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Economics

Bedtime for Bondo

 “By sacrificing quality an investor can obtain a higher income return from his bonds. Long experience has demonstrated that the ordinary investor is wiser to keep away from such high-yield bonds. While, taken as a whole, they may work out somewhat better in terms of overall return than the first-quality issues, they expose the owner to too many individual risks of untoward developments, ranging from disquieting price declines to actual default.”

  • Ben Graham, ‘The Intelligent Investor’.

They call them ‘junk bonds’ for a reason. They now constitute an offence against linguistic decency: ‘high yield’ no longer even is. Consider the chart below:

BofA Merrill Lynch High Yield Master II Index (spread vs US Treasuries)

High Yield Master II Index

(Source: BofA Merrill Lynch, St. Louis Federal Reserve)

(The index in question is a benchmark for the broad high yield bond market.) Not for nothing did the Financial Times report at the weekend that “Retail investors are getting increasingly nervous about high-yield bonds”.

They should also be getting increasingly nervous about government bonds. Consider, first, this chart:

                                                                                                                                                                             UK long bond yield

(Source: Thomson Reuters, Credit Suisse)

In the entire history of the UK Gilt market, yields have never been as low. This suggests that Gilt buyers at current levels are unlikely to enjoy an entirely blissful investment experience.

Just to round up this analysis of bond investor hyper-exuberance, consider this last chart, which puts interest rates (in this case, the UK base rate) in their historical context:

UK base rates, 1700 to 2014

UK Base Rates

(Source: The Bank of England, Church House)

(*The Bank Rate has comprised variously the Bank Rate, Minimum Lending Rate, Minimum Band 1 Dealing Rate, Repo Rate and Official Bank Rate.)

There is one (inverse) correlation in investment markets that is pretty much iron-clad. If interest rates go up, bond prices go down. This is entirely logical, since the coupon payments on bonds are typically fixed. If interest rates rise, that stream of fixed coupon payments loses its relative attractiveness. The bond price must therefore fall to compensate fixed coupon investors. So now ask yourself a question: in what direction are interest rates likely to go next ? Your answer may have some bearing on your preferred asset allocation.

Bond investors may be acting rationally inasmuch as they believe that central banks will keep interest rates “lower for longer”. But even more rational investors are now starting, loudly, to question the wisdom of central banks’ maintenance of emergency monetary stimulus measures, at least five years after the Global Financial Crisis flared up. Speaking at the ‘Delivering Alpha’ conference covered by CNBC, respected hedge fund manager Stanley Druckenmiller commented as follows:

“As a macro investor, my job for 30 years was to anticipate changes in the economic trends that were not expected by others – and therefore not yet reflected in securities prices. I certainly made my share of mistakes over the years, but I was fortunate enough to make outsized gains a number of times when we had different views from various central banks. Since most investors like betting with the central bank, these occasions provided our most outsized returns – and the subsequent price adjustments were quite extreme. Today’s Fed policy is as puzzling to me as during any of those periods and, frankly, rivals 2003 in the late-stages to early-2004, as the most baffling of a number of instances I have in mind. We at Duquesne [Capital Management] were mystified back at that time why the funds rate was one percent with the ‘considerable period’ attached to it, given the vigorous economic growth statistics available at the time. I recall walking in one day and showing my partners a bunch of charts of economics statistics of that day and asking them to take the following quiz: Suppose you had been on Mars the last five years and had just come back to planet Earth. I showed them five charts and I said, ‘If you had to guess, where would you guess the Federal funds rate was?’ Without exception, everyone guessed way north of one percent, as opposed to the policy at the time which was a verbal guarantee that they would stay at one percent for a ‘considerable period of time.’ So we were confident the Fed was making a mistake, but we were much less confident in how it would manifest itself. However, our assessment by mid-2005 that the Fed was fueling an unsustainable housing Bubble, with dire repercussions for the greater economy, allowed our investors to profit handsomely as the financial crisis unfolded. Maybe we got lucky. But the leadership of the Federal Reserve did not foresee the coming consequences as late as mid-2007. And, surprisingly, many Fed officials still do not acknowledge any connection between loose monetary policy and subsequent events..”

“I hope we can all agree that these once-in-a-century emergency measures are no longer necessary five years into an economic and balance sheet recovery. There is a heated debate as to what a ‘neutral’ Fed funds rate would be. We should be debating why we haven’t moved more meaningfully towards a neutral funds rate. If for no other reason, so the Fed will have additional weapons available if the outlook darkens again. Many Fed officials and other economists defend their current policies by claiming the economy is better than it would have been without their ongoing stimulus. No one knows for sure, but I believe that is logical and correct. However, I also believe if you’d asked the same question in 2006 – that the economy was better in 2004 to 2006 than it would have been without the monetary stimulus that preceded it. But was the economy better in total from 2003 to 2010 – without the monetary stimulus that preceded it? The same applies today. To economists and Fed officials who continually cite that we are better off than we would have been without zero rate policies for long, I ask ‘Why is that the relevant policy time frame?’ Five years after the crisis, and with growing signs of economic normalization, it seems time to let go of myopic goals. Given the charts I just showed and looking at economic history, today’s Fed policy seems not only unnecessary but fraught with unappreciated risk. When Ben Bernanke and his colleagues instituted QE1 in 2009, financial conditions in the real economy were in a dysfunctional meltdown. The policy was brilliantly conceived and a no-brainer from a risk/reward perspective. But the current policy makes no sense from a risk/reward perspective. Five years into an economic and balance sheet recovery, extraordinary money measures are likely running into sharply diminishing returns. On the other hand, history shows potential long-term costs can be quite severe. I don’t know whether we’re going to end with a mal-investment bust due to a misallocation of resources; whether it’s inflation; or whether the outcome will actually be benign. I really don’t. Neither does the Fed.”

No more charts. If these three don’t get the message across, nothing will.

The bond environment, ranging from high yield nonsense to government nonsense, is now fraught, littered with uncertainty and unexploded ammunition, and waiting nervously for the inevitable rate hike to come (or bracing for a perhaps messy inflationary outbreak if it doesn’t). There are clearly superior choices on a risk-reward basis; we think Ben Graham-style value stocks are the logical and compelling alternative.

Economics

Is Paul Krugman Leaving Princeton In Quiet Disgrace?

Professor Paul Krugman is leaving Princeton.  Is he leaving in disgrace?

Not long, as these things go, before his departure was announced Krugman thoroughly was indicted and publicly eviscerated for intellectual dishonesty by Harvard’s Niall Ferguson in a hard-hitting three-part series in the Huffington Post, beginning here, and with a coda in Project Syndicateall summarized at Forbes.com.  Ferguson, on Krugman:

Where I come from … we do not fear bullies. We despise them. And we do so because we understand that what motivates their bullying is a deep sense of insecurity. Unfortunately for Krugtron the Invincible, his ultimate nightmare has just become a reality. By applying the methods of the historian – by quoting and contextualizing his own published words – I believe I have now made him what he richly deserves to be: a figure of fun, whose predictions (and proscriptions) no one should ever again take seriously.

