I’ve recently written for Save Our Savers attempting to square the massive expansion of Britain’s monetary base since March 2009 with the fact that inflation has now been within the Bank of England’s target range of 2% (+/- 1%) since June 2012. Here I’d like to expand a little.
Since March 2009 Britain’s monetary base, also known as narrow money or M0, has increased by 321%. We can see that the majority of this is in the form of increased bank reserves, up 642% since March 2009
Source:The Bank of England, series Notes in circulation – RPWB55A, and Reserve Balances – RPWB56A
This is just what we’d expect to see following the Bank of England’s Quantitative Easing, where the Bank creates new money and uses it to purchase bonds from banks – that new money becomes bank reserves. Those banks have sat on that money (not using it as a basis for new credit creation and feeding into M4) which is why, while narrow (M0) money has exploded, broad (M4) money has barely budged, increasing by just 7.4% since March 2009.
Source:The Bank of England, series Notes in circulation (RPWB55A) and Reserve Balances (RPWB56A) (M0), and Monthly amounts outstanding of M4 (monetary financial institutions’ sterling M4 liabilities to private sector) (in sterling millions) seasonally adjusted (LPMAUYN) (M4)
This relative restraint in M4 growth explains the relative restraint in inflation. There is no great mystery as to why banks which have just seen their assets tank and ravage their balance sheets should want to hold more reserves. The key question is what happens next.
The chart above shows the ratio of M0 to M4 since May 2006; how many pounds of broad money each pound of narrow money is supporting. From 25:1 between May 2006 and March 2009, it slumped via successive bouts of Quantitative Easing to about 6:1 since September 2012.
Now, on the one hand banks might stick to this new, lower ratio. Chastened by their experiences with mortgage backed assets they might desire a permanently lower reserve to asset ratio and all QE will have been is a vast recapitalisation of banks.
On the other hand, as ‘recovery’ kicks in they might start to increase their reserve to asset ratio. They might not scale the giddy heights of 25:1 again, but they will be multiplying out from a monetary base which has tripled in size. Britain’s monetary base is now £362 billion and M4 is about six times that, £2.2 trillion. But if renewed confidence in the banking sector saw banks return to higher ratios, the resulting M4 figures would be as follows:
Here, we are told, the Bank of England will be able to ‘drain’ this liquidity from the system. It would do this by reversing QE; selling bonds to banks and effectively destroying the base money it receives in return. But a massive increase in the supply of bonds relative to the demand for them will lower their price. This is the same as raising their yield and this is the same as raising a key interest rate.
It is worth pondering for a moment the scale of bond sales and consequent rise in interest rates which might be necessary to drain this base money from the financial system. We must hope either that the economy can stand it or that banks keep holding these reserves.
“Now the New Year reviving old desires
The thoughtful Soul to Solitude retires”
- Rubaiyat of Omar Khayyam
Yes folks, it’s that time of year again; but unlike old Khayyam who reflected bucolically on the continuing availability of wine, we must turn our thoughts to the dangers and opportunities of the coming year. They are considerable and multi-faceted, but instead of being drawn into the futility of making forecasts I will only offer readers the barest of basics and focus on the corruption of currencies. My conclusion is the overwhelming danger is of currency destruction and that gold is central to their downfall.
As we enter 2014 mainstream economists relying on inaccurate statistics, many of which are not even relevant to a true understanding of our economic condition, seem convinced that the crises of recent years are now laid to rest. They swallow the line that unemployment is dropping to six or seven per cent, and that price inflation is subdued; but a deeper examination, unsubtly exposed by the work of John Williams of Shadowstats.com, shows these statistics to be false.
If we objectively assess the state of the labour markets in most welfare-driven economies the truth conforms to a continuing slump; and if we take a realistic view of price increases, including capital assets, price inflation may even be in double figures. The corruption of price inflation statistics in turn makes a mockery of GDP numbers, which realistically adjusted for price inflation are contracting.
