Authors

Economics

One Leg to Stand on

Here’s a question for all the cheering QEuro fans out there. If you came across a country where both real and nominal money supply were growing at rates in the low teens – something its people had not experienced for almost a decade and close to the fastest seen in the last four – would you consider it to be a victim of ‘deflation’? If not, what help do you suppose an expansionary central bank would be to it?

Courtesy of Bloomberg
Really, Mr. Draghi?!?

 

Imagine next what would be the state of that nation if, in a five year burst of temporary insanity, it had it had contracted 2 ½ times as many bank loans as it had when it first went mad and that it had thus registered four times the net indebtedness (loans less deposits) as when it began– a deficit which nearly equalled the combined shortfall of its two largest neighbours put together, despite the fact that they were three times as heavily populated.

Now you might well suppose that, if such a thing could ever be advisable in such circumstances, the central bank could readily offer an effective incentive to carry the tendency further were it only to act to suppress interest rates across the curve.

But consider instead what would be the case if, after another five, nearly six, years of blood, sweat, toil and tears, that nation had rid itself of 30% of its loans, had added 25% to its stock of deposits, and had therefore shrunk its net indebtedness by an impressive two-thirds to return itself to where it was in relation to national income eleven years previously. If you were also told that households, having gone into hock to the tune of 28% net from an initial position of small surplus, were now, thankfully, back in credit, would you imagine that the plight of the saver might outweigh that of the borrower in the ordering of their priorities?

If so, you would be considering whether Spain should rejoice at Snr. Draghi’s latest coup de main or whether it should balefully consider that he was not only gilding a lily, but bedizening one from which the bloom had long since faded, into the bargain?

Courtesy of Bloomberg
The Prodigal returns. Spanish finances & liquidity improving

 

Nor might you sing Hosannas if you were Swiss or Danish since it is principally in those two peripheral nations that the overspill is most violent. Denmark has cancelled this year’s government bond auction schedule in a kind of QE by omission even as the central bank has continued to force interest rates deeper and deeper into negative territory – to the point where there are apocryphal tales being told of a people who are among the developed world’s most indebted being paid to take out floating-rate mortgages.

That will end well, if true!

As for the Swiss, it seems that the habit dies hard of putting the national balance sheet at the disposal of those wanting to short the euro at subsidised rates. We say this because, even though the €1.20 hard floor was abolished in the middle of the month, in the two weeks since, sight deposit balances have risen by some CHF44 billion – clearly a much higher run rate than during the preceding six weeks when a mere CHF29 billion was accumulated. The most that can be said for this is that the SNB has been improving its average (assuming the very strong hints of continued intervention are confirmed), getting euros on board at rates from CHF0.85 to CF1.05 so far and again depressing bond yields further below zero.

Courtesy of Bloomberg
Courtesy of Bloomberg

With Syriza trying to work out how far they can push a Union which would gladly be shot of them if that were not to open the infamous box of a certain over-inquisitive Greek lady; with Bepe Grillo still trying to engineer a referendum on the euro membership of his native Italy; Podemos pulling the aggrieved of Spain into the streets in their thousands; and the AfD having come out of their conference in Bremen all signed up to fighting the mainstream parties, not each other, the pressure will persist. There will be many trying to find a safer haven for all those shiny new euros with which Mario will be happy to furnish them so they can express their doubts over the course he is taking in cold, hard(er) cash. The Danes and the Swiss may therefore end up with rather more of them than they otherwise might wish.

If we look beyond this to the wider markets, we can see the ripples from the stone thrown in by the ECB spreading as far away as China where the press is starting to run stories about how disadvantageous the rise of the yuan is becoming for a nation tacitly hoping for a quick, external outlet for some of the unwanted goods which its heavily underutilized industrial base is all too capable of producing.

Coupled with the growing unease of some of those who have borrowed those ever rising dollars to dabble in the onshore market – possibly via the medium of one of those commodity plays whose collateral value is not exactly beyond question these days – this is beginning to test the mettle of the PBoC at its idiosyncratic daily fix (the one where it simply refuses to entertain any bids beyond the rate it has settled upon and so allows a recalcitrant market no outlet for its frustrations).

Though nothing definitive has yet occurred and even if, rather than breaking any key levels, the stock market is tending to churn up and down near the highs, one is hard pressed not to give in to the foreboding that the sands are shifting: that, grain by grain, the cosy consensus of the last several quarters is starting to erode.

Courtesy of Bloomberg
Courtesy of Bloomberg

Take for example the fact that the US market is beginning to lose some of the effortless predominance it has so long enjoyed. Indeed, that leadership – wherein a rising stock market draws in the capital with which to move the dollar higher while the rise in the dollar makes the equities denominated therein gain more ground on their global rivals – has been challenged these past three weeks or so to a 2-sigma extent not seen since mid-2010.

Courtesy of Bloomberg
Courtesy of Bloomberg

This reversal, though not yet so large as to magnify our nascent sense of alarm, does add to the suspicion that change is in the air. That said, however, some longer term projections do still allow for the possibility that stocks might yet press on to complete the current 3QE pattern which began with assistance from all three big CBs, back in late 2012, and so map out a full TMT bubble move before the reaction truly sets in (q.v., the Nasdaq Composite). So what we are presented with is another case of letting the market decide which way it wants to move before committing ourselves too heavily to one side or the other. Note, too, that this is a waiting game which itself marks a very different phase from the straightforward momentum chase of recent months.

Courtesy of Bloomberg
Courtesy of Bloomberg

If stocks are ambivalent, fixed income seems to entertain no such doubts. Even that bear market dog-with-fleas, the 5-year T-Note, is back to its lowest yield since the ‘taper tantrum’ while the next quinquennial slice of the curve has made record lows, narrowing the spread between spot and forward 5s by 175bps in three months to reach the lowest level of recent times. We can perhaps best observe the developments by a glance at the eurodollar curve.

Courtesy of Bloomberg
Courtesy of Bloomberg

But, far from placating the market, even the remarkable run of successive record lows in bond yields is starting to raise the eyebrows of many of those whose wills are beginning to be bent to the policymakers’ doom-laden croaking about the imminence of ‘deflation’. It would be amusing if it were not so serious: in order to justify their crass, hyperactive heterodoxy, the central bankers are having to scare the very horses they are simultaneously trying to lead oh-so calmly to water.

Another frequently cited storm warning is the 5-year forward break-even inflation reading as derived from the difference between vanilla and index-linked govvies. Your author must here confess to feeling this is far too arbitrary a number. We gauge the ‘inflation expectations’ which the authorities have insisted are key to judging the success of monetary policy from a spread – and now, worse, from a hypothetical forward spread which is the derived difference of two other arbitrary pairs of differences. Yet all this is reckoned in a segmented bond market subject to both institutional and regulatory imperatives, to vicissitudes of issuance, and to a vast official distortion made worse by the fact that, at very low nominal rates the reluctance to price the residual ‘real’ yields on linkers too far into the negative column is compressing the BEI spread between them – a phenomenon additionally exacerbated in the forward version by dint of the rapidly flattening yield curve.

WHAT DOES BEI ADD?   Courtesy of Bloomberg
WHAT DOES BEI ADD? Courtesy of Bloomberg

It would be wiser to bear in mind that just because we can define and measure the 5y5y break-even does not of itself imbue the measure with any genuine informational significance even if one cannot deny that it has come to exercise a certain lurid fascination in the mind of the market as well as in that of the official rate-setter.

Adding a further strand to this hangman’s noose, many of yesterday’s Peak Resource commodity bulls have undergone a temperamental slump which matches for its giddiness that of the prices of the industrial commodities themselves. Again, the spectre of ‘deflation’ has come to peer over our shoulder as we watch the tape.

Here we would only caution that the inferences people are deriving from commodity prices may not be as cast-iron (sorry) as they appear because it is not, in fact, so easy to disentangle the factors contributing to that decline in a world where we have so many broken pricing mechanisms in play.

Take crude, for one. Given the extraordinary growth in supply of which we have long been aware and given, too, the muted growth of (physical) demand in a world unable to shake off the shackles of the last boom, the presence of record long positioning in speculative markets at the end of July was a clear omen of doom, even if the timing of the sudden, catastrophic phase shift from a three-year sideways, ever-narrowing range to a runaway cascade was impossible to predict in advance.

All sorts of commodities in their turn have acted similarly over this last cycle; silver, gold, copper, tin, nickel, iron ore, rubber, uranium, minor metals, some ags, and so on – but the booms and busts have not all been coincident, a divergence from which we can infer that they are as much a story of a rolling wave of fickle, speculative over-exposure and subsequent mass liquidation as they are of anything to do with underlying, real-side economic factors at work in their use.

‘Doctor’ Copper is another commodity to which many outsiders like to refer, yet its medical credentials have been called into question by the huge distortions entailed in many years of shadowy Chinese malfeasance. What is therefore impossible to decide is how much the current slide relates to weaker contemporary real demand and how much is due to the unwinding of the greatly exaggerated, financially-enhanced, apparent demand from which we are presently correcting.

Again, the malinvestment bubble in mining itself was both enormous and – given the echo effects of loose credit firstly on selling prices and then on project finance – thoroughly comprehensible. But to move from diagnosis to prognosis, what we again have to ask is this: if we accept that there was a period of widespread over-expansion in the industry – albeit one formerly hidden by a credit-enabled take-up of the end product at ever higher prices – is today’s fall-out the same thing as evidence of a generally weaker economy, or is it just a belatedly more accurate reflection of what the state of that economy has truly been all along? The solution to that riddle, if one could reach one, would tell one whether the big losses to come will be confined mainly to the commodity sector itself or dispersed more generally across the equity universe.