Princeton, according to Bloomberg News, acknowledged Krugman’s departure with an extraordinarily tepid comment by a spokesperson. “He’s been a valued member of our faculty and we appreciate his 14 years at Princeton.”

Shortly after Krugman’s departure was announced no less than the revered Paul Volcker, himself a Princeton alum, made a comment — subject unnamed — sounding as if directed at Prof. Krugman.   It sounded like “Don’t let the saloon doors hit you on the way out.  Bub.”

To the Daily Princetonian (later reprised by the Wall Street Journal, Volcker stated with refreshing bluntness:

The responsibility of any central bank is price stability. … They ought to make sure that they are making policies that are convincing to the public and to the markets that they’re not going to tolerate inflation.

This was followed by a show-stopping statement:  “This kind of stuff that you’re being taught at Princeton disturbs me.”

Taught at Princeton by … whom?

Paul Krugman, perhaps?  Krugman, last year, wrote an op-ed for the New York Times entitled  Not Enough Inflation.  It betrayed an extremely louche, at best, attitude toward inflation’s insidious dangers. Smoking gun?

Volcker’s comment, in full context:

The responsibility of the government is to have a stable currency. This kind of stuff that you’re being taught at Princeton disturbs me. Your teachers must be telling you that if you’ve got expected inflation, then everybody adjusts and then it’s OK. Is that what they’re telling you? Where did the question come from?

Is Krugman leaving in disgrace? Krugman really is a disgrace … both to Princeton and to the principle of monetary integrity. Eighteenth century Princeton (then called the College of New Jersey)president John Witherspoon, wrote, in his Essay on Money:

Let us next consider the evil that is done by paper. This is what I would particularly request the reader to pay attention to, as it was what this essay was chiefly intended to show, and what the public seems but little aware of. The evil is this: All paper introduced into circulation, and obtaining credit as gold and silver, adds to the quantity of the medium, and thereby, as has been shown above, increases the price of industry and its fruits.

“Increases the price of industry and its fruits?”  That’s what today is called “inflation.”

Inflation is a bad thing.  Period.  Most of all it cheats working people and those on fixed incomes who Krugman pretends to champion.  Volcker comes down squarely, with Witherspoon, on the side of monetary integrity. Krugman, cloaked in undignified sanctimony, comes down, again and again, on the side of … monetary finagling.

Krugman consistently misrepresents his opponents’ positions, constructs fictive straw men, addresses marginal figures, and ignores inconvenient truths set forward by figures of probity such as the Bank of England and theBundesbankthoughtful work such as that by Member of Parliament (with a Cambridge Ph.D. in economic history) Kwasi Kwarteng, and, right here at home, respected thought leaders such as Steve Forbes and Lewis E. Lehrman (with whose Institute this writer has a professional affiliation).

Professor Krugman, on July 7, 2014, undertook to issue yet another of his fatwas on proponents of the classical gold standard.  His New York Times op-ed, Beliefs, Facts and Money, Conservative Delusions About Inflation, was brim full of outright falsehoods and misleading statements. Krugman:

In 2010 a virtual Who’s Who of conservative economists and pundits sent an open letter to Ben Bernanke warning that his policies risked “currency debasement and inflation.”  Prominent politicians like Representative Paul Ryan joined the chorus.

Reality, however, declined to cooperate. Although the Fed continued on its expansionary course — its balance sheet has grown to more than $4 trillion, up fivefold since the start of the crisis — inflation stayed low.

Many on the right are hostile to any kind of government activism, seeing it as the thin edge of the wedge — if you concede that the Fed can sometimes help the economy by creating “fiat money,” the next thing you know liberals will confiscate your wealth and give it to the 47 percent. Also, let’s not forget that quite a few influential conservatives, including Mr. Ryan, draw their inspiration from Ayn Rand novels in which the gold standard takes on essentially sacred status.

And if you look at the internal dynamics of the Republican Party, it’s obvious that the currency-debasement, return-to-gold faction has been gaining strength even as its predictions keep failing.

Krugman is, of course, quite correct that the “return-to-gold faction has been gaining strength.” Speculating beyond the data thereafter Krugman goes beyond studied ignorance.  He traffics in shamefully deceptive statements.

Lewis E. Lehrman, protege of French monetary policy giant Jacques Rueff, Reagan Gold Commissioner, and founder and chairman of the Lehrman Institute, arguably is the most prominent contemporary advocate for the classical gold standard.  Lehrman never rendered a prediction of imminent “runaway inflation.”  Only a minority of classical gold standard proponents are on record with “dire” warnings, certainly not this columnist.  So… who is Krugman talking about?

Of the nearly two-dozen signers of (a fairly mildly stated concern) open letter to Bernanke which Krugman cites as prime evidence, only one or two are really notable members of the “return-to-gold faction.” Perhaps a few other signers might have shown some themselves in sympathy the gold prescription. Most, however, were, and are, agnostic about, or even opposed to, the gold standard.

Indicting gold standard proponents for a claim made by gold’s agnostics and opponents is a wrong, cheap, bad faith, argument.  More bad faith followed immediately.   Whatever inspiration Rep. Paul Ryan draws from novelist Ayn Rand, Ryan is by no means a gold standard advocate.  And very few “influential conservatives” (unnamed) “draw their inspiration” from Ayn Rand.

Nor are most proponents of the classical gold standard motivated by a fear that paper money is an entering wedge for liberals to “confiscate your wealth and give it to the 47 percent.”  A commitment to gold is rooted, for most, in the correlation between the gold standard and equitable prosperity.  Income inequality demonstrably has grown far more virulent under the fiduciary Federal Reserve Note regime — put in place by President Nixon — than it was, for instance, under the Bretton Woods gold+gold-convertible-dollar system.

Krugman goes wrong through and through.  No wonder Ferguson wrote: “I agree with Raghuram Rajan, one of the few economists who authentically anticipated the financial crisis: Krugman’s is “the paranoid style in economics.” Krugman, perversely standing with Nixon, takes a reactionary, not progressive, position. The readers of the New York Times really deserve better.

Volcker is right. “The responsibility of any central bank is price stability.” Krugman is wrong.

Prof. Krugman was indicted and flogged publicly by Niall Ferguson. Krugman thereafter announced his departure from Princeton.  On his way out Krugman, it appears, was reprimanded by Paul Volcker.  Krugman has been a disgrace to Princeton.  Is he leaving Princeton in quiet disgrace?

