“Central bankers control the price of money and therefore indirectly influence every market in the world. Given this immense power, the ideal central banker would be humble, cautious and deferential to market signals. Instead, modern central bankers are both bold and arrogant in their efforts to bend markets to their will. Top-down central planning, dictating resource allocation and industrial output based on supposedly superior knowledge of needs and wants, is an impulse that has infected political players throughout history. It is both ironic and tragic that Western central banks have embraced central planning with gusto in the early twenty-first century, not long after the Soviet Union and Communist China abandoned it in the late twentieth. The Soviet Union and Communist China engaged in extreme central planning over the world’s two largest countries and one-third of the world’s population for more than one hundred years combined. The result was a conspicuous and dismal failure. Today’s central planners, especially the Federal Reserve, will encounter the same failure in time. The open issues are, when and at what cost to society ?”
- James Rickards, ‘The death of money: the coming collapse of the international monetary system’, 2014. [Book review here]
“Sir, On the face of it stating that increasing the inheritance tax allowance to £1m would abolish the tax for “all except a very small number of very rich families” (April 5) sounds a very reasonable statement for the Institute for Fiscal Studies to make, but is £1m nowadays really what it used to be, bearing in mind that £10,000 was its equivalent 100 years ago ?
“A hypothetical “very rich” person today could have, for example, a house worth £600,000 and investments of £400,000. If living in London or the South East, the house would be relatively modest and the income from the investments, assuming a generous 4 per cent return, would give a gross income of £16,000 a year, significantly less than the average national wage.
“So whence comes the idea that nowadays such relatively modest wealth should be classified as making you “very rich” ? The middle-aged should perhaps wake up to the fact that our currency has been systematically debased, though it may be considered impolite to say so as it challenges the conventional political and economic wisdom. To be very rich today surely should mean you have assets that give you an income significantly higher than the national average wage ?”
- Letter to the editor of the Financial Times from Mr John Read, London NW11, 12 April 2014
“The former coach house in Camberwell, which has housed the local mayor’s car, was put on the market by Southwark council as a “redevelopment opportunity”. At nearly £1,000 per square foot, its sale value is comparable to that of some expensive London homes.”
- ‘London garage sells for £550,000’ by Kate Allen, The Financial Times, 12 April 2014.
“Just Eat, online takeaway service, slumped below its float price for the first time on Tuesday as investors dumped shares in a raft of recently floated web-based companies amid mounting concern about their high valuations..
“Just Eat stunned commentators last week when it achieved an eye-watering valuation of £1.47 billion, more than 100 times its underlying earnings of £14.1 million..
““They have fallen because the company was overvalued. Just Eat was priced at a premium to Dominos, an established franchise that delivers and makes the pizzas and has revenues of £269 million. Just Eat by comparison is a yellow pages for local takeaways where there is no quality control and no intellectual property and made significantly less revenues of £96.8 million. A quality restaurant does not need to pay 10 per cent commission to Just Eat to drive customers through the door,” Michael Hewson, chief market analyst at CMC Markets said.”
- ‘Investors lose taste for Just Eat as tech stocks slide’ by Ashley Armstrong and Ben Martin,
The Daily Telegraph, 8 April 2014.
Keep interest rates at zero, whilst printing trillions of dollars, pounds and yen out of thin air, and you can make investors do some pretty extraordinary things. Like buying shares in Just Eat, for example. But arguably more egregious was last week’s launch of a €3 billion five-year Eurobond for Greece, at a yield of just 4.95%. UK “investors” accounted for 47% of the deal, Greek domestic “investors” just 7%. Just in case anybody hasn’t been keeping up with current events, Greece, which is rated Caa3 by Moody’s, defaulted two years ago. In the words of the credit managers at Stratton Street Capital,
“The only way for private investors to justify continuing to throw money at Greece is if you believe that the €222 billion the EU has lent to Greece is entirely fictional, and will effectively be converted to 0% perpetual debt, or will be written off, or Greece will default on official debt while leaving private creditors untouched.”
In a characteristically hubris-rich article last week (‘Only the ignorant live in fear of hyperinflation’), Martin Wolf issued one of his tiresomely regular defences of quantitative easing and arguing for the direct state control of money. One respondent on the FT website made the following comments:
“The headline should read, ‘Only the EXPERIENCED fear hyperinflation’. Unlike Martin Wolf’s theorising, the Germans – and others – know only too well from first-hand experience exactly what hyperinflation is and how it can be triggered by a combination of unforeseen circumstances. The reality, not a hypothesis, almost destroyed Germany. The Bank of England and clever economists can say what they like from their ivory towers, but meanwhile down here in the real world, as anyone who has to live on a budget can tell you, every visit to the supermarket is more expensive than it was even a few weeks ago, gas and electricity prices have risen, transport costs have risen, rents have risen while at the same time incomes remain static and the little amounts put aside for a rainy day in the bank are losing value daily. Purchasing power is demonstrably being eroded and yet clever – well paid – people would have us believe that there is no inflation to speak of. It was following theories and forgetting reality that got us into this appalling financial mess in the first place. Somewhere, no doubt, there’s even an excel spreadsheet and a powerpoint presentation with umpteen graphs by economists proving how markets regulate themselves which was very convincing up to the point where the markets departed from the theory and reality took over. I’d rather trust the Germans with their firm grip on reality any day.”
As for what “inflation” means, the question hinges on semantics. As James Turk and John Rubino point out in the context of official US data, the inflation rate is massaged through hedonic quality modelling, substitution, geometric weighting and something called the Homeowners’ equivalent rent. “If new cars have airbags and new computers are faster, statisticians shave a bit from their actual prices to reflect the perception that they offer more for the money than previous versions.. If [the price of ] steak is rising, government statisticians replace it with chicken, on the assumption that this is how consumers operate in the real world.. rising price components are given less relative weight.. homeowners’ equivalent rent replaces what it actually costs to buy a house with an estimate of what homeowners would have to pay to rent their homes – adjusted hedonically for quality improvements.” In short, the official inflation rate – in the US, and elsewhere – can be manipulated to look like whatever the authorities want it to seem.
But people are not so easily fooled. Another angry respondent to Martin Wolf’s article cited the “young buck” earning £30K who wanted to buy a house in Barnet last year. Having saved for 12 months to amass a deposit for a studio flat priced at £140K, he goes into the estate agency and finds that the type of flat he wanted now costs £182K – a 30% price increase in a year. Now he needs to save for another 9 years, just to make up for last year’s gain in property prices.
So inflation is quiescent, other than in the prices of houses, shares, bonds, food, energy and a variety of other financial assets.
The business of rational investment and capital preservation becomes unimaginably difficult when central banks overextend their reach in financial markets and become captive to those same animal spirits. Just as economies and markets are playing a gigantic tug of war between the forces of debt deflation and monetary inflation, they are being pulled in opposite directions as they try desperately to anticipate whether and when central bank monetary stimulus will subside, stop or increase. Central bank ‘forward guidance’ has made the outlook less clear, not more. Doug Noland cites a recent paper by former IMF economist and Reserve Bank of India Governor Raghuram Rajan titled ‘Competitive Monetary Easing: Is It Yesterday Once More ?’ The paper addresses the threat of what looks disturbingly like a modern retread of the trade tariffs and import wars that worsened the 1930s Great Depression – only this time round, as exercised by competitive currency devaluations by the larger trading economies.
