Bank gearing in the Eurozone

According to the ECB’s Bank Lending Survey for October banks eased their credit standards in the last quarter, while their risk perceptions increased.

This apparent contradiction suggests that the 137 banks surveyed were at the margin competing for lower-quality business, hardly the sign of a healthy lending market. Furthermore, the detail showed enterprises were cutting borrowing for fixed investment sharply and required more working capital instead to finance inventories and perhaps to cover trading losses.

This survey follows bank lending statistics since the banking crisis to mid-2014, which are shown in the chart below (Source: ECB).

Euro bank lending 14112014

It is likely that some of the contraction in bank lending has been replaced with bond finance by the larger credit-worthy corporations, and Eurozone banks have also preferred buying sovereign bonds. Meanwhile, the Eurozone economy obviously faces a deepening crisis.

There are some global systemically important banks (G-SIBs) based in the Eurozone, and this week the Financial Stability Board (FSB) published a consultation document on G-SIBs’ capital ratios in connection with the bail-in procedures to be considered at the G20 meeting this weekend. The timing is not helpful for the ECB, because the FSB’s principle recommendation is that G-SIBs’ Tier 1 and 2 capital should as a minimum be double the Basel III level. This gives operational leverage of between 5 and 6.25 times risk-weighted assets, compared with up to 12.5 times under Basel III.

The FSB expects the required capital increase to be satisfied mostly by the issue of qualifying debt instruments, so the G-SIBs will not have to tap equity markets. However, since Eurozone G-SIBs are faced with issuing bonds at higher interest rates than the returns on sovereign debt, they will be tempted to scale back their balance sheets instead. Meanwhile bank depositors should note they are no longer at the head of the creditors’ queue when their bank goes bust, which could affect the non-G-SIB banks with higher capital ratios.

If G-SIBs can be de-geared without triggering a bank lending crisis the world of finance should eventually be a safer place: that’s the intention. Unfortunately, a bail-in of a large bank is unlikely to work in practice, because if an important bank does go to the wall, without the limitless government backing of a bail-out, money-markets will almost certainly fail to function in its wake and the crisis could rapidly become systemic.

Meanwhile, it might appear that the ECB is a powerless bystander watching a train-wreck in the making. Businesses in the Eurozone appear to only want to borrow to survive, as we can see from the October Bank Lending Survey. Key banks are now being told to halve their balance sheet gearing, encouraging a further reduction in bank credit. Normally a central bank would respond by increasing the quantity of narrow money, which the ECB is trying to do despite the legal hurdles in its founding constitution.

However, it is becoming apparent that the ECB’s intention to increase its balance sheet by up to €1 trillion may not be nearly enough, given that the FSB’s proposals look like giving an added spin to contraction of bank credit in the Eurozone.


Understanding the Money Creation and Society Debate

Together with colleagues spanning four parties – Michael Meacher (Lab), Caroline Lucas (Green), Douglas Carswell (UKIP) and David Davis (Con) – I have secured a debate on Money Creation and Society for Thursday 20 November. Here’s a quick guide to understanding the debate.

First, we have a system of paper or “fiat” money: it exists due to legal mandate as opposed to being a physical commodity like gold. Reserves, notes and coins are created by the state but claims on money are created by the banks when they lend. Most of the money we have was created by banks lending.

This excellent video from Dominic Frisby is a great place to begin:

There was once a time when the literature about money creation was sufficiently off the mainstream to be dismissed. The Bank of England now explains:

I published a short paper on what is wrong with the current system and what to do about it, first inBanking 2020 and then Jesús Huerta de Soto kindly republished it in his journal Procesos De Mercado Vol.X nº2 2013. A further monetary economist privately reviewed the paper but errors and omissions remain my own. You can download it here:

Recent emergency monetary policy has been dominated by Quantitative Easing: the Bank of England has provided a report on The distributional effects of asset purchases (PDF). However, the financial system has been chronically inflationary throughout my lifetime, ever since the Bretton Woods currency system ended.

If QE has distributional effects, why not all money creation?

Here is a historic price index from the Office for National Statistics and House of Commons Library: Consumer Price Inflation since 1750 (PDF).

Price Index 1750-2003

And here is the growth of broad money from 1982 to date via the Bank of England (series LPMAUYM). Note that the money supply stopped accelerating in the course of the crisis, during the period of QE:

M4: 1982-2014

No one can argue prosperity has not increased over the period but if distributional effects matter at all, one must ask “Who benefits?” Via Positive Money, here’s where the new money went:

Sectoral lending

As I said in debate on 6 Dec 2011:

Why are we in this debt crisis? I have just checked the M4 money supply figures—I am sorry to return to aggregates, but needs must. When Labour came to power the money supply was about £700 billion and it is now about £2.1 trillion, so it has tripled over the past 14 years. Unfortunately, most economists talk about money flowing into the economy as if it were water poured into a tank that found its own level immediately, but what if it is like treacle or honey? What if it builds up in piles when poured into the economy and takes a while to spread out? What if that money was loaned into existence in response to individual choices led by the excessively low interest rates pushed by the central bank? What if it was loaned into existence in particular sectors, such as the housing sector, where prices have more than doubled over the same period, and what if it was the financial sector that received the benefit of that new money first? Would that not explain why financiers and bankers are so much wealthier than everyone else, and why economic activity and wealth has been reorientated towards the south-east?

This debate will explore the effects on society of long-term money creation by private banks’ lending in the context of the present financial system.

Further reading:


The Gold Standard Did Not Cause The Great Depression, Part 2

As noted in my previous column, AEI’s James Pethokoukis and National Review‘s Ramesh Ponnuru — among many others — appear to have fallen victim to what I have called the “Eichengreen Fallacy.”  This refers to the demonstrably incorrect proposition that the gold standard caused the Great Depression.

Pethokoukis proves exactly right in observing that “Benko is a gold-standard advocate and apparently doesn’t much like the words ‘Hitler’ or ‘Nazi’ to be in the same area code of any discussion of once again linking the dollar to the shiny yellow metal.”  “Doesn’t much like” being falsely linked with Hitler?  Perhaps an apology is more in order than an apologia.

My objecting to a demonstrably false implication of the (true) gold standard in the rise of Nazism does not constitute a display of ill will but rather righteous indignation.  To give Pethokoukis due credit he thereupon generously devoted anAEIdea blog to reciting Peter Thiel’s praise for the gold standard, praise which triggered a hysterical reaction from the Washington Post‘s Matt O’Brien.