Originating at Forbes.com: http://www.forbes.com/sites/ralphbenko/2014/07/14/is-paul-krugm

Economics

Competition and Finance

[Editor's note: The Cato Institute will be publishing Cobden Senior Fellow Kevin Dowd's work "Competition and Finance" for free in ebook format. The following outlines the contributions of this important work.]

Originally published in 1996, Cato is proud to make available in digital format, Professor Kevin Dowd’s groundbreaking unification of financial and monetary economics, Competition and Finance: A Reinterpretation of Financial and Monetary Economics.

Dowd begins his analysis with a microeconomic examination of which financial contracts and instruments economic actors use, after which he extends this analysis to how these instruments impact a firm’s financial structure, as well as how firms manage that financial structure.  After bringing the reader from individual agent to the foundations of corporate financial policy, Dowd then builds a theory of financial intermediation, or a theory of “banking”, based upon these micro-foundations.  He uses these foundations to explain the role and existence of various forms of intermediaries found in financial markets, including brokers, mutual funds and of course, commercial banks.

Most scholarship in financial economics ends there, or rather examines in ever deeper detail the workings of financial intermediaries.  Dowd, after having developed a theory of financial intermediation from micro-foundations, derives a theory of monetary standards, based upon his developed media of exchange and its relation to the payments system.  While much of Competition and Finance breaks new theoretical ground, it is this bridge from micro-finance to macro-economics and monetary policy that constitutes the work’s most significant contribution.  In doing so, Dowd also lays the theoretical groundwork for a laissez-faire system of banking and money, demonstrating how such would improve consumer welfare and financial stability.

As Competition and Finance has been out-of-print in the United States, our hope is to make this important work available to a new generation of scholars working in the fields of financial and monetary economics.  If the recent financial crisis demonstrated anything, it is the need for a more unified treatment of financial and monetary economics.  Competition and Finance provides such a treatment.

Economics

New private monies can outcompete government monetary systems

[Editor's note: this article was originally published by the IEA here]

I would like to thank the IEA for today publishing my monograph, New Private Monies, which examines three contemporary cases of private monetary systems.

The first is the Liberty Dollar, a private mint operated by Bernard von NotHaus, whose currency became the second most widely used in the United States. It was highly successful and its precious metallic basis ensured it rose in value over time against the inflating greenback. In 2007, however, Uncle Sam shut it down, successfully charging von NotHaus with counterfeiting and sundry other offences. In reality, the Liberty Dollar was nothing like the greenback dollar. Nor could it be, as its purpose was to provide a superior dollar in open competition, not to pass itself off as the inferior dollar it was competing against, which has lost over 95 per cent of its value since the Federal Reserve was founded a century ago. For this public service of providing superior currency, Mr. von NotHaus is now potentially facing life in the federal slammer. As he put it:

‘This is the United States government. It’s got all the guns, all the surveillance, all the tanks, it has nuclear weapons, and it’s worried about some ex-surfer guy making his own money? Give me a break!’

The second case is e-gold, a private digital gold transfer business – a kind of private gold standard – run by Dr Doug Jackson out of Nevis in the Caribbean. By 2005, e-gold had risen to become second only to PayPal in the online payments industry. Jackson correctly argued that it was not covered by any existing US financial regulation, not just because of its offshore status but also because it was a payment system rather than a money transmitter or bank as then-defined, and not least because gold was not legally ‘money’. Yet despite its efforts to clarify its evolving regulatory and tax status, and despite helping them to catch some of the biggest cyber criminals then in operation, US law enforcement turned on the company: they trumped up charges of illegal money transmission and blackmailed its principals into a plea bargain.

Both these cases illustrate that there is a strong demand for private money and that the market can meet that demand and outcompete government monetary systems. Unfortunately, they also illustrate the perils of private money issuers operating out in the open where they are vulnerable to attack by the government. Perhaps they should operate undercover instead…

This takes us to the third case study: Bitcoin, a new type of currency known as crypto-currency, a self-regulating and highly anonymous computer currency based on the use of strong cryptography.

To quote its designer, Satoshi Nakamoto:

‘The root problem with conventional currency is all the trust that is required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust…

‘Bitcoin’s solution is to use a peer-to-peer network to check for double-spending…the result is a distributed system with no single point of failure.’

Bitcoin is produced in a kind of electronic ‘mining’ process, in which successful ‘miners’ are rewarded with Bitcoin. The process is designed to ensure that the amounts produced are almost exactly known in advance. Since its inception in 2009, the demand for Bitcoin has skyrocketed, albeit in a very volatile way, forcing its price from 3 cents to (currently) just under $600. Perhaps the best-known use of Bitcoin has been on the dark web drugs market Silk Road, the ‘Amazon.com of illegal drugs’, but Bitcoin is increasingly popular for all manner of mundane legal uses as well.

Bitcoin is a wonderful innovation, but the pioneers in any industry are rarely the ones who last. Despite Bitcoin’s success to date, it is doubtful whether being the first mover is an advantage in the longer term: design flaws in the Bitcoin model are set in concrete and competitors can learn from them. The crypto-currency market is also an open one and a considerable number of competitors have since entered the field. Most of these will soon fail, but no-one can predict which will be best suited to the market and achieve long-run success. Most likely, Bitcoin will eventually be displaced by even better crypto-currencies.

Crypto-currencies have momentous ramifications. As one blogger put it:

‘As long as my encrypted [Bitcoin] wallet exists somewhere in the world, such as on an email account, I can walk across national borders with nothing on me and retrieve my wealth from anywhere in the world with an internet connection.’

This gives Bitcoin great potential as an internationally mobile store of value that offers a high degree of security against predatory governments. Bitcoin now fulfils the role once met by bank secrecy – the ability to protect one’s financial privacy.

There is no easy way in which the government can prevent the use of Bitcoin to evade its control. The combination of anonymity and independence means that governments cannot bring Bitcoin down by taking out particular individuals or organisations because the system has no single point of failure. They could shut down whatever sites they like, but the Bitcoin community would carry on.

Strong cryptography therefore offers the potential to swing the balance of power back from the state toward the individual. Censorship, prohibition, oppressive taxes and repression are being undermined as people increasingly escape into the cyphersphere where they can operate free from government harassment.

We now face the prospect of a peaceful crypto-anarchic society in which there is no longer any government role in the monetary system and, hopefully, no government at all.

Welcome to crypto-anarchy.

 

New Private Monies: A Bit-Part Player can be downloaded here.

Economics

ECB embraces QE faulty logic

Editor’s note: this article, under the title “No end to central bank meddling as ECB embraces ‘quantitative easing’, faulty logic” appears on Detlev Schlichter’s site. It is reprinted with kind permission.

The 2nd edition of his excellent Paper Money Collapse is available for pre-order.

“Who can print money, will print money” is how my friend Patrick Barron put it succinctly the other day. This adage is worth remembering particularly for those periods when central bankers occasionally take the foot off the gas, either because they genuinely believe they solved the problem, or because they want to make a show of appearing careful and measured.

