As Governor of the Bank of England Sir Mervyn King told us in 2010: ‘Of all the many ways of organising banking, the worst is the one we have today.’
Notes and coins are irredeemable: the promise to pay the bearer on demand cannot be fulfilled, except with another note or coin with the same face value. Notes and coins are tokens worth less than their face value and are issued lawfully and exclusively by the state. This is fiat money.
When this money is deposited at the bank it becomes the bank’s property and a liability. The bank does not retain a full reserve on demand deposits. In the days of gold as money, fractional reserves on demand deposits explained how banks created credit. Today, credit expansion is not bounded by the redemption of notes, coins, and bank deposits in gold.
Because banks are funded by demand deposits but create credit on longer terms, they are risky investment vehicles subject to runs in a loss of confidence. States have come to provide taxpayer-funded deposit insurance. This subsidises commercial risk, producing more of it and creating moral hazard amongst depositors who need not concern themselves with the conduct of banks.
The state also provides a privileged lender of last resort: the central bank. It lends to illiquid but solvent banks getting them through moments of crisis. In a fiat money system, central banks have the power to create reserves and otherwise intervene openly in the money markets. Today this is most evident in the purchase of government bonds with new money, so-called quantitative easing.
The central banks also manipulate interest rates in the hope of maintaining a particular rate of price inflation through just the right rate of credit expansion to match economic growth. That otherwise free-market economists and commentators support such obvious economic central planning is one of the absurdities of contemporary life.
Compounding these flaws is the limited liability corporate form. Whereas limited liability was introduced to protect stockholders from rapacious directors, its consequence today is ensuring no one taking commercial risks within banks stands to share in the downside. This creates further moral hazard.
Regulatory decisions have been taken to encourage banks to make bad loans and dispose of them irresponsibly. Among these are the US Community Reinvestment Act and the present government’s various initiatives to promote the housing market and further credit expansion.
Having insisted banks make bad loans, the regulatory state imposed the counterproductive International Financial Reporting Standards (IFRS) which can over-value assets and over-state the capital position of banks. This drives the creation of financial products and deals which appear profitable but which are actually loss-making. Since these notoriously involve vast quantities of instruments tied to default, the system is booby-trapped.
Amongst the many practical consequences of these policies was the tripling of the money supply (M4) in the UK from £700 billion in 1997 to £2.2 trillion in 2010. Credit expansion at this rate has had predictable and profound consequences including asset bubbles, sectoral and geographic imbalances, unjust wealth inequality, erosion of physical capital, excess consumption over saving, and the redirection of scarce resources into unsustainable uses.
Moreover, credit cannot be expanded without limit. Eventually, the real world catches up with credit not backed by tangible assets: booms are followed by busts.
The essay provides some objectives for monetary reform and sets out proposals from Dowd et al and Huerta de Soto.
I was pleased that the Parliamentary Commission on Banking Standards highlighted problems with incentives and accounting – the conversation is going in the right direction. At some point, when it becomes apparent that Mervyn King was right and we do have the worst possible banking system, I hope decision makers will realise that banks and the product in which they deal, money, are inseparable and that meaningful banking reform demands monetary reform.
Blue-chip mystique still clings to it but you can feel the reputational parabola slowly gathering momentum on the downside. Its projects are too large and diffuse, the resources to achieve them too crude and there are mounting signs of unhappiness and confusion at the top.
Given their long-standing rock star status, pity the central banker; the fall from grace may be vertiginous.
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The Governor of the Old Lady seems more attuned to this unfolding trend than most. On my reading, he metaphorically ran up the white flag in a recent speech. It was the oddest mixture of explanations, implicit apologies and rationalisations imaginable from such an august perch. Do have a look; it’s not long.
King finished with an amusing touch: “As for the MPC [Monetary Policy Committee], you can be sure we shall be looking for as much guidance as we can find, divine or otherwise. What better inspiration than the memory of those children on Rhossili beach singing Cwm Rhondda.”
Perhaps the South Wales Chamber of Commerce seemed a forgiving place to lay out some of central banking’s many puzzles.
Put simply, his message was: I know what we’re doing seems a bit crazy, and I know all the fundamental problems are still out there waiting to be solved, but what else can we do?
What’s even scarier is that I understand what he means. After all, most of the really important stuff, like correcting the monstrous accumulated imbalances of recent decades and setting a more sensible course for the future, isn’t within the Bank of England’s remit. And yet, because the magic wand is in their hands, everyone looks to them to do something. Anything.
Which, as we know, they did. Cumulative QE (so far) of £375 billion, or 25% of GDP, enough for top spot amongst its Western institutional colleagues. As King suggested, the market is well and truly sated:
During the crisis central banks have provided liquidity to banks on a truly extraordinary scale, so much so that there were no takers for additional liquidity in our latest auction. It is still useful to keep their auction facility as an insurance policy. But banks are now overflowing with liquid assets.
Insurance policy indeed. Any more QE would seem in danger of plunging the whole business into farce.