What today’s reverse Malthusianism does overlook is the inarguable case that, if we made a miraculous scientific breakthrough tomorrow which unlocked what was an essentially limitless and near-free source of energy, we would all be unequivocally better off. Reasoning from such a Garden of Eden scenario, we can be resolute in maintaining that a supply-led fall in prices is good overall – not just for ‘consumers’ – but for intermediary producers of all other goods and services, too. And, yes, it may well be, as has been bandied about, that some 10% of US earnings are energy related and so in jeopardy, but devotees of Bastiat’s Things Which are Not Seen will have already asked themselves how much the earnings of energy users have been depressed by the success of the energy providers and whether, therefore, the ongoing rebalancing is the unmitigated evil some fear it to be.

Above all, we might take comfort from the realisation that oil & gas consumption still only amounts to 5% or so of global GDP. Or we could, were we not also to bring to mind the injunction that in a non-linear system such as ours we cannot entirely discount that large effects emanate from small causes or that, given its high profile, the sector’s travails could contribute meaningfully to a souring of general sentiment and so perhaps take us across that critical mass threshold beyond which rotations and reversals morph into landslides of liquidation. But to see why we think this is even possible, we need to go back a step or two to explain what we think is the source of such fragility.

Back in the immediate aftermath of LEH, we wrote that the scale of the coming reflation would be unprecedented and that it would certainly boost commodity and asset prices in the short run, but we also warned that we needed the debt overhang to be rapidly eradicated, renewed entrepreneurship to be promoted, and heavy-handed state intervention to be avoided (we entertained few real hopes on that that last score) if the recovery were to take root. Otherwise, we predicted, we would find ourselves on a tedious roller-coaster of anaemic growth interspersed with weary episodes of recurrent stagnation where the supposed triumph of the authorities’ 1933 moment would give way to their dread of repeating a 1937 one, meaning they could never pull the trigger on ending their stimulus programmes. This, we envisaged, would ensure that the whole system would become ever more addicted to the medicine and ever more subject to its unwelcome side-effects.

We also felt, back then, that if we were to avoid this switchback turning into a negative-g log flume of downturn, the West had to have its house in order by the time that China realised it was doing more harm than good with its own gargantuan injections and that it had to revise its whole approach as a consequence. So it is proving to be.

In the interim, we have all been strung along by the persistent faith that, this quarter, the next, or the one after that, Europe would once more arise from the ashes. When that seemed too much of a stretch we were briefly distracted instead with the foolishness that was Abenomics, and all the while we had the cheery presumption that the Daddy of them all, the US, was slowly getting back on track and so would be enough to keep our illusions alive.

But now we have nothing – or close thereto – to which to cling except for the fact that while so many central banks remain so doggedly accommodative we cannot seem to bring ourselves not to plunge for a further rise in the market. The pockets of our trousers have, after all, long since burned through as a result of all the hot money which has been thrust into them these past several years.

But, whatever the imperatives to remain fully invested and highly leveraged, it cannot be denied that the underpinnings of our optimism are becoming ever more slender. Japan has predictably disappointed. Europe again stands on the verge of major political upheaval and the reaction to the oft-promised QEuro has either been muted (in the real world) or actively counter-productive (in its disruptive, possibly system-threatening effect on the capital and currency markets), suggesting that clinical tolerance is setting in there, too.

EMs are over-owned, are becoming disfavoured, and are anyway not weighty enough to swing the balance. Add to this the sad fact that America is fostering conflict and instability all around the Eastern and Southern rim of Europe and we are left only with the belief in US economic recovery – at first stoutly resisted, but later held with all the fervour of the true convert – to maintain our faith. Hence, as we said, the outperformance of Wall St amid the growing strength of the dollar, a constellation which has even induced high-ranking pundits of the kind who should – but somehow never do – know better to start exulting recklessly at the putative ‘decoupling’ of the Land of the Free from the rest of the poor, huddled mass of humanity.

Now though, the States is starting to stutter as well – with a run of softer-than-expected macro data, fears of what the shale shock will mean both for jobs and credit, and a few wobbles on the corporate earnings front (even if many of these are only strong-dollar, money illusion effects).

In the recent past, such bad news would have been perversely seen as market positive for its capacity to call forth more from the Mighty Oz’s bag of monetary tricks. But what can we now expect from the ‘Goldilocks’ scenario of weakness calling forth some form of official, ‘Greenspan Put’ compensation? Only the weak, negative assistance that it might further delay the day the Fed finally takes its first baby steps to renormalization. There is therefore not much by way of porridge in that particular bowl, we fear!

In such a world, it would not take much for the multitude of stale longs to become anxious. Though it will be said – as it always is – that there is copious ‘cash on the sidelines’ waiting for exactly such an opportunity or, conversely, that a setback in one market must lead to a rise in another (‘the money has to go somewhere’), this overlooks the fact that asset prices can only advance on such a broad and enduring front as they have if they are being fed a steady nourishment of a credit created expressly for that purpose.

When this is the case, it is just as true in reverse; that when people take fright and the assets begin to fall, or the carry trade starts to go awry, the associated credit can quickly evaporate – that where the money ‘goes’ is whence it came: into fractional reserve oblivion. The one place where the classic Fisherian ‘debt deflation’ – or, if you prefer, the Hayekian ‘secondary depression’ – can most easily occur is in the market for financial claims, especially when that market may already have reached its ‘permanently high plateau’.

It may not happen just yet, but it certainly pays to be alert to the possibility that, one fine morning, it surely will.

Money

Swiss National Bank policy and its implications for currencies, assets and central banking

Swiss National Bank policy and its implications for currencies, assets and central banking

  • The SNB unpegged from the Euro and sustained balance sheet losses, they will survive
  • The Euro has been helped lower but rumours of a new SNB target are rife
  • The long run appreciation of the Swiss Franc (CHF) is structural and accelerating, the Swiss economy will adjust
  • If G7 central bank balance sheets expanded to Swiss levels, relative to GDP, QE would triple

On Thursday 15th January the Swiss National Bank (SNB) finally, and unexpectedly, threw in the towel and ceased their foreign exchange intervention to maintain a pegged rate of EURCHF 1.20. The cap was introduced in September 2011 after a 28% appreciation in the CHF since the beginning of the Great Financial Crisis (GFC) – from 1.68 to 1.20. After plumbing the depths of 0.85 the EURCHF rate settled at 0.99 – around 18% higher in a single day. This is a huge one day move for a G10 currency and has inflicted collateral damage on leveraged traders, their brokers and those who borrowed in CHF to finance asset purchases in other currencies.Citibank estimates that is has also cost the SNB CHF 60bln. Here is a 10 year chart of EURCHF: –

EURCHF_10_yr

Source: Bigcharts.com

The Swiss SMI stock Index declined from 9259 to 8400 (-9.2%) whilst the German DAX Index rose from 9933 to 10,032 (+1.1%). Swiss and German bond yields headed lower. Swiss bonds now exhibit negative nominal yields out to 15 years – the table below is from Wednesday 4th February:-

Maturity Yield
1 week -1.35
1 month -1.65
2 month -1.55
3 month -1.4
6 month -1.38
1 year -1.11
2 year -0.823
3 year -0.768
4 year -0.632
5 year -0.505
6 year -0.419
7 year -0.305
8 year -0.257
9 year -0.181
10 year -0.111
15 year -0.024
20 year 0.196

 

Source: Investing.com

Swiss inflation is running at -0.3% so the real-yields are fractionally better due to the mild deflation seen in the past couple of months. I expect this deflation to deepen and persist.

Thomas Jordan – Chairman of the governing board of the SNB – made the following statement at a press conference which accompanied the SNB decision:-

Discontinuation of the minimum exchange rate

The Swiss National Bank (SNB) has decided to discontinue the minimum exchange rate of CHF 1.20 per euro with immediate effect and to cease foreign currency purchases associated with enforcing it. The minimum exchange rate was introduced during a period of exceptional overvaluation of the Swiss franc and an extremely high level of uncertainty on the financial markets. This exceptional and temporary measure protected the Swiss economy from serious harm. While the Swiss franc is still high, the overvaluation has decreased as a whole since the introduction of the minimum exchange rate. The economy was able to take advantage of this phase to adjust to the new situation. Recently, divergences between the monetary policies of the major currency areas have increased significantly – a trend that is likely to become even more pronounced. The euro has depreciated substantially against the US dollar and this, in turn, has caused the Swiss franc to weaken against the US dollar. In these circumstances, the SNB has concluded that enforcing and maintaining the minimum exchange rate for the Swiss franc against the euro is no longer justified.

Interest rate lowered

At the same time as discontinuing the minimum exchange rate, the SNB will be lowering the interest rate for balances held on sight deposit accounts to –0.75% from 22 January. The exemption thresholds remain unchanged. Further lowering the interest rate makes Swiss-franc investments considerably less attractive and will mitigate the effects of the decision to discontinue the minimum exchange rate. The target range for the three-month Libor is being lowered by 0.5 percentage points to between –1.25% and –0.25%.

Outlook for inflation and the economy

The inflation outlook for Switzerland is low. In December we presented a conditional inflation forecast, which predicts inflation of –0.1% for this year. Since this forecast was published, the oil price has once again fallen significantly, which will further dampen the inflation outlook for a time. However, lower oil prices will stimulate growth globally, and this will influence economic developments in Switzerland positively. Swiss franc exchange rate movements also impact inflation and the economic situation.

The SNB remains committed to its mandate of ensuring medium-term price stability while taking account of economic developments. In concluding, let me emphasise that the SNB will continue to take account of the exchange rate situation in formulating its monetary policy in future. If necessary, it will therefore remain active in the foreign exchange market to influence monetary conditions.

On Tuesday 27th January the CHF fell marginally after SNB Vice President Jean-Pierre Danthine told Swiss newspaper Tages Anzeiger – Die Presse war voller Spekulationen, that the SNB remains ready to intervene in the currency market. One comment worthy of consideration, with apologies for the “google-translate”, is:-

Q. Does the SNB did not develop a new monetary policy? Just as Denmark, which has tied its currency to the euro in 30 years? Or as Singapore, which manages its currency based on a trade-weighted basket of currencies?

