Credit ratings agencies have come under fire for not being proactive enough in recognizing bad sovereign risks. Even if the ratings agencies were a little quicker with the downgrades, the result would not be significantly different for investors. This is because there are two paths to default.
Credit ratings agencies exist to measure one thing – the risk that an entity will explicitly default on its obligations. In this regard, ratings agencies by-and-large do fairly well. What they do not do well (nor is it their job), is to assess the risk of the other default, the one by inflation.
Charles Goodhart argues that we can see the distinction if we compare the plights of two countries. England has high debt to GDP levels, yet has retained its rating through the recent downward revisions. France, by comparison, has lower debt levels and was recently downgraded. What gives?
Some would argue, as the ratings agencies do, that France is threatened because she cannot inflate her worries away. The Euro blocks this option, as Paris must succumb to Frankfurt on monetary affairs. England faces no such constraint, or at least, not an insurmountable one. The Bank of England might be nominally independent from Her Majesty’s Government. Yet what the crown gives it can take away. The BoE can be a direct policy arm of parliament if need be. When faced with insolvency, such a course of action is foreseeable.
Inflation (both measured and expected) is already higher in the UK than in France. While the investor buying French debt worries about a small chance at not getting his money back, the buyer of British bonds faces the fact that the bond’s nominal value is continually eroded at a faster rate than his French counterpart.
For the investor, it makes no difference which default occurs. Whether explicitly at a moment through insolvency or slowly through inflation, the effect is the same. Long drawn out tortures can be just as effective as swift death sentences (sometimes more so).
Investors fixated on credit ratings are cognizant of only half the story. Given this, one wonders if the official ratings mean anything at all.
Take the United States, for example. Its recent downgrade brought into question Washington’s ability to pay off its national debt (among other obligations). But that was just making explicit what was already implicit for decades. As inflation ate away at the nominal value of the debt, the country was slowly defaulting by another means.
Some may look at the low interest rates on US Treasuries right now, and argue that the risk of default is low. These investors would likely be correct. One could also argue that interest rates are low because the Fed has been purchasing large quantities of them, and without this intervention rates would signal a much different story. This story is also likely correct. But the latter story is just removing the explicit default risk from the Treasury and giving it to the Fed. The Fed will just buy more bonds from the Treasury to finance the payoff of the existing ones if the threat of default nears. This amounts to default not at the hands of Treasury, not explicitly anyhow. This becomes a Fed-orchestrated default, through the process of inflation.
Rating agencies do investors a great favour by pointing out the explicit default risk of different debt securities. Investors would do well to recognize the limited relevance of these ratings, especially in light of the continual implicit defaults we are exposed to through inflation.
Both the US Federal Reserve and the European Central Bank are now offering limitless quantities of new money – the ECB to support the banks, and the Fed for reasons (despite explanations) that are not entirely clear. The Fed in its press release announced that it expected interest rates to “warrant exceptionally low levels for the Federal Funds Rate at least through late 2014.” The fact that the central banks governing the two most important currencies in the world are issuing money to all-comers at very little interest cost for up three years has not been lost on gold and silver, whose prices shot up in response to the Fed’s announcement.
The Fed has effectively extended its zero interest rate policy (ZIRP) for another 18 months. The reason stated is “low rates of resource utilisation and a subdued outlook for inflation in the medium run”. More important perhaps and unsaid is the presidential election due later this year and the need to finance a deficit that seems impossible to cut.
The Fed is running huge risks with its extended ZIRP, principally with monetary inflation morphing into price inflation. To help achieve its low inflation target the Fed uses the Personal Consumption Expenditures Price Index (PCEPI), which assumes that consumers switch spending from higher priced goods to those that are stable or falling. The result is that this index rises at about one-third less than the Consumer Price Index, which itself rises at less than half the CPI calculated on the more honest methodology used before 1980. The upshot is that the Fed uses inflation targets that are so heavily adjusted that they are effectively meaningless.
To the Keynesians at the Fed, subdued inflation is linked with a sluggish economy, and here the Fed is very selective in its approach. It admits that employment is picking up, and household spending “continues to advance”; but instead chooses to worry over slowing fixed investment and a depressed housing sector. Surely, whatever your views, there are enough signs of economic stabilisation to justify sitting on the fence, instead of committing to ZIRP for an extra 18 months.
I take the view that Gross Domestic Product is likely to surprise on the upside, as I wrote in an article for GoldMoney on 10 January. In that article I gave concrete reasons why, and suggested that money will begin to flow from capital markets into the economy. This is important, because GDP is only a money quantity and can rise without any underlying economic progression – the difference being reflected in the prices of goods and services. So GDP can actually rise with no underlying improvement in economic activity, it merely reflecting higher prices.
Changes in the prices of goods and services are actually impossible to measure and so cannot be quantified. Under-reporting price increases by using an index approximation such as the GDP deflator, which represents price inflation similarly to the PCEPI, artificially inflates real GDP. It will be interesting to hear what excuse the Fed comes up with then for the continuing for even longer with ZIRP. The reality is that the Fed and other central bankers are cornered and have only one tool left: issue as much paper money as it takes to prevent systemic financial calamity. This realisation is only just dawning on individuals with savings to protect, which is why precious metals were right to rise so sharply.
This article was previously published at GoldMoney.com.
This phrase has suddenly started appearing in economic research, and will probably do so more frequently in the coming months. Its origin is a Bank for International Settlements working paper co-authored by Carmen Reinhart and Belen Sbrancia, economists well enough known to merit attention. So what is it all about?
Financial repression includes directed lending to governments by captive funds such as pension and insurance funds, artificial caps on interest rates, restrictions on capital flows and a generally tighter connection between government and banks. Some or all of these devices have been used in the past to reduce the level of government debt to GDP, particularly in the two decades after the Second World War. Many countries reduced the level of their outstanding debt by a significant amount over a 10 to 20 year timeframe through these techniques, assisted by moderate levels of inflation.
Two of the alternatives to financial repression listed in the paper are clearly unpalatable: default, and “a burst of high inflation”. Two further alternatives are either impractical or politically unattractive: economic growth, which is slipping away further into the future, and austerity plans involving years of unpopular policies with the risk of a deflationary depression. For these reasons, financial repression seems the default option to Reinhart and Sbrancia.
Some of its elements are already being implemented. eurozone bail-outs involve contributions from government-controlled pension funds. Bank and financial regulation allocates lower risk weightings to government debt, giving it a systemic subsidy despite current events. Interest rates are being held below the rate of inflation by central banks, lowering the cost of borrowing for most governments to artificially cheap levels.
But will it work this time? To do so will require private individuals to continue with an unquestioning belief in the soundness of their paper currencies. In the wake of Bretton Woods, when there was a gold exchange standard underpinning the dollar, together with higher levels of national patriotism, the might of the dollar was never questioned. Instead, we now have a US dollar-standard with substantial levels of foreign ownership of government debt and an increasingly sceptical public. This suggests that financial repression would probably bring on a currency crisis.
Reinhart and Sbrancia are not recommending financial repression, but they are right to point out its attractions to governments in financial difficulties. It is, in the cliché often used today, a description of the various means of kicking the can down the road. This is something governments have been doing for a long time: it has generally worked in the past, so they are almost certain to assume it will work again now.
However, economic and financial problems are rapidly mounting. Today’s situation is very different from the end of WW2 with all that destructive spending replaced by people rebuilding for the future, as they did in the 1950s and 1960s. Instead, our systemic and economic problems are leading to yet more deterioration in government finances. No amount of financial repression can fix that.
In this video Philipp Bagus, Assistant professor of Economics at Madrid’s Universidad Rey Juan Carlos and author of The Tragedy of the Euro and Alasdair Macleod of the GoldMoney Foundation talk about the eurozone facing the problem that is characterised in the “tragedy of the commons” analogy. Bagus explains this phenomenon by way of an example of overfished and over-exploited oceans due to a lack of property rights on oceans. In Europe, governments run larger deficits than their “competitors” in order to externalise the costs to all users of the currency. Knowing these incentives, the Stability and Growth Pact was put in place as per the early 1990s Maastricht Treaty, capping budget deficits at 3% of GDP and the debt to GDP level at 60%. However there was no enforcement of these rules which is why there have already been more than 80 infringements to this stability pact without any repercussions.
