madame Yellen to begin would be to register active support for the Brady-Cornyn Centennial Monetary Commission designed to conduct a thorough, empirical, bipartisan study of what Fed policies have worked. What policies of the Federal Reserve have proven, in practice, or credibly portend to be, conducive to equitable prosperity and healthy economic mobility?
Should the correlation between the (infelicitously stated if technically accurate) “40 years of narrowing inequality following the Great Depression” and the Bretton Woods gold-exchange standard be ignored? Why ignore this? Should the tight correlation of “the most sustained rise in inequality since the 19th century” with the extended experiment in fiduciary dollar management be ignored? Why ignore that?
What might be learned from the successes of the Great Moderation inaugurated by Paul Volcker? Is Volcker’s recent call for a “rules-based” system, a position from which Madam Yellen staunchly dissents, pertinent? Discuss.
Madame Yellen? Let’s have a national conversation about monetary policy and its effects on economic mobility. It really is time to bring to a decisive end many decades of Magooonomics and the disorders that derive therefrom. Fire Magoo. Show the world that you are Keynes’s one in a million.
Originating at Forbes.com: http://www.forbes.com/sites/ralphbenko/2014/10/20/janet-yellen-the-new-magoo-2/