Book Reviews

A Vindication of Commercial Society

In the Wealth of Nations Adam Smith outlines a commercial society:

When the division of labour has been once thoroughly established, it is but a very small part of a man’s wants which the produce of his own labour can supply. He supplies the far greater part of them by exchanging… the produce of his own labour… for such parts of the produce of other men’s labour as he has occasion for. Every man thus lives by exchanging, or becomes in some measure a merchant, and the society itself grows to be what is properly a commercial society.

The last sentence of the just quoted passage forms the leitmotif of this immensely accomplished and insightful book by Christopher Berry, Professor Emeritus in Political Theory at Glasgow University. The book’s cover is graced by a drawing of the inner court of that university where Smith, in a letter of thanks upon his installation as its rector in 1787, reports he had spent “by far the most useful and therefore as by far the happiest and most honourable period” of his life, both as student and subsequently successor to his one-time teacher there, Francis Hutcheson, in the Chair of Moral Philosophy.

Hutcheson, an Ulster-born Presbyterian Scot, had, in turn, also been educated there before moving to Dublin to open and run an academy. It was there Hutcheson acquired international fame that led to his appointment at Glasgow by writing and publishing in 1725 a celebrated tract on the origin of our moral ideas. This tract had been heavily influenced by works in ethics with which he first became acquainted in Dublin written by John Locke’s former tutee, the third Earl of Shaftesbury to whom Hutcheson dedicated the first edition of his own tract. Shaftesbury, in a letter to the Swiss theologian Jean Le Clerc in March 1705, made the following highly prescient observation about that great efflorescence of ideas in Europe in the eighteenth century, subsequently known as the Enlightenment, in which Adam Smith’s Scotland was to play such a prominent part:

There is a mighty light which spreads itself over the world especially in those two free nations of England and Holland… and if Heaven sends us soon a peace… it is impossible but letters and knowledge must advance in greater proportion than ever.

Shaftesbury made this remark early on during the so-called War of Spanish Succession which raged in Europe for more than a decade until 1714. It was during it that, to forestall its becoming allied with and used as springboard for invasion by its traditional enemy, France, England was to engineer political union with Scotland, in return for which it provided its economically backward northern neighbour with an enormous economic stimulus. Within a few decades, this previous economic and cultural backwater became the epitome of a commercial society whose idea was to fascinate and absorb the intellectual energies of that small country’s band of literati whose most illustrious member was Adam Smith.

Berry’s book is about how these Scottish literati conceptualised and reacted to this novel form of society their country was fast turning into during the half century between publication of David Hume’s Treatise of Human Nature in 1739-40 and the sixth edition of Adam Smith’s Theory of Moral Sentiments in 1790. It would be hard to exaggerate the importance of their achievement. As was noted by Arthur Herman in his 2001 book How the Scots Invented the Modern World:

The Scots created the basic ideals of modernity… When we gaze out on the contemporary world shaped by technology, capitalism, and modern democracy… we are in effect viewing the world through the same lens as the Scots did… In 1700 Scotland was Europe’s poorest independent country… [By 1800] this small, underpopulated, and culturally backward nation had] rose to become the driving wheel of modern progress… [I]f you want a monument to the Scots, look around you.

As Berry observes, the Enlightenment was not just a collection of forward-looking intellectuals and their ideas. It was also a set of formal and informal institutions through which the intellectuals propagated these ideas and drew mutual support and encouragement.

In his opening chapter, Berry explains just how tight-knit this set of institutions was in Scotland’s case. At their core were its universities whose curricula became modernised more than a century before England’s did. Closely connected with them was a large network of clubs and debating societies which brought together academics, merchants, lawyers and clergymen in a highly fruitful symbiosis. As Berry remarks ‘these various societies were an important part of the institutional fabric and played a leading role within Scotland… By forming a point of convergence for universities, the law, the church and the ‘improving’ gentry… the idea of a commercial society took on an institutional form… thinking about “commercial society” was woven into the fabric; it was not some detached academic exercise.’

What, then, did Scotland’s eighteenth century thinkers observe about the new form of society that they were witnessing springing up around them?

In the second chapter of his book, Berry offers a highly useful account of their understanding of this idea from which the following vignettes are taken:

One of the ideas for which the Scots are best known is their notion of the four stages (hunting, herding, farming, commerce)… To understand their own commercial era meant for the Scots placing it in a narrative that began with the destruction of the Roman Empire, but in which the pivotal ‘event’ is the collapse of feudalism… [T]he history… portrayed in the four stages rests on a particular model of ‘natural’ development… from concrete to abstract, from simple to complex, from rude to cultivated or civilised…. A commercial society does indeed have a distinctive property regime but that is only one aspect of the complex inter-related whole which defines that type of society.

The remaining chapters of Berry’s book explore various aspects that comprised a commercial society in the eyes of Scotland’s literati. Of them, the much greater opulence and freedom it confers on all its members, relative to other social formations, constitute its two chief distinguishing features as well as its most salient advantages over them. As Berry puts it:

Although in the Scots’ writings there is no explicit definition or even delineation of what constitutes ‘civilisation’ (a new term), nevertheless there was a definitive difference between Athens and Edinburgh (the so-called ‘Athens of the North’). The latter was civilised and free. The Scots are clear that their own (and similar) society is civilised… Contrary to Stoic and republican ‘frugality’ or Christian asceticism… Smith [along with his fellow Scottish literati] is firmly repudiating any notion that poverty is ennobling or redemptive… Smith’s and others’ repudiation of the nobility of poverty is a key factor in the vindication of a commercial society.

Underpinning commercial societies, in the eyes of the Scottish literati, is the rule of law as the one institution on which depends the mutual trust between strangers involved in regular trade, contract, credit, and paper money. As Berry explains with characteristic cogency:

The argument relies on a series of [posited] causal connections: stability from a framework of law causes security and security is a causal precondition for the development of a market and extension of contracts and exchange. This goes to the heart of the idea of a commercial society… What the authority of law provides is security of property for all… Perhaps the most decisive development [in the establishment of the rule of law] was the separation and independency of the judiciary for it is that which ensures the impartiality of administration [of justice] that imparts security to all.

Yet, a problem remains as to how such rule becomes established and what maintains it. There is a problem here, of which the Scottish literati were acutely aware and did their best to address. Berry explains the problem so: ‘In a commercial society we live predominantly among “an assembly of strangers”… Since the bulk of our dealings are impersonal then they must be conducted on the basis of adhering to the complementary impersonal (abstract) rules of justice… [Yet] the Scots are aware that this society can be construed to appear to rely to a reprehensible extent on “self” or “private”, rather than, “social” or “public”, interest.’

Self-love is the animating force behind commerce, yet the viability of commerce presupposes a degree of self-restraint on the part of those who engage in it, out of consideration for others. From whence arises the motivation needed to energise such self-restraint? Their answer was that such consideration arose from individual moral conscience variously understood, with Smith having characteristically described its restraining power the most graphically as well as illuminatingly. He writes of it in one of the most memorable passages in his Theory of Moral Sentiments:

When our passive feelings are almost always so sordid and so selfish, how comes it that our active principles should often be so generous and so noble?… It is not the soft power of humanity, it is not that feeble spark of benevolence… that is thus capable of counteracting the strongest impulses of self-love. It is a stronger power, a more forcible motive which exerts itself upon such occasions. It is reason, principle, conscience, the inhabitant of the breast, the man within, the great judge and arbiter of our conduct…

While the rule of law could thus be supposed capable of prevailing within commercial society through the moral probity induced in members by the strictures of their consciences, the Scottish literati remained exercised by the notion that commerce had a morally deleterious effect on those whose livelihoods were gained by means of it, which increasingly meant everyone in a commercial society. The source of such concern lay in the ancient republican notion that true freedom and virtue demanded a form of active citizenship governed by a concern for the public good for which a narrow preoccupation with mercenary self-interest characteristic of commerce simply had no place. Berry terms this concern ‘the luxury critique’ of commercial society and characterises it so:

A free state depended on virtuous (free) men devoted to the public good for which they were willing to fight (and die)… A society where wealth is valued will produce a generation… [that]will devote itself to private ends and… be unwilling to act foe the public good, where crucially central to such action is a willingness to fight… Once poisoned by luxury they invest life itself with value and become afraid of death, with the consequence that the society will be militarily weak – a nation of cowards… will easily succumb.