They talk about possible solutions to the euro crisis. Bagus points out that there are basically three different ways to go about it. Firstly, governments could make drastic cuts in public spending and privatise public assets in order to balance their budgets. However, there will be – and is – strong political resistance to such proposals. Secondly, the eurozone could disintegrate, driven by a reluctance of German citizens to pay for other countries’ expenditures. And lastly, central banks and governments could decide to print their way out of the crisis, leading to high inflation.
Bagus says that as long as the incentive for running deficits exists there won’t be an increase in countries’ savings rates. Macleod points out that there is great institutional resistance to breaking up the euro. Bagus explains that the official opinion towards the euro is positive in Germany; however the sentiment on the streets looks quiet different. But as long as there is no political party devoted to this issue this mood is not likely to gain traction at least as long as inflation remains moderate.
Amid the ongoing expansion of the money supply and persistent deficits, Bagus can’t see the dollar gaining in value over the medium to long term. He also says that ECB policies are a lot more pragmatic than the ones undertaken by the US Federal Reserve. Talking about sound money, Bagus explains different ways to go about its introduction. One way would be to back all the money in existence by gold, adjusting the price of gold accordingly. Another would be to take away legal tender laws and have competing currencies. However this would require the governments to impose dramatic reforms, which is partly why they will oppose such measures.
This interview was recorded on November 15 2011 in Madrid.
So, here we are, drawing to the close of another year and still we struggle with the legacy of the last Boom, still we search around for macro economic Tooth-Fairy, ‘liquidity’ solutions to the problems caused by our earlier misallocations of capital instead of facing the fact that insolvent entities need to be liquidated and their assets put to work by people who’ve shown they can run their businesses successfully without a government crutch!
Thus, having started the year with gains of almost 10%, nominal total returns for MSCI World equities are off 7%, with the US flat and the Eurozone down by nearly 20% – as are the Emerging Markets in which it seems every portfolio manager (as well as a great number of real business leaders) is putting so much faith. Junk returns have been their lowest in more than eight years, barring period of the Crash itself. In commodities, Base Metals are off by a quarter; Ags by a fifth; and Energy is flat – largely thanks to the little local difficulty experienced by the dear, departed Colonel!
Only the Precious Metals show anything substantially in the plus column, being up 7%, and even that gain is due to gold alone and nothing else. So, with those flight-to-quality stalwarts, Bunds, up 17% and UST’s up 28% – their best showing in 13 and 26 years, respectively – it’s been another bust for the ‘Risk On’ front-runners of global recovery ever since the Fed let its distortive, but otherwise largely ineffective QE-II programme expire in the summer.
Are things going to get any better in the near future? In answering this, we should never underestimate the efforts of all those at work in the market economy whose only honest route to material self-satisfaction is to provide a service which their fellows will value, in their turn. Diligence and determination, leavened with a soupçon of entrepreneurial insight and fuelled by the dedication of earned surpluses to capital re-accumulation is ultimately the only remedy for the ills which afflict us and it would be foolish indeed to say that this process is not ongoing, however much it is being hampered by the stupidity of the Philosopher Kings.
That said, our blind persistence with the worst kind of Rooseveltian ‘experimentation’ and our obsession with monetary necromancy constitute nothing less than a major inhibition of this immunological response of self-healing through thrift and innovation.
Indeed, one has to fear that the faulty signals given off by all the measures so far taken – many of them beyond even the conception of all but the most wild-eyed monetary cranks before we started down into this particular Vale of Tears – have already caused some of those same healing mechanisms to turn cancerous. Who can say how much well-intentioned effort over the past three years – however fruitful it has appeared to have been in the interim – has been misled into taking for permanent and self-sustaining what is only a short-lived artefact of a massive monetary and fiscal intervention which cannot continue indefinitely without bringing about the complete destruction of the market order – and, probably, the liberal society which it fosters?
Beside the peril this engenders for even the most perspicacious entrepreneur (a man who, no matter how well-endowed with exceptional Kirznerian vision, can never, to quote Hayek, really know his place on the complex, topological manifold which is the modern productive structure), the difficulties it throws up for us players in the sigils and ciphers of capital may seem trivial enough. Yet, it cannot be healthy for any of us when, with so much of the basic pricing mechanism in the market not functioning – whether because of accounting suspensions, bail-outs and support schemes, currency interventions, the imposition of zero interest rates, collateral squeezes, the disease of HFT – we all have been reduced to trying to work out what constellation of data, or what political mood will next allow Bernanke or his peers to launch their helicopters, financing both public wastefulness and private denialism, and so give us all a few months’ trading rally.
So perverse has this become that the market can sometimes persuade itself that, in this Bizarro-world which we inhabit, weak data is to be construed a positive since it increases the likelihood of another burst of official inanity, despite the fact that such actions as will then be taken will not only fail to address the underlying problems, but will surely add new woes to the list, every time they are undertaken.
So, for example, much has been made of the fact that, next year, the usual rotation of bottoms on seats means will we not only get an even more Dovish mix on the FOMC (sic!), but that 2012 is an election year, meaning that the Administration will be expecting the usual helpful policy settings pretty early in the spring, with the aim of producing an artificial slew of good news, right about the time people go to vote in the Fall.
What this really implies is that we have actually become conditioned to welcome the periodic alternation of the authorities’ heavy-footed recourse to the accelerator and the brake, in total disregard of the damaging consequences such a hysteresis inevitably entrains.
Are we doomed to stage a re-run of QEI, QEII and the rest, only to see the cost of living go up for ordinary folks by more than their incomes; only for the whole economy to roll over again when the groundswell of complaints leads to the stimulus being temporarily withdrawn again? If so, we will inculcate two, decidedly unhelpful lessons in the public mind: one, that prices – while not immune from cyclical swings – will ratchet higher and higher at each pass; and, two, that while cost control can be relaxed if those rising prices offer some undue security of return to the producer, it is nonetheless not wise to over-commit one’s resources during the initial sugar-rush for fear of being over-extended when it is next suspended.
The term for what may then result is ‘stagflation’.
In Europe – where the most acute dangers seem to lie at present – this may seem some way from being the case. Monetary growth has, after all, slowed to such a point that – ceteris paribus – we should expect price rises to show clear signs of slackening in the coming months unless the users and holders of the euro lose a sufficient degree of faith in their money that they strive more anxiously to get rid of it, regardless of its objectively less ample supply. Signals will naturally be hard to unscramble here, but among the symptoms would almost certainly be a weakening of the currency’s value on the foreign exchanges. The fact that this has begun to occur is by no means conclusive to the case but should nevertheless alert us to be on the look-out for other such behaviours for confirmation that this inflationary erosion of trust may be under way.
Europe’s travails are being all the more drawn out because of the incomplete realisation that the scale of the vulnerabilities built up during the last 10 years’, risk-dulled Rake’s Progress is unlikely to respond to piecemeal solutions – certainly not to a belated reimposition of the original Stability Pact, however laudable such a Gladstonian form of finance might be. Nor is it politically reasonable to expect the populace to endure quarter after quarter of grinding ‘austerity’ in order to keep their debtors happy, with no prospect of any early relief from their torment.
There may, truly, be little chance that such an approach will lead to growth, as the Keynesian defenders of Big Government and unsound finance never cease to assert, but this is because theirs is a very extravagant version of ‘austerity’, indeed. Under this, their beloved Leviathan – even if pared of some of its ability to use debt to corrupt the elections and pervert representational accountability – must otherwise be restricted in its diet as little as possible.
Thus, it continues to commandeer scarce resources, pushing up their prices beyond the level at which some enterprising fellow could use them to expand his own business. Thus, too, the state still imposes its grossly-expanded menu of priorities on individuals thereby denied a due measure of choice in their own affairs. Worse, yet, by persuading such persons that public services (and disservices) are ‘free’, the state precludes a proper ordering of them in people’s subjective rankings while instilling the message that they are somehow a ‘right’. They are typically abused as a result, while the ‘broken window’ effect prevents some hidden other from taking their place and thereby increasing general satisfaction.