Pethokoukis’s earlier (and repeated) vilification of gold was followed by a column in the Washington Times by a director of the venerable Committee for Monetary Research and Education Daniel Oliver, Jr., Liberty and wealth require sound money. In it, Oliver states:

What if liberty and riches at times diverge, though? A shibboleth of mainstream economists, repeated recently in The National Review, of all places, is that countries recovered from the Great Depression in the order that they abandoned the gold standard. … No doubt, money printing — the modern equivalent of leaving the gold standard — can plug the holes in banks’ balance sheets when the demand deposits at the base of the credit structure are withdrawn. This is the policy recommended by National Review Senior Editor Ramesh Ponnuru and other “market monetarists” such as the American Enterprise Institute’s James Pethokoukis ….

I am not in complete accord with all of Oliver’s propositions therein. Ponnuru is on solid ground in contradicting Oliver’s imputation of sentiments to him he does not hold and does not believe.  Yet Ponnuru weakens his defense by citing, among other things, a

recent summary of the history of gold standards in the United States that George Selgin wrote for the Cato Institute. It is a very gold-friendly account, but it ‘concludes that the conditions that led to the gold standard’s original establishment and its successful performance are unlikely to be replicated in the future.’

“Unlikely to be replicated in the future?”  Prof Selgin is a brilliant economist, especially in the elite field of monetary economics.  Yet as Niels Bohr reportedly once said, “Prediction is very difficult, especially about the future.” This citation in no way advances Ponnuru’s self-defense.

Let it be noted that Cato Institute recently announced a stunning coup in recruiting Prof. Selgin to head its impressive new Center For Monetary and Financial Alternatives. As stated in its press release, “George Selgin, a Professor Emeritus of Economics at the University of Georgia and one of the foremost authorities on banking and monetary theory and history, gave up his academic tenure to join Cato as director of the new center.” Cato’s recruitment, from the Mercatus Institute, of a key former House subcommittee aide, the formidable Lydia Mashburn, to serve as the Center’s Manager also shows great sophistication and purpose.

Prof. Selgin hardly would give up a prestigious university post to engage in a quixotic enterprise.  I, among many, expect Selgin rapidly to emerge as a potent thought leader in changing the calculus of what is, or can be made, policy-likely.  Also notable are the Center’s sterling Council of Economic Advisors, including such luminaries as Charles Calomiris; its Executive Advisory Council; Senior Fellows; and Adjunct Scholars.  It is, as Prof. Selgin noted in a comment to the previous column, “a rather … diverse bunch.”

The Center presents as an array of talent metaphorically reminiscent of the 1927 Yankees. These columns do not imply Cato to be a uniform phalanx of gold standard advocates but rather a sophisticated group of thought leaders committed to monetary and financial alternatives, of which the classical gold standard is one, respectable, offering.  Prof. Selgin’s own position frankly acknowledging the past efficacy of the true gold standard represents argument from the highest degree of sophistication.

Ponnuru is on the weakest possible ground in citing the “commonplace observation that countries recovered from the Great Depression in the order they left gold.”  This is as misleading as it is commonplace. Ponnuru, too, would do well to break free of the Eichengreen Fallacy and assimilate the crucial fact that a defective simulacrum, not the true gold standard, led to and prolonged the Great Depression.

The perverse effects of the interwar “gold” standard led to a significant rise in commodities prices … and the ensuing wreckage of a world monetary system by the, under the circumstances, atavistic definition of the dollar at $20.67/oz of gold.  The breakdown of the system meticulously is documented in a narrative history by Liaquat Ahamed, Lords of Finance: The Bankers Who Broke The World, which received the Pulitzer Prize in history.  That road to Hell tidily was summed up in a recent piece in The Economist, Breaking the Rules: “The short-lived interwar gold standard … was a mess.”  As EPPC’s John Mueller recently observed, in, “the official reserve currencies which Keynes advocated fed the 1920s boom and 1930s deflationary bust in the stock market and commodity prices.”

The predicament — caused by the gold-exchange standard adopted in Genoa in 1922 — required a revaluation of the dollar to $35/oz, duly if eccentrically performed by FDR under the direction of commodities price expert economistGeorge Warren.  That revaluation led to a dramatic and rapid lifting of the Great Depression.  Thereafter, as Calomiris, et. al, observe in a publication by the Federal Reserve Bank of St. Louis, the Treasury sterilized gold inflows.  That sterilization, together with tax hikes, most likely played a major role in leading to the double dip back into Depression.

The classical gold standard — an early casualty of the First World War — was not, indeed could not have been, the culprit.  There is a subtle yet crucial distinction between the gold-exchange standard, which indeed precipitated the Great Depression, and the classical gold standard, which played no role.There is much to be said for the classical gold standard as a policy conducive to equitable prosperity.  It commands respect, even by good faith opponents.

For the discourse to proceed we first must lay to rest the Eichengreen Fallacy (and all that is attendant thereon). Once having dispelled that toxic fallacy let the games begin and let the best monetary policy prescription win.

Originating at


Road to nowhere

Spring 2010: A gradual recovery
Autumn 2010: A gradual and uneven recovery
Spring 2011: European recovery maintains momentum amid new risks
Autumn 2011: A recovery in distress
Spring 2012: Towards a slow recovery
Autumn 2012: Sailing through rough waters
Winter 2012: Gradually overcoming headwinds
Spring 2013: Adjustment continues
Autumn 2013: Gradual recovery, external risks
Winter 2013: Recovery gaining ground
Spring 2014: Growth becoming broader-based
Autumn 2014: Slow recovery with very low inflation.. ”

European Commission economic headlines, as highlighted by Jason Karaian of Quartz, in ‘How to talk about a European recovery that never arrives’.

“Well we know where we’re going
But we don’t know where we’ve been
And we know what we’re knowing
But we can’t say what we’ve seen
And we’re not little children
And we know what we want
And the future is certain
Give us time to work it out
We’re on a road to nowhere..”

‘Road to nowhere’ by Talking Heads.