A. Denmark is the euro zone financially and politically closer than Switzerland. The binding to Europe is a long standing. Means that this solution is for Switzerland hardly considered. The arrangement of Singapore is worthy of consideration. But what is decisive is the long-term. Apart from Switzerland and other small and open economies such as Sweden and Norway are done well over the years with a flexible exchange rate.

Rumours of a new unofficial corridor of EURCHF 1.05-1.10 are now circulating – strikingly similar to the level reached prior to the September 2011 peg.

Breaking the Bank

Another rumour to have surfaced after the currency move was that the SNB had become concerned about the size of their balance sheet relative to Swiss GDP. The chart below is from 2013 but it shows the relative scale of SNB QE:-

Central Bank Balance-of-percentage-GDP - source SNB

Source: SNB and snbchf.com

Estimates of the loss sustained by the SNB, due to the appreciation of the CHF, vary, but, rather like countries, central banks don’t tend to “go bust”. The Economist – Broke but never Bust takes up the subject (my emphasis in bold):-

…For one thing central banks are far bigger. Between 2006 and 2014 central-bank balance-sheets in the G7 jumped from $3.4 trillion to $10.5 trillion, or from 10% to 25% of GDP. And the assets they hold have changed. The SNB, aiming to protect Swiss exporters from an appreciating currency, has built up a huge stock of euros, bought with newly created francs.

…Bonds that paid 5% or more ten years ago now yield nothing, and other investments have performed badly (the SNB was stung by a drop in the value of gold in 2013 and cut its dividend to zero). Concerned that its euro holdings might lose value the SNB shocked markets on January 15th by abruptly ending its euro-buying spree.

…With capital of €95 billion supporting a €2.2 trillion balance-sheet, the Eurosystem (the ECB and the national banks that stand behind it) is 23 times levered; a loss of 4% would wipe out its equity. Since two central banks have suffered devastating crunches recently (Tajikistan in 2007, Zimbabwe in 2009) the standard logic seems to apply: capital-eroding losses must be avoided.

But the worries are overdone. For one thing central banks are healthier than they appear. On top of its equity, the Eurosystem holds €330 billion in additional reserves. These funds are designed to absorb losses as assets change in value. Even if the ECB were to buy all available Greek debt—around €50 billion—and Greece were to default, the system would lose just 15% of these reserves; its capital would not be touched.

And even if a central bank’s equity were wiped out it would not go bust in the way high-street lenders do. With liabilities outweighing its assets it might seem unable to pay all its creditors. But even bust central banks retain a priceless asset: the power to print money. Customers’ deposits are a claim on domestic currency, something the bank can create at will. Only central banks that borrow heavily in foreign currencies they cannot mint (as in Tajikistan) or in failing states (Zimbabwe) get into deep trouble.

The Economist goes on to highlight the risk that going “cap in hand” to their finance ministries will weaken central banks’ “independence” and might prove inflationary. In the current environment inflation would be a nice problem for the SNB, or, for that matter, the ECB or BoJ to have. As for the limits of central bank balance sheet expansion, the SNB – at 80% of GDP – have blazed a trail for their larger peers to follow.

Is it the money supply?

A further unofficial explanation of the SNB move concerns the unusually large expansion of Swiss money supply since the GFC. In early January an article from snbchf.comThe Risks on the Rising SNB Money Supply discussed how the SNB might be thinking (my emphasis): –

Since the financial crisis central banks in developed nations increased their balance sheets. The leading one was the American Federal Reserve that increased the monetary base (“narrow money”), followed by the Bank of Japan and recently the ECB. Only partially the extension of narrow money had an effect on banks’ money supply, so called “broad money”. For the Swiss, however, the rising money supply concerns both narrow and broad money. Broad money in Switzerland rises as strong as it did in Spain or Ireland before the financial crisis.

They go on to discuss the global effects of QE:-

…The SNB had the choice between a stronger currency and, secondly, an excessive appreciation of the Swiss assets.  With the introduction of the euro floor, it opted for the second alternative and increased its monetary base massively in order to absorb foreign currency inflows. Implicitly the central bank helped to push up asset prices even further. Hence it was rather foreign demand for Swiss assets that helped to increase the demand for credit and money in the real economy.

…The SNB printed a lot of money especially in the years before and just after the euro introduction until 2003, to weaken the franc and the “presumed slow” Swiss growth. The money increase, however, did not affect credit growth more than it should have: investors preferred other countries to Switzerland to buy assets. Finally the central bank increased interest rates a bit and reduced money supply between 2006 and 2008. Be aware that in 2006/2007 there is a statistical effect with the inclusion of “Raiffeisen” group banks into M3. Since 2009, things have changed M3 is rising with an average of 7.7% per year, while before 2009 it was 3% per year. Banking lending to the private sector is increasing by 3.9% per year while it was 1.7% between 1995 and 2005.

…Since April 2014, money supply M3 has suddenly stopped at around 940 billion CHF. Before it had increased by 80 bln. CHF per year from 626 bln. in each year since 2008.  We explained before that Fed’s QE translated in higher lending in dollars, dollars that found their way into emerging markets. The same thing happens in Switzerland with newly created Swiss francs. Not all of them remained in the Swiss economy, but they were loaned out to clients from Emerging Markets. Hence the second risk does not directly concerns the Swiss economy and the euro, but the relationship between its banks and emerging markets and the risks of a strong franc for banks’ balance sheets.

 

Here is a chart of M3 and bank lending in Switzerland, the annotation is from snbchf.com:-

Swiss-M3-and-Lending-2014-Ireland

Source: SNB and snbchf.com

The SNBs decision to unpeg seems a brutal way to impose discipline on the domestic lending market and an unusual way to test increased bank capital requirements, however, I believe this was the least bad time to escape from the corner into which they had boxed themselves. The recent fall in M3 should put some upward pressure on the CHF – until growth slows and reverses the process.

The SNB said this about money supply and bank lending in their Q4 2014 Quarterly Bulletin(my emphasis):-

Growth in money supply driven by lending

The expansion of the money supply witnessed since the beginning of the financial and economic crisis is mainly attributable to bank lending. An examination of components of the M3 monetary aggregate and its balance sheet counterparts, based on the consolidated balance sheet of the banking sector, shows that approximately70% of the increase in the M3 monetary aggregate between October 2008 and October 2014 (CHF 311 billion) was attributable to the increase in domestic Swiss franc lending (CHF 216 billion). The remaining 30% of the M3 increase was due in part to households and companies switching their portfolio holdings from securities and foreign exchange into Swiss franc sight deposits.

Stable mortgage lending growth in the third quarter

In the third quarter of 2014 – as in the previous quarter – banks’ mortgage claims, which make up four-fifths of all domestic bank lending, were up 3.8% year-on-year. Mortgage lending growth thus continued to slow, as it has for some time now, despite the fact that mortgage rates have fallen to a historic low. A breakdown by borrower shows that the growth slowdown has taken place in mortgage lending to households as well as companies.

This slower growth in mortgage lending may be attributed to various measures taken since 2012 to restrain the banks’ appetite for risk and strengthen their resilience. These include the banks’ own self-regulation measures, which subject mortgage lending to stricter minimum requirements. Moreover, at the request of the SNB, the Federal Council activated the countercyclical capital buffer in 2013 and increased it this year. This obliges the banks to back their mortgage loans on residential property with additional capital. The SNB’s bank lending survey also indicates that lending standards have been tightened and demand for loans among households and companies has declined.

…Growing ratio of bank lending to GDP

The strong growth in bank lending recorded in recent years is reflected in the ratio of bank loans to nominal GDP. After a sharp rise in the 1980s, this ratio remained largely unchanged until mid-2008. Since the onset of the financial and economic crisis, it has increased again substantially. This increase suggests that banks’ lending activities have supported aggregate demand. However, strong lending growth also entails risks for financial stability. In the past, excessive growth in lending has often been the root cause of later difficulties in the banking industry.

Switzerland’s banking sector is truly multi-national, deposits continue to arrive, despite penal “negative” rates, meanwhile, many CHF bank loans have been made to international clients. The sharp appreciation of the CHF will force the banking sector to make additional provisions for non-performing international loans. Further analysis of the effect of relative money supply growth, between Switzerland and the Eurozone (EZ) on the EURCHF exchange rate, can be found in this post by Frank Shostak – Post Mortem on the Swiss Franc’s Euro-Peg. He makes an interesting “Austrian” case for a weakening of the CHF versus the EUR over-time.

Swiss Francs in the long run

My first ever journey outside the UK was to Switzerland, that was back in 1971 when a pound sterling bought CHF 10.5. The Swiss economy has had to deal with a constantly rising exchange rate ever since. The chart below of the CHF Real Trade-Weighted value shows this most clearly: –

Real_Effective_CHF_Exchange_rate_EURCHF18_01_2013-

Source: Pictet

This chart only goes up to mid-2013, since then the USDCHF has moved from 0.88 and 0.99 by early January – after the unpegging the rate is near to its mid-point at 0.93. According to theGuardian – What a $7.54 Swiss Big Mac tells us about global currencies – the Swiss currency is now 33% overvalued. Exporters will be hit hard and the financial sector is bound to be damaged by commercial bank lending policies associated with pegging the CHF to a declining EUR. On Monday Bank Julius Baer (BAER.VX) announced plans to cut costs by CHF 100mln, domestic job cuts were also indicated – more institutions are sure to follow their lead. Meanwhile, there are bound to be emerging market borrowers which default. The Swiss economy will slow, exacerbating deflationary forces, but lower prices will improve the purchasing power of the domestic population. Switzerland’s trade balance hit a record high in July 2014 and came close to the same level in November:-

switzerland-balance-of-trade

Source: Trading Economics and Swiss Customs

In a recent newsletter – The Swiss Release the Kraken – John Maudlin quoted fellow economist Charles Gave in a tongue in cheek assessment of the SNB’s action:-

They [the SNB] didn’t mind pegging the Swiss franc to the Deutsche mark, but it is becoming more and more obvious that the euro is more a lira than a mark. A clear sign is the decline of the euro against the US dollar.