Conclusion: The current non-system [a polite term for non-consensual, non-cooperative chaos] in international monetary policy [competitive currency devaluation] is, in my view, a source of substantial risk, both to sustainable growth as well as to the financial sector. It is not an industrial country problem, nor an emerging market problem, it is a problem of collective action. We are being pushed towards competitive monetary easing. If I use terminology reminiscent of the Depression era non-system, it is because I fear that in a world with weak aggregate demand, we may be engaged in a futile competition for a greater share of it. In the process, unlike Depression- era policies, we are also creating financial sector and cross-border risks that exhibit themselves when unconventional policies come to an end. There is no use saying that everyone should have anticipated the consequences. As the former BIS General Manager Andrew Crockett put it, ‘financial intermediaries are better at assessing relative risks at a point in time, than projecting the evolution of risk over the financial cycle.’ A first step to prescribing the right medicine is to recognize the cause of the sickness. Extreme monetary easing, in my view, is more cause than medicine. The sooner we recognize that, the more sustainable world growth we will have.
The Fed repeats its 2% inflation target mantra as if it were some kind of holy writ. 2% is an entirely arbitrary figure, subject to state distortion in any event, that merely allows the US government to live beyond its means for a little longer and meanwhile to depreciate the currency and the debt load in real terms. The same problem in essence holds for the UK, the euro zone and Japan. Savers are being boiled alive in the liquid hubris of neo-Keynesian economists explicitly in the service of the State.
Doug Noland again:
“While I don’t expect market volatility is going away anytime soon, I do see an unfolding backdrop conducive to one tough bear market. Everyone got silly bullish in the face of very serious domestic and global issues. Global securities markets are a problematic “crowded trade.” Marc Faber commented that a 2014 crash could be even worse than 1987. To be sure, today’s incredible backdrop with Trillions upon Trillions of hedge funds, ETFs, derivatives and the like make 1987 portfolio insurance look like itsy bitsy little peanuts. So there are at this point rather conspicuous reasons why Financial Stability has always been and must remain a central bank’s number one priority. Just how in the devil was this ever lost on contemporary central bankers?”
Editor’s note: this article, under the title “No end to central bank meddling as ECB embraces ‘quantitative easing’, faulty logic” appears on Detlev Schlichter’s site. It is reprinted with kind permission.
The 2nd edition of his excellent Paper Money Collapse is available for pre-order.
“Who can print money, will print money” is how my friend Patrick Barron put it succinctly the other day. This adage is worth remembering particularly for those periods when central bankers occasionally take the foot off the gas, either because they genuinely believe they solved the problem, or because they want to make a show of appearing careful and measured.
The US Federal Reserve is a case in point. Last year the Fed announced that it was beginning to ‘taper’, that is, carefully reduce its debt monetization program (‘quantitative easing’, QE), and this policy, now enacted, is widely considered the beginning of policy normalization and part of an ‘exit strategy’. But as Jim Rickards pointed out, the Fed already fully tapered twice – after QE1 and after QE2 – only to feel obliged to ‘qe’ again some time later. Whether Ms Yellen is going to see the present ‘taper’ through to its conclusion and whether the whole project will in future be remembered as an ‘exit strategy’ remains to be seen.
So far none of the big central banks has achieved the ‘exit’ despite occasional noises to the contrary. Since the start of the financial crisis in the summer of 2007, the global trend has been in one direction and one direction only: From easy money we moved to easier money. QE has been followed by more QE. As I mentioned before, the Fed’s most generous year in its 100-year history was 2013, any talk of ‘tapering’ notwithstanding.
ECB mistrusted by Keynesian consensus
Whenever the European Central Bank reduces its money printing and scales back its market rigging, it invariably unleashes the fury of the Keynesian and inflationist commentariat. In the eyes of its numerous critics, the ECB lacks the proper money-printing credentials of the more pro-active and allegedly more ‘modern’ central banks. It still has a whiff of the old Bundesbank about it, although a few years back, when the ECB flooded the European banking system with cheap liquidity, its balance sheet was larger as a share of GDP than those of its comrades, the Fed and the Bank of England.
The ECB went through two periods of restraint since the crisis: In early 2011 it began to hike interest rates, and in 2013, after the eurozone debt crisis died down, the ECB allowed its balance sheet to shrink by more than €700 billion as banks repaid cheap loans from the central bank. This stood in stark contrast to the Fed’s balance sheet expansion of about $1,000 billion over the same period. The first episode of restraint came to an end in 2012 when the ECB reversed its rate hikes and then cut rates further, ultimately to a new low of just 0.25 percent. Presently, we are still in the second period of restraint, although it too appears to be about to end soon as the ECB’s boss Mario Draghi hinted in his press conference last week at a newfound willingness to embrace unconventional policies to combat ‘deflation’ or even ‘long periods of low inflation’. (The ECB’s harmonized index of consumer prices stood probably at just 0.5% last month.) This means the ECB is likely to cut rates to zero or below soon, or to start asset purchases (‘QE’), or probably both.
This move is hardly surprising in the big scheme of things as outlined above, and the ECB will explain it officially with its mandate to keep inflation below but close to 2 percent, from which it does not want to deviate in either direction. This target itself is silly as it assumes that inflation of 1.8 percent is inherently better than inflation of zero (true price stability, if it ever was attainable), or inflation of minus 1.8 percent (deflation). This is, of course, precisely the argument that has been relentlessly and noisily trumpeted by the easy-money advocates in the media, the likes of Martin Wolf and Wolfgang Münchau in the Financial Times, and the reliably shrill Ambrose Evans-Pritchard in The Daily Telegraph, among others. A certain measure of inflation is deemed good, very low inflation is bad, and anything below zero, even mild deflation, potentially a disaster. But why should this be the case?
Moderate deflation, that is, slowly declining money prices, may or may not be a symptom of problems elsewhere in the economy, but that slowly declining money prices as such constitute an economic problem lacks any foundation in economics and can easily and quickly be refuted by even a cursory look at economic history. In the 19th century we find extended periods of ongoing, moderate deflation in many economies that simultaneously experienced solid growth in output and substantial rises in living standards, a “coincidence”, wrote Milton Friedman and Anna Schwartz in their influential A Monetary History of the United States, 1867 – 1960, that “casts serious doubts on the validity of the now widely held view that secular price deflation and rapid economic growth are incompatible.”
Many commentators advance the argument that falling prices depress consumption as purchases get constantly deferred. Even the usually more sober FT-writer John Authers seems to have succumbed to this argument as he explained to his readers last Saturday that prices “fall, thanks to sluggish economic activity. Consumers do not buy now, as goods will be cheaper in future. This lack of consumption slows growth further, and pushes prices down even further.” (John Authers, “Draghi has to back his QE words with action” Financial Times, Saturday April 5/ Sunday April 6 2014, page 24)
This argument, constantly regurgitated by the cheerleaders of money-printing, is weak. First of all, it is certainly no argument in the present environment of close to zero but still positive inflation. If the ECB plans to fight even very low inflation, as Draghi stated at the ECB press conference, than this argument does nothing to support that policy. Certainly, no one defers any purchases when prices are just stable. However, and more importantly, even in a mildly deflationary environment of let’s say 1 to 2 percent per annum, the argument does appear to be a stretch.
Argument ignores time preference
Consumers only contemplate buying something that they consider an economic good, that is, that they consider useful, that they want because it expends some (subjective) use-value to them. In deferring a purchase they can, in a deflationary environment, save money but at the cost of not enjoying the possession of what they want for some time. By not buying a toaster now you may be able to buy it 1 or 2 percent cheaper in a year’s time, or 2 to 4 percent cheaper in two years’ time (always assuming, of course, that the mild deflation persists that long, which nobody can guarantee), but even these small monetary gains come at the expense of not enjoying ownership of the toaster for two years. The small monetary gain obtained by delaying purchases is not for free, as the argument seems to assume, but comes at the cost of waiting. I suggest that only a very small number of items, and only those for which there is very marginal demand indeed, would be affected.
Time preference is not a concept of psychology, it is a constituting element of human action. It is a priori to human action, which means it exists independent of experience or of personal circumstances as it is already entailed in the very concept of what constitutes an ‘economic good’.
