The Honorable Ron Paul says:
Why is gold good money? Because it possesses all the monetary properties that the market demands: it is divisible, portable, recognizable and, most importantly, scarce – making it a stable store of value.
True. Yet those properties are not the most relevant today. The most important characteristic that makes gold a good reference point for money today is its enormous stock to flow ratio as the recent gold report by Erste Bank points out.
By neglecting the stock to flow ratio argument and using other, less important ones, it is much easier for anti-gold economists to confuse the public. For instance, Paul Krugman and others mercilessly criticize gold by conflating deflation with contraction and inflation with expansion.
Gold is money not because it is scarce but because it is abundant (relative to its production and consumption). This factor makes for a huge buffer that stabilizes its value against other things.
The same can be said about water. Water is abundant on Earth. Water evaporates from the land and oceans, falls down as rain and snow, rivers bring it back to oceans – at widely volatile rates.
Approximately 505,000 km3 of water falls as precipitation each year. But the world’s water supply is estimated at 1,386,000,000 km3 (97 per cent of which is stored in oceans). A huge stock to flow ratio that makes for a useful reference point.
The Erste Bank’s Gold Report concludes:
We believe that gold is not precious because it is scarce, but because the opposite is true: gold is precious because the annual production is so low relative to the stock. The aggregate volume of all the gold ever produced comes to about 170,000 tonnes. This is the stock. Annual production was close to 2,600 tonnes in 2011. That is the flow. Dividing the former by the latter, we receive the stock-to-flow ratio of 65 years (which is far more than for any other good offered in the world economy).
Gold has acquired this feature over centuries, and cannot lose it anymore.
Most commodities are consumed, whereas gold stocks are augmented, gradually.
Let’s suppose then that production of gold increases twofold or is cut in half. No big deal. There is a huge reserve to make up for difference. This does not really apply to any other commodity.
It should be also noted that CPI is a sum of two different and separate things.
CPI has a monetary component and a component related to business cycle.
When too much money is created the prices rise – prices of gold first, then other commodities and liquid assets. The prices of goods that are included in CPI rise thereafter.
But there may be other reasons for a rise in CPI. Let us assume that monetary policy in a given country is OK, but the economy is growing really fast, as was Ireland and Estonia before the crisis. CPI had been rising there due to the (relatively) huge inflow of capital – there was more demand than supply for everything, especially immovable property. Symmetrically, one can get a drop of CPI in a recession.
This is how adjusting interest rates works. Interest rates are not a monetary instrument, but an instrument to effect business cycle. By raising interest rates central banks depress economic activity and force marginal firms out of business. This reduces CPI. Symmetrically, central banks try to revive growth by reducing interest rates in an attempt to bring about an increase in CPI.
Why was there no surge in CPI after such a huge injection of money after September 2008?
There appear two things working in opposite directions here: too much money pushing prices up and severe recession bringing them down. Taken together they made, and are making, for modest CPI increases. In 1970 monetary expansion was much stronger (23X rise in gold prices against 3 fold now) and real economic growth as weak as it was, was stronger than it has been.
This article was previously published at The Gold Standard Now.
Once again, the European press is trumpeting the triumph of the prodigals after a week in which both the Spanish and the French were accorded more time to get their budgetary house in order – a move which, given the downward economic trajectory of the pair, has something of a whiff of force majeure about it – and the German Finance Minister Schaeuble acknowledged that, yes, the fiscal pact around which he and his boss have built so much of their electoral credibility did in fact encompass a ‘certain flexibility’.
In the wake of a mass demonstration on the streets of Paris at which the Left Front’s heavily-defeated presidential candidate Melenchon fulminated that “We do not want the world of finance in power!” – an expostulation delivered to the strains of ‘Ca ira!’, one supposes – Schaeuble’s Gallic counterpart Moscovici was hardly in a position to soft-pedal the German concession, instead vaunting grandiosely in his turn that, “We are witnessing the end of the dogma of austerity… we are at a decisive turning point in the history of the European Project”.
Brave words, indeed, but Frau Merkel, for one, begged to disagree – or, at least, to dissemble for the benefit of her domestic audience. “If one regularly spends more than one earns, something must be awry,” she opined, while one of her party’s spokesmen, Steffen Seibert declared that, “Our contention is that the… crisis has its roots in the overindebtedness of many member states… in to low a degree of competitiveness.” No prizes for guessing to whom he was referring.
Last week’s supposed poster boy for the new laxity, Commissar – sorry, Commissioner – Barroso, was also out on the circuit, denying that he had endorsed any such slippage by telling Welt am Sonntag that he had been “deliberately misinterpreted”, that – au contraire, mes amis – “growth which depends upon debt is unsustainable” and that the blame for the ‘Project’s’ woes should not be pinned on German policy but rather on “excessive outlays, lack of competitiveness” – that word again – “and irresponsible finance.” “Each nation,” he went on, “should look to clean up the mess on its own doorstep.”
Amid all this posturing, it does strike your author as a touch ironic that while the commentariat treats Europe’s persistence with its failed experiment in ‘fauxterity’ as a clear and undeniable symptom of the mental inadequacy of its ruling elite, the members of that same consensus themselves retain what is, if anything, an even more delusional faith in the combined evils of inflation and Big Government as the magical means with which to conjure away all our present woes.
In case you hadn’t noticed, fellas, we have been reinforcing monetary-fiscal failure for the past five years, by continuing to ply the patient with ever stronger doses of what it was that made him ill in the first place. Just multiply the DAX by the youth unemployment rate if you want a snapshot of where your approach has gone horribly wrong – of where you have let the GINI out of the bottle, as it were – and you might realise that if there is anyone who needs to reconsider their attachment to a discredited dogma, it is you!
Whisper it, but even your hero seems to be getting the drift. For witness that, in his latest speech in Rome, Mario Draghi was happy to say that “Fiscal policies must follow a sustainable path, separate and distinct from cyclical fluctuations. Without this prerequisite, lasting growth is not possible… Particularly for countries with structurally high levels of public debt…”, before going on to assert far more boldly that – as we have said since Day One of the crisis – “…to mitigate the inevitable recessionary effects of fiscal consolidation, the composition of such measures must favour the reduction of current public spending and of taxes, particularly in a context such as in Europe where taxation is already high by international standards….” [our emphasis].
Though we must be careful not to read too much into the man’s words, it is hard not to hope that this might reflect the first fragile flowering of a genuinely new approach – of the inauguration of a policy of REAL austerity, this time of the invigorating kind which incorporates a partial lifting of the deadening hand of the state, rather than the enervating, bastardized version of slower spending growth and rapidly rising taxes with which we have been so far afflicted and which has only served to compound the financial shock delivered by the collapse of the last bubble.
All this remains to be seen but, in the here-and-now, the temptation to use this effusion of political hot-air as an excuse to buy yet more stocks, more ailing sovereign debt, and more junk credit has become well-nigh irresistible, especially since Super-Mario not only overrode what he hinted was some internal opposition to an official rate cut at the latest ECB meeting, but also managed to leave dangling before a slavering crowd of stimulus junkies a tantalising hint that he might soon push the level below zero. In case we were too obtuse to get the point, he underlined his intentions with another of his famously portentous, almost Delphic pronouncements: that even though the ECB council was still scrambling to divine whether anything could possibly go wrong with such step into the unknown, he, Draghi, stood ‘ready to act’.
It was not the first time in recent days, of course, that the marbled halls of Mount Olympus had echoed to the sonorous baritone of the Gods as they sought to reassure us poor mortals that they had matters well in hand: that they had taken time off from their weighty contemplation of the sublime, the eternal, and the infinite to tend instead to our petty concerns. Had not the Bernanke Fed subtly quashed all thoughts that it might soon ‘taper’ its own open-handed distribution of milk and honey with that one, equally Pythian phrase: “the Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation”?
How can a man NOT want to buy the market in the face of the solicitous stance being taken by the venerated possessors of such unchallenged omniscience?
For all this, the imposition of the near-mythical, negative deposit rate might seem to entail more problems than advantages, not least because it would effectively act as a tax, a drain upon the earnings, of the very same banks that the last five year’s ruinous policies have been attempting to bolster. Bear in mind that, even after the recent redemptions, European banks have a hefty €628 billion parked with the ECB and so a 50bp levy on this could amount annually to perhaps 15% of industry-wide profits.
Nor can banks simply avoid this by withdrawing their funds: outside money – the kind created by the central bank – is, after all – outside. This means that its supply can only be altered with the complicity of the bank of issue itself which must therefore allow its myrmidons to pay back more of their LTROs, covered bond repos, and so forth – a reduction of liquidity which one might think would run counter to the original intention. Thus, one supposes, the idea will be that the banks will enact the Gesellian wet dream of passing on the cost to their own depositors, of taxing their money instead.
Here we must consider the fact that while the individual can easily seek to disembarrass himself of what he now considers an excess proportion of money among his holdings, collectively the public can only have their aggregate stock of inside (bank-created) monies diminished in one of three ways: they must repay their loans (deleverage further); the banks themselves must call in said loans (intensify the crunch); or people who hold a demand account must swap it for a term deposit (which does not constitute money-proper), or invest in a long-term security issued by the bank itself (we specify this last because a moment’s thought will reveal that the purchase of non-bank paper simply passes the parcel to the seller or issuer of said obligations who must then rid himself of them in his turn).
While that latter condition might seem an ideal juncture at which the banks could seek to boost their levels of capital (albeit at an average price:book of significantly less than one), the truth is that what the authorities seem most keen to provoke is a what is technically called a ‘monetary disequilibrium’ – that is, the situation where the public’s demand to hold money is thrown out of kilter. Under such conditions – and given the nominal inflexibility discussed above – the money stock can only be effectively reduced if its real value falls; if prices rise and so reduce its worth; i.e., if there is an inflation.
