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.”


The Economist discovers the Entrepreneur.

In its latest edition, in a piece entitled ‘Monetary policy: Tight, loose, irrelevant’, the ineffably dire Ekonomista considers the work of three members of the Sloan School of Management who conducted a study of the factors which – according to their rendering of the testimony of the 60-odd years of data which they analysed in their paper, “The behaviour of aggregate corporate investment” – have historically exerted the most influence on the propensity for American businesses to ‘invest’.


The article itself starts by deploying that unfailingly patronising, ‘it’s economics 101′ cliché by which we should really have long ago learned to expect some weary truism will soon be rehashed as fresh journalistic wisdom.

It may be only partly an exaggeration to say that the weekly then adopts a breathless, teen-hysterical approach to a set of results which, with all due respect to the worthies who compiled them, should have been instantly apparent to anyone devoting a moment’s thought to the issue (and if that’s too big a task for the average Ekonomista writer, perhaps they could pause to ask one of those grubby-sleeved artisans who actually RUNS a business what it is exactly that they get up to, down there at the coalface of international capitalism). Far from being a Statement of the Bleedin’ Obvious, our fearless expositors of the Fourth Estate instead seem to regard what appears to be a tediously positivist exercise in data mining as some combination of the elucidation of the nature of the genetic code and the first exposition of the uncertainty principle. This in itself is a telling indictment of the mindset at work.

For can you even imagine what it was that our trio of geniuses ‘discovered’? Only that firms tend to invest more eagerly if they are profitable and if those profits (or their prospect) are being suitably rewarded with a rising share price – i.e. if their actions are contributing to capital formation, realised or expected, and hence to the credible promise of a maintained, increased, lengthened or accelerated schedule of income flows – that latter condition being one which also means the firms concerned can issue equity on advantageous terms, where necessary, in the furtherance of their aims.


[As an aside, do you remember when we used to ISSUE equity for purposes other than as a panic measure to keep the business afloat after some megalomaniac CEO disaster of over-leverage or as part of a soak-the-patsies cash-out for the latest batch of serial shell-gamers and their start-up sponsors?]


Shock, horror! Our pioneering profs then go on to share the revelation that firms have even been known to invest WHEN INTEREST RATES ARE RISING; i.e., when the specific real rate facing each firm (rather than the fairly meaningless, economy-wide aggregate rate observable in the capital market with which it is here being conflated) is therefore NOT estimated to constitute any impediment to the future attainment (or preservation) of profit. Whatever happened to the central bank mantra of the ‘wealth effect’ and its dogma about ‘channels’ of monetary transmission? How could those boorish mechanicals in industry not know they are only to invest when their pecuniary paramounts signal they should, by lowering official interest rates or hoovering up oodles of government securities?


At this point we might stop to insist that the supercilious, wielders of the ‘Eco 101’ trope at the Ekonomista note that these firms’ own heightened appetite for a presumably finite pool of loanable funds should firmly be expected to nudge interest rates higher precisely in order to bring forth the necessary extra supply thereof, just as a similar shift in demand would do in any other well-functioning market (DOH!), so please could they take the time in future to ponder the workings of cause and effect before they dare to condescend to us.


They might also reflect upon the fact that when the banking system functions to supplement such hard-won funds with its own, purely ethereal emissions of unsaved credit – thereby keeping them too cheap for too long and so removing the intrinsically self-regulating and helpfully selective effect which their increasing scarcity would otherwise have had on proposedschemes of investment – they pervert, if not utterly vitiate, a most fundamental market process. Having a pronounced tendency to bring about a profound disco-ordination in the system to the point of precluding a holistic ordering of ends and means as well as of disrupting the timetable on which the one may be transformed into the other, we Austrians recognize this as theprimary cause of that needless and wasteful phenomenon which is the business cycle. It is therefore decidedly not a cause for perplexity that investment, quote: ‘…expands and contracts far more dramatically than the economy as a whole as the Ekonomista wonderingly remarks


Nigh on unbelievable as it may appear to the policy-obsessed, mainstream journos who reviewed the academics’ work, all of this further implies that the past two centuries-odd of absolutely unprecedented and near-universal material progress did NOT take place simply because the central banks and their precursors courageously and unswervingly spent the whole interval doing ‘whatever it took’ to progressively lower interest rates to (and in some cases, through) zero! Somewhere along the line, one supposes that the marvels of entrepreneurship must have intruded, as well as what Deidre McCloskey famously refers to as an upsurge in ‘bourgeois dignity’ – i.e., the ever greater social estimation which came to be accorded to such agents of wholesale advance. This truly must shake the pillars of the temple of the cult of top-down, macro-economic command of which the Ekonomista is the house journal.