In 1975, Charles Ellis, the founder of Greenwich Associates, wrote one of the most powerful and memorable metaphors in the history of finance. Simon Ramo had previously studied the strategy of one particular sport in ‘Extraordinary tennis for the ordinary tennis player’. Ellis went on to adapt Ramo’s study to describe the practical business of investing. His essay is titled ‘The loser’s game’, which in his view is what the ‘sport’ of investing had become by the time he wrote it. His thesis runs as follows. Whereas the game of tennis is won by professionals, the game of investing is ‘lost’ by professionals and amateurs alike. Whereas professional sportspeople win their matches through natural talent honed by long practice, investors tend to lose (in relative, if not necessarily absolute terms) through unforced errors. Success in investing, in other words, comes not from over-reach, in straining to make the winning shot, but simply through the avoidance of easy errors.
Ellis was making another point. As far back as the 1970s, investment managers were not beating the market; rather, the market was beating them. This was a mathematical inevitability given the over-crowded nature of the institutional fund marketplace, the fact that every buyer requires a seller, and the impact of management fees on returns from an index. Ben W. Heineman, Jr. and Stephen Davis for the Yale School of Management asked in their report of October 2011, ‘Are institutional investors part of the problem or part of the solution ?’ By their analysis, in 1987, some 12 years after Ellis’ earlier piece, institutional investors accounted for the ownership of 46.6% of the top 1000 listed companies in the US. By 2009 that figure had risen to 73%. That percentage is itself likely understated because it takes no account of the role of hedge funds. Also by 2009 the US institutional landscape contained more than 700,000 pension funds; 8,600 mutual funds (almost all of whom were not mutual funds in the strict sense of the term, but rather for-profit entities); 7,900 insurance companies; and 6,800 hedge funds.

Perhaps the most pernicious characteristic of active fund management is the tendency towards benchmarking (whether closet or overt). Being assessed relative to the performance of an equity or bond benchmark effectively guarantees (post the impact of fees) the institutional manager’s inability to outperform that benchmark – but does ensure that in bear markets, index-benchmarked funds are more or less guaranteed to lose money for their investors. In equity fund management the malign impact of benchmarking is bad enough; in bond fund management the malign impact of ‘market capitalisation’ benchmarking is disastrous from the get-go. Since a capitalisation benchmark assigns the heaviest weightings in a bond index to the largest bond markets by asset size, and since the largest bond markets by asset size represent the most heavily indebted issuers – whether sovereign or corporate – a bond-indexed manager is compelled to have the highest exposure to the most heavily indebted issuers. All things equal, therefore, it is likely that the bond index-tracking manager is by definition heavily exposed to objectively poor quality (because most heavily indebted) credits.

There is now a grave risk that an overzealous commitment to benchmarking is about to lead hundreds of billions of dollars of invested capital off a cliff. Why ? To begin with, trillions of dollars’ worth of equities and bonds now sport prices that can no longer be trusted in any way, having been roundly boosted, squeezed, coaxed and manipulated for the dubious ends of quantitative easing. The most important characteristic of any investment is the price at which it is bought, which will ultimately determine whether that investment falls into the camp of ‘success’ or ‘failure’. At some point, enough elephantine funds will come to appreciate that the assets they have been so blithely accumulating may end up being vulnerable to the last bid – or lack thereof – on an exchange. When a sufficient number of elephants start charging inelegantly towards the door, not all of them will make it through unscathed. Corporate bonds, in particular, thanks to heightened regulatory oversight, are not so much a wonderland of infinite liquidity, but an accident in the secondary market waiting to happen. We recall words we last heard in the dark days of 2008:

“When you’re a distressed seller of an illiquid asset in a market panic, it’s not even like being in a crowded theatre that’s on fire. It’s like being in a crowded theatre that’s on fire and the only way you can get out is by persuading somebody outside to swap places with you.”

The second reason we may soon see a true bonfire of inanities is that benchmarked government bond investors have chosen collectively to lose their minds (or the capital of their end investors). They have stampeded into an asset class historically and euphemistically referred to as “risk free” which is actually fraught with rising credit risk and systemic inflation risk – inflation, perversely, being the only solution to the debt mountain that will enable the debt culture to persist in any form. (Sufficient economic growth for ongoing debt service we now consider impossible, certainly within the context of the euro zone; any major act of default or debt repudiation, in a debt-based monetary system, is the equivalent of Armageddon.) As Japan has just demonstrated, whatever deflationary tendencies are experienced in the indebted western economies will be met with ever greater inflationary impulses. The beatings will continue until morale improves – and until bondholders have been largely destroyed. When will the elephants start thinking about banking profits and shuffling nervously towards the door ?

Meanwhile, central bankers continue to waltz effetely in the policy vacuum left by politicians. As Paul Singer of Elliott Management recently wrote,

“Either out of ideology or incompetence, all major developed governments have given up (did they ever really try?) attempting to use solid, fundamental policies to create sustainable, strong growth in output, incomes, innovation, entrepreneurship and good jobs. The policies that are needed (in the areas of tax, regulatory, labour, education and training, energy, rule of law, and trade) are not unknown, nor are they too complicated for even the most simple-minded politician to understand. But in most developed countries, there is and has been complete policy paralysis on the growth-generation side, as elected officials have delegated the entirety of the task to central bankers.”

And as Singer fairly points out, whether as workers, consumers or investors, we inhabit a world of “fake growth, fake money, fake jobs, fake stability, fake inflation numbers”.

Top down macro-economic analysis is all well and good, but in an investment world beset by such profound fakery, only bottom-up analysis can offer anything approaching tangible value. In the words of one Asian fund manager,

“The owner of a[n Asian] biscuit company doesn’t sit fretting about Portuguese debt but worries about selling more biscuits than the guy down the road.”

So there is hope of a sort for the survival of true capitalism, albeit from Asian biscuit makers. Perhaps even from the shares of biscuit makers in Europe – at the right price.


Into the unknown

“Sir, Your headline “Fed’s grand experiment draws to a close” (, October 29) combines ignorance of what quantitative easing is with insouciance as to its potential effects – both of these mistakes being perennial features of FT coverage of QE. The “experiment”, as you call it, is not at an end; it is, with the purchases now ending, at its height. Only when the Fed starts selling the securities it has purchased back into the market will the US’s QE begin its withdrawal from that height; only when the last purchased security has been sold back into the market, or allowed to expire with consequent permanent expansion of the money supply, will the “grand experiment” (I would prefer that you called it “reckless gamble”) be at its end.

“Only at that point will we even start to see the results – on interest rates, on securities prices, on the economy. The outcome, as has so often been the case with such Keynesian experiments, is unlikely to be pretty.”

  • Letter to the FT from Jon Moynihan, London SW3.

The other potential cause of a sell-off in markets is through a central bank mistake. Some think the liquidity created by QE will eventually leak into higher inflation, but there is no sign of this as yet. More likely is a decline into deflation which would lead to financial distress as debts become more difficult to repay.

“If that does show signs of happening, then we may indeed get to see QE4 rolled out. Daddy might have let go of the market’s hand for the moment but he’s still close by.”