In that regard, the impulse to buy stocks on what is no more than a vague expression of intent might not seem so wholly irrational, after all. To see this in what is admittedly a toy example, suppose that half the population holds only cash and no equities (call these sticks-in-the-mud Group A), while the remainder has a reverse proportion of all equities, no cash to an equal overall nominal value held in their portfolios (call the ‘Nothing but Blue Skies’ crowd, Group B). The aggregate cash ratio from which we start is therefore 50% (albeit thanks to a not-to-be-exceeded and somewhat unrealistic divergence of preferences between our two cohorts).
Now suppose the members of Group A change their outlook on life and seek to acquire equities from Group B, paying successively higher prices for ever smaller increments in order to tempt their counterparts into the trade. Under some fairly crude assumptions, after four rounds of such bidding, with one third of the stock of equities having exchanged against two-thirds the stock of money, equity prices will have tripled, the cash ratio of both groups will have converged on 25%, and aggregate net worth will have doubled (to the relative advantage of the initial equity holders, but to the outright, if decidedly notional, benefit of all).
Note, however, that none of this says that the equities are worth three times as much for even if the monetary disturbance has somehow meant that earnings have also tripled (and this is far from being guaranteed even should revenues rise in proportion), this may represent no material gain whatsoever, but only register the inflation of a wider range of prices which here has not been consequent upon an increase in the stock of money per se but solely upon a diminution in its societal valuation.
Herein lies the great gaping hole at the centre of official policy. Yes, the central banks can increase the stock of outside money almost without limit. Yes, they can make it as unattractive as possible for anyone to hold this (though when we come to think about the impact of negative rates, let us not forget that people are generally happy to pay to have their other valuables safely stored, or that bank charges used to be a routine imposition upon the short-term depositor). And yes, to some extent they can assume that their actions will enhance the relative appeal of things other than money or its partial substitutes.
But what they cannot ever gauge is how much influence they can exert, nor how quickly their will may be done, nor even upon what specific mix of goods, services, or claims their policy will have most impact. As the great Richard Cantillon pointed out three centuries since, the whole question is highly path dependent and the path actually followed will be the result of an incredible cascade of interactions between individual, subjective choices, each one altering the quantum field in which the next has to be taken. As we Austrians have been saying for the past one hundred years, this affects relative prices much more profoundly than it does average ones. Crucially, it is in that matrix of relative prices that you find the motivations for all economic actions and the justification or otherwise for both the composition of the capital stock and the distribution and employment of labour. If entrepreneurial uncertainty and personal bewilderment have been major contributors to our ongoing malaise, as many of us have been arguing, it should be clear that we seek to introduce further sources of instability and potential disruption only at our peril.
Nor can our Sorcerer’s Apprentices be entirely sure that, as the demons they have summoned out of the vasty deep continue to chip away at the foundations of trust in the very currency which they, the necromancers, are charged with upholding, they do not unleash a catastrophic collapse of the whole superstructure of values and contractual chains which towers above them, reducing the whole economic system to chaos in the process.
If you can convince me that any mortal can hold such a complex tangle of possible outcomes within their comprehension, I will allow that our monetary heretics may be right to do away with the combined practical experience and theoretical understanding of all those who have gone before them over the ages. Until you do, I shall be forced to withhold my endorsement and to mutter darkly about the unexpiable sin of hubris instead.
According to a European Central Bank Governing Council member Ewald Nowotny, Federal Reserve Chairman Ben Bernanke sees no risk to inflation in the United States. According to Nowotny, Bernanke had given a “very optimistic” portrayal of the U.S. outlook.
“They see absolutely no danger of an expansion in inflation,” Nowotny said. Bernanke had said U.S. inflation should be 1.3 percent this year.
Fed forecasts put inflation by the end of this year in a range of 1.3 to 1.7 percent. The yearly rate of growth of the consumer price index (CPI) stood at 1.5% in March against 2% in February and 2.7% in March last year.
Also the growth momentum of the core CPI (the CPI less food and energy) has eased in March from the month before. Year-on-year the rate of growth has softened to 1.9% from 2% in February and 2.3% in March last year.
For Bernanke and most experts the key factor that sets the foundation for healthy economic fundamentals is a stable price level as depicted by the consumer price index.
On this way of thinking a stable price level doesn’t obscure the visibility of the relative changes in the prices of goods and services.
Consequently, it is held, this leads to the efficient use of the economy’s scarce resources and hence results in better economic fundamentals.
A stable price level enables businesses to see clearly market signals that are conveyed by the relative changes in the prices of goods and services.
For instance, let us say that a relative strengthening in people’s demand for potatoes versus tomatoes took place. This relative strengthening, it is held, is going to be depicted by the relative increase in the prices of potatoes versus tomatoes.
Now in a free market businesses pay attention to consumer wishes as manifested by changes in the relative prices of goods and services. Failing to abide by consumer wishes will lead to the wrong production mix of goods and services and will lead to losses.
Hence in our case businesses, by paying attention to relative changes in prices, are likely to increase the production of potatoes versus tomatoes.
On this way of thinking if the price level is not stable then the visibility of the relative price changes becomes blurred and consequently, businesses cannot ascertain the relative changes in the demand for goods and services and make correct production decisions.
This leads to a misallocation of resources and to the weakening of economic fundamentals. In short, unstable changes in the price level obscure changes in the relative prices of goods and services.
Consequently, businesses will find it difficult to recognize a change in relative prices when the price level is unstable.
Based on this way of thinking it is not surprising that the mandate of the central bank is to pursue policies that will bring price stability i.e. a stable price level.
By means of various quantitative methods the Fed’s economists have established that at present policy makers must aim at keeping price inflation at 2%. Any significant deviation from this figure constitutes deviation from the growth path of price stability.
Observe that Fed policy makers are telling us that they have to stabilize the price level in order to allow the efficient functioning of the market economy.
Obviously this is a contradiction in terms since any attempt to manipulate the so called price level implies interference with markets and hence leads to false signals as conveyed by changes in relative prices.
By means of setting targets to interest rates and by means of monetary pumping it is not possible to strengthen economic fundamentals, but on the contrary it only makes things much worse. Here is why.
Policy of price stability leads to more instability
Let us say that the so called price level is starting to exhibit a visible decline in growth momentum. To prevent this decline the Fed starts to aggressively push money into the banking system.
As a result of this policy, after a time lag, the price level has stabilized. Should we regard this as a successful monetary policy action? The answer is categorically no.
Given that monetary pumping sets in motion the diversion of wealth from wealth generating activities to non-wealth generating activities obviously this leads to the weakening of the wealth generation process and to economic impoverishment.
Note that the economic impoverishment has taken place despite price level stability. Also, note that in order to achieve price stability the Fed had to allow an increase in the growth momentum of its balance sheet and consequently in the growth momentum of the money supply.
It is the fluctuations in the balance sheet and the subsequent fluctuations in the growth momentum of money supply that matter here. It is this that sets in motion the menace of the boom bust cycle regardless of whether the price level is stable or not.
While increases in money supply are likely to be revealed in general price increases, this need not always be the case. Prices are determined by real and monetary factors.
Consequently, it can occur that if the real factors are pulling things in an opposite direction to monetary factors, no visible change in prices might take place.
In other words, while money growth is buoyant prices might display low increases.
Clearly, if we were to pay attention to the so called price level and disregard increases in the money supply, we would reach misleading conclusions regarding the state of the economy.
On this, Rothbard wrote,
“The fact that general prices were more or less stable during the 1920s told most economists that there was no inflationary threat, and therefore the events of the great depression caught them completely unaware”
(America’s Great Depression, Mises Institute, 2001 , p. 153).
During the 1926 to 1929 the alleged stability of the price level caused most economic experts including the famous American economist Irving Fisher to conclude that US economic fundamentals were doing fine and that there was no threat of an economic bust.
The yearly rate of growth of the CPI displayed stability during 1926 to 1929 (see chart). Most experts have ignored the fact that the yearly rate of growth of the US central bank balance sheet jumped to 42% by June 1928 from minus 14% in February 1927.
The sharp fall in the growth momentum of the Fed’s balance sheet after June 1928 (see chart) set in motion an economic bust and the Great Depression.
At present the Fed continues to push money aggressively into the banking system with its balance sheet standing at $3.3 trillion as at the end of April against $0.9 trillion in January 2008. We suggest however that a fall in the growth momentum of AMS since October 2011 raises the likelihood of a bust in the months ahead.
If one adds to all this the possibility that the process of real wealth generation has been badly damaged by the Fed’s loose policies it shouldn’t surprise us that we could enter a severe slump in the months ahead.
Summary and conclusion
For most economists the key to healthy economic fundamentals is price stability. A stable price level, it is held, leads to the efficient use of the economy’s scarce resources and hence results in better economic fundamentals. It is not surprising that the mandate of the Federal Reserve is to pursue policies that will generate price stability. We suggest that by means of monetary policies that aim at stabilizing the price level the Fed actually undermines economic fundamentals.
“We have Stone Age emotions. We have medieval institutions.. And we have god-like technology.” – Edward O. Wilson.
The BBC reported last week that researchers from IBM had created the world’s smallest motion picture after manipulating individual atoms with a scanning tunnelling microscope. They separately reported the proposals of two Dutch engineers to introduce self-lighting weather warnings on motorways, and a dedicated driving lane that could recharge electric cars as they passed over it. As artist Daan Roosegarde pointed out, auto manufacturers spend billions of dollars on car design, research and development,
but somehow the roads.. are completely immune to that process. They are still stuck in the Middle Ages, so to speak.
Another staggering gulf lies between what we as individuals are capable of doing – more or less anything to which we put our minds – and what our governments are capable of doing – more or less nothing, other than mindlessly to continue the dismal and seemingly inexorable cycle of tax, borrow and spend. At a recent City debate hosted by Marcus Ashworth of Espirito Santo Investment Bank, ‘Is monetary activism the answer?’, Steve Baker MP and Ewen Stewart of Walbrook Economics essentially revealed the paucity of government thinking through generations, and across the political spectrum, that gave rise to such a desperate question in the first place.