Remarkably, the Ekonomista’s piece is also daringly heterodox in inferring that, given this highly singular insensitivity to market interest rates, we might therefore return more assuredly to the long-forsaken path of growth if Mario Draghi and his ilk were to treat themselves to a long, contemplative sojourn, taking the waters at one of Europe’s idyllic (German) spa townsinstead of constantly hogging the limelight by dreaming up (and occasionally implementing) ever more involved, Cunning Plans directed towards driving people to act in ways in which they would otherwise not choose to do, but in which Mario and Co. conceitedly deem that they should.


Rather, the hacks have the temerity to assert – and here, Keynes be spared! – it might do much more for the investment climate if the Big Government to which they so routinely and so obsequiously defer were to pause awhile in its unrelenting programme to destroy all private capital, to suppress all economic initiative, and to restrict the disposition of income to thecentralized mandates of its minions and not to trust them to the delocalized vagaries of the market – all crimes which it more readily may perpetrate under the camouflage provided by the central banks’ mindless and increasingly counter-productive, asset-bubble inflationism.


Having reached this pass, might we dare to push the deduction one step closer to its logical conclusion and suggest that the only reason we continue today to suffer a malaise which the self-exculpatory elite (of whom none is more representative than the staff of the Ekonomista itself) loves to refer to as ‘secular stagnation’ is because its own toxic brew of patent nostrums is making the unfortunate patient upon whom it inflicts them even more sick? That, pace Obama the Great, The One True Indispensable Chief of the NWO, the three principal threats we currently face are not Ebola, but QE-bola – a largely ineradicable pandemic of destruction far more virulent than even that dreadful fever; not the locally disruptive Islamic State but the globally detrimental Interventionist State – the perpetrator of a similarly backward and repressive ideology which the IMF imamate seeks to impose on us all; and definitely not the Kremlin’s alleged (though highly disputable) revanchism being played out on Europe’s ‘fringe’ but the Kafkaesque reality of stifling and undeniable regulationism at work throughout its length and breadth?


We might end by reminding the would-be wearer of the One Ring, as He lurks warily, watching the opinion polls from His lair in the White House, that in being so active in propagating each one of these genuinely existential threats to our common well-being, He (capitalization ironically intended) will not so much ‘help light the world’ – as He nauseatingly claimed in His purple-drenched, sophomore’s set-piece at the UN recently – as help extinguish what little light there still remains to us poor, downtrodden masses.







The offending article:



Monetary policy

Tight, loose, irrelevant


Interest rates do not seem to affect investment as economists assume




IT IS Economics 101. If central bankers want to spur economic activity, they cut interest rates. If they want to dampen it, they raise them. The assumption is that, as it becomes cheaper or more expensive for businesses and households to borrow, they will adjust their spending accordingly. But for businesses in America, at least, a new study* suggests that the accepted wisdom on monetary policy is broadly (but not entirely) wrong.


Using data stretching back to 1952, the paper concludes that market interest rates, which central banks aim to influence when they set their policy rates, play some role in how much firms invest, but not much. Other factors—most notably how profitable a firm is and how well its shares do—are far more important (see chart). A government that wants to pep up the economy, says S.P. Kothari of the Sloan School of Management, one of the authors, would have more luck with other measures, such as lower taxes or less onerous regulation.


Establishing what drives business investment is difficult, not. These shifts were particularly manic in the late 1950s (both up and down), mid-1960s (up), and 2000s (down, up, then down again). Overall, investment has been in slight decline since the early 1980s.


Having sifted through decades of data, however, the authors conclude that neither volatility in the financial markets nor credit-default swaps, a measure of corporate credit risk that tends to influence the rates firms pay, has much impact. In fact, investment often rises when interest rates go up and volatility increases.


Investment grows most quickly, though, in response to a surge in profits and drops with bad news. These ups and downs suggest shifts in investment go too far and are often ill-timed. At any rate, they do little good: big cuts can substantially boost profits, but only briefly; big increases in investment slightly decrease profits.


Companies, Mr Kothari says, tend to dwell too much on recent experience when deciding how much to invest and too little on how changing circumstances may affect future returns. This is particularly true in difficult times. Appealing opportunities may exist, and they may be all the more attractive because of low interest rates. That should matter—but the data suggest it does not.


* “The behaviour of aggregate corporate investment”, S.P. Kothari, Jonathan Lewellen, Jerold Warner



Fed introduces new economic indicator to better assess the labour market

Economists at the Federal Reserve have devised a new indicator, which they hold will enable US central bank policy makers to get better information regarding the state of the labour market. The metric is labelled as the Labour Market Conditions Index (LMCI).

Note that one of the key data Fed policy makers are paying attention to is the labour market. The state of this market dictates the type of monetary policy that is going to be implemented.