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King, as he often does, got to the nub of the matter early on in his speech:
In the long run, we will need to rebalance our economy away from domestic spending and towards exports, to reduce the trade deficit, to repay our debts, and to raise the rate of national saving and investment. So you are probably puzzled by the fact that we seem to be doing exactly the opposite of that today. Almost 4 years ago now, I called this the “paradox of policy” – policy measures that are desirable in the short term appear diametrically opposite to those needed in the long term. Although we cannot avoid long-term adjustment to our economy, we can try to slow the pace of the adjustment in order to limit the immediate damage to output and employment.
He’d be only too aware, I’m sure, that our current intolerable mess is the result of giving in to a long succession of apparently desirable short-term policy measures. In each of the would-be and actual recessions of recent decades, politicians and central bankers strove to “limit the immediate damage to output and employment.” And, for the most part, succeeded. Trouble is, of course, in doing so earlier excesses were never allowed to sort themselves out; instead, they were carried forward with compound interest and then added to afresh.
How does one ever decide that now, finally, is the moment to pay the piper?
Thing is, even if King thought the time was now (or, quite possibly, a few years ago), it’s out of his hands. He can advise, plead, cajole, threaten to resign, but he can’t decide. So too with his compatriots elsewhere, many of whom have also been delicately (and sometimes not so delicately) pointing out the limits of of monetary policy and pleading for deeper structural reform.
As King said immediately after his comment about banks now overflowing with liquid assets:
Their problem remains insufficient capital. Just as in 2008, there is a deep reluctance to admit the extent of the undercapitalisation of the banking system in many parts of the industrialised world. The verdict of the market is clear – without central banks support banks still find it expensive to borrow.
What’s true of the banking system is no less true for the economy more generally. There’s way too much debt and not enough equity. Until that imbalance is dealt with (together with all the real world distortions it fostered) there’s no chance of organic growth, just the hyped up, artificial variant produced by great bouts of fiscal and monetary stimulus.
Central bankers are burdened with a kind of original sin. After all, without their unfailing support and encouragement (together with the very nature of the fiat fractional reserve banking systems over which they preside), the credit excesses of recent decades would have been quite impossible. Can any of them coolly and dispassionately disentangle and measure the system in which they’re so deeply embedded?
I don’t know, but it’s not hard to imagine King lying awake in the early hours of the morning.
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So what’s the endgame?
With overall debt levels rising (still), rates pinned to the floor and vast amounts of excess liquidity sloshing about (thank you Mervyn, Ben, Mario et al), a private sector busily trying to repair its collective balance sheet and economies everywhere in the doldrums because of massive imbalances, anyone who says they know the answer is dreaming.
What we can say is that policy is distinctly, perhaps even irretrievably, assymmetrical. Central bankers are conditioned to leap into action at the merest hint of renewed weakness, much less deflation. As with both fiscal and monetary stimulus in recent decades, the political incentives all run one way. In the absence of sustained, reassuring economic growth, it’s hard to see what might change this bias.
Right now, all the resulting excess liquidity is mostly languishing in reserves at various central banks, collecting a paltry return and seemingly doing no harm. There’s a bit of fresh lending going on here and there, but demand is low and the banks, generally, remain relatively cautious. Fact is, central bankers are tearing their hair out because of the financial system’s lack of responsiveness.
Careful what you wish for, perhaps? According to Ashwin Parameswaran, the market’s current willingness to hold unusually large quantities of money because of the crisis induced desire for safety and liquidity may not hold if “real rates turn significantly negative”:
Once real rates become sufficiently negative, credit growth explodes and the positive feedback loop of ever higher inflation fuelled not just by currency repudiation but by active exploitation of the banking and central bank discount window to access essentially free loans is set in motion. In other words, hyperinflation in modern capitalist economies is characterised not just by a collapse in the demand for deposits but an explosion in demand for loans at the free lunch level of nominal interest rates enforced by the central bank.
Whether these huge reserves might one day wreak unexpected havoc is something I’ve long wondered about too. What I hadn’t realised until I read Ashwin’s links was how critically important explosive private credit growth has often been in earlier hyperinflations.
It makes perfect sense, of course. Once the incentives are strong enough (and what could be stronger than seriously negative real rates?) the whole machinery of credit and money creation is unleashed. One shudders to think how silly things could get.
Could it really happen today, in the US, the UK, or Japan? Could central bankers miscalculate or lose control so badly as to set this particular doomsday machine in motion?
Cassandra though I often am in these matters, I struggle to see it. After all, there’s no shortage of historical horror stories at hand. Still, like armies, central bankers are inclined to fight the last war, and after the 1930s they’re understandably paranoid about letting debt deflation get the upper hand. As Bernanke said at a conference honouring Milton Friedman on his 90th birthday: “Regarding the great depression. You’re right, we [the Fed] did it. We’re very sorry. But thanks to you, we won’t do it again.”