Given this dreadful predilection to keep the state as swollen as possible, the Keynesian parody of ‘austerity’ can only mean a greater proportionate diversion of a lesser stream of income to its belly. The hard-pressed citizenry not only sees its gross wage packet shrink (something which, alas, may be necessary to price them back into jobs) but the tax-take soar on its members, their prospective employers, and their would-be capital-provisioners, too.
Nor, given the implicit threat that, the minute the storm has passed, the state will go back to living out its Neo-Jacobin fantasies on credit, will the crushing burden of past debts be lifted, for any such full or partial repudiation will be deemed greatly to impair its future ability to borrow. Thus, the gluttonous jacks-in-office casually increase their call upon the living standards of today’s subjects in order to preserve their future potential to alienate that of their children, once more.
No-one, of course wants to do the sensible thing: to allow for meaningful debt write-offs against the promise of budgets which are balanced by cutting expenditures to the bare, safety-net bone and only by raising taxes as a very last resort – and then on consumption, not on capital, for preference. Combine this with a broad programme of liberalisation and a decimation of the ranks of bureaucratic Nannies who so stifle self-reliance and individual endeavour and we might just encourage that so-far elusive replacement of profligate public by profitable private sector activity. Whisper it, but growth might then begin flourish among the Ozymandian ruins of the Warfare-Welfare state.
Oh, and if any of this puts banks in jeopardy, let them fail where they must and encourage the swift application of transparent judicial action to re-distribute both the deposit base and the loan book (suitably marked-down and written off necessary) among the hands of the well-capitalised and the still-solvent.
Instead of this, the establishment is shielding the banks from the consequences of their own folly, even as it is dragging them down in a drowning man’s clutch by linking them ever more tightly to the fortunes of the governments whom they have already treated in far too lax a fashion. Beside this, the mooted ‘fiscal union’ is short-hand for more ‘German Reparations’ – this time, for winning the peace, not losing the war – while unrestrained ECB bond-buying is clearly a road to ruin, even if it is disguised by laundering it through the IMF, or offering ‘unlimited’ term funds to bond-buying banks, or setting up its own SIV in the form of a leveraged, bank-licensed ESM.
We Anglos tend chronically to underestimate the determination of the Euro nomenklatura to hold their grand project together and therefore do not always appreciate the degree of pain they are willing to endure to that end, but – really – is there any chance they will see this through without radically revising their approach? If not, ought we not to try to imagine what will give way first? The 27 as a unitary body? Frau Merkel’s insistence on fiscal self-reliance? Or the ECB’s self-image as a grander Bundesbank? The ramifications of each are as different as they are profound.
Finally, we come to our favourite bone of contention – China!
Money supply there is growing at the slowest pace in at least fifteen years; funds seem to be leaking back out of the country as confidence in yuan appreciation wanes; property sales – on which so much finance (and, one suspects, so many ‘profits’) depend – have all but evaporated; SMEs are bleeding badly, squeezed between higher costs, tighter credit, and sagging external markets. Is there still room for doubt that the end of the last three years’ orgy of credit expansion – that 20% a year, 40% of GDP bloating of bank assets – has brought about the inevitable ‘hard landing’?
Again, the stock promoters in the West want to reassure us (a) that China’s all-knowing bosses can ‘fine-tune’ this – to put that horribly overworked phrase to use – and that – YAWN! – weakness now means much more stimulus next quarter, so this is only a blip – a ‘buying opportunity.’
Forgive the cynicism, but your author seems to remember that Ben Bernanke thought he could ‘fine tune’ things back in 2007/08 about the same time that Mervyn King and his team were confident of achieving the mythical ‘soft landing’ in Britain. On top of that, we have the signal success of all our efforts at re-inflating a collapsing property bubble to reinforce our confidence in Beijing’s abilities to do likewise.
In the circumstances, there is no danger of our being overly sanguine about the depth and seriousness of the underlying problems in China: even the key, annual central economic work conference in Beijing summed up the world situation as ‘extremely grim and complex’. Remarkably, however, that same meeting declared that ‘prudent’ monetary and ‘flexible’ fiscal policy (no indiscriminate easing, but lots of tinkering with tax and subsidy) would serve to deliver a stability defined as a ‘means to maintain basically steady macro-economic policy, relatively fast economic growth, stable consumer prices and social stability’.
Good luck with that, chaps!
Both arising out of and then compounding all this economic disquiet we have an ongoing crisis of legitimacy in politics.
We have the Tea Party and Occupy Wall Street active on the opposite ends of the US political spectrum. We have the rise of splinter groups like the ‘Real Finns’ in their homeland or the ‘Pirate Party’ in Germany. We have worries about what reaction there will be when the tyranny of ‘technocratic’ government by Goldman Sachs alumni really bites home. We have the Arab Spring. We have street protests in Moscow and persistent rumblings about civil unrest in China.
Not helping matters, the US and its allies are sabre-rattling in the Gulf and stirring up trouble in the South China Seas, while even comic opera Argentina seems to be sorely tempted by the chance to make another grab for ‘Las Malvinas’ now that the interloping Brits seem to be on their uppers.
On the one hand, a shake up of the cosy orthodoxy which led us into the dire straits in which we find ourselves is no bad thing – assuming this all stops short of bloodshed, of course – but, on the other, the pervading sense of impermanence can only add to the uncertainties faced by economic decision makers everywhere, whether entrepreneurs, managers, investors, or ordinary householders.
As we have often argued, this is only likely to dampen further the chances of generating a self-sustaining recovery – so much so, in fact, that it would almost be better for policy-making to be suspended, here, far short of any ideal formulation, so that at least everyone knows the obstacles they will have to surmount and the nature of the challenges they will face and so can set about planning to overcome them.
But to expect career bureaucrats and lifelong, professional politicians to simply cease and desist in their collectivist conceit that they and only they can fix what they simultaneously deny they first broke is, well, to expect those seasonally-fattened gallinaceous bipeds to welcome the onset of Yule!
A Merry Christmas and a Prosperous New Year to one and all!
Apologies to my readers that no new contributions have appeared on the Schlichter Files for two weeks, and in particular that I did not get around to responding to some of the questions and comments on my blog. I hope to rectify this shortly. I was committed to a few speaking engagements in connection with my book Paper Money Collapse – The Folly of Elastic Money and the Coming Monetary Breakdown. Also, the brokerage firm CLSA was so kind to arrange a whole string of meetings with their clients in London and in Milan on the topic of the book, and this has taken up most of my time last week.
Last week was supposed to be a major week for Europe. We had the ECB meeting on Thursday and then another EU summit to ‘solve’ the eurozone debt crisis on Thursday and Friday. Of course, nothing has changed, nothing has been solved, and quite frankly, I do not see any reasons whatsoever for changing my analysis of what is going on and how all of this is likely to end – badly, that is. If anything, the events of last week confirm that authorities are adamant to continue travelling further on the road to complete currency destruction – not only in the eurozone but equally in the U.S. and the UK, although the latter two are managing to escape closer scrutiny by markets for the time being. As usual, I felt that most of the commentary in the media was missing the main points.
The problems around the world are essentially the same. After decades of ongoing and generous expansion of the fiat money supply, of artificially low interest rates and cheap credit, banks are hopelessly overextended, asset markets are distorted, and sovereign states are bust. I sometimes get pushback on the last point. Are they really bust? – Yes, most of them are. They have acquired debt loads and spending habits – now very deep-rooted and practically impossible to eradicate – that require constant new borrowing at fairly low interest rates – cheap credit forever. Obviously, that is not going to happen. The end of the forty-year credit boom has arrived. The private sector is no longer playing ball.
What needs to happen? The overextended credit edifice needs to be cut back to a size that is commensurate with the underlying pool of real voluntary savings and with underlying real income streams. Money printing and the constant attempt to manipulate lending rates down have to stop. The market has to finally be allowed to set interest rates that reflect the true cost of available savings, and to liquidate what is not sustainable. Deleveraging, default, and debt deflation are necessary to bring the economic structure back into balance. Is this painful? – You bet. It is also unavoidable. There is no other solution. Yet, the solution is deemed politically unacceptable and it is thus being fought tooth and nail. Not only in the US and the UK, also in Europe.