Among the Scots literati, Adam Ferguson and Lord Kames who were the most exercised by this issue. Hume and Smith by contrast tended to consider such concern about the morally corrupting effects of luxury misplaced, being redolent of nostalgia for a bygone era irretrievably passed whose claim in any case to greater valour than modernity was in their view highly exaggerated. Berry is particularly instructive in detailing the argumentative stratagems through which Hume and Smith sought to defuse and repudiate the luxury critique of commerce.

Thus, in the case of Hume, Berry notes: ‘The Spartan regime, where everyone has a “passion for the public good”, is contrary to “the natural bent of the mind”, and ‘to govern men along Spartan lines would require a “miraculous transformation of mankind”.’ Similarly, for Hume: ‘The supposed causal link between luxury and military weakness fails the test of constant conjunction, as manifest by the cases of France and England, that is, the two most powerfulbecause the two most polished and commercial societies’. Likewise: ‘For Smith, militias are outmoded… in an “opulent and civilised nation” a professional army is the means to preserve civilisation against invasion from a “poor and barbarous nation”… In explicit repudiation of the position of “men of republican principles”.., he claims [a professional] army’ can… ‘be favourable to liberty’… in those circumstances where the chief officers… are drawn from the “principal nobility and gentry”.’

Berry is rightly not oblivious to the morally detrimental effects that Smith identified commercial society having on its members. He notes that: ‘In Book 5 of the Wealth of Nations he [Smith] observes… that the dexterity of the specialised operative (read pin-maker) is bought at the cost of his “intellectual, social and martial virtues”.’ Yet, for all that, contrary to many recent expositors of Smith such as Denis Rasmussen and Ryan Hanley, Berry contends that:

Smith is… not to be saddled with the possession of some profound disquiet about the soul of modern man… Smith’s purpose in identifying these threats to these virtues, these deficiencies or ailments of commercial society, is programmatic…. [T]he point is to identify where government action, and the public purse, is called for in order to remedy the deficiencies…

The remedy for torpid intellectual virtues is… [publicly-funded] education… [T]he shortfall in the “pin-maker’s” social virtues… [can be remedied by] use of the tax system to reduce the number of alehouses… [plus state support of] “public diversions”, such as drama, music, dancing and the like… to lift the “melancholy and gloomy humour” that Smith associates with the “disagreeably rigorous and unsocial character “of [austere religious] sects [to which he considers are especially prone migrants to large cities from rural backgrounds]… When it comes to addressing the erosion of the martial virtues… [Smith] refers to the military exercises that the Greeks and Romans made the citizens perform… He does not say the exercises should be compulsory but… recurrence of the phrase ‘premiums and badges of distinction’ with respect both to parish schools and the Greek and Roman republics suggests… [Smith favored] a government-backed incentive structure to encourage participation in activities that would help the decline of the martial spirit.

What is being suggested here is that whatever morally subversive effects commerce might have upon populaces whose ways of life had become deeply informed by it can all be adequately addressed by judicious forms of state intervention be they public subsidy of schooling, of the arts, or of sport. Berry ably sums up the resultant idea of a commercial society when he observes that:

What the Scots’ idea seems to resemble is the outlines of a “liberal” picture of society… The complex interlocking whole is not some perfect functioning system… [T]he Scots are well-aware of commercial society’s imperfections just as they remain cautiously optimistic that these will be eroded by progress.

Whether we can share their optimism remains an open question. Even should we not be able to, we can nonetheless still share their common confidence that this form of societal organisation is superior to all others. Berry is to be commended for having explained so clearly and carefully why members of the Scottish Enlightenment shared such confidence and why we might do so too.

Ethics

In defence of capitali$m

[This article was written for BMS World Mission and can be found here.]

I want an end to poverty. I want a social system which operates justly in the general interest without boom and bust. I want to force even the most selfish into the service of others. I want to bring good news to the poor.

We do not live in the Garden of Eden. Scarcity is a fundamental fact. I see a world in which I cannot survive alone. In so far as we enjoy abundance, it is because we share the work of providing for one another.

That sharing of work implies a serious problem: how shall we decide how much of what to produce?

There is a choice: either voluntary ownership, control and risk bearing in the means of production, or collective ownership through the state plus economic planning. We must choose between capitalism or socialism.

Capitalism allocates effort and resources through the price system plus profit and loss accounting. When prices are formed through voluntary exchange of the goods and services people want, a profit shows that value is being created for customers, in their opinion. A loss indicates the collective opinion of society that value is being destroyed.

Only the price system reveals the shifting preferences in the minds of billions of individuals. That is why economic planning by authority always fails. It is why actual socialist societies are highly authoritarian: ever more power is applied in a futile attempt to make planning work.

"only the price system reveals the shifting preferences of billions"

Understanding our present plight requires insight into the financial system.

Banks lend money into existence. They do not merely lend what people have saved. When a loan is made, bank deposits are created out of nothing. That’s why the UK money supply tripled between 1997 and 2010 from about £700 billion to just over £2.2 trillion.

A society simply cannot triple its money supply in 13 years without profound consequences. Understand that new money went first into the financial system and housing, London and the South East and you have a good explanation for the structural problems in our economy.

We had a chronic oversupply of credit, then sudden undersupply. It is a typical failure of economic planning by authority, a failure of central banking.

The “greedy bankers” argument is inadequate. Thanks to various state-provided guarantees, bankers were gambling with other people’s money, at other people’s risk. Of course they frequently succumbed to temptation. Then governments forced us to bail them out. The injustice of it is palpable.

Look at the cost of energy, the queues on our roads or land use decisions and the story is the same: comprehensive regulation failing to produce the right results. Yes, there is often private investment but it is protected by legal privileges. Even without considering the high level of state spending, it is impossible to sustain the argument that our economy has been too free.

We have preached capitalism but practiced socialism before blaming inevitable failure on the market.

The Peruvian economist Hernando De Soto asked why people in the developing world do not prosper despite being clever, industrious and willing to take risks. Marx believed the problem is that the poor have formal rights but no property.

De Soto demonstrated the opposite. The poorest of the poor in the developing world possess $9.3 trillion worth of land, roughly the size of US GDP and over 70 times the entire world’s foreign aid budget. It turns out the poor in developing countries possess real property but inadequate rights. Co-operation cannot work for the common good without strong property rights and contractual exchange.

We have lived through a deep crisis of the Third Way. How we respond to it is crucial. Is justice and sustained, inclusive prosperity to be delivered through a return to comprehensive economic planning by authority or should we try freedom?

The only system capable of co-ordinating the shared work of providing for one another in this world of scarcity is founded on property rights, voluntary exchange, prices, profit and loss. It is the only system capable of bending even the most selfish to the service of others. Governments must stop deranging it if we are to bring good news to the poor through voluntary co-operation in free markets.

Media

Interview with St. Louis Fed Vice President on Bitcoin

Dr David Andolfatto, who is Vice President of the St. Louis Fed, has been one of the most forward-looking people at central banks around the world when it comes to crypto-currencies. Here he speaks with Max Rangeley, Editor at The Cobden Centre, and gives his views on what Bitcoin means for commerce, finance, and the dollar itself.

Max: How have you found the reactions to Bitcoin within the Fed?

David: Bitcoin is barely on the radar screen for most Fed researchers and policymakers. This is to be expected, given the large size of the Fed’s balance sheet and the debate over how to conduct monetary policy with the existence of large excess reserves. But I am aware of a small group of researchers scattered throughout the Fed system that seem interested in the Bitcoin phenomenon. Some, like Francois Velde of the Chicago Fed, have written nice primers on the phenomenon. I am also aware of a cryptocurrency workshop that meets monthly at the New York Fed. The reaction of most people (who study it) might be described as “academic agnosticism” in the sense that people are curious, but not enthusiastically in favor or against the idea.

Max: How do you see Bitcoin being used in the future? Do you foresee private currencies being commonly used on the high street alongside state-backed currencies, or remaining largely online phenomena?