This gloomy conclusion should come as no surprise to thoughtful souls in any era. These conditions are the logical outcome of the corruption of currencies. I have no doubt that if in 1920-23 the Weimar Republic used today’s statistical methodology government economists would be peddling the same conclusions as those of today. The error is to believe that expansion of money quantities is a cure-all for economic ills, and ignore the fact that it is actually a tax on the vast majority of people reducing both their earnings and savings.
This is the effect of unsound money, and with this in mind I devised a new monetary statistic in 2013 to quantify the drift away from sound money towards an increasing possibility of monetary collapse. The Fiat Money Quantity (FMQ) is constructed by taking account of all the steps by which gold, as proxy for sound money, has been absorbed over the last 170 years from private ownership by commercial banks and then subsequently by central banks, all rights of gold ownership being replaced by currency notes and deposits. The result for the US dollar, which as the world’s reserve currency is today’s gold’s substitute, is shown in Chart 1.
The graphic similarities with expansions of currency quantities in the past that have ultimately resulted in monetary and financial destruction are striking. Since the Lehman crisis the US authorities have embarked on their monetary cure-all to an extraordinary degree. We are being encouraged to think that the Fed saved the world in 2008 by quantitative easing, when the crisis has only been concealed by currency hyper-inflation.
Are we likely to collectively recognise this error and reverse it before it is too late? So long as the primary function of central banks is to preserve the current financial system the answer has to be no. An attempt to reduce the growth rate in the FMQ by minimal tapering has already raised bond market yields considerably, threatening to derail monetary policy objectives. The effect of rising bond yields and term interest rates on the enormous sums of government and private sector debt is bound to increase the risk of bankruptcies at lower rates compared with past credit cycles, starting in the countries where the debt problem is most acute.
With banks naturally reluctant to take on more lending-risk in this environment, rising interest rates and bond yields can be expected to lead to contracting bank credit. Does the Fed stand aside and let nature take its course? Again the answer has to be no. It must accelerate its injections of raw money and grow deposits on its own balance sheet to compensate. The underlying condition that is not generally understood is actually as follows:
The assumption that the Fed is feeding excess money into the economy to stimulate it is incorrect.
Individuals, businesses and banks require increasing quantities of money just to stand still and to avoid a second debt crisis.
I have laid down the theoretical reasons why this is so by showing that welfare-driven economies, fully encumbered by debt, through false employment and price-inflation statistics are concealing a depressive slump. An unbiased and informed analysis of nearly all currency collapses shows that far from being the product of deliberate government policy, they are the result of loss of control over events, or currency inflation beyond their control. I expect this to become more obvious to markets in the coming months.
Gold’s important role
Gold has become undervalued relative to fiat currencies such as the US dollar, as shown in the chart below, which rebases gold at 100 adjusted for both the increase in above-ground gold stocks and US dollar FMQ since the month before the Lehman Crisis.
Given the continuation of the statistically-concealed economic slump, plus the increased quantity of dollar-denominated debt, and therefore since the Lehman Crisis a growing probability of a currency collapse, there is a growing case to suggest that gold should be significantly higher in corrected terms today. Instead it stands at a discount of 36%.
This undervaluation is likely to lead to two important consequences. Firstly, when the tide for gold turns it should do so very strongly, with potentially catastrophic results for uncovered paper markets. The last time this happened to my knowledge was in September 1999, when central banks led by the Bank of England and the Fed rescued the London gold market, presumably by making bullion available to distressed banks. The scale of gold’s current undervaluation and the degree to which available monetary gold has been depleted suggests that a similar rescue of the gold market cannot be mounted today.
The second consequence is to my knowledge not yet being considered at all. The speed with which fiat currencies could lose their purchasing power might be considerably more rapid than, say, the collapse of the German mark in 1920-23. The reason this may be so is that once the slide in confidence commences, there is little to slow its pace.
In his treatise “Stabilisation of the Monetary Unit – From the Viewpoint of Monetary Theory” written in January 1923, Ludwig von Mises made clear that “speculators actually provide the strongest support for the position of notes (marks) as money”. He argued that considerable quantities of marks were acquired abroad in the post-war years “precisely because a future rally in the mark’s exchange rate was expected. If these sums had not been attracted abroad they would have necessarily led to an even steeper rise in prices on the domestic market”.