Strange things are happening in the bond market. Few of them are stranger than the reports that a French fund management colleague of Bill Gross (formerly of Pimco) took such exception to public excoriation from his stamp-collecting associate that he quit the business to sell croques monsieur from a food truck. According to the Wall Street Journal, Gross told Jeremie Banet in front of Pimco’s entire investment committee that, “I never understand what you’re saying. Ever.” With those credentials, M. Banet is clearly supremely qualified to become the next chairman of the Federal Reserve. As it is, he elected to return to his job managing an inflation-linked bond portfolio.

He has his work cut out. Consider the sort of volatility that the 10 year US Treasury bond – the closest thing the financial world has to a “risk-free rate” – experienced on 15th October (below).

Intra-day yield, 10 year US Treasury bond, 15th October 2014

10 day Treasury Bond Yield

Source: Bloomberg LLP

Having begun the day sporting a 2.2% yield, the 10 year note during the trading session experienced an extraordinary surge in price that took its yield down briefly towards 1.85%. Later in the same session the buying abated, and the bond closed with a yield of roughly 2.14%. During the same trading session, equity markets sold off aggressively (the UK’s FTSE 100 index, for example, closed down almost 3% on the day). What accounts for such melodrama ?

Analyst Russell Napier takes up the story:

“There it was — a real market come and gone in half an hour, like a pregnant panda at Edinburgh zoo. What did it mean and what should you do? You should pay attention to what happens to the direction of prices when volumes surge and markets work. When the veil is lifted, pay attention to what you see beneath. Last Wednesday, in the space of half an hour of active trading, the Treasury market had one of its most rapid rises ever recorded and equities fell sharply.

“There is a very simple lesson that when the markets finally break through the manipulation they move to price in deflation and not inflation. This is key because it means financial repression has failed. Such repression requires the artificial depression of interest rates but, crucially, it must be paired with boosting inflation above such rates. On October 15th 2014, if only for a few short minutes, market forces broke out and the failure of central bankers was briefly evident.”

These days, you don’t tend to hear the words ‘failure’ and ‘central bankers’ in the same sentence (unless the topic happens to be Zimbabwe). But perhaps the omniscience and omnipotence of central bankers is somewhat overstated. On October 29th, the US Federal Reserve followed a long-rehearsed script and announced that it had “decided to conclude its asset purchase program [also known as QE] this month.”

So now stock and bond markets will have to look after themselves, so to speak. The Economist’s Buttonwood columnist described it as “Letting go of Daddy’s hand”. That coinage nicely speaks to the juvenilisation to which markets have been reduced during six long years of financial repression, unprecedented central bank asset purchases, and the official manipulation of interest rates. Only the asset purchases have abated (for now): the financial repression, one way or another, will go on.

Whether the asset purchases have really disappeared, or merely been suspended, will be a function of how risk markets behave over the coming months and years. We would not be in the least surprised to see petulant markets rewarded with yet more infusions of sweets.

Yet some still associate QE with success. The Telegraph’s Ambrose Evans-Pritchard, or his sub-editor, reckon that central bankers deserve a medal for saving society. He dismisses any scepticism as “hard money bluster”. Economist David Howden, on the other hand, can see somewhat further than the end of his own nose:

“One of the true marks of a great economist is an ability to see past the obvious outcomes and into the veiled results of policies. Friedrich Bastiat’s great essay on “that which is seen, and that which is not seen” provides a cautionary parable that disastrous analyses result when people don’t bother looking further than the immediate results of an action.

“Nowhere is this lesson more instructive than with the Fed’s QE policies of the past 6 years.

“Consider the Austrian business cycle theory. The nub of the theory is that changes in the money market have broader results on the greater economy. In its most succinct form, when a central bank pushes interest rates lower than they should be (by buying assets, for example), the greater economy gets distorted. Some of these distortions are immediately apparent, as consumers buy more goods and everyone takes on more debt as a result of lower interest rates. Some of the distortions are not immediately apparent. The investment decision of firms gets skewed as interest rates no longer reflect savings preferences, and the whole economy becomes fragile over time as erroneous investments add up (what Mises coined “malinvestments”).

“When a financial crisis or economic recession hits, it’s almost never because of some event that apparently happened at the same time. The crisis of 2008 did not occur because of the collapse of Lehman Brothers. It happened because the whole financial system and greater economy were fragile following years of cheap credit at the hands of the Greenspan Fed. If anything, Lehman was a result of this and a great (if unfortunate) example of the type of bad business decisions firms are lured into by loose money. It wasn’t the cause of the troubles but a result of them. And if Lehman didn’t go under to spark the credit crunch, some other fragile financial institution would have.

“The Great Depression is a similar case in point. It wasn’t the stock market crash in 1929 that “created” the Great Depression. It was a decade of loose money policies by the Fed that created a shaky economy. Again, if anything the stock market crash was the result of stock prices being too buoyant and in need of a repricing to reflect economic fundamentals. Just like today, stocks rose to such storied heights as a result of cheap credit, not because of the seemingly “great” investments funded by it.

“The Fed has lowered interest rates since July 2006. We have just come off the period with the most rapid and extreme increase in the money supply ever recorded in American history. The seeds of the next Austrian business cycle have been sown. In fact, they are probably especially fertile seeds when one considers that the monetary policy has been so loose by historical standards. Just as cheap credit of the 1920s beget the Great Depression, that of the 1990s beget the dot-com bust and that of the mid-2000s beget the crisis of 2008, this most recent period will also give birth to a financial crisis.”

Although our crystal ball is no more polished than anyone else’s, our fundamental views are clear. Bonds are already grotesquely expensive, yet may get more so (we’re not investing in “the usual suspects” so we don’t much care). Most stock markets are pricey – but in a world beset by QE (and prospects for more, in Europe and Asia) which prices can we really trust ? By a process of logic, elimination and deduction, out of the major asset classes, only quality listed businesses trading at or ideally well below a fair assessment of their intrinsic worth offer any semblance of value or attractiveness. Pretty much everything else amounts to nothing more than paper, prone to arbitrary gusts from some very powerful, and very windy, bureaucrats. We note also that former Fed chairman Alan Greenspan, no doubt looking to polish his legacy, managed to front-run the Fed’s QE announcement by pointing to the merits of gold within a government-controlled, fiat currency system. Strange days indeed.