If you experienced no time preference in relation to a specific good you would be indifferent as to whether you enjoyed the possession of that good today or tomorrow. And tomorrow you would be indifferent as to whether you enjoyed it that day or the next, and so forth. Logically, you would be indifferent as to whether you enjoyed possession of it at all, and this means that the good in question is not an economic good for you. You do not care for it.
As George Reisman put is succinctly: To want something means, all else being equal, to want it sooner rather than later.
Be honest, how many purchases over the past 12 months would you not have made had you had a reasonable chance of obtaining the item in question at a 1 or 2 percent discount if you waited a year?
That the prospect of falling prices does not usually deter consumption can be readily seen today in the market for consumer electronics (mobile phones, computers), which has been in deflation – and considerable deflation – for quite some time.
Argument ignores opportunity costs of holding money
The argument also seems to ignore that holding one’s wealth in the form of money involves opportunity costs. Rather than sitting on cash you could enjoy the things you could buy with it. In a deflationary environment, your cash hoard’s purchasing power slowly rises and you can afford ever more nice things with your money, which means the opportunity cost of not spending it constantly goes up. (In a way, while you are waiting four years to buy your toaster at an 8 percent discount to today’s price, buying the toaster is also becoming marginally more attractive to others who are presently holding cash and who may initially not even had an interest in a toaster.)
I think that all that would follow from secular (that is ongoing, systematic but moderate) deflation is that cash would be a more meaningful competitor for other depositories of deferred consumption. Saving by simply holding money makes sense in a deflationary environment, so other vehicles to save with (bonds and shares) would have to offer a return reasonably above the expected deflation rate to attract savings. I think this is not an unreasonably high hurdle.
Furthermore, if what Authers and others describe were true for even marginal deflation, that is, if marginal deflation indeed led to more deflation and a progressively weakening economy, the reverse must logically be true for marginal inflation. Consumers would accelerate their purchases to avoid the 1 or 2 percent loss in purchasing power per annum, and this would quickly drive inflation higher. If two percent deflation led to cash hoarding and a collapse in consumption, would the 2 percent inflation advocated today as ‘price stability’ not lead to a spike in money velocity and an inflationary boom? Either scenario seems highly unrealistic.
Monetary causes versus non-monetary causes
If we use the economic terminology correctly, then inflation and deflation are always monetary phenomena, that is, they always have monetary causes. (As an aside, I here use the now standard definition of inflation as an ongoing, trending rise in the general price level, and deflation as the opposite, rather than the traditional meaning of inflation as an expansion of the money supply and deflation as a contraction.) However, the starting point of the present discussion is simply some low readings on the official inflation statistics in the eurozone. And that those could have non-monetary causes, that they could be the consequence of a crisis-driven drop in real demand in certain industries and certain countries is a realistic assumption and is in fact implied by the arguments of the QE-advocates. Outright deflation is presently being recorded in Greece, Cyprus, and Spain. And John Authers’ short statement on deflation in the FT also starts from the assumption that “prices fall thanks to sluggish economic activity.”
But to the extent that recorded deflation is not due to a general rise in money’s purchasing power (due to a general rise in money demand or an unchanged or falling money supply, to which I come soon) but the result of some producers slashing certain prices in certain industries and regions, and of those price drops not being fully compensated by rising prices somewhere else in eurozone, then this has various implications:
Consumers cannot simply assume that this is a lasting trend. The liquidation of capital misallocations and the discounting of merchandise to get it moving are crisis phenomena and cannot simply be extrapolated into the future the way consumers may have extrapolated the secular deflation of gold standard economies in the 19th century. But the straight extrapolation of very recent price changes into the future is at the core of the argument that even small deflation would be disastrous.
Furthermore, it would seem bizarre to advice merchants to not slash prices when demand drops as that would, according to the logic advanced by Authers et al, only lead to further postponement of consumption and a further drop in demand as consumers would simply expect price declines to continue. Would hiking prices be a better strategy to counter falling demand? Should we reconsider the concept of the “sale” and of “discounting” inventory to encourage buying?
To a considerable degree, the reduction in certain prices for ‘real’ economic reasons could be part of the economic healing process. It is a way for many producers, sectors of the economy, and economic regions, to regain competitiveness. It is true that falling wages in certain industries or regions make it more difficult for workers to repay mortgages and consumer loans but often the lower wage may be the only way to avoid unemployment, which would make repaying debt harder still. Behind the often-quoted headline inflation rate of presently 0.5% per annum lie numerous relative price changes by which the economy re-balances. All discussions about the ‘price index’ ignore these all-important changes in relative prices. It so happens that what goes on with the multitude of individual prices in the economy adds up, according to the techniques of the ECB statisticians, to a 0.5% harmonized inflation rate at the moment, and it may all add up to -0.5% next month or next year, or maybe even – 1 percent. To simply conclude from this one aggregate price number that the economy is getting progressively sicker would be wrong.
There is no escaping the fact that recent economic difficulties are the result of imbalances that accumulated during the credit boom that preceded the 2007/2008 financial crisis, of which the eurozone debt crisis was an after quake. Artificially cheap money created the credit boom and these imbalances. A period of liquidation, contraction, changing relative prices and occasionally falling prices is now necessary, and short-circuiting this process via renewed central bank intervention seems counterproductive and ultimately dangerous.
There is, of course, the possibility that proper monetary causes are behind the eurozone’s low inflation and soon deflation, and that those might persist. Banks still feel constrained in their ability to extend new loans and thus create new money. The growth in bank lending and thus in wider monetary aggregates may fall short of the growth in money demand. But it is an essential feature of money that any demand for it can be fully satisfied with a rise in its price. Demand for money is always demand for readily exercisable purchasing power, and by allowing the market to lift the purchasing power of money, that is, through deflation, that demand can be met. The secular, moderate and largely harmless deflation of 19th century gold standard economies had essentially the same origin. Money production did not keep pace with money demand, so money demand was satisfied via slowly falling prices.
And here the same conclusion applies: a more restrained approach to lending, credit risk, and financial leverage, now adopted by banks and the public at large as a consequence of the crisis, may be a good thing, and for the central bank to mess with this process and to use ‘unconventional’ means to force more bank lending and money creation onto the system, out of some misguided commitment to the arbitrarily chosen statistical goal of ‘2-percent inflation’ seems foolish. If successful in raising the headline inflation rate it may succeed in creating the same imbalances (excessive leverage, misallocations of capital and distorted asset prices) that have created the recent crisis.
One commentator recently said the eurozone could ill afford deflation considering the size of its bloated banking sector. But the question is if it can afford the level of lending to attain 2 percent inflation considering the size of its bloated banking sector.
The fallacy of macroeconomics and macroeconomic policy
Let me be clear: I do not recommend a zero-inflation target or a target of moderate deflation. Moderate deflation in and of itself is a little a solution as moderate inflation in and of itself is a problem. I recommend no target as I reject the entire concept of ‘monetary policy’, of the notion that a state agency could conceivably enhance, through clever manipulation of interest rates and bank reserve policy, the coordinating powers of the market that help people realize their personal economic objectives through free trade.
We should remember that no one participates in the economy and in trade and commerce because his or her goal is that the general price level goes up by 2 percent, or that nominal GDP increases by 5 percent. People have their own personal objectives. The market is simply a powerful tool for voluntary and decentralized plan-coordination among independent individuals and groups of individuals that pursue their own goals. It is best left undisturbed. This entire project of ‘monetary policy’ is absurd in the extreme, regardless of what the target is.