Mr. Draghi has been trying to talk the euro down for at least a year. This should not come as a surprise. After all, in the old pre-euro days, every time Italy had a problem, the solution was always to devalue.

But the Swiss, not being as smart as the Italians, do not believe in devaluations. You see, in Switzerland they have never believed in the ‘euthanasia of the rentier’, nor have they believed in the Keynesian multiplier of government spending, nor have they accepted that the permanent growth of government spending as a proportion of gross domestic product is a social necessity. The benighted Swiss, just down from their mountains where it was difficult to survive the winters, have a strong Neanderthal bias and have never paid any attention to the luminaries teaching economics in Princeton or Cambridge. Strange as it may seem, they still believe in such queer, outdated notions as sound money, balanced budgets, local democracy, and the need for savings to finance investments. How quaint!

Of course, the Swiss are paying a huge price for their lack of enlightenment. For example, since the move to floating exchange rates in 1971, the Swiss franc has risen from CHF4.3 to the US dollar to CHF0.85 and appreciated from CHF10.5 to the British pound to CHF1.5. Naturally, such a protracted revaluation has destroyed the Swiss industrial base and greatly benefited British producers [not!]. Since 1971, the bilateral ratio of industrial production has gone from 100 to 175…in favor of Switzerland.

And for most of that time Switzerland ran a current account surplus, a balanced budget, and suffered almost no unemployment, all despite the fact that nobody knows the name of a single Swiss politician or central banker (or perhaps because nobody knows a single Swiss politician or central banker, since they have such limited power? And that all these marvelous results come from that one simple fact: their lack of power.)

The last time I looked, the Swiss population had the highest standard of living in the world – another disastrous long-term consequence of not having properly trained economists of the true faith.

Swiss unemployment has been trending higher recently (3.4% in December) and this figure may rise as sectors such as banking and tourism adjust to the new environment, however, this level of unemployment is still enviable by comparison with other developed countries.

The following charts give an excellent insight into the nature of trade in the Swiss economy. Firstly, exports:-

Swiss_ExportsByCountry

Source: snbchf.com

The importance of the EZ is evident (46.4% excluding UK) however the next chart shows a rather different perspective:-

Swiss_TradeBalanceByCountry

Source: snbchf.com

The relative importance of the USA is striking – 11% of exports but nearly half of the trade surplus – so too, is the magnitude of the deficit with Germany, in fact, within Europe, only Spain and the UK are export surplus markets.

A closer look at the break-down of Imports and Exports by sector provides an additional dimension:-

Swiss-Imports-Exports-by-Type

Source: snbchf.com

The SNB already highlighted the import of energy as a significant factor – Switzerland’s energy bill is now much lower than it was in July 2014. The export of pharmaceuticals has always been of major importance – many of these products are inherently price inelastic, the rise in the currency will have less impact on Switzerland than it might do on other developed economies.

Conclusion and investment opportunities

“The reports of my death are greatly exaggerated.” Mark Twain

Contrary to what several commentators have been suggesting, I do not believe the SNB capitulation marks the beginning of the end of central bank omnipotence – they were never that omnipotent in the first place. The size of the SNB balance sheet is also testament to the limits of QE – if the other G7 central banks expand to 80% of GDP the total QE would more than triple from $10.5 trln to $33.6 trln – and what is to say that 80% of GDP is the limit?

Swiss Markets

Switzerland will benefit from a floating currency in the longer term, although the recent abrupt appreciation may lead to a recession – which in turn should reduce upward pressure on the CHF. Criticism of the SNB for creating greater volatility within the Swiss economy is only partially justified, the excessive rise of the CHF effective exchange rate was due to external factors and the SNB felt it needed to be managed, the subsequent rise in the US$ has brought the CHF back to a more realistic level but the current environment of zero interest rate policy adopted by several major central banks has parallels with the conditions seen after the collapse of Bretton Woods.

I believe the SNB anticipates an acceleration in the long term trend rate of appreciation of the CHF. Swiss exports, even to the US, will be impaired but German imports will be cheaper – with a record trade surplus, this is a good time to start the adjustment of market expectations about the value of the CHF going forward. Swiss companies are used to planning within a framework which incorporates a steadily rising value of their currency – now they must anticipate an acceleration in that trend.

The money and bond markets will remain distorted and, in the event of another EZ crisis, the SNB may increase the penalties for access to the “safe-haven” Switzerland represents: and, as indicated, they may intervene again if the capital flows become excessive. 20 year, or longer, Confederation Bonds, alone, offer positive carry, buying call spreads on shorter maturities is a strategy worth considering.

The SMI Index is likely to lag the broader European market, but negative bond yields offer little alternative to stocks and domestic investors will exhibit a renewed cognizance of the risk of foreign currency investments. The SMI Index, at around 8550, is only 7.6% below the level it was trading prior to the SNB announcement. Swiss stocks will undoubtedly benefit from any export led European economic recovery. Meanwhile, the relative strength of the US economy appears in tact – the Philadelphia Fed Leading Indexes for December – released earlier this week – suggest economic expansion in 49 states over the next six months.

Eurozone Markets

The EZ has already been aided by the departure of its strongest “shadow” member; combined with the ECB’s Expanded Asset Purchase Programme (EAPP) this should drive the EUR lower. European stocks have already taken heart, fuelled by the new liquidity and international competitiveness.

European bond spreads continue to compress. Fears of peripheral countries exiting the single currency area will provide volatility but for the major countries – France, Italy and Spain – any weakness is still a buying opportunity, but at these, often negative real-yields, they should be viewed as a “trading” rather than an “investment” asset

Money

European Central Bank plan to unleash massive pumping is likely to further undermine the process of wealth generation

The European Central Bank (ECB) is planning to pump 1.1 trillion euro’s into the banking system to fend off price deflation and revive economic activity. The ECB president and his executive board are planning to spend 60 billion euro’s a month from March 2015 to September 2016.

Most experts hold that the ECB must start acting aggressively against the danger of deflation. The yearly rate of growth of the consumer price index (CPI) fell to minus 0.2% in December last year from 0.3% in November and 0.8% in December 2013.

Many commentators are of the view that the ECB should initiate an aggressive phase of monetary pumping along the lines of the US central bank. Moreover the balance sheet of the ECB has in fact been shrinking. On this the yearly rate of growth of the ECB balance sheet stood at minus 2.1% in January against minus 8.5% in December. Note that in January last year the yearly rate of growth stood at minus 24.4%.

EMU CPI

EMU CPI

Why is a declining rate of inflation bad for economic growth? According to the popular way of thinking declining price inflation sets in motion declining inflation expectations. This, so it is held, is likely to cause consumers to postpone their buying at present and that in turn is likely to undermine the pace of economic growth.

In order to maintain their lives and well being individuals must buy present goods and services, so from this perspective a fall in prices as such is not going to curtail consumer outlays. Furthermore, a fall in the growth momentum of prices is always good for the economy.

An expansion of real wealth for a given stock of money is going to manifest in a decline in prices (remember a price is the amount of money per unit of real stuff), so why should this be regarded as bad for the economy?

After all, what we have here is an expansion of real wealth. A fall in prices implies a rise in the purchasing power of money, and this in turn means that many more individuals can now benefit from the expansion in real wealth.

Now, if we observe a decline in prices on account of an economic bust, which eliminates various non-productive bubble activities, why is this bad for the economy?

The liquidation of non-productive bubble activities – which is associated with a decline in the growth momentum of prices of various goods previously supported by non-productive activities – is good news for wealth generation.

The liquidation of bubble activities implies that less real wealth is going to be diverted from wealth generators. Consequently, this will enable them to lift the pace of wealth generation. (With more wealth at their disposal they will be able to generate more wealth).

So as one can see a fall in price momentum is always good news for the economy since it reflects an expansion or a potential expansion in real wealth.

Hence a policy aimed at reversing a fall in the growth momentum of prices is going to undermine and not strengthen economic growth.

We hold that the various government measures of economic activity reflect monetary pumping and have nothing to do with true economic growth.

An increase in monetary pumping may set in motion a stronger pace of growth in an economic measure such as gross domestic product. This stronger growth however, should be regarded as a strengthening in the pace of economic impoverishment.

It is not possible to produce genuine economic growth by means of monetary pumping and an artificial lowering of interest rates. If this could have been done by now world poverty would have been erased.

Summary and conclusion

The European Central Bank (ECB) is planning to pump 1.1 trillion euro’s into the banking system to fend off price deflation and revive economic activity in the Euro-zone. Most experts are supportive of the ECB’s plan. We question the whole logic of the monetary pumping.

A fall in the growth momentum of prices either on account of real wealth expansion or on account of the demise of bubble activities is always good news for wealth producers.

Hence any policy that is aimed at preventing a fall in prices is only likely to strengthen bubble activities and undermine the process of wealth generation.

Economics

Swiss National Bank abandons franc’s cap against the euro

On January 15th 2015 the Swiss National Bank (SNB) has announced an end to its three year old cap of 1.20 franc per euro. (The SNB introduced the cap in September 2011). The SNB has also reduced its policy interest rate to minus 0.75% from minus 0.25%. The Swiss franc appreciated as much as 41% to 0.8517 per euro following the announcement, the strongest level on record – it settled during the day at around 0.98 per euro.

