“There are two ways of learning how to ride a fractious horse; one is to get on him and learn by actual practice how each motion and trick may be best met; the other is to sit on a fence and watch the beast a while, and then retire to the house and at leisure figure out the best way of overcoming his jumps and kicks. The latter system is the safest; but the former, on the whole, turns out the larger proportion of good riders. It is very much the same in learning to ride a flying machine; if you are looking for perfect safety, you will do well to sit on a fence and watch the birds, but if you really wish to learn, you must mount a machine and become acquainted with its tricks by actual trial.”
“So, too, for the stock market. It is easy to study stock tables in solitude from the comfort of your office and declare the market efficient. Or you can be a full-time investor for a number of years and, if your eyes are open, learn that it is not. As with the Wrights, the burden of proof is somehow made to fall on the practitioner to demonstrate that he or she has accomplished something the so-called experts said could not be done (and even he may find himself explained away as aberrational). Almost none of the burden seems to fall on the armchair academics, who cling to their theories even in the face of strong evidence that they are wrong.”
Days of miracle and wonder in the bond markets.. but not necessarily in any good way. Last week we highlighted the seeming anomaly that even as there has never been so much debt in the history of the world, it has also never been so expensive. Between 2000 and 2013, the value of outstanding tradeable debt rose from $33 trillion to $100 trillion, according to research from Incrementum AG. (Over the same period, total equity market capitalisation rose “merely” from $49 trillion to $66 trillion.) Although we would suggest there is now no semblance of traditional value in conventional government debt whatsoever, it could yet get more expensive still.
Albert Edwards of SocGen deserves some credit for maintaining his ‘Ice Age’ thesis over a sustained period of widespread scepticism from other market participants. He summarises it as follows:
“First, that the West would drift ever closer to outright deflation, following Japan’s template a decade earlier. And second, financial markets would adjust in the same way as in Japan. Government bonds would re-rate in absolute and relative terms compared to equities, which would also de-rate in absolute terms..
“Another associated element of the Ice Age we also saw in Japan is that with each cyclical upturn, equity investors have assumed with child-like innocence