It is the fallacy of macroeconomics that certain statistical aggregates, such as CPI, GDP or nominal GDP, are deemed reliable representatives of what goes on in a complex market economy, and it is dangerous hubris to believe that the state should define ‘targets’ for these statistical aggregates and then use policy intervention to achieve them. This might be an approach intellectually suitable for the ruler of a communist or fascist society. It is fundamentally at odds with free trade and a free market, and it must and will fail. That should have been a clear lesson from the financial crisis.
Instead, the mainstream consensus, deeply influenced by Keynesianism and macroeconomics, continues to embrace policy activism and intervention. I fully expect central banks to continue on their path towards more aggressive meddling and generous fiat money production. It won’t take long for the ECB to take the next step.
Incoming from Dave Doctor at Monetary Choice:
The dollar price of Amazon Prime, the two-day delivery program for Amazon, rises on April 17th to $99, from the original $79 price set in 2005, a 25 percent increase. However, when measured in gallons of gas and pounds of coffee, the price or cost declined, by 27 percent in gas and 53 percent in coffee. This is not surprising since Amazon is much more efficient now. The dollar price rose because there are twice as many dollars, created by banks to fund the U.S. federal government’s deficit and low-interest loans, all at the expense of savers.
After settling at 3.9% in July 2011 the yearly rate of growth of the consumer price index (CPI) fell to 1.6% by January this year. Also, the yearly rate of growth of the consumer price index less food and energy displays a visible downtrend falling from 2.3% in April 2012 to 1.6% in January.
On account of a visible decline in the growth momentum of the consumer price index (CPI) many economists have concluded that this provides scope for the US central bank to maintain its aggressive monetary stance.
Some other economists, such as the president of the Chicago Federal Reserve Bank’s Charles Evans are even arguing that the declining trend in the growth momentum of the CPI makes it possible for the Fed to further strengthen monetary pumping. This, Evans holds, will reverse the declining trend in price inflation and will bring the economy onto a path of healthy economic growth. According to the Chicago Federal Reserve Bank president the US central bank should be willing to let inflation temporarily run above its target level of 2%. He also said that an unemployment rate of about 5.5% and an inflation rate of about 2% are indicative of a healthy economy.
But how is it possible that higher price inflation will make the economy stronger? If price inflation slightly above 2% is good for the economy, why not aim at a much higher rate of inflation, which will make the economy much healthier?
Contrary to Evans a strengthening in monetary pumping to lift the rate of price inflation will only deepen economic impoverishment by allowing the emergence of new bubble activities and by the strengthening of existing bubble activities.
It will increase the pace of the wealth diversion from wealth generators to various non-productive activities, thereby weakening the process of wealth generation.
Evans and other economists are of the view that a strengthening in monetary pumping will strengthen the flow of monetary spending, which in turn will keep the economy stronger.
On this way of thinking an increase in the monetary spending of one individual lifts the income of another individual whose increase in spending boosts the incomes of more individuals, which in turn boosts their spending and lifts the incomes of more individuals etc.
If, for whatever reasons, people curtail their spending this disrupts the monetary flow and undermines the economy. To revive the monetary flow it is recommended that the central bank should lift monetary pumping. Once the monetary flow is re-established this sets in motion self-sustaining economic growth, so it is held.
Again we suggest that monetary pumping cannot set in motion self-sustaining economic growth. It can only set in motion an exchange of something for nothing i.e. an economic impoverishment.
As long as the pool of real wealth is still growing monetary pumping can create the illusion that it can grow the economy. Once however, the pool is declining the illusion that the Fed’s loose policies can set in motion an economic growth is shattered.
If on account of the deterioration of the infrastructure a baker’s production of bread per unit of time is now 8 loaves instead of 10 loaves and the shoemaker’s production per unit of time is now 4 pair of shoes instead of 8 pair of shoes, then no amount of money printing can lift the production of real wealth per unit of time i.e. of bread and shoes. Monetary pumping cannot replace non-existent tools and machinery.
On the contrary the holders of newly printed money who don’t produce any real wealth will weaken the ability of wealth generators to produce wealth by diverting to themselves bread and shoes thereby leaving less real wealth to fund the maintenance and the expansion of the infrastructure.
Now, Fed officials give the impression that once they put the economy onto the so called self-sustained growth path the removal of the monetary stimulus will not generate major side effects. Note that a loose monetary policy sets in motion bubble activities. The existence of these activities is supported by the monetary pumping, which diverts to them real wealth from wealth generating activities.
Once monetary pumping is aborted bubble activities are forced to go under since they cannot fund themselves without the support of loose monetary policy – an economic bust ensues. The illusion that the Fed can bring the economy onto a self-sustaining growth path is shattered.
Summary and conclusion
On account of a visible decline in the growth momentum of the US price index many economists have concluded that this provides scope for the US central bank (the Fed) to maintain its aggressive monetary stance. Some economists such as the president of the Chicago Federal Reserve Bank, Charles Evans, even argue that the declining trend in the growth momentum of the CPI makes it possible for the Fed to further strengthen monetary pumping. This, it is held, will reverse the declining trend in price inflation and will bring the US economy onto a path of healthy economic growth. We suggest that contrary to Evans a strengthening in monetary pumping will only deepen economic impoverishment by allowing the emergence of new bubble activities and by the strengthening of existing bubble activities.
Hyperinflation in Hungary, 1946. (Photo by Mizerak Istvan)
Confronted with the possibility that the endgame of the present experiment in extreme monetary accommodation may be higher inflation and even currency disaster, many private investors and portfolio managers respond that they should be okay, since their wealth is protected through allocations to equities and real estate. In contrast to cash and fixed income securities, which are certain to get obliterated in an inflationary environment, equities and real estate are considered some form of ‘hard’ or ‘real’ asset, not just nominal paper promises. “Why should I own gold? A well-diversified portfolio of top international companies should give me good protection against any major disaster,” a senior portfolio manager told me. “I don’t know about gold. What’s so special about it? But I own real estate. If we enter a high inflation scenario, real estate will maintain its value”, a private investor said. But how probable is it that those strategies are going to work?
The wages of fear
Let us consider the overall backdrop first. Most experiments with unconstrained paper money in history ended in hyperinflation and currency collapse. Those that didn’t were terminated by a political decision to return to commodity-linked, inelastic money voluntarily, a move that required a combination of economic literacy and political backbone that I will leave to the reader to assess if it can be found in sufficient measure among today’s political and bureaucratic elite. Our present fiat money experiment is close to 43 years old and showing signs of serious strain: For a number of years now central banks have been manoeuvring themselves into a corner where they must keep rates at zero and keep propping up certain asset prices through targeted money printing operations to maintain the mirage of the system’s solvency, and there are little signs that any of them is going to find a way out anytime soon.
I know, I know, there are two alternative memes making the rounds presently. One maintains that a deflationary correction is more likely than inflation. The other that a recovery is on track and that this will allow central banks to pull back. The former is not entirely silly. One of the side-effects of relentless bubble blowing is indeed that Mr. Market will occasionally insist on deflating the bubbles. But then the global monetary politburo that holds the keys to the printing presses knows better what the world needs and won’t let Mr. Market do his work. Thus, money-printing will continue. Remember Mr. Bernanke and his apodictic declaration that a ‘determined’ government can always create higher inflation. The second meme is popular but silly, and not the topic of this essay.
The first thing to say is that the idea of equities being a good protector against monetary disaster sounds too good to be true. Here is an asset class that benefits immensely from the current policy of “quantitative easing” and interest rate repression, as even the most hardened believers in equity-markets as disinterested and trustworthy barometers of economic health will find it hard to argue that present valuations purely reflect solid company fundamentals, yet equities should also do well when the recovery finally enters self-sustainable speed and the central bankers exit, and even offer protection for when central bankers don’t exit and we finally go into inflationary meltdown. – Wow! Stop the presses! Here is an asset class that you cannot lose with. (Well, maybe with the exception of the deflationary collapse.)