The US Federal Reserve is a case in point. Last year the Fed announced that it was beginning to ‘taper’, that is, carefully reduce its debt monetization program (‘quantitative easing’, QE), and this policy, now enacted, is widely considered the beginning of policy normalization and part of an ‘exit strategy’. But as Jim Rickards pointed out, the Fed already fully tapered twice – after QE1 and after QE2 – only to feel obliged to ‘qe’ again some time later. Whether Ms Yellen is going to see the present ‘taper’ through to its conclusion and whether the whole project will in future be remembered as an ‘exit strategy’ remains to be seen.

So far none of the big central banks has achieved the ‘exit’ despite occasional noises to the contrary. Since the start of the financial crisis in the summer of 2007, the global trend has been in one direction and one direction only: From easy money we moved to easier money. QE has been followed by more QE. As I mentioned before, the Fed’s most generous year in its 100-year history was 2013, any talk of ‘tapering’ notwithstanding.

ECB mistrusted by Keynesian consensus

Whenever the European Central Bank reduces its money printing and scales back its market rigging, it invariably unleashes the fury of the Keynesian and inflationist commentariat. In the eyes of its numerous critics, the ECB lacks the proper money-printing credentials of the more pro-active and allegedly more ‘modern’ central banks. It still has a whiff of the old Bundesbank about it, although a few years back, when the ECB flooded the European banking system with cheap liquidity, its balance sheet was larger as a share of GDP than those of its comrades, the Fed and the Bank of England.

The ECB went through two periods of restraint since the crisis: In early 2011 it began to hike interest rates, and in 2013, after the eurozone debt crisis died down, the ECB allowed its balance sheet to shrink by more than €700 billion as banks repaid cheap loans from the central bank. This stood in stark contrast to the Fed’s balance sheet expansion of about $1,000 billion over the same period. The first episode of restraint came to an end in 2012 when the ECB reversed its rate hikes and then cut rates further, ultimately to a new low of just 0.25 percent. Presently, we are still in the second period of restraint, although it too appears to be about to end soon as the ECB’s boss Mario Draghi hinted in his press conference last week at a newfound willingness to embrace unconventional policies to combat ‘deflation’ or even ‘long periods of low inflation’. (The ECB’s harmonized index of consumer prices stood probably at just 0.5% last month.) This means the ECB is likely to cut rates to zero or below soon, or to start asset purchases (‘QE’), or probably both.

Poor logic

This move is hardly surprising in the big scheme of things as outlined above, and the ECB will explain it officially with its mandate to keep inflation below but close to 2 percent, from which it does not want to deviate in either direction. This target itself is silly as it assumes that inflation of 1.8 percent is inherently better than inflation of zero (true price stability, if it ever was attainable), or inflation of minus 1.8 percent (deflation). This is, of course, precisely the argument that has been relentlessly and noisily trumpeted by the easy-money advocates in the media, the likes of Martin Wolf and Wolfgang Münchau in the Financial Times, and the reliably shrill Ambrose Evans-Pritchard in The Daily Telegraph, among others. A certain measure of inflation is deemed good, very low inflation is bad, and anything below zero, even mild deflation, potentially a disaster. But why should this be the case?

Moderate deflation, that is, slowly declining money prices, may or may not be a symptom of problems elsewhere in the economy, but that slowly declining money prices as such constitute an economic problem lacks any foundation in economics and can easily and quickly be refuted by even a cursory look at economic history. In the 19th century we find extended periods of ongoing, moderate deflation in many economies that simultaneously experienced solid growth in output and substantial rises in living standards, a “coincidence”, wrote Milton Friedman and Anna Schwartz in their influential A Monetary History of the United States, 1867 – 1960, that “casts serious doubts on the validity of the now widely held view that secular price deflation and rapid economic growth are incompatible.”

Many commentators advance the argument that falling prices depress consumption as purchases get constantly deferred. Even the usually more sober FT-writer John Authers seems to have succumbed to this argument as he explained to his readers last Saturday that prices “fall, thanks to sluggish economic activity. Consumers do not buy now, as goods will be cheaper in future. This lack of consumption slows growth further, and pushes prices down even further.” (John Authers, “Draghi has to back his QE words with action” Financial Times, Saturday April 5/ Sunday April 6 2014, page 24)

This argument, constantly regurgitated by the cheerleaders of money-printing, is weak. First of all, it is certainly no argument in the present environment of close to zero but still positive inflation. If the ECB plans to fight even very low inflation, as Draghi stated at the ECB press conference, than this argument does nothing to support that policy. Certainly, no one defers any purchases when prices are just stable. However, and more importantly, even in a mildly deflationary environment of let’s say 1 to 2 percent per annum, the argument does appear to be a stretch.

Argument ignores time preference

Consumers only contemplate buying something that they consider an economic good, that is, that they consider useful, that they want because it expends some (subjective) use-value to them. In deferring a purchase they can, in a deflationary environment, save money but at the cost of not enjoying the possession of what they want for some time. By not buying a toaster now you may be able to buy it 1 or 2 percent cheaper in a year’s time, or 2 to 4 percent cheaper in two years’ time (always assuming, of course, that the mild deflation persists that long, which nobody can guarantee), but even these small monetary gains come at the expense of not enjoying ownership of the toaster for two years. The small monetary gain obtained by delaying purchases is not for free, as the argument seems to assume, but comes at the cost of waiting. I suggest that only a very small number of items, and only those for which there is very marginal demand indeed, would be affected.

Time preference is not a concept of psychology, it is a constituting element of human action. It is a priori to human action, which means it exists independent of experience or of personal circumstances as it is already entailed in the very concept of what constitutes an ‘economic good’.

If you experienced no time preference in relation to a specific good you would be indifferent as to whether you enjoyed the possession of that good today or tomorrow. And tomorrow you would be indifferent as to whether you enjoyed it that day or the next, and so forth. Logically, you would be indifferent as to whether you enjoyed possession of it at all, and this means that the good in question is not an economic good for you. You do not care for it.

As George Reisman put is succinctly: To want something means, all else being equal, to want it sooner rather than later.

Be honest, how many purchases over the past 12 months would you not have made had you had a reasonable chance of obtaining the item in question at a 1 or 2 percent discount if you waited a year?

Exactly.

That the prospect of falling prices does not usually deter consumption can be readily seen today in the market for consumer electronics (mobile phones, computers), which has been in deflation – and considerable deflation – for quite some time.

Argument ignores opportunity costs of holding money

The argument also seems to ignore that holding one’s wealth in the form of money involves opportunity costs. Rather than sitting on cash you could enjoy the things you could buy with it. In a deflationary environment, your cash hoard’s purchasing power slowly rises and you can afford ever more nice things with your money, which means the opportunity cost of not spending it constantly goes up. (In a way, while you are waiting four years to buy your toaster at an 8 percent discount to today’s price, buying the toaster is also becoming marginally more attractive to others who are presently holding cash and who may initially not even had an interest in a toaster.)