EuroCHF
We suggest that the key factor in determining a currency rate of exchange is relative monetary pumping. Over time, if the rate of growth of money supply in country A exceeds the rate of growth of money supply in country B then that country’s currency rate of exchange will come under pressure versus the currency of B, all other things being equal.
Whilst other variables such as the interest rate differential or economic activity also drive the currency rate of exchange, they are of a transitory and not of a fundamental nature. Their influence sets in motion an arbitrage that brings the rate of exchange in line with the influence of the money growth differential.
We hold that until now the rise in the money growth differential between Switzerland and the EMU during July 2011 and April 2012 was dominating the currency rate of exchange scene. (It was pushing the franc down versus the euro).The setting of a cap of 1.20 to the euro to supposedly defend exports was an unnecessary move since the franc was in any case going to weaken. The introduction of the cap however prevented the arbitrage to properly manifest itself thereby setting in motions various distortions. (Note again the money growth differential was weakening the franc versus the euro).
A fall in the money growth differential between April 2012 and April 2013 is starting to dominate the currency scene at present i.e. it strengthens the franc against the euro. So from this perspective it is valid to remove the cap and allow the arbitrage to establish the “true” value of the franc. (This reduces the need to pump domestic money in order to defend the cap of 1.20). Observe that as opposed to 2011, this time around, by allowing the franc to find its “correct” level the SNB it would appear has decided to trust the free market.
Note that since April 2013 the money growth differential has been rising – working towards the weakening of the franc versus the euro – and this raises the likelihood that the SNB might decide again some time in the future on a new shock treatment.

 

AMSSwissVsEuroGrowth

We hold that by tampering with the foreign exchange market the SNB sets in motion fluctuations in the growth momentum of money supply (AMS) and this in turn generates the menace of the boom/bust cycles. (Note the close correlation between the fluctuations in the growth momentum of foreign exchange reserves, the SNB’s balance sheet and AMS).

 

SNBAssetsVsForeignReserves

Also, observe that by introducing the cap and then removing it the SNB, contrary to its own intentions, has severely shocked various activities such as exports. Note that the SNB is supposedly meant to generate a stable economic environment.

Money

Money worries

“I hold all idea of regulating the currency to be an absurdity; the very terms of regulating the currency and managing the currency I look upon to be an absurdity; the currency should regulate itself; it must be regulated by the trade and commerce of the world; I would neither allow the Bank of England nor any private banks to have what is called the management of the currency.”

–       Richard Cobden.

 

“Raj, 33, a London-based photographer and amateur commodities trader who has used Alpari since 2009, said he currently had about £24,000 trapped in his account at the company.

‘It was completely out of the blue, a total shock,’ he said. ‘I’ve never had any issues with them. I’ve been calling and I just keep getting their answerphone.’”

–       From ‘Forex brokers suffer escalating losses in fallout from Swiss ditching franc cap’, The Financial Times, 17 January 2015.

 

“I don’t know what to say. I’ve been investing since January and I’ve never seen anything like it.”

–       Unnamed Hong Kong housewife during the Asian financial crisis, 1997/8.

 

“But the Swiss, not being as smart as the Italians, do not believe in devaluations. You see, in Switzerland, they have never believed in the ‘euthanasia of the rentier’, nor have they believed in the Keynesian multiplier of government spending, nor have they accepted that the permanent growth of government spending as a proportion of gross domestic product is a social necessity.

 

“The benighted Swiss, just down from their mountains where it was difficult to survive the winters, have a strong Neanderthal bias and have never paid any attention to the luminaries teaching economics in Princeton or Cambridge. Strange as it may seem, they still believe in such queer, outdated notions as sound money, balanced budgets, local democracy and the need for savings to finance investments. How quaint!

 

“Of course, the Swiss are paying a huge price for their lack of enlightenment. For example, since the move to floating exchange rates in 1971, the Swiss franc has risen from CHF4.3 to the US dollar to CHF0.85 and appreciated from CHF10.5 to the British pound to CHF1.5. Naturally, such a protracted revaluation has destroyed the Swiss industrial base and greatly benefited British producers. Since 1971, the bilateral ratio of industrial production has gone from 100 to 175… in favour of Switzerland.

 

“And for most of that time Switzerland ran a current account surplus, a balanced budget and suffered almost no unemployment, all despite the fact that nobody knows the name of a single Swiss politician or central banker (or perhaps because nobody knows a single Swiss politician or

central banker, since they have such limited power? And that all these marvellous results come from that one simple fact: their lack of power).

 

“The last time I looked, the Swiss population had the highest standard of living in the world—another disastrous long term consequence of not having properly trained economists of the true faith.”

–       Charles Gave of Gavekal, ‘Swexit !’.

 

 

“An increase in the quantity of money only serves to dilute the exchange effectiveness of each franc or dollar; it confers no social benefit whatever. In fact, the reason why the government and its controlled banking system tend to keep inflating the money supply, is precisely because the increase is not granted to everyone equally. Instead, the nodal point of initial increase is the government itself and its central bank; other early receivers of the new money are favoured new borrowers from the banks, contractors to the government, and government bureaucrats themselves. These early receivers of the new money, Mises pointed out, benefit at the expense of those down the line of the chain, or ripple effect, who get the new money last, or of people on fixed incomes who never receive the new influx of money. In a profound sense, then, monetary inflation is a hidden form of taxation or redistribution of wealth, to the government and its favoured groups, and from the rest of the population.. every change in the supply of money stimulated by government can only be pernicious.”

–       Murray Rothbard.

 

 

“The longer the boom of inflationary bank credit continues, the greater the scope of  malinvestments in capital goods, and the greater the need for liquidation of these unsound  investments. When the credit expansion stops, reverses, or even significantly slows down, the  malinvestments are revealed. Mises demonstrated that the recession, far from being a strange, unexplainable aberration to be combated, is really a necessary process by which the market  economy liquidates the unsound  investments of the boom, and returns to the right consumption /  investment proportions to satisfy consumers in the most efficient way.

 

“Thus, in contrast to the interventionists and statists who believe that the government must  intervene to combat the recession process caused by the inner workings of free market capitalism,  Mises demonstrated precisely the opposite: that the government must keep its hands off the  recession, so that the recession process can quickly eliminate the distortions imposed by the government-created inflationary boom.”

–       Murray Rothbard, again.

 

 

“I don’t know what’s going to happen in Europe but there is one thing I am certain about – eventually, someone is going to take a big loss.  As investors, the most important thing we can do is to make sure that we aren’t the parties taking that loss.”

–       Jeffrey Gundlach, cited by Joshua Brown, September 2011.

 

 

“The designers of the good ship euro wanted to create the greatest liner of the age. But as everybody now knows, it was fit only for fair-weather sailing, with an anarchic crew and no lifeboat. Its rules of economic seamanship were rudimentary, and were broken anyway. When it  struck a reef two years ago, the water flooded one compartment after another.. European officials now recognise the folly of creating the euro without preparing for trouble. It would be wise to be  planning now for what to do if it sinks.. Even now, after decades of “European construction”, many Eurocrats cannot conceive of the euro as a wreck. Those who have worked hardest to keep it afloat are exhausted and know it is not in their power to save it anyway.”

–       Charlemagne in ‘The Economist’, November 2011.

 

 

“Sir, It was a very cruel joke to publish Richard Barwell‟s recent letter (“Exit from first round of QE now seems premature”), particularly as it followed hot on the heels of Fed chairman Ben Bernanke’s announcement of so much more of the stuff. It was certainly a delicious coinage of Mr Barwell’s to suggest that this argument “makes no sense in theory”. This reminded me of those scientists who also contend that bumble bees cannot fly – in theory. Can I suggest that the FT letters page imposes some kind of moratorium on self-interested and highly conflicted “advice” from an academic school – economics – that having brought us to the brink, is now in danger of theorising itself into total absurdity ? To read that Mr Barwell is employed by the one organisation that has done more than any other to destabilise if not destroy the UK financial system – RBS – was the icing on this particularly ironic cake.

 

“QE does nothing more than put yet more capital into the hands of bankers who can then either play in the markets with it, or sit on it. In doing so, it also devalues its practitioners’ currencies versus those of regimes that have fundamentally sound economic policy. If our government and central bank wanted to do something properly constructive with all this newly created money, perhaps it could invest it into our country’s jaded infrastructure, rather than inflating further asset bubbles, the “wealth effect” of which is likely to be wholly illusory.”

–       Tragically unpublished letter to the Financial Times from the author, November 2010.

 

“What really broke Germany was the constant taking of the soft political option in respect of money.”

–       Adam Fergusson, ‘When Money Dies’.

 

Still think QE is the answer for the euro zone ?

Money

The present monetary system the key cause for boom-bust cycles

Originally, paper money was not regarded as money but merely as a representation of gold. Various paper certificates represented claims on gold stored with the banks. Holders of paper certificates could convert them into gold whenever they deemed necessary. Because people found it more convenient to use paper certificates to exchange for goods and services, these certificates came to be regarded as money.

 

Paper certificates that are accepted as the medium of exchange open the scope for fraudulent practice. Banks could now be tempted to boost their profits by lending certificates that were not covered by gold. In a free-market economy, a bank that over-issues paper certificates will quickly find out that the exchange value of its certificates in terms of goods and services will fall. To protect their purchasing power, holders of the over-issued certificates naturally attempt to convert them back to gold. If all of them were to demand gold back at the same time, this would bankrupt the bank. In a free market then, the threat of bankruptcy would restrain banks from issuing paper certificates unbacked by gold. On this Mises wrote,

 

People often refer to the dictum of an anonymous American quoted by Tooke: “Free trade in banking is free trade in swindling.” However, freedom in the issuance of banknotes would have narrowed down the use of banknotes considerably if it had not entirely suppressed it. It was this idea which Cernuschi advanced in the hearings of the French Banking Inquiry on October 24, 1865: “I believe that what is called freedom of banking would result in a total suppression of banknotes in France. I want to give everybody the right to issue banknotes so that nobody should take any banknotes any longer.”1

This means that in a free-market economy, paper money cannot assume a “life of its own” and become independent of commodity money.
The government can, however, bypass the free-market discipline. It can issue a decree that makes it legal for the over-issued bank not to redeem paper certificates into gold. Once banks are not obliged to redeem paper certificates into gold, opportunities for large profits are created that set incentive to pursue an unrestrained expansion of the supply of paper certificates. The uncurbed expansion of paper certificates raises the likelihood of setting off a galloping rise in the prices of goods and services that can lead to the breakdown of the market economy.