The ECB should be bolder

As inflation rates continue to fall across the Eurozone one might expect Austrian economists to rejoice. After all, inflation reduces our purchasing power and acts as a hidden form of taxation. Failure to control inflation caused some of the greatest social and political disturbances of the twentieth century, and attempts to centrally plan the monetary system are destined to failure. George Selgin’s “Less than Zero” is the seminal account of how deflation can be beneficial, and why central banks should be willing to tolerate it. However it also provides a useful, and highly relevant distinction between “good” and “bad” deflation. The underlying point that needs to be expressed is that not all deflation is ghastly. Indeed the readily available examples of falling prices – such as the Great Depression – are not representative. Allowing a fear of deflation to prevent deflation in any circumstance will commit monetary policy to steady and suboptimally high inflation. The Great Moderation is perhaps the best example of the harm that can be done when we fail to allow increases in productivity to manifest themselves in falling prices. But the relevant point is whether this is the situation we find ourselves in right now.


Austrians tended to be ahead of the expectations revolution therefore to some extent it isn’t inflation or deflation per se that matters, but how it ties into expectations. If the inflation rate is falling, and especially if it’s falling more than expected, we have problems. If inflation is 2% a year, but this is anticipated, then the costs of inflation are reasonably low. If it’s -2% a year, and anticipated, ditto. The problems occur if we transition from one to the other.


Inflation in the Eurozone is currently 0.3%, and the rate has been steadily falling since early 2012. There’s two main reasons why we may expect falling pressure on prices. One is that the underlying capacity of the economy has increased. Positive productivity shocks will increase the potential growth rate, make it easier to produce output for a given amount of inputs, and make things cheaper. In terms of Dynamic AD-AS analysis, it constitutes an increase in the Solow curve. This is good deflation. But it also implies that real GDP will be rising.


Alternatively, prices might be falling because of a reduction in what Keynesians call “aggregate demand”, Monetarists call “nominal income”, or what Austrians call “the total income stream”. These are all various ways to refer to total spending. This could fall as a result of a monetary contraction, or an increase in the demand for money. It’s important to realise that whilst central banks are the prime culprits of the former, they are also a key instigator of the latter. Keynesians might blame it on “animal spirits”, but we can also think of this as “regime uncertainty”. These are two ways to treat confidence as a meaningful concept, and something that can be negatively affected by central bank policy.


Many commentators attribute low inflation to low oil prices. On the surface this seems like a positive supply shock and hence the reason for low prices is a good one. However the reason oil prices are low is because of increases in supply and decreases in demand. The former is a result of IS getting the keys to the pumps. The latter is due to a slowdown in China. Neither of these bode well for the global economy. Both of them have reduced confidence.


We can see this negative AD shock in the data. With GDP growth of just 0.7% this means that total spending is just 1%. This is significantly lower than where we would like it to be in a world with a greater rate of achievable growth and a 2% inflation target.


So what needs to be done? Austrians are loathe to advocate monetary activism and for good reason. But the goal of monetary policy is not inactivism, but neutrality. The issue comes down to the costs of adjustment. If aggregate demand remains at 1% then people will adjust their expectations, prices will adjust, and output will return to normal. During the Great Depression Hayek advocated this path, even though he recognised that prices take time to adjust, and whilst they do so unemployment would rise. His reasoning was that increasing the load on price adjustments will increase their flexibility. In a time of chronic wage and price inflexibility it was a moment to bust the unions. However he later came round to the idea that those costs were too high. The collateral damage of using a downturn to put more emphasis on nominal wage adjustments was unfair. For the mass unemployed, nominal wage rigidities isn’t their fault. So instead of placing the burden on wage adjustments, central banks have the option of maintaining a certain level of total income. This avoids the necessity of a nominal wage adjustment, in part because inflation allows real wages to adjust.


The fact that we are starting to see inflation expectations fall implies that this is only the beginning of an economic adjustment. If the total income stream continues to grow at a less than expected (and possibly even a negative) rate then we will have plenty new problems to worry about. This isn’t just the economy responding to the pre 2007 boom. This is the economy responding to fresh problems being introduced by central bank incompetence.


The difficulty for the ECB – and possibly the explanation for why things are so much worse in the Eurozone than in the US or UK – is that they don’t have the same tools available. But let’s leave a debate over tools for another time. The bottom line is that the ECB should be striving to give clear guidance and generate credibility for pursuing a steady increase in a target nominal variable. Monetary policy cannot generate wealth – all it can do is buy time for governments to sort out their competitiveness and improve their public finances. The fact that they aren’t making use of the breathing room provided by central banks is their fault. But monetary policy can destroy wealth, and a failure to maintain a steady total income stream is contributing to those competitiveness and public finance problems. I would love to believe that this impending deflation is the good sort, or that Eurozone labour markets were flexible enough to allow prices to do all the heavy lifting. But I fear that we’re seeing an impending catastrophe, and the ECB needs to take bolder action to prevent making things even worse.


For a more detailed explanation of the ideas expressed in this post, take a look at my new textbook on Austrian Economics.


Janet Yellen, Politicizing the Fed?

Janet Yellen gave a widely noted speech, Perspectives on Inequality and Opportunity from the Survey of Consumer Finances, at the Conference on Economic Opportunity and Inequality held  by the Federal Reserve Bank of Boston on October 17th.

The speech presented as a if ghostwritten for her by Quincy Magoo, that beloved cartoon character described by Wikipedia as “a wealthy, short-statured retiree who gets into a series of comical situations as a result of his nearsightedness compounded by his stubborn refusal to admit the problem.” What was most interesting was how political was the speech… and what Madame Yellen didn’t say.

Her omission even raised an eyebrow of one of the commentariat’s most astute Fed sympathizers, The Washington Post‘s Ylan Q. Mui. Mui:  “Yellen did not address in her prepared text whether the Fed has contributed to inequality. Nor did she weigh in on whether it may actually be slowing down economic growth, an idea that is gaining traction among economists but which remains controversial.”

Yellen’s speech drew a public comment from the Hon. Steve Lonegan, director of monetary policy for American Principles Project and project director of its sister organization’s grass roots campaign (which I professionally advise):

There is a strong correlation between the post-war equitable prosperity to which Madam Yellen alluded and the post-war Bretton Woods gold-exchange standard.  And there is a strong correlation between the increase in inequality under the Federal Reserve Note standard put into effect by President Richard Nixon to supplant Bretton Woods.

The monetary policy of the United States has a profound impact on wage growth and prices, both domestically and internationally.  Hence the importance of a thorough, objective, and empirical look at its policies — from Bretton Woods through the era of stagflation, the Great Moderation, and the “Little Dark Age” of the past decade.