David: Who can say how the future will evolve, especially in this space? My best guess is that Bitcoin will find a niche market. It’s cool to use bitcoin to pay for your Starbucks latte on university campuses (this is what my university is doing). It may very well find a place on the high street, at least among some shops catering to the “cool” crowd. But for advanced economies, at least, it is hard to see how consumers will benefit directly by using bitcoins instead of dollars or pounds. As Satoshi Nakamoto wrote in his seminal 2008 paper introducing Bitcoin, “…the [current] system works well enough for most transactions…”

Max: If the use of private currencies became more widespread, do you think that central banks would ever track monetary aggregates in circulation, even if just approximately, much as M2, M3 etc are tracked now?

David: Anything is possible, but I doubt it. One issue is that there many of these “wildcat” currencies, with more appearing every day (every online game has its own currency for example, as do most social media sites). In a sense, these currencies are “local” monies (much like the local currencies that have always existed, like the Ithaca hour, for example). I’m not sure how a statistical agency could keep track of all these little local currencies, or whether it would even be worthwhile to do so. But who knows?

Max: If private currencies were to become widely used around the world, do you think that this could have an effect on the business cycle, since central banks would not have as much control over monetary factors?

David: I do not think it would have much of an effect on the business cycle, which I think is rooted more in “real” and “financial” factors, rather than “monetary” factors, per se.

Max: You mentioned in your presentation on Bitcoin that although supply is fixed, demand can fluctuate significantly, which causes volatility, would you say this is a weakness inherent in private currencies, or is there the possibility that algorithms could evolve to incorporate a degree of elasticity?

David: Remember that Bitcoin is *more* than a private currency: it is a payment system and monetary policy with *no trusted intermediary* involved. Most private currencies entail the use of trusted third parties. EVE online, for example, an online game founded in 2003 has evidently managed its money supply in a manner that keeps its value relatively stable. It may be possible to code an “elastic money supply” rule in the Bitcoin protocol, but it is not immediately clear to me how this might work. Injecting new money into the system would be easy. The tricky part would be in how to destroy money (having the algorithm debit Bitcoin wallets that are secured by private keys).

Max: You mentioned that you welcome the competition for central banks; if private currencies became widely used, could it chip away at American supremacy, a degree of which is based on the dollar, the so-called “exorbitant privilege”?

David: In my view, America supremacy is not based on the dollar. The status of the dollar simply reflects American supremacy, which is based fundamentally on the structure of that economy (something “real” not “monetary”). The America dollar already faces stiff competition from a variety of alternative candidates, including the Yen, the Euro, and gold. If gold cannot displace the USD, why would we expect Bitcoin to?

Politics

New Normal

Just over three weeks ago, in his keynote address to the Global Corporocracy at the so-called ‘Summer Davos’ meeting in Tianjin, Li Keqiang firmly stated that:  ‘…we [have] focused more on structural readjustment and other long-term problems, and refrained from being distracted by the slight short-term fluctuations of individual indicators.’

 

He went on to downplay the fetish for the 7.5% GDP number, saying that ‘…we believe the actual economic growth rate is within the proper range, even if it is slightly higher or lower than the… target.’

 

As if that were not clear enough, Finance Minister Lou Jiwei rather spoiled Madame Lagarde’s infrastructure orgy at the Sep 20th weekend G20 meeting in Australia when he pointed out that China had already tried the very approach which his Western peers are itching to undertake – and which they hope can be financed by a grab at their citizens’ private pension funds.

 

Lou pointed out that while the programme may well have provided a short term fillip to ‘growth’, it brought environmental damage, capital misallocation, and dangerously increased indebtedness in its train. As if that were not enough of an ‘ice bucket challenge’ for his audience of panting Keynesians, he reiterated Li’s diagnosis that his government’s macro-economic policy would ‘continue to focus on the general objectives, in particular to maintain employment growth and price stability’ and that [emphasis added], ‘policy adjustments will not change on a single economic indicator’.

 

However determinedly deaf certain Occidental wise monkeys were to this pronouncement, Lou’s local market traders certainly took the words to heart: rebar, rubber, and iron ore fell 4% to major new lows in the Monday session, while a whole range of metals, petrochemicals, and others dropped 2% or more. If the impending Golden Week holiday may have been enough to discourage any further initiative selling of the metals over the succeeding few days (steel, iron, rubber, and cotton were NOT similarly spared), nevertheless the verdict was clear: the pain would continue.

 

Li himself seemed to be resolutely sticking to his guns. In the two policy announcements he has made since his big speech, he has continued to tinker with microeconomic reforms (e.g., liberalizing delivery services) and to enact fiscal measures (notably the introduction of  a series of accelerated depreciation measures aimed both at alleviating the current tax burden and at encouraging SMEs to undertake a little more capex in future). Nowhere is there any hint that the regime’s nerve has failed or therefore that the spigots are about to be opened once more.

 

The latest kite to be flown on this account is the speculation raised by the WSJ that PboC chief Zhou Xiaochuan will be ‘retired’ at the upcoming autumn plenum. Though no confirmation of any sort has been forthcoming so far, we have already been subjected to no shortage of punditry as to the whys and wherefores of the supposed move.

 

Chief among these have been somewhat conflicting conspiracy theories that his expulsion would represent variously a reassertion of its influence by the factions so far largely being steam-rolled by Xi and, in almost exact opposition to this, a move by Xi to ride himself of a turbulent monetary priest who – wait for it – has proved too reluctant to swamp the ailing economy with the massive amounts of liquidity Xi has now decided is necessary in complete contradiction of the programme he and his team have been pursuing!

 

Though we have no special insight into this matter, it does strike us as unlikely that Zhou is suddenly now regarded as an enemy – this is, after all, the man whose gravitas and reputation for calm confidence was deemed so valuable to the incoming administration that it deliberately bent the rules concerning the mandatory retirement of top officials in order to keep him in his post. It seems far more probable, therefore, that if the personnel change is indeed to be affected – and the fulsome encomium to this ‘wise old sage’ which was carried in all the main outlets over the weekend rather diminishes the prospect – his baton would be passed on to someone of like mind. Several commentators have already noted that this may well be the case if the go-to man tipped to be his successor, Guo Shuqing, actually does get the nod.

 

Whether the incumbent stays or goes, however, the very fact that the mere rumour of his departure was enough to have the stimulus junkies drooling that their itch for the next fix would soon be assuaged is revealing of the parlous state to which we have all been reduced in our QEternity, Goldilocks world of an utter reliance on the foibles of central bank heads to determine where we should place our next bets, to the exclusion of all other factors.

 

Giving this crowd some brief hope, the PboC did in fact adjust the repo rate lower and also offered (in its usual, frustratingly opaque manner) a CNY500 billion injection of funds to the five biggest state-owned banks even though this may have been no more than a partial offset to the ongoing lack of foreign exchange accumulation – of especial significance now that the CBRC has clamped down on end-period deposit hunting – and/or a timely assist aimed at preventing the IPO flood from dampening a rekindled enthusiasm for stocks.

 

The realisation that the country’s current afflictions might not be susceptible of alleviation in the time-honoured Yellen-Draghi fashion seems to be spreading. With the capital market queue for bank refinancing now said to stretch to CNY600 billion and with the count of bad and doubtful loans rising rapidly (if still hugely understated), the lenders seem to have a somewhat different focus than that of showering credit on each and every would-be borrower.

 

Nor are borrowers beating down their doors, at least according to the results of the central bank’s latest quarterly survey. This has loan demand falling below the lows of 2012, so no wonder the monthly data dump shows the pace of increase in yuan loans on bank books dropping to the lowest levels of the past eight years. No wonder either when, as CASS academician Yu Yongding told an audience at Tsinghua University, a recent NBS survey found that lending rates for the average SME was no less than 25.1% annualized.

 

The combination of usurious rates and burgeoning liabilities (especially accounts receivable which are up more than 14% yoy) means that financing costs for SOEs are rising at a rate of 16.7% p.a. (as the MOF tells us), while those for joint-stock enterprises are growing 14.4%, and for the usually more profitable HK, Macau & Taiwanese owned-firms at no less than 27.2%, so says the NBS. The Chinese Enterprise Confederation also reported that the top 205 state-owned manufacturing companies’ income margin was a mere 1.8% this past year, while that for their 295 private counterparts was a less than stellar 2.8% (for comparison, over the past 4 ½ years, US manufacturers have returned an average of 10.6¢ pre- and 8.7¢ after-tax on each $1 of sales).