We should maybe get a tad suspicious if an asset class claims to be the winner in all seasons. Maybe the explanation is psychological. People like to own assets that are sufficiently mainstream, which means they have done well in the past, and assets that offer an income stream (dividends or interest payments), because even if they attach (as I do) a meaningful probability to high inflation and even to currency disaster, the timing of it all is difficult and waiting is so much easier when you are sitting on an income stream. I suspect that there could be an element of wishful thinking at work when investors argue that equities offer disaster protection as well. Like most other people I, too, want to have it all but I believe the universe was not quite so kind to us and arranged things differently. Usually, life requires harsher trade-offs. So at present, the returns from rising equity markets and the paltry returns from fixed income are the ‘wages of fear’ that investors get paid for driving nitroglycerin-filled trucks through the financial jungle, just as in Henri-George Clouzot’s eponymous 1953-classic. Remember: the way to hell is paved with positive carry!
Equities versus gold
I am not denying that equities do have, in principle, the potential to offer some degree of protection against inflation and other financial calamities imposed by government. A reader from Germany recently wrote to me how his father had managed to protect large chunks of his personal wealth through World War II and subsequent currency reform by holding shares in some of Germany’s top companies (and diligently avoided bonds – in particular government bonds!). There can be little doubt that owning claims to the capital of well-established productive concerns is superior to owning securitised promises of politicians. But what about equities versus gold? In my view, gold is still the essential self-defense asset against fiat money disaster, certainly in case of hyperinflation but probably even in a deflationary calamity.
If you own gold you own a universal monetary asset, a global, inelastic and apolitical form of money. Its value is not derived from any specific enterprise, any industry or nation, or any issuing authority. It is nation-less, boundary-less, completely global in its appeal – an international and for all I can say ‘eternal’ form of money. (I like Bitcoin but I don’t think it is quite up there yet.) If you own equities instead you hold claims on the future income stream of specific and hopefully continuingly productive enterprises. Shares are not just claims on any “hard” assets that a company may own, such as land or factory buildings but constitute claims on the future profitability of particular business models. But inflations are macro-economic fiascos. They are disasters, and disasters of a peculiar kind. Some firms may indeed benefit, at least initially, from rising and even high inflation but for many companies inflation will create severe problems. Many companies will indeed go under.
One of the many problems with inflation is that it greatly complicates economic calculation (to the point of making it almost impossible), and that it encourages entrepreneurial error. It can, of course, be said that encouraging entrepreneurial error is the very modus operandi of any policy of easy money: artificially low interest rates ‘work’ by creating an illusion of high savings availability, of a low time preference of the public that should enhance the feasibility of long term investment projects. Via low interest rates entrepreneurs are lured into investment projects that are bound to lack, in the long run, the necessary support from the public’s true voluntary savings. ‘Easy money’ encourages investment always and everywhere under false pretences. But the point here is that, once inflation really kicks in, the errors are likely to compound.
A common problem of calculation under inflation is that many companies will report ‘phantom’ or ‘apparent’ profits, which result from rising sales revenue being booked as income while the also rapidly rising replacement costs for machinery or semi-finished goods are often not fully reflected in depreciation charges, and often remain difficult to ascertain anyway as high inflation is also volatile inflation. Some of what is shown as profit will ultimately simply constitute ‘eating into capital’. Long term planning and economic calculation are greatly disrupted by inflation. In any case, inflation will create some winners but also many losers, even to the point of company failures. High inflation economies are sick economies and usually not a good place to invest.
Historical example: Germany 1918-1923
In 1931 the Italian economist and statistician Costantino Bresciani-Turroni published a study of Weimar Germany’s descent into hyperinflation under the title Le Vicende del Marco Tedesco, which was translated into English under the title The Economics of Inflation, and published in 1937. Among many other things, Bresciani-Turroni also looked at how equities fared: in rapidly depreciating paper money terms, in dollar terms (which means versus gold), and relative to the wholesale price index.
Such studies must always be taken with a generous helping of salt, for a number of reasons. First, history can tell us what happened (in specific and always unique instances) but not what must happen (as a general rule). The social sciences know no laboratory experiments. The next inflationary meltdown may look different from this one. There is no reason to believe that what was observed in Germany at the time must be prototypical for all currency collapses going forward. Second, any study that uses historical data, meaning statistics, is potentially subject to challenges on account of the methodologies used and the accuracy of the underlying data, and this is the case many times over when data series are of such staggering volatility and even somewhat dubious reliability as they are in the case of Germany’s quick descent into monetary chaos. Be that as it may, the study is still very interesting.
Sensibly, Bresciani-Turroni starts his account in the summer of 1914, when Germany left the international gold standard to allow for inflationary war financing. As almost always in the history of money, the state decreed to get rid of the gold anchor so that it could fund itself by printing money freely, and not, as the fairy tales that modern macroeconomists tell themselves will have it, because the gold standard was oh so inflexible and deflationary, which it was, of course, but that was a good thing.
Bresciani-Turroni takes the average of an official German stock index for the year 1913, the last gold standard year, as the base and sets it at 100. He then charts the index in paper mark prices through to 1923, and also calculates the index adjusted for the mark’s steep depreciation versus the dollar, and adjusted according to the index of wholesale prices.
I give you the conclusion right away: If you had held paper marks throughout you would have lost everything. Paper marks became worthless by the end of 1923. Equities did much better but over the whole period underperformed the dollar (and thus gold) and the wholesale price index. By the end of 1923, the stock index that was on average 100 in 1913 stood at 26.80 if adjusted for the dollar exchange rate, according to Bresciani-Turroni’s calculation. In gold-terms you had thus lost more than 70 percent of your purchasing power by staying invested in German equities. Adjusted for wholesale price inflation, the index stood at 21.27. Yes, you avoided total annihilation of your wealth but you were still almost 80 percent poorer measured in the real prices of goods and services and also about 70 percent poorer in gold terms.
What is also fascinating is the sheer volatility of the stock market throughout that period. In 1918, the year of the armistice, the index dropped 30 percent in nominal terms, more than 50 percent in dollar terms, and more than 40 percent when adjusted for inflation. In nominal terms, the index reached a low of 88 in late 1918 (remember: the average of 1913 = 100) and never looked back. It rose to 127 by the end of 1919, 274 by the end of 1920, 731 by the end of 1921, 8,981 by the end of 1922, and it finally reached 26,890,000,000,000 (that is 26.89 trillion) by the end of 1923. Yet, it still underperformed gold and wholesale prices.
In 1919 the nominal index rose 30 percent, yet in gold/dollar terms German equities lost more than 70 percent that year. The years 1920 and 1921 are of particular interest. Inflation had set off a speculative frenzy in Germany. “Playing” the stock market had suddenly become a national obsession. Over those two years the nominal stock index did indeed keep pace with the ongoing destruction of the German Mark. By the end of 1921, you would have even come out slightly ahead of gold and overall prices when compared to early 1920 as a starting point. However, this changed again dramatically in 1922 when the German public shifted its focus to foreign exchange and gold as protectors of their real wealth. Although the nominal stock index grew more than tenfold in 1922, German equities lost 70 percent of their value in gold terms and in wholesale items. The public turned their back on stocks as they sensed that Germany was heading for economic ruin. In October 1922 stock prices were in fact so depressed that some truly bizarre situations occurred:
“…all the share capital of a great company, the Daimler, was , according to the Bourse quotations, scarcely worth 980 million paper marks. Now, since a motor-car made by that company cost at that time on an average three million marks, it follows that ‘the Bourse attributed a value of 327 cars to the Daimler capital, with the three great works, the extensive area of land, its reserves and its liquid capital and its commercial organization developed in Germany and abroad.’”