That is why the Brady-Cornyn Centennial Monetary Commission, and the Federal Reserve Transparency Act which recently passed the House with a massive bipartisan majority, are critical steps forward to ending wage stagnation and helping workers and median income families begin to rise again.  As President Kennedy once said, “Rising tide lifts all boats.”

Madam Yellen addresses four factors in what she calls “income and wealth inequality.”  Madame Yellen stipulates that “Some degree of inequality in income and wealth, of course, would occur even with completely equal opportunity because variations in effort, skill, and luck will produce variations in outcomes. Indeed, some variation in outcomes arguably contributes to economic growth because it creates incentives to work hard, get an education, save, invest, and undertake risk.”

Even with that ostentatious stipulation, the Fed Chair’s speech is amplifying one of the Democratic Party’s foremost election themes, “income inequality.”  The New York Times‘s Neil Irwin observed of this speech: “Nothing about those statements would seem unusual coming from a left-leaning politician or any number of professional commentators. What makes them unusual is hearing them from the nation’s economist-in-chief, who generally tries to steer as far away from contentious political debates as possible.”

Her speech could be read as an Amen Corner to Elizabeth Warren’s stump speech, on behalf of Sen. Al Franken’s reelection effort, that The game is riggedand the Republicans rigged it.Her speech could be read as a little election-season kiss blown to Sen. Franken (D-Mn), who voted for her confirmation and then glowed on Madame Yellen very publicly.

One cringes at the thought that the Fed even might be giving the appearance of playing politics.  To align the Fed, even subtly, with either party’s election themes during an election season would seem a deeply impolitic, and unwise, violation of the Fed’s existential principle of political independence.  House Financial Services Committee chair Jeb Hensarling and Sen. Mike Crapo (R-Id), should he accede to the chairmanship of the Senate Banking Committee, might just wish to call up Madam Yellen for a public conversation about avoiding even the appearance of impropriety.

The Fed’s independence is as critical as it is delicate. To preserve it demands as much delicacy by the officials of the Federal Reserve System as by the Congress. As Barack Obama might say, here is a “teachable moment” for our new Fed chair.

Also troubling is the decision by the Chair to focus her mental energy, and remarks, on four areas entirely outside the Fed’s jurisdiction: resources available for children; higher education that families can afford; opportunities to build wealth through business ownership; and inheritances.  These might be splendid areas for a president’s Council of Economic Advisors (which Madame Yellen chaired, commendably, under President Clinton).  Good topics for a professor emerita at the University of California, Berkeley, Haas School of Business, as is Madam Yellen.

They are, however, at best mere homilies from the leader of the world’s most powerful central bank. We would like to hear Madam Yellen talk about monetary policy and its possible role in the diminishing of economic mobility. It does not seem like too much to ask.

Since Madame Yellen, rightly, is considered an eminent Keynesian (or Neo-Keynesian), why not begin with Keynes? In The Economic Consequences of the Peace, Chapter VI, Keynes addressed this very point. The brilliant young Keynes was addressing the insidious power of inflation, not now in evidence and not portended by the data.  Yet let it be noted that there is more than one way to debauch a currency:

Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. … By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become ‘profiteers,’ who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. …

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.

America and the world needs, and rightly expects, the chair of the Federal Reserve to be that one in a million able to diagnose.  Madame Yellen is called upon to step up her game and pivot from pious homilies to the heart of the matter.  If Keynes could call out how bad monetary policy can strike “at confidence in the equity of the existing distribution of wealth,” perhaps so too ought his followers.

What is to be done? Wikipedia also observes of Mr. Magoo that “through uncanny streaks of luck, the situation always seems to work itself out for him, leaving him no worse than before.”  We devoutly hope that Madame Yellen — and, thus, the economy — will be the beneficiary of “uncanny streaks of luck.”  Hope is not a strategy.  Relying on luck tautologically is a dicey way of bringing America, and the world, to a renewed state of equitable prosperity.

Rely on luck?  It really is time to shift gears.  An obvious place for Madame Yellen to begin would be to register active support for the Brady-Cornyn Centennial Monetary Commission designed to conduct a thorough, empirical, bipartisan study of what Fed policies have worked.   What policies of the Federal Reserve have proven, in practice, or credibly portend to be, conducive to equitable prosperity and healthy economic mobility?

Should the correlation between the (infelicitously stated if technically accurate) “40 years of narrowing inequality following the Great Depression” and the Bretton Woods gold-exchange standard be ignored?  Why ignore this?  Should the tight correlation of “the most sustained rise in inequality since the 19th century” with the extended experiment in fiduciary dollar management be ignored? Why ignore that?

What might be learned from the successes of the Great Moderation inaugurated by Paul Volcker?  Is Volcker’s recent call for a “rules-based” system, a position from which Madam Yellen staunchly dissents, pertinent? Discuss.

Madame Yellen?  Let’s have a national conversation about monetary policy and its effects on economic mobility.  It really is time to bring to a decisive end many decades of Magooonomics and the disorders that derive therefrom.  Fire Magoo.  Show the world that you are Keynes’s one in a million.

Originating at


Like treating cancer with aspirin

“Sir, Your editorial “A Nobel award for work of true economic value” (October 15) cites the witty and memorable line of JM Keynes about wishing that economists could be “humble, competent people, on a level with dentists”, which concludes his provocative 1930 essay on the economic future. You fail to convey, however, the irony and condescension of the original text of the arrogant, intellectual elitist Keynes, who, while superlatively competent, was assuredly not humble. With the passage of 84 years, the irony has changed directions, for modern dentistry is based on real science, and has made huge advances in scientific knowledge, applied technology and practice, to the great benefit of mankind. It is obviously far ahead of economics in these respects, and it is indeed unlikely that economics will ever be able to rise to the level of dentistry.”

  • Letter to the FT from Alex J. Pollock of the American Enterprise Institute, 20th October 2014.

Changing people’s minds, apparently, has very little to do with winning the argument. Since people tend to make decisions emotionally, ‘evidence’ is a secondary issue. We are attempting to argue that the policy of QE, quantitative easing, is not just pointless but expensively pointless. Apparently, instead of using cold logic, we will have to reframe our argument as follows:

  1. Agree with our argumentative opponents;

  2. Reframe the problem;

  3. Introduce a new solution;

  4. Provide a way to “save face”.

In terms of argumentative opponents, they don’t come much bigger than the former Fed chairman himself, Ben Bernanke. And it was Bernanke himself who rather pompously declared, shortly before leaving the Fed this year, that

“The problem with QE is it works in practice, but it doesn’t work in theory.”