At that time other currencies, particularly the US dollar, were freely exchangeable with gold, so foreign speculators were effectively selling gold to buy marks they believed to be undervalued. Today the situation is radically different, because Western speculators have sold nearly all the gold they own, and if you include the liquidation of gold paper unbacked by physical metal, in a crisis they will be net buyers of gold and sellers of currencies. Therefore it stands to reason that gold is central to a future currency crisis and that when it happens it is likely to be considerably more rapid than the Weimar experience.
I therefore come to two conclusions for 2014: that we are heading towards a second and unexpected financial and currency crisis which can happen at any time, and that the lack of gold ownership in welfare-driven economies is set to accelerate the rate at which a collapse in purchasing power may occur.
A number of people have asked me to expand on how the rapid expansion of money supply leads to an effect the opposite of that intended: a fall in economic activity. This effect starts early in the recovery phase of the credit cycle, and is particularly marked today because of the aggressive rate of monetary inflation. This article takes the reader through the events that lead to this inevitable outcome.
There are two indisputable economic facts to bear in mind. The first is that GDP is simply a money-total of economic transactions, and a central bank fosters an increase in GDP by making available more money and therefore bank credit to inflate this number. This is not the same as genuine economic progress, which is what consumers desire and entrepreneurs provide in an unfettered market with reliable money. The second fact is that newly issued money is not absorbed into an economy evenly: it has to be handed to someone first, like a bank or government department, who in turn passes it on to someone else through their dealings and so on, step by step until it is finally dispersed.
As new money enters the economy, it naturally drives up the prices of goods bought with it. This means that someone seeking to buy a similar product without the benefit of new money finds it is more expensive, or put more correctly the purchasing power of his wages and savings has fallen relative to that product. Therefore, the new money benefits those that first obtain it at the expense of everyone else. Obviously, if large amounts of new money are being mobilised by a central bank, as is the case today, the transfer of wealth from those who receive the money later to those who get it early will be correspondingly greater.
Now let’s look at today’s monetary environment in the United States. The wealth-transfer effect is not being adequately recorded, because official inflation statistics do not capture the real increase in consumer prices. The difference between official figures and a truer estimate of US inflation is illustrated by John Williams of Shadowstats.com, who estimates it to be 7% higher than the official rate at roughly 9%, using the government’s computation methodology prior to 1980. Simplistically and assuming no wage inflation, this approximates to the current rate of wealth transfer from the majority of people to those that first receive the new money from the central bank.
The Fed is busy financing most of the Government’s borrowing. The newly-issued money in Government’s hands is distributed widely, and maintains prices of most basic goods and services at a higher level than they would otherwise be. However, in providing this funding, the Fed creates excess reserves on its own balance sheet, and it is this money we are considering.
The reserves on the Fed’s balance sheet are actually deposits, the assets of commercial banks and other domestic and foreign depository institutions that use the Fed as a bank, in the same way the rest of us have bank deposits at a commercial bank. So even though these deposits are on the Fed’s balance sheet, they are the property of individual banks.
These banks are free to draw down on their deposits at the Fed, just as you and I can draw down our deposits. However, because US banks have been risk-averse and under regulatory pressure to improve their own financial position, they have tended to leave money on deposit at the Fed, rather than employ it for financial activities. There are signs this is changing.
Rather than earn a quarter of one per cent, some of this deposit money has been employed in financial speculation in derivative markets, or found its way into the stock market, gone into residential property, and some is now going into consumer loans for credit-worthy borrowers.
In addition to the government’s deficit spending, these channels represent ways in which money is entering the economy. Furthermore, anyone working in the main finance centres is being paid well, so prices in New York and London are driven higher than in other cities and in the country as a whole. They spend their bonuses on flashy cars and country houses, benefiting salesmen and property values in fashionable locations. And with stock prices close to their all-time highs, investors with portfolios everywhere feel financially better off, so they can increase their spending as well.