Fed policy makers are of the view that it is the task of the central bank to navigate the economy toward a path of stable self-sustaining economic growth.

One of the indicators that is believed could inform policy makers about how far the economy is from this path is the state of the labour market.

A strengthening of the labour market is seen as indicative that the economy may not be far from the desired growth path.

A weakening in the labour market is interpreted as indicating that the distance is widening and the economy’s ability to stand on its own feet is diminishing.

Once the labour market shows strengthening this also raises the likelihood that the Fed will reduce its support to the economy. After all, to provide support whilst the economy is on a path of stable self-sustained growth could push the economy away from this path towards a path of accelerating price inflation, so it is held.

Conversely, a weakening labour market conditions raises the likelihood that the Fed will either maintain or strengthen its loose monetary stance. Failing to do so, it is held, could push the economy onto a path of price deflation and economic crisis.

The uniqueness of the LMCI, it is held, is that it covers a broader range of labour market pieces of information thereby raising the likelihood of depicting a more correct state of labour market conditions than an individual piece of information could provide.

The LMCI is derived from 19 indicators such as the number of people employed full time and part time, the labour participation rate, the hiring rate, hiring plans etc.

When the index is rising above the zero line it is interpreted that labour market conditions are strengthening. A fall in the index below the zero line is taken as a deterioration in the labour market.

In September the index rose by 2.5 points after gaining 2 points in August. Note however that in April this year the index increased by 7.1 points. Following the logic of Fed policy makers and assuming that they will pay some attention to the LMCI, if the index were to continue strengthening then the Fed may start considering tightening its monetary stance.


We suggest that the Fed’s responses to the LMCI are not going to bring the economy onto a path of stability and self-sustaining economic growth, but on the contrary will lead to more instability and economic impoverishment.

The state of a particular indicator such as the LMCI cannot tell us the state of the pool of real wealth i.e. whether it is expanding or shrinking.

It is not important to have people employed as such but to have them employed in wealth generating activities. Employment such as digging ditches and building non-wealth generating projects are only depriving wealth generators from the expansion of the pool of real wealth. This undermines the ability to grow the economy and leads to economic misery.

The belief that the Fed can navigate and grow the economy is wishful thinking. All that Fed officials can do is to pump money and tamper with the interest rate structure. None of this however can lead to economic growth.

The key to economic growth is the expansion in capital goods per individual. This expansion however must be done in accordance with the dictates of the free market and not on account of an artificial lowering of interest rates and monetary pumping.

Loose monetary policy will only result in the expansion of capital goods for non-wealth generating projects i.e. capital consumption.


Only by means of the allocation of resources in accordance with the dictates of the market can a wealth generating infrastructure be established. Such infrastructure is going to lead to economic prosperity.

To conclude then, the Fed’s new indicator adds more means for US central bank officials to tamper with the economy, which will lead to greater economic instability and economic impoverishment.


Summary and conclusions

The Fed has introduced a new economic indicator labelled the Labour Market Conditions Index (LMCI). The LMCI is derived from 19 labour market related indicators; hence it is held it is likely to provide a more realistic state of the labour market.

This in turn will enable Fed policy makers to navigate more accurately the economy toward a path of stable non-inflationary economic growth.

We suggest that what is required is not information about the strength of the labour market as such but information on how changes in labour market conditions are related to the wealth generation process.

This however, the LMCI doesn’t provide. Since Fed officials are likely to react to movements in the LMCI we hold this will only lead to a deepening in the misallocation of resources and to a further weakening of the wealth generation process.


Ten problems, or just one?

“Sir, The next financial apocalypse is imminent. I know this to be true because the House & Home section in FT Weekend is now assuming the epic proportions last seen before the great crash. Twenty-four pages chock full of adverts for mansions and wicker tea-trays for $1,000. You’re all mad.


Sell everything and run for your lives.”


  • Letter to the FT from Matt Long, Seilh, France, 3rd October 2014.


“Investors unfortunately face enormous pressure—both real pressure from their anxious clients and their consultants and imagined pressure emanating from their own adrenaline, ego and fear—to deliver strong near-term results. Even though this pressure greatly distracts investors from a long-term orientation and may, in fact, be anathema to good long-term performance, there is no easy way to reduce it. Human nature involves the extremes of investor emotion—both greed and fear—in the moment; it is hard for most people to overcome and act in opposition to their emotions. Also, most investors tend to project near-term trends—both favourable and adverse—indefinitely into the future. Ironically, it is this very short-term pressure to produce—this gun to the head of everyone—that encourages excessive risk taking which manifests itself in several ways: a fully invested posture at all times; for many, the use of significant and even extreme leverage; and a market-centric orientation that makes it difficult to stand apart from the crowd and take a long-term perspective.”