 

Would you be borrowing more in a decelerating economy if these were your business metrics?

 

Reflecting all this on the macro side, Want China Times reported that, with several Chinese provinces finding it ‘hard’ to reach their GDP numbers, voices are being raised in favour of a lowering of the goalposts (the message naturally being far more important than the medium in Leninist thinking).

 

Recall here that the official spin keeps emphasizing both the long-term nature of the shift to the ‘New Normal’ (which one unnamed cynic dared to translate as ‘recession’!) and continually pleads the medium-term difficulties associated with the ‘Three Overlay’ constellation – viz., the problems of changing the emphasis from the quantity to the quality of output; the ‘structural’ shift away from investment and toward consumption as the focus of future development; and the tribulations of eliminating (‘digesting’ in Newspeak) some of the excess capacity and crippling debt levels built up during the ‘stimulus’ the Party unleashed in the attempt to combat the effects of the financial crisis.

 

Significantly, at the grandly titled ‘2014 Co-prosperity Capital Wealth Summit’ held on Sunday, former NBS chief economist and State Department advisor Yao Jingyuan opined that this baleful cyclical conjunction would last for another three to five years. Simultaneously, Shengsong Cheng of the central bank pointed out – in what may be the first serious attempt at disassociating the regime from its previous expectational anchor – that if China were to grow at no more than 6.7% p.a. over the remainder of the decade, the desideratum of doubling the size of the economy over the whole of that ten year stretch would still have been achieved. It would also seriously embarrass many of the Sinomaniacs’ determinedly bullish projections.

 

As Want China Times also wrote, besides the growing shortfalls in Jiangsu, Shandong, Shanxi, Heilongjiang, Hunan, and Guangdong provinces, Shenzhen is labouring under the burden of a fall in two-way trade volumes of 28% over the first seven months of the year in addition to a 60% plunge in newly constructed real estate.

 

As 21st Century Herald has pointed out, the upshot has been that many local governments are trimming outlays, dipping into reserves, and even indulging in asset fire-sales in order to stem the fiscal haemorrhage. Even then, in order to meet revenue goals, resort has been made to a neat, fraudulent round-robin whereby local businesses borrow the money with which to pay fictional taxes and then recoup the outlay in the form of phony subsidies, rebates, and contracts. An official at one northern city admitted that up to 15% of his authority’s budget consisted of such shenanigans but that in certain county governments the padding amounted to 30% of the total. No wonder the expansion of bank balance sheets is having so little effect on genuine activity.

 

Further to the regional tale of woe, the local stats bureau made it known that even mighty Shanghai’s industries saw an actual drop in the value of output of 2.5% yoy in August, figures which represent a truly stunning reversal from June’s +7.1 gain and the first half’s overall increase of +4.4%.

 

Meanwhile, the CISA reported that implied steel consumption has failed to grow so far this year for the first time in the new millennium. No surprise then that rumours continue to swirl about the possible CNY10’s of billions involved in the potential bankruptcy of Sinosteel. Likewise, Reuters reported that ‘sources at the country’s major oil companies have predicted that China’s diesel consumption is set to post its first decline in more than a decade.’ How much of even that is real demand is another moot point given that SAFE has just announced the identification of $10 billion in fake cross-border transactions in a scandal which has progressively widened out from the initial Qindao port incident to encompass no less than 24 separate provinces and cities thus far.

 

Globally, the impact is being felt in the bellwether chemical industry.  As the American Chemistry Council noted, there was a ‘worrying’ slide in operating rates during what is typically the seasonally strong second quarter.  Things have not improved much since. Q2.   The ACC showed Germany dropping from 4.8% growth in February to a fall of 3.5% in August.  India crashed from +12.9% in January to +3.4% in August. Japan fell from +9.2% in March to just +0.8% in August. Mexico went from 1% growth in April to -2.8% and Russia slowed from +4.2% in January to -10.4% last month.

 

Only one major country managed to maintain a relatively strong growth level. You may not be surprised to learn that this stalwart was China, where output peaked at +11.1% in April, was still a strong +8.8% four months later. Why the anomaly? No real mystery: the country has swung from being a net importer of bulk chemicals to being a net exporter, much as it has in refined oil products and also in some metals. No-one dare utter the word, ‘dumping’!

 

All of this is a sharp contrast to the first stages of Chinese expansion when the country purchased large quantities of raw and semi-processed items – without much regard to their cost – either to employ them in building out its own industries and infrastructure (as Mr Lou pointed out) or to incorporate – along with a range of other bought-in, more sophisticated components – into finished-goods exports bound for Western consumers who were borrowing a goodly portion of the necessary invoice amounts.

 

Nowadays, many of those foreign customers are either unwilling or unable add any  more to their slate, while the prevailing quest for China’s factory owners is to find some way of more profitably utilising some of the vast overcapacity they have built up in the interim.

 

One consequence is that, even allowing for possible distortions in the data, it is clear that things are running no where near as hot as they once were. Taking the five years to the peak of the last cycle, Chinese industrial corporations enjoyed compound annual revenue growth of over 25% and profit growth of 37%. Fast forward and since the end of 2012, earnings growth and – perhaps even more tellingly – revenues are up by a much lesser 10% or so. Not a basis on which to be too gung-ho on further capital outlays, nor one in which double-digit rises in wage costs can continue to be blithely accommodated.

 

At the largest of scales, evidence of this change can also be found. During the whole of the two decades before Crash, world trade volumes rose at 7.2% a year, compounded: since the start of 2011, that pace has slowed to a tardy 2.0%, meaning that now, some six years on from the Snowball Earth episode, we are only at three quarters of the level we would have attained had the crisis not intervened. And, as we know, all this is closely related in a complex web of cause-and-effect to the rate global money growth. That latter is facing its own challenges given that the ongoing steep rise in the dollar reduces the effective global heft of the monies being emitted by just about everyone other than the Chinese themselves with their similarly-soaring currency.

 

In passing, economic turmoil may be one thing with which the leadership has to contend, but the upsurge of violence in Xinjiang – where up to 50 people were reported killed during a bomb attack on two Luntai police stations – and the rather more peaceful, if no less weighty, street protests in HK – with their uncomfortable echoes of East European ‘Colour’ revolutions – are another matter entirely.

 

All told, the Chinese CCP and its new leaders have some sizeable challenges to overcome in the months ahead.

Economics

A difficult question

In a radio interview recently* I was asked a question to which I could not easily give a satisfactory reply: if the gold market is rigged, why does it matter?
I have no problem delivering a comprehensive answer based on a sound aprioristic analysis of how rigging markets distorts the basis of economic calculation and why a properly functioning gold market is central to all other financial prices. The difficulty is in answering the question in terms the listeners understand, bearing in mind I was told to assume they have very little comprehension of finance or economics.
I did not as they say, want to go there. But it behoves those of us who argue the economics of sound money to try to make the answer as intelligible as possible without sounding like a committed capitalist and a conspiracy theorist to boot, so here goes.

Manipulating the price of gold ultimately destabilises the financial system because it is the highest form of money. This is why nearly all central banks retain a holding. The fact we don’t use it as money in our daily business does not invalidate its status. Rather, gold is subject to Gresham’s Law, which famously states bad money drives out the good. We would rather pay for things in government-issue paper currency and hang on to gold for a rainy day.

As money, it is on the other side of all asset prices. In other words stocks, bonds and property prices can be expected to rise measured in gold when the gold price falls and vice-versa. This relationship is often muddled by other factors, the most obvious one being changing levels of confidence in paper currencies against which gold is normally priced. However, with bond yields today at record lows and equities at record highs this relationship is apparent today.

Another way to describe this relationship is in terms of risk. Banks which dominate asset markets become complacent about risk because they are greedy for profit. This leads to banks competing with one another until they end up ignoring risk entirely. It happened very obviously with the American banking crisis six years ago until house prices suddenly collapsed, threatening to take the whole financial system down. In common with all financial bubbles everyone ignored risk. History provides many other examples.