I think that all that would follow from secular (that is ongoing, systematic but moderate) deflation is that cash would be a more meaningful competitor for other depositories of deferred consumption. Saving by simply holding money makes sense in a deflationary environment, so other vehicles to save with (bonds and shares) would have to offer a return reasonably above the expected deflation rate to attract savings. I think this is not an unreasonably high hurdle.

Furthermore, if what Authers and others describe were true for even marginal deflation, that is, if marginal deflation indeed led to more deflation and a progressively weakening economy, the reverse must logically be true for marginal inflation. Consumers would accelerate their purchases to avoid the 1 or 2 percent loss in purchasing power per annum, and this would quickly drive inflation higher. If two percent deflation led to cash hoarding and a collapse in consumption, would the 2 percent inflation advocated today as ‘price stability’ not lead to a spike in money velocity and an inflationary boom? Either scenario seems highly unrealistic.

Monetary causes versus non-monetary causes

If we use the economic terminology correctly, then inflation and deflation are always monetary phenomena, that is, they always have monetary causes. (As an aside, I here use the now standard definition of inflation as an ongoing, trending rise in the general price level, and deflation as the opposite, rather than the traditional meaning of inflation as an expansion of the money supply and deflation as a contraction.) However, the starting point of the present discussion is simply some low readings on the official inflation statistics in the eurozone. And that those could have non-monetary causes, that they could be the consequence of a crisis-driven drop in real demand in certain industries and certain countries is a realistic assumption and is in fact implied by the arguments of the QE-advocates. Outright deflation is presently being recorded in Greece, Cyprus, and Spain. And John Authers’ short statement on deflation in the FT also starts from the assumption that “prices fall thanks to sluggish economic activity.”

But to the extent that recorded deflation is not due to a general rise in money’s purchasing power (due to a general rise in money demand or an unchanged or falling money supply, to which I come soon) but the result of some producers slashing certain prices in certain industries and regions, and of those price drops not being fully compensated by rising prices somewhere else in eurozone, then this has various implications:

Consumers cannot simply assume that this is a lasting trend. The liquidation of capital misallocations and the discounting of merchandise to get it moving are crisis phenomena and cannot simply be extrapolated into the future the way consumers may have extrapolated the secular deflation of gold standard economies in the 19th century. But the straight extrapolation of very recent price changes into the future is at the core of the argument that even small deflation would be disastrous.

Furthermore, it would seem bizarre to advice merchants to not slash prices when demand drops as that would, according to the logic advanced by Authers et al, only lead to further postponement of consumption and a further drop in demand as consumers would simply expect price declines to continue. Would hiking prices be a better strategy to counter falling demand? Should we reconsider the concept of the “sale” and of “discounting” inventory to encourage buying?

To a considerable degree, the reduction in certain prices for ‘real’ economic reasons could be part of the economic healing process. It is a way for many producers, sectors of the economy, and economic regions, to regain competitiveness. It is true that falling wages in certain industries or regions make it more difficult for workers to repay mortgages and consumer loans but often the lower wage may be the only way to avoid unemployment, which would make repaying debt harder still. Behind the often-quoted headline inflation rate of presently 0.5% per annum lie numerous relative price changes by which the economy re-balances. All discussions about the ‘price index’ ignore these all-important changes in relative prices. It so happens that what goes on with the multitude of individual prices in the economy adds up, according to the techniques of the ECB statisticians, to a 0.5% harmonized inflation rate at the moment, and it may all add up to -0.5% next month or next year, or maybe even – 1 percent. To simply conclude from this one aggregate price number that the economy is getting progressively sicker would be wrong.

There is no escaping the fact that recent economic difficulties are the result of imbalances that accumulated during the credit boom that preceded the 2007/2008 financial crisis, of which the eurozone debt crisis was an after quake. Artificially cheap money created the credit boom and these imbalances. A period of liquidation, contraction, changing relative prices and occasionally falling prices is now necessary, and short-circuiting this process via renewed central bank intervention seems counterproductive and ultimately dangerous.

There is, of course, the possibility that proper monetary causes are behind the eurozone’s low inflation and soon deflation, and that those might persist. Banks still feel constrained in their ability to extend new loans and thus create new money. The growth in bank lending and thus in wider monetary aggregates may fall short of the growth in money demand. But it is an essential feature of money that any demand for it can be fully satisfied with a rise in its price. Demand for money is always demand for readily exercisable purchasing power, and by allowing the market to lift the purchasing power of money, that is, through deflation, that demand can be met. The secular, moderate and largely harmless deflation of 19th century gold standard economies had essentially the same origin. Money production did not keep pace with money demand, so money demand was satisfied via slowly falling prices.

And here the same conclusion applies: a more restrained approach to lending, credit risk, and financial leverage, now adopted by banks and the public at large as a consequence of the crisis, may be a good thing, and for the central bank to mess with this process and to use ‘unconventional’ means to force more bank lending and money creation onto the system, out of some misguided commitment to the arbitrarily chosen statistical goal of ‘2-percent inflation’ seems foolish. If successful in raising the headline inflation rate it may succeed in creating the same imbalances (excessive leverage, misallocations of capital and distorted asset prices) that have created the recent crisis.

One commentator recently said the eurozone could ill afford deflation considering the size of its bloated banking sector. But the question is if it can afford the level of lending to attain 2 percent inflation considering the size of its bloated banking sector.

The fallacy of macroeconomics and macroeconomic policy

Let me be clear: I do not recommend a zero-inflation target or a target of moderate deflation. Moderate deflation in and of itself is a little a solution as moderate inflation in and of itself is a problem. I recommend no target as I reject the entire concept of ‘monetary policy’, of the notion that a state agency could conceivably enhance, through clever manipulation of interest rates and bank reserve policy, the coordinating powers of the market that help people realize their personal economic objectives through free trade.

We should remember that no one participates in the economy and in trade and commerce because his or her goal is that the general price level goes up by 2 percent, or that nominal GDP increases by 5 percent. People have their own personal objectives. The market is simply a powerful tool for voluntary and decentralized plan-coordination among independent individuals and groups of individuals that pursue their own goals. It is best left undisturbed. This entire project of ‘monetary policy’ is absurd in the extreme, regardless of what the target is.

It is the fallacy of macroeconomics that certain statistical aggregates, such as CPI, GDP or nominal GDP, are deemed reliable representatives of what goes on in a complex market economy, and it is dangerous hubris to believe that the state should define ‘targets’ for these statistical aggregates and then use policy intervention to achieve them. This might be an approach intellectually suitable for the ruler of a communist or fascist society. It is fundamentally at odds with free trade and a free market, and it must and will fail. That should have been a clear lesson from the financial crisis.

