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By Alasdair Macleod, on 12 November 11
In the last two weeks the headlines have switched from Greece to Italy. Financial and economic commentators who dismissed Greece as a small cog in the Euroland machine are now seriously alarmed and see no solution to Europe’s sovereign debt crisis other than the short-term expedient of getting the European Central Bank to print lots of money. They castigate Germany’s sound money approach, ignoring the fact that it has been central to Germany’s economic success, preferring to commend the loose-money economics of the unsuccessful “PIIGS” (Portugal, Ireland, Italy, Greece and Spain). And when listening to them, just remember that none of them foresaw this crisis, when it was obvious to Austrian economists in the early days of the banking crisis.
Keynesian and monetarists believed that the problems surfacing in the PIIGS would be resolved by economic growth, which would follow so long as governments maintained their deficit spending. As events are now proving, this analysis was flawed, which is why Keynesians are now confused. They should open their minds and absorb Austrian economic theory to gain a proper understanding of human actions and how people are affected by money and credit.
The first thing they will learn is that the economic benefits of credit expansion are a myth. All it does, by a process of capital redistribution – from savers to those who are first in line to receive the new money – is distort the economy and restrict its long-term potential. By lowering interest rates and diverting private sector resources from genuine production to government spending, the economy becomes less efficient and malinvestments occur. The mistake has been to only consider the visible benefits, such as short-term job creation, while ignoring the destructive effects of deficit financing.
The distortions created by easy money and deficit spending will naturally try to reverse themselves as surely as night follows day. The recession that follows the temporary boom is the way an economy cures itself from unsound money and government intervention. This is hard for interventionist governments to accept because it strikes at the heart of their existence. And while printing money and credit is always popular with an electorate that does not understand what is happening to their money, reversing the process is readily noticed and immensely unpopular.
This brings us back to Euroland’s problems. The creation of the euro twelve years ago allowed banks to expand credit massively in the mistaken belief that sovereign risk had been eliminated. The result was that spendthrift governments availed themselves of cheap credit. Eurozone governments, particularly the PIIGS but also France and Belgium, have squandered huge sums to prevent the unwinding of malinvestments and other economic distortions, preferring to perpetuate existing malinvestments. The only solution is for them to let the unwinding happen, which is what the financial markets (for which read reality) are now forcing them to do.
What we are seeing, the markets unwinding economic distortions from the past, is a necessary process and therefore beneficial, a point which goes completely unrecognised. If only governments had the sense to understand this, it is not too late to plan wisely for regenerated economies and a sounder Europe. Unfortunately, the gut reaction of the political class and its advisors is to continue as before at all costs, deferring this necessary adjustment and increasing its eventual severity.
There is no joy for the informed spectator in seeing continuing economic destruction. However harsh it may be in the short-term, the EU elite needs to start paying attention to Austrian School remedies to Europe’s financial woes – and fast.
This article was previously published at GoldMoney.com
By Detlev Schlichter, on 8 November 11
Keynesian and other mainstream economists cannot explain the present crisis. That doesn’t seem to bother them.
All they can offer is a description of symptoms, such as with their favourite phrase of lack of ‘aggregate demand’, which, if you think about it, doesn’t really explain anything. How come demand dropped? Why did it drop now and not at any other time? Whose demand dropped? (Hint: mine didn’t.)
“Sigmund Freud meets Dr. Ruth”
But hey, when faced with a lack of proper economic explanations, you can always fall back on some amateur psychology. Everything must be down to what goes on in people’s heads, right? People just get all mixed up. Too pessimistic. Animal spirits, anybody? That’s why it is always up to those cool-headed guys and gals in government to use their policy tools to change expectations, change the psychology of people, cajole everybody into some elevated state of positive thinking and hence more economic activity. Save the masses from their own silly notions in their tiny heads, like saving and getting rid of debt. They all just clam up and save. Pitiful. But most importantly, why even worry about explaining the recession if you are confident, if you simply know deep down in your heart, how to get out of it.
Most politicians don’t know any better. They certainly don’t know any economics. So the same toxic policy mix of Keynesian deficit spending and Monetarist money printing has been implemented around the world since this crisis started four years ago. Just like in any other recession of the past forty years, ever since Nixon cut the last link to gold and fulfilled every interventionist’s wildest fantasy: unlimited paper money under full control of the state! Yeah, baby, no more recessions!
Alas, it is not working, is it?
Rates were cut and the state did not only spend money it didn’t have, as usual, it spent much more money it didn’t have. But the economy did not recover. So more of this policy was implemented. And then, more again. In fact, by any standard, never before in modern times has the economy been ‘stimulated’ more through Keynesian and Monetarist government intervention than over the past four years. Balance sheets of major central banks have tripled, banks have been receiving limitless funds for free and will continue to do so forever, and governments are running deficits the likes of which mankind has only ever seen at the height of major wars, and which are increasingly funded by the printing press.
It is still not working.
You would probably guess that the interventionists of Keynesian and other ilk would be a bit more humble by now. Maybe check a few of those premises in their models? Or maybe start thinking again about those elusive explanations for what’s wrong with the economy in the first place? Are we really suffering from a lack of paper money and government spending? Maybe it is not simply down to all of us being too depressed, morose, and in need of some policy Prozac. Maybe something else is broken.
Alas, no. The academically trained Keynesian economist is too committed to his or her beliefs to let the facts get in the way. Why has policy not worked? Because, wait for it, we have been too timid. We need the same policy. We just need more of it. A lot more.
More monetary madness
Here is the High Priestess of Keynesianism, Christina Romer in her recent op-ed in the New York Times. She suggests a radical policy ‘change’ at the Federal Reserve: toward more money printing.
Rather astutely, she calls for Helicopter-Ben to embrace a Volcker-moment. Maybe by quoting the poster boy of the Reaganites and the hard money crowd she hoped to reach a new audience for her tiring and dreary old policy recipe of more and bolder interventionism. She almost had me fooled. Wait a minute, I thought. Volcker? He is the guy who abruptly stopped the printing press and allowed high real market rates to cleanse the system of the dislocations of previous booms and to squeeze inflation out of the system, thus giving the paper dollar another lease of life – albeit one that is quickly running out. I thought, has Christina finally seen the light? Has she begun to realize how massively disruptive a constantly expanding supply of fiat money is for an economy? Is she calling, as I do, for an end to this monetary madness of zero policy rates and quantitative easing?
Well, no, she isn’t. She wants the Fed to print more money, much more. She wants the Fed to adopt a nominal GDP target. This will allow the Fed to become even more aggressive in its monetary policy and to communicate this aggressiveness better. Make people trust in that aggressiveness. And this is important for Romer. The communication. As we have seen, for the good Keynesian the policy was never wrong. The policy was just not ambitious enough. All it needs is a more ambitious goal and better communication. People just have these bad thoughts and wrong expectations. The public is just not playing ball, not going along with this enlightened economic program. Well, we’ll teach them.
The Volcker-analogy works like this for Romer: In 1979 inflation was too high and small rate hikes didn’t work. So Volcker implemented a much tighter policy and crushed inflation. And it worked because people believed him. Today unemployment is too high. Gradual policy easing – not sure what planet Christina is on but from where she is sitting monetary policy in the U.S. must have appeared to be gradual, hmmm – is not working either. So Bernanke needs to become more aggressive, and publicly so. Because if people believe that you stick to your policy, which – please remember – was of course the right policy to begin with, then the policy will really begin to work. You just need to drill it into those blockheads.
Every first semester economics student, not only those at Berkeley where Romer is economics professor, should be able to tear this apart with ease. The analogy with Volcker is, of course, completely silly. Volcker used monetary policy to fix a monetary problem, inflation. Stopping inflation by not printing money any more is pretty straightforward. The link is kind of — direct? To be honest, it doesn’t even matter whether the public believes or not. If you stop printing money, inflation will drop. Period. The link is that direct. You don’t need the accompanying belief system.
Was there full employment in Weimar Germany?
However, unemployment or the level of ‘aggregate demand’ is decidedly not a monetary phenomenon. Only in the airy-fairy dreamland of macroeconomic models is there a direct link. To assume that we can simply and straightforwardly establish whatever nominal growth rate and level of employment we desire by means of the printing press is precisely the type of naïve ‘building bloc economics’ that got us into this mess in the first place. According to this world view, the economy is just a machine, and all we need to do is to pull the right levers. Or it is like a cooking recipe, in which we need to simply change the ingredients a bit and – voila! The soufflé will rise!
It is precisely because (a certain type of) economists have been telling us – wrongly! – that we can have more growth and high employment by constantly debasing money that we created this highly levered economy over the past four decades that is so thoroughly addicted to ever larger fixes of cheap credit and that is now choking on excessive debt and weak banks. By printing money and artificially lowering interest rates we have, again and again, bought near-term economic growth at the expense of long-term economic imbalances. That this was bad economics everybody is now learning the hard way. Everybody, that is, except Christina Romer. Her simple world view is unshaken.
It is this weird combination of childlike belief in the simplicity of the problem (aggregate demand, lack of optimism) and the striking arrogance of the notion that the government can and should control the economy by simply pulling at the right strings hard enough, that makes Romer’s article such an illustrative example of the intellectual dead end that is mainstream economics today.
Romer has apparently no notion of relative prices and of the importance, in particular, of interest rates for coordinating saving with investment. She cannot see that lowering interest rates administratively and injecting new money into the financial system will have many additional effects, other than lifting some statistical measure of aggregate economic activity. Easy money will always change resource use and capital allocation. Cheap credit encourages borrowing and debt accumulation, and will cause additional problems for the economy later.
Romer cannot perceive these complexities. In her ivory tower, the world is one of simple statistical aggregates and large wholes that you can direct and mend to your liking. You just add the desired real growth rate (2.5 percent) and the acceptable inflation rate (2 percent) and stir it nicely to come up with the nominal growth rate (4.5 percent). How hard can it be?
We have some indication that Bernanke is not very sympathetic to this proposal at present. It doesn’t look like this will become official policy any time soon. But who knows? A lot of what is now accepted monetary and fiscal policy in major countries and debated dispassionately by financial market economists would only a few years ago have been the mark of the economic crank, or the populist policy program of some economic backwater just before it was put under IMF surveillance.