All the extra spending boosts GDP, and to some extent it has a snowball effect. Banks loosen their purse strings a little more, and spending increases further. But the number of people benefiting is only a small minority of the population. The rest, low-paid workers on fixed incomes, pensioners, people living on modest savings in cash at the bank, and part time employed as well as the unemployed find their cost of living has gone up. They all think prices have risen, and don’t understand that their earnings, pensions and savings have been reduced by monetary inflation: they are the ultimate victims of wealth transfer.
While luxury goods are in strong demand in London and New York, general merchants in the country find trading conditions tough. Higher prices are forcing most people to spend less, or to seek cheaper alternatives. Manufacturers of everyday goods have to find ways to reduce costs, including firing staff. After all if you transfer wealth from ordinary folk they will simply spend less and businesses will suffer.
So we have a paradox: growth in GDP remains positive; indeed artificially strong because of the under-recording of inflation, while in truth the economy is in a slump. The increase in GDP, which reflects the money being spent by the fortunate few before it is absorbed into general circulation, conceals a worse economic situation than before. The effect of an expansion of new money into an economy does not make the majority of people better off; instead it makes them worse off because of the wealth transfer effect. No wonder unemployment remains stubbornly high.
It is the commonest fallacy in economics today that monetary inflation stimulates activity. Instead, it benefits the few at the expense of the majority. The experience of all currency inflations is just that, and the worse the inflation the more the majority of the population is impoverished.
The problem for central banks is that the alternative to maintaining an increasing pace of monetary growth is to risk triggering a widespread debt crisis involving both over-indebted governments and also over-extended businesses and home-owners. This was why the concept of tapering, or putting a brake on the rate of money creation, destabilised worldwide markets and was rapidly abandoned. With undercapitalised banks already squeezed between bad debts and depositor liabilities, there is the potential for a cascade of financial failures. And while many central bankers could profit by reading and understanding this article, the truth is they are not appointed to face up to the reality that monetary inflation is economically destructive, and that escalating currency expansion taken to its logical conclusion means the currency itself will eventually become worthless.
This article was previously published at GoldMoney.com.
We use the term “reserve currency” when referring to the common use of the dollar by other countries when settling their international trade accounts. For example, if Canada buys goods from China, it may pay China in US dollars rather than Canadian dollars, and vice versa. However, the foundation from which the term originated no longer exists, and today the dollar is called a “reserve currency” simply because foreign countries hold it in great quantity to facilitate trade.
The first reserve currency was the British pound sterling. Because the pound was “good as gold,” many countries found it more convenient to hold pounds rather than gold itself during the age of the gold standard. The world’s great trading nations settled their trade in gold, but they might hold pounds rather than gold, with the confidence that the Bank of England would hand over the gold at a fixed exchange rate upon presentment. Toward the end of World War II the US dollar was given this status by international treaty following the Bretton Woods Agreement. The International Monetary Fund (IMF) was formed with the express purpose of monitoring the Federal Reserve’s commitment to Bretton Woods by ensuring that the Fed did not inflate the dollar and stood ready to exchange dollars for gold at $35 per ounce. Thusly, countries had confidence that their dollars held for trading purposes were as “good as gold,” as had been the Pound Sterling at one time.
However, the Fed did not maintain its commitment to the Bretton Woods Agreement and the IMF did not attempt to force it to hold enough gold to honor all its outstanding currency in gold at $35 per ounce. The Fed was called to account in the late 1960s, first by France and then by others, until its gold reserves were so low that it had no choice but to revalue the dollar at some higher exchange rate or abrogate its responsibilities to honor dollars for gold entirely. To it everlasting shame, the US chose the latter and “went off the gold standard” in September 1971.
Nevertheless, the dollar was still held by the great trading nations, because it still performed the useful function of settling international trading accounts. There was no other currency that could match the dollar, despite the fact that it was “delinked” from gold.