So it’s not inconceivable. It just needs inflation to get away enough to generate juicy negative real rates. With so much dry tinder already around and central banks all leaning one way, that’s not inconceivable either. Remember too that while individual banks can get rid of reserves through making loans or purchasing investments, overall, banks can’t. What one loses, another gains. One can therefore imagine an accelerating rush by individual banks to deploy reserves, all of it, at a systemic level, entirely fruitless and on the other side newly hungry demand intent on exploiting negative real rates. While the notion of hyperinflation still seems . . . well, a bit hyper, it doesn’t strike me as an easy beast to rein in if it bolts.
To bring it under control, central banks would either have to vaporise sufficient reserves through sales from their portfolio to give banks pause, or, raise the rate they pay on reserves high enough to discourage the process. Neither seems attractive. Brave indeed would be the central banker who embarked on the former in these bone china delicate times. As for the latter, with reserves so high (and still growing) it sure wouldn’t be cheap.
James Turk interviews Doug Casey, the American-born economist, professional investor, author and advocate of the free market, in an illuminating, entertaining and yet ultimately chilling interview from November 2011.
For those of you with busy lives who don’t have the time to sit through an hour of Casey’s sage-like wisdom, this wide-ranging chat with one of the world’s foremost investors covers some key areas of vital importance to the Cobden Centre – namely the role of government and chiefly central banks in causing current and past crises.
On a side note, Casey’s clear thinking on what constitutes a strong economy is particularly timely as the Bank of England’s Governor, Sir Mervyn King, has rejected blame for the financial meltdown and instead lambasted banks that had “grown too quickly and borrowed too much”. He fails to acknowledge the role played by the Bank in creating the crisis – apparently a central interest rate never higher than 6% since 2000 despite a household savings ratio which has plummeted in the same period is nothing to be concerned about. Artificially low interest rates orchestrated by the central bank, which disregarded the level of real resources available, were one of the key ingredients in this unholy mess and the rapid and unsustainable expansion of our banking system that Sir Mervyn decries. The regulatory interventions since the crisis by the Bank and by government to “save the economy” remind me of an arsonist returning to a blaze they started while posing as a fireman.
So the questions for Doug Casey are, what conditions are needed for there to be a healthy, growing economy and why is the model we have today a complete perversion of basic economics?
The way you become wealthy is by producing more than you consume, and by saving the difference… The net savings in society provide the capital to expand and develop new technologies.
Oh that simple? A growing economy based on savings and investment in productive enterprise. Unfortunately, the combination of what Jim Grant calls the “Phd standard” in monetary policy discouraging savings, an economic model which views spending cheap credit as the alpha and omega of economic growth, and successive governments taxing, borrowing and spending their way into bankruptcy is an aberration from Casey’s common sense approach. As he puts it:
The problem we have today is that there are no net savings in the Western World – it’s all debt. Trillions and trillions of dollars of debt, on most levels. And what that means is that we’ve been living out of capital accumulated by generations past, and we’re living out of projected future income.
Turning to the endless merry-go-round of boom and bust, in his view (and that of Austrian economists across the globe) business cycles are “created by the government’s debasement of the currency, which is called inflation”. The new money created to bring this about “causes people to do things that they otherwise wouldn’t.” Also, like debt, it “tends to make people think that they are richer than they are”. In this way, you can see that the present UK government’s policy of trying to reinflate the bubble caused by excessive consumer spending, a low rate of savings and an unsustainable credit boom is simply an attempt to sustain the illusion of prosperity.
Turning to the ongoing and seemingly never-ending crisis we are now experiencing, described as the “greater depression”, Casey establishes three broad definitions of a depression, the effects of which are experienced simultaneously.
The first, is a “period of time during which most people’s standard of living drops significantly”. So far, so horrible.
The second, is a period of time “when the business cycle climaxes”. Again, we’ve certainly had this part – all our chickens tried to come home to roost. Casey claims this would be entirely avoidable under a free market economic system, besides the odd fluctuation.
The third, and most important, depression is when “distortions and misallocations of capital are liquidated”, allowing the economy to recover and grow. Unfortunately, this is exactly what the various stimulus packages, bailouts, and subsidies have prevented from happening. The UK’s over-leveraged banks, overinflated asset and housing markets, a good deal of unviable businesses and a massively bloated service sector have all been allowed to shuffle on, soaking up capital that might be allocated towards more productive purposes and dragging the economy down under a mountain of debt.
In addition to this, the response to the crisis by “stupid governments all over the world, with their quantitative easing measures, are basically going to destroy their national currencies” and “destroy the savings of the middle class”, leading to a “sociological earthquake”. So the arsonist starts the blaze, returns dressed as a fireman, then begins spraying the fire with jet fuel. As it becomes a raging inferno, he tells everyone that it would have been much worse if they hadn’t acted.
If you weren’t already preparing to either kill yourself or hike off into the hills to live out a nomadic existence in the Highlands, to top it off Casey predicts more of the rioting seen in London and Vancouver in recent years as “people find that they aren’t going to be able to improve themselves” and turn violent. Just what everyone needed – a good riot and some overturned cars.