But what is striking is this: such rubbish emanates from the highest echelons of academic economics in America. Christina Romer is economics professor in Berkeley, California, and I fear that a lot of very bright young people burden themselves and their families with student loans and waste valuable time absorbing such drivel. If Romer is all that economics in Berkeley has to offer, why not emulate the late Steve Jobs and drop out?
This article was previously published at Paper Money Collapse.
By Detlev Schlichter, on 5 November 11
Reproduced by kind permission of Jacob Wolinsky at ValueWalk.com
Can you tell us a little bit about your background?
I studied economics in my home country, Germany, and joined J.P. Morgan as a trader in Frankfurt in 1990. By 1996 I had become a portfolio manager in J.P. Morgan’s asset management division and moved to London, which I still call my home. I specialized in European and global bond portfolios. From 1998 to 2001 I worked at Merrill Lynch Investment Managers, which has since become part of BlackRock, and in 2001 I joined Western Asset Management, the Pasadena-based bond specialist. For Western I oversaw their London-based investment team and was lead portfolio-manager for all their global strategies. When I left Western in 2009 my team there oversaw roughly $65 billion in assets under management for institutional clients from around the world. I look back on my years in the business with many fond memories. I worked with some interesting people and had some fascinating clients. But by 2009 I had become very pessimistic on our financial system as a result of my study of Austrian School economics and my own experience after almost two decades in the business. The two perspectives combined to form a rather unpleasant outlook. I wanted to step outside the industry, think things through, and write a book about it.
What investing style do you subscribe to?
I am not sure I subscribe to any identifiable style, or that I even consider it particularly desirable to do so. Let me explain. I spent almost 20 years in the institutional asset management business. There is very limited room to develop your own style to begin with. These companies are asset-gathering companies. They need to constantly grow and attract new clients. In order to do that they not only try to establish a decent track record but also a specific house style and a clear and distinguishable process that they can market. They try to create a brand. As a portfolio manager you have to play along and do things in a way that fits the process. Incidentally, that was something I was actually quite good at. Now it so happens that certain styles work for some time and then stop working. Markets constantly change. In the industry, however, whenever somebody has good numbers for a while and a good story about how those numbers have been generated, he is usually in a sweet spot. New clients come rushing in. But I have become very cynical in this regard. That is usually the moment you should sell these firms or money mangers. I accept that my take on the style-question is unusual. But that is how I see it.
The truth is I tried many different things over the years. Only now, that I am out on my own, outside the mainstream industry, can I look at things with an entirely open mind, which is refreshing. I like Doug Casey’s distinction between traders, investors and speculators. Many people call themselves investors when what they really do is trading. This is certainly true of many ‘investors’ in the asset management industry. I would now call myself a speculator. Most of the time you do nothing. Until you spot a major dislocation, or a major event or an opportunity, something that you have a completely different view on from most other people. That’s when you go in and take risk. Example: I am convinced this crisis is misunderstood by most. We are witnessing the failure of our fiat money system. This will get much worse. I try to position myself for it.
What attracted you to the Austrian school of thought?
I came across some writings by F.A. Hayek by chance more than twenty years ago. I can honestly say that I felt immediately that I was reading something special, something that made sense, that was true. I found it exceptionally convincing, and it made a huge impression on me. For the next four years I read everything Hayek wrote. Then, I discovered the other Austrians, Mises, Rothbard, Menger. To sum it up, I would say that it is the methodology that makes the Austrian School so special. Ludwig von Mises, for me, is the unsurpassed master of the Austrian School. He understood better than anybody what economics is about, what it can do and what it cannot do, and how it should go about it. Austrian School Economics starts with the individual actor. Purposeful individual action and human cooperation on markets is the driving force behind all economic phenomena. From the starting point of the individual, the Austrians reconstruct and explain all institutions of the market – from the bottom up, so to speak. By contrast, most modern economists approach economics as if it was a natural science, where we must collect observations, statistical data, and look for patterns. This is the right approach for natural sciences because in nature we can’t perceive of purposeful action. But we do understand the actions of humans in the economy. The approach can be and has to be different. Furthermore, macroeconomists implicitly assume that the statistical aggregates and the large wholes that they work with in their models (consumption, investment, retail spending, aggregate demand, and so forth) are what really interact with one another in the real world. This is a tremendous intellectual error. The economy is ultimately driven by countless individual decision-makers. The Austrians do not lose sight of that.
It is no surprise to me that the Austrian School has such a strong appeal for real-life entrepreneurs and risk-takers. No other school of thought understands entrepreneurship, risk-taking, capital accumulation and capital maintenance, relative prices and the real-life elements of time and error, like the Austrian School does. Of course, politicians, central bankers and state bureaucrats are, by contrast, drawn towards mainstream macroeconomics. It gives them the illusion that the economy can be planned and manipulated from the top down.
What inspired you to write a book?
When you begin to understand Austrian monetary theory you realize that our financial system is built on quicksand – elastic, constantly expanding fiat money to be produced without limit and at full discretion by the central banks. I realized that the growing instabilities and dislocations that I observed in my work-life as a portfolio manager over the past two decades were the inevitable consequence of our monetary infrastructure. What amazed me was that nobody around me saw it that way. Whenever a credit boom threatened to turn into a credit bust – as it sooner or later must – everybody was calling for a monetary stimulus, for lower rates and for policy accommodation to extend the credit boom further. Such a policy may indeed prevent a correction now, but only at the cost of making an even bigger correction necessary in the future. But everybody in financial markets is so indoctrinated with a specific and narrow subset of modern macroeconomics – I would say the most toxic aspects of Keynesianism and Monetarism – that everybody believes any policy to be a good one if it only creates some near-term GDP boost. There is no perception of long-term dislocations and market imbalances, of what the consequences of such a policy of artificially cheap credit must ultimately be. I think a gigantic intellectual bubble exists in which most financial market participants operate. That bubble will probably only get pricked by real events, i.e. the massive crisis that is now unfolding. But I wanted to try and give people a different perspective, to debunk some of the erroneous common wisdom that is readily accepted by so many people in the business.
Can you explain to people what your definition of money is?
Money is the medium of exchange. It is the most fungible good in the economy and therefore most readily facilitates exchange of property. It is neither a consumption good nor an investment good. We hold it not to satisfy any of our consumption needs, nor to generate a return. We have demand for it because it gives us flexibility. To hold money balances means to hold purchasing power in its most readily tradable form.
Capitalism developed on the basis of inelastic, inflexible and apolitical commodity money, such as gold and silver – inelastic in its supply and outside political control. Today we live in a world of entirely elastic paper money under discretion of the state, and for the first time in history, such a system spans the entire globe. Remember also, that today’s fiat money system only came into full bloom on August 15, 1971.
Today, most mainstream economists maintain that the perfect elasticity of the money supply is a plus. My book argues that this is wrong. The relative inelasticity of gold makes gold a superior form of money. Elastic money systems must ultimately collapse. Throughout history they always have.
Can you tell us about the US system pre-Fed era?
I should stress first that I am not a monetary historian, although there is a short chapter on the history of paper money systems in my book – all of these systems collapsed by the way. Understanding monetary systems requires theory. History can illuminate concepts or raise new questions. Only theory can explain.
Prior to the founding of a central bank, the Federal Reserve, in 1913 and the subsequent abandonment of a gold anchor in 1933 (domestically) and 1971 (internationally), the US used, for the most part, commodity money. I say ‘for the most part’ as America conducted some interesting experiments with paper money as well, all of them complete disasters. In fact, one of the first historic examples of a paper money system outside Medieval China, was Massachusetts, which, in 1690 when still a British colony, issued paper money to fund military excursions into French Quebec. Then there were the famous continentals, a paper money issued by the Continental Congress in 1775 to fund the Revolutionary War. These early experiments with paper money ended like they always do – with worthless paper tickets. Then in the early part of the 19th century the dollar was defined as a specific amount of gold. This was proper commodity money, a gold standard. There was no central bank. Gold was money. Commercial banks had to redeem their banknotes in specie, which set tight limits on bank credit creation. But the government couldn’t stop interfering, in particular whenever it needed cheap credit, usually to fund wars. Requirements to redeem in physical gold were lifted on a couple of occasions, so in the wake of the War of 1812, when the US was fighting Britain again, and most famously during the Civil War, when the greenbacks were issued and soon inflated into worthlessness. In 1879, the US joined Britain, and in fact most of the then industrialized world, in what became known as the Classical Gold Standard. After the inflation of the greenback era, a corrective deflation was allowed to unfold (but strong economic growth continued nevertheless), and from 1879 to 1914 there was no meaningful deflation or inflation in the system at all. This was a time of hard, inflexible and stable money. This was a period– in the US and globally – of solid economic growth, rising living standards and growing international trade, and of harmonious economic relationships between countries. The Classical Gold Standard was not perfect but probably the best monetary system we have had so far.
Many people have proposed going back to the gold standard? We had many depressions and recessions while on the gold standard, do you think it would be a good idea?
Yes, we should definitely return to a gold standard — not one that is “managed” by the government, but a proper gold standard with no involvement of the state. I wouldn’t hold my breath, however. As we have seen, governments love fiat money. It gives them control over the economy. We will eventually return to some form of gold standard but only after the complete collapse of the present system in a major crisis.
The elasticity of money – which means periods of money expansion and credit booms followed by periods of monetary stagnation or contraction – is the main cause of business cycles. How did this occur under a gold standard? Answer: the spread of deposit banking and fractional-reserve banking, in particular in the late 19th century. These banking practices introduced an element of elasticity into the money supply. They can be profitable for the banks but they are risky and are destabilizing for the broader economy, even under gold standard conditions. That is why many Austrians argue for a 100-percent gold standard, for 100 percent reserve banking. I am not in that camp. I think fractional-reserve banking should not be banned, cannot be banned, and ultimately does not need to be banned. Many of these issues can be solved in a free market. We may have the occasional recession but the system can cope with that.
However, the Fed was founded in a joined effort by politicians and bankers in order not to restrict and contain fractional-reserve banking but, to the contrary, in order to encourage and subsidize it. Money has since not become less elastic but much more elastic. Of course, credit cycles still occur. They now only get much, much bigger. We had a thirty-year credit boom. We will now get a major credit bust. Compared to what we are facing now, the recessions of the gold standard era will look like a walk in the park.