Therefore, gold is unlike other assets because a rising gold price reflects an increasing perception of general financial risk, ensuring downward pressure on other financial asset prices. So while the big banks are making easy money ignoring risks in equity and bond markets, they will not want their party spoiled by warning signs from a rising gold price.

This is a long way from proof that the gold market is manipulated. But the big banks, and we must include central banks which are obviously keen to maintain financial confidence, have the motive and the means. And if they have these they can be expected to take the opportunity.

So why does it matter if the gold price is rigged? A freely-determined gold price is central to ensuring that reality and not financial bubbles guides us in our financial and economic activities. Suppressing the gold price is rather like turning off a fire alarm because you can’t stand the noise.

*File on 4: BBC Radio4 due to be broadcast on 23 September at 8.00pm UK-time and repeated on 28 September at 5.00pm.

Economics

Bank Run Incentive, Central Bank Bankruptcy, and The Fallacy of the Credit Theory of Money

[Editor's Note: this is from the World Dollar Foundation, and can be found here]
Part 1: The Bank Run Incentive

There is an incentive to start bank runs due to a) the fallacy of fractional-reserve banking, and b) the fallacy of deposit “guarantees”.

A. The Fallacy of Fractional-reserve banking

A fractional-reserve bank issues more property titles than there is actual underlying property. The total value of property titles cannot exceed the total value of actual underlying property. Therefore, holders of property titles have an incentive to act quickest in withdrawing the actual underlying property. Those who act slowest are the losers, as they fail to withdraw any of the actual underlying property.

B. The Fallacy of Deposit “Guarantees”

In the event of a systemic run on fractional-reserve banks, all of the actual underlying property is withdrawn. Therefore, no actual underlying property exists with which the government could fulfil deposit “guarantees”, unless new underlying property is created.

However, the government does not create new underlying property at will. Only the central bank can create new underlying property, doing so on the expectation that it is to be repaid, for its subsequent destruction. Therefore, the central bank will not issue the government with the new underlying property to fulfil the deposit “guarantees” with, unless it believes the government can credibly repay it. In other words, the deposits are not “guaranteed” at all by the party that actually has the power to create new underlying property.

If the central bank determines that the government cannot credibly repay, it is a concession that the risk is too high that the central bank cannot meet its own liability to destroy the property (upon its intended repayment). Therefore, the government that forces the central bank (against its wishes) to issue it with new underlying property can perceivably drive the central bank into declaring bankruptcy, jeopardising the entire monetary system.

However, even if we reject the idea that deposit “guarantees” are a fallacy, there is still a big problem. The entire monetary system is jeopardised by the reality that the business model of the central bank is, in fact, bankrupt. This fact is seemingly unbeknownst to even the central bankers themselves, and is covered next in Part 2.

Part 2: The Bankrupt Business Model of the Central Bank

The business model of the central bank is bankrupt due to a) the impossibility of making a profit in the long run, b) the virtual certainty of making a loss in the long run.

A. The Impossibility of Making a Profit in the Long Run

The central bank lends money into existence, and destroys it upon its repayment. It is impossible for more money to be repaid than is lent into existence. Therefore, it is impossible for the central bank to make a profit in the long run.

B. The Virtual Certainty of Making a Loss in the Long Run

All money lent into existence carries the risk of not being repaid. Therefore, it is virtually impossible for the central bank to recover 100% of the money it lends into existence. Therefore, it is virtually guaranteed that the central bank makes a loss in the long run.

In terms of the balance sheet (a “snapshot” of the present affairs) of the central bank, it must be the case that it its liabilities always exceed its assets, provided that the provision for doubtful debts is correctly factored in.

However, in order for the central bank not to be declared bankrupt, it must be held that there is no virtual certainty of making a loss in the long run. Therefore, it must be held that the central bank can recover 100% of the money it lends into existence (with virtual certainty). This incorrect belief is based on a fallacy called the credit theory of money, covered next in Part 3.

Part 3: The Fallacy of the Credit Theory of Money

According to the credit theory of money, the value of money ultimately rests on the obligation of the debtor to pay his debt. It is held that money must, in the long run, return to the creator of the money, for the money keeps being chased by those debtors who have an obligation to pay their debt to the creator of the money.

However, the credit theory of money is a fallacy. The value of money ultimately rests on its use as a medium of exchange, eliminating the inefficient “double coincidence of wants” present in barter. Money can circulate among members of the trading public (in perpetuity) for precisely this reason.

There is no rule that money must eventually return to those who have debts to pay, and indeed this is a highly unrealistic assumption, due to a) market forces in the supply of goods and services, b) market forces in the supply of money.

A. Market forces in the supply of goods and services

In the market economy, there is no rule that those who receive a greater amount of loans must outcompete those who receive a lesser amount of loans. Those who who receive a lesser amount of loans can win in market competition by being more efficient in meeting the demands of the trading public.

In addition, when investment is financed by credit not backed by true saving, it is termed “malinvestment”, as it tends to be inconsistent with the tastes and preferences of consumers and producers, and of the availability of scarce resources, thus increasing the likelihood of defaults.

B. Market forces in the supply of money

By having a (credit) money creator, winners and losers are created as a result of artificial barriers or prejudices or preferences. The recipients of greater amounts of loans tend to be benefitted, but the key winner is, of course, the (credit) money creator itself, as it canperpetually misappropriate wealth from the rest of society.

This fundamentally unfair system means there can be legitimate demand for heterogeneity to be introduced into the money supply. For instance, if in a given time period, the (credit) money creator expands the supply of money by a disproportionately large amount, the market could decide to scale down the value of these monetary units, as it amounts toexpropriation of the existing holders of money. Alternatively, new monetary units could be rejected entirely. There is simply no need to have a growing supply of money in order to have a growing economy. Instances such as these would make it highly challenging for the money to assuredly go back to the debtors of the (credit) money creator.

Another strong market incentive is to switch to an alternative monetary system, such as one with the use of precious metals such as gold or silver, or one with the use of World Dollar, a new currency based on the idea that the ultimate basis for money, a social convention, is for it to be issued to everyone, equally. If the market does switch, the (credit) money risks declining rapidly in value, even to the extent of becoming entirely worthless.

Economics

Back to the future

“Sir, Arnaud Montebourg, the former French economy minister and the sourest note in the Hollande repertoire, dares to complain of “absurd” austerity policies ? (“Hollande purges cabinet following leftwing revolt”, August 26.) If those policies are absurd, it is because they were not accompanied by the structural reforms so badly needed to make the French economy healthy. I am speaking of long outdated redundancy and seniority labour laws, oppressive regulations for the business sector and the unbearable bureaucratic roadblocks that stand in the way of start-ups.

“To these, one can also add the traditional Gallic mindset of envy, if not outright hostility, towards those French citizens and other Europeans who are willing to work longer, harder and smarter and want to make good money; a mindset that Mr Montebourg never hesitated to parade before the world. Now that he and his cohorts on the left of the Socialist party have departed the government, perhaps François Hollande can move forward and leapfrog France from the 19th to the 21st century.” Letter to the FT from Stan Trybulski, Branford, Connecticut, 28th August 2014.

“There’s a great deal of ruin in a nation.” Adam Smith.

“You will never understand bureaucracies until you understand that for bureaucrats, procedure is everything and outcomes are nothing.” Thomas Sowell.

Much of what we think we know isn’t necessarily so. The invention of the printing press with movable type ? Traditionally credited to fifteenth-century Germany and Johannes Gutenberg, it was actually invented in eleventh-century China. Paper also originated in China long before it was used in the West. As did paper money and toilet paper (albeit today, these are pretty much interchangeable). English agriculturalist Jethro Tull is widely credited with the discovery of the seed drill in 1701. It was in fact invented by the Chinese 2,000 years beforehand. The first blast furnace for iron smelting is associated with Coalbrookdale – tragically close to schools in the West Midlands. It was actually introduced by the Chinese before 200 BC. The Chinese were also first to use the fishing reel, matches, the magnetic compass, playing cards, the toothbrush and the wheelbarrow. Perhaps even golf. So how did a society apparently so dynamic and innovative by comparison with the West then enter a centuries’ long decline ?