 
To prevent such a breakdown, the supply of the paper money must be managed. The main purpose of managing the supply is to prevent various competing banks from over-issuing paper certificates and from bankrupting each other. This can be achieved by establishing a monopoly bank-i.e., a central bank-that manages the expansion of paper money.
To assert its authority, the central bank introduces its paper certificates, which replace the certificates of various banks. (The central bank’s money purchasing power is established on account of the fact that various paper certificates, which carry purchasing power, are exchanged for the central bank money at a fixed rate. In short, the central bank paper certificates are fully backed by banks certificates, which have the historical link to gold.)

 

The central bank paper money, which is declared as the legal tender, also serves as a reserve asset for banks. This enables the central bank to set a limit on the credit expansion by the banking system. Note that through ongoing monetary management, i.e., monetary pumping, the central bank makes sure that all the banks can engage jointly in the expansion of credit out of “thin air” via the practice of fractional reserve banking. The joint expansion in turn guarantees that checks presented for redemption by banks to each other are netted out, because the redemption of each will cancel the other redemption out. In short, by means of monetary injections, the central bank makes sure that the banking system is “liquid enough” so that banks will not bankrupt each other.
It would appear that the central bank can manage and stabilize the monetary system. The truth, however, is the exact opposite. To manage the system, the central bank must constantly create money “out of thin air” to prevent banks from bankrupting each other. This leads to persistent declines in money’s purchasing power, which destabilizes the entire monetary system.

 
Observe that while, in the free market, people will not accept a commodity as money if its purchasing power is subject to a persistent decline, in the present environment, central authorities are coercively imposing money that suffers from a steady decline in its purchasing power. Since the present monetary system is fundamentally unstable it is not possible to fix it. Even Milton Friedman’s scheme to fix the money rate growth at a given percentage won’t do the trick. After all a fixed percentage growth is still money growth, which leads to the exchange of nothing for something-i.e., economic impoverishment and the boom-bust cycle. Moreover, we can conclude that there cannot be a “correct” money supply rate of growth. Whether the central bank injects money in accordance with economic activity or fixes the rate of growth, it further destabilizes the economy.

 

The central bank can keep the present paper standard going as long as the pool of real wealth is still expanding. Once the pool begins to stagnate-or, worse, shrinks then no monetary pumping will be able to prevent the plunge of the system. A better solution is of course to have a true free market and allow the gold to assert its monetary role. As opposed to the present monetary system in the framework of a gold standard money cannot disappear and set in motion the menace of the boom-bust cycles. In fractional reserve banking, when money is repaid and the bank doesn’t renew the loan, money evaporates. Because the loan has originated out of nothing, it obviously couldn’t have had an owner. In a free market, in contrast, when money i.e. gold is repaid, it is passed back to the original lender; the money stock stays intact.

 

1.  Mises , Human Action p 446.

Economics

Crisis? What Crisis?

[The following is a shortened version of an original which first appeared on the author’s website, www.truesinews.com ]

As Britain fast approaches what is arguably the most intriguingly unpredictable election of the modern era, the question must be also asked, how well situated is the country – economically speaking – to endure such a vigorous test of its political institutions?

To this observer, the answer would be ‘not very well, at all.’ Britain, you see, is rapidly sliding back into its bad old ways of spending too much, saving too little, and all the while allowing the state to loom far too large in people’s affairs, bolstered by the fact that far too many members of the populace are loth to give up their long-accustomed habit of trying to live at their neighbours’ expense and of borrowing from abroad whatever dole transfers the state cannot raise in taxes at home.

Let us start with the latest economic round to see what we mean. Though hours worked in the UK, along with both overall and private sector GDP, are each enviably some 3-5% above the pre-Crash peak – a constellation of which many Eurozone countries can still only dream – this has come about only through a 7-year reduction in real wages of a cumulative 11%.

Pricing people back into jobs this way is one thing – if decidedly more unfair on all the other innocent victims of the Bank of England’s inflationism than would have been a simple pay cut – but it is also significant that, having trended up at around 2.3% per annum for almost four decades, real GDP per hour worked has shown no improvement whatsoever since Northern Rock closed its doors, seven long years ago. If we add in the fact that the UK has officially seen net inward migration of 1.5 million people in that same period, we can perhaps see how much of that growth has been achieved – through the blunt instrument of adding a big slug of low wage, low output, imported labour to the mix.

Sadly, in its policies of determined monetary laxity, Fred Karney’s army have added two malign side-effects to the short term boost to growth for which they are so widely praised. Firstly, the combination of Gilt-enacted QE with near zero interest rates has loosened the constraints on a state sector which still routinely spends a sum equivalent to almost one half of private GDP, with around a sixth of that being borrowed, even now amid a recovery vigorous enough to elicit a full measure of George Osborne’s headline-hogging boastfulness. Alarmingly, too, the punishment of savers and the encouragement of borrowers has reached a point where households have become net debtors at the aggregate level for the first time since the GFC while, simultaneously, non-financial corporates have collectively swung into the red for the first time since they were borrowing to relieve Culpability Brown of his pricey mobile phone airwave licences, back at the height of the Tech Bubble.

Mortgage debt is rising by £20 billion a year, consumer credit by £10 billion (the most since late ’08), student loans by £7 billion. Disposable income grew £29 billion in that same time which means debt:income may be swelling once more, from a point still north of 130%.

As a result, while state prodigality has diminished from its peak deficit of 10.7% of GDP (seen between QI-09 and QI-10) to today’s 5.9%, the non-financial private sector has gone from a point where it was saving 8.8% (and so funding four-fifths of Leviathan’s excesses) to a point where it, too, is now looking for 0.5% of GDP for its own consumptive purposes (all figures 4Q moving averages).

No wonder then that the current account deficit has blown up to a six decade high of 6.0% of GDP, despite the co-existence of a record surplus of 5.1% on the service account (the arithmetically astute will quickly infer that this must entail a similarly swingeing deficit on visible trade – a shortfall which in fact stretches to a hefty 7.1%). For comparison, when Chancellor Dennis Healey suffered the ignominy of appealing to the IMF for help in 1976, the balance of payments was only 1.5% in the red (though the tally had briefly hit 4.3% a year or two before, in the immediate aftermath of the first oil shock).

In fact, if we only look at the latest reported data – those for QIII – there is a chance that the BOP number may be revised to yet a deeper nadir since, in the three months to September, the ONS presently estimates that the public deficit was 5.1% of GDP, while households borrowed a six-year high balance of 2.6% of GDP and corporates took up a 14-year high credit of 2.2%, making for an aggregate shortfall of no less than 9.9%. Subtracting a net positive contribution of 0.2% from the domestic financial sector, that still leaves 9.7% to be financed, in theory, from foreigners and thereby to determine the scale of the current account deficit.

Performing the calculation in a different manner, the UK government has borrowed £109 billion ($167 billion) in the twelve months to September, an overspend which has leaked almost entirely abroad and has thus required a £98 billion ($150 billion) contribution in goods sold on credit from the world beyond Albion’s shining seas.

So, let us forget for a moment the controversy over the gaping hole which persists in the government’s finances and the laughably misnamed policy of ‘austerity’ which the regime has adopted to try to deal with this. Instead, let us lift our eyes to a horizon beyond our shores and we can surely agree that the sum of £130 a month per capita is not at all an unimpressive pace at which to be adding to a net external deficit of £450 billion (25% of GDP) or to an ex-FDI gross liability of £8,840 billion (490% of GDP), against which mountain of potentially nervy obligations the Treasury disposes of a defence against a classic ‘sudden stop’ of a paltry £63 billion in FX reserves (equal to around two months’ worth of goods imports).

Thus, not only is a full-employment Britain a country which must run an unsustainably large external deficit (since it is already setting records with 6% of the workforce still out of a job), but it has again been seduced into being one where all sectors are borrowing, not saving, largely in order to finance present consumption, meaning it is prey to a rather nasty, Hayekian ‘intertemporal’ disequilibrium – the cardinal economic sin of enjoying overmuch jam today at the cost of jam foregone tomorrow.

One day the piper to whose shrill accompaniment we are now dancing our merry jig (our Chuck Prince Charleston?) will present us with a bill which we are unlikely to be able to meet absent a great deal of sacrifice and possibly not without suffering a veritable collapse in the value of the currency to boot.

Since this is the time of year when we pundits traditionally have to set out scenarios containing an element of surprise, allow us to posit a very pleasant one, amid all the foreboding outlined above. Imagine if you will that, shortly after the election is held, our migrant cuckoo of a central bank governor will be fluttering off and away, back to his native Canada to ready his own political promotion – either by reinforcing the governing team if Junior Trudeau’s Liberals triumph there in October or perhaps by taking over the leadership should the latter’s bid ends in failure. One thing of which we can be fairly sure is that Moralising Mark will not hang around long to see a political melt-down in Britain mutate into a full blown sterling crisis and so add a few unsightly blots to his heretofore Teflon-coated escutcheon.

Economics

Beyond satire

Je ne suis pas Charlie. I am not Charlie, I am not brave enough.

“Across the world, and certainly across Twitter, people are showing solidarity with the murdered journalists of satirical French magazine Charlie Hebdo, proclaiming in black and white that they too share the values that got the cartoonists killed. Emotionally and morally I am entirely with that collective display — but actually I and almost all those declaring their solidarity are not Charlie because we simply do not have their courage.