Why do most policy makers seem to be in the Keynesian school and not the Austrian school of thought?
Please remember my answer to the question above about the appeal of the Austrian School. The methodology of the Austrians is superior, but the methodology of mainstream macroeconomics, and Keynesianism in particular, is appealing to politicians. These schools perceive the economy as an organism that sometimes performs below potential, which then provides a convenient excuse for the politicians to get involved. Keynesianism has popularized the concept of ‘aggregate demand’. A recession is now seen simply as a lack of aggregate demand. So politicians have a pseudo-scientific excuse to run deficits and spend money they don’t have. Strangely, the fact that “lack of aggregate demand” can at best be a symptom but hardly an explanation of the recession does not appear to bother too many people.
Truth is, the recession is the result of imbalances that the economy accumulated during the previous artificial credit boom. Once these dislocations (such as excessive levels of debt, overextended banks and inflated asset markets) exist, the cleansing of a recession is needed and unavoidable. That is not a popular message among politicians.
Greece was forced to implement austerity and the budget deficit as % of GDP went up and unemployment skyrocketed. What are your thoughts on the reason why this occurred?
That is not surprising at all. You have to remember that in today’s world GDP is a very poor measure of economic health. In the EU, 50 percent of recorded economic activity is conducted by the public sector. In my adopted home country, the UK, it is 53 percent. The public sector spends more money than all private individuals and corporations put together. This is more socialism than capitalism.
We don’t have to assume that everything the state does is pure waste. For some of these things there would be a proper demand even in a state-less free market. However, we – and in fact the state bureaucrats as well – have no means of telling what is truly demanded by the buying public and what is of marginal or of no productivity, and what is thus complete waste, because the public sector operates outside of market prices and without the guidance of profit and loss. But whatever the state does enters the GDP statistic just the same.
So whenever the state is being cut back – which hardly ever happens, only in cases of default, which is why I am a big advocate of government defaults – a lot of things drop out of the GDP statistics and unemployment goes up because public sector employees are laid off. This drop in GDP is not a lasting problem. We know that a lot of state activity was at least suboptimal to begin with. Now resources (including labor) are being redirected to the private sector, where they will eventually be employed again, and this will enhance wealth and prosperity in the long run. In my view, Greece should stop paying anything to her creditors, declare full default, and shrink the state drastically. For a short while, the statistics would look dreadful. Then Greece would have a massive and lasting recovery. With no debt, a small state and a free economy it could, after some time, outperform everybody else in Europe.
Taxes went up in the Clinton era and the economy still boomed, do you think slightly increasing taxes will be detrimental to the economy?
I object to taxes for moral and ethical reasons (which are subjective) and economic considerations (which are objective). Taxes are always detrimental to the economy. They were so, too, under Clinton. It so happened that other things outweighed their negative impact. Remember, the mega credit boom that started in the early 80s was still in full swing, the Greenspan put was still operable, the NASDAQ bubble was still being inflated. Some of the growth of those years was genuine, that is, based on entrepreneurship, capital creation and innovation, but a lot of it was also the result of easy money. Under these circumstances the tax hikes were not felt that much, that is all.
Today’s environment is very different. The credit boom has ended, and has ended for good. The state and the financial sector have benefitted most from decades of cheap credit and are now severely overstretched. The economy overall is much weaker. Higher taxes would be detrimental. Also, the idea that the gigantic government deficits could be closed with higher taxes is idiotic. To the US I would give the same advice as I just gave to Greece: default, shrink the state massively, go back to hard money. Alas, they won’t do it.
I am curious what you think about the major currencies; Dollar, Euro, Yen, some of the emerging countries?
They are all locked in a deadly race to the bottom. All these currency-areas face the same problems, which are the typical problems of a fiat money system reaching its endgame: massive public debt, uncontrollable deficits, weak banks, addiction to cheap credit and constant asset price inflation. None of these governments want to face up to the reality that they are broke and that what the economy needs is for the market to be allowed to liquidate unsustainable levels of debt and other economic imbalances. As that is deemed politically unacceptable, they will continue to try and buy time by producing ever more currency units and injecting them into financial markets. Inflation and currency destruction will be the endgame. I would stay away from paper money as much as I can. Buy gold and silver instead, and certain other real assets. To guess which of these paper currencies will hit the bottom first is a mug’s game, in my view.
Is inflation or deflation a bigger threat right now?
Inflation and deflation are both unpleasant but it is wrong to call them both an equal threat right now. Allowing deflation now would have a clear advantage, namely it would bring the economy back to a state of balance and toward more proportionate and sustainable structures. A deflationary correction that would allow the liquidation of market dislocations would be painful but it would ultimately restore the economy to health.
If all market interventions, including cheap money from the Fed, would cease now, we would indeed face a sharp economic contraction and most likely a period of deflation. But this is ultimately unavoidable anyway. Current economic structures are simply unsustainable, and the market has a way of dealing with what is unsustainable: liquidate it. The market is craving a cleansing recession, including drops in certain prices. As I said before, this is deemed politically unacceptable. That is why we will get ever more aggressive monetary policy and ever more money printing. This will not solve our problems but it will lead to inflation and most likely complete currency collapse. My outlook for the coming years is inflation, much higher inflation, not deflation. The reason for that is policy.
Hopefully you won’t consider the following analogy tasteless but to ask what is the bigger threat, inflation or deflation, is a bit like asking a cancer patient what is the bigger threat, death or chemotherapy. Nobody will readily embrace either. But it appears to me that in constantly telling us that we need to avoid deflation at all cost, today’s policy establishment is telling us that we should avoid chemotherapy and accept death by hyperinflation.
What are your opinions on Gold?
Gold is the essential self-defense asset. Whenever fiat money systems enter their endgame and are about to collapse, gold comes back. It is the eternal form of money. As Greenspan once said (and he said it when he was already the head the world’s foremost paper money central bank): In extremis, nobody accepts paper money. Gold will always be accepted.
At its current price of $1,720 an ounce I still consider it cheap. Much more fiat money will be created in coming months and years. You want to own something that is not simultaneously somebody else’s liability (such “money in the bank” on your deposit or savings account) and that cannot be created for political purposes at will and without limit, such as paper dollars.
Don’t trade gold, accumulate it.
QEII, Operation Twist, thoughts?
These operations get ever more extreme. It is just part of the logic of the system. We are in a mess because of the trillions that were created out of thin air in the past. To keep the system going a bit longer, the central banks now have to produce ever more money ever faster. Will it stimulate the economy? Yeah, right.
Like a little hamster in his wheel, Bernanke will have to run ever faster to keep the printing press humming and keep the system from correcting. We will get QE 3 and QE 4, no question. By the way, Operation Twist could already be QE3 in disguise. On the face of it, the Fed is just selling short duration Treasuries and buying long duration Treasuries. But the Fed also promised to keep interbank rates near zero for a long time (meaning: forever), and to achieve that they may be buying back short-term Treasuries pretty soon. Listen, there are no exit strategies. The Fed’s balance sheet will continue to grow. It is already bigger than M1. We will get more and more money……
Flashback to September 2008, what do you think the Government should have done?
Nothing. I like Jim Grant’s term: “constructive inaction”. If you believe that the Fed and the government saved us from another Great Depression with all their bailouts and quantitative easing, think again. All they did was postpone the depression – and to make the final disaster worse. All these imbalances are still with us, many of them are larger and have been moved to the state’s balance sheet. Nothing is fixed.
But if you think that this advice – do nothing – is unrealistic and that the government, after having actively supported the build-up of this credit edifice for decades, cannot simply walk away from it once the house of cards finally unravels, then I would suggest the following: Any actions by the government should have been directed toward sustaining the payment infrastructure and maybe to minimize the fallout for bank depositors, who for a long time have actively be lured into entrusting their savings to an increasingly leveraged, government-supported banking system, which has now checkmated itself. I am not suggesting a debt-funded bailout of the deposit base. But the US government allegedly sits on 260 million ounces of gold, some of it confiscated from its own population. Current market value: $450 billion. That could have been handed back to the banks as a backstop against their deposits. This could have been the first step towards abolishing the Fed and returning the country to a gold standard.
If you were Ben Bernanke what would you do now?
Abdicate. His mandate is contradictory and impossible. He is supposed to provide a stable medium of exchange for the American public, and at the same time provide an unlimited backstop for Wall Street and Washington. Well, it is one or the other. We already know which one he chose.
Same question, Barack Obama?
Abdicate is again a good option.
I am not an American so I am looking at this from a distance. It strikes me that the presidencies of George W. Bush and Barrack Obama were both unmitigated disasters for their country. I don’t even think the two as men are necessarily bad or evil. As individuals they may be decent and have good intentions. But the politics are just shockingly bad. The growth of the state, of government involvement in the economy and in all walks of life, the budget deficits, the ever-growing debt pile, the aggressive monetization of debt and the dependency on cheap credit and ongoing market manipulation – this is a complete shipwreck by any standard but, if I may say so, particularly shameful for a country that for freedom-loving people around the world was once a beacon of liberty, opportunity and capitalism. As a generally pro-American libertarian, I can’t tell you how much it hurts to see this once great country go to bits like this.
What needs to be done? Stop printing money, return the country to a gold standard, default on the debt (it will never be repaid anyway!), shrink the state aggressively, stop all foreign wars – the military is the government’s biggest single expenditure item at close to $1 trillion a year.
If you think this is unrealistic then let me tell you that I think all of this will ultimately happen – but not by choice but by necessity, as a result of a massive crisis.
If you were Angela Merkel or Jean-Claude Trichet?
I think that what I said about Bernanke and Obama broadly applies to Merkel and Trichet as well. At the core, the problems are the same. Europe’s problem is not that many different countries share the same currency. Many more and much more different countries did the same between 1879 and 1914 under the gold standard, and it worked very well. The problem is precisely that they do not share an international, apolitical and inelastic commodity money, but a fully elastic and politicized fiat money that comes with built-in expectations of government and bank bailouts. Stop printing money, return to hard and de-politicized money, preferably a gold standard, and shrink the state – the advice is the same.
Who are you endorsing for US President? Ron Paul?