Niall Ferguson, in his excellent book ‘Civilization’ (Penguin, 2012) puts forward six “identifiably novel complexes of institutions and associated ideas and behaviours” that account for the cultural and economic outperformance of the West between, say, the 16th and 20th centuries:

Competition
Science
Property rights
Medicine
The consumer society
The work ethic.

He defines these trends as follows:

1. Competition: “a decentralization of both political and economic life, which created the launch-pad for both nation-states and capitalism”.
2. Science: “a way of studying, understanding and ultimately changing the natural world, which gave the West (among other things) a major military advantage over the Rest”.
3. Property rights: “the rule of law as a means of protecting private owners and peacefully resolving disputes between them, which formed the basis for the most stable form of representative government”.
4. Medicine: “a branch of science that allowed a major improvement in health and life expectancy, beginning in Western societies, but also in their colonies”.
5. The consumer society: “a mode of material living in which the production and purchase of clothing and other consumer goods play a central economic role, and without which the Industrial Revolution would have been unsustainable”.
6. The work ethic: “a moral framework and mode of activity derivable from (among other sources) Protestant Christianity, which provides the glue for the dynamic and potentially unstable society created by “killer apps” 1 to 5”.

For our purposes we are most interested in Ferguson’s first “killer app”, Competition. But we will also refer to it in a slightly different context – “the lack of bureaucracy”. As the chart below shows, from 1000 AD to its high water mark in the 1960s, UK GDP relative to China’s was a one-way bet. Since then, however, the trend has gone into reverse.

UKChina GDP Ratio

Source: Niall Ferguson / Penguin Books
What can account for this dramatic reversal of economic fortunes ? Economic reforms in China, led by Deng Xiaoping in the late 1970s, are likely to be responsible for at least part of the turnaround. But the relentless and sclerotic expansion of the State in Britain has also played a role.

UK general government expenditure (green) and private expenditure (black) as a proportion of GDP

Govt Expenditure

Source: David B. Smith / Steve Baker MP

As the chart above shows, at the turn of the last century, UK state spending accounted for roughly 10% of the economy and the private sector accounted for the rest. But as the welfare state has swelled, government spending has mushroomed to account, now, for something like half or more of the entire economy. And state spending, by and large, is inefficient spending – at least by comparison with the inevitably more disciplined for-profit sector. In other words, our relative economic prospects have declined in inverse proportion to the expansion (metastasis) of the State. In turn, bureaucratic parasitism likely accounts for productivity differentials in the euro zone; the German State accounts for roughly 45% of its economy, the French State 56%.

This might account for the differential between German and French productivity

Holland Merkel Umbrellas
As might this

Holland Watch
Politicians have been able to swell the State thus far only with assistance by two groups: with the involuntary support of taxpayers, and with the connivance of central bankers. Popular resentment of what is laughably termed ‘austerity’ threatens the ongoing indulgence of the first group; the almost terminal straining of market forces by the latter runs the risk of a disorderly collapse of confidence in bond markets, after which continued Western deficit spending would be virtually impossible.

We seem to be close to the endgame. Even as perversely, record-low bond yields (indiscriminately – across markets as diverse as Austria, Belgium, Germany, Holland, Finland, Ireland, Italy and Spain) have sent desperate investors scurrying into stocks instead, those same investors are, with extra perversity, displaying a similar lack of discrimination and not even attempting to locate relative value within markets. Extraordinarily, the Wall Street Journal points out that

“Investors are pouring money into Vanguard Group, the epitome of the hands-off approach to investing, flocking to funds that track market indexes and aren’t run by stock pickers or star managers. The inflow has pushed the mutual-fund giant to almost $3 trillion in assets under management for the first time. The surge is part of a sea change in the fund business in which investors are increasingly opting for products that track the market rather than relying on managers to pick winners… Investors poured a net $336 billion into passively managed stock and bond funds in 2013, handily beating the $53 billion invested in traditional mutual funds of the same type, according to Morningstar. So far this year through July, investors put a net $177 billion into those passive funds, compared with $74 billion in actively managed funds… Through July, passively managed stock funds have seen a net $128.4 billion in investor inflows, compared with $18 billion for traditional stock funds…”

Nor is this lack of judicious investment a product of bullish US market sentiment. The same arbitrary index-following – at all-time highs – is being pursued in the UK. Trade magazine FTAdviser reports that

“Retail investors put more money into tracker funds in July than in any other month since records began, according to the latest IMA data.”

Index-tracking may have merit at the bottom of the market, but at the top ?

Having singularly failed to reform or restructure their dilapidated economies, many governments throughout the West have left it to their central banks to keep a now exhausted credit bubble to inflate further. Unprecedented monetary stimulus and the suppression of interest rates have now boxed both central bankers and many investors into a corner. Bond markets now have no value but could yet get even more delusional in terms of price and yield. Stock markets are looking increasingly irrational relative to the health of their underlying economies. The euro zone looks set to re-enter recession and now expects the ECB to unveil outright quantitative easing. If the West wishes to regain its economic vigour versus Asia, it would do well to remember what made it so culturally and economically exceptional in the first place.

Economics

Stocks and the Stockdale Paradox

 “Anything can happen in stock markets and you ought to conduct your affairs so that if the most extraordinary events happen, you’re still around to play the next day.”

  • Warren Buffett.

Vice Admiral James Stockdale has a good claim to have been one of the most extraordinary Americans ever to have lived. On September 9th, 1965 he was shot down over North Vietnam and seized by a mob. Having broken a bone in his back ejecting from his plane he had his leg broken and his arm badly injured. He would spend the next seven years in Hoa Lo Prison, the infamous “Hanoi Hilton”. The physical brutality was unspeakable, and the mental torture never stopped. He would be kept in solitary confinement, in total darkness, for four years. He would be kept in heavy leg-irons for two years, on a starvation diet, deprived even of letters from home. Throughout it all, Stockdale was stoic. When told he would be paraded in front of foreign journalists, he slashed his own scalp with a razor and beat himself in the face with a wooden stool so that he would be unrecognisable and useless to the enemy’s press. When he discovered that his fellow prisoners were being tortured to death, he slashed his wrists to show his torturers that he would not submit to them. When his guards finally realised that he would die before cooperating, they relented. The torture of American prisoners ended, and the treatment of all American prisoners of war improved. After being released in 1973, Stockdale was awarded the Medal of Honour. He was one of the most decorated officers in US naval history, with 26 personal combat decorations, including four Silver Stars. Jim Collins, author of the influential study of US businesses, ‘Good to Great’, interviewed Stockdale during his research for the book. How had he found the courage to survive those long, dark years ?

“I never lost faith in the end of the story,” replied Stockdale.

“I never doubted not only that I would get out, but also that I would prevail in the end and turn the experience into the defining moment of my life, which in retrospect, I would not trade.”

Collins was silent for a few minutes. The two men walked along, Stockdale with a heavy limp, swinging a stiff leg that had never properly recovered from repeated torture. Finally, Collins went on to ask another question. Who didn’t make it out ?

“Oh, that’s easy,” replied Stockdale. “The optimists.”

Collins was confused.

“The optimists. Oh, they were the ones who said, ‘We’re going to be out by Christmas.’ And Christmas would come, and Christmas would go. Then they’d say, ‘We’re going to be out by Easter.’ And Easter would come, and Easter would go. And then Thanksgiving. And then it would be Christmas again. And they died of a broken heart.”

As the two men walked slowly onward, Stockdale turned to Collins.

“This is a very important lesson. You must never confuse faith that you will prevail in the end – which you can never afford to lose – with the discipline to confront the most brutal facts of your current reality, whatever they might be.”

As Collins’ book came to be published, this observation came to be known as the Stockdale Paradox. For Collins, it was exactly the same sort of behaviour displayed by those company founders who had led their businesses through thick and thin. The alternative was the average managers at also-ran companies that enjoyed average returns at best, or that failed completely.