As the graph below makes clear, in duration – if not necessarily in scale – the current economic crisis is now worse than the Great Depression. There are realistically just two schools of thought as to how an economic depression should be tackled. The neo-Keynesians advocate deficit spending, on the basis that government stimulus is merely taking the other side of a retrenching private sector. As the facile mud-slinging over Reinhart & Rogoff’s recent debt research reveals, the idea that a state can simply have too much debt for its own good gets little traction in the neo- Keynesian camp, which effectively suspends respect for mathematics, logic or sound economics whenever it happens to suit. The Austrians, on the polar opposite side of the debate, advocate a policy of non-interference with the free market process of economic adjustment. Less euphemistically, the Austrian perspective favours what Depression-era US Treasury Secretary Andrew Mellon recommended as painful but ameliorative policy:
Liquidate labour, liquidate stocks, liquidate farmers, liquidate real estate.. it will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people. [Emphasis ours.]
Source: http://www.niesr.ac.uk/about-monthly-GDP-estimates; Steve Baker MP
As we wrote back in January 2012, we side with the Austrians, specifically Murray Rothbard, and his classic study, ‘America’s Great Depression’:
If government wishes to see a depression ended as quickly as possible, and the economy returned to normal prosperity, what course should it adopt ? The first and clearest injunction is: don’t interfere with the market’s adjustment process. The more the government intervenes to delay the market’s adjustment, the longer and more gruelling the depression will be, and the more difficult will be the road to complete recovery.
Thus far, on the basis alone of the recession chart above, Rothbard would appear to be winning the debate. There is no counter-factual, of course, from the 1930s – Roosevelt’s ‘New Deal’ intervened (in every sense). But it is both interesting and relevant to note Treasury Secretary Mellon’s earlier objective, namely to tackle the US’ vast federal debt load accumulated from World War One. This he did by taking an axe to income tax rates. The top marginal tax rate was cut
from 73% in 1922 to 24% by 1929. The overall public debt fell from $33 billion immediately after the war to approximately $16 billion by 1929. Note those quaint billions, with a ‘b’.
So, to return to the monetary activism debate, how did we get here ? Steve Baker lays it all out. In essence, the state has eaten itself. Before World War One, as the graph below reveals, UK government spending never accounted for much more than 10% of the economy. Now it accounts for almost half of it.
So we are not merely facing a financial crisis but in Steve Baker’s words, we are also beset by a profound crisis of political economy. Governments whose spending has spiralled out of control typically resort to three expedients: more taxation; more borrowing; and currency debauchery. As government spending crowded out the productive sector throughout the 20th Century, the extent of inflation over recent decades has been monstrous:
*January 1974 = 100 (linear scale)
Source: Consumer price inflation since 1750, O’Donoghue et al, Office for National Statistics, 10 March 2004
Since a substantial number of the advocates for yet more government borrowing are pressing for a narrowly Keynesian response, it is worth republishing what Keynes himself thought of the inflationary outcome:
By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth..
..There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.
So the business of investing can no longer be conducted in a rational economic environment. Free market cleansing of malinvestments made during the boom years cannot occur because the free market itself has been suspended. Overmighty governments and their economic agents, notably the central banks, are once again showing the futility of a policy of supporting national champions – those champions today, ironically, being banks that would under any other environment be forced into insolvency. This is not a problem existentially limited to the UK. It afflicts most of the “developed” western economies – developed in the sense that a body riddled with cancer can be said to be “developed”.
So we do the best job we can under such extreme circumstances. We take shelter in credit of unimpeachable quality (not Gilts or US Treasuries) as an alternative to sitting idly in useless cash. We sail close to shore within attractively valued listed equity investments of businesses catering to a constituency of rising wealth (the Asian domestic consumer, for example) instead of one catering to the bombed-out, tapped-out, over-indebted and over-taxed western consumer. We diversify further into uncorrelated managed funds, and we diversify still further into currency that cannot simply be printed into exhaustion: the precious, monetary metals whose fundamental values are still so widely misunderstood in such a bleakly dishonest financial landscape. And we wait – and now actively agitate – for the sort of political radicals capable of understanding both how we got into this mess, and how we might shrink the overmighty state in order to get out of it. It may be a long wait. People, notably political zealots, have a tendency to cling to irrational beliefs rather than sound thinking. As Edward O. Wilson once said,
Men would rather believe than know.
This article was previously published at The price of everything.
Regular readers will know I am in the inflation, possibly hyperinflation camp; but there are those that think the future is more likely to be deflationary. In the main this is the view of neoclassical economists, Keynesians and monetarists, who generally foresee a 1930s-style slump unless the economy is stimulated out of it.
Rather than repeatedly go into the errors of their ways, we must accept that they are in charge. They have decided that prices must not fall, and they see moderate price inflation as a necessary stimulant to business: this is the reasoning behind Helicopter Ben Bernanke’s defining statement, when he made it clear that central banks could spray the economy with endless fiat money if need be.
Given this determination to stop prices falling, worries that the outlook is deflationary are unlikely to be realised. But there is a second group of commentators which believes that in a slump there will be an unstoppable credit contraction as banks are forced to foreclose on failing businesses. This, they say, will lead to a mad dash for cash to pay off debt, leading to fire-sales of assets as credit contraction spreads to otherwise sound businesses. The imperative to pay down debt will overwhelm central banks’ attempts to replace it with cash.
The error here is to misunderstand where we are in this sorry tale. The belief common to all deflationists, that the developed world has so far avoided a severe economic contraction, is wrong. The fact that this is not often recognised must be blamed on the irrelevance of nearly all government statistics. Not only are they self-serving, but they do not allow for the increasing meaninglessness of government money. The only hard statistics are unemployment, which despite official attempts to water them down, cannot conceal the fact that there has been a slump since the banking crisis.
The banking crisis marked a sudden increase in consumer preferences in favour of money, assuredly egged on by banks who switched almost overnight from risk-tolerant to risk-averse. This is why GDP numbers in most major countries took such a heavy knock, reflecting money being withdrawn from economic activity. That was the event deflationists are worrying about today.
So deflationists are forecasting an event that happened five years ago and their fears have already been disproved by massive monetary intervention. That is not to say the slump is over: far from it. Current indications are that things are about to get worse everywhere. But the nightmare cycle of falling asset prices becoming self-feeding and a dash for cash has already been prevented.
So successful was the Fed leading other central banks to save the world in 2009 that the precedent is established: if things take a turn for the worse or a systemically important financial institution looks like failing, Superman Ben and his cohort of central bankers will save us all again.
Call it kryptonite, or failing animal spirits if you like. It is closer to the truth to understand we are witnessing the early stages of erosion of confidence in government and ultimately its paper money. Ordinary people are finally beginning to suspect this, signalled by the world-wide rush into precious metals last month.
This article was previously published at GoldMoney.com.
In this article I will argue that the recent slide in the gold price has generated substantial demand for bullion that will likely bring forward a financial and systemic disaster for both central and bullion banks that has been brewing for a long time. To understand why, we must examine their role and motivations in precious metals markets and assess current ownership of physical gold, while putting investor emotion into its proper context.
In the West (by which in this article I broadly mean North America and Europe) the financial community treats gold as an investment. However, of the global pool of gold, which GoldMoney estimates to be about 160,000 tonnes, the amount actually held by western investors in portfolios is a very small fraction of this amount. Furthermore investor behaviour, which in itself accounts for just part of the West’s bullion demand, is sharply at odds with the hoarders’ objectives, which is behind underlying tensions in bullion markets. To compound the problem, analysts, whose focus incorporates portfolio investment theories and assumptions, have very little understanding of the economic case for precious metals, being schooled in modern neo-classical economic theories.
These economic theories, coupled with modern investment analysis when applied to bullion pricing, have failed to understand the growing human desire for protection from monetary instability. The result has for a considerable time been the suppression of bullion prices in capital markets below their natural level of balance set by supply and demand. Furthermore, the value put on precious metals by hoarders in the West has been less than the value to hoarders in other countries, particularly the growing numbers of savers in Asia.
These tensions, if they persist, are bound to contribute to the eventual destruction of paper currencies.
The ownership of gold
The amount of gold bullion that backs investor-driven markets is not statistically recorded, but we can illustrate its significance relative to total stocks by referring back to the time of the oil crisis of the mid-1970s. In 1974 the global stock of gold was estimated to be half that of today, at about 80,000 tonnes. Monetary gold was about 37,000 tonnes, leaving 43,000 tonnes in the form of non-monetary bullion, coins and jewellery. Let us arbitrarily assume, on the basis of global wealth distribution, that two thirds of this was held by the minority population in the West, amounting to about 30,000 tonnes.
This figure probably grew somewhat before the early 1980s, spurred by the bull market and growing fear of inflation, which saw investors buy mainly coins and mining shares. Demand for gold bars was driven by the rapid accumulation of dollars in the oil-exporting nations, as well as some hoarding by wealthy investors from all over the world through Switzerland and London.
The sharp rise in global interest rates in the Volcker era, the subsequent decline of the inflation threat and the resulting bear market for gold inevitably led to a reduction of bullion holdings by wealthy investors in the West. Swiss and other private banks, employing a new generation of fund managers and investment advisors trained in modern portfolio theories, started selling their customers’ bullion positions in the 1980s, leaving very little by 2000. In the latter stages of the bear market, jewellery sales in the West became a replacement source of bullion supply, but this was insufficient to compensate for massive portfolio liquidation.