“Charlie Hebdo’s leaders were much, much braver than most of us; maddeningly, preposterously and — in the light of their barbarous end — recklessly brave. The kind of impossibly courageous people who actually change the world. As George Bernard Shaw noted, the “reasonable man adapts himself to the world while the unreasonable man persists in trying to adapt the world to himself”, and therefore “all progress depends upon the unreasonable man”. Charlie Hebdo was the unreasonable man. It joined the battle that has largely been left to the police and security services..

“It is an easy thing to proclaim solidarity after their murder and it is heart-warming to see such a collective response. But in the end — like so many other examples of hashtag activism, like the #bringbackourgirls campaign over kidnapped Nigerian schoolchildren — it will not make a difference, except to make us feel better. Some took to the streets but most of those declaring themselves to be Charlie did so from the safety of a social media account. I don’t criticise them for wanting to do this; I just don’t think most of us have earned the right.”

“But the rest of us, like me, who sit safely in an office in western Europe — or all those in other professions who would never contemplate taking the kind of risks those French journalists took daily — we are not Charlie. We are just glad that someone had the courage to be.”

–       Robert Shrimsley in the Financial Times, 8 January 2015.

 

“Your right to swing your arms ends just where the other man’s nose begins.”

–       Zechariah Chafee , Jr.

 

“I do not agree with what you have to say, but I’ll defend to the death your right to say it.”

–       Voltaire.

 

On All Saint’s Day, 1st November 1755, an earthquake measuring roughly 9 on the Richter scale struck the Portuguese capital, Lisbon. At least 30,000 people are estimated to have perished. A little over half an hour after the original quake, a tsunami engulfed the lower half of the city. Those not affected by the quake or the tsunami were then beset by a succession of fires, which burned for five days. 85% of Lisbon’s buildings were destroyed. Ripples from the earthquake were felt far afield. Finland and North Africa felt aftershocks; a smaller tsunami made landfall in Cornwall.

 

Such destruction had a follow-on impact, in both philosophical and theological terms. In June 1756, the Inquisition responded with an auto-da-fé – a witch-hunt, effectively, for heretics.

 

One, much-loved, novel happens to cover both of these events, along with a third, from March 1757, when the British Admiral John Byng was executed for cowardice in the face of the French enemy at the battle of Minorca. This inspired the famous line, “Dans ce pays-ci, il est bon de tuer de temps en temps un amiral pour encourager les autres”: “In this country, it is wise to kill an admiral from time to time to encourage the others.”

 

That novel was written by a Frenchman, François-Marie Arouet, in 1758. We know him better today by his nom de plume: Voltaire. And his satirical magnum opus that catalogued these various disasters was called ‘Candide’.

 

‘Candide’ is a triumph of the style of novel best described as ‘picaresque’. It’s crammed with eminently quotable lines – the ‘Pulp Fiction’ of its day, if you will. Candide himself is a naïf who wanders with wide-eyed innocence through a savage and corrupt world. But in its Professor Pangloss it offers us the perfect encapsulation of today’s rogue economist, the unworldly and confused academic whose misguided practice of a false science has dreadful implications for the rest of us. A good modern-day example would be Martin Wolf, the FT’s chief economics correspondent, who on Friday complained about the UK’s property planning regime being “Stalinist”. Mr Wolf should try looking in the mirror more often – he is an ardent supporter of Stalinist monetary policy, for example.

 

As investors we are all now the subjects of a grotesque monetary experiment. This experiment has never been tried before, and its outcome remains uncertain. The unproven thesis, however, runs something like this: six years into a second Great Depression, the only “solution” is for central banks to print ever greater amounts of money. Somehow, gifting free money to the banks that helped precipitate the crisis will lead to a ‘trickle down’ wealth effect. Instead of impoverishing those with savings, inflation will be some kind of miraculous curative, and it must be encouraged at all costs.

 

It bears repeating: we are in an extraordinary financial environment. In the words of the fund managers at Incrementum AG,

 

“We are currently on a journey to the outer reaches of the monetary universe.”

 

On January 25th, Greece goes to the polls. Greek voters face the unedifying choice of re-electing the buffoons who got the country into its current mess or electing rival buffoons issuing comparably ridiculous economic promises that cannot possibly be fulfilled. Voltaire would be in his element. But Greece is hardly alone. Just about every government in the euro zone fiddled its figures to qualify for membership of this not particularly exclusive club, and now the electorate of the euro zone is paying the price. Not that any of this is new news; the euro zone has been in crisis more or less since its inception. If it hadn’t been for sterling’s inglorious ethnic cleansing from the exchange rate mechanism in September 1992, the UK might be in the same boat. Happily, for once, the market was allowed to prevail. The market triumphed over the cloudy vision of bewildered politicians, and the British chancellor ended up singing in the bath. (That he had been a keen advocate of EMU and the single currency need not concern us – consistency or principles are not necessarily required amongst politicians.)

But the market – a quaint concept of a bygone age – has largely disappeared. It has been replaced throughout the West by bureaucratic manipulation of prices, in part known as QE but better described as financial repression. Anyone who thinks the bureaucrats are going to succeed in whatever Panglossian vision they’re pursuing would be well advised to read Schuettinger and Butler’s ‘Forty centuries of wage and price controls’. The clueless bureaucrat has a lot of history behind him. In each case it is a history of failure, but history is clearly not much taught – and certainly not respected – in bureaucratic circles these days. The Mises bookstore describes the book as a “popular guide to ridiculous economic policy from the ancient world to modern times. This outstanding history illustrates the utter futility of fighting the market process through legislation. It always uses despotic measures to yield socially catastrophic results.”

The subtitle of Schuettinger and Butler’s book is ‘How not to fight inflation’. But inflation isn’t the thing that our clueless bureaucrats are fighting. The war has shifted to one against deflation – because consumers clearly have to be protected from everyday lower prices.

Among the coverage of last week’s dreadful events in Paris, there has been surprisingly little discussion about the belief systems of religions other than Islam. We think that Stephen Roberts spoke a good deal of sense when he remarked to a person of faith:

“I contend that we are both atheists. I just believe in one fewer god than you do. When you understand why you dismiss all the other possible gods, you will understand why I dismiss yours.”

There is altogether too much worship of false gods in our economy and what remains of our market system. Some hubris amongst our technocratic “leaders” would be most welcome. Until we get it, the requirement to concentrate on only the most explicit examples of value remains the only thing in investment that makes any sense at all.

 

Economics

2015: the year of the slump?

2014 ended with two ominous developments: the strength of the US dollar and a collapse in key commodity prices.

It is tempting to view both events as one, but the continuing fall in oil prices through December reveals they are sequential: first there was a greater preference for dollars compared with other currencies and this still persists, followed by a developing preference for all but the weakest currencies at the expense of raw materials and energy. These are two steps on a path that should logically lead to a global slump.

Dollar strength was the first warning that things were amiss, leading to higher interest rates in many of the emerging economies as their central banks sought to control investment outflows. Since this followed a prolonged period of credit expansion these countries appear to be entering the bust phase of the credit-driven boom-and-bust cycle; so for them, 2015 at a minimum will see a slump in economic activity as the accumulated malinvestments from the past are unwound. According to the IMF database, emerging market and developing economies at current prices account for total GDP of over $30 trillion, compared with advanced economies’ GDP totalling $47 trillion. It is clear that a slump in the former will have serious repercussions for the latter.

As the reserve currency the dollar is central to the exchange value of all other currencies. This is despite attempts by China and Russia to trade without it. Furthermore and because of this dependency, the global economy has become more geared to the dollar over the years because it has expanded relative to the US. In 2000, the US was one-third of global GDP; today it is about one-fifth.

The second development, falling energy and commodity prices, while initially driven by the same factors as dollar strength, confirms the growing likelihood of a global slump. If falling prices were entirely due to increased supply of the commodities involved, we could rejoice. However, while there has been some increase in energy and commodity supply the message is clear, and that is demand at current prices has unexpectedly declined, and prices are now trying to find a new equilibrium. And because we are considering world demand, this development is being missed or misread by economists who lack a global perspective.

The price of oil has approximately halved in the last six months. The fall has been attributed variously to the west trying to bankrupt Russia, or to Saudi Arabia driving American shale production out of business. This misses the bigger picture: according to BP’s Statistical Review 2014, at the beginning of last year world oil consumption comfortably exceeded supply, 91.3million barrels per day compared with 86.8. This indicates that something fundamental changed in 2014 to collapse the price, and that something can only be a sudden fall in demand in the second half.

Iron ore prices have also halved over the last six months, but other key commodities, such as copper which fell by only 11% over the period, appear to have not yet adjusted to the emerging markets slump. This complies with business cycle theory, because in the early stages of a slump businesses remain committed to their capital investment plans in the vain hope that conditions will improve. This being the case, the collapse in demand for energy can be expected to deepen and spread to other industrial raw materials as manufacturers throw in the towel and their investment plans are finally abandoned.

Therefore the economic background to the financial outlook for the global economy is not encouraging. Nor was it at the beginning of 2014, when it was obviously going to be a difficult year. The difference a year on is that the concerns about the future are more crystallised. This time last year I wrote that we were heading towards a second (to Lehman) and unexpected financial and currency crisis that could happen at any time. I only modify that to say the crisis has indeed begun and it has much further to go this year. This is the background against which we must briefly consider some of the other major currencies, and precious metals.

Japan and the yen

The complacency about Japan in the economic and investment communities is astonishing. Japan is committed to a scale of monetary inflation that if continued can only end up destroying the yen. The Bank of Japan is now financing the equivalent of twice the government deficit (¥41 trillion) by issuing new currency, some of which is being used to buy Japanese equity ETFs and property REITs. By these means pricing in bond, equity and commercial property markets has become irrelevant. “Abenomics” is about financing the government and managing the markets under the Keynesian cover of stimulating both the economy and animal spirits. In fact, with over ¥1.2 quadrillion of public sector debt the government is caught in a debt trap from which it sees no escape other than bluff. And since Abenomics was first embarked upon two years ago, the yen has fallen from 75 to the US dollar to 120, or 37%.