At the risk of stating the blindingly obvious, this is hardly a ‘good news’ market. Ebola. Ukraine. Iraq. Gaza. In a more narrowly financial sphere, the euro zone economy looks to be slowing, with Italy flirting with a triple dip recession, Portugal suffering a renewed banking crisis, and the ECB on the brink of rolling out QE. If government bond yields are a reflection of investor confidence, the fact that two-year German rates have gone below zero is hardly inspiring.

And we have had interest rates held at emergency levels for five years now – gently igniting who knows what form of as yet unseen problems to come. In Europe interest rates seem set to stay low or go even lower. But in the UK and the US, the markets nervously await the first rate hike of a new cycle while central bankers bluster and dither.

What are the implications for global asset allocation and stock selection ?

Both in absolute terms and relative to equities, most bond markets (notably the Anglo-Saxon) are ridiculously overvalued. Since the risk-free rate has now become the return-free risk, cash now looks like the superior asset class diversifier.

As regards stock markets, price is what you pay, and value (or lack thereof) is what you get. On any fair analysis, the US market in particular is a fly in search of a windscreen. Using Professor Robert Shiller’s cyclically adjusted price / earnings ratio for the broad US stock market, shown below, US stocks have only been more expensive than they are today on two occasions in the past 130 years: in 1929, and in 2000. The peak-to-trough fall for the Dow Jones Industrial Average from 1929 equated to 89%. The peak-to-trough fall for the Dow from 2000 equated to “just” 38%. Time will tell just how disappointing (both by scale and by duration) the coming years will be for US equity market bulls.

But we’re not interested in markets per se – we’re interested in value opportunities incorporating a margin of safety. If the geographic allocations within Greg Fisher’s Asian Prosperity Fund are any guide, those value opportunities are currently most numerous in Japan and Vietnam. In the fund’s latest report he writes:

“Interestingly, and despite China’s continued underperformance, the Asian markets in aggregate have done better at this stage in 2014 than last year, while other global markets have fared less well. In our view the reason is simple – a combination of more attractive valuations than western markets, especially the US, but also, compared with 12-18 months ago, recognisably poor investor sentiment and consequently under-positioning in Asia, leading to the chance of positive surprises.”

Cylically adjusted price / earnings ratio for the S&P 500 Index

Cyclically Adjusted PE Ratios

Source: www.econ.yale.edu/~shiller/data/ie_data.xls

The Asian Prosperity Fund is practically a poster child for the opportunity inherent in global, unconstrained, Ben Graham-style value investing. Its average price / earnings ratio stands at 9x (versus 18x for the FTSE 100 and 17x for the S&P 500); its price / book ratio stands at just one; historic return on equity is an attractive 15%; average dividend yield stands at 4.2%. And this from a region where long-term economic growth seems entirely plausible rather than a delusional fantasy.

Vice Admiral Stockdale was unequivocal: while we need to confront the “brutal facts” of the marketplace, we also need to keep faith that we will prevail. To us, that boils down to avoiding conspicuous overvaluation (in most bond markets, for example, and a significant portion of the developed equity markets) and embracing equally conspicuous value – where poor sentiment is likely to intensify subsequent returns. In this uniquely oppressive financial environment, with the skies darkening with the prospect of a turn in the interest rate cycle, we think optimism could be fatal. Or as Warren Buffett once observed,

“You pay a very high price in the stock market for a cheery consensus.”

Economics

World War One and the End of the Bourgeois Century

[Editor's Note: this first appeared on mises.org]

Last week marked the 100 Anniversary of the beginning of World War I. That war, which produced over 37 million casualties, not counting the related famines and epidemics that came in the war’s wake, also destroyed the political systems of numerous countries, setting the stage for fascism and communism in Europe. In the United States, and of course also throughout Europe, the war led to paranoia and political repression rarely seen during the previous century, and in the United States, the Wilson administration’s “anti-sedition” efforts led to a large-scale destruction of basic American liberties unmatched even by the Alien and Sedition acts of the eighteenth century.

For Americans especially, the war and the more than 100,000 American war dead gained nothing more than a post-war depression. While some Europeans could at least claim to be fighting against physical invasion, the Americans fought for nothing except to defend some authoritarian regimes from some other authoritarian regimes. The idea that the war had something to do with “democracy” was obviously untrue even at the time, and in retrospect, the claim is all the more ridiculous given the rise of totalitarianism, which was fostered by the Treaty of Versailles.

The deadly effects of the war, the repressive measures enacted by supposedly enlightened regimes, and how the war paved the way for its even bloodier sequel twenty-five years later, have been covered by a number of excellent historians and economists, including Ralph RaicoRobert Higgs, Hunt Tooley, and Murray Rothbard. The war led to revolutions in ideology, public administration, government, and war itself. Few of these changes improved the lives of ordinary people, and most of these changes led to the commodification and cheapening of human life and human freedom.

The revolutionary nature of the war is little disputed today, but rather than focus on the war itself or its aftermath, it may also be helpful to consider what the war relegated to the dustbin of history.

The Economics of the Bourgeois Century

What some historians now call “the bourgeois century” was the ninety-nine years between the Napoleonic Wars and the beginning of the First World War. From 1815 to 1914, there was no major war in Europe and the standard of living increased far beyond anything ever witnessed before as industrialization, mechanization, and the resulting increases in worker productivity spread throughout the continent.

During the middle of the century, free trade became more widespread than ever, with labor and capital enjoying never-before-seen freedom to move across national borders. Throughout much of central and western Europe, no passport was necessary to move between nation states. Indeed, passports and border checkpoints became associated with despotic and backward countries like Russia.

It was during this period that we saw the rise of the Cobdenites (also known as the Manchester liberals) in Britain who, beginning with the Anti-Corn Law League, slowly rolled back the mercantilist rule of the landed nobility who opposed free trade. The rise of the middle classes both economically and politically were buttressed by mass movements of classical liberalism Europe-wide that demanded greater economic freedoms for themselves and fewer tax-funded privileges for the ruling classes.

As free trade spread, and lessened the advantages of controlling foreign colonies, imperialism receded as well, and an international peace movement arose with John Cobden, dubbed “the international man” as one of its celebrities.

At the same time, many luxuries became available to the middle classes, and this was a time when much of what we now take for granted was quite novel. It was during this time that something that might be recognized as “the weekend” became known. For most people it was still just a one-day affair (Sunday), but it was the first time in human history that average people had the ability to not only stop work for a few hours, but to actually spend some money on recreation such as a short trip to the seaside, or shopping, organized sports, or a trip to a museum, play, or other cultural event.

The new economic realities led to major changes in families as well. For the first time, a large number of parents could afford to formally educate their children in schools or with books. More leisure and income also meant that parents could give children individual attention, play games in the home, read books as a family and more. Fewer and fewer children needed to work to help the family maintain a subsistence living. With the economic liberation of children also came much better conditions for women who became far better educated, and became valued for their ability to manage complex tasks such as the education of children, household hygiene (no small matter in a nineteenth century city) twice-a-day food shopping and more. Moreover, men and women began to engage in the odd practice of marrying for reasons of “sentiment and physical attraction” as marrying for financial reasons became less a matter of life and death. Just as leisure on Sundays allowed for more public recreation, leisure time within the family allowed for more “private” recreation as well, which was complimented by marriage manuals, such as those found in France, that reminded men to tend to women’s sexual needs.

The Rise of Imperialism and the Road to World War I

Naturally, sex, family, and an afternoon at the beach struck many conservative politicians and “deep thinkers” as frivolous wastes of time. Family time and leisure was wasted on mere ordinary people when far more “honorable” pursuits such as nation-building, colonial adventurism, and the art of war were being neglected.

Certainly Otto von Bismarck, a great enemy of the liberals, was expressing contempt for such domestic pursuits when he declared his disdain for the Manchester liberals as “Manchester moneybags” who were concerned not with the glory of the nation-state, but with making money.

By the late nineteenth century, bourgeois liberalism was in decline. Assaulted on one side by the Marxists and other socialists, and on the other side by conservatives, nationalists, and imperialists, the great powers of Europe began to sink back into mercantilism, nationalism, and imperialism. The Scramble for Africa was representative of the new imperialism as the European great powers looked ever more aggressively for new colonies. Meanwhile, the British tightened their grip on India while inventing the concentration camp in its efforts to starve the Boers into submission.