So by the year 2000, Western ownership of non-monetary gold suffered the severe attrition of a twenty-year bear market and the reduction of inflation expectations. Portfolios, which routinely had 10-15% exposure to gold 40 years ago even today have virtually no exposure at all. Given that jewellery consumption in Europe and North America was only 400-750 tonnes per annum over the period, by the year 2000 overall gold ownership in the West must have declined significantly from the 1974 guesstimate of 30,000 tonnes. While the total gold stock in 2000 stood at 128,000 tonnes, the virtual elimination of portfolio holdings will have left Western holders with little more than perhaps an accumulation of jewellery, coins and not much else: bar ownership would have been at a very low ebb.
Since 2000, demand from countries such as India and more recently China is known to have increased sharply, supporting the thesis that gold has continued to accumulate at an accelerating pace in non-Western hands.
Western bullion markets have therefore been on the edge of a physical stock crisis for some time. Much of the West’s physical gold ownership since 2000 has been satisfied by recycling scrap originating in the West, suggesting that total gold ownership in the West today barely rose before the banking crisis despite a tripling of prices. Meanwhile the disparity between demand for gold in the West compared with the rest of the world has continued, while the West’s investment management community has been actively discouraging investment.
The result has been that nearly all new mine production and Western central bank supply has been absorbed by non-Western hoarders and their central banks. While post-banking crisis there has presumably been a pick-up in Western hoarding, as evidenced by ETF and coin sales and some institutional involvement, it is dwarfed by demand from other countries. So it is reasonable to conclude that of the total stock of non-monetary gold, very little of it is left in Western hands. And so long as the pressure for migration out of the West’s ownership continues, there will come a point where there is so little gold left that futures and forwards markets cease to operate effectively. That point might have actually arrived, signalled by attempts to smash the price this month.
This admittedly broad-brush assessment has important implications for the price stability essential to bullion banks operating in paper markets as well as for central banks attempting to maintain confidence in their paper currencies.
Precious metals in capital markets
In the West itself, the attitudes of the investment community are fundamentally different from even those of the majority of Western hoarders, who are looking for protection from systemic and currency risks as opposed to investment returns. Western investors are generally oblivious to the implications, the most fundamental of which is that falling prices actually stimulate physical demand. Before the recent dramatic slide in prices the investment community undervalued precious metals compared with Western hoarders, let alone those in Asia, encouraging physical bullion to migrate from financial markets both to firmer hands in the West as well as the bulk of it to non-West ownership. There is now irrefutable evidence that these flows have accelerated significantly on lower prices in recent weeks, as rational price theory would lead one to expect.
Pricing bullion is therefore not as simple as the investment community generally believes. It is being put about, mostly on grounds of technical analysis, that the bull markets in gold and silver have ended, and precious metals have entered a new downtrend. The evidence cited is that medium and longer-term moving averages have been violated and are now falling; furthermore important support levels have been breached.
These developments, which arise out of the futures and forward markets, have rattled Western investors who thought they were in for an easy ride. However, a close examination of futures trading shows the bearish case even on investment grounds is flawed, as the following two charts of official statistics provided by weekly Commitment of Traders data clearly show.
The Money Managers category is the clearest reflection in the official data of investor portfolio positions, representing sizeable mutual and hedge funds. In both cases, the number of long contracts is at historically low levels, and shorts, arguably the better reflection of money-manager sentiment, remain close to high extremes. On this basis, investor sentiment is clearly very bearish already, with the investment management community already committed to falling prices. Put very simplistically there are now more buyers than sellers.
Money Managers are in stark opposition to the Commercials, who seek to transfer entrepreneurial risk to Money Managers and other investor and speculator categories. The official statistics break Commercials down into two categories: Producer/Merchant/Processor/User, and Swap Dealers. Both categories include the activities of bullion banks, which in practice supply liquidity to the market. Because investors and speculators tend to run bull positions, bullion banks acting as market-makers will in aggregate always be short. A successful bullion bank trader will seek to make trading profits large enough to compensate for any losses on his net short position that arise from rising prices.
A bullion bank trader must avoid carrying large short positions if in his judgement prices are likely to rise. He will be more relaxed about maintaining a bear position in falling markets. Crucially, he must keep these opinions private, and the release of market statistics are designed to accommodate these dealers’ need for secrecy.
Bullion banks’ position details are disclosed at the beginning of every month in the Bank Participation Reports, again official statistics. They are broken down into two categories, based on the individual bank’s self-description on the CFTC’s Form 40, into US and Non-US Banks. Their positions are shown in the next two charts (note the time scale is monthly).
In both gold and silver, the bullion banks have managed to reduce their exposure from extreme net short over the last four months. The reduction of their market exposure suggests that they have been deliberately transferring this risk to other parties, and is consistent with an anticipation that bullion prices will rise. It is the other side of the high level of bearishness reflected in the Money Manager category shown in the first two charts. The bullion banks control the market; the Money Managers are merely tools of their trade.
There has been little reduction in open interest in gold and it has remained strong in silver, because risk has been transferred rather than extinguished. Daily official statistics on open interest are provided by the exchange and summarised in the next two charts (note that data is daily).
From these charts it can be seen that recent declines in the gold price are failing to reduce open interest further, and in silver open interest remains stubbornly high. Therefore, attempts by bullion banks to reduce their net short exposure by marking prices down are showing signs of failure.
We can therefore conclude that investor sentiment is at bearish extremes and the bullion banks have reduced their net short exposure to levels where it risks rising again. Therefore the downside for precious metals prices appears to be severely limited, contrary to sentiments expressed by technical analysts and in the media.
This market position is against a background of a growing shortage of physical bullion, which is our next topic.
Casual observers of precious metal prices are generally unaware that the headline writers focus on activity in the futures markets and generally ignore developments in physical bullion. This is consistent with the fact that market data is available in the former, while dealing in the latter is secretive. However, as with icebergs, it is not what you see above the water that matters so much as that which is out of sight below.
It is not often understood in investment circles that gold and silver are commodities for which the laws of supply and demand are not overridden by investor psychology. Therefore, if the price falls, demand increases. Indeed, the increase in demand has far outweighed selling by nervous investors; even before the price-drop, demand for both silver and gold significantly exceeded supply. Evidence ranges from readily available statistics on record demand for newly-minted gold and silver coins and the net accumulation of gold by non-Western central banks, to trade-based information such as imports and exports of non-monetary gold as well as reports from trade associations reporting demand in diverse countries such as India, China, the UK, US, Japan and even Australia.
All this evidence points in the same direction: that physical demand is increasing on every price drop. There is therefore a growing pricing conflict between futures and forward markets, which do not generally involve settlement but the rolling-over of speculative positions, and of the underlying physical metal. Furthermore, analysts make the mistake of looking at gold purely in terms of mining and scrap supply, when nearly all gold ever mined is theoretically available to the market, in the right conditions and at the right price. The other side of this larger coin is that if the price of gold is suppressed by activity in paper markets to below what it would otherwise be, the stimulus for physical demand, being based on a 160,000 tonne market, is likely to be considerably greater on a given price drop than analysts who are myopic beyond 2,750 tonnes of annual mine production might expect. The numbers that are available confirm this to have been the case, particularly over the last few weeks, with reports from all over the world of an unprecedented surge in demand.
This is at the root of a developing crisis of which few commentators are as yet aware. Demand for physical has accelerated the transfer of bullion from capital markets to hoarders everywhere and from the West’s capital markets to other countries, which has been the trend since the oil crisis in the mid-Seventies. This is what’s behind an acute shortage of physical gold in capital markets, explaining perhaps why bullion banks feel the need to reduce their short positions.
While we can detail their exposure in futures markets, meaningful statistics are not available in over-the-counter forward markets, particularly for London, which dominates this form of trading. Forwards are considerably more flexible than futures as a trading medium, generating trading profits, commissions, fees and collateralised banking business. The ability to run unallocated client accounts, whereby a client’s gold is taken onto a bank’s balance sheet, is in stable market conditions an extremely profitable activity, made more profitable by high operational gearing. The result is that paper forward positions are many multiples of the physical bullion available. The extent of this relationship between physical bullion and paper is not recorded, but judging by the daily turnover in London there is an enormous synthetic short physical position. For this reason a sharply rising price would be catastrophic and any drain on bullion supplies rapidly escalates the risk.
Overseeing this market is the Bank of England co-operating with other Western central banks and the Bank for International Settlements, whose combined interest obviously favours price stability. They have been quick to supply the market if needed, confirmed by freely-admitted leasing operations in the past, and by secretive supply into the market, which has been detected by independent supply and demand analysis over the last 15 years. Furthermore, as currency-issuing banks, central banks are unlikely to take kindly to market signals that suggest gold is a better store of value than their own paper money.
We can only speculate about day-to-day interventions by Western central banks in gold markets. In this regard it seems that the slide in prices on the 12th and 15th April was triggered by a very large seller of paper gold; if this market story and the amount mentioned are correct, it can only be central bank intervention, acting to deliberately drive prices lower. Given the market position, with Money Managers in the futures markets already short and highly vulnerable to a bear squeeze, the story seems credible. The objective would be to persuade holders of physical ETFs and allocated gold accounts to sell and supply the market, on the assumption that they would behave as investors convinced the bull market is over.
For the last 40 years gold bullion ownership has been migrating from West to elsewhere, mostly the Middle East and Asia, where it is more valued. The buyers are not investors, but hoarders less complacent about the future for paper currencies than the West’s banking and investment community. There was a shortage of physical metal in the major centres before the recent price fall, which has only become more acute, fully absorbing ETF and other liquidation, which is small in comparison to the demand created by lower prices. If the fall was engineered with the collusion of central banks it has backfired spectacularly.
The time when central banks will be unable to continue to manage bullion markets by intervention has probably been brought closer. They will face having to rescue the bullion banks from the crisis of rising gold and silver prices by other means, if only to maintain confidence in paper currencies. Any gold held by struggling eurozone nations, theoretically available to supply markets as a stop-gap, will not last long and may have been already sold.