I think the entire political process, not only in the US, but in all modern mass democracies, has become a most degrading and dispiriting spectacle. I agree with P.J. O’Rourke: Don’t vote. It only encourages the bastards. Politics needs to be thoroughly delegitimized as a problem-solving device. It creates more problems than it solves. So I am not endorsing anybody.
Having said this, Ron Paul is, of course, by far the best choice from my point of view. I don’t think that this will surprise you considering what I said above. He is right about ending the wars, abolishing the Fed, returning to a gold standard, shrinking the state. But I fear that he doesn’t have a snowball’s chance in hell to win the presidency. So the crisis will continue. Don’t bet on politics. Trust your own reason. Be prepared.
By Sean Corrigan, on 2 November 11
In a recent op-ed in the Globe & Mail, Davos Man’s indefatigable mouthpiece for failed, mainstream thinking, Martin Wolf, passed the following verdict on the UK authorities:-
What Mr. Cameron recommends is even nigh on impossible. Why is that? Is it not common sense that if one has borrowed too much, one must pay it back? Alas, what makes sense for individuals does not make sense for an economy, because one person’s spending is another person’s income. Consider a closed economy. Income and spending must match. If the private sector decided to spend less than its income, to pay down debt and if the government also decided to stop borrowing, aggregate incomes would fall until they could no longer achieve what they wanted. All they would obtain, by following Mr. Cameron’s advice, is a race to the economic bottom
Were it not that their own confused thrashings about in the wellsprings of knowledge so muddy the waters that laymen—above all those most dangerous of laymen who have their hands on the levers of power—quickly lose all faith in their own ability to deliver a sensible analysis of the world around them, this would almost be funny.
Never ones to be overnice about maintaining a rigorous distinction between ‘money’ and wealth’; always eager to present the results of their own serial befuddlement and blind-alley reasoning as examples of ‘paradox’ or ‘fallacies of composition’; so entirely ignorant of the role of time or capital in the system that it condemns them to live in a kind of economic Flatland—they truly should be greeted with nothing more than a vitriolic, Swiftian scorn whenever they dare to start pontificating, rather than being according the hushed respect which so many confer upon their profound-sounding inanities.
In taking the latest outpouring from Mr. Wolf as an example, the first thing we should notice is that Keynesians are entirely happy to dismiss our Austrian idea of a ‘structure of production’ (of which their hallowed GDP components are only one, subjectively-selected subset), yet, when they start to espouse (as Wolf is doing here) their tautologous ‘circular flow of money’ argument, much less their insupportable ‘multiplier effect’, they are suddenly willing to rely upon the actual existence of a larger, ‘subsurface’, Hayekian component to the lesser, above-water, final sales part of the iceberg of spending and making upon which they are so fixated.
Moreover, even if we accept the lack of a deeper appreciation of the role of higher order activity which categorises these economic Neanderthals, this childish simplification of only considering the various ‘sectors’ as if such a statistically-compliant, but monstrous aggregation had any real world validity is really an intolerable reduction to the absurd of the workings of a vastly complex, ever-changing, economic network.
To say that ‘if the household sector doesn’t borrow, then government must’ is to roll the very different tastes, circumstances, and capabilities of – let’s take the case of the US – 300-odd million individuals, living in 100-odd million households, into one, indistinguishable blob of clay and then to throw it into the scales against the only true monolith in existence – Leviathan. Likewise, they do this when they talk about the ‘company sector’ as if the innumerably rich range of business enterprises, all eagerly beavering away to try to generate their various interested parties an income, is nothing but a mass of mindless automatons, marching monotonically to the same beat, as if they were part of a birthday parade for Kim Jong-Il.
They make a similar – but possibly even greater – error when they say that ‘if no-one at home will borrow, then someone abroad must do so’ and then fret that if that uncountable, planet-girdling, to-them-utterly-homogenous, ‘offshore sector’ does not wish to run the trade deficit which is that net borrowing’s usual counterpart (the crude mercantile implication being, of course, that ‘it’ will not wish to do so), then we’re all doomed. This is now to lump the 6.7 BILLION people outside our current exemplar of the US into a single, unthinking ant hill of identical preferences and possibilities!!!!
An extension of this approach is the constant appeal to the shibboleth that ‘we can’t ALL export our way out of difficulties’ – in direct contradiction of the truth that this is exactly what we each attempt to do, every single day of our working lives!
I try to export my skills to you and those like you endeavour to do the same – sometimes to me, but often to a group which does not (and, moreover, NEED not) actually include me at all. As we each expand our ability to produce those goods and services of economic value which we constantly seek to ‘export’ across our interpersonal boundaries – so as to profit from our comparative advantage of talents – and irrespective of whether these boundaries coincide with the artificial divisions which a ‘territorial monopoly of violence’ lays down (i.e., of whether they synch with political borders) – the chances are that we will all become richer in the process.
This is no less the case when—as is well-nigh inevitable— we find the odd, residual imbalance between A and B (and even the less common one between C and everyone else from D through Z) on that single instant when we take the misleading, if regular, snapshot upon which we depend for accounting and tax-related purposes of the inconceivably extended, thrummingly dynamic matrix of global interchange in which we cannot help but be participants.
Yes, to sustain spending above one’s means may lead one into difficulties, especially when that spending is not being directed to wealth-creation or future income generation and even more particularly when it is being financed (rather than savings-funded) by an inflationary increase in money and credit. Hence the present difficulties of US mortgagees, Chinese property speculators, and the many European sucklers at the fast-drying teat of the tutelary Provider State.
But, otherwise, such exercises in five-finger arithmetic are, at best, a travesty of economic reality and, at worst, a breeding ground for ill-judged macro-intervention and invidious, nationalistic finger-pointing.
A similar distortion comes about when it is argued that if present policies reduce spending and if, therefore, prices begin to fall, profits will evaporate and set in train a feedback of even lower incomes and outlays in the future.
Again, this is true only insofar as it goes and, typically, the Keynesian propounders of this deflationary doom do not go anywhere near far enough.
The key to resolving this supposed conundrum lies in those last two items—incomes and outlays. Profit is the difference between income and outgo (less such legal deductibles as depreciation, etc). So, even if most prices were to fall for the reasons the likes of Mr. Wolf often suggest they should, there is nothing to say that a given entrepreneur’s unit costs may not go down faster than his selling prices—particularly if the difficult climate induces him to maximise his efficiency, eliminate all sub-marginal activities, and focus narrowly on what is his most remunerative unertaking. In this case, it is impossible to argue that he will not be left with a profit.
Moreover, even if the monetary count of whatever profit that left him with turns out to be lower than it was before, there is nothing to say that this will not now allow him to buy just as many – and possibly more – goods and services as was his wont (including the direct purchase of labour services) since, as was first postulated, prices have meanwhile fallen, boosting the real or effective value of his net income!
Granted, this does require the unstinting exercise of an unsentimental flexibility on the part of all counterparties involved and it may even require the renegotiation of any monetarily-fixed obligations, such as debt contracts. It also presumes that, at root, whatever credit contraction there may be underway is not allowed simultaneously to shrink the core money supply, else that latter’s real value has no chance of re-equilibrating itself.
To say that none of this is easy to achieve under today’s political and institutional framework is, alas, a truism, but neither is that admission one of finally accepting defeat. Certainly it does not mean that, instead of seeking to apply a judicious dose of social and legal lubricant to the state-stiffened joints of the exchange mechanism, we should douse the whole structure in gasoline and set light to it, as recommended by the sort of economists who are accorded the greatest number of column inches in our most prestigious national newspapers.
Truly, there is no hope for the world while we allow our self-serving political elite to derive post hoc justification for its members’ depredations from dilettantes such as Wolf – ‘second-hand dealers in ideas’ all – who are irredeemably prey to the many logical fallacies and faults of truncated reasoning which allow them to persist in propagating such errant nonsense with such unshakable conviction.
By Alasdair Macleod, on 26 October 11
Speech to the Committee for Monetary Research and Education
At the Fall Meeting, 20th October 2011.
Before addressing the consequences of today’s macro-economic policies I want to tell you my philosophy. I support sound money for two very good reasons:
1. Firstly, it is a basic human right to choose to save, without our savings being debased by the tax of monetary inflation. Those that are worst affected by this inflation tax are not the rich (they benefit), but the poor and the barely well-off, which is why monetary inflation undermines society and why the right to sound money should be respected. If government gives itself a monopoly over money, it has a duty to protect the property rights vested in it.
2. Secondly, it is a basic right for us to own our own money rather than have it owned by the banks. For them to take our money and expand credit on the back of it debases it. It is an abuse of an individual’s property rights and a banking licence is a government licence to do so. If anyone else was to do this, they would be guilty of fraud. Banks should be custodians of our money, and it should not appear on their balance sheets as their property.
If we had stuck to these sound money principles, several benefits automatically follow, some of which I will briefly summarise for you, and I will have a little more to say about them in a moment:
1. With sound money, governments cannot print money to fund their activities, so the true cost of government becomes apparent to the electorate. The result is that in a democracy the electorate votes for small government because profligate politicians simply do not get elected. Indeed, we need sound money for democracy to work.
2. With sound money, governments are unable to go to war without taxpayers being conscious of the true cost. This is a great incentive for peace and an electorate that accepts the benefits of free markets, and therefore peaceful trade, is less belligerent.
3. With sound money, savings are protected. Prices tend to fall gradually over time, reflecting improved efficiencies in production and of economic progress generally. So the purchasing power of savings increases over the years. For a pensioner, the purchasing power of his savings grows. He can then afford the healthcare he increasingly requires as he ages, and he can afford to leave something for his family when he dies. His savings work with his needs, which is the opposite of the situation in our inflation-ridden economies. In a sound money economy, our pensioners look after themselves and need not be a burden on the state.
4. With sound money, business cycles do not occur. The business cycles we are familiar with are in fact credit-driven cycles, the result of central banks expanding money and overseeing bank credit. They are the result of the misconception that monetary expansion leads to growth. It doesn’t: it merely distorts the economy by favouring a select few at the expense of the many.
These are just some of the benefits of sound money; benefits we can only dream about today. So long as we have unsound money we will have difficulties that will always end in a crisis. Today, we have sunk to the point where the answer to everything is found in more money and bank credit instead of the genuine production of goods and services.