The entities that are most under stress in this scenario are the banks and the debt-addicted states. You know my forecast: the central banks will be asked to underwrite the states and the banks directly with the help of the printing press on an ever-larger scale, and this will ultimately lead to higher inflation and finally to paper money collapse: the end of our present fiat money system, the latest experiment in the sad history of unlimited and fully elastic state money systems.
While this is broadly a global story, many people question whether it really applies to Europe. Isn’t the ECB more conservative, more Bundesbank-like, and thus less prone to debt monetization than the other central banks? Is there not some real effort being made in Europe to sort out the fiscal problems? – No. Most of it is simply theatre that has no or little implication for the final outcome. Let me explain.
The EasyB.
Like the other major central banks around the world, the ECB played its role in setting the world up for the credit bust by providing the cheap credit for the preceding credit boom. The ECB’s balance sheet – or rather the consolidated statement of the Eurosystem as it is correctly termed – started out at less than €690 billion in 1999. On the eve of the present credit crunch, in the summer of 2007, the balance sheet had reached a size of €1.2 trillion. In fact, over this period the ECB’s balance sheet had grown faster than that of the Fed. Like all other central banks, the ECB has, since the crisis began, become the lender-of-last resort to ever more banks and also to state institutions. At the end of 2011, the ECB’s balance sheet will be more than €2.4 trillion – its largest size ever, and also more than 20% larger than at the start of the year!
And as Mr. Draghi, the ECB’s top central banker, told us on Thursday, the growth of the central bank’s balance sheet will continue. More than four years after the crisis started and more than three years after Lehman collapsed, none of the problems in the European banking community are fixed. This is evidently the case as the European banking sector is still in desperate need of ongoing and, this is important, growing central bank support. In fact, the ECB announced more ‘liquidity’ measures to prop up the banking system this week. It also stated that it would lend money against an even wider range of collateral than previously. These measures are similar to the ones announced a week earlier by the major central banks around the world, which were also designed to lessen funding pressures among the banks. We can only conclude that the state of the banking sector must be extremely precarious.
Can all these banks ultimately be ‘eased’ back into lasting health and operational independence by the central banks? Of course, not. A reduction in banking capacity via a shrinking of balance sheets and potentially via defaults is ultimately unavoidable. Again, the banking sector overdosed on years of cheap credit. The boom will not be extended forever. Rehab is inevitable. So are the present measures of the central banks aimed at slowing this process, at postponing it, at sabotaging it or even completely avoiding it? I fear that the key decision-makers don’t even know the answer themselves. They simply want to buy some time, I guess.
The ECB had by Thursday night also fully reversed its timid and tentative rate hikes from spring and summer and was thus back to record-low policy rates. Developments last week thus confirmed my outlook: None of these central banks have an exit strategy. If you believe that these so-called unconventional and extreme measures are temporary, and that policy will be normalized at some stage, you are mistaken, in my view. The biggest direct beneficiaries of cheap money from the central banks are now the ‘private’ banks and the sovereigns, and as the shrinkage and/or failure of these entities is deemed politically unacceptable, and as the states in particular cannot cut back their expenditures and thus their deficits meaningfully, the central banks will continue to print money.
It is somewhat astonishing that in financial market debate and in large parts of the media coverage of ECB policy, the idea is conveyed that the ECB was being particularly stringent. This is due to the fact that many now demand that the ECB provides not only ‘unlimited’ direct support to the banks but that it should also manipulate directly the prices of certain financial assets, in particular the prices of governments bonds of weaker eurozone states, to an unlimited degree, because many banks hold huge quantities of them and they struggle with the lower and, I would suggest, more appropriate market prices for these securities. ‘Unlimited’ bond buying, however, is something that the ECB struggles with, at least officially, and that hits some raw nerves in Germany. Draghi’s negative assessment of large-scale bond buying in the press conference made all the headlines last week, and this is what helped to give the impression of conservatism and policy tightness.
The whole affair is complete theatre, of course. The ECB has indeed been engaged in sizable price-fixing operations in the government bond market for quite some time and is still conducting these operations today. Every week, the ECB buys bonds of weaker eurozone states in an attempt to lift their prices above normal market-clearing levels. Such indirect funding of state spending via the printing press is against ECB-rules, as Mr. Draghi confirmed again in his press conference. However, it is being done continuously by the ECB and defended with the ridiculous excuse that these operations are needed to allow a proper transmission of ECB policy. This is a blatant lie, of course, but apparently all this money-printing, market manipulation and rule-breaking still doesn’t go far enough for many in the financial industry who now demand even more money printing and more market manipulation. Please remember that the ECB presently limits its bond buying to €20 billion per week. If it only continues at this pace, which I expect it to do until it will give up its faint resistance and accelerate bond buying, the present procedures will add up to more than another €1trillion by next Christmas, and thus mean that the ECB’s balance sheet has expanded by another 42% in a single year! But, according to financial market economists, that is not enough!
None of this is a solution but all that market participants (and politicians) want is apparently some peace and quiet, a little pause in this unfolding disaster. Of course, it is only a question of time and the ECB will accommodate the wishes for even more aggressive money-printing. Again, I consider most of the debate theater.
Inflation will rise
What will all this money-printing mean for the purchasing power of money? – The answer is clear in my view: it will mean rising inflation, then accelerating inflation when confidence in paper money erodes and when central banks will find it impossible to restore such confidence through tighter policy.
It is truly remarkable that four years into a major credit correction, none of the major economies has registered any deflation. Of course, those who have an irrational fear of deflation and declare it an evil to be avoided at all cost will consider this a success. The truth is, a deflationary correction would be the natural response at the end of an extended inflationary boom based on artificially cheap money. Deflation would be part of a necessary, if in many ways painful adjustment process. This process is aborted via aggressive money printing from the central banks. We can clearly see that nothing has been solved and that the channels through which money debasement occurs have simply changed but that it is still ongoing.
Inflation in the eurozone may not be very high at present but it is above target and it will, in my view, continue to rise. The idea that all this money printing is not only harmless but also positive because it avoids deflation is nonsense. In the case of Britain, we are told every month that the Bank of England needs to keep rates low and its balance sheet expanding to avoid deflation and economic contraction when inflation has continuously been above target and in fact rising. Something similar is now unfolding in Europe. Easy money is supposed to help the banks and the states but enough of it is leaking into the wider economy to continually debase the monetary unit, while failing to initiate another artificial boom in the wider economy. I consider what we are seeing in Britain a good blueprint of what will unfold elsewhere in coming quarters: rising inflation (now above 5 percent in the UK), ongoing central bank balance sheet expansion (whether labelled officially ‘quantitative easing’ or something else), an overall weak economy with rising unemployment, failure to reign in budget deficits.
Fiscal consolidation and fiscal integration
It can only be a sign of desperation that grown and otherwise intelligent people believe that the solution to Europe’s debt problem is fiscal integration or policy coordination. This is at a minimum naïve. Debt levels and budget deficits are not where they are today because of a lack of coordination or integration among the member states. They are where they are because NONE of the states can live within their means.
Fact is that all members of the club have been shown to be habitual over-spenders and fiscal-rule breakers for years. The risk that in a fiat-money union some members may run excessive deficits and then expect to get bailed out by the other states or via the printing press, thus being rescued by a process that involves taking from the tax-payers in other countries (via fiscal transfers) or by taking from their own savers and savers in other countries (via higher inflation), was understood and clearly seen from the start of EMU. That is why certain rules were implemented: budget deficits shouldn’t exceed 3 percent, overall debt levels not 60 percent, there was a no-bail-out provision, and the ECB was banned from bailing out states with the printing press. ALL of these rules have now been broken. Germany insisted on the Maastricht criteria which restricted overall state debt to 60 percent of GDP. Germany herself is now at 83 percent – and happily signing up to new commitments in bail-out-funds that should not be possible under EU rules to begin with.
All fiscal rules have by now been broken. Bail-outs have been implemented and the ECB is funding member states to the tune of €20 billion per week!
But now, these politicians tell us, now we can finally trust them. Because all these cheaters and fraudsters will now check on one another very thoroughly as part of ‘fiscal integration’ under a new set of self-imposed restrictions and with a new treaty, and this will turn a club of rogues and rascals into a group of prudent and trustworthy guardians of the public purse.