This will likely develop into another financial crisis at the worst possible moment, when central banks are already being forced to flood markets with paper currency to keep interest rates down, banks solvent, and to finance governments’ day-to-day spending. Its importance is that it threatens more than any other of the various crises to destabilise confidence in government-backed currencies, bringing an early end to all attempts to manage the others systemic problems.
History might judge April 2013 as the month when through precipitate action in bullion markets Western central banks and the banking community finally began to lose control over all financial markets.
This article was previously published at GoldMoney.com.
In a previous life as a London-based ‘global strategist’ (I was never sure what that was) I was known as someone who was worried by QE and more generally, about the willingness of our central bankers to play games with something which I didn’t think they fully understand: money. This may be a strange, even presumptuous thing to say. Surely of all people, one thing central bankers understand is money?
They certainly should understand money. They print it, lend it, borrow it, conjure it. They control the price of it… But so what? What should be true is not necessarily what is true, and in the topsy-turvy world of finance and economics, it rarely is. So file the following under “strange but true”: our best and brightest economists have very little understanding of economics. Take the current malaise as prima facie evidence.
Let me illustrate. Of the many elemental flaws in macroeconomic practice is the true observation that the economic variables in which we might be most interested happen to be those which lend themselves least to measurement. Thus, the statistics which we take for granted and band around freely with each other measuring such ostensibly simple concepts as inflation, wealth, capital and debt, in fact involve all sorts of hidden assumptions, short-cuts and qualifications. So many, indeed, as to render reliance on them without respect for their limitations a very dangerous thing to do. As an example, consider the damage caused by banks to themselves and others by mistaking price volatility (measurable) with risk (unmeasurable). Yet faith in false precision seems to us to be one of the many imperfections our species is cursed with.
One such ‘unmeasurable’ increasingly occupying us here at Edelweiss is that upon which all economic activity is based: trust. Trust between individuals, between strangers, between organisations… trust in what people read, and even people’s trust in themselves. Let’s spend a few moments elaborating on this.
First, we must understand the profound importance of exchange. To do this, simply look around you. You might see a computer monitor, a coffee mug, a telephone, a radio, an iPad, a magazine, whatever it is. Now ask yourself how much of that stuff you’d be able to make for yourself. The answer is almost certainly none. So where did it all come from? Strangers, basically. You don’t know them and they don’t know you. In fact virtually none of us know each other. Nevertheless, strangers somehow pooled their skills, their experience and their expertise so as to conceive, design, manufacture and distribute whatever you are looking at right now so that it could be right there right now. And what makes it possible for you to have it? Exchange. To be able to consume the skills of these strangers, you must sell yours. Everyone enters into the same bargain on some level and in fact, the whole economy is nothing more than an anonymous labor exchange. Beholding the rich tapestry this exchange weaves and its bounty of accumulated capital, prosperity and civilization is a marvelous thing.
But we must also understand that exchange is only possible to the extent that people trust each other: when eating in a restaurant we trust the chef not to put things in our food; when hiring a builder we trust him to build a wall which won’t fall down; when we book a flight we entrust our lives and the lives of our families to complete strangers. Trust is social bonding and societies without it are stalked by social unrest, upheaval or even war. Distrust is a brake on prosperity, because distrust is a brake on exchange.
But now let’s get back to thinking about money, and let’s note also that distrust isn’t the only possible brake on exchange. Money is required for exchange too. Without money we’d be restricted to barter one way or another. So money and trust are intimately connected. Indeed, the English word credit derives from the Latin word credere, which means to trust. Since money facilitates exchange, it facilitates trust and cooperation. So when central banks play the games with money of which they are so fond, we wonder if they realize that they are also playing games with social bonding. Do they realize that by devaluing money they are devaluing society?
To see the how, first understand how monetary policy works. Think about what happens in the very simple example of a central bank’s expanding the monetary base by printing money to buy government bonds.
That by this transaction the government has raised revenue for the government is obvious. The government now has a greater command over the nation’s resources. But it is equally obvious that no one can raise revenue without someone else bearing the cost. To deny it would imply revenues could be raised for free, which would imply that wealth could be created by printing more money. True, some economists, it seems, would have the world believe there to be some validity to such thinking. But for those of us more concerned with correct logical practice, it begs a serious question. Who pays? We know that this monetary policy has redistributed money into the government’s coffers. But from whom has the redistribution been?
The simple answer is that we don’t and can’t know, at least not on an amount per person basis. This is unfortunate and unsatisfactory, but it also happens to be true. Had the extra money come from taxation, everyone would at least know where the burden had fallen and who had decreed it to fall there. True, the upper-rate tax payers might not like having a portion of their wealth redirected towards poorer members of society and they might not agree with it. Some might even feel robbed. But at least they know who the robber is.
When the government raises revenue by selling bonds to the central bank, which has financed its purchases with printed money, no one knows who ultimately pays. In the abstract, we know that current holders of money pay since their cash holdings have been diluted. But the effects are more subtle. To see just how subtle, consider Cantillon’s 18th century analysis of the effects of a sudden increase in gold production:
If the increase of actual money comes from mines of gold or silver… the owner of these mines, the adventurers, the smelters, refiners, and all the other workers will increase their expenditures in proportion to their gains. … All this increase of expenditures in meat, wine, wool, etc. diminishes of necessity the share of the other inhabitants of the state who do not participate at first in the wealth of the mines in question. The altercations of the market, or the demand for meat, wine, wool, etc. being more intense than usual, will not fail to raise their prices. … Those then who will suffer from this dearness… will be first of all the landowners, during the term of their leases, then their domestic servants and all the workmen or fixed wage-earners … All these must diminish their expenditure in proportion to the new consumption.
In Cantillon’s example, the gold mine owners, mine employees, manufacturers of the stuff miners buy and the merchants who trade in it all benefit handsomely. They are closest to the new money and they get to see their real purchasing powers rise.
But as they go out and spend, they bid up the prices of the stuff they purchase to a level which is higher than it would otherwise have been, making that stuff more expensive. For anyone not connected to the mining business (and especially those on fixed incomes: “the landowners, during the term of their leases”), real incomes haven’t risen to keep up with the higher prices. So the increase in the gold supply redistributes money towards those closest to the new money, and away from those furthest away.
Another way to think about this might be to think about Milton Friedman’s idea of dropping new money from a helicopter. He used this example to demonstrate how easy it would theoretically be for a government to create inflation. What he didn’t say was that such a drop would redistribute income in the same way more gold from Cantillon’s mines did, towards those standing underneath the helicopter and away from everyone else.
So now we know we have a slightly better understanding of who pays: whoever is furthest away from the newly created money. And we have a better understanding of how they pay: through a reduction in their own spending power. The problem is that while they will be acutely aware of the reduction in their own spending power, they will be less aware of why their spending power has declined. So if they find groceries becoming more expensive they blame the retailers for raising prices; if they find petrol unaffordable, they blame the oil companies; if they find rents too expensive they blame landlords, and so on. So now we see the mechanism by which debasing money debases trust. The unaware victims of this accidental redistribution don’t know who the enemy is, so they create an enemy.
Keynes was well aware of this insidious dynamic and articulated it beautifully in a 1919 essay:
By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. … Those to whom the system brings windfalls… become “profiteers” who are the object of the hatred…. the process of wealth-getting degenerates into a gamble and a lottery.
Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.
Deliberately impoverishing one group in society is a bad thing to do. But impoverishing a group in such an opaque, clandestine and underhanded way is worse. It is not only unjust but dangerous and potentially destructive. A clear and transparent fiscal policy which openly redistributes from the rich to the poor can at least be argued on some level to be consistent with ‘social justice.’ Governments can at least claim to be playing Robin Hood. There is no such defense for a monetary driven redistribution towards recipients of the new money and away from everyone else because if the well-off are closest to the money, well, it will have the perverse effect of benefitting them at the expense of the poor.
Take the past few decades. Prior to the 2008 crash, central banks set interest rates according to what their crystal ball told them the future would be like. They were supposed to raise them when they thought the economy was growing too fast and cut them when they thought it was growing too slow. They were supposed to be clever enough to banish the boom-bust cycle, and this was a nice idea. The problem was that it didn’t work. One reason was because central bankers weren’t as clever as they thought. Another was because they had a bias to lower rates during the bad times but not raise them adequately during the good times. On average therefore, credit tended to be too cheap and so the demand for debt was artificially high. Since that new debt was used to buy assets, the prices of assets rose in a series of asset bubbles around the world. And this unprecedented, secular and largely global credit inflation created an illusion of prosperity which was fun for most people while it lasted.
But beneath the surface, the redistributive mechanism upon which monetary policy relies was at work. Like Cantillon’s gold miners, those closest to the new credit (financial institutions and anyone working in finance industry) were the prime beneficiaries. In 2012 the top 50 names on the Forbes list of richest Americans included the fortunes of eleven investors, financiers or hedge fund managers. In 1982 the list had none.
Besides this redistribution of wealth towards the financial sector was a redistribution to those who were already asset-rich. Asset prices were inflated by cheap credit and the assets themselves could be used as collateral for it. The following chart suggests the size of this transfer from poor to rich might have been quite meaningful, with the top 1% of earners taking the biggest a share of the pie since the last great credit inflation, that of the 1920s.
Who paid? Those with no access to credit, those with no assets, or those who bought assets late in the asset inflations and which now nurse the problem balance sheets. They all paid. Worse still, future generations were victims too, since one way or another they’re on the hook for it.
So with their crackpot monetary ideas, central banks have been robbing Peter to pay Paul without knowing which one was which. And a problem here is this thing behavioural psychologists call self-attribution bias. It describes how when good things happen to people they think it’s because of something they did, but when bad things happen to them they think it’s because of something someone else did. So although Peter doesn’t know why he’s suddenly poor, he knows it must be someone else’s fault. He also sees that Paul seems to be doing OK. So being human, he makes the obvious connection: it’s all Paul and people like Paul’s fault.