  • Seth Klarman, Presentation to MIT, October 2007.



“At first, the pendulum was swinging towards infinite interest, threatening the dollar with hyperinflation. Right now the pendulum is swinging to the other extreme, to zero interest, spelling hyper-deflation. This is just as damaging to producers as the swing towards infinite interest was in the early 1980’s. It is impossible to predict whether one or the other extreme in the swinging of the wrecking ball will bring about the world economy’s collapse. Hyperinflation and hyper-deflation are just two different forms of the same phenomenon: credit collapse. Arguing which of the two forms will dominate is futile: it blurs the focus of inquiry and frustrates efforts to avoid disaster.”


  • Professor Antal Fekete, ‘Monetary Economics 101: The real bills doctrine of Adam Smith. Lecture 10: The Revolt of Quality’.


“Low interest rate policy has the following grave consequences:


  • Normally conservative investors are increasingly under duress and due to the outlook for interest rates remaining low for a long time, are taking on excessive risk. This leads to capital misallocation and the formation of bubbles.
  • The sweet poison of low interest rates and easy money therefore leads to massive asset price inflation (stocks, art, real estate).
  • Through carry trades, interest rates that are structurally too low in the industrialized nations lead to asset bubbles and contagion effects in emerging markets.
  • A structural weakening of financial markets, as reckless behaviour of market participants is fostered (moral hazard).
  • A change in human behaviour patterns, due to continually declining purchasing power. While thrift is slowly but surely transmogrified into a relic of the past, taking on debt becomes rational.
  • The acquisition of personal wealth becomes gradually more difficult.
  • The importance of money as a medium of exchange and a unit of account increases in importance relative to its role as a store of value.
  • Incentives for fiscal probity decline. Central banks have bought time for governments. Large deficits appear less problematic, there is no incentive to implement reform, resp. consolidate public finances in a sustainable manner.
  • The emergence of zombie-banks and zombie-companies. Very low interest rates prevent the healthy process of creative destruction. Zero interest rate policy makes it possible for companies with low profitability to survive, similar to Japan in the 1990s. Banks are enabled to nigh endlessly roll over potentially delinquent loans and consequently lower their write-offs.
  • Unjust redistribution (Cantillon effect): the effect describes the fact that newly created money is neither uniformly nor simultaneously distributed in the population. Monetary expansion is therefore never neutral. There is a permanent transfer of wealth from later to earlier receivers of new money.”
  • Ronald-Peter Stöferle, from ‘In Gold We Trust 2014 – Extended Version’, Incrementum AG.



The commentary will have its next outing on Monday 27th October.



“When sorrows come,” wrote Shakespeare, “they come not single spies, but in battalions.” Jeremy Warner for the Daily Telegraph identifies ten of them. His ‘ten biggest threats to the global economy’ comprise:

  • Geopolitical risk;
  • The threat of oil and gas price spikes;
  • A hard landing in China;
  • Normalisation of monetary policy in the Anglo-Saxon economies;
  • Euro zone deflation;
  • ‘Secular stagnation’;
  • The size of the debt overhang;
  • Complacent markets;
  • House price bubbles;
  • Ageing populations.

Other than making the fair observation that stock markets (for example) are not entirely correlated to economic performance – an observation for which euro zone equity investors must surely be hugely grateful – we offer the following response.

  • Geopolitical risk, like the poor, will always be with us.
  • Yes, the prices for oil and natural gas could spike, but as things stand WTI crude futures have fallen by over 15% from their June highs, in spite of the clear geopolitical problems. And the US fracking revolution, in combination with fast-improving fundamentals for solar power, may turn out to be a secular (and disinflationary) game-changer for energy prices.
  • China, however, is tougher to dismiss. If we had any meaningful exposure to Chinese equity or debt we would be more concerned. But we don’t, so we aren’t.
  • Five of Jeremy Warner’s ‘threats’ are inextricably linked. The pending normalisation of monetary policy in the UK and US clearly threatens the integrity of the credit markets. It’s worth asking whether either central bank could possibly afford to let interest rates rise. This begets a follow-on question: could the markets afford to let the central banks off the hook ? Could we, in other words, finally see the return of the long absent and much desired bond market vigilantes ? That monetary policy rates are so low is a function of the growing prospect of euro zone deflation (less of a threat to solvent consumers, but deadly for heavily indebted governments). Absent a capitulation by the Bundesbank to Draghi’s hopes or intentions for full-blown QE, it’s difficult to see how the policy log-jam gets resolved. But since all German government paper out to three years now offers a negative yield, it’s difficult to see why any euro zone debt is worth buying today for risk-conscious investors. Cash is probably preferable and gives optionality into the bargain. ‘Secular stagnation’ is now a fair definition of the euro zone’s economic prospects. But all things lead back to Warner’s point 7: the size of the debt overhang. Since this was never addressed in the immediate aftermath of the Global Financial Crisis, it’s hardly a surprise to see its poison continue to drip onto all things financial. And since the policy response has been to slash rates and keep them at multi-century lows, it’s hardly a surprise to see property prices in the ascendant.
  • Complacent markets ? Check. But stocks have lost a lot of their nerve over the last week. Not before time.
  • Ageing populations ? Yes, but this problem has been widely discussed in the investment community over the past two decades – it simply isn’t new news.