He describes the prevailing perception that government is a “magic cornucopia” that can “make everybody wealthy” or “raise everybody’s wages” as ridiculous, having nothing that it hasn’t stolen first from society as a whole. His disgust with attitudes to government and with government itself is palpable. National debts should be defaulted on for “moral reasons” and to avoid citizens being turned into “veritable serfs” to “repay a mortgage against future generations” that is completely unsustainable and in order to punish those that have financed an ever-expanding state.
Casey is particularly derisive of our dear Continent, describing Europe as “constipated, highly regulated, highly taxed”, going downhill since World War One due to the “wrong philosophical values” and shortly to become no more than a “petting zoo for the Chinese”. Unfortunately, it’s not just us as we are all in an “existential nightmare” with no way out, and the best you can do is “Hold onto your hat” as “we’re in for a wild ride”.
More unemployment. More recession. More massive public debt. More print-more-money-and-pray quantitative easing.
More Mervyn King bleating on about the stalled economy – but failing to explain why he has missed his inflation target for years.
What passes for economic “debate” in Britain today is between those who still believe monetary stimulus is the way to engineer growth versus those who say we need fiscal stimulus.
Each time more monetary stimulus fails to produce prosperity, the fans of fiscal stimulus say we need to spend more. Each time public debt gets a little bit less manageable, those who favour monetary stimulus claim it is they who are right.
But what if they are both wrong?
If central bankers knew how to make us wealthy, the West would be booming. Instead, having handed them the macroeconomic controls, we find ourselves trapped in a decades long spiral of debt and stagnation.
It was attempts by central bankers like Mr King to engineer growth through monetary manipulation that landed us in this mess to start with. Further monetary stimulus today can no more restore us to prosperity than fiscal stimulus was able to in the 1970s. Debauched monetarism is no more the answer than debauched Keynesianism.
If you cannot engineer growth from on high, who in Whitehall is working on plans to set the economy free to grow from below?
What “winter of discontent”-style event might it take to prove that we need something altogether bolder and more radical than the current bankrupt orthodoxy.
“In my several decades as a financial and economics commentator – covering banking crises dating back to the early 1970s and the Latin American debt catastrophes of the early 1980s – I have never heard a sitting [Bank of England] governor talk in such apocalyptic terms about the parlous state of the global financial system.”
- Alex Brummer, The Daily Mail.
So what precisely did our inflation-fighter-in-chief actually say?
Well, that euro zone instability had created
an exceptionally threatening environment
as falling government debt prices, softening confidence and distressed asset sales threaten to
into a systemic financial crisis. Also, the UK financial system was encouraged to continue building up capital to bolster against an
situation not of its own making and which it could not resolve. Also,
The crisis in the euro area is one of solvency not liquidity. And the interconnectedness of major banks means the banking systems and economies around the world are all affected. Only the governments directly involved can find a way out of this crisis.
If debt is not to [continue] exploding to ever more unsustainable levels, transfers will be required together with the plan to restore the competitiveness within the euro area. There comes a point where the creditors need to realise that the scale of the debt owed to them is so large that they may have to be part of the solution.
Strong stuff from a fellow who looks like the hamster in “Danger Mouse”. It is all a waste of time, of course, more than a day late and more than a trillion short in whichever currency you care to proffer.
Perhaps things are not quite as bad as they seem. Last week in London we had the pleasure of hearing Gordon Corrigan speaking at Owen James’s always stimulating “Meeting of Minds” investment seminar. The intention of his speech was to put to rest a few myths about Britain’s role in the Great War. There was undeniable tragedy during those dreadful four years, but could there be a chance, asked the ex-Gurkha Major, that the Brits have tended to mythologise the whole World War One experience, magnify the national role, and accentuate the negative – a process that hardens with every passing year?
The late Alan Clark once quoted a conversation between a German general and one of his men that has not just entered the national psyche but become firmly embedded there. These British fight like lions, observed the soldier. Yes they do, replied the general: lions led by donkeys. But apparently Alan Clark made it up. No such conversation ever took place.
And there are evidently plenty of other established “facts” about the Great War that turn out to be somewhat detached from the actualité.
The popular British view of the Great War is of a useless slaughter of hundreds of thousands of patriotic volunteers, flung against barbed wire and machine guns by stupid generals who never went anywhere near the front line. When these young men could do no more, they were hauled before kangaroo courts, given no opportunity to defend themselves, and then taken out and shot at dawn. The facts are that over 200 British generals were killed, wounded or captured in the war, and that of the five million men who passed through the British Army 2,300 were sentenced to death by military courts, of whom ninety per cent were pardoned
The popular conception is that nearly every family in Britain had somebody killed in it. But according to the official census reports, there were approximately 9,800,000 households in Britain in 1914. The British lost 704,208 dead in the Great War. So statistically, only one family in 14 lost a member. Although there were undoubtedly certain parts of the country where fatalities were concentrated due to the way in which British infantry were recruited back then, there were large swathes of the country from where no one was killed. Corrigan has spoken of his own family, and his own black-clad Great Aunt, who never married – perhaps because all of her boyfriends and potential boyfriends met their end at the front ? “Nonsense,” suggests an uncle – his Great Aunt never married because she was “simply too damned ugly”.