The long-term consequence of monetary inflation is that voters now believe that a government always has the money to provide everything they need. So they naturally vote for more government. They do not question the source of government’s money. They have also been encouraged to believe that the freedom for everyone to do what they want with their own money only enriches the few, when the opposite is the case. People have become genuinely frightened by the thought of free markets. For this reason, governments regulate most of the private sector. Between government spending and government regulation, the private sector is now dominated by government interference. A minimal amount of capitalism is tolerated in economies that are otherwise socialistic; yet our ills are blamed on the only part of the economy that actually works.
The most effective curb on political ambition is sound money. But we don’t have sound money. So government abuses its monopoly power over the currency to pay for its ambitions. Fiat money gives a free rein to the ambitious politician. The First World War was made possible by German economists, led by George Knapp, the Keynes of his day. He showed the Kaiser the way to finance a war without increasing taxes. In the four years from 1913 the Reichsbank increased paper money in circulation to pay for 85% of Germany’s war expenditure for those years. Of course, after that the script did not go to plan, and as we all know it ended with the total collapse of the currency in 1923.
Collapse the currency, and you collapse savings. Savings today are continually devalued by the expansion of money and credit. Only a fool lends his money for an interest return, and savers are therefore forced to speculate to protect themselves. The result is that there is now a separate destabilising pool of foot-loose capital. It is used by the financial engineers of Wall Street and the City of London to offer higher speculative returns. It has become the feedstock for spendthrift borrowers, particularly governments, who have no intention of ever repaying it.
The damage of unsound money to business has been acute. Business cycles are actually credit cycles, the result of the central banks’ monetary policies. It is easy to understand why the expansion of money and credit drives us into cycles of boom and bust – the exact opposite of what it is meant to achieve.
Take the example of businesses operating with sound money. A business developing a new product or improving an existing one has to invest its own funds, or find a lender with savings. In either case, this takes money away from consumption, money that is reallocated into savings and from there into the proposed investment. And because this money is not spent on consumption, the labour and raw materials required for any new project become available. There is a shift of resources from consumption into savings, from savings into investment, and from there into capital goods. A balance is maintained within the economy and there is no boom and bust. It is a non-cyclical process, driven only by peoples’ economic needs. Business activity is inherently stable.
Now look at the situation when business investment is financed by newly created money and bank credit instead of savings. The process starts with the central bank lowering interest rates. Cheap credit makes investment appear attractive, so the businessman borrows to invest in his business. But many other businessmen are encouraged by the same cheap credit to do the same thing at the same time.
Businesses start investing simultaneously. The randomness has gone. But it gets worse: cheap money also supports consumption, because saving money is less attractive due to lower interest rates.
So our businessman has to bid up for labour, because it hasn’t been released by lower consumption, and he is in competition with the other businesses also taking advantage of cheap credit. He has to pay up for raw materials, for the same reasons. The combination of industry and consumers responding to cheap finance, in the short-term will drive the economy better. But with no extra resources available, prices rise due to bunched demand. And since the quantity of money in the economy has increased, its purchasing-power also falls; exacerbating price inflation even more.
And with prices now rising strongly, interest rates also now rise from artificially low levels. Our businessman’s plans are totally screwed. He got the cost of labour and raw materials completely wrong, and because interest rates have shot up, his Return-On-Investment calculations turn out to be far too optimistic. And to make matters worse, the deteriorating economic conditions that follow, as surely as night follows day, force him to accept that his sales projections were also too optimistic.
His fellow entrepreneurs are in the same boat. Businesses start cutting back. They act as a crowd on the way up and on the way down.
The essential point is fake money has created a business cycle which didn’t exist before. It is never just a question of central banks getting their timing wrong, as many suppose.
The central bank then compounds the problems it has created by again lowering interest rates with the downturn. More than anything else it is scared of a fall in GDP, so it cannot allow the distortions and false investments of the earlier round of monetary stimulation to unwind properly.
But next time round, the businessman is not so easily tricked. He builds greater margins into his investment calculations. So the economy becomes slower to respond to a new, deeper round of interest rate cuts. The central bank has to act more aggressively to create yet more fake money, to get a result.
These credit expansions work like a ratchet, becoming more destabilising over each credit cycle.
The businessman eventually wises up, overcomes his patriotic instincts and moves his manufacturing to somewhere where at least some of the factors of production are available. He needs to plan for ten, fifteen, twenty years. He cannot afford to ride destructive credit-driven cycles of three or four years. It is cheaper for him to build a factory in the jungle and train up hard-working natives. It is unsound money that has driven him abroad more than any other factor. Over a number of these credit cycles, the economy in countries with falling savings, like the US and UK, becomes more and more dependent on consumption, and less and less on manufacturing.
And eventually, to encourage GDP growth, consumers are encouraged to actually borrow to spend and abandon saving altogether. So on every credit cycle, savings diminish and debt increases, finally accelerating to unsustainable levels of debt. And that is where we arrived in 2008. That marked the end of the road for the post-war Keynesian experiment.
So understanding our economic condition from a sound money perspective gives us a unique viewpoint. It makes it easier to see through the fog of weak money. It also allows us to see through the problems posed by reconciling contrary statistics. And it is here that the establishment deludes itself as well as the rest of us.
The abuse of the GDP statistic is the most important delusion of all, because all economic policy is directed at ensuring it grows. But we must stop and think what it actually represents. GDP is not economic output, it is its money-value, which is a very different thing. It gives us no information about the relative values of the goods and services that constitute the economy.
It is crucial to appreciate this distinction, so by way of explanation let us again assume sound money. This is like an economy operating with gold as money and without credit expansion. To keep it simple, assume that trade is in balance, and there are no net capital flows to or from other countries. Therefore, at the end of the year, there is exactly the same amount of money, or gold, as there was at the start of the year.
What does this mean for GDP? It is exactly the same of course, irrespective of actual economic activity. It doesn’t matter how much people save, because those savings are reapplied into the production of capital goods. The rest goes on consumption. It really doesn’t matter what proportion is private sector and how much is government. But if you start with a million ounces of gold, after a year you still have a million ounces of gold. The only difference is what a million ounces buys. The reconciliation between the start and the end of the year is obviously a combination of prices and how efficiently the available gold is deployed.
In practice, human nature constantly strives for improvement, so over a period of time in a free market the purchasing power of sound money increases. This was borne out by the experience of Britain, which went on the gold standard in 1821 and only went off it before the First World War. During that time, Britain freed up her economy by dropping tariffs and other restrictions on free trade, and we became the most powerful nation on earth. The purchasing power of the gold sovereign increased substantially over those ninety-odd years.
So if we look at how an economy operates in a sound-money environment, we see that the benefits of free-markets flow to consumers, savers and businesses. We can see that any attempt to measure these benefits by changes in GDP are simply absurd. It therefore follows that any change in GDP represents a change in the quantity of money in an economy and not of the level of production.
Now, for some of us this is quite a discovery. We are so used to thinking that GDP is the economy that government policies are now entirely focused on boosting it, mistaking it for the economy itself. It justifies mainstream macro-economic theory, because within that money identity, there is no differentiation between good and bad deployment of economic resources. This, in the minds of most economists, is why badly targeted government spending is no different from the productive private sector’s use of economic resources. It persuades Keynesians and Monetarists that injecting government spending into an economy or expanding the quantity of money in the economy is a valid route to recovery.
Understand this error and you understand why unemployment in the United States is already at depression levels, but according to the GDP statistic you have only just arrived at the brink of a possible economic downturn. Understand this error, and you understand the frantic attempts to get more money and credit into the economy rather than address the real issues. Understand the error of confusing the condition of an economy with its accounting identity and understand the policy mistakes yet to be made.
So we can see that governments are doing just about everything wrong. They have completely failed to understand the productive difference between free markets and government intervention. They have no knowledge of the real cost of diminishing the productive private sector to pay for the unproductive public sector. The activities of central banks have encouraged boom-bust cycles that have led to the accumulation of debt in both private and public sectors to the point where it has finally become unsustainable. In the process, they have destroyed savings, which are the necessary pre-requisite, the bed-rock for any sustainable recovery.
This is the background to today’s crisis. Governments everywhere are now trying to borrow the largest amounts of money in history, all at the same time. And to those who say that global savings are high, I say those savings are in the hands of the Chinese and Indian workers, who wisely are more likely to buy gold and silver than our government debt.
Governments are now waking up to the fact that real economic growth is disappearing far into the future and taking their hoped-for tax revenues with it. The debt-trap has snapped firmly shut. Some countries, such as the Eurozone members, who cannot print money to finance themselves, are simply the first victims of the imbalance between the financing requirements of governments and the available capital. Others, such as the UK and US, who can print money, do so to defer funding problems and keep their borrowing costs low; but it is only a matter of time before they are found out.
Price inflation will put an end to these artificially low bond yields, if markets don’t first: it has always been this way in the past and now is no different. We already see prices measured in paper currencies rising everywhere. Commodity prices are reflecting the increased quantities of paper money and credit. Prices of essentials, such as food and energy, have been rising sharply. But there are still people who think that the risk is deflation not inflation. Presumably the Fed thinks so, since it has stated that it expects interest rates to stay at close to zero until mid-2013. They will be in for a shock, and here’s why.
They are about to learn the difference between sound money and their fiat money. Real money cannot be issued by central banks. Fiat money is an undated interest-free claim on a government whose central bank merely tells us that it is money. The difference is important, because in a depression, the purchasing power of real money, measured in goods, increases. In the same depression the purchasing power of fake money falls with the financial condition of the issuing government and with its accelerating supply. This is the dynamic behind the rise in the price of gold over the last decade.
The rising inflation I’ve talked about is measured in fiat money. The rise will accelerate because when you are in a debt trap the only way bills get paid is to issue increasing quantities of fiat money and to borrow. And remember, in a depression tax revenues collapse, while social security costs escalate. To defer the “Grecian moment” we have become unhappily familiar with, both the US and the UK will require more fiat money and bank credit than we can imagine.
So what those who worry about a depression haven’t noticed, is that we have been in one for some time. That comes of confusing GDP with real goods and services. Produce enough fake money and GDP looks good. What doesn’t is the level of unemployment. Doubtless George Knapp – remember him? The German predecessor to Keynes? – Knapp would have felt good that German GDP from 1920 to 1923 looked fantastic. But then there was the small matter of a collapse in the fiat money of the day, and GDP hadn’t yet been invented anyway.