Instead of learning the lessons of previous hyperinflations, mainstream economists fall for the official line and ignore the facts. The facts are simple: Japan is a welfare state with an increasing and unsustainable ratio of retirees to tax-paying workers. She is the leading advanced nation on a debt path the other welfare nations are closely following. Consensus forecasts that the Japanese economy will be stimulated into recovery in 2015 are wide of the mark: instead she is destroying her currency and private sector wealth with it.

Eurozone and the euro

In the short-term the Eurozone is being revisited by its Greek problem. Whether or not the next Greek government backs off from confronting the other Eurozone members and the ECB remains to be seen. The problems for the Eurozone lie considerably deeper than Greece, made worse by politicians who have been reluctant to use the time bought by the ECB to address the structural difficulties of the 19 Eurozone members. The result is the stronger northern bloc (Germany, Netherlands, Finland and Luxembourg) is being crippled by the burden of the Mediterranean states plus Portugal plus France. And Germany and Finland have suffered the further blow of losing valuable export business from Russia.

In the coming months the Eurozone will likely face gas shortages from Russia through the trans-Ukrainian pipeline, and price deflation driven by energy and other commodity prices. Price deflation spurs two further points to consider, one false and the other true: lower prices are deemed to be recessionary (false), and falling prices increase the burden of real debt (true). The consequence is that the ECB will seek ways to expand money supply aggressively to stop the Eurozone from drifting into an economic crisis. In short, the Eurozone will likely develop its own version of Abenomics, the principal difference being the Eurozone’s timeline is behind Japan’s.

US and UK

Japan and the Eurozone account for total GDP of $18.3 trillion, slightly more than the US and added to the emerging and developing economies, gives a total of $48 trillion, or 62% of global GDP for nations leading the world into a slump. So when we consider the prospects for the US and the UK, together producing $20.4 trillion or 26% of the world’s GDP, their prospects are not good either. The UK as a trading nation exposed to the Eurozone has immediate risk, while the US which is not so dependent on international trade, less so.

Precious metals

The foregoing analysis is of the primary economic drivers for 2015 upon which all else will ultimately depend. The risk of a global slump can be called a first order event, while the possibility of a banking crisis, derivatives default or other market dislocation brought on by a slump could be termed a second order event. There is no point in speculating about the possibility and timing of second order events occurring in 2015, because they ultimately depend on the performance of the global economy.

However, when it becomes clear to investors that the global economy is indeed entering a slump, financial and systemic risks are certain to escalate. Judging this escalation by monitoring markets will be difficult because central banks, exchange stability funds and sovereign wealth funds routinely intervene in markets, rendering them misleading as price signals.

Precious metals are the only assets beyond the long-term control of governments. They can distort precious metal markets in the short term by expanding the quantity of derivatives, and there is a body of evidence that these methods have been employed in recent years. But most price distortion today appears to have come from bullion and investment banks who are fully committed to partying in bonds, equities and derivatives, and for which gold is a spoiler. This complacency is bound to be undermined at some point, and a global economic slump is the likely catalyst.

The dangers of ever-inflating currencies are clearly illustrated by the Fiat Money Quantity, which has continued to expand at an alarming rate as shown in the chart below.

FMQ 09012015

FMQ measures the amount of fiat currency issued as a replacement for gold as money, so is a measure of unbacked monetary expansion. At $13.52 trillion last November it is $5.68 trillion above the long-established pre-Lehman crisis growth path, stark evidence of a depreciating currency in monetary terms. Adjusting the price of gold for this depreciation gives a price today the equivalent of $490 in dollars at that time and quantity, so gold has roughly halved in real currency terms since the Lehman crisis.

Conclusion

There is compelling evidence that 2015 will see a global slump in economic activity. This being the case, financial and systemic risks will increase as evidence of the slump accumulates. It can be expected to undermine global equities, property and finally bond markets, which are currently all priced for economic stability. Even though these markets are increasingly controlled by central bank intervention, it is dangerous to assume this will continue to be the case as financial and systemic risks accumulate.

Precious metals are ultimately free from price management by the state. Furthermore, they are the only asset class notably under-priced today, given the enormous increase in the quantity of fiat money since the Lehman crisis.

In short, 2015 is shaping up to be very bad for fiat currencies and very good for gold and silver.

Economics

The Japanese Deflation Myth and the Yen’s Slump

[Editor’s Note: this piece, by Brendan Brown, first appeared at mises.org last year]

 

The slide of the yen since late summer has brought it to a level some 40 percent lower against the euro and US dollar than just two years go. Yet still Japan’s Prime Minister Shinzo Abe and his central bank chief Haruhiko Kuroda warn that they have not won the battle against deflation. That caution is absurd — all the more so in view of the fact that there was no deflation in the first place.

Some cynics suggest that Abe’s and Haruhiko’s battle cry against this phoney phantom is simply a ruse to gain Washington’s acquiescence in a big devaluation. But whatever the truth about their real intent, Japan’s monetary chaos is deepening.

Japanese Prices Have Been Stable

The CPI in Japan at the peak of the last cycle in 2007 was virtually at the same level as at the trough of the post-bubble recession in 1992, and up a few percentage points from the 1989 cycle peak. Hence, Japan alone has enjoyed the sort of price stability as might be enjoyed in a gold-standard world. Prices have fallen during recessions or during periods of especially-rapid terms-of-tradeimprovement or productivity growth. They have risen during cyclical booms or at times of big increases in the price of oil.

If price-indices in Japan were adjusted fully to take account of quality improvements they would have been falling slightly throughout, but that would also have been the case under the gold standard and was fully consistent with economic prosperity.

Such swings in prices are wholly benign. For example, lower prices during recession coupled with expectation of higher prices in expansion induce businesses and households to spend more. A valid criticism of the Japanese price experience of the past two decades has been that these swings have lacked vigour due to various rigidities. Particularly valid is the claim that price falls should have been larger during the post-bubble recession of 1990-93 and subsequent potential for recovery would have been correspondingly larger.

Prices in Japan did fall steeply during the Great Recession (2008-10) but the perceived potential for recovery was squeezed by the Obama Monetary Experiment (the Fed’s QE) which meant an immediate slide of the US dollar. It was in response to the related spike of the yen that Prime Minister Abe prepared his counter-stroke. This involved importing the same deflation-phobic inflation-targeting policies that the Obama Federal Reserve was pursuing. Washington could hardly criticize Tokyo for imitating its own monetary experiment.

Deflation and “The Lost Decade”

The architects of the Obama Monetary Experiment have cited as justification Japan’s “lost decade” and the supposed source in deflation. In fact, though, the only period during which the Japanese economy underperformed other advanced economies (as measured by the growth of GDP per capita) was from 1992-97. The underperformance of that period had everything to do with insufficient price and wage flexibility downward, the Clinton currency war, and the vast malinvestment wrought by the prior asset price inflation, coupled with a risk-appetite in Japan shrunken by the recent experience of bust.

Moreover, as time went on, from the early 1990s, huge investment into the Tokyo equity market from abroad compensated for ailing domestic risk appetites. Yes, Japan’s economy could haveperformed better than the average of its OECD peers if progress had been made in de-regulation, and if Japan had had a better-designed framework of monetary stability to insulate itself from the Greenspan-Bernanke asset price inflation virus of the years 2002-07. (The Greenspan-Bernanke inflation caused speculative temperatures in the yen carry trade to reach crazy heights.) But deflation was never an actual or potential restraint on Japanese prosperity during those years.

True, there was a monetary malaise. Japan’s price stability was based on chance, habit, and economic sclerosis rather than the wisdom of its monetary policy. It had been the huge appreciation of the yen during the Clinton currency war that had snuffed out inflation. Then the surge of cheap imports from China had worked to convince the Japanese public that inflation had indeed come to an end. Lack of economic reform meant that the neutral rates of interest remained at a very low level and so the Bank of Japan’s intermittent zero rate policies did not stimulate monetary growth.

The monetary system in Japan had no secure pivot in the form of high and stable demand for non-interest bearing high-powered money. In Japan the reserve component of the monetary base is virtually indistinguishable from a whole range of close substitutes and banks had no reason to hold large amounts of this (given deposit insurance and the virtual assurance of too-big-to-fail help in need). Monetary policy-making in Japan meant highly discretionary manipulation of short-term interest rates in the pursuance of fine-tuning the business cycle rather than following a set of rules for monetary base expansion.

The Yen After Abenomics

When Prime Minister Abe effected his coup against the old guard at the Bank of Japan there was no monetary constitution to flout. Massive purchases of long-dated Japanese government bonds by the Bank of Japan are lowering the proportion of outstanding government debt held by the public in fixed-rate form. But this is all a slow-developing threat given a gross government debt to GDP ratio of around 230 percent and a current fiscal deficit of 6 percent of GDP. Bank of Japan bond-buying has strengthened irrational forces driving 10-year yields down to almost 0.5 percent despite underlying inflation having risen to 1 percent per annum.

It is doubtless the possibility of an eventual monetization of government debt has been one factor in the slump of the yen. More generally, as the neutral level of interest rates in Japan rises in line with demographic pressures (lower private savings, increased social expenditure) one might fear that BoJ manipulation of rates will eventually set off inflation. Part of the yen’s slump, though, is due to a tendency for that currency to fall when asset price inflation is virulent in the global economy. This stems from the huge carry trade in the yen.

The yen could indeed leap when the global asset price-inflation disease — with its origins in Fed QE — moves to its next phase of steep speculative temperature fall. The yen is now in real effective exchange rate terms at the record low point of the Japan banking crisis in 1997 or the global asset inflation peak of 2007. So, the challenge for investors is to decide when the Abe yen has become so cheap in real terms that its hedge properties make it a worthwhile portfolio component.