By Gordon Corrigan’s account, British soldiers actually spent more time playing football than facing the enemy. By regularly rotating the soldiery and never keeping men in maximum danger for more than relatively short periods of time, the British army was alone among the major forces on the Western Front in never suffering a collapse of morale leading to mutiny.
One in 65 of the British population was killed in the war; for the French, the figure was one in 28. One in every 12 men mobilised in Britain was killed; for the French, one in six. For the Germans, one in 31 of the population was killed, one in every seven mobilised, as shown in the table below:
Population in 1914
Percentage of soldiers killed
Percentage of population killed
Source: Mud, Blood and Poppycock: Britain and the Great War
France, with a population six and a half million less than that of the UK, mobilised more men and suffered nearly twice as many deaths. Unlike in the UK, the demographic effect on France was enormous.
The perception of soldiering in the Great War has the young patriot enlisting in 1914 to do his bit and then being shipped off to France.
Arriving at one of the Channel Ports he marches all the way up the front, singing ‘Tipperary’ and smoking his pipe, forage cap on the back of his head. Reaching the firing line, he is put into a filthy hole in the ground and stays there until 1918. If he survives, he is fed a tasteless and meagre diet of bully beef and biscuits. Most days, if he is not being shelled or bombed, he goes “over the top” and attacks a German in a similar position a few yards away across no man’s land. He never sees a general and rarely changes his lice-infested clothes, while rats gnaw the dead bodies of his comrades.
Just on the topic of transportation, many soldiers were moved by train until a few miles from the front, and as the war went on, motor lorries and even London buses were used as troop carriers. And as Corrigan has already pointed out, the rotation of troops alone ensured that conditions were altogether more bearable than the popular conception would have it.
But back to the present. The war then may have been ultimately much less bleak for the British, for example, than the media and propaganda have portrayed. That does not mean that the peace now is any less bad for any of us than Mervyn King suggests. As investors we remain trapped in a surreal nightmare in which clueless politicians and desperate central bankers can see nothing other than money printing as a way out of the gloom. In the euro zone the problem is worse to the extent that the currency crisis is not merely severe but existential. Tragically, former voices of sanity such as The Telegraph’s Ambrose Evans-Pritchard seem to have now taken leave of their senses and joined with the inflationists, as this recent mad piece indicates.
This crisis can be stopped very easily by monetary policy.. to expand the quantity of money..
Oh, really? I am indebted to Tony Deden for the following quotation, from Alasdair Macleod in excerpts from a speech given to the Committee for Monetary Research and Education, given in New York on 20 October 2011:
I support sound money for two very good reasons. Firstly, it is a basic human right to choose to save, without our savings being debased by the tax of monetary inflation. Those who 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.
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 in their balance sheets as their property..
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.
Are you listening in the chancellories of Europe? Here in Britain we may not have had lions led by donkeys, but we now have liars throughout finance being led by junkies addicted to the printing of money. As democracies throughout the continent now topple to be replaced by technocrat stooges, and as the monetary and social chaos accelerates, we must hope that we at least manage to avoid the devastating political mistakes our forebears throughout Europe committed almost a century ago.
Since the Great Financial Crisis started (in truth, since well before), we have unwaveringly maintained three main tenets in relation to how one should deal with the aftermath of a credit-driven, mass misallocation of resources.
Firstly, we have said that, even if we did accept, arguendo, the trite macroeconomic mumbo-jumbo of over-aggregation, that tired old, maintenance-of-spending-at-any-cost, Keynesian game of trying to compensate for the overstretch of one particular ‘sector’ of the economy by passing ‘the bad, or depreciating, half crown to the other fellow’ is most likely to tangle us in an inextricable knot of surindebtedness if the ‘fellow’ is a governmental body. We say this, since the specious initial advantage of the state’s temporary ability to ignore the imperatives of accounting logic is doomed to be overwhelmed by the legal intractability associated with that same entity’s eventual financial exhaustion. Furthermore, this mere procedural failing is always horribly compounded by the dilution of the sense of direct responsibility which accompanies its involvement in any plight in which the relevant country lands itself.
Secondly, we have stood foursquare behind the idea that all the losses are actually incurred during the heady euphoria of the Boom, that the Bust is nothing more than the overdue recognition of those mistakes, and that to procrastinate thereafter in their acknowledgement is not to avoid the pain, but to exacerbate it in much the same way as a sufferer from a cancer can do himself nothing but harm by trying to delay the awfulness of the therapy which sadly must await him.
Thirdly, it has been our avowed belief that, contrary to the accepted wisdom, there are very few useful macro solutions to such a condition, but only micro ones; that recovery is built one job, one company at a time, from the bottom up.