We saw one particularly eye-catching chart last week, via Grant Williams, comparing the leverage ratios of major US financial institutions over recent years (shown below).

Leverage Ratios


Source: Grant Williams, ‘Things that make you go Hmmm…’


The Fed’s leverage ratio (total assets to capital) now stands at just under 80x. That compares with Lehman Brothers’ leverage ratio, just before it went bankrupt, of just under 30x. Sometimes a picture really does paint a thousand words. And this, again, brings us back to the defining problem of our time, as we see it: too much debt in the system, and simply not enough ideas about how to bring it down – other than through inflationism, and even that doesn’t seem to be working quite yet.


In a recent interview with Jim Grant, Sprott Global questioned the famed interest rate observer about the likely outlook for bonds:


What would a bear market in bonds look like? Would it be accompanied by a bear market in the stocks?

“Well, we have a pretty good historical record of what a bear market in bonds would look like. We had one in modern history, from 1946 to 1981. We had 25 years’ worth of persistently – if not steadily – rising interest rates, and falling bond prices. It began with only around a quarter of a percent on long-dates US Treasuries, and ended with about 15% on long-dated US Treasuries. That’s one historical beacon. I think that the difference today might be that the movement up in yield, and down in price, might be more violent than it was during the first ten years of the bear market beginning in about 1946. Then, it took about ten years for yields to advance even 100 basis points, if I remember correctly. One difference today is the nature of the bond market. It is increasingly illiquid and it is a market in which investors – many investors – have the right to enter a sales ticket, and to expect their money within a day. So I’m not sure what a bear market would look like, but I think that it would be characterized at first by a lot of people rushing through a very narrow gate. I think problems with illiquidity would surface in the corporate debt markets. One of the unintended consequences of the financial reforms that followed the sorrows of 2007 to 2009 is that dealers who used to hold a lot of corporate debt in inventories no longer do so. If interest rates began to rise and people wanted out, I think that the corporate debt market would encounter a lot of ‘air pockets’ and a lot of very discontinuous action to the downside.”

We like that phrase “a lot of very discontinuous action to the downside”. Grant was also asked if it was possible for the Fed to lose control of the bond market:


“Absolutely, it could. The Fed does not control events for the most part. Events certainly will end up controlling the Fed. To answer your question – yeah. I think the Fed can and will lose control of the bond market.”


As we have written on innumerable prior occasions, we wholeheartedly agree. Geopolitics, energy prices, demographics – all interesting ‘what if’ parlour games. But what will drive pretty much all asset markets over the near, medium and longer term is almost entirely down to how credit markets behave. The fundamentals, clearly, are utterly shocking. The implications for investors are, in our view, clear. And as a wise investor once observed, if you’re going to panic, panic early.



A market reset due

Recent evidence points increasingly towards global economic contraction.

Parts of the Eurozone are in great difficulty, and only last weekend S&P the rating agency warned that Greece will default on its debts “at some point in the next fifteen months”. Japan is collapsing under the wealth-destruction of Abenomics. China is juggling with a debt bubble that threatens to implode. The US tells us through government statistics that their outlook is promising, but the reality is very different with one-third of employable adults not working; furthermore the GDP deflator is significantly greater than officially admitted. And the UK is financially over-geared and over-dependent on a failing Eurozone.

This is hardly surprising, because the monetary inflation of recent years has transferred wealth from the majority of the saving and working population to a financial minority. A stealth tax through monetary inflation has been imposed on the majority of people trying to earn an honest living on a fixed salary. It has been under-recorded in consumer price statistics but has occurred nonetheless. Six years of this wealth transfer may have enriched Wall Street, but it has also impoverished Main Street.

The developed world is now in deep financial trouble. This is a situation which may be coming to a debt-laden conclusion. Those in charge of our money know that monetary expansion has failed to stimulate recovery. They also know that their management of financial markets, always with the objective of fostering confidence, has left them with market distortions that now threaten to derail bonds, equities and derivatives.