Instead, the mainstream consensus, deeply influenced by Keynesianism and macroeconomics, continues to embrace policy activism and intervention. I fully expect central banks to continue on their path towards more aggressive meddling and generous fiat money production. It won’t take long for the ECB to take the next step.

Economics

Money derivative creation in the modern economy

It isn’t often that a Bank of England Quarterly Bulletin starts “A revolution in how we understand economic policy” but, according to some, that is just what Money creation in the modern economy, a much discussed article in the most recent bulletin, has done.

In the article Michael McLeay, Amar Radia, and Ryland Thomas of the Bank’s Monetary Analysis Directorate seek to debunk the allegedly commonplace, textbook understanding of money creation. These unnamed textbooks, they claim, describe how the central bank conducts monetary policy by varying the amount of narrow or base money (M0). This monetary base is then multiplied out by banks, via loans, in some multiple into broader monetary measures (e.g. M4).

Not so, say the authors. They begin by noting that most of what we think of as money is actually composed of bank deposits. These deposits are created by banks when they make loans. Banks then borrow the amount of narrow or base money they require to support these deposits from the central bank at the base rate, and the quantity of the monetary base is determined that way. In short, the textbook argument that central bank narrow or base money creation leads to broad money creation is the wrong way round; bank broad money creation leads to central bank narrow money creation. The supposedly revolutionary connotations are that monetary policy is useless, even that there is no limit to the amount of money banks can create.

In fact there is much less to this ‘revolution’ than meets the eye. Economists and their textbooks have long believed that broad money is created and destroyed by banks and borrowers(1). None that I am aware of actually thinks that bank lending is solely or even largely based on the savings deposited with it. Likewise, no one thinks the money multiplier is a fixed ratio. It might be of interest as a descriptive datum, but it is of no use as a prescriptive tool of policy. All the Bank of England economists have really done is to describe fractional reserve banking which is the way that, these days, pretty much every bank works everywhere.

But there’s an important point which the Bank’s article misses; banks do not create money, they create money derivatives. The narrow or base money issued by central banks comprises coins, notes, and reserves which the holder can exchange for coins and notes at the central bank. The economist George Reisman calls this standard money; “money that is not a claim to anything beyond itself…which, when received, constitutes payment”.

This is not the case with the broad money created by banks. If a bank makes a loan and creates deposits of £X in the process, it is creating a claim to £X of standard money. If the borrower makes a cheque payment of £Y they are handing over their claim on £Y of reserve money. The economist Ludwig von Mises called this fiduciary media, as Reisman describes it, “transferable claims to standard money, payable by the issuer on demand, and accepted in commerce as the equivalent of standard money, but for which no standard money actually exists”. They are standard money derivatives, in other words.

Banks know that they are highly unlikely to be called upon to redeem all the fiduciary media claims to standard money in a given period so, as the Bank of England economists explain, they expand their issue of fiduciary media by making loans; they leverage. Between May 2006 and March 2009 the ratio of M4 to M0, how many pounds of broad money each pound of narrow money was supporting, stood around 25:1.

But because central banks and banks create different things consumer preferences between the two, standard money or standard money derivatives, can change. In one state of affairs, call it ‘confidence’, economic agents are happy to hold these derivatives as substitutes for standard money. In another state of affairs, call it ‘panic’, those same economic agents want to swap their derivatives for the standard money it represents a claim on. This is what people were doing when they queued up outside Northern Rock. A bank run can be described as a shift in depositors’ preferences from fiduciary media to standard money.

Why should people’s preferences switch? In the case of Northern Rock people came to doubt that they would be able to actually redeem their fiduciary media for the standard money it entitled them to because of the vast over issue of fiduciary media claims relative to the standard money the bank held to honour them. Indeed, when Northern Rock borrowed from the Bank of England in September 2007 to support the commitments under its broad money expansion it increased the monetary base just as the Bank of England economists argue.

But there are limits to this. A bank will need some quantity of standard money to support its fiduciary media issue, either to honour withdrawals by depositors or settle accounts with other banks. If it perceives its reserves to be inadequate it will need to access new reserves. And the price at which it can access those reserves is the Bank of England base rate. If this base rate is relatively high banks will constrain their fiduciary media/broad money issue because the profits earned from making new loans will not cover the potential cost of the standard/narrow money necessary to support it. And if the base rate is relatively low banks will expand their fiduciary media/broad money issue because the standard/narrow money necessary to support it is relatively cheap.

Some commentators need to calm themselves. As the Bank of England paper says, the central bank does influence broader monetary conditions but it does so via its control of base rates rather than the control of the quantity of bank reserves. The reports of the death of monetary policy have been greatly exaggerated.

Notes:
(1) “Banks create money. Literally. But they don’t do so by printing up more green pieces of paper. Let’s see how it happens. Suppose your application for a loan of $500 from the First National Bank is approved. The lending officer will make out a deposit slip in your name for $500, initial it, and hand it to a teller, who will then credit your checking account with an additional $500. Total demand deposits will immediately increase by $500. The money stock will be larger by that amount. Contrary to what most people believe, the bank does not take the $500 it lends you out of someone else’s account. That person would surely complain if it did! The bank created the $500 it lent you” – The Economic Way of Thinking by Paul Heyne, Peter Boettke, and David Prychitko, 11th ed., 2006, page 403. Perhaps the Bank of England economists need to read a better textbook?

Economics

Five years of disastrously low interest rates have left Britain addicted to cheap credit

The Bank of England

This article originally appeared in The Telegraph on 5 March 2014. It is reproduced by permission of the author.

Five years ago today, the Bank of England cut interest rates about as low as they can go: 0.5 percent. And there they have remained.

If rates have been rock bottom for five years, our central bankers have been cutting them for even longer. You need to go back almost nine years to find a time when real interest rates last rose. Almost a million mortgage holders have never known a rate rise.

And this is all a Good Thing, according to the orthodoxy in SW1. Sure, low rates might hit savers, who don’t get such good returns, but for home owners and businesses, it’s been a blessing.

Don’t just compare the winners with the losers, say the pundits. Think of the whole economy. Rates were set at rock bottom shortly after banks started to go bust. Slashing the official cost of borrowing saved the day, they say.

I disagree. Low interest rates did not save the UK economy from the financial crisis. Low interest rates helped caused the crisis – and keeping rates low means many of the chronic imbalances remain.

To see why, cast your mind back to 1997 and Gordon Brown’s decision to allow the Bank of England to set interest rates independent of any ministerial oversight.

Why did Chancellor Brown make that move? Fear that populist politicians did not have enough discipline. Desperate to curry favour with the electorate, ministers might show themselves to be mere mortals, slashing rates as an electoral bribe.

The oppostite turned out to be the case.  Since independence, those supermen at the central bank set rates far lower than any minister previously dared.  And the results of leaving these decisions to supposedly benign technocrats at the central bank has been pretty disastrous.