This whole idea only deserves ridicule. It is completely laughable. Of course, it will not work. Sadly, it is also presented to the public with that specifically distasteful ingredient of bureaucratic micro-management. Obviously, the member states only trust one another to obey the rules if all decision-making is minutely coordinated and policy-setting on everything from corporate tax laws to bank regulation carefully centralized under a new European super-state. We will get more state-interference, more centralization, more meddling in markets, more and higher taxes and more capital misallocation. What we will not get is less government spending. All power to the bureaucracy!
The endgame does not change because of any of this. The only question is this: Will this impress the markets and restore some stability for a while? I doubt it.
In the meantime, the debasement of paper money continues.
“In my several decades as a financial and economics commentator – covering banking crises dating back to the early 1970s and the Latin American debt catastrophes of the early 1980s – I have never heard a sitting [Bank of England] governor talk in such apocalyptic terms about the parlous state of the global financial system.”
- Alex Brummer, The Daily Mail.
So what precisely did our inflation-fighter-in-chief actually say?
Well, that euro zone instability had created
an exceptionally threatening environment
as falling government debt prices, softening confidence and distressed asset sales threaten to
spiral
into a systemic financial crisis. Also, the UK financial system was encouraged to continue building up capital to bolster against an
extraordinarily serious
situation not of its own making and which it could not resolve. Also,
The crisis in the euro area is one of solvency not liquidity. And the interconnectedness of major banks means the banking systems and economies around the world are all affected. Only the governments directly involved can find a way out of this crisis.
And
If debt is not to [continue] exploding to ever more unsustainable levels, transfers will be required together with the plan to restore the competitiveness within the euro area. There comes a point where the creditors need to realise that the scale of the debt owed to them is so large that they may have to be part of the solution.
Strong stuff from a fellow who looks like the hamster in “Danger Mouse”. It is all a waste of time, of course, more than a day late and more than a trillion short in whichever currency you care to proffer.
Perhaps things are not quite as bad as they seem. Last week in London we had the pleasure of hearing Gordon Corrigan speaking at Owen James’s always stimulating “Meeting of Minds” investment seminar. The intention of his speech was to put to rest a few myths about Britain’s role in the Great War. There was undeniable tragedy during those dreadful four years, but could there be a chance, asked the ex-Gurkha Major, that the Brits have tended to mythologise the whole World War One experience, magnify the national role, and accentuate the negative – a process that hardens with every passing year?
The late Alan Clark once quoted a conversation between a German general and one of his men that has not just entered the national psyche but become firmly embedded there. These British fight like lions, observed the soldier. Yes they do, replied the general: lions led by donkeys. But apparently Alan Clark made it up. No such conversation ever took place.
And there are evidently plenty of other established “facts” about the Great War that turn out to be somewhat detached from the actualité.
The popular British view of the Great War is of a useless slaughter of hundreds of thousands of patriotic volunteers, flung against barbed wire and machine guns by stupid generals who never went anywhere near the front line. When these young men could do no more, they were hauled before kangaroo courts, given no opportunity to defend themselves, and then taken out and shot at dawn. The facts are that over 200 British generals were killed, wounded or captured in the war, and that of the five million men who passed through the British Army 2,300 were sentenced to death by military courts, of whom ninety per cent were pardoned
The popular conception is that nearly every family in Britain had somebody killed in it. But according to the official census reports, there were approximately 9,800,000 households in Britain in 1914. The British lost 704,208 dead in the Great War. So statistically, only one family in 14 lost a member. Although there were undoubtedly certain parts of the country where fatalities were concentrated due to the way in which British infantry were recruited back then, there were large swathes of the country from where no one was killed. Corrigan has spoken of his own family, and his own black-clad Great Aunt, who never married – perhaps because all of her boyfriends and potential boyfriends met their end at the front ? “Nonsense,” suggests an uncle – his Great Aunt never married because she was “simply too damned ugly”.
By Gordon Corrigan’s account, British soldiers actually spent more time playing football than facing the enemy. By regularly rotating the soldiery and never keeping men in maximum danger for more than relatively short periods of time, the British army was alone among the major forces on the Western Front in never suffering a collapse of morale leading to mutiny.
One in 65 of the British population was killed in the war; for the French, the figure was one in 28. One in every 12 men mobilised in Britain was killed; for the French, one in six. For the Germans, one in 31 of the population was killed, one in every seven mobilised, as shown in the table below:
Country
Population in 1914
Men mobilised
Men killed
Percentage of soldiers killed
Percentage of population killed
France
39,000,000
8,500,000
1,391,000
16.4
3.7
United Kingdom
45,750,000
8,375,000
702,410
8.4
1.5
Germany
60,300,000
13,250,000
1,950,000
14.7
3.2
Source: Mud, Blood and Poppycock: Britain and the Great War
France, with a population six and a half million less than that of the UK, mobilised more men and suffered nearly twice as many deaths. Unlike in the UK, the demographic effect on France was enormous.
The perception of soldiering in the Great War has the young patriot enlisting in 1914 to do his bit and then being shipped off to France.
Arriving at one of the Channel Ports he marches all the way up the front, singing ‘Tipperary’ and smoking his pipe, forage cap on the back of his head. Reaching the firing line, he is put into a filthy hole in the ground and stays there until 1918. If he survives, he is fed a tasteless and meagre diet of bully beef and biscuits. Most days, if he is not being shelled or bombed, he goes “over the top” and attacks a German in a similar position a few yards away across no man’s land. He never sees a general and rarely changes his lice-infested clothes, while rats gnaw the dead bodies of his comrades.
Just on the topic of transportation, many soldiers were moved by train until a few miles from the front, and as the war went on, motor lorries and even London buses were used as troop carriers. And as Corrigan has already pointed out, the rotation of troops alone ensured that conditions were altogether more bearable than the popular conception would have it.
But back to the present. The war then may have been ultimately much less bleak for the British, for example, than the media and propaganda have portrayed. That does not mean that the peace now is any less bad for any of us than Mervyn King suggests. As investors we remain trapped in a surreal nightmare in which clueless politicians and desperate central bankers can see nothing other than money printing as a way out of the gloom. In the euro zone the problem is worse to the extent that the currency crisis is not merely severe but existential. Tragically, former voices of sanity such as The Telegraph’s Ambrose Evans-Pritchard seem to have now taken leave of their senses and joined with the inflationists, as this recent mad piece indicates.
This crisis can be stopped very easily by monetary policy.. to expand the quantity of money..
Oh, really? I am indebted to Tony Deden for the following quotation, from Alasdair Macleod in excerpts from a speech given to the Committee for Monetary Research and Education, given in New York on 20 October 2011:
I support sound money for two very good reasons. Firstly, it is a basic human right to choose to save, without our savings being debased by the tax of monetary inflation. Those who are worst affected by this inflation tax are not the rich, they benefit; but the poor and the barely well-off, which is why monetary inflation undermines society and why the right to sound money should be respected. If government gives itself a monopoly over money, it has a duty to protect the property rights vested in it.
Secondly, it is a basic right for us to own our own money rather than have it owned by the banks. For them to take our money and expand credit on the back of it debases it. It is an abuse of an individual‟s property rights and a banking licence is a government licence to do so. If anyone else was to do this, they would be guilty of fraud. Banks should be custodians of our money, and it should not appear in their balance sheets as their property..
Sound money guarantees a stable yet progressive economy where people are truly equal. It allows people to save properly for their retirement so that they will not become a burden on the state. It leads to democracy voting for small governments. It encourages peaceful trade and discourages war. It is the only path, after this mess, that leads us to long-lasting and peaceful prosperity. We really need everyone to understand this for the sake of our future.
Are you listening in the chancellories of Europe? Here in Britain we may not have had lions led by donkeys, but we now have liars throughout finance being led by junkies addicted to the printing of money. As democracies throughout the continent now topple to be replaced by technocrat stooges, and as the monetary and social chaos accelerates, we must hope that we at least manage to avoid the devastating political mistakes our forebears throughout Europe committed almost a century ago.
Everyone seems to be searching for a roadmap for the Euro-crisis. A precedent to guide policymaking and financial decisions would give some assurance that feasible outcomes are available. I have argued elsewhere (here, here and here) that there are examples for individual countries to follow. But what of the eurozone as a whole?
With luck, precedent for the precarious situation the 17 members of the euro-club face is available. Across the pond, the United States of America once faced a similar challenge.