There are two characteristics of a currency that make it useful in international trade: one, it is issued by a large trading nation itself, and, two, the currency holds its value vis-à-vis other commodities over time. These two factors create a demand for holding a currency in reserve. Although the dollar was being inflated by the Fed, thusly losing its value vis-à-vis other commodities over time, there was no real competition. The German Deutsche mark held its value better, but German trade was a fraction of US trade, meaning that holders of marks would find less to buy in Germany than holders of dollars would find in the US. So demand for the mark was lower than demand for the dollar. Of course, psychological factors entered the demand for dollars, too, since the US was seen as the military protector of all the Western nations against the communist countries for much of the post-war period.
Today we are seeing the beginnings of a change. The Fed has been inflating the dollar massively, reducing its purchasing power in relation to other commodities, causing many of the world’s great trading nations to use other monies upon occasion. I have it on good authority, for example, that DuPont settles many of its international accounts in Chinese yuan and European euros. There may be other currencies that are in demand for trade settlement by other international companies as well. In spite of all this, one factor that has helped the dollar retain its reserve currency demand is that the other currencies have been inflated, too. For example, Japan has inflated the yen to a greater extent than the dollar in its foolish attempt to revive its stagnant economy by cheapening its currency. So the monetary destruction disease is not limited to the US alone.
The dollar is very susceptible to losing its vaunted reserve currency position by the first major trading country that stops inflating its currency. There is evidence that China understands what is at stake; it has increased its gold holdings and has instituted controls to prevent gold from leaving China. Should the world’s second largest economy and one of the world’s greatest trading nations tie its currency to gold, demand for the yuan would increase and demand for the dollar would decrease. In practical terms this means that the world’s great trading nations would reduce their holdings of dollars, and dollars held overseas would flow back into the US economy, causing prices to increase. How much would they increase? It is hard to say, but keep in mind that there is an equal amount of dollars held outside the US as inside the US.
President Obama’s imminent appointment of career bureaucrat Janet Yellen as Chairman of the Federal Reserve Board is evidence that the US policy of continuing to cheapen the dollar via Quantitative Easing will continue. Her appointment increases the likelihood that demand for dollars will decline even further, raising the likelihood of much higher prices in America as demand by trading nations to hold other currencies as reserves for trade settlement increase. Perhaps only such non-coercive pressure from a sovereign country like China can wake up the Fed to the consequences of its actions and force it to end its Quantitative Easing policy.
This article was previously published at Mises.org.
We are now into a second week of a partial Federal Government shut-down, which is causing considerable concern, centred on the Government’s ability to finance its debt and pay interest without a budget agreed for the new fiscal year. Should this continue into next week and beyond, the Fed will have to enter damage-limitation mode if the Treasury cannot issue any more bonds because of the separate problem of the debt ceiling.
Most likely, QE will have to be switched from financing the government to buying Treasuries already owned by the private sector. Any attempt to reduce the monthly addition of raw money will simply result in bond yields and then interest rates rising. And indeed, already this week we have seen yields on short-term T-bills rise in anticipation of a possible default. The market is naturally beginning to discount the possibility that the Fed may not be able to control the situation.
The T-bill issue is very serious, because they are the most liquid collateral for the $70 trillion shadow banking system. And without the liquidity they provide securities and derivative markets, we can say that Round Two of the banking crisis could make Lehman look like a picnic in the park.
This is the sort of event deflationists have long been expecting. According to their analysis there comes a point where debt liquidation is triggered and there is a dash for cash as assets collapse. But they reckon without allowing for the fact that deposits can only be encashed at the margin; otherwise they are merely transferred, and only destroyed when banks go under. This is the risk the Fed anticipates, and we can be certain it will move heaven and earth to avoid bank insolvencies.
Furthermore the deflationists do not have a satisfactory argument for the effect on currency exchange rates. Iceland went through a similar deflationary event to that risked in the US today when its banking system collapsed and the currency halved overnight. Today a dollar collapse on the back of a banking crisis would also disrupt all other fiat currencies, forcing central banks to coordinate intervention to conceal the currency effect. This leaves gold as the only true reflector of loss of confidence in the dollar and therefore all other fiat currencies.