There is, of course, no counter-factual. We will never know what might have happened if, say, the world’s central banks had elected not to throw trillions of dollars at the world’s largest banks and instead let the free market work its magic on an overleveraged financial system. But to suggest credibly that QE has worked, we first have to agree on a definition of what “work” means, and on what problem QE was meant to solve. If the objective of QE was to drive down longer term interest rates, given that short term rates were already at zero, then we would have to concede that in this somewhat narrow context, QE has “worked”. But we doubt whether that objective was front and centre for those people – we could variously call them “savers”, “investors”, “the unemployed” or “honest workers” – who are doubtless wondering when the economy will emerge from its current state of depression. As James Grant recently observed in the FT (“Low rates are jamming the economy’s vital signals”), it’s quite remarkable how, thus far, savers in particular have largely suffered in silence.

So yes, QE has “succeeded” in driving down interest rates. But we should probably reframe the problem. The problem isn’t that interest rates were or are too high. Quite the reverse: interest rates are clearly already too low – at least for savers, and for that matter investors in the euro zone and elsewhere. All the way out to 3 year maturities, investors in German government bonds, for example, are now faced with negative interest rates, and still they’re buying. This isn’t monetary policy success; this is madness. We think the QE debate should be reframed: has QE done anything to reform an economic and monetary system urgently in need of restructuring ? We think the answer, self-evidently, is “No”. The answer is also “No” to the question: “Can you solve a crisis of too much indebtedness by a) adding more debt to the pile and simultaneously b) suppressing interest rates ?” The toxic combination of more credit creation and global financial repression will merely make the ultimate Minsky moment that much more spectacular.

What accentuates the problem is market noise. @Robustcap fairly points out that there are (at least) four groups at play in the markets – and that at least three of them aren’t adding to the sum of human wisdom:

Group 1 comprises newsletter writers, and other dogmatic “End of the world newsletter salesmen” using every outlet to say “I told you so…” (even though some of them have been saying so for the last 1000 S&P handles..).

Group 2 comprises Perma-Bulls and other Wall Street product salesmen, offering “This is a buying opportunity” and other standard from-the-hip statements whenever the Vix index reaches 30 and the market trades 10% off from its high, at any time.

Group 3 includes “any moron with a $1500 E-trade account, twitter, Facebook etc…”, summing to roughly 99% nonsense and noise.

Group 4, however, comprises “True investors and traders” asking questions such as, “Is this a good price ?”; “Is this a good level ?”; “What is my risk stepping in here, on either side ?”; “Am I getting better value than I am paying for ?”; “What is the downside / upside ?” etc.

“With the “magnification” of noise by social media and the internet in general, one must shut off the first three groups and try to engage, find, follow, communicate with the fourth group only, those looking at FACTS, none dogmatic, understand value, risk, technicals and fundamentals and most importantly those who have no agenda and nothing to sell.”

To Jim Rickards, simply printing money and gifting it to the banks through the somewhat magical money creation process of QE is like treating cancer with aspirin: the supposed “solution” does nothing to address the root cause of the problem. The West is trapped in a secular depression and “normal” cyclical solutions, such as monetary policy measures, are not just inappropriate, but damnably expensive for the rest of us. Only widespread economic restructuring will do. And that involves hard decisions on the part of politicians. Thus far, politicians have shown themselves predictably not up to the task. Or in the words of Jean-Claude Juncker,

“We all know what to do; we just don’t know how to get re-elected after we’ve done it.”

And let’s not forget that other notable Junckerism,

“When it becomes serious, you have to lie.”

No cheers for democracy, then.

So, back to the debate:

  1. Yes, QE has driven down long term interest rates.

  2. But the problem wasn’t the cost of capital. The problem was, and remains, an oversupply of debt, insufficient economic growth, and the risk, now fast becoming realised, of widespread debt deflation. To put it another way, the world appears to be turning Japanese after all, despite the best efforts of central bankers and despite the non-efforts of politicians.

  3. The solution is fundamental economic restructuring along with measures that can sustainedly boost economic growth rather than just enriching the already rich through artificial financial asset price boosterism. Government spending cuts will not be optional, although tax cuts might be. The expansion of credit must end – or it will end in an entirely involuntary market-driven process that will be extraordinarily messy.

  4. How to “save face” ?

This is where we start to view the world, once again, through the prism of investments – not least since we’re not policy makers. For those wondering why a) markets have become that much more volatile recently (and not just stocks – see the recent wild trading in the US 10 year government bond) and b) inflation (other than in financial asset prices) seems weirdly quiescent – the answer has been best expressed by both Jim Rickards and by the good folk at Incrementum. The pertinent metaphor is that of the tug of war. The image below (source: Incrementum) states the case.

Inflation vs Deflation

The blue team represents the markets. The markets want deflation, and they want the world’s unsustainable debt pile to be reduced. There are three ways to reduce the debt pile. One is to engineer sufficient economic growth (no longer feasible, in our view) to service the debt. The second is to default (which, in a debt-based monetary system, amounts to Armageddon). The third brings us over to the red team: explicit, state-sanctioned inflationism, and financial repression. The reason why markets have become so volatile is that from day to day, the blue and red teams of deflationary and inflationary forces are duking it out, and neither side has yet been convincingly victorious. Who ultimately wins ? We think we know the answer, but the outcome will likely be a function of politics as much as investment forces (“markets”). While we wait for the outcome, we believe the most prudent and pragmatic course of action is to seek shelter in the least overpriced corners of the market. For us, that means explicit, compelling value and deep value equity. Nothing else, and certainly nothing by way of traditional government or corporate debt investments, or any form of equity or bond market index-tracking, makes any sense at all.


Markets and reality disconnected

The behaviour of financial markets these days is frankly divorced from reality, with value-investing banished.

Markets have become distorted by Rumsfeld-knowns such as interest rate policy and “market guidance”, and Rumsfeld-unknowns such as undeclared market intervention by the authorities. On top of these distortions there is remote investing by computers programmed with algorithms and high-frequency traders, unable to make human value-assessments.

Take just one instance of possible “market guidance” that occurred this week. On Thursday 16th October, James Dullard of the St Louis Fed hinted that QE might be extended. In the ensuing four trading sessions the Dow rallied over 5%. Was this comment sparked by signs of slowing economic growth, or by a desire to buoy up sliding equity markets? Then there is the vested interest of keeping government funding costs low, which raises the question whether or not exceptionally low bond yields, particularly in the Eurozone, are by design or accidental.