After the revolutionary War, the US was faced with a band of individual member states (emphasis placed on the “States” aspect of the USA). The Articles of Confederation allowed each state the exclusive right to tax its population. The Continental Congress was given the right to issue paper money – “Continentals”, as they were known.
Individual states refused to give the Continental Congress the ability to tax, nor did they consent to sharing their tax revenue with it. With no ability to raise funds through taxation, the Continental Congress turned to the only fund-raising means available – issuing new Continentals. The phrase “Not worth a Continental” predictably resulted, as hyperinflation set in.
This course of events prompted Alexander Hamilton and his Federalists to argue for a stronger central government, with the ability to both tax and issue debt. The ratification of the U.S. Constitution in 1789 was the culmination of this drive.
This is the situation roughly analogous to what the eurozone faces today.
Each of the 17 member states has the ability to tax but not to issue currency. The European Central Bank has the ability to issue currency, but not to tax. Some countries can no longer remain solvent through increasing taxes alone. Two solutions result:
Allow individual states the right to issue money.
Allow for a centralized fiscal agency to collect taxes for redistribution within the eurozone.
Option 1 amounts to a breakup of the currency union. Option 2 is currently the more popular option. By having a fiscal union with one tax-collecting agency, transfer payments can solve country specific insolvencies. (Of course, longer-term issues remain, but that is for another article.)
Is such a solution as efficient, or equitable, as we are led to believe?
The longevity of the United States suggests that fiscal union is not such a bad idea for a currency union. But important differences exist between the eurozone’s future and the US.
First, with no central fiscal agent for the eurozone there is no central spending required, unlike with the Continental Congress. Each eurozone member state funds its own activities. For example, there is no joint military that requires funding, as is the case with the United States. Hence, there is no threat that the ECB would hyperinflate the euro to fund its fiscal activities (as it has none). This was decidedly not the case with the Continental Congress.
Second, has the centralization of fiscal power been beneficial to the US? The longevity argument is not as strong as one might think. America has, after all, defaulted explicitly on its debt four times in its history. It has evaded insolvency numerous times by inflating its liabilities away. But such an action is default by another means. It has taken from the citizens in the form of an inflation tax to pay for its excesses.
Third, with a central fiscal agency, the US Congress has continually seen a strengthening of its role and scope. New agencies to displace the rights of the individual states have become the norm. The bill to fund the increase in federal activities has risen commensurately. The cost of a centralized fiscal agency in the US has been paid with increasing taxes – whether explicitly through the income tax, or implicitly through the inflation tax.
If the eurozone finds itself amidst a crisis set off by too much government spending (an insolvency crisis) does anyone seriously think the solution is a centralized fiscal agency with the incentive to increase its own indebtedness?
As the United States’ own history demonstrates, calls for a centralized fiscal agency to complete a currency union are misplaced at best and damaging at worst. If history is any guide, fiscal consolidation will result in increased indebtedness on a supranational level. This indebtedness is solved in one of two ways: increased taxes on the member states, or increased inflation. Neither of these seems like a welcome option.
I think this is a complicated question to answer, and both sides of the debate have a tendency to over simplify.
If we understand the goal of QE to be an increase in aggregate demand such that the Bank of England’s implicit and explicit objectives are met, I think it’s reasonable to conclude that it worked “better” than its critics feared, but not as well as its advocates hoped. In other words, I think output is higher than it would have been without QE, inflation is lower than some people warned, but the former is lower than and the latter higher than the MPC would like.
In this week’s column for City AM I wanted to highlight an irony in the debate. If “above target inflation makes little difference if expectations remain anchored” one possible explanation of the muted effects of QE is the Bank’s decision to retain an inflation target. Therefore:
We now have the odd situation where those warning of impending hyperinflation – the sternest critics of QE – provide the intellectual prerequisites for it to work. By contrast, in pandering to those concerns, its proponents ensure that it will not.
It strikes me that unless the Bank of England allows inflation expectations to rise, QE will have a muted effect.
Can you tell us a little bit about your background?
I studied economics in my home country, Germany, and joined J.P. Morgan as a trader in Frankfurt in 1990. By 1996 I had become a portfolio manager in J.P. Morgan’s asset management division and moved to London, which I still call my home. I specialized in European and global bond portfolios. From 1998 to 2001 I worked at Merrill Lynch Investment Managers, which has since become part of BlackRock, and in 2001 I joined Western Asset Management, the Pasadena-based bond specialist. For Western I oversaw their London-based investment team and was lead portfolio-manager for all their global strategies. When I left Western in 2009 my team there oversaw roughly $65 billion in assets under management for institutional clients from around the world. I look back on my years in the business with many fond memories. I worked with some interesting people and had some fascinating clients. But by 2009 I had become very pessimistic on our financial system as a result of my study of Austrian School economics and my own experience after almost two decades in the business. The two perspectives combined to form a rather unpleasant outlook. I wanted to step outside the industry, think things through, and write a book about it.
What investing style do you subscribe to?
I am not sure I subscribe to any identifiable style, or that I even consider it particularly desirable to do so. Let me explain. I spent almost 20 years in the institutional asset management business. There is very limited room to develop your own style to begin with. These companies are asset-gathering companies. They need to constantly grow and attract new clients. In order to do that they not only try to establish a decent track record but also a specific house style and a clear and distinguishable process that they can market. They try to create a brand. As a portfolio manager you have to play along and do things in a way that fits the process. Incidentally, that was something I was actually quite good at. Now it so happens that certain styles work for some time and then stop working. Markets constantly change. In the industry, however, whenever somebody has good numbers for a while and a good story about how those numbers have been generated, he is usually in a sweet spot. New clients come rushing in. But I have become very cynical in this regard. That is usually the moment you should sell these firms or money mangers. I accept that my take on the style-question is unusual. But that is how I see it.
The truth is I tried many different things over the years. Only now, that I am out on my own, outside the mainstream industry, can I look at things with an entirely open mind, which is refreshing. I like Doug Casey’s distinction between traders, investors and speculators. Many people call themselves investors when what they really do is trading. This is certainly true of many ‘investors’ in the asset management industry. I would now call myself a speculator. Most of the time you do nothing. Until you spot a major dislocation, or a major event or an opportunity, something that you have a completely different view on from most other people. That’s when you go in and take risk. Example: I am convinced this crisis is misunderstood by most. We are witnessing the failure of our fiat money system. This will get much worse. I try to position myself for it.
What attracted you to the Austrian school of thought?
I came across some writings by F.A. Hayek by chance more than twenty years ago. I can honestly say that I felt immediately that I was reading something special, something that made sense, that was true. I found it exceptionally convincing, and it made a huge impression on me. For the next four years I read everything Hayek wrote. Then, I discovered the other Austrians, Mises, Rothbard, Menger. To sum it up, I would say that it is the methodology that makes the Austrian School so special. Ludwig von Mises, for me, is the unsurpassed master of the Austrian School. He understood better than anybody what economics is about, what it can do and what it cannot do, and how it should go about it. Austrian School Economics starts with the individual actor. Purposeful individual action and human cooperation on markets is the driving force behind all economic phenomena. From the starting point of the individual, the Austrians reconstruct and explain all institutions of the market – from the bottom up, so to speak. By contrast, most modern economists approach economics as if it was a natural science, where we must collect observations, statistical data, and look for patterns. This is the right approach for natural sciences because in nature we can’t perceive of purposeful action. But we do understand the actions of humans in the economy. The approach can be and has to be different. Furthermore, macroeconomists implicitly assume that the statistical aggregates and the large wholes that they work with in their models (consumption, investment, retail spending, aggregate demand, and so forth) are what really interact with one another in the real world. This is a tremendous intellectual error. The economy is ultimately driven by countless individual decision-makers. The Austrians do not lose sight of that.
It is no surprise to me that the Austrian School has such a strong appeal for real-life entrepreneurs and risk-takers. No other school of thought understands entrepreneurship, risk-taking, capital accumulation and capital maintenance, relative prices and the real-life elements of time and error, like the Austrian School does. Of course, politicians, central bankers and state bureaucrats are, by contrast, drawn towards mainstream macroeconomics. It gives them the illusion that the economy can be planned and manipulated from the top down.