In 1923, stocks did again remarkably well. In what looks like a classic “crack-up boom”, in which everybody desperately tries to get out of paper currency and rushes to buy just anything, the equity index did outperform gold, dollar, and wholesale prices. Despite this impressive sprint, equities were still, over the entire period, a suboptimal tool for wealth protection.
Some observations on real estate
Interestingly, owning real estate proved disastrous for many people in Weimar Germany. There is no detailed analysis in Bresciani-Turroni’s study but the anecdotal references are hardly encouraging. Rents were regulated by law and in the rapid inflation of 1922 and 1923 could apparently not be adjusted quickly enough. Real estate became a zero-yielding asset while maintenance costs exploded:
“In 1922 and 1923, because of the rapid depreciation of the mark, the old house-rents became ridiculous. Consequently the value of houses fell considerably. Many landlords, for whom houses were now valueless because the rents did not cover maintenance expenses, were forced to sell them.”
Germany’s hyperinflation was an economic, social and political disaster. It impoverished large sections of the German middle class, in particular those who were conservative with their finances, who saved and who entrusted their savings to the state-sponsored financial infrastructure: banks, insurance companies, government bonds, mortgage bonds. Real estate investments offered poor protection and even equities were suboptimal. Having gold bars stored in a Swiss safe deposit (or even a German one) would have done the trick.
Again, history does not – usually – repeat itself. Next time things may unfold differently. Yet, gold certainly remains my favorite asset.
This article was previously published at DetlevSchlichter.com.
This week marked the fifth anniversary of the 0.5% Bank of England base rate and the Bank of England’s Quantitative Easing program which has so far seen the Bank conjure up £375 billion of new base money and spend it on British government debt. It’s difficult to imagine money being any ‘easier’.
Or is it? At his Money Illusion blog this week, Scott Sumner asked
1. Japan has had interest rates near zero for nearly 2 decades. Is this easy money, despite an NGDP that is lower than in 1993? Despite almost continual deflation? Despite a stock market at less than one half of 1991 levels. Despite almost continually falling house prices? If it’s easy money, how much longer before the high inflation arrives?
2. The US has had near zero interest rates for more than 5 years. Is this easy money? If so, how much longer until the high inflation arrives? If rates stay near zero for 2 more years, and inflation stays low, will you still call it easy money? How about 5 more years? Ten more years? Twenty?
It is a key tenet of Market Monetarist thought that a low base rate or Fed funds rate is no indicator of whether money is ‘easy’ or not. The correct indicator, they argue, is the growth rate of nominal GDP; if it’s slumping money is too tight, if it’s roaring on it’s too loose, and if it’s ticking along at some predetermined rate all is rosy in the monetary garden. As a result of this analysis Market Monetarists like Sumner believe the Bank of England’s low base rates and vast monetary base expansion do not indicate ‘easy money’. Are they right?
Well, first we have to define what we mean by ‘easy money’. It’s a rhetorical term rather than a textbook one so here’s my definition (which, if you don’t accept it, probably scuppers the following analysis so feel to substitute your own); money is ‘easier’ the more people who want credit can get it.
There are two points to make. First, the choice of ‘credit’ rather than ‘money’ is deliberate. When most of us ‘borrow money’ we are, in fact, accessing credit which is some derivative of, or claim on money. Secondly, a point I’ve made previously, economy wide aggregates often tell us little of interest or use. Often more useful and interesting is to disaggregate. Instead of looking at the availability of credit to the British economy look instead at the availability of credit to different bits of it.
Looked at like this we would have to say that for most businesses and individuals in the UK, despite the tripling of the monetary base since March 2009, credit is not easily available and money cannot be said to be ‘easy’. The most recent Bank of England lending report in January noted that “The rate of decline in the stock of lending to UK businesses eased slightly in the year to November compared to 2012. The annual rate of growth in the stock of secured lending to individuals rose slightly to 0.8% in the three months to November” –November’s fall in business lending being the biggest in six months.
But banks certainly do have ‘easy’ money. That tripling of the monetary base, as I wrote recently, has flowed onto their balance sheets and stayed there. The money multiplier has collapsed and growth of base money, M0, has not led to growth in broader monetary aggregates such as M4, which would influence nominal GDP. The open handed stance of the Bank of England isn’t showing up as ‘easy’ money as Market Monetarists see it because ‘easy’ money for banks isn’t translating into ‘easy’ money for the rest of the economy.
Do we have easy money? On my definition that depends on who ‘we’ is. Banks face little constraint on their ability to access credit from the Bank of England so for them the answer is yes. The rest of us who rely on those banks find it rather tighter.
 For fans of mathematical notation, if E is monetary ease and C is availability of credit then E=f(C)
 If we think of a river, with M0 pouring out of the spring at Threadneedle Street and the broad delta downriver being M4, banks’ demand for money has built a big dam stopping the river flowing. The Market Monetarist solution to this is to get the spring pouring out enough money that it flows over the top of this dam – in Quantity Theory notation to offset the decline in V stemming from banks’ increased money demand (which with downwardly sticky P would pull down y) with sufficient expansion of M.
I’ve recently written for Save Our Savers attempting to square the massive expansion of Britain’s monetary base since March 2009 with the fact that inflation has now been within the Bank of England’s target range of 2% (+/- 1%) since June 2012. Here I’d like to expand a little.
Since March 2009 Britain’s monetary base, also known as narrow money or M0, has increased by 321%. We can see that the majority of this is in the form of increased bank reserves, up 642% since March 2009
Source:The Bank of England, series Notes in circulation – RPWB55A, and Reserve Balances – RPWB56A
This is just what we’d expect to see following the Bank of England’s Quantitative Easing, where the Bank creates new money and uses it to purchase bonds from banks – that new money becomes bank reserves. Those banks have sat on that money (not using it as a basis for new credit creation and feeding into M4) which is why, while narrow (M0) money has exploded, broad (M4) money has barely budged, increasing by just 7.4% since March 2009.
Source:The Bank of England, series Notes in circulation (RPWB55A) and Reserve Balances (RPWB56A) (M0), and Monthly amounts outstanding of M4 (monetary financial institutions’ sterling M4 liabilities to private sector) (in sterling millions) seasonally adjusted (LPMAUYN) (M4)
This relative restraint in M4 growth explains the relative restraint in inflation. There is no great mystery as to why banks which have just seen their assets tank and ravage their balance sheets should want to hold more reserves. The key question is what happens next.
The chart above shows the ratio of M0 to M4 since May 2006; how many pounds of broad money each pound of narrow money is supporting. From 25:1 between May 2006 and March 2009, it slumped via successive bouts of Quantitative Easing to about 6:1 since September 2012.
Now, on the one hand banks might stick to this new, lower ratio. Chastened by their experiences with mortgage backed assets they might desire a permanently lower reserve to asset ratio and all QE will have been is a vast recapitalisation of banks.
On the other hand, as ‘recovery’ kicks in they might start to increase their reserve to asset ratio. They might not scale the giddy heights of 25:1 again, but they will be multiplying out from a monetary base which has tripled in size. Britain’s monetary base is now £362 billion and M4 is about six times that, £2.2 trillion. But if renewed confidence in the banking sector saw banks return to higher ratios, the resulting M4 figures would be as follows:
Here, we are told, the Bank of England will be able to ‘drain’ this liquidity from the system. It would do this by reversing QE; selling bonds to banks and effectively destroying the base money it receives in return. But a massive increase in the supply of bonds relative to the demand for them will lower their price. This is the same as raising their yield and this is the same as raising a key interest rate.
It is worth pondering for a moment the scale of bond sales and consequent rise in interest rates which might be necessary to drain this base money from the financial system. We must hope either that the economy can stand it or that banks keep holding these reserves.