Therefore, the most beneficial role for Leviathan is not some crazed, Frankenstein process of pulling levers and administering potions in some swivel-eyed, Gene Wilder fashion, but is one of expediting the renegotiation of now-unfulfillable contracts; of impartially overseeing a just transfer of assets from the failed to the well-founded; and of ensuring as few scarce resources as possible—in this time of unexpected penury—are pre-empted by the dead hand of the bureaucracy and, hence, are made available to the putative builders of a new, more prosperous tomorrow.
In all of this, we have been generally cynical of the ability of politicians to deny themselves the chance to carve their effigy on an imaginary Mt Rushmore of interventionists. We have been even more deprecatory of the nomenklatura of would-be Plato’s who advise them, those ’socialists of the chair’ who blindly fill their pink column inches with the ludicrous argument that the only remedy for the failure of government interference is more interference. We have been vehemently opposed to the machinations of central bankers—the ultimate succourers, when not the original seeders, of the Boom—who continue to frame every response in terms of the provision of liquidity to their precious cartel of institutionally parasitic, fractional reserve banks.
Despite this, it has been hard to suppress the faint fluttering of a hope lately freed from its hard chrysalis of doubt by the integrity of some members of the northern European political class and their nominees within the Heart of Darkness of the central bank itself.
Germany—with both tacit and expressed support from among the Dutch, the Finns, the Slovaks, and others—has wrestled itself close enough to doing the right thing—to writing off much of the debt; to making the imprudent private owners and creditors face their responsibilities; and to insisting on guarantees of future good housekeeping from the incontinent debtors—to merit our applause, even if its courage eventually does fail it, or the temptation to take the road to hell along which everyone else is frantically pointing finally does prove too hard to resist.
However, any sense of the victory we entertain in this critical war of ideas—albeit four years late and several trillion dollars short—has to be tempered greatly by the awful truth that two of the major central banks have already succumbed, once more, to their liquidity fetish, while a third is patently ravening for the chance to overcome the present domestic impediments to further action.
One of them, the ECB, is slowly transforming itself into a Fed—over the careers of ex-Bundesbankers perhaps, but nonetheless inexorably so.
Believe, if you will, that all such measures as those announced this week are ‘temporary’—only to be countenanced for the duration of the emergency—and, as our New York friends say, I have a bridge to sell you in Brooklyn.
Yes, it is true that interbank lending has frozen, that the vast apparatus of sovereign finance is creaking alarmingly, and that real money supply growth in the Zone is hovering just above the zero bound. Of these, however, only the third is a potentially justifiable field for central bank intervention in extremis.
The first is a consequence of the long-suppressed mistrust of one another’s balance sheets being expressed by the banks themselves; a fear which could be dispelled overnight if they would each do no more than is required of any public corporation, namely, to produce an honest set of accounts, even if this would be to undertake an exercise in triage—of the merciless sorting of the weak from the strong. To recognise its origin is already to point to where the cure may be found—extended repo operations and expanded bond purchases do not lie along that way.
The second handicap is the legacy of long years of populist vote-buying whereby venal politicians have far too liberally dispensed a morally corrupting patronage, not by having to undertake the invidious task of clearly identifying the winning net recipients of tax monies from the losing net payers standing beside them at the hustings, but by recourse to the seemingly painless expedient of borrowing funds which are never intended to be repaid and which are, in great part, the result of inflationary credit creation on the part of the same central and commercial banks who are now so threatened by the fall of all these democratic Bourbons. Again, to make this diagnosis is to indicate what form the remedy must take and to show that the prostitution of the central bank, so as to maintain the status quo ante, will prove futile, if not fatal, to the patient
As for the Bank of England—well, yes again, real money supply has been running at a negative rate in the UK for some good few months past, dragging activity lower as it has. Yet a very good part of this real contraction is because the Bank has also managed to ignite a nasty rise in prices in violation of its rather open-ended mandate to moderate these over a self-determined and highly elastic ‘medium-term’.
As we have said before, the fact that the UK still manages to run a near-record trade deficit amid a severe recession and during an ostensible private sector credit crunch, despite a 25% drop in sterling’s real effective exchange rate such as to take it to a level only matched during the IMF crisis of the mid-70s Labour administration, is testimony both to the fact that the overall squeeze is not so intense as it seems and to the failure of all this macro-meddling to restore a semblance of competitiveness to a hollowed-out nation.
Where the leakage occurs, of course, is in the realm of the state where, for all the gnashing of teeth and tearing of hair about the ‘austerity’ programme, spending continues to rise, with the change in the state component of expenditures in Q2 outstripping that of households for the fifth quarter out of the last six. Total state outlays are still making new record highs, both outright and as a proportion of non-state GDP—that latter ratio now bumping up against the 60% mark, no less.
So it is all very well for Mervyn King to bleat about facing the most severe financial crisis since the 1930s, or to casually dismiss the cries of the thrifty that their livelihoods are being crushed in the vice of rising prices and falling returns to capital, but it is he and his predecessors, together with the political masters they serve, who have led us into these straits, by dint of their unshrinking embrace of a perverted orthodoxy of inflationary entitlement—of the entitlement of welfare recipients to their doles, of office-seekers to their votes, and of inveterate financial gamblers to their place at the tables of the state-sponsored, state-regulated, and state-underwritten casino.