Today people are stumbling towards an awareness of some of these problems. Most visible to everyone so far is the parlous state of the banks. While it would be foolish to completely discount systemic risk, we should bear in mind two things. Firstly, the central banks are now very aware of this risk, which is different from the time of the Bear Sterns and Lehman collapses. So you can reasonably bet that every scenario that frightens us has been anticipated. The banks themselves are now acutely aware of counterparty risk. Secondly, the evolution of banking over the years has given central banks enormous control over their banking systems. It is wrong to think that you can compare the situation today to that of the banking crisis triggered by the collapse of Kredit Anstalt in 1931. The ECB in Europe only has to stand by with unlimited funds when necessary. Indeed, there has been a run on the Greek banks for at least the last eighteen months without systemic failure. All that is required is for the ECB to make its fiat money available in sufficient quantities.
In a few months we will enter 2012. The immediate stresses of today will probably diminish when enough fiat money has been thrown at them. So to my mind the two biggest headaches for next year will be increasing price inflation, the result of too much paper money chasing too few goods if you like, and rising interest rates. I do not expect the Fed to keep its promise of zero rates into 2013. I do expect them to blame unexpected stagflation.
And finally, we must understand that when it comes to resolving our current difficulties, the order of events is bound to be crisis first, solution second. I wish it could be the other way round, but that is the political reality. What we must do meanwhile is get the message home why the establishment has got its macroeconomics so wrong, and why the only solution is to progress towards sound money.
Today I have only focused on two aspects of the problem: the destabilising effects of credit-driven business cycles, and the misapplication of a statistic, GDP, which should have no importance whatsoever. There is much, much more in this sorry tale. I have touched on the role of savings, without going into how their destruction through monetary inflation is now bankrupting governments. I have not gone into the fallacies surrounding trade imbalances, which are always the result of unsound money. I have not asked how we are to feed our elderly and poor, who have become reliant on government pensions and hand-outs, which governments can increasingly ill-afford.
Please just accept, even if you don’t follow my analysis, that sound money guarantees a stable yet progressive economy where people are truly equal. It allows people to save properly for their retirement so that they will not become a burden on the state. It leads to democracy voting for small governments. It encourages peaceful trade and discourages war. It is the only path, after this mess, that leads us to long-lasting and peaceful prosperity. We really need everyone to understand this for the sake of our future.
Thank you.
This speech was previously published at FinanceAndEconomics.org.
By Toby Baxendale, on 9 September 11
A great letter to the editor of the FT from Terry Smith:
Sir, I refer to the debate being conducted in the pages of the Financial Times between those who propose further Keynesian measures, such as Martin Wolf (“Struggling with a great contraction”, August 31), and those who do not accept that they will work, such as Wolfgang Schäuble (“Austerity is the only cure for the eurozone”, September 6).
Such so-called Keynesian measures as advocated by, among others, Ed Balls, Samuel Brittan, Paul Krugman, George Magnus and Barack Obama as well as Mr Wolf have not worked to date, and they will not work. Their advocates seem to assume that their repeated failure to solve our economic problems just means that the medicine must be repeated, which reminds me of Richard Nixon’s motto that “if two wrongs don’t make a right, try three”.
I say “so-called” Keynesians because these advocates seem not to realise that Keynes’ theories did not rescue us from the Great Depression. They are also asymmetric in their application of his theories – calling for ever larger deficit spending, having overlooked the bit about running a surplus in a boom. But above all, they do not seem to realise that they cannot work in a period of debt deflation in which a recession is preceded by the collapse of the banking system, as their current failure is demonstrating.
To the ordinary person in the street, the idea that we can rescue ourselves from a crisis caused by excessive borrowing by borrowing even more must seem mad. In this respect they are possessed of far more common sense than those who are currently advocating just such a course of action and purport to be our leaders.
The first step in rectifying this situation should be to make a clear and unambiguous statement about the actual debt the UK is carrying.
To give a lead to this, today we have circulated to every member of parliament a tin can emblazoned with the UK debt figure – £3,589bn including commitments for public sector pension commitments, private finance initiative and banking sector guarantees, so that they can see what it is they are metaphorically “kicking down the road” with their present policies. This, ahead of the party conference season, I hope might spur some considered and honest debate on this issue.
It is time for those who wish to lead us out of this crisis to tell people how bad the current situation really is and the painful remedies which will be needed to remedy it.
Terry Smith, Chief Executive, Tullett Prebon, London EC2, UK
By Robert Thorpe, on 26 August 11
Recently, Paul Krugman claimed that the threat of an invasion by space aliens could bring the US economy out of recession in eighteen months. I expect many readers of this site found that both funny and worrying. It reminded me of an excellent science fiction novel I read years ago, “The Forever War” by Joe Haldeman.
Most political movements try to present themselves as positive about humanity. But privately their supporters often admit to seeing “noble lies” and social engineering more positively than they would publicly say. I don’t think libertarians or classical liberals are completely immune to this. In “The Forever War” a leftist author criticises conservatives, but also allows himself to think through the consequences of the ideas of American leftists.
Novels about interstellar war are often quite macho and conservative. “The Forever War” was seen as a response to one of those books, “Starship Troopers” by Robert Heinlein. It begins with an attack by aliens on starships travelling from earth to colonize other planets. It then follows a soldier, Private Mandella, through the ensuing war against the aliens. It becomes clear much later that the start of the war had been a mistake by jumpy humans, not a hostile alien attack. That is rather like the “Gulf of Tonkin Incident” in the Vietnam war. Haldeman wrote “The Forever War” in the early 70s after his own service in Vietnam; the interstellar war he describes is eerily similar to the Vietnam war and clearly a commentary on it.
When the soldiers first return to earth an army captain comes to meet them, he says:
“I’m twenty-three, so I was still in diapers when you people left for Aleph … to begin with, how many of you are homosexual?” Nobody. “That doesn’t really surprise me. I am, of course. I guess about a third of everybody in Europe and America is.
“Most governments encourage homosexuality – the United Nations is neutral, leaves it up to the individual countries – they encourage homolife because it’s the one sure method of birth control.”
Over the course of the book that policy becomes stricter and heterosexuality comes to be seen as a mental illness. It’s interesting to consider if future governments will try strategies like this. As the story progresses it hints that governments have encouraged recreational drug use too for the same reason.
The captain continues:
“… the population of the world is nine billion. It’s more than doubled since you were drafted. And nearly two-thirds of those people get out of school only to go on relief”.
“Relief”, it turns out, is the dole. Here we have the “Gloomy Keynesian” idea that as technology progresses unemployment becomes much greater. It turns out that jobs are rationed and only certain people are eligible so there is a thriving black market in faking this eligibility. Haldeman supposes that the war provides the Keynesian solution to this problem: producing the technology to fight the war creates employment and stimulates output.
Haldeman writes:
The main effect of the war on the home front was economic, unemotional – more taxes but more jobs as well. After twenty-two years, only twenty-seven returned veterans, not enough to make a decent parade. The most important fact about the war to most people was that if it ended suddenly, Earth’s economy would collapse.
And at the very end of the book when some ancient history is discussed:
… the old soldiers were still around, and many of them were in positions of power. They virtually ran the United Nations Exploratory an Colonization Group, that was taking advantage of the newly discovered Collapsar jump to explore interstellar space.
Many of the early ships met with accidents and disappeared. The ex-military men were suspicious. They armed the colonizing vessels, and the first time they met a Tauran ship they blasted it.
They dusted off their medals and the rest was going to be history.
You couldn’t blame it all on the military though. The evidence they presented for the Taurans having been responsible for the early causalities was laughably thin. The few people who pointed this out were ignored.
The fact was, Earth’s economy needed a war, and this one was ideal. It gave a nice hole to throw buckets of money into, but would unify humanity rather than dividing it.
Here we see the problems many leftists have with their own ideas. If Keynes is right about economics or if Malthus is right about population [1] then that has dark implications. Of course there’s nothing wrong with an idea that leads us to a dark place if that idea is right, but there’s no need to worry if it’s wrong.
Writing about the recent earthquake in Virginia, Steve Horwitz gave a very clear criticism of this kind of thinking:
… the problem with the ‘disasters are good for the economy’ nonsense, and GDP more generally, is that it confuses a flow with a stock. GDP measures a flow of activity, not a stock of wealth. Destroying things and then rebuilding them might increase economic activity in the area affected (by drawing resources from elsewhere), but leaves us with less wealth than we would have had without the disaster. That is the real meaning of the Broken Window Fallacy.
It’s a mistake to think that Keynesians want to waste resources in order to increase employment. Their argument is that it isn’t very important how efficient a spending project is during a recession. They would prefer it if the output of a project were useful because if it were, that would clearly be beneficial. But, they don’t require a project to be efficient; their view is that if no good spending projects are politically feasible, then bad ones will do. They believe that during a recession there are great spin-off benefits to spending on output. They believe that it will stimulate production and employment and make society wealthier in the long run.
Keynesian commentators often seem to believe that the level of GDP output proves that a certain amount of capital wealth exists to be used, so when GDP increases that means society is richer. GDP is certainly an indicator of wealth; output can only be produced because capital and labour exist to produce it. But, many different levels of output are possible with the same capital. The amount of existing stocks of goods that are processed into new outputs depends on the demand for those new outputs.
In the recent controversy over the Virginia earthquake some Keynesian commentators I’ve read have expressed the view that it’s all about “crowding out”. Crowding out is a macroeconomic idea often put forward by critics of the Keynesians. In its simplest form, the argument is that every pound the government tax from someone, or borrow from someone, is a pound that would have been spent on private sector output. So, according to this argument “stimulus” policies will have no beneficial effect. I agree with this idea to some extent. The problem with it is that the private sector doesn’t only sell GDP output; existing assets are also for sale, including financial assets such as bonds and share. That means a person may receive income and spend it on things that aren’t output. Also, once the seller of an asset receives the proceeds he may not spend them on output either; he may buy another asset. Eventually somebody in the chain will spend on output, though that may take a long time. This means a government could increase output by taxing people who are likely to spend their money on assets and using the proceeds to buy output goods.