But Paul has a different way of looking at it. Also being human, he assumes he’s doing OK because he’s doing something right. He doesn’t know what the problem is other than Peter’s bad attitude. Needless to say, he resents Peter for his bad attitude. So now Peter and Paul don’t trust each other. And this what happens when you play games with society’s bonding.
When we look around we can’t help feeling something similar is happening. The 99% blame the 1%; the 1% blame the 47%. In the aftermath of the Eurozone’s own credit bubbles, the Germans blame the Greeks. The Greeks round on the foreigners. The Catalans blame the Castilians. And as 25% of the Italian electorate vote for a professional comedian whose party slogan “vaffa” means roughly “f**k off” (to everything it seems, including the common currency), the Germans are repatriating their gold from New York and Paris. Meanwhile in China, that centrally planned mother of all credit inflations, popular anger is being directed at Japan, and this is before its own credit bubble chapter has fully played out. (The rising risk of war is something we are increasingly worried about…). Of course, everyone blames the bankers (“those to whom the system brings windfalls… become ‘profiteers’ who are the object of the hatred”).
But what does it mean for the owner of capital? If our thinking is correct, the solution would be less monetary experimentation. Yet we are likely to see more. Bernanke has monetized about a half of the federally guaranteed debt issued since 2009 (see chart below). The incoming Bank of England governor thinks the UK’s problem hasn’t been too much monetary experimentation but too little, and likes the idea of actively targeting nominal GDP. The PM in Tokyo thinks his country’s every ill is a lack of inflation, and his new guy at the Bank of Japan is revving up its printing presses to buy government bonds, corporate bonds and ETFs. China’s shadow banking credit bubble meanwhile continues to inflate…
For all we know there might be another round of illusory prosperity before our worst fears are realised. With any luck, our worst fears never will be. But if the overdose of monetary medicine made us ill, we don’t understand how more of the same medicine will make us better.
We do know that the financial market analogue to trust is yield. The less trustful lenders are of borrowers, the higher the yield they demand to compensate. But interest rates, or what’s left of them, are at historic lows. In other words, there is a glaring disconnect between the distrust central banks are fostering in the real world and the unprecedented trust lenders are signaling to borrowers in the financial world.
Of course, there is no such thing as “risk-free” in the real world. Holders of UK cash have seen a cumulative real loss of around 10% since the crash of 2008. Holders of US cash haven’t done much better. If we were to hope to find safety by lending to what many consider to be an excellent credit, Microsoft, by buying its bonds, we’d have to lend to them until 2021 to earn a gross return roughly the same as the current rate of US inflation. But then we’d have to pay taxes on the coupons. And we’d have to worry about whether or not the rate of inflation was going to rise meaningfully from here, because the 2021 maturity date is eight years away and eight years is a long time. And then we’d have to worry about where our bonds were held, and whether or not they were being lent out by our custodian. And of course, this would all be before we’d worried about whether Microsoft’s business was likely to remain safe over an eight year horizon.
We are happy to watch others play that game. There are some outstanding businesses and individuals with whom we are happy to invest. In an ideal world we would have neither Peters nor Pauls. In the imperfect one in which we live, we have to settle for trying hard to avoid the Pauls, who we fear mistake entrepreneurial competence for proximity to the money well. But when we find the real thing, the timeless ingenuity of the honest entrepreneurs, the modest craftsmen and craftswomen who humbly seek to improve the lot of their customers through their own enterprise, we find inspiration too, for as investors we try to model our own practice on theirs. It is no secret that our quest is to find scarcity. But the scarce substance we prize above all else is trustworthiness. Aware that we worry too much in a world growing more wary and distrustful, it is here we place an increasing premium, here that we seek refuge from financial folly and here that we expect the next bull market.
This article was previously published in Edelweiss Journal, Issue 12 (11 March 2013)
Cyprus may or may not prove to be a ‘watershed’ for the European crisis but what we can say for now (tempting fate outrageously as we do) is that, for all the dire warnings that this ‘confiscation’ will provoke a Continent-wide bank run, the initial reaction of the wider populace has been to treat the matter as something of ‘a quarrel in a far away country between people of whom we know nothing’.
That said, there is a wider issue at stake, beyond the inequity or otherwise of penalising small depositors, or the opportunism of imposing a haircut on those stock music hall villains, the Russian oligarchs, whose holding companies populate the corporate register of this otherwise economically–insignificant little island.
This is, namely, that however much we might express our contempt for a European elite which has so far exhibited a mix of pusillanimity and shameless political calculation in trying to avoid having their constituents face up to the cost of either their caprice or credulousness during the boom, the Cypriot ‘tax’—in reality a haircut—must serve as a necessary, if horribly belated, reminder to all of what it is exactly that modern-day banking entails.
It is high time that the Man on the Clapham Omnibus realised that his banker is nothing more than his, the depositor’s, debtor—and not a very reliable one, at that. Nor will it do our Everyman any harm to be shown once more that, for all the marbled halls and pseudo-classical gravitas of the banker’s typical premises, his profession is nothing more than a highly-leveraged, actuarial gamble, largely reliant not so much on the shrewdness of the banker himself as upon his cynical awareness that he can stretch to almost no enormity of bad judgement or abused trust such that it will pierce the carapace of privilege and protection with which he is furnished by a venal political class itself hopelessly in hock to the lenders of the counterfeit monies with which it buys the votes necessary to keep its members in the enjoyment of the many perks of office. A further lesson might be drawn from this last assertion which is that, far from being the soundest of borrowers, sovereign entities throughout history have been the worst, zero risk-weighting and mandatory ‘liquidity’ holdings notwithstanding.
Though there has been much expression of outrage at this ‘assault upon private property’, the sorry truth is that this is only the most recent—if also the most blatant—of the many transfers of wealth from the populace at large to the balance sheets of their bankers. Should you need any convincing of this, I am sure the poor, put-upon Irish could quote you chapter and verse about the miseries of the debt slavery imposed upon them by their overlords in Frankfurt, while it is beyond human wit to reckon the number of the prudent and thrifty now being denied a due return on their hard-won savings by the arrogance of the central bankers to whose crass, ’reflationary’ redistributionism they are now subject.
It should also be emphasised that it is no more than just that the owners and creditors of a failed institution share proportionately in its ruin, or conversely contribute in due measure to its rescue—though, naturally, the choice between these alternatives should lie with them as individuals. That the institution in question is a purveyor of banking services, rather than of beauty products or bed linen is totally beside the point. As the latest of several heavyweight commentators (such as members of the Chapter 14 group or Richard Fisher of the Dallas Fed in the US), Willem Buiter endorses this view in his latest piece where, he says, it is high time we ‘resolved’ our commercial banks à outrance, relying on the near limitless power of the central bank to maintain the basic stock of money and to staunch any systemic haemorrhage as and where needed. After all, if we are to be saddled with the institutional evil of a central bank, we may as well enlist its baleful power in a good cause for once.
That the powers-that-be, having driven the masses through the drip-drip torment of ‘Fauxterity’ in the attempt to save their own banks, have only now dared to try to implement such a process of ‘bail-in’ in a small , politically-impotent country such as Cyprus certainly reeks of hypocrisy and double standards. Nor is it exactly a matter of justice that the admittedly nugatory exposures of the banks’ stock and bond holders have again gone unscathed, or that even depositors of healthy banks (assuming there are any) are being compelled to pay for the sins of their less sanitary peers. Nevertheless, as we have said several times before, the lesson that must be taught when dealing with bankers, as with any other recipient of one’s funds, is Caveat commodator! Let the lender beware
Slowly, slowly, amid all this chaos, the commentariat is coming around to espouse several key tenets of our Austrian creed. Five years too late for many of the downtrodden victims of the crash, alas, and with nary a nod of recognition to the fact that their beloved Keynes is an idol with feet of clay, but at least they themselves are beginning to inch tentatively along the road to Damascus-am-Donau.
The first of these contentions is that the crisis itself is always the result of an inflation of money and credit—whether this is unleashed as a deliberate act of commission before, or supinely accommodated by the monetary authority after, the fact. The danger here is not so much that consumer goods prices rise as the money and its substitutes swell in availability, but is rather that the inflation distorts, if not entirely suppresses, the critical signals sent about relative scarcities and the subjective human preferences which set these. Especially problematic are those least directly observable signals which act across time and which are therefore transmitted by interest rates in particular and by asset pricing in general. In scrambling these, inflation progressively fixes too much precious capital into the wrong, ultimately barren foundations and leads too many people to exert their limited human energies in pursuing foredoomed endeavours.
The second Austrian lemma is that when the boom turns to bust, the wisest course, that is to say the one which will involve the least long-run hardship and impose the lowest threat of a widespread descent into lingering hopelessness, is not one that will involve the exercise of either misplaced compassion (if we are charitable) or of naked, political short-termism (if we are not). The answer, when the bust threatens to push the economy beyond its self-regulating ‘corridors’ is to widen them as much as possible by pursuing an Auflockerung—a lifting of the man-made impediments to swift adjustment—and to eschew all attempts at propping up as much of the Boom’s inherently unsound and demonstrably unremunerative superstructure as is possible by a crude and usually fruitless macro-manoeuvring.
The dispelling of the boom-time enchantment typically leaves many saddled with ill-advised levels of obligation which they cannot now honour in the easy manner formerly envisaged. It reveals that many of those in command of economic assets have woefully misapplied and mismanaged them, even where this has not been deliberately fraudulent. It shows that large numbers of people have imagined themselves more prosperous than they really were and have therefore spent and borrowed according to a perniciously false scale of values.