Those worrying about deflation ignore the fact that it is the fiat currency that takes it on the chin while gold rises – every time without exception. This was even the experience of the 1930s, when Roosevelt suspended convertibility, increased the price of gold by 40% to $35 per ounce, and the banking crisis was contained.
Of course there is likely to be some short-term uncertainty; but against the Fiat Money Quantity (FMQ) gold is down 30% compared with the price pre-Lehman crisis. This is shown in the chart below.
With gold at an extreme low in valuation terms, current events, whichever way they go, seem unlikely to drive it much lower. A wise man perhaps should copy the Asians, who know a thing or two about paper currencies, and are buying gold in ever-increasing quantities.
This article was previously published at GoldMoney.com.
Recent statistics are confirming “economic recovery” in the UK and even some of the weaker eurozone states. I put this in quotes, because what we are seeing is expanding nominal GDP, which is not the same thing. GDP reflects money and credit going into the economy, which everyone believes is the same thing.
Instead of economic recovery, GDP is reflecting money leaving financial markets, particularly bonds, for less interest-rate sensitive havens. Globally, bonds represent invested capital of over $150 trillion, or more than twice global GDP, so even marginal amounts unleashed by rising bond yields can be financially destabilising and the effect on GDP growth could be electric. The mistake of confusing economic progress (a better description of what we all desire) with GDP is about to bite the economic establishment big-time and pressure for interest rates to rise early and substantially will intensify as a result, dragged up by those rising bond yields.
The problem facing central planners is that this GDP chimera is driven by a predominantly financial community that has money to invest in capital assets such as housing and even motor cars. The vast majority of economic actors, comprised of pensioners, low-wage workers living from payday to payday and the unemployed are simply disadvantaged as prices, already often beyond their reach, become even more unaffordable. It is a misfortune encapsulated in the concept of the Pareto Principle, otherwise known as the 80/20 rule, the law of the vital few, where the substantial majority will be badly squeezed by rising prices generated by the spending of that few.
The central planners are understandably focused on the misfortunes of the majority. For many of them, as prices start to rise so too do costs for their employers, many of which will be squeezed out of business. How can interest rates possibly be permitted to rise in the face of these dangers?
Central banks have drawn their line in the sand over interest rates and they will eventually be forced to reconsider their position. They are almost certain to be too slow in raising interest rates and so the markets will continually expect higher bond yields and higher interest rates to come. For those of us with long memories it is a repeat of the late-seventies stagflation era. Except this time, aggressively raising interest rates to stabilise the purchasing power of the currency is not an option: it will simply break the banking system lumbered with its share of the $150 trillion invested in bonds.
Markets are blithely assuming that central banks are in control of events. They are not even in control of their own governments’ profligacy, and they are losing their control over markets as well, as the tapering episode showed. The fatal error of rescuing both the banking system and government finances by reckless currency inflation is in the process of becoming apparent to all. Unless this policy is somehow reversed we risk a global rerun of the collapse of the German mark in 1923.
This article was previously published at GoldMoney.com.
It was not too surprising that there is going to be no tapering for some very good reasons. The commencement of tapering would have led deliberately to bond yields rising, triggered by an increase in sales of government bonds to the public and at the same time escalating sales by foreign governments as they attempt to retain control over their own currencies and interest rates. This was the important lesson from floating the rumour of tapering in recent months.
The reason tapering was not going to happen is summarised as follows:
1. Monetarists and therefore central bankers believe that rising bond yields and interest rates will strangle economic recovery. They want to see more robust evidence of recovery before permitting that to happen.
2. Rising bond yields would have required the Fed to raise interest rates sooner rather than later to stem the flight of bank deposits from the Fed’s own balance sheet held as excess reserves, which only earn 0.25%.
3. Importantly, the global banking system has too much of its collective balance sheet invested in fixed-interest bonds, and is also exposed to rising interest rates through interest rate swap derivatives. Tapering would almost certainly have precipitated a second bank crisis starting at the system’s weakest point.