Today, central banking’s greatest worry is falling prices. The early signs are now upon us, reflected in dollar strength, as well as falling commodity and energy prices. In an economic contraction exposure to foreign currencies is the primary risk faced by international businesses and investors. The world’s financial system is based on the dollar as reserve currency for all the others: it is the back-to-base option for international exposure. The trouble is that leverage between foreign currencies and the US dollar has grown to highly dangerous levels, as shown below.

Total World Money 2013

Plainly, there is great potential for currency instability, compounded by over-priced bond markets. Greece, facing another default, borrows ten-year money in euros at about 6.5%, while Spain and Italy at 2.1% and 2.3% respectively. Investors accepting these low returns should be asking themselves what will be the marginal cost of financing a large increase in government deficits brought on by an economic slump.

A slump will obviously escalate risk for owners of government bonds. The principal holders are banks whose asset-to-equity ratios can be as much as 40-50 times excluding goodwill, particularly when derivative exposure is taken into account. The stark reality is that banks risk failure not because of Irving Fisher’s debt-deflation theory, but because they are exposed to a government debt bubble that will inevitably burst: only a two per cent rise in Eurozone bond yields may be sufficient to trigger a global banking crisis. Fisher’s nightmare of bad debts from failing businesses and falling loan collateral values will merely be an additional burden.


Macro-economists refer to a slump as deflation, but we face something far more complex worth taking the trouble to understand.

The weakness of modern macro-economics is it is not based on a credible theory of prices. Instead of a mechanical relationship between changes in the quantity of money and prices, the purchasing power of a fiat currency is mainly dependent on the confidence its users have in it. This is expressed in preferences for money compared with goods, and these preferences can change for any number of reasons.

When an indebted individual is unable to access further credit, he may be forced to raise cash by selling marketable assets and by reducing consumption. In a normal economy, there are always some people doing this, but when they are outnumbered by others in a happier position, overall the economy progresses. A slump occurs when those that need or want to reduce their financial commitments outnumber those that don’t. There arises an overall shift in preferences in favour of cash, so all other things being equal prices fall.

Shifts in these preferences are almost always the result of past and anticipated state intervention, which replaces the randomness of a free market with a behavioural bias. But this is just one factor that sets price relationships: confidence in the purchasing power of government-issued currency must also be considered and will be uppermost in the minds of those not facing financial difficulties. This is reflected by markets reacting, among other things, to the changing outlook for the issuing government’s finances. If it appears to enough people that the issuing government’s finances are likely to deteriorate significantly, there will be a run against the currency, usually in favour of the dollar upon which all currencies are based. And those holding dollars and aware of the increasing risk to the dollar’s own future purchasing power can only turn to gold and subsequently those goods that represent the necessities of life. And when that happens we have a crack-up boom and the final destruction of the dollar as money.

So the idea that the outlook is for either deflation or inflation is incorrect, and betrays a superficial analysis founded on the misconceptions of macro-economics. Nor does one lead to the other: what really happens is the overall preference between money and goods shifts, influenced not only by current events but by anticipated ones as well.


Recently a rising dollar has led to a falling gold price. This raises the question as to whether further dollar strength against other currencies will continue to undermine the gold price.

Let us assume that the central banks will at some time in the future try to prevent a financial crisis triggered by an economic slump. Their natural response is to expand money and credit. However, this policy-route will be closed off for non-dollar currencies already weakened by a flight into the dollar, leaving us with the bulk of the world’s monetary reflation the responsibility of the Fed.

With this background to the gold price, Asians in their domestic markets are likely to continue to accumulate physical gold, perhaps accelerating their purchases to reflect a renewed bout of scepticism over the local currency. Wealthy investors in Europe will also buy gold, partly through bullion banks, but on the margin demand for delivered physical seems likely to increase. Investment managers and hedge funds in North America will likely close their paper-gold shorts and go long when their computers (which do most of the trading) detect a change in trend.

It seems likely that a change in trend for the gold price in western capital markets will be a component part of a wider reset for all financial markets, because it will signal a change in perceptions of risk for bonds and currencies. With a growing realisation that the great welfare economies are all sliding into a slump, the moment for this reset has moved an important step closer.


The Rise And Fall And Rise And Fall Of King Dollar, Part 2

As stated in the preceding column, here, eminent labor economist Jared Bernstein recently called, in the New York Times, for the dethroning of “King Dollar,” claiming that the reserve currency status of the dollar has cost the United States as many as “six million jobs in 2008, and these would tend to be the sort of high-wage manufacturing jobs.”

Six million is about as many jobs as presidents Bush and Obama together, over 13+ years, created. So this is a big claim.  Whether or not one accepts the magnitude of the jobs deficit proclaimed by Dr. Bernstein, reserve currency status comes with heavy costs.