Once this mass deception becomes known, it would be folly to assume that the ‘undeserving’ can be spared any and all suffering in the ensuing bust. It is also clear that there will be far greater numbers of the plaintive than the pleased when the Wheel of Fortune starts on its inevitable downward course. But nothing in this implies that any purpose is served by indulging in a denial of the gravity of the circumstance. It is a further grave misstep to trust that a ‘socialization’ of the problem will somehow help, or to expect genuine benefits to accrue from a wilful attempt to further confuse the accounts—which is essentially what the unholy concert of the fiscal and monetary authorities usually seek to do. To the contrary, to act to deaden the pain through a policy of obfuscation, procrastination, and the dispersion of responsibility is not only to prolong the suffering in the here and now but to make a future recurrence much more likely.
All of the misconceptions fostered in the easy money boom require for their remedy a forthright and fearless recognition of what can hardly fail to be unpalatable facts. Like a patient confronted with the news that his ailment is at once more serious and more advanced than he had been given to suspect, or like the general who discovers to his horror that his previously quiescent foe is even now marching in strength upon his flanks, this is no time for palliatives, or for futile ’If Only’s’. It is time for corrective action: for harsh treatment if necessary; for a rapid re-arrangement of one’s dispositions and for an immediate abandonment of one’s earlier illusions.
The more rapidly that a misguided lender and his now discomfited borrower can renegotiate their arrangement, the more resolutely they can each own up to their disappointments, and the more determinedly they can avoid the sunk cost fallacies of regret, the quicker each can disencumber himself of his past errors of judgement and so the earlier each may begin to re-establish what he has lost by acting henceforth in a manner more suited to the changed situation in which he and most of his fellows now find they must go about their business.
It is far preferable to undergo a timely, strategic withdrawal, the better to prepare both the recovery of lost ground and hopefully the advance beyond it, than to become trapped in a personal Stalingrad where a combination of an unwillingness to recognise the scale of the reverse suffered and a naïve hope in a rescue miraculously being effected from above condemns one both to an unavailing struggle and to a final reckoning of loss far more shattering than what was initially required.
One of the most insidious ways to postpone this catharsis is for the central bank to slash interest rates and to flood the world with liquidity, goading the populace into repeating that very falsification of price of assets and of the discount between today and tomorrow which led its members to their present state of ruin.
If we recognise that our savings have been wasted, that our investments have gone sour, that our wealth has been reduced, then the price of what must be a more scarce endowment of productive capital should reflect this. Rates should be higher, not lower. Moreover, with yesterday’s attempts at providing for our present needs having been led so far astray, we will all have to put more emphasis on securing current rather than future provision. Again, rates should be higher, not lower. With the sorry lesson fresh in our minds that any chancer can start a business when credit replaces capital and when its rent is set artificially low, we should all be more choosy about whom we are to entrust with our savings. A third time, rates should be higher, not lower
To clarify this last point, it should be obvious that we should never be overly willing to see funds placed, willy-nilly, at the disposal of men who, however praiseworthy their initiative, are sufficiently foolhardy as to want to undertake projects of such a marginal nature that they will fold at the first whiff of adversity—at the merest uptick of interest rates, the first drop in sales or hike in costs, at the smallest fluctuation of exchange rates. Instead we should look for men whose product is really likely to satisfy consumer demand, men whose entrepreneurial antennae have unearthed a reasonably durable arbitrage between input and output prices, and men whose confidence in the schedule of prospective returns to their efforts does not require a vanishingly small rate of interest for its maintenance. If this is true of start-up companies in the upswing, it is doubly true of those stranded on the beach when the flood tide of the boom recedes.
But what do we get instead? We get the present, abominable, inverted Bagehotism of lending on no very good security at all, to all and sundry, and at a highly subsidised rate of interest. By this perverse means we attempt to perpetuate people in the errors of the boom, to succour the weak at the expense of the strong, and to practice Aufhalterung—a gumming up of the system—in place of Auflockerung.
Miracle of miracles, there are those who are beginning to recognise this, whether from the ranks of Britain’s recovery professionals at R3, or in the shape of well-known UK investor John Moulton, who severally risk much ill-informed opprobrium by daring to bemoan the policy of allowing zombie companies to hoard resources, manpower, and space on overburdened bank balance sheets. On another tack, Ronald McKinnon and his Stanford University colleague John Taylor (he of ‘Rule’ fame) argue correctly that ZIRP discourages much lending — whether direct or disintermediated — since risk palpably outweighs a return which is deliberately ’repressed’ to or even, in real terms, below zero.
In Axel Leijonhufvud’s pithy characterisation, when depressions occur, we are made captives of the past while inflations act to preclude us from mapping out our course into the future. He also suggests that, in the former case, monetary policy may be less effective than might be thought because once it has percolated, as it inevitably will, from the wallets of the income-poor to the pockets of the income-sufficient, the latter may have little incentive to re-employ it—whether they seek to hold it as a backstop amid economic uncertainty, or from a Ricardian-equivalence foreboding about higher taxes, or again because an elevated appraisal of risk seems vastly to outweigh a purposefully scanty reward. If prices, moreover, are not allowed to fall out of an irrational fear of ‘deflation’, the real value of their reserve will not increase and so gently encourage them to transmute a portion of it back into a medium of exchange: the Pigou effect will not come into play and so another means of self-equilibration will be denied us.
Can we really say that such is not the fate to which Ben Bernanke will consign us, strive though he will to dissolve our contractual ties in the acid of inflation instead?
NB: The mischievous thought arises that since what Blackhawk Ben and his acolytes really seek is for us all to lose faith in our money as a store of value, so that we go out and spend it as fast as we can, they should be cheering the Cyprus experiment to the rafters!
On Friday, I spoke against monetary activism once again, complaining about the use of expectation management and new monetary instruments in an attempt to defibrillate the economy. It’s a mistake, not least because a failure to contain inflationary expectations could be catastrophic, as I set out last year. Mark Carney understands the argument that monetary activism will cause a damaging “intertemporal misallocation of capital” but he chooses to believe wise intervention elsewhere can compensate. I am sure this is wrong.
This morning, I rediscovered Mises’ short 1951 essay Inflation Must End in a Slump. The essential characteristics of the real world have not changed since but currency debasement subsequently became much worse. Here’s the article:
This country [the USA], and with it most of the Western world, is presently going through a period of inflation and credit expansion. As the quantity of money in circulation and deposits subject to check increases, there prevails a general tendency for the prices of commodities and services to rise. Business is booming.
Yet such a boom, artificially engineered by monetary and credit expansion, cannot last forever. It must come to an end sooner or later. For paper money and bank deposits are not a proper substitute for non-existing capital goods.
Economic theory has demonstrated in an irrefutable way that a prosperity created by an expansionist monetary and credit policy is illusory and must end in a slump, an economic crisis. It has happened again and again in the past, and it will happen in the future, too.
If one wants to avoid the recurrence of periods of economic depression, one must start by preventing the emergence of artificial booms. One must prevent the governments from embarking upon a policy of cheap interest rates, deficit spending, and borrowing from the commercial banks.
This is, of course, a very difficult task. Governments are in this regard very obstinate. They long for the popularity that booming business conditions seldom fail to win for the party in power. The Unavoidable crash, they think, will appear only later; then the other party will be in power and will have to account to the voters for the evils which their predecessors have sown.
Thus there is no doubt that we shall one day have to face again an economic recession, although it is impossible to determine the date of its outbreak and the degree of its severity. It will be bad indeed. But worse than the crisis itself could prove the psychological and ideological consequences of an erroneous interpretation of its causes.
For the spokesmen of the artificial expansionist policy are busy denying that economic crises are the inevitable effect of the preceding expansionist policy. They are anxious to exonerate the governments. As they see it, inherent shortcomings of the capitalist mode of production cause the periodical recurrence of bad business. There is no other means, they conclude, to avoid a crisis than to put the economic system under the full tutelage of a central planning board.
This is essentially the doctrine of Karl Marx. Those supporting it, those passionately attacking the insight that it is the policy of inflation and credit expansion which produces economic depressions are – sometimes unwittingly – serving the cause of the Communists. When the slump comes, people indoctrinated by their teachings will argue precisely as Stalin expects them to. They will think: The efforts to preserve capitalism have proved vain; capitalism necessarily results in the recurrence of economic catastrophes; if we want stability, we must turn toward Communism.
In the antagonism between the doctrine of the economists who ascribe the emergence of economic crises to the policy of credit expansion and the official doctrine that ascribes them to alleged inherent defects of capitalism there is much more at stake than a merely doctrinal quarrel. The way in which people will react to the – unfortunately hardly avoidable – letdown of business that will follow the end of the present armament boom may decide the fate of our civilization.
People must learn in time what the inevitable consequences are of the monetary and credit policies adopted by the present administration. They must realize that what the collapse of the artificial boom will establish will not be any insufficiency of capitalism, private enterprise, and the market economy, but the failure of the methods of financing public expenditure as practiced by the New Deal and the Fair Deal.
A comprehension of the nature of the boom will also make people more cautious in their business dealings. They will not fall victim to the deception that the boom will go on forever.
This article was previously published at SteveBaker.info.
The purpose of this essay is to put the latest crisis in the context of longer-term debt trends in the US and to attempt some predictions in respect to the US economy and financial markets.
Statistics are records of past events. Analyzing statistics means interpreting history, and this can only be done on the basis of theory. We must first have some theoretical notions to be able to render past events intelligible. Of course, historic data cannot be in conflict with the theory used, as that would put the validity of the latter in doubt. But we can neither use statistics to prove the correctness of a theory nor directly discover new theories (although history may give us ideas about potential theories). Before we look at the data I should give a brief outline of my theory, which readers of my book Paper Money Collapse will be familiar with.
The theory – short version
Paper Money Collapse challenges the prevailing consensus on money. This consensus holds that it is good to have something called ‘monetary policy’. Most mainstream economists today, while accepting the superiority of markets when it comes to allocating scarce resources to their most urgent uses, also maintain that in the field of money state involvement is desirable, and that a smoothly functioning economy requires a constantly expanding supply of state paper money and the guidance (manipulation) of certain market prices (interest rates) by a central bureaucracy, i.e. the central bank. More precisely, this bureaucracy should keep expanding the supply of money in such a way that money’s purchasing power declines continuously (moderate, controlled inflation) and that, whenever the economy is weak, it should use its powers to ‘stimulate’ the economy towards faster growth, usually through accelerated base money production and administratively lowered interest rates.