I don’t think the crowding out explanation helps us very much. As Horwitz says, the important issue isn’t whether output falls, everybody know output falls during a recession. The important question is: what does a fall in output mean?
One possibility is that investors and businesses are being irrationally cautious. Instead of investing in new projects which could earn profits in the future for them and increase output to the benefit of everyone they rush into relatively secure investments such as money, bonds, blue chip stocks and gold. Keynesians are fond of the idea of the irrationality of the market because it supports this view (they aren’t particularly interested in disputing Austrian Business Cycle Theory as a cause of recessions). I think this possibility is a distraction; to the degree that markets can be irrational it’s close to impossible to say in which direction they’re being irrational [2].
There is an alternative view, though: investors may be making a sensible decision to avoid investing in new projects because the risk/reward ratio is too poor to make it worth their while. That decision may certainly reduce employment in the short-run, but that doesn’t show that it reduces society’s overall wealth. It may well be that this decision isn’t only sensible for investors. The processing of existing resources into new goods doesn’t necessarily add value from anyone’s point of view. Keynesian economists often assume that it’s always worthwhile to convert existing resources into output at the same rate that prevailed before a recession. There is no reason to think this is true.
[1] – Those interested in the history of economic thought will notice the influence of Malthus. Thomas Malthus was good at coming to unsettling conclusions. He suggested that real wages will fall in the long-run to the minimum necessary for subsistence, consigning the human race to poverty in the long term. Malthus also proposed a macroeconomic theory similar to Keynes’s, long before him.
[2] – This is the weakest form of the Efficient Markets Hypothesis.
By John Phelan, on 27 July 11
July 26th saw one of the most eagerly anticipated economic events of recent years. At the London School of Economics (former employer of Friedrich von Hayek), Professor George Selgin and Dr. Jamie Whyte for the Hayekians and Professor Lord Skidelsky and Duncan Weldon for the Keynesians gathered in front of a packed lecture hall to debate Keynes vs. Hayek. Two other lecture halls were required for the overspill. The debate will be broadcast on BBC Radio Four on August 3rd.
In front of a boisterous crowd, Hayek won fairly easily. Skidelsky’s haughty style contrasted with Selgin’s bullishness and the perennial Keynesian failure to look at the origins of the bust won over nobody in an admittedly partisan crowd. But even an hour of discussion left a few things hanging.
China
One questioner asked whether the Chinese stimulus package had been so much more successful than America’s because the totalitarianism of China allowed the government to direct the spending more effectively than in the US with its dispersed government.
To my great surprise this question was largely ignored by the Hayekians and waved through by the Keynesians, Skidelsky murmuring his approval for the proposition. I was surprised this question generated so little comment because it proves one of Hayek’s key propositions, namely that economic control goes hand in hand with political and social control.
To Hayek there was no such thing as ‘the economy’, as some separate area of human activity which can be tweaked and tinkered with. The economy is, instead, the whole arena of what Hayek’s mentor called Human Action. Or as Ronald Reagan put it, “a government can’t control the economy without controlling people”
We see this with Mussolini’s declaration that “Fascism entirely agrees with Mr. Maynard Keynes” or with the fascistic Blue Eagle which represented the National Industrial Recovery Act of Roosevelt’s New Deal. The effectiveness of China’s Keynesian stimulus came at the price of Tiananmen Square.
Keynesian diagnosis
One of Skidelsky’s repeated attacks on Hayek was that while he had plenty to say about how we got into the bust he had nothing to say about how we get out of it. Selgin dealt with this very well, but there is another point: if a doctor has no idea why your foot is hurting, would you blithely accept his prescription that it needs to be sawn off?
Whereas Austrian economics is famous for its theory of business cycles, with unsustainable booms leading to busts in which bad investments are liquidated, Keynesian theory is silent about the business cycle. All we get is the concept of “animal spirits”, which simply states that at some point for some reason business people suddenly decide en masse to stop investing, and boom turns to bust. As an explanation for why an economy hits the skids, animal spirits is up there with “in the long run we are all dead” — a typical Keynesian shrug of the shoulders.
And it doesn’t even fit the current slump. The economy hit the skids, as Austrian theory always suggested it would, when the Federal Reserve raised interest rates to stifle the inflation caused by the unsustainable credit expansion of the boom period. Many investments that were viable in an environment of easy credit were sustainable no longer. Animal spirits played no part in this. If Keynes was wrong about the diagnosis, why should we place any faith in his prescription?
Mellon and liquidation
This led inevitably to the introduction of a quote attributed to Andrew Mellon, Secretary of the Treasury under President Hoover when the Wall Street Crash hit:
liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate…it will purge the rottenness out of the system
There are two grounds on which to question this. First, this quote comes from Hoover’s memoirs and Hoover was the original executor of Keynesian stimulus.
Second, what actually is wrong with it? Look back at the recent boom. In Britain, the US, Ireland, Spain and elsewhere, we had rocketing house prices based on low interest rates. Lots of house building got under way to cash in, and lots of people were drawn into the construction industry.
Now, if we have too many houses as a result of the boom’s over-investment, we do not need new houses built. It follows that we also need fewer people building them. Elements of the construction industry, in other words, will be liquidated just as Mellon said.
They have to be. Consider the alternative: construction workers are laid off in large numbers and a movement begins to ‘do something’. All that can be done is either monetary or fiscal action directed to keeping these workers building houses we do not need. Anything else is Mellon’s liquidation.
Keynes famously said that unemployment could be solved
If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez faire to dig the notes up again
His modern day disciples, it seems, think that we can build a prosperous economy around the building of houses no one will ever live in.
Larry Summers
I have to give Weldon some credit. For anyone even vaguely involved in the economic policy making of the last government to show his face in public takes real nerve. He was rewarded with a titter from the smattering of Keynesians when he quoted with approval the words of Larry Summers, who described the coalition’s belief that spending cuts are necessary for recovery as “oxymoronic”. Weldon suggested that Summers could have dispensed with the ‘oxy’.
This is, of course, the same Larry Summers who said of the recent Japanese tsunami
It may lead to some temporary increments, ironically, to GDP as a process of rebuilding takes place. In the wake of the earlier Kobe earthquake Japan actually gained some economic strength
Perhaps Weldon could find an adjective for this?
It is quite a bizarre argument that a man can destroy his house in year one, rebuild it in year two, and at the end of that second year pat himself on the back for increasing his GDP by the cost of his new house. But then you are through the looking glass with Keynesianism. The doctrine holds, after all, that the more you spend the richer you get. Predictably it wasn’t an argument which impressed the tough crowd at the LSE.
By John Phelan, on 29 March 11
Several thoughts pirouetted across my mind as I watched the coverage of Saturday’s protest and riots.
I wondered why anti-capitalists were wearing clothing with prominent labels (don’t they know their Naomi Klein?); I wondered why defenders of the public sector were attacking publicly owned banks; I wondered how one protester could say, when interviewed, “Of course, we all know there need to be cuts” while a sea of people drifted past her waving signs saying ‘No cuts’; I wondered why Ed Miliband, a bloke without an alternative, was addressing the March for an Alternative.
But most of all I was struck by what a boon this all was for the economy, or so some would tell you. The standard Keynesian narrative of the Depression of the 1930’s, for example, holds that it was all about a collapse in aggregate demand which was only solved by, first, New Deal spending, and then war spending. As Paul Krugman once put it
Faced with the Depression, institutional economics turned out to have very little to offer, except to say that it was a complex phenomenon with deep historical roots, and surely there was no easy answer. Meanwhile, model-oriented economists turned quickly to Keynes — who was very much a builder of little models. And what they said was, “This is a failure of effective demand. You can cure it by pushing this button.” The fiscal expansion of World War II, although not intended as a Keynesian policy, proved them right
The fact that large swathes of the planet’s human and physical capital was blown to atoms represented simply an ‘opportunity for growth’.
So surely all the random destruction in the West End should be a good thing? Perhaps not. Back in 1850, Frédéric Bastiat asked “Have you ever witnessed the anger of the good shopkeeper, James B., when his careless son happened to break a square of glass?” In his classic, Economics In One Lesson, Henry Hazlitt took up the story
A young hoodlum, say, heaves a brick through the window of a baker’s shop. The shopkeeper runs out furious, but the boy is gone. A crowd gathers, and begins to stare with quiet satisfaction at the gaping hole in the window and the shattered glass over the bread and pies. After a while the crowd feels the need for philosophic reflection. And several of its members are almost certain to remind each other or the baker that, after all, the misfortune has its bright side. It will make business for some glazier. As they begin to think of this they elaborate upon it. How much does a new plate glass window cost? Fifty dollars? That will be quite a sum. After all, if windows were never broken, what would happen to the glass business? Then, of course, the thing is endless. The glazier will have $50 more to spend with other merchants, and these in turn will have $50 more to spend with still other merchants, and so ad infinitum. The smashed window will go on providing money and employment in ever-widening circles. The logical conclusion from all this would be, if the crowd drew it, that the little hoodlum who threw the brick, far from being a public menace, was a public benefactor.
Now let us take another look. The crowd is at least right in its first conclusion. This little act of vandalism will in the first instance mean more business for some glazier. The glazier will be no more unhappy to learn of the incident than an undertaker to learn of a death. But the shopkeeper will be out $50 that he was planning to spend for a new suit. Because he has had to replace a window, he will have to go without the suit (or some equivalent need or luxury). Instead of having a window and $50 he now has merely a window. Or, as he was planning to buy the suit that very afternoon, instead of having both a window and a suit he must be content with the window and no suit. If we think of him as a part of the community, the community has lost a new suit that might otherwise have come into being, and is just that much poorer.
The glazier’s gain of business, in short, is merely the tailor’s loss of business. No new “employment” has been added. The people in the crowd were thinking only of two parties to the transaction, the baker and the glazier. They had forgotten the potential third party involved, the tailor. They forgot him precisely because he will not now enter the scene. They will see the new window in the next day or two. They will never see the extra suit, precisely because it will never be made. They see only what is immediately visible to the eye.