As former president of the Federal Reserve Bank of Dallas Bob McTeer wrote in a column entitled Reserve Currency Status — A Mixed Blessing:

The advantages of reserve currency status for the dollar are well known. The world’s willingness to accumulate dollar reserves in the post World War II period first removed and later reduced the requirement of maintaining balance of payments equilibrium, or, more specifically, current account balance. By removing or weakening this restraint, U.S. policymakers had more freedom than policymakers in other countries to pursue strictly domestic objectives. We ran current account deficits year after year, balanced, or paid for, by capital inflows from our trading partners. The good side of that was that we could import real goods and services for domestic consumption or absorption and pay for them with paper, or the electronic equivalent. In other words, our contemporary standard of living was enhanced by others’ willingness to hold our currency without “cashing it in” for goods and services, or, before 1971, gold.

The bad side of our reserve currency status, although seldom recognized, was that the very leeway that enhanced our current standard of living built up debt (and/or reduced foreign assets) to dangerous levels. I remember well when, in 1985, the United States ceased being a net creditor nation to the rest of the world and, instead, became a net debtor nation. Our net indebtedness has only grown over the years, and hangs over us like the legendary sword of Damocles.

Sword of Damocles? Lehrman, in his Money, Gold, and History states:

[W]hen one country’s currency — the dollar reserve currency of today — is used to settle international payments, the international settlement and adjustment mechanism is jammed — for that country — and for the world.  This is no abstract notion. …

The reality behind the “twin deficits” is simply this: the greater and more permanent the Federal Reserve and foreign reserve facilities for financing the U.S. budget and trade deficits, the greater will be the twin deficits and the growth of the Federal government.  All congressional, administrative and statutory attempts to end the U.S. deficit have proved futile, and will prove futile, until the crucial underlying flaw — namely the absence of an efficient international settlements and adjustment mechanism — is remedied by international monetary reform inaugurating a new international gold standard and the prohibition of official reserve currencies.

By pinning down the future price level by gold convertibility, the immediate effect of international monetary reform will be to end currency speculation in floating currencies, and terminate the immense costs of inflation hedging.  Gold convertibility eliminates the very costly exchange of currencies at the profit-seeking banks.  Thus, new savings will be channeled out of financial arbitrage and speculation, into long-term financial markets.

Increased long-term investment and improvements in world productivity will surely follow, as investment capital moves out of unproductive hedges and speculation — made necessary by floating exchange rates — seeking new and productive investments, leading to more quality jobs.

The sobering views expressed by McTeer and by Lehrman more than neutralize Heritage Foundation’s Bryan Riley and William Wilson’s valiant championship of the dollar’s reserve currency status, in opposition to Bernstein.  Heritage’s championship is gallant but … unpersuasive.

John Mueller, who served as gold standard advocate Jack Kemp’s chief economist and now as the Ethics and Public Policy Center’s Lehrman Institute Fellow in Economics and Director, Economics and Ethics Program, crisply observes in an interview for this column:

As Kenneth Austin lucidly reminded us, it is a necessity of double-entry bookkeeping that any increase in foreign official dollar reserves equals the increase in combined US  current and private capital account deficits. Denying the connection requires magical thinking. The entire decline in the international investment position since 1976 is due to Congress’s borrowing from foreign central banks–that is, the dollar’s official reserve currency role–while the books of private US residents with the rest of the world have remained close to balance.

There are differing schools of thought among the gold standard’s most prominent adherents as to the significance of merchandise deficit account.  Their theoretical differences about current accounts are likely to prove, operationally, immaterial.

Both the Forbes and Lehrman schools share mortal opposition to mercantilism.  Both passionately oppose the cheapening of the dollar.  Both see the gold standard as a critical mechanism to restoring the brisk growth of, as Lehrman termed it, “quality jobs” … and the restoration of median family income growth that began, profoundly, to stagnate with Nixon’s destruction of Bretton Woods.

In this columnist’s own earnest, if much less erudite, view the most significant element of the reserve currency curse derives from how it subtracts capital from the real, e.g. goods and services, economy.  Corporate earnings are taken, in return for local currency, into the coffers of the relevant international central bank. That central bank then promptly loans the proceeds directly to the federal government of the United States by purchase of treasury instruments.

The way the world of central banking works thus subverts a process extolled by Adam Smith (in the context of his analysis of the benefits of fractional reserve money) in Wealth of Nations.  Smith:

When, therefore, by the substitution of paper, the gold and silver necessary for circulation is reduced to, perhaps, a fifth part of the former quantity, if the value of only the greater part of the other four-fifths be added to the funds which are destined for the maintenance of industry, it must make a very considerable addition to the quantity of that industry, and, consequently, to the value of the annual produce of land and labour.