“Now the New Year reviving old desires
The thoughtful Soul to Solitude retires”
- Rubaiyat of Omar Khayyam
Yes folks, it’s that time of year again; but unlike old Khayyam who reflected bucolically on the continuing availability of wine, we must turn our thoughts to the dangers and opportunities of the coming year. They are considerable and multi-faceted, but instead of being drawn into the futility of making forecasts I will only offer readers the barest of basics and focus on the corruption of currencies. My conclusion is the overwhelming danger is of currency destruction and that gold is central to their downfall.
As we enter 2014 mainstream economists relying on inaccurate statistics, many of which are not even relevant to a true understanding of our economic condition, seem convinced that the crises of recent years are now laid to rest. They swallow the line that unemployment is dropping to six or seven per cent, and that price inflation is subdued; but a deeper examination, unsubtly exposed by the work of John Williams of Shadowstats.com, shows these statistics to be false.
If we objectively assess the state of the labour markets in most welfare-driven economies the truth conforms to a continuing slump; and if we take a realistic view of price increases, including capital assets, price inflation may even be in double figures. The corruption of price inflation statistics in turn makes a mockery of GDP numbers, which realistically adjusted for price inflation are contracting.
This gloomy conclusion should come as no surprise to thoughtful souls in any era. These conditions are the logical outcome of the corruption of currencies. I have no doubt that if in 1920-23 the Weimar Republic used today’s statistical methodology government economists would be peddling the same conclusions as those of today. The error is to believe that expansion of money quantities is a cure-all for economic ills, and ignore the fact that it is actually a tax on the vast majority of people reducing both their earnings and savings.
This is the effect of unsound money, and with this in mind I devised a new monetary statistic in 2013 to quantify the drift away from sound money towards an increasing possibility of monetary collapse. The Fiat Money Quantity (FMQ) is constructed by taking account of all the steps by which gold, as proxy for sound money, has been absorbed over the last 170 years from private ownership by commercial banks and then subsequently by central banks, all rights of gold ownership being replaced by currency notes and deposits. The result for the US dollar, which as the world’s reserve currency is today’s gold’s substitute, is shown in Chart 1.
The graphic similarities with expansions of currency quantities in the past that have ultimately resulted in monetary and financial destruction are striking. Since the Lehman crisis the US authorities have embarked on their monetary cure-all to an extraordinary degree. We are being encouraged to think that the Fed saved the world in 2008 by quantitative easing, when the crisis has only been concealed by currency hyper-inflation.
Are we likely to collectively recognise this error and reverse it before it is too late? So long as the primary function of central banks is to preserve the current financial system the answer has to be no. An attempt to reduce the growth rate in the FMQ by minimal tapering has already raised bond market yields considerably, threatening to derail monetary policy objectives. The effect of rising bond yields and term interest rates on the enormous sums of government and private sector debt is bound to increase the risk of bankruptcies at lower rates compared with past credit cycles, starting in the countries where the debt problem is most acute.
With banks naturally reluctant to take on more lending-risk in this environment, rising interest rates and bond yields can be expected to lead to contracting bank credit. Does the Fed stand aside and let nature take its course? Again the answer has to be no. It must accelerate its injections of raw money and grow deposits on its own balance sheet to compensate. The underlying condition that is not generally understood is actually as follows:
The assumption that the Fed is feeding excess money into the economy to stimulate it is incorrect.
Individuals, businesses and banks require increasing quantities of money just to stand still and to avoid a second debt crisis.
I have laid down the theoretical reasons why this is so by showing that welfare-driven economies, fully encumbered by debt, through false employment and price-inflation statistics are concealing a depressive slump. An unbiased and informed analysis of nearly all currency collapses shows that far from being the product of deliberate government policy, they are the result of loss of control over events, or currency inflation beyond their control. I expect this to become more obvious to markets in the coming months.
Gold’s important role
Gold has become undervalued relative to fiat currencies such as the US dollar, as shown in the chart below, which rebases gold at 100 adjusted for both the increase in above-ground gold stocks and US dollar FMQ since the month before the Lehman Crisis.
Given the continuation of the statistically-concealed economic slump, plus the increased quantity of dollar-denominated debt, and therefore since the Lehman Crisis a growing probability of a currency collapse, there is a growing case to suggest that gold should be significantly higher in corrected terms today. Instead it stands at a discount of 36%.
This undervaluation is likely to lead to two important consequences. Firstly, when the tide for gold turns it should do so very strongly, with potentially catastrophic results for uncovered paper markets. The last time this happened to my knowledge was in September 1999, when central banks led by the Bank of England and the Fed rescued the London gold market, presumably by making bullion available to distressed banks. The scale of gold’s current undervaluation and the degree to which available monetary gold has been depleted suggests that a similar rescue of the gold market cannot be mounted today.
The second consequence is to my knowledge not yet being considered at all. The speed with which fiat currencies could lose their purchasing power might be considerably more rapid than, say, the collapse of the German mark in 1920-23. The reason this may be so is that once the slide in confidence commences, there is little to slow its pace.
In his treatise “Stabilisation of the Monetary Unit – From the Viewpoint of Monetary Theory” written in January 1923, Ludwig von Mises made clear that “speculators actually provide the strongest support for the position of notes (marks) as money”. He argued that considerable quantities of marks were acquired abroad in the post-war years “precisely because a future rally in the mark’s exchange rate was expected. If these sums had not been attracted abroad they would have necessarily led to an even steeper rise in prices on the domestic market”.
At that time other currencies, particularly the US dollar, were freely exchangeable with gold, so foreign speculators were effectively selling gold to buy marks they believed to be undervalued. Today the situation is radically different, because Western speculators have sold nearly all the gold they own, and if you include the liquidation of gold paper unbacked by physical metal, in a crisis they will be net buyers of gold and sellers of currencies. Therefore it stands to reason that gold is central to a future currency crisis and that when it happens it is likely to be considerably more rapid than the Weimar experience.
I therefore come to two conclusions for 2014: that we are heading towards a second and unexpected financial and currency crisis which can happen at any time, and that the lack of gold ownership in welfare-driven economies is set to accelerate the rate at which a collapse in purchasing power may occur.
A number of people have asked me to expand on how the rapid expansion of money supply leads to an effect the opposite of that intended: a fall in economic activity. This effect starts early in the recovery phase of the credit cycle, and is particularly marked today because of the aggressive rate of monetary inflation. This article takes the reader through the events that lead to this inevitable outcome.
There are two indisputable economic facts to bear in mind. The first is that GDP is simply a money-total of economic transactions, and a central bank fosters an increase in GDP by making available more money and therefore bank credit to inflate this number. This is not the same as genuine economic progress, which is what consumers desire and entrepreneurs provide in an unfettered market with reliable money. The second fact is that newly issued money is not absorbed into an economy evenly: it has to be handed to someone first, like a bank or government department, who in turn passes it on to someone else through their dealings and so on, step by step until it is finally dispersed.
As new money enters the economy, it naturally drives up the prices of goods bought with it. This means that someone seeking to buy a similar product without the benefit of new money finds it is more expensive, or put more correctly the purchasing power of his wages and savings has fallen relative to that product. Therefore, the new money benefits those that first obtain it at the expense of everyone else. Obviously, if large amounts of new money are being mobilised by a central bank, as is the case today, the transfer of wealth from those who receive the money later to those who get it early will be correspondingly greater.
Now let’s look at today’s monetary environment in the United States. The wealth-transfer effect is not being adequately recorded, because official inflation statistics do not capture the real increase in consumer prices. The difference between official figures and a truer estimate of US inflation is illustrated by John Williams of Shadowstats.com, who estimates it to be 7% higher than the official rate at roughly 9%, using the government’s computation methodology prior to 1980. Simplistically and assuming no wage inflation, this approximates to the current rate of wealth transfer from the majority of people to those that first receive the new money from the central bank.