Mr. King’s response to all this? Why, again to make it easy for the state to spend more and difficult for many of the most vulnerable elements of the nation to spend as much. Bravo, indeed!
So, while Chairman Bernanke can, for now, only threaten to increase the disruption he causes to the market’s pricing signals and to its ability to allocate resources optimally over time, his peers are already at work doing much the same mischief.
Caught up with the demands of their real dual mandate—that of keeping the ruling class happy while looking after the interests of their cabal of big bankers—few of them will stop to listen to what businessmen are telling them, though the message is being broadcast in the most clarion of tones.
Take the most recent Duke University/CFO Magazine quarterly survey of senior US executives as a case in point.
Asked to list external concerns in order of importance, the perennial question of sufficient demand for the firm’s products came top, but a clear second place was secured by the category ‘Federal Government agenda/policies’ – aka, REGIME UNCERTAINTY!
As for internal worries, the ability to maintain margins was top, the cost of health care, second, and the ability to forecast, third—over to you, Mssrs Bernanke and Obama, once more, for creating and fostering such extreme REGIME and MARKET UNCERTAINTY!
And the result of all this? Exactly what we showed in graphical form and briefly discussed in our last edition:-
A third of CFOs say they will not deploy excess cash this year, because they want to retain it should credit markets tighten. Twenty-nine percent say they are hoarding cash due to economic uncertainty, and 31% say they don’t have any excess cash to spend.
More worrying still for all those executives and traders who keep telling us that while business in the Old World may be slow, Asia will keep firing away and so save their bacon, the separate respondents from that particular region also manifested an uncharacteristically subdued tenor. We quote as follows:-
Optimism about the regional economy in Asia (not counting China) fell, with optimists and pessimists now evenly balanced. Last quarter, optimists outnumbered pessimists by two to one. In China, 69 percent of firms have grown more pessimistic about the economic outlook.
The top internal concern among Asian CFOs is difficulty in planning due to extreme uncertainty, working capital management and employee morale. The top external concerns in Asia are global financial instability, intense pricing pressure and weak consumer demand. Chinese CFOs also worry about government policies.
But, carry on regardless! The present approach has been so successful that while one in ten Americans with a full-time job lost it in the slump, barely one in six of those unfortunates has found similar work since, leaving the total at 2000 levels and its fraction of the population at 1975 and 1983 recessionary depths, despite the intervening incorporation of women into the workforce. As for manufacturing—supposedly doing well on the cheapest dollar of the modern era—almost one quarter of the hours worked here were lost from the local maximum of 2006, of which, again, less than a sixth have since been replaced, leaving total hours fully a third below the stationary average of 1984-2001, and still stuck where they were in St. Roosevelt’s bleak 1940s!
Meanwhile, the 3mma of US NAPM new orders has dipped below the 50 watershed for the first time since the crisis, an event which has historically signalled a further deterioration over the succeeding six months in 70% of cases, and an ill omen we must interpret in light of the fact that the magnitude of the last few months’ fall in this component has only been exceeded three times in the past century—in 1974/5, 1980, and in 2009 itself.
Even in Germany, 2009-10’s impressive growth in factory orders has begun to peter out to the point that there has been little further sustained growth so far this year. Meanwhile, at the other end of the world, a PMI of Korean orders languishes at a 2-year low, while exports of capital goods from Taiwan have not been this weak since early 2010.
It may be too much to say that the wheels are coming off the recovery, but they are certainly beginning to wobble.
The UK is in sorry shape today. The British can at least take comfort in knowing that things are still not anywhere near as bad as they were over a half century ago during the gloomy days of the Blitz. Yet in contemplating where Britain is today, and comparing it to other dark periods, it would be well-advised to keep everything in historical perspective.
The Blitz was terrible, but it was far from the worst that could have happened. While the constant fear of bombing, mandatory curfews and destroyed cities rendered a great tragedy on Britain, the steady supply of Nazi bombs saved her from another fate. While German bombers were busy emptying their destructive cargo onto Britain, they were unable to drop a different type of cargo that would have meant not just sudden impairment of the livelihoods of the British (as did the bombs) but their future prosperity as well.
Operation Bernhard was hatched in 1942 by SS Major Bernhard Krüger (whose claim to fame now rests on naming what would become one of the War’s most devious plots after himself). The plan involved flooding the British economy with £5, £10, £20, and £50 notes. In what was the largest counterfeiting operation in history, a team of 142 “counterfeiters” (i.e., inmates) at the Sachsenhausen concentration camp toiled for three years to amass a sizeable British fortune: 8,965,080 Bank of England notes were produced with a total value of £134,610,810.