Those who support the theory that it is all an evil plot will also note that governments and their central banks through exchange stability funds (set up with the explicit purpose of market intervention), wealth funds and state pension funds have some $30 trillion to direct as they see fit. The reality is that there is intervention across a range of markets; but most of the mispricing is in the hands of private, not government investors. For evidence look no further than the record level of brokers’ loans to buyers of equities, who with greed worthy of a latter-day South-Sea Bubble seek to gear up their speculative profits.

These are not markets with widespread public participation, buying dot-coms and the like. Instead ordinary people have given their savings and pension funds to professionals who speculate on their behalf. It is the professionals who talk about the Yellen put, meaning the Fed simply won’t let prices fall significantly. We can fret about who is actually responsible for market distortions, instead we should ask who benefits.

Governments: in the past they have covered their debts through a process dubbed financial repression, when artificially low interest rates and bond yields were the principal mechanism whereby wealth is transferred from savers to the government. This process still goes on today. Forget government inflation figures: when did a bank deposit net of taxes last give a positive return after your cost of living increases?

Zero interest rate policy lays the process bare, and turns savers into borrowers. Mr Average has replaced savings with mortgages and car loans. And while the elderly and other passive savers are still defenceless against financial repression, the process has taken on a new twist. The transfer of wealth to governments now targets investment managers.

Investment and hedge funds we invest with together with the banks which take our deposits speculate on our behalf. They think that with a Yellen or Draghi put underwriting markets a ten-year government bond with a two per cent yield is an attractive investment. In doing so they are transferring financial resources to governments in a variation on old-fashioned financial repression.

Our dysfunctional markets have become little more than the essential prerequisite, as Louis XIV’s finance minister Colbert might have said, to plucking the goose for the largest amount of feathers with the minimum of hissing.


Four Reasons the Bernanke-Yellen Asset-Price Inflation May Be Nearing Its End

There are strong indications that the remarkable run up of asset prices in the last few years is beginning to run out of steam and may be on the verge of collapse. We will leave aside the question of whether the asset inflation is symptomatic of a garden-variety inflationary boom or is a more virulent bubble phenomenon in which prices are rising today simply because buyers anticipate that they will rise tomorrow.

The Evidence

1. The dizzying climb of London real estate prices since the financial crisis, noted in a recent postby Dave Howden, may be fizzling out. Survey data from real-estate agents indicate London housing prices in September fell 0.1 percent from August, their first decline since November 2012. Meanwhile, an index of U.K. housing prices declined for the first time in 17 months. In explaining the “pronounced slowdown” in the London real estate market, the research director of Hometrack Ltd. commented, “Buyer uncertainty is growing in the face of a possible interest-rate rise, a general election on the horizon and recent warnings of a house-price bubble,” which is playing out “against a backdrop of tougher mortgage affordability checks and limits on high loan-to-income lending.”

2. Just released data from the Dow Jones S&P/Case Schiller Composite Home Price Indices through July 2014 shows a marked deceleration of U.S. housing prices. 17 of the 20 cities included in the 20-City Composite Index experienced lower price increases in July than in the previous month. Both the 10- and 20-City Index recorded a 6.7 percent year-over-year rate of increase, down sharply from the post-crisis peak of almost 14 percent less than a year ago.

3. More ominously, U.S. Total Household Net Worth (HNW), as recently reported by the Fed for the second quarter of 2014, reached a record high of $81.5 trillion, over $10 trillion higher than the level at the peak of the asset bubble in 2007. Furthermore, the 2014 figure was $20 trillion higher than the level of the post-crisis — and pre-QE — year of 2008, when asset prices and the real structure of production were just beginning to adjust to the massive capital consumption and malinvestment wreaked by the Great Asset Inflation of 1995-2005. The increase in household wealth has been driven mainly by the increase in prices of financial assets which was generated by the Fed’s zero interest rate policy and its force feeding of additional bank reserves into the financial system via its quantitative easing programs. (See chart below). These policies falsify profit and wealth calculations and give rise to unsustainable investments and overconsumption. Once interest rates begin to adjust to their natural levels, however, asset prices are revealed to be grossly inflated and collapse. The asset inflation may be reversed even without an increase of interest rates, if people lose confidence in the narratives fabricated and propagated by government policymakers, economists, and the financial commentators to promote the continuation of the inflation in asset markets. Furthermore it is risible to believe that real wealth in the US in terms of the factories and other capital goods to which financial assets are merely ownership claims, has increased by over one-third since 2008, especially in light of the additional malinvestment and overconsumption caused by monetary and fiscal policy “stimulus” since then.

4. If we look at HNW in historical perspective, we note that, in the chart below, the HNW/GDP (or wealth to income) ratio is now at an all-time high. From 1952 to the mid-1990s this ratio averaged a little more than 350 percent and never went above 400 percent until 1998 as the dot-com bubble was blowing up. It peaked at nearly 450 percent before the bubble collapsed causing the ratio to plummet to slightly below 400 percent, indicating the beginning of the purging of the illusory capital gains created during the asset inflation.

But just as the adjustment was beginning to take hold in 2002, the Greenspan Fed played the deflationphobia card, driving interest rates to postwar lows and pumping up the money supply (MZM) by $2 trillion from beginning of 2001 to the end of2005. During this second phase of the Great Asset Inflation, the HNW/GDP ratio again reached a new high before plunging below 400 percent during the financial crisis. And, tragically, the nascent readjustment of financial markets to the underlying reality of the economy’s shattered and shrunken production structure was yet again aborted by government intervention in the form of the heterodox monetary policies of Bernankeism combined with the outsized deficits of the Obama administration. These policies succeeded in driving the HNW/GDP ratio to yet another new high, but without having the expected stimulatory effect on consumption and investment spending.


In sum, I do not expect that the ratio will rise much above 500 percent — Americans have just not saved enough since 1995 to have increased their real wealth from 3.5 times to 5 times their annual income. Nor is there much reason to expect a plateau anywhere near the current level. Once interest rates begin to rise — and rise they must, whether as a result of Fed policy or not — the end of the asset price inflation will be at hand. The result will be another financial crisis and accompanying recession. The Fed and the Administration will no doubt attempt to bail and stimulate their way out but given the still dangerously enervated state of the financial system and the real economy, it will be like dosing a horse that has already been overdosed to death. Thus my forecast for the U.S. economy one year to two years out echoes that of Clubber Lang, the villain in the movie Rocky III. When questioned about his forecast for the forthcoming fight against Rocky, Lang replied, “Pain.”