The resilience of palpable nonsense is staggering. If, as Bastiat and Hazlitt demonstrate, the idea that the trashing of businesses is good for business, then consider what Clinton-era Treasury Secretary Larry Summers said about the Japanese earthquake recently
It may lead to some temporary increments ironically to GDP as a process of rebuilding takes place. In the wake of the earlier Kobe earthquake Japan actually gained some economic strength
This is crass rubbish. Lots of new building activity may take place in Japan but they will simply be restocking on, say, housing. Rebuilding the house you have just watched destroyed does not make you better off.
Yet this drivel has the imprimatur of The Master himself who wrote in The General Theory
Pyramid-building, earthquakes, even wars may serve to increase wealth
That will no doubt come as a great comfort to West End workers and homeless Japanese.
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By Sean Corrigan, on 16 March 11
Rather than pretending to a level of insight into the scale of Japan’s problems which neither we nor anyone else truly possesses at this stage of the disaster, we think it might be worthwhile instead to run through some general considerations of what ramifications might be felt in its aftermath.
Before we do, however, we cannot abstain from expressing our utter contempt for the many idiots who have already begun parroting the standard Keynesian nonsense that this calamity will ultimately ‘prove positive for GDP ’, or that the rebuilding efforts can only redound to the nation’s well-being to the extent that they shake it out of its ongoing ’deflation’.
As is their wont, such imbecile Cargo Culters are once again making a fetish of a coarse-grained statistic which is supposed — however imperfectly — to offer a rough measure of material progress being made in the real economy and not the converse, leading them to lose all focus on what is actually happening to people’s living standards and wealth accumulation.
Japan has been stricken with a huge loss of productive capital — as well as an appalling toll of human suffering — and this cannot do anything other than to leave the nation discernibly poorer and, by extension, to curtail its ability to make people across the world better off than they otherwise would be by offering them valuable goods and services as part of that beneficent mutual enrichment which is the international division of labour, conducted under conditions of free(ish) exchange.
Contrary to popular belief, the Japanese have not, in fact, been trapped in a deflationary slough of stagnation these past two decades as both the real and nominal supply of money have risen throughout his period (with the exception of the worst months of the GFC itself), while real per capita national income has also increased modestly, especially on a PPP, or TWI-adjusted basis. Granted, the consumer price basket has trended lower at a rate of less than 1% a year, but this is something which is presumably no more than a reflection of ongoing productivity gains — ones delivered, to boot, in a country formerly marvelled at for the extreme levels of its domestic pricing.
But, even were we to subscribe to this myth of secular slump, the idea that to eradicate a large quantum of people’s possessions or to evaporate a sizeable fraction of their nest-eggs would be to contribute to their prosperity is to reckon that in futilely striving to heft his rock up the hill for all eternity, Sisyphus was the most tireless ‘engine of growth’ for Hades at large.
If you go to the trouble of cooking yourself a dinner, only for the dog to snatch it from the sill where you placed it to cool, do you congratulate yourself on your own good fortune as you troop back to the larder to begin again? If a sudden hailstorm strips bare the groaning ears of your wheat crop the day before you were due to harvest it, do you cheerily go about preparing the field for replanting, content in the knowledge that your doubled labour is being duly recorded in the plus column by a mindless government data-gatherer?
After all, if the awful spectacle of vast swathes of land littered with shattered buildings and crumpled vehicles — or the concern that they suffer the invisible hazards of radioactive contamination — offers such grand opportunities for advancement, why stop there?
Why wait for the vagaries of the climate, or the tortured creaking of continental plates to bring about such a ’stimulus’ to growth? Why not declare war on ourselves and unleash our titanic arsenals of destruction on our own towns and cities, and rain down hellfire upon our own farms and gardens, razing the first to the ground and sowing the last with salt, until we make a self-inflicted Carthage of them, one in whose midst we can hope to become rapidly richer than our neighbours as, shivering and starving, we pick our way among the debris of our former civilisation to the nearest construction site?
This is all such arrant nonsense that you should banish from your consideration, henceforth and forever, all of the jejune scribblings of the fool whom you once catch propounding it!
But enough of this! The real crux of the matter is to look at the two sides of Japan, Inc. — both as a user (and end-consumer) of certain goods and as a provider of often highly-valued and not easily replicated material inputs to the world economy in exchange.
All else being equal, the country will be consuming some goods (e.g., lumber, steel, copper wire, concrete, fossil fuel) far more directly in the near future and, moreover, consuming them with little onward production of value from their use.
The first order effect of this would be expected to push up preferentially the prices of both the materials they will be absorbing and those whose production by them is temporarily being reduced.
Conversely, the consumption patterns of the ordinary Japanese will also suffer a compositional shift away from the enjoyment of certain goods and services and, ceteris paribus, the prices of these should be less well supported as a consequence.
Where they no longer supply goods to the market — initially being completely unable to do so., perhaps, and, later, devoting selectively less resources to that production as they first tackle the problems of rebuilding — there is certainly scope for their competitors to prosper, but also significant dangers that the partial or total absence of such goods will disrupt production in factories and fab plants elsewhere, too. [Incidentally, the possible fall in the external surplus this comprises is one offset for the fabled yen ‘repatriation’ flows which the market so fears]
In short, where Japan’s goods are competing for sales, others may benefit at her expense: where they are complementary to them, they will equally share in her ruin. In the counter-weighting of these two factors will be decided the first question of whether output suffers beyond her shores and of what impetus is given to what prices.
By confounding entrepreneurial planning, dislocating production schedules, hampering timely onward delivery, etc., the damage could be widespread and should certainly belie Monday’s initial market insouciance. Given that profitable production is the only true source of sustainable consumption and that business-to-business spending is normally a good multiple of what is captured in the blessed GDP numbers, the earthquake-induced fall in Japanese incomes could soon be reflected elsewhere, too.
Where business planning (and the structure of financial exposures which embody this) has been too casual in its concern for such upsets (however unforeseeable the particulars of this one were), such frictions can rapidly mount to the point where they strip the drive-train of all further functionality and the firm finds itself staring failure in the face.
In this context, we again must draw attention to the alarming upsurge in pestilential credit practices — such as cov-lite, loans, PIK notes, PE dividend-stripping, and buoyant junk financing in general — which so exacerbated the last bust and which have been allowed to re-infect the economic corpus with the active cheer-leading of its central banks, especially the one housed in the Mariner Eccles building.
Furthermore, financial markets have entered this crisis having only grudgingly tempered their inordinate, Fed-fostered levels of bullishness (that, as a result of the Arab unrest) and with leverage, carry–trades, and crowding therefore all notably elevated.
A narrow replay of the kind of crash which followed the San Francisco earthquake and fire of 1907 are perhaps not to be looked for in the absence of a hard money kernel to the pyramid of credit, but that is not to say that ‘contagion’ and the forced liquidation concomitant with it cannot course through other financial channels instead, especially since people are all too aware of the continued fragility of the associated plumbing, even here, on the third anniversary of the Bear, Stearns bail out.
One obvious fracture plane could be the finances of Japan itself, a legacy of two decades of failed New Deals whose eventual unravelling has been exciting the attention of the bears for some good while since. The usual defence is that Japan ‘owes much of the debt to itself’ – a macro-accounting identity which an Austrian is willing to concede while questioning its practical validity.
That some elements of Japanese society have debts greatly in excess of assets (principally, the state) while others (mainly in the private sector) are in the opposite condition is only a comfort inasmuch as it reduces the nation’s exposure to the vicissitudes of the forex market or to the vagaries of offshore investor sentiment.
Thus, while it may provide a convenient smokescreen under the cover of which today’s hard-won savings are funnelled to Leviathan, there to plug the holes left by the squandering of yesterday’s savings, as well as to disburse the doles from which a good percentage of tomorrow’s savings are, in turn, generated, this quadrillion yen round-robin cannot permanently disguise the chronic nature and mind-stretching scale of the capital consumption it entails.
The circling financial vultures are therefore looking forward to the moment when domestic Japanese investment is no more sufficient to absorb all the government’s issues, (without perhaps contemplating the drain on the other improvidents when the giant, state-owned — or state-cajoled — institutions sell their USTs and kangaroo bonds, and realise their Nasdaq holdings and Eurobank CoCos in the effort to plug this gap).
What they now anticipate is that the costs likely to arise in the course of rebuilding the nation cannot fail to have advanced the date of that long-awaited morrow when the piper must be paid and JGB yields start to soar in consequence (even though, were we consistent, the Keynesian theory of fruitful holocaust would suggest ‘growth’ could, meanwhile, repair the finances painlessly).
In this, they may even be right, yet their positioning may well not survive to see the great denouement, for the route to a complete breakdown in the Japanese fiscal position surely lies through the Nihonbashi and the unbridled monetization powers of the BOJ.
Indeed, the additional threat posed to the economy — not just of Japan, but to those of all of its foreign trading partners — is not so much that the government runs out of cash, but that the whole country comes to drown in the stuff.
Indeed, while recognising the short-term, emergency need to reassure people that they will continue to have access to a medium of exchange and a functioning payments system, it is more than a little worrisome that the Bank has doubled its long-term QE programme, citing a desire to ’pre-empt a deterioration in business sentiment… from adversely affecting economic activity’ and to ‘…make contributions…’ in order to ‘…overcome deflation…’
As we wrote of a New Zealand whose own affliction has been swiftly forgotten in this larger tragedy, no good can come of a policy which can only serve to add to the confusion and bewilderment already occasioned by the violence of the tectonic shift in trying to suppress — by means of a crude resort to the printing press — the all-too evident fact that Japan is less well endowed with capital than it was and thus, that interest rates should naturally rise to reflect this inescapable verity.
It is not Yen that Japan now finds itself short of, but potable water, medical supplies, bridging materials, constructional steel, and electric power. The BOJ cannot help deliver these more readily or more efficiently by debauching the currency via its attempt to divorce financial asset prices from the diminished earning potential they incorporate.
Similarly perilous is the incitement this will give to the pump-primers elsewhere in maintaining — or even extending — their own easing programmes. Nor will they be consistent in this for, if they conveniently ignore the rise in food and energy prices, they will just as conveniently point to any liquidation-induced falls in these groupings to confirm the accuracy of their interpretation. On top of this, the many extant doves will be only too happy to protract their tenure as supposed saviours of the universe by enacting extra easing measures should Japan’s woes conspire to slow the upward momentum in the local recovery
Do not write-off QE-III just yet.
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