The initial plan called for bombing runs to drop the currency from the sky. Britons know a good deal when they see one – pounds sent from heaven would be a ray of sunshine in an otherwise dreary wartime economy. As the counterfeit pounds were spent, inflation would be triggered. The once proud British economy would be brought to its knees as skyrocketing prices would foil entrepreneurs’ plans, destroy savings, and otherwise wreak havoc on the economy.
Luckily, the tenacity of the British paid off. The Luftwaffe, increasingly hindered as the war wore on, lacked the bombers to drop the counterfeit notes over the British countryside. Disaster was averted.
And yet today we have a similar plan in action. Mervyn King, governor of the Bank of England, has undertaken his own little “Operation Bernhard.” The base money supply of the United Kingdom – the notes and coins in circulation – has increased by over 75 percent over the last decade. That supply of dingy notes and tarnished coins that weigh down Britons’ pockets has grown by leaps and bounds that Major Krüger could only dream of.
While the Nazi’s could only produce £134,610,810 over the course of the war, this is about 7 percent of what the Bank of England was able to produce in 2010 alone! Even at the height of the operation it is claimed that about 1 million counterfeit notes were produced per month. Even if we concede that all of these notes were of the largest denomination printed (£50), this would still only amount to £600 million a year. Even this massive figure pales in comparison to the approximately 1.9 billion extra pounds of currency that the Bank of England put into circulation last year.
To put it in other words: In the last year the Bank of England pursued an operation that was over twice as effective as the Nazi’s could only dream of during the height of the war. Mervyn King and his colleagues have pursued an inflationary policy the likes of which Britain’s largest enemies could only wish for during the war.
I know that you are supposed to have love for thine enemies, but this all begs the question: Mr King, whose side are you on anyway?
Ultimately, the problem with modern banks is that they do not operate in a free market. They haven’t done for decades. Deposit insurance means depositors take no interest in the stability of the banks they give their money to. The inevitability of bailouts means bondholders and shareholders take no interest either. Expansionary monetary policy encourages banks to lend too much and reserve too little. Accounting regulations encourage all banks to invest in certain asset classes, ensuring that when problems emerge, they are likely to be systemic. All of these things are government interventions, and all of them make the financial sector more risky and less stable.
In a speech last night in Newcastle-Upon-Tyne the head of the UK’s central bank continued on his admirable path of admitting that the banking bailout and policy of currency debasement have simply transferred the cost of the bank bailout onto the shoulders of ordinary families and, in particular, has drained the funds of those foolish enough to support our economy and banking system by saving in sterling.
How embarrassed do the Bank of England’s senior officials feel this morning on rereading their own confident and optimistic misrepresentation of money printing (quantitative easing) less than two years ago? The Bank of England’s own website still displays the following assurance that QE is a well conceived tool of monetary policy that has been implemented to stimulate the economy and control inflation:
The instrument of monetary policy shifted towards the quantity of money provided rather than its price (Bank Rate). But the objective of policy is unchanged – to meet the inflation target of 2 per cent on the CPI measure of consumer prices. Influencing the quantity of money directly is essentially a different means of reaching the same end.
The latest official CPI number is 3.7%.
As Jesus Huerta de Soto explained in his Hayek lecture in October 2010
The spontaneous reaction of the market against the effects of credit expansions: first the financial crisis and second the deep economic recession.
De Soto again from the same lecture:
The financial crisis begins the moment the market, which as I have said is very dynamically efficient (Huerta de Soto 2010a, 1-30), discovers that the true market value of the loans granted by banks during the boom is only a fraction of what was originally thought. In other words, the market discovers that the value of bank assets is much lower than previously thought and, as bank liabilities (which are the deposits created during the boom) remain constant, the market discovers the banks are in fact bankrupt, and were it not for the desperate action of the lender of last resort in bailing out the banks, the whole financial and monetary system would collapse.
Let us consider the UK format of this rescue: a transfer of wealth from savers and ordinary taxpaying workers, to banks. Surely this can only conceivably be justified if the bailed out banks cease to behave as independent profit seeking businesses with vast direct stakes in so many limbs of the UK economy (via massive leveraged loan portfolios and direct private equity stakes, SIV and securitisation holdings in almost all industries with predictable cash generation - utilities, PFI, social housing rental streams) that they treat other businesses in similar industries as competitors to be shunned, or worse, crushed.
Surely the direct investments should be sold to enable the banks to act as genuine engines of economic recovery by allocating resources to understanding and supporting UK businesses?
If banks returned to lending to businesses, rather than effectively buying so many, a behavioural shift might start to occur.
But there has been no such behavioural shift. In a paper which I am drafting for the Adam Smith Institute, I will focus on three trends which evidence the contrary:
The continued increase in derivative and repo market activity driven by the ease of declaring as profit years of hoped for income which, against the banking crisis background is, unlikely to materialise;
The brittleness of bank balance sheets caused by abuse of mark to market rules regarding illiquid transactions (both parties to transactions marking them at wildly differing prices in each case to favour the reporting bank)
The enormous rise in Basel 2 regulatory arbitrage, highlighting the staggering incompetence of these regulations and their authors.