What inspired you to write a book?
When you begin to understand Austrian monetary theory you realize that our financial system is built on quicksand – elastic, constantly expanding fiat money to be produced without limit and at full discretion by the central banks. I realized that the growing instabilities and dislocations that I observed in my work-life as a portfolio manager over the past two decades were the inevitable consequence of our monetary infrastructure. What amazed me was that nobody around me saw it that way. Whenever a credit boom threatened to turn into a credit bust – as it sooner or later must – everybody was calling for a monetary stimulus, for lower rates and for policy accommodation to extend the credit boom further. Such a policy may indeed prevent a correction now, but only at the cost of making an even bigger correction necessary in the future. But everybody in financial markets is so indoctrinated with a specific and narrow subset of modern macroeconomics – I would say the most toxic aspects of Keynesianism and Monetarism – that everybody believes any policy to be a good one if it only creates some near-term GDP boost. There is no perception of long-term dislocations and market imbalances, of what the consequences of such a policy of artificially cheap credit must ultimately be. I think a gigantic intellectual bubble exists in which most financial market participants operate. That bubble will probably only get pricked by real events, i.e. the massive crisis that is now unfolding. But I wanted to try and give people a different perspective, to debunk some of the erroneous common wisdom that is readily accepted by so many people in the business.
Can you explain to people what your definition of money is?
Money is the medium of exchange. It is the most fungible good in the economy and therefore most readily facilitates exchange of property. It is neither a consumption good nor an investment good. We hold it not to satisfy any of our consumption needs, nor to generate a return. We have demand for it because it gives us flexibility. To hold money balances means to hold purchasing power in its most readily tradable form.
Capitalism developed on the basis of inelastic, inflexible and apolitical commodity money, such as gold and silver – inelastic in its supply and outside political control. Today we live in a world of entirely elastic paper money under discretion of the state, and for the first time in history, such a system spans the entire globe. Remember also, that today’s fiat money system only came into full bloom on August 15, 1971.
Today, most mainstream economists maintain that the perfect elasticity of the money supply is a plus. My book argues that this is wrong. The relative inelasticity of gold makes gold a superior form of money. Elastic money systems must ultimately collapse. Throughout history they always have.
Can you tell us about the US system pre-Fed era?
I should stress first that I am not a monetary historian, although there is a short chapter on the history of paper money systems in my book – all of these systems collapsed by the way. Understanding monetary systems requires theory. History can illuminate concepts or raise new questions. Only theory can explain.
Prior to the founding of a central bank, the Federal Reserve, in 1913 and the subsequent abandonment of a gold anchor in 1933 (domestically) and 1971 (internationally), the US used, for the most part, commodity money. I say ‘for the most part’ as America conducted some interesting experiments with paper money as well, all of them complete disasters. In fact, one of the first historic examples of a paper money system outside Medieval China, was Massachusetts, which, in 1690 when still a British colony, issued paper money to fund military excursions into French Quebec. Then there were the famous continentals, a paper money issued by the Continental Congress in 1775 to fund the Revolutionary War. These early experiments with paper money ended like they always do – with worthless paper tickets. Then in the early part of the 19th century the dollar was defined as a specific amount of gold. This was proper commodity money, a gold standard. There was no central bank. Gold was money. Commercial banks had to redeem their banknotes in specie, which set tight limits on bank credit creation. But the government couldn’t stop interfering, in particular whenever it needed cheap credit, usually to fund wars. Requirements to redeem in physical gold were lifted on a couple of occasions, so in the wake of the War of 1812, when the US was fighting Britain again, and most famously during the Civil War, when the greenbacks were issued and soon inflated into worthlessness. In 1879, the US joined Britain, and in fact most of the then industrialized world, in what became known as the Classical Gold Standard. After the inflation of the greenback era, a corrective deflation was allowed to unfold (but strong economic growth continued nevertheless), and from 1879 to 1914 there was no meaningful deflation or inflation in the system at all. This was a time of hard, inflexible and stable money. This was a period– in the US and globally – of solid economic growth, rising living standards and growing international trade, and of harmonious economic relationships between countries. The Classical Gold Standard was not perfect but probably the best monetary system we have had so far.
Many people have proposed going back to the gold standard? We had many depressions and recessions while on the gold standard, do you think it would be a good idea?
Yes, we should definitely return to a gold standard — not one that is “managed” by the government, but a proper gold standard with no involvement of the state. I wouldn’t hold my breath, however. As we have seen, governments love fiat money. It gives them control over the economy. We will eventually return to some form of gold standard but only after the complete collapse of the present system in a major crisis.
The elasticity of money – which means periods of money expansion and credit booms followed by periods of monetary stagnation or contraction – is the main cause of business cycles. How did this occur under a gold standard? Answer: the spread of deposit banking and fractional-reserve banking, in particular in the late 19th century. These banking practices introduced an element of elasticity into the money supply. They can be profitable for the banks but they are risky and are destabilizing for the broader economy, even under gold standard conditions. That is why many Austrians argue for a 100-percent gold standard, for 100 percent reserve banking. I am not in that camp. I think fractional-reserve banking should not be banned, cannot be banned, and ultimately does not need to be banned. Many of these issues can be solved in a free market. We may have the occasional recession but the system can cope with that.
However, the Fed was founded in a joined effort by politicians and bankers in order not to restrict and contain fractional-reserve banking but, to the contrary, in order to encourage and subsidize it. Money has since not become less elastic but much more elastic. Of course, credit cycles still occur. They now only get much, much bigger. We had a thirty-year credit boom. We will now get a major credit bust. Compared to what we are facing now, the recessions of the gold standard era will look like a walk in the park.
Why do most policy makers seem to be in the Keynesian school and not the Austrian school of thought?
Please remember my answer to the question above about the appeal of the Austrian School. The methodology of the Austrians is superior, but the methodology of mainstream macroeconomics, and Keynesianism in particular, is appealing to politicians. These schools perceive the economy as an organism that sometimes performs below potential, which then provides a convenient excuse for the politicians to get involved. Keynesianism has popularized the concept of ‘aggregate demand’. A recession is now seen simply as a lack of aggregate demand. So politicians have a pseudo-scientific excuse to run deficits and spend money they don’t have. Strangely, the fact that “lack of aggregate demand” can at best be a symptom but hardly an explanation of the recession does not appear to bother too many people.
Truth is, the recession is the result of imbalances that the economy accumulated during the previous artificial credit boom. Once these dislocations (such as excessive levels of debt, overextended banks and inflated asset markets) exist, the cleansing of a recession is needed and unavoidable. That is not a popular message among politicians.
Greece was forced to implement austerity and the budget deficit as % of GDP went up and unemployment skyrocketed. What are your thoughts on the reason why this occurred?
That is not surprising at all. You have to remember that in today’s world GDP is a very poor measure of economic health. In the EU, 50 percent of recorded economic activity is conducted by the public sector. In my adopted home country, the UK, it is 53 percent. The public sector spends more money than all private individuals and corporations put together. This is more socialism than capitalism.
We don’t have to assume that everything the state does is pure waste. For some of these things there would be a proper demand even in a state-less free market. However, we – and in fact the state bureaucrats as well – have no means of telling what is truly demanded by the buying public and what is of marginal or of no productivity, and what is thus complete waste, because the public sector operates outside of market prices and without the guidance of profit and loss. But whatever the state does enters the GDP statistic just the same.
So whenever the state is being cut back – which hardly ever happens, only in cases of default, which is why I am a big advocate of government defaults – a lot of things drop out of the GDP statistics and unemployment goes up because public sector employees are laid off. This drop in GDP is not a lasting problem. We know that a lot of state activity was at least suboptimal to begin with. Now resources (including labor) are being redirected to the private sector, where they will eventually be employed again, and this will enhance wealth and prosperity in the long run. In my view, Greece should stop paying anything to her creditors, declare full default, and shrink the state drastically. For a short while, the statistics would look dreadful. Then Greece would have a massive and lasting recovery. With no debt, a small state and a free economy it could, after some time, outperform everybody else in Europe.
Taxes went up in the Clinton era and the economy still boomed, do you think slightly increasing taxes will be detrimental to the economy?