Setting interest rates low is simply a form of price fixing. Set the price of anything – bread, coffee, rental accommodation – artificially low and first you get a glut, as whatever is available gets bought up.

Then comes the shortage. With less incentive to produce more of those things, the supply dries up. So, too, with credit.

With interest rates low, there is less incentive to save. Since one persons savings mean another’s borrowing, less saving means less real credit in the system. With no real credit, along comes the candyfloss variety, conjured up by the banks – and we know what happened next.  See Northern Rock…

When politicians praise low interest rates, yet lament the lack of credit, they demonstrate an extraordinary, almost pre-modern, economic illiteracy.

Too many politicians and central bankers believe cheap credit is a cause of economic success, rather than a consequence of it. We will pay a terrible price for this conceit.

Low interest rates might stimulate the economy in the short term, but not in a way that is good for long-term growth. As I show in my paper on monetary policy, cheap credit encourages over-consumption, explaining why we remain more dependent than ever on consumer- (and credit-) induced growth.

Cheap credit cannot rebalance the economy. By encouraging over-consumption, it leads to further imbalances.

Think of too much cheap credit as cholesterol, clogging up our economic arteries, laying down layer upon layer of so-called “malinvestment”.

“Saved” by low rates, an estimated one in 10 British businesses is now a zombie firm, able to service its debts, but with no chance of ever being able to pay them off.

Undead, these zombie firms can sell to their existing customer base, keeping out new competition. But what they cannot do is move into new markets or restructure and reorganise. Might this help explain Britain’s relatively poor export and productivity performance?

What was supposed to be an emergency measure to get UK plc through the financial storm, has taken on an appearance of permanence. We are addicted to cheap credit. Even a modest 1 per cent rate rise would have serious consequences for many.

Sooner or later, interest rates will have to rise. The extent to which low interest rates have merely delayed the moment of reckoning, preventing us from making the necessary readjustments, will then become painfully evident.

We are going to need a different monetary policy, perhaps rather sooner than we realise.

Economics

The madness of contemporary economists

The Bank of England is considering negative interest rates to “stimulate” the economy, together with more QE. It’s one thing to pay a bank for safe-keeping and other services, another for the central bank to manipulate the credit markets as a whole. It is explicitly a policy of expropriating savers, of which there is much to be said on another occasion. Allister Heath provides sensible comment here.

What the Bank of England is trying to do is restart the money creation process which dropped us into this mess while keeping expectations of inflation low. It’s an extremely dangerous game, one which Hayek explored in his Nobel lecture: it is a policy which cannot create sustainable prosperity but which may create massive inflation, with all its destructive effects.

Having mostly failed to see this crisis coming before failing to predict even the general pattern of events, senior economists now want more of the medicine which already nearly killed the patient. This may look like madness or stupidity to those of us without a high level of formal education in economics. It is neither. Contemporary economists are trapped in an intellectual prison founded on now-old errors of method and epistemology: the knowledge and simplifications necessary to make their mathematical models work are unavailable and invalid respectively.

As a result, economists and central bankers in particular think it is their task to intervene when the choices and actions of tens of millions of people produce aggregate statistics they, and politicians, don’t like. Massive economic disruption and misallocation of resources — ultimately, human suffering — is the result. Unfortunately, it looks like those few who hold the terrible power of monetary policy are determined to test their ideas to destruction.

Following the UK credit rating downgrade, I gave Newsnight an interview. They chose a couple of sentences in which I pointed out the reality that welfare, health, education and debt interest are about 3/4 of spending on 2012 figures and that they will have to be cut eventually if we are serious about the state living within its means. You can find it at 17:00. If I had been given longer, I would have said those things you can find in this interview with RT:

We have been on a merry-go-round of deficit spending, excruciating taxes, heavy borrowing and easy money for most of 40 years. That merry-go-round is now running down and will stop. Attempts to spin it up through monetary policy are extremely dangerous: they will store up worse trouble for later.

If the Government does not act to end expansionist policy in time by a return to balanced budgets, by ending government borrowing from the commercial banks, by stopping quantitative easing and by letting the market determine the height of interest rates, then it will have chosen the German way of 1923.

This article originally appeared on stevebaker.info.

Economics

Ron Paul’s monetary policy anthology

I received an email the other day from Paul-Martin Foss, Legislative Assistant at the Office of Congressman Ron Paul:

Dear Friends of Dr. Paul,

If you are receiving this email, it is because you are a friend of Dr. Paul, a witness at one of our monetary policy hearings, a contributor to what has become Dr. Paul’s Monetary Policy Anthology, or likely some combination of the three.

To honor and preserve Dr. Paul’s legacy as Chairman of the Subcommittee on Domestic Monetary Policy, we have compiled an anthology containing all of Dr. Paul’s activities as chairman. It contains all of his hearings within the DMP subcommittee, transcripts of our Tea Talk Lecture Series, transcripts of his exchanges with Fed Chairman Bernanke, etc.

As a single document, the anthology as formatted runs to over 5000 pages, so we are splitting it into multiple sections and hosting it on Dr. Paul’s Congressional website. Today is the only day that those files will be available online, because today is the last day of the 112th Congress and our website will likely be taken down by close of business today.

Mr Foss subsequently uploaded the files to Dropbox for posterity. We have also archived them in our Downloads section. Here are the direct links:

Economics

Did the savings glut or massive monetary expansion cause the boom and the bust?

Ambrose Evans-Pritchard recently pinned the blame for the financial crisis on “Asia’s `Savings Glut’”. This idea is not new. For readers who may have missed it the first time, we’re republishing this article from September 2009 which argues that monetary policy caused the boom, the bust and the savings glut.

Martin Wolf - Global Imbalances

Martin Wolf – Global Imbalances

Distinguished commentator and economist Martin Wolf of the FT holds that the savings glut was the source of the excess liquidity that caused the current crisis in which we all find ourselves.

Wolf’s views are expressed crisply in this PowerPoint presentation. In summary, he tells how the Mercantilist approach of the emerging nations after the Asian crisis of the 90s led to a policy of setting exchange rates to encourage exports and limit imports, supported by the stockpiling of foreign currency (a majority in USD) to fund the whole program. The imbalances can be seen as either a “savings glut” or a “money glut.”

I believe from reading Wolf’s articles in the FT that the suggestion is that the savings glut nations not only have policies of fixing exchange rates to encourage exports over imports but also that the people in those nations have a much greater propensity to save than their Western counterparts. It is argued that this demand for money, certainly in USD, causes the Federal Reserve to embark on an expansionist policy.