4. The cost of funding the US Government’s deficit would have risen, difficult when the debt ceiling has to be renegotiated yet again.
5. Rising US interest rates will most probably destabilise emerging market currencies, risking a new Asian crisis.
6. It is a bad time to shift the burden of government funding back into the markets, because foreign holders have shown they will sell into rising yields.
The Fed has reaffirmed that zero interest rates will be with us for some time to come. It simply has no choice: it has to play down the risk of inflation. The result will be more price inflation, which is bad for the dollar and good for gold. This was reflected in the US Treasury yield curve, where prices of long maturities fell yesterday relative to the short end.
The markets had wrongly talked themselves into believing that tapering was going to happen, when the rumour was no more than an experiment. In the process precious metals were sold, driven by increasingly bearish technical talk every time a support level was breached. It is hardly surprising therefore that the recovery in gold and silver prices last night was dramatic, with gold moving up $70 and silver by $2 from intra-day lows. It looks like a significant second bottom is now in place above the June lows and the bear position, coupled with the shortage of physical metal will drive prices in the coming weeks.
The implications of the Fed not going ahead with tapering are bad for the dollar and won’t stop bond yields at the long end from rising. It shows that the whole US economy is in a massive debt trap that cannot be addressed for powerful reasons. The reality is the expansion of cash and deposits in the US banking system is tending towards hyperinflation and is proving impossible to stop. That is the message from this week’s FOMC meeting, and I expect it to gradually dawn on investors world-wide in the coming weeks.
I chanced this morning on the superb collection of essays from Ludwig von Mises, The Causes of the Economic Crisis and Other Essays Before and After the Great Depression (PDF).
In his Stabilization of the Monetary Unit—From the Viewpoint of Theory written in 1923, he showed considerable foresight:
Only the hopelessly confirmed statist can cherish the hope that a money, continually declining in value, may be maintained in use as money over the long run. That the German mark is still used as money today [January 1923] is due simply to the fact that the belief generally prevails that its progressive depreciation will soon stop, or perhaps even that its value per unit will once more improve. The moment that this opinion is recognized as untenable, the process of ousting paper notes from their position as money will begin. If the process can still be delayed somewhat, it can only denote another sudden shift of opinion as to the state of the mark’s future value. The phenomena described as frenzied purchases have given us some advance warning as to how the process will begin. It may be that we shall see it run its full course.
Obviously the notes cannot be forced out of their position as the legal media of exchange, except by an act of law. Even if they become completely worthless, even if nothing at all could be purchased for a billion marks, obligations payable in marks could still be legally satisfied by the delivery of mark notes. This means simply that creditors, to whom marks are owed, are precisely those who will be hurt most by the collapse of the paper standard. As a result, it will become impossible to save the purchasing power of the mark from destruction.
And in 1946, he commented on using easy money and deficit spending to stimulate the economy after a long period of cheap credit (The Trade Cycle and Credit Expansion):
In discussing the situation as it developed under the expansionist pressure on trade created by years of cheap interest rates policy, one must be fully aware of the fact that the termination of this policy will make visible the havoc it has spread. The incorrigible inflationists will cry out against alleged deflation and will advertise again their patent medicine, inflation, rebaptizing it re-deflation. What generates the evils is the expansionist policy. Its termination only makes the evils visible. This termination must at any rate come sooner or later, and the later it comes, the more severe are the damages which the artificial boom has caused. As things are now, after a long period of artificially low interest rates, the question is not how to avoid the hardships of the process of recovery altogether, but how to reduce them to a minimum. If one does not terminate the expansionist policy in time by a return to balanced budgets, by abstaining from government borrowing from the commercial banks and by letting the market determine the height of interest rates, one chooses the German way of 1923.
The Bank of England hopes to avoid all this by manipulating people’s expectations about inflation and GDP growth. I don’t think it can be done – too many commentators can see through it.