I object to taxes for moral and ethical reasons (which are subjective) and economic considerations (which are objective). Taxes are always detrimental to the economy. They were so, too, under Clinton. It so happened that other things outweighed their negative impact. Remember, the mega credit boom that started in the early 80s was still in full swing, the Greenspan put was still operable, the NASDAQ bubble was still being inflated. Some of the growth of those years was genuine, that is, based on entrepreneurship, capital creation and innovation, but a lot of it was also the result of easy money. Under these circumstances the tax hikes were not felt that much, that is all.
Today’s environment is very different. The credit boom has ended, and has ended for good. The state and the financial sector have benefitted most from decades of cheap credit and are now severely overstretched. The economy overall is much weaker. Higher taxes would be detrimental. Also, the idea that the gigantic government deficits could be closed with higher taxes is idiotic. To the US I would give the same advice as I just gave to Greece: default, shrink the state massively, go back to hard money. Alas, they won’t do it.
I am curious what you think about the major currencies; Dollar, Euro, Yen, some of the emerging countries?
They are all locked in a deadly race to the bottom. All these currency-areas face the same problems, which are the typical problems of a fiat money system reaching its endgame: massive public debt, uncontrollable deficits, weak banks, addiction to cheap credit and constant asset price inflation. None of these governments want to face up to the reality that they are broke and that what the economy needs is for the market to be allowed to liquidate unsustainable levels of debt and other economic imbalances. As that is deemed politically unacceptable, they will continue to try and buy time by producing ever more currency units and injecting them into financial markets. Inflation and currency destruction will be the endgame. I would stay away from paper money as much as I can. Buy gold and silver instead, and certain other real assets. To guess which of these paper currencies will hit the bottom first is a mug’s game, in my view.
Is inflation or deflation a bigger threat right now?
Inflation and deflation are both unpleasant but it is wrong to call them both an equal threat right now. Allowing deflation now would have a clear advantage, namely it would bring the economy back to a state of balance and toward more proportionate and sustainable structures. A deflationary correction that would allow the liquidation of market dislocations would be painful but it would ultimately restore the economy to health.
If all market interventions, including cheap money from the Fed, would cease now, we would indeed face a sharp economic contraction and most likely a period of deflation. But this is ultimately unavoidable anyway. Current economic structures are simply unsustainable, and the market has a way of dealing with what is unsustainable: liquidate it. The market is craving a cleansing recession, including drops in certain prices. As I said before, this is deemed politically unacceptable. That is why we will get ever more aggressive monetary policy and ever more money printing. This will not solve our problems but it will lead to inflation and most likely complete currency collapse. My outlook for the coming years is inflation, much higher inflation, not deflation. The reason for that is policy.
Hopefully you won’t consider the following analogy tasteless but to ask what is the bigger threat, inflation or deflation, is a bit like asking a cancer patient what is the bigger threat, death or chemotherapy. Nobody will readily embrace either. But it appears to me that in constantly telling us that we need to avoid deflation at all cost, today’s policy establishment is telling us that we should avoid chemotherapy and accept death by hyperinflation.
What are your opinions on Gold?
Gold is the essential self-defense asset. Whenever fiat money systems enter their endgame and are about to collapse, gold comes back. It is the eternal form of money. As Greenspan once said (and he said it when he was already the head the world’s foremost paper money central bank): In extremis, nobody accepts paper money. Gold will always be accepted.
At its current price of $1,720 an ounce I still consider it cheap. Much more fiat money will be created in coming months and years. You want to own something that is not simultaneously somebody else’s liability (such “money in the bank” on your deposit or savings account) and that cannot be created for political purposes at will and without limit, such as paper dollars.
Don’t trade gold, accumulate it.
QEII, Operation Twist, thoughts?
These operations get ever more extreme. It is just part of the logic of the system. We are in a mess because of the trillions that were created out of thin air in the past. To keep the system going a bit longer, the central banks now have to produce ever more money ever faster. Will it stimulate the economy? Yeah, right.
Like a little hamster in his wheel, Bernanke will have to run ever faster to keep the printing press humming and keep the system from correcting. We will get QE 3 and QE 4, no question. By the way, Operation Twist could already be QE3 in disguise. On the face of it, the Fed is just selling short duration Treasuries and buying long duration Treasuries. But the Fed also promised to keep interbank rates near zero for a long time (meaning: forever), and to achieve that they may be buying back short-term Treasuries pretty soon. Listen, there are no exit strategies. The Fed’s balance sheet will continue to grow. It is already bigger than M1. We will get more and more money……
Flashback to September 2008, what do you think the Government should have done?
Nothing. I like Jim Grant’s term: “constructive inaction”. If you believe that the Fed and the government saved us from another Great Depression with all their bailouts and quantitative easing, think again. All they did was postpone the depression – and to make the final disaster worse. All these imbalances are still with us, many of them are larger and have been moved to the state’s balance sheet. Nothing is fixed.
But if you think that this advice – do nothing – is unrealistic and that the government, after having actively supported the build-up of this credit edifice for decades, cannot simply walk away from it once the house of cards finally unravels, then I would suggest the following: Any actions by the government should have been directed toward sustaining the payment infrastructure and maybe to minimize the fallout for bank depositors, who for a long time have actively be lured into entrusting their savings to an increasingly leveraged, government-supported banking system, which has now checkmated itself. I am not suggesting a debt-funded bailout of the deposit base. But the US government allegedly sits on 260 million ounces of gold, some of it confiscated from its own population. Current market value: $450 billion. That could have been handed back to the banks as a backstop against their deposits. This could have been the first step towards abolishing the Fed and returning the country to a gold standard.
If you were Ben Bernanke what would you do now?
Abdicate. His mandate is contradictory and impossible. He is supposed to provide a stable medium of exchange for the American public, and at the same time provide an unlimited backstop for Wall Street and Washington. Well, it is one or the other. We already know which one he chose.
Same question, Barack Obama?
Abdicate is again a good option.
I am not an American so I am looking at this from a distance. It strikes me that the presidencies of George W. Bush and Barrack Obama were both unmitigated disasters for their country. I don’t even think the two as men are necessarily bad or evil. As individuals they may be decent and have good intentions. But the politics are just shockingly bad. The growth of the state, of government involvement in the economy and in all walks of life, the budget deficits, the ever-growing debt pile, the aggressive monetization of debt and the dependency on cheap credit and ongoing market manipulation – this is a complete shipwreck by any standard but, if I may say so, particularly shameful for a country that for freedom-loving people around the world was once a beacon of liberty, opportunity and capitalism. As a generally pro-American libertarian, I can’t tell you how much it hurts to see this once great country go to bits like this.
What needs to be done? Stop printing money, return the country to a gold standard, default on the debt (it will never be repaid anyway!), shrink the state aggressively, stop all foreign wars – the military is the government’s biggest single expenditure item at close to $1 trillion a year.
If you think this is unrealistic then let me tell you that I think all of this will ultimately happen – but not by choice but by necessity, as a result of a massive crisis.
If you were Angela Merkel or Jean-Claude Trichet?
I think that what I said about Bernanke and Obama broadly applies to Merkel and Trichet as well. At the core, the problems are the same. Europe’s problem is not that many different countries share the same currency. Many more and much more different countries did the same between 1879 and 1914 under the gold standard, and it worked very well. The problem is precisely that they do not share an international, apolitical and inelastic commodity money, but a fully elastic and politicized fiat money that comes with built-in expectations of government and bank bailouts. Stop printing money, return to hard and de-politicized money, preferably a gold standard, and shrink the state – the advice is the same.
Who are you endorsing for US President? Ron Paul?
I think the entire political process, not only in the US, but in all modern mass democracies, has become a most degrading and dispiriting spectacle. I agree with P.J. O’Rourke: Don’t vote. It only encourages the bastards. Politics needs to be thoroughly delegitimized as a problem-solving device. It creates more problems than it solves. So I am not endorsing anybody.
Having said this, Ron Paul is, of course, by far the best choice from my point of view. I don’t think that this will surprise you considering what I said above. He is right about ending the wars, abolishing the Fed, returning to a gold standard, shrinking the state. But I fear that he doesn’t have a snowball’s chance in hell to win the presidency. So the crisis will continue. Don’t bet on politics. Trust your own reason. Be prepared.