The Fed is busy financing most of the Government’s borrowing. The newly-issued money in Government’s hands is distributed widely, and maintains prices of most basic goods and services at a higher level than they would otherwise be. However, in providing this funding, the Fed creates excess reserves on its own balance sheet, and it is this money we are considering.
The reserves on the Fed’s balance sheet are actually deposits, the assets of commercial banks and other domestic and foreign depository institutions that use the Fed as a bank, in the same way the rest of us have bank deposits at a commercial bank. So even though these deposits are on the Fed’s balance sheet, they are the property of individual banks.
These banks are free to draw down on their deposits at the Fed, just as you and I can draw down our deposits. However, because US banks have been risk-averse and under regulatory pressure to improve their own financial position, they have tended to leave money on deposit at the Fed, rather than employ it for financial activities. There are signs this is changing.
Rather than earn a quarter of one per cent, some of this deposit money has been employed in financial speculation in derivative markets, or found its way into the stock market, gone into residential property, and some is now going into consumer loans for credit-worthy borrowers.
In addition to the government’s deficit spending, these channels represent ways in which money is entering the economy. Furthermore, anyone working in the main finance centres is being paid well, so prices in New York and London are driven higher than in other cities and in the country as a whole. They spend their bonuses on flashy cars and country houses, benefiting salesmen and property values in fashionable locations. And with stock prices close to their all-time highs, investors with portfolios everywhere feel financially better off, so they can increase their spending as well.
All the extra spending boosts GDP, and to some extent it has a snowball effect. Banks loosen their purse strings a little more, and spending increases further. But the number of people benefiting is only a small minority of the population. The rest, low-paid workers on fixed incomes, pensioners, people living on modest savings in cash at the bank, and part time employed as well as the unemployed find their cost of living has gone up. They all think prices have risen, and don’t understand that their earnings, pensions and savings have been reduced by monetary inflation: they are the ultimate victims of wealth transfer.
While luxury goods are in strong demand in London and New York, general merchants in the country find trading conditions tough. Higher prices are forcing most people to spend less, or to seek cheaper alternatives. Manufacturers of everyday goods have to find ways to reduce costs, including firing staff. After all if you transfer wealth from ordinary folk they will simply spend less and businesses will suffer.
So we have a paradox: growth in GDP remains positive; indeed artificially strong because of the under-recording of inflation, while in truth the economy is in a slump. The increase in GDP, which reflects the money being spent by the fortunate few before it is absorbed into general circulation, conceals a worse economic situation than before. The effect of an expansion of new money into an economy does not make the majority of people better off; instead it makes them worse off because of the wealth transfer effect. No wonder unemployment remains stubbornly high.
It is the commonest fallacy in economics today that monetary inflation stimulates activity. Instead, it benefits the few at the expense of the majority. The experience of all currency inflations is just that, and the worse the inflation the more the majority of the population is impoverished.
The problem for central banks is that the alternative to maintaining an increasing pace of monetary growth is to risk triggering a widespread debt crisis involving both over-indebted governments and also over-extended businesses and home-owners. This was why the concept of tapering, or putting a brake on the rate of money creation, destabilised worldwide markets and was rapidly abandoned. With undercapitalised banks already squeezed between bad debts and depositor liabilities, there is the potential for a cascade of financial failures. And while many central bankers could profit by reading and understanding this article, the truth is they are not appointed to face up to the reality that monetary inflation is economically destructive, and that escalating currency expansion taken to its logical conclusion means the currency itself will eventually become worthless.
This article was previously published at GoldMoney.com.
We use the term “reserve currency” when referring to the common use of the dollar by other countries when settling their international trade accounts. For example, if Canada buys goods from China, it may pay China in US dollars rather than Canadian dollars, and vice versa. However, the foundation from which the term originated no longer exists, and today the dollar is called a “reserve currency” simply because foreign countries hold it in great quantity to facilitate trade.
The first reserve currency was the British pound sterling. Because the pound was “good as gold,” many countries found it more convenient to hold pounds rather than gold itself during the age of the gold standard. The world’s great trading nations settled their trade in gold, but they might hold pounds rather than gold, with the confidence that the Bank of England would hand over the gold at a fixed exchange rate upon presentment. Toward the end of World War II the US dollar was given this status by international treaty following the Bretton Woods Agreement. The International Monetary Fund (IMF) was formed with the express purpose of monitoring the Federal Reserve’s commitment to Bretton Woods by ensuring that the Fed did not inflate the dollar and stood ready to exchange dollars for gold at $35 per ounce. Thusly, countries had confidence that their dollars held for trading purposes were as “good as gold,” as had been the Pound Sterling at one time.
However, the Fed did not maintain its commitment to the Bretton Woods Agreement and the IMF did not attempt to force it to hold enough gold to honor all its outstanding currency in gold at $35 per ounce. The Fed was called to account in the late 1960s, first by France and then by others, until its gold reserves were so low that it had no choice but to revalue the dollar at some higher exchange rate or abrogate its responsibilities to honor dollars for gold entirely. To it everlasting shame, the US chose the latter and “went off the gold standard” in September 1971.
Nevertheless, the dollar was still held by the great trading nations, because it still performed the useful function of settling international trading accounts. There was no other currency that could match the dollar, despite the fact that it was “delinked” from gold.
There are two characteristics of a currency that make it useful in international trade: one, it is issued by a large trading nation itself, and, two, the currency holds its value vis-à-vis other commodities over time. These two factors create a demand for holding a currency in reserve. Although the dollar was being inflated by the Fed, thusly losing its value vis-à-vis other commodities over time, there was no real competition. The German Deutsche mark held its value better, but German trade was a fraction of US trade, meaning that holders of marks would find less to buy in Germany than holders of dollars would find in the US. So demand for the mark was lower than demand for the dollar. Of course, psychological factors entered the demand for dollars, too, since the US was seen as the military protector of all the Western nations against the communist countries for much of the post-war period.
Today we are seeing the beginnings of a change. The Fed has been inflating the dollar massively, reducing its purchasing power in relation to other commodities, causing many of the world’s great trading nations to use other monies upon occasion. I have it on good authority, for example, that DuPont settles many of its international accounts in Chinese yuan and European euros. There may be other currencies that are in demand for trade settlement by other international companies as well. In spite of all this, one factor that has helped the dollar retain its reserve currency demand is that the other currencies have been inflated, too. For example, Japan has inflated the yen to a greater extent than the dollar in its foolish attempt to revive its stagnant economy by cheapening its currency. So the monetary destruction disease is not limited to the US alone.
The dollar is very susceptible to losing its vaunted reserve currency position by the first major trading country that stops inflating its currency. There is evidence that China understands what is at stake; it has increased its gold holdings and has instituted controls to prevent gold from leaving China. Should the world’s second largest economy and one of the world’s greatest trading nations tie its currency to gold, demand for the yuan would increase and demand for the dollar would decrease. In practical terms this means that the world’s great trading nations would reduce their holdings of dollars, and dollars held overseas would flow back into the US economy, causing prices to increase. How much would they increase? It is hard to say, but keep in mind that there is an equal amount of dollars held outside the US as inside the US.
President Obama’s imminent appointment of career bureaucrat Janet Yellen as Chairman of the Federal Reserve Board is evidence that the US policy of continuing to cheapen the dollar via Quantitative Easing will continue. Her appointment increases the likelihood that demand for dollars will decline even further, raising the likelihood of much higher prices in America as demand by trading nations to hold other currencies as reserves for trade settlement increase. Perhaps only such non-coercive pressure from a sovereign country like China can wake up the Fed to the consequences of its actions and force it to end its Quantitative Easing policy.
This article was previously published at Mises.org.