The mechanics of the reserve currency system preempt these funds’ ready availability for “the maintenance of industry.” The mechanics of the dollar as a reserve asset, therefore, finance bigger government while insidiously preempting productivity, jobs, and equitable prosperity.

This columnist agrees wholeheartedly with Bernstein on what seem his three most important points.  The reserve currency status of the dollar causes American workers, and the world, big problems. The exorbitant privilege deserves and demands far more attention than it receives.  Moving the dollar away from being the world’s reserve currency would be a great deal easier than many now assume.

Bernstein, in his blog,  identifies four mechanisms as “out there” (without explicitly endorsing, or critiquing, them): by legislation (which this columnist views as playing with tariff fire); taxation (thereby “raising the price of currency management,” which this columnist finds hardly an obvious source of job creation); reciprocity (demanding the right to buy foreign treasuries); and an international reserve currency.

Mueller says of Bernstein’s legislative and tax proposals, “you simply can’t solve a monetary problem with a fiscal solution.”

As for reciprocity, the United States Treasury, even under a Joe Biden or even a Bernie Sanders presidency, is never going to turn away ready lenders. This homely truth seems about as self-evident as it gets.  Beyond that, even if China were to undertake market-oriented reforms — and, according to the Wall Street Journal, the political winds seem to be blowing the other way just now — the RMB accounts for only 1.64% of global payments. It is not even close to being a power player. Beyond the beyond … it is well beyond dubious to expect international central banks enthusiastically to bulk up on the debt instruments of the People’s Republic of China for the indefinite future.

An “international reserve currency,” however, is a sound proposition if well designed.  Proposing SDRs for that role does not hold up. As then-Treasury Secretary Tim Geithner, during a hearing of the House Appropriations Subcommittee on Foreign Operations on March 9, 2011, stated, “There is no risk of the SDR playing that [a reserve currency] role.  The SDR is not a currency.  It’s a unit of account.  And it can’t provide the role that many people aspire to it.  There is no risk of that happening.”  Mueller, elucidating why this is so, states:

It’s not possible to solve the problems caused by tying other nations’ domestic currencies to one nation’s inconvertible domestic currency (the dollar), by tying them all to a basket of  inconvertible domestic fiat currencies–that is, to a subset of themselves. The result has no anchor. And the world economy always gravitates to a single “final asset,” because using several multiplies transactions costs.

There appear to be but two technically plausible ways of getting there.  One is Nobel economics laureate Robert Mundell’s proposal of a world currency.  The other, of course, represents a sort of “reversion to the mean.” Restore a 21st century international gold standard.

While the gold standard is very unfashionable it by no means is absurd. Then-World Bank Group president Robert Zoellick, in 2010, was dead on when he observed in an FT column that “Although textbooks may view gold as the old money, markets are using gold as an alternative monetary asset today.”  About a year later, the Bank of England issued a startling but meticulous white paper demonstrating that the “Federal Reserve Note standard” materially has underperformed, in every area considered, both the Bretton Woods gold-exchange standard and the classical gold standard itself.

As previously referenced in this column Bundesbank president Jens Weidmann, in a 2012 speech, forthrightly stated:

Concrete objects have served as money for most of human history; we may therefore speak of commodity money. A great deal of trust was placed in particular in precious and rare metals – gold first and foremost – due to their assumed intrinsic value. In its function as a medium of exchange, medium of payment and store of value, gold is thus, in a sense, a timeless classic.

The gold standard, notwithstanding Churchill’s not-to-be-repeated 1925 blunder, is in no way a prescription for austerity.  The classical gold standard, properly constructed, is a recipe for workers, and median income families, to flourish economically.

We have not flourished, consistently, since its last remnants were destroyed by President Nixon on August 15, 1971.  So… what to do?

The first thing to do is to address the important issue, squarely. By shrewdly posing the right question Jared Bernstein has raised the odds, perhaps significantly, that we finally will find our way to the right answer. Getting out of the woods may be no more complicated than following JFK/LBJ economic advisor Walter Heller’s most famous dictum: “Put aside principle and do what’s right.”

Adroitly resolving the reserve currency issue as part of implementing an international reserve currency is far more likely to be fruitful in generating quality jobs, by the millions, than are earnest jeremiads, such as that by Dr. Bernstein himself, that “American political elites have completely failed to understand what the Fed should be doing right now.”  Relying on central bankers consistently to get discretionary management right represents a triumph of hope over experience.  Or as novelist Rita Mae Brown memorably observed, “insanity is doing the same thing over and over again but expecting different results.”

Let us take Keynes, in The Economic Consequences of the Peace, chapter VI, to heart:

Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. 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.

As Steve Forbes pithily puts it, “You’ve got to get the money right.”  Time to lift the reserve currency curse.  Time to fix the dollar.

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