From page 15 of Wolf’s presentation:

  • My own view is that the savings glut caused the money glut, by driving the Federal Reserve to pursue expansionary monetary policies, which then led to the reserve accumulations in the creditor countries
  • But it is also possible to view the Federal Reserve as the causal agent: the money glut causes the savings glut
  • Either way, the reserve accumulations and fixed exchange rates played a big role in the story

I interpret Wolf’s remarks to mean that when the massive accumulated USD reserves in the emerging nations were partially spent, a surge in liquidity arrived back at the shores of the USA, causing a housing bubble, subprime lending, less than secure CDO’s etc and the bust we now observe.

Wolf is in good company. It would seem that Federal Reserve Chairman Ben Bernanke has endorsed this view in at least the following two recent speeches.

Chairman Ben S. Bernanke, Council on Foreign Relations, Washington, D.C., March 10, 2009 :

Financial Reform to Address Systemic Risk

The world is suffering through the worst financial crisis since the 1930s, a crisis that has precipitated a sharp downturn in the global economy. Its fundamental causes remain in dispute. In my view, however, it is impossible to understand this crisis without reference to the global imbalances in trade and capital flows that began in the latter half of the 1990s. In the simplest terms, these imbalances reflected a chronic lack of saving relative to investment in the United States and some other industrial countries, combined with an extraordinary increase in saving relative to investment in many emerging market nations. The increase in excess saving in the emerging world resulted in turn from factors such as rapid economic growth in high-saving East Asian economies accompanied, outside of China, by reduced investment rates; large buildups in foreign exchange reserves in a number of emerging markets; and substantial increases in revenues received by exporters of oil and other commodities. Like water seeking its level, saving flowed from where it was abundant to where it was deficient, with the result that the United States and some other advanced countries experienced large capital inflows for more than a decade, even as real long-term interest rates remained low.

Chairman Ben S. Bernanke, The Morehouse College, Atlanta, Georgia, April 14, 2009:

Four Questions about the Financial Crisis

Importantly, in our global financial system, saving need not be generated in the country in which it is put to work but can come from foreign as well as domestic sources. In the past 10 to 15 years, the United States and some other industrial countries have been the recipients of a great deal of foreign saving. Much of this foreign saving came from fast-growing emerging market countries in Asia and other places where consumption has lagged behind rising incomes, as well as from oil-exporting nations that could not profitably invest all their revenue at home and thus looked abroad for investment opportunities. Indeed, the net inflow of foreign saving to the United States, which was about 1-1/2 percent of our national output in 1995, reached about 6 percent of national output in 2006, an amount equal to about $825 billion in today’s Dollars.

Saving inflows from abroad can be beneficial if the country that receives those inflows invests them well. Unfortunately, that was not always the case in the United States and some other countries. Financial institutions reacted to the surplus of available funds by competing aggressively for borrowers, and, in the years leading up to the crisis, credit to both households and businesses became relatively cheap and easy to obtain.

The Error

I submit that these two great economists have made a grave error. The government of the USA has legal tender laws that allow only it, ultimately, to create USD via its sanctioned agent, the US Federal Reserve. As it is in charge of the stock of Dollars and the fractional-reserve banking system, it is (counterfeiting aside) the sole source of all issuances.

As I have pointed out in other articles on this site, we use money to exchage our goods and services that we make/provide for sale for other goods and services. Money is the final good for which all other goods and services exchange. Dollars in the USA are the final good you use to exchange your goods for goods offered by other people. A price of a good exchanged for another good is the amount of money paid for that good.

If the pool of money is getting larger, there will be more Dollars to exchange for goods and services. If the quantity of goods and services offered for sale and the number of Dollars in circulation are growing at the same rate, it is possible to argue, if you are prepared to set aside the problems of relative prices, that the “general price level” will be unaffected. However, any economist would argue that if the supply of money increases faster than the supply of goods and services, prices will rise: like any other good, money is devalued by creating more of it.

Therefore, the cause of the crisis can be found only at the door of the monetary authority that created the money in the first place – i.e. the Federal Reserve and other deficit-nation central banks – and not with the saving glut nations. All they have done is seek to exchange some of their goods and services for some of the goods and services of the USA, expressing a time preference along the way. This transfer of ownership does not in itself “bid up prices” to create an “asset price boom”: it is the creation of new money which devalues it.

If new Dollars are locked away for a time and only return to their original economy in an abrupt fashion, they could well seem to be the cause of a sudden asset price bubble, but the prior cause can only be the creation and supply of the wherewithal to do this in the first place.

A Note on Mercantilism

Wolf mentions in his PowerPoint presentation quite rightly that the modern trade regime we have is “in short, a mercantilist hybrid”. Many of the Classical Economist and Political Philosophers such as Hume, Locke, Smith and in later times David Ricardo, point out in various writings that the bullion (gold and silver) that was invariably money was not wealth as such but that the goods they exchanged against were. So, create more money with no associated increase in productivity and the prices of things will rise. Consequently, the Mercantalist goal of having exports higher than imports and thus more bullion at home would just mean that prices would rise at home and cause a flow of that specie to move away from home. Therefore, if in the analogy you substitute US Dollars for bullion, our saving glut nations will get nowhere fast pursuing this policy.

Gold represented claims on already produced wealth. Thus it makes perfect sense that the more wealthy (industrially-devloped, capitalistic etc) countries had more gold historically. As we do not have a link to gold anymore, the USD acts in its capacity as the World Reserve Currency, like gold of old. Using this analogy, the gold producer / gold miner writ large is the Fed and other Central Banks. Dollars will flow away from the mine in exchange for goods and services and this causes a transfer of ownership of goods and services from people in the USA to people in the saving glut nations but can have nothing to do with asset price bubbles as the money was printed by the Fed and no one else. To argue that the savings glut itself has caused the asset price boom is seemingly to endorse the Mercantalist doctrine that was so clearly discredited many moons ago.

Some other reflections on this concept of a “Savings Glut” disturb me and lead me to question whether it is really a meaningful concept at all.

These saving glut nations still seem to have massive gluts but if spending the glut caused the bubble, you would expect the glut to have fallen as well; seemingly, it has not.

If nations save to create a glut, they must indeed refrain from consumption on domestic goods to boost the supply of export goods. This means cheap goods arrive on the shores of the deficit nations. Can this cause a boom across the economy? I think not.

The deficit nations are largely well-developed. As a 40-year-old entrepreneur with a mature business and a happy family, all well rooted in Hertforsdhire, I often say to my wife, “If I was 18 again, I would be straight out to China to exploit some of those massive developmental opportunities. The whole economy seems to be like Manchester was in the Victorian times.” So why do savings there, which should attract a greater rate of return there, not stay there?

In summary, the Fed has more than doubled its money supply since the mid 90’s as have other leading deficit nations. The savings glut and the boom and bust is only attributable to the lax money creation programs of irresponsbile central bankers around the world. They have a poor understanding of economic history and they make an intellectual mistake in misunderstanding what those Classical thinkers knew: money is not wealth.