In the late nineteenth century, Bismarck was hard at work inventing the welfare state and hammering together Germany into one unified nation-state. By the turn of the century, one of the few remaining liberals, Vilfredo Pareto in Italy, was able to declare that socialism had finally triumphed in Europe.

In the decade before the First World War, The generation of European liberals such as Gustav de Molinari, Cobden, John Bright, Herbert Spencer, Eugen Richter, and others were dead or near death. There were few young, new liberal scholars to replace them.

At the same time, trade barriers abound throughout Europe as the great powers turned to the economics of imperialism characterized by mercantilism, tariffs, border controls, regulation, and militarism.

Conclusion

Europe during the bourgeois century was certainly no utopia. The new cities were filled with disease, pollution, and crime. Medical science had yet to achieve what it would in the twentieth century, and of course, standards of living remained low when compared to today. But even if we consider these problems, which plague many societies even today, the enormous gains made for ordinary people, thanks to industrialization and the rise of free trade, were fostered all the more by the rise of classical liberalism which actively sought to avoid war, political repression, and economic intervention as the means to a more prosperous society.

Indeed, historian Daniel Yergin would come to refer to this period as the time of “the first era of globalization” and to note that “the world economy experienced an era of peace and growth that, in the aftermath of the carnage of World War I, came to be remembered as a golden age.”

Liberalism was already deeply in decline by 1914, but the First World War was perhaps the final nail in the coffin. Following the war, depression followed, and for Europe, this was followed by hyperinflation in many places, political instability, a declining standard of living — and finally — fascism, communism, and war. In the United States, which managed to avoid most of the destruction of the war, prosperity was achieved during the 1920s, only to be lost and followed by fifteen years of depression and war.

One hundred years after the beginning of the end for bourgeois Europe, we are fortunate to be looking on a new classical liberalism, now known as libertarianism, which is not in decline, but instead is making great strides globally in the face of a still-ascendant ideology of interventionism, mercantilism, and war. We can hope that a third world war will not bring it all crashing down.

Economics

A time of universal deceit

 

“Individuals who cannot master their emotions are ill-suited to profit from the investment process.”
– Ben Graham.

“What really broke Germany was the constant taking of the soft political option in respect of money..
“Money is no more than a medium of exchange. Only when it has a value acknowledged by more than one person can it be so used. The more general the acknowledgement, the more useful it is. Once no one acknowledged it, the Germans learnt, their paper money had no value or use – save for papering walls or making darts. The discovery which shattered their society was that the traditional repository of purchasing power had disappeared, and that there was no means left of measuring the worth of anything. For many, life became an obsessional search for Sachverte, things of ‘real’, constant value: Stinnes bought his factories, mines, newspapers. The meanest railway worker bought gewgaws. For most, degree of necessity became the sole criterion of value, the basis of everything from barter to behaviour. Man’s values became animal values. Contrary to any philosophical assumption, it was not a salutary experience.
“What is precious is that which sustains life. When life is secure, society acknowledges the value of luxuries, those objects, materials, services or enjoyments, civilised or merely extravagant, without which life can proceed perfectly well but which make it much pleasanter notwithstanding. When life is insecure, or conditions are harsh, values change. Without warmth, without a roof, without adequate clothes, it may be difficult to sustain life for more than a few weeks. Without food, life can be shorter still. At the top of the scale, the most valuable commodities are perhaps water and, most precious of all, air, in whose absence life will last only a matter of minutes. For the destitute in Germany and Austria whose money had no exchange value left existence came very near these metaphysical conceptions. It had been so in the war. In ‘All Quiet on the Western Front’, Müller died “and bequeathed me his boots – the same that he once inherited from Kemmerick. I wear them, for they fit me quite well. After me Tjaden will get them: I have promised them to him.”
“In war, boots; in flight, a place in a boat or a seat on a lorry may be the most vital thing in the world, more desirable than untold millions. In hyperinflation, a kilo of potatoes was worth, to some, more than the family silver; a side of pork more than the grand piano. A prostitute in the family was better than an infant corpse; theft was preferable to starvation; warmth was finer than honour; clothing more essential than democracy; food more needed than freedom.”
– Adam Fergusson, ‘When Money Dies: the nightmare of the Weimar hyperinflation’.

“We are currently on a journey to the outer reaches of the monetary universe,” write Ronni Stoeferle and Mark Valek in their latest, magisterial ‘In Gold we Trust’. Their outstanding work is doubly valuable because, as George Orwell once wrote,

“In a time of universal deceit, telling the truth is a revolutionary act.”

Orwellian dystopia; Alice-Through-The-Looking-Glass World; state-sanctioned inflationist (deflationist?) nightmare; choose your preferred simile for these dismal times. The reality bears restating: as the good folk of Incrementum rightly point out,

“..the monetary experiments currently underway will have numerous unintended consequences, the extent of which is difficult to gauge today. Gold, as the antagonist of unbacked paper currencies, remains an excellent hedge against rising price inflation and worst case scenarios.”

For several years we have advocated gold as a (necessarily only partial) solution to an unprecedented, global experiment with money that can only end badly for money. The problem with money is that comparatively few people understand it, including, somewhat ironically, many who work in financial services. Rather than debate the merits of gold (we think we have done these to death, and we acknowledge the patience of those clients who have stayed the course with us) we merely allude to the perennial difficulty of investing, namely the psychology of the investor. In addition to being the godfather of value investing, Ben Graham was arguably one of the first behavioural economists. He wisely suggested that investors should

“Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it – even though others may hesitate or differ. You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”

Graham also observed,

“In the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand.”

Judgment has clearly been tested for anyone who has elected to hold gold during its recent savage sell-off. The beauty of gold, much as with a classic Ben Graham value stock, is that as it gets cheaper, it gets even more attractive. This should be self-evident, in that an ounce of gold remains an ounce of gold irrespective of its price. This puts gold (and value stocks) markedly at odds with momentum investing (which currently holds sway over most markets), where once a price uptrend in a given security breaks to the downside, it’s time to head for the hills.
A few highlights from the Incrementum research:
 Since 1971, when President Nixon untethered the dollar from its last moorings to gold, “total credit market debt owed” in the US has risen by 35 times. GDP has risen by just 14 times. The monetary base, on the other hand, has risen by, drum roll please.. some 54 times.
 If, like Incrementum and ourselves, you view gold primarily as a monetary asset and not as an industrial commodity, it has clearly made sense to have some exposure to gold during these past four decades of monetary debauchery.
 They say a picture paints a thousand words. Consider the following chart of total US credit market debt and ask yourself: is this sustainable?

 

A time of universal deceit (1)

(Click image to view larger version)

 

To repeat, there are only three ways of trying to handle a mountain of unsustainable debt. The options are:
1) Maintain economic growth at a sufficient rate to service the debt. We believe this is grossly unlikely.
2) Repudiate the debt. Since we also operate within a debt-based monetary system (in which money is lent into being by banks), default broadly equates to Armageddon.
3) Inflate the debt away.

At the risk of pointing out the obvious, which path do we consider the most likely? Which path does it suit grotesquely over-indebted governments and their client central banks to pursue?
But it does not suit central banks to be caught with their fingers in the inflationary cookie jar, so they now have to pretend that deflation is Public Enemy Number One. Well, deflation is certainly a problem if you have to service unserviceable debts. So it should come as no surprise if this predicament is ultimately resolved through an uncontrollable and perhaps inevitable inflationary or stagflationary mess.

So we have the courage of our knowledge and experience. (In fact, of other people’s experience, too. As the title of Robert Schuettinger and Eamonn Butler’s book puts it, we have ‘Forty Centuries of Wage and Price Controls’ and their inevitable failure to draw upon. We know how this game ends, we just don’t know precisely when.) We have formed a conclusion based on facts and we know our judgment is sound. For the last two years, the crowd has disagreed with us on gold. We think we are right because we think our data and reasoning are right. Not that we don’t see value in other things, too: bonds of unimpeachable quality offering a positive real return; uncorrelated assets; value and ‘deep value’ stocks. And we ask a final question: if not gold, then what? Are we deceiving ourselves – or are our central bankers in the process of deceiving everyone?