Paper Money Collapse argues that all these notions are erroneous and dangerous. Constant monetary expansion is not needed (not even in a growing economy) and is always highly disruptive. The continuous expansion of fiat money, naturally via financial markets, systematically distorts interest rates, which must lead to capital misallocations and other economic imbalances that will make recessionary corrections at a later stage inevitable. The recessions that ‘easy’ monetary policy is then supposed to shorten or ease are thus nothing but the result of previous monetary expansion.
Recessions can only be avoided by avoiding artificial booms through credit expansion. Once monetary expansion has led to sizable economic distortions the recession becomes unavoidable – and even necessary to cleanse the economy of dislocations. But to make matters worse, in our present system of unconstrained fiat money creation, recessions are – whenever they occur – countered by accelerated money creation (usually via new bank reserves from the central bank) and further cuts in interest rates. Imbalances are thus not being purged from the economy. Instead they accumulate over time making the financial system and the economy overall progressively more unstable. The system is moving towards a point of catharsis: either a complete purge is finally allowed to unfold (painful) or ever more fiat money is created until the public loses confidence in fiat money itself and a hyperinflationary currency collapse occurs (more painful).
I maintain that this theory is logically consistent and not in conflict with past events.
Clearly identifying, let alone quantifying, imbalances is exceedingly difficult if not impossible. It is usually during crises that imbalances become visible as such. Consequently, analyzing data requires a considerable degree of judgement. In the following I look at ‘excessive indebtedness’ as a major dislocation caused by fiat money expansion.
The present monetary system naturally encourages the excessive accumulation of debt, and discourages deleveraging and disinflation, although at certain points in time these may be difficult to avoid altogether. During the financial crisis deflationary and recessionary forces briefly gained the upper hand. To what extent have they purged the system of money-induced imbalances? Has a meaningful ‘cleansing’ of imbalances taken place? If so, has the economy ‘healed’?
I had a look at the Federal Reserve’s Flow of Funds data and the following picture emerges.
Over the 31 years from 1981 to the end of 2012, total debt outstanding in the US economy grew from $5,255 billion to $56,280 billion. The debt load has increased continuously from year to year – with only one single exception: 2009, when total debt declined by just 0.2%. Debt has grown faster than nominal GDP in 27 out of 31 years. The average growth rate in total debt was 8% per annum, compared to 5.4% for nominal GDP. In 1981, total debt outstanding was 168% of GDP, today it is 359% of GDP.
In 1981, total debt broke down as follows: household debt was about 48% of GDP; business debt was about 53% of GDP; the public sector owed about 38% of GDP and the financial sector 29% of GDP. Note that of the four major sectors, the public sector and the financial sector were the two smaller ones. Debt of the financial sector was only slightly more than half of corporate debt.
Things looked very different by the end of 2012: Household debt had ballooned to 82% of GDP and corporate debt to 81%. Public sector debt now stood at 93% of GDP and financial sector debt at 103% of GDP. The public and financial sector had become the largest debtors.
While corporate debt was about 7.5 times larger in absolute terms at the end of 2012 than at the end of 1981, financial sector debt was 17 times larger. Over the 26 years from 1981 to the eve of the current financial crisis in 2007, financial sector debt grew at an average clip of more than 12% per annum compared to about 6% for nominal GDP over the same period. When we entered the present financial crisis in 2007, financial sector debt stood at an all-time high for any sector in US financial history, at 131% of GDP.
I maintain that such a dramatic growth in overall indebtedness, as well as the specific breakdown of that growth by sector, is symptomatic of our unconstrained fiat money system with its constant money growth and lender-of-last-resort central banks that encourage debt accumulation and promote high-leverage strategies in the financial sector. That this has led to substantial economic instability is now self-evident.
Has the US economy deleveraged since 2007?
The two sectors that were most exposed in 2007 were households (via the residential mortgage market) and the financial sector. Both sectors have shed debt since 2007. Both have deleveraged. Households reduced their debt from a record $13,712 billion in 2007 to $12,831 billion at the end of 2012. These $881 billion mean a reduction of 6.4%. The financial sector was forced to cut debt even more: From 2007 to 2012, total outstanding debt of the financial sector was reduced by more than $2,100 billion, a reduction of 12%.
Such reductions in debt were unprecedented in the 31-year history we are looking at here. At no point before had household debt and financial sector debt declined on a year-over-year basis. In this respect, the events of the recent crisis were indeed unique. ‘Cleansing’ has occurred. But how meaningful are these reductions? In absolute terms – total amounts of debt outstanding – both sectors are roughly back to where they were …..in Q3 of 2006, barely a year before the crisis started! Not much has happened in absolute terms. However, in recent years, the economy has continued to grow moderately, so as a percentage of GDP, household debt is today roughly where it was in 2002/3, and financial sector debt is about where it was in 2001/2. In relative terms, a decade of excess has thus been unwound.
Nevertheless, as mentioned above, the total debt load has continued to grow and stands at an all-time record today. The reason for this is mainly the explosion in public sector debt. While households and financial firms have cut debt by $3 trillion since 2007, the state has taken on an additional $6.6 trillion in new debt over the same period– almost all of it at the federal level! In fact, outstanding debt of the federal government has more than doubled since 2007!
The trend of ever-rising overall debt has thus continued. The deleveraging in the household and financial sector has, however, resulted in a reduced pace of debt accumulation overall, despite heavy borrowing from the federal government. In 2010, for the first time since 1992, the economy has grown faster than total debt, and this has continued in 2011 and in 2012, if at a slowing pace. Consequently, total debt stands at 359% of GDP today, slightly down from its peak of 381% in 2009. At 359% debt-to-GDP is back to where it was at in early 2007. Again, not much deleveraging has occurred in total.
Conclusion and outlook
I cannot see that the recent crisis has already brought about some kind of fundamental healing of the US economy, some much needed purge of monetary excesses. Yes, households and the financial industry have trimmed back and are now probably in better shape than a few years ago. Household debt numbers now seem to be stabilizing, meaning deleveraging could be coming to an end, while there is no sign yet that financial deleveraging has concluded. Of course, given the prevailing belief system, those who control the levers of the fiat money system are doing what they can to discourage further deleveraging. Zero interest rates and open-ended QE are hardly conducive to debt reduction.
Here are my present forecasts, and they are necessarily highly speculative:
- Super-easy monetary policy will continue as far as I can see. The Fed has declared that it wants to use monetary policy to boost employment (the hubris of the bureaucrat!). But deleveraging in the financial sector, if it persists, would be a problem for the Fed’s strategy. The financial sector is crucial in transmitting easy policy. The Fed can thus reasonably be expected to continue leaning against deleveraging with all its might. And if and when deleveraging turns into re-leveraging, the Fed will probably nurture it for some time.
- Public sector profligacy is not a crisis phenomenon but has been in full bloom since 2002 and is now in large part structural. A political solution looks unlikely any time soon. The state will thus continue to be the main driver behind the overall growth in debt. Funding this debt accumulation is not a problem with the Fed now the biggest marginal buyer of Treasury securities and the Fed unlikely to abandon super-easy policy anytime soon.
- The corporate sector has not been a major driver in this story so far. Recently, corporate debt has begun to expand again. It is not unreasonable to assume that this will continue.
- In aggregate, the picture could be the following: outstanding debt of the public sector will continue to grow rapidly, corporate debt mildly to maybe strongly; household indebtedness might stagnate. The wild card remains the financial sector. My guess is that what little overall deleveraging we experienced – measured as a modest decline in total debt in relation to the economy’s capacity for income-generation, i.e. GDP – is in the process of being reversed. The interventionists (i.e. the mainstream) will hail this as a success of policy. ‘Debt-deflation’ has been avoided – for now. A more realistic assessment is that the economy is as much on financial steroids as a few years ago, and – in aggregate – as fragile. Expanding debt levels further from here will require interest rates that are continuously depressed through policy and an even more activist and interventionist central bank. The Fed is fully on board with this.
- Deflation is very unlikely from here. The debasement of paper money continues. Inflation rates should begin to move higher.
Debt-GDP-ratios of 359% (now) or 381% (2009) are unusual historically. The ratio was below 200% at the start of the Great Depression and it peaked at a touch above 300% in 1933, when nominal GDP collapsed. The current debt load is unprecedented. But then, countries such as Japan and the UK have total debt in excess of 500 percent of GDP. Disaster still looks inevitable but maybe not imminent.
…a final word on the bond market.
It so happens that the start year of the above analysis – 1981 – also marked the peak in bond yields in the US. 10-year Treasury notes reached 15% back in 1981 and went on a downward path from there that lasts to this day. We have had an almost uninterrupted, 31-year bull market in bonds. Not only Treasuries but also corporate and mortgage debt are presently trading at or near historic lows in yield. Although the US economy never had to carry more debt – certainly never more in absolute terms and almost never more relative to GDP – the compensation that investors get for holding all this debt has never been lower!
Sure, inflation was still high in the early 1980s but the structural drop in inflation was over by 1992. CPI inflation has broadly moved sideways in a stable range since the early 1990s without any additional disinflationary momentum.
It seems that over the past three decades the debtors were encouraged to take out ever more debt because the lenders – the bond buyers – were happy to hold ever more debt at ever lower yields. A market in which demand for assets keeps rising at persistently rising prices (persistently falling yields) has all the ingredients of a bubble. I think the US bond market – and by extension, international bond markets – could be the greatest bubble in history.
The big question is when will this bubble pop?
This article was previously published at DetlevSchlichter.com.