Nevertheless, they are going to give it a try. The best that can be said for it in the context of the German experience which Mises predicted and lived through is that at least if coming events are well understood, contemporary errors may at last produce the paradigm shift in economic thought necessary to put us on a more just and moral economic path.
This post originally appeared on www.stevebaker.info.
The Daily Mail reports Interest rates: How keeping them at a record low is a deliberate government ploy to pay off its debts:
A stealth raid by the Bank of England has stripped savers of more than £170billion, a Money Mail investigation can reveal.
By slashing the base rate to a record low of 0.5?per cent and allowing the cost of living to soar for more than four years, the Bank has whittled away the value of cash sitting in High Street accounts through a ‘secret tax’.
And it is not just savers who have effectively had their money pinched. Anyone who has a fixed monthly income, such as pensioners, or has had a tiny pay rise, has also lost out.
I campaign constantly against the injustice which is being manufactured by our centrally-planned system of money and bank credit so I am glad that the arguments are going mainstream.
We are in the midst of a great battle between debtors and creditors. Deeply indebted governments are on the side of those in debt. Too many claims on real goods have been created by bank lending so now the central banks are destroying those claims by stealth.
The implications for our society will be profound. I cannot help thinking that the whole enterprise would have already come crashing down if the public could see the tens and hundreds of billions of Pounds – and Dollars and Yen… – as paper in wheelbarrows going to governments’ favoured friends.
Given that the alternative is higher interest rates, sound money and a painful correction, governments and central banks think they are taking the easy way out. We’ll see.
This article was previously published at SteveBaker.info.
There is some evidence in the UK of a pick-up in consumer spending, probably echoed elsewhere. There are two likely factors behind this, the first perhaps being seasonal, aided by the fine weather. The second is less obvious, but combines with the first to encourage purchases of big ticket items; and this is cheap consumer finance coupled with growing expectations of higher interest rates in the future.
Interest rate expectations are therefore fuelling demand for big-ticket items, such as autos and electronic goods, where the cost of credit has been cut to maintain sales. There also appears to be growing demand for fixed-rate mortgages, and thanks to banks willing to borrow short and lend long there are some very tempting refinancing deals available. In summary, low financing costs plus a decent summer is the basis for kick-starting economic optimism.
Economists are already revising their GDP growth expectations upwards. However, there is likely to be a growing tendency for prices to rise due to capacity constraints in companies that have bolstered their profits by withholding investment for the last three or four years. Consequently price rises will be greater than generally expected.
The situation in the US is similar, with an added factor. US consumers are more responsive to confidence in stock markets and property prices than in the UK, and here the news has been bullish. Interest rates are low, and they will rise, so buy those big-ticket items now. The cost of buying and financing the average house purchase has already risen an estimated 40%.
Governments and economists will think they have the recovery they have wished for. Unfortunately it will almost certainly be marred by price inflation greater than the increase in demand suggests. So while nominal GDP growth rates will turn out to be somewhat better than currently expected, the talk will be of temporary capacity constraints.
The end result is that while central banks will realise that price inflation is a growing problem they will be reluctant to use higher interest rates to choke off inflation. And if consumers see central banks are behind this curve, further consumer borrowing will be encouraged.
This leads into the second phase of inflation. The first was expansion of cash and deposit money and the second is its mobilisation. The price effect is likely to be dramatic as money shifts from Wall Street to Main Street (or in British terms, from the City of London to the high street). However, there is an additional currency effect which few economists factor in: markets begin to discount the future purchasing power of paper currencies, bringing anticipated and higher prices forward in time, while central banks appear to be reluctant to raise interest rates. The Volcker remedy of raising interest rates to choke off inflation is simply not a policy-maker’s option.
The central banks are bound to be more focused on the damage from rising bond yields to government deficits and bank balance sheets. They will also be acutely aware of the effect higher borrowing costs has on today’s high levels of consumer debt.
The conclusion is that the central banks’ inflationary response to the banking crisis five years ago is going to get considerably more difficult in the coming months as monetary inflation morphs into price inflation.
This article was previously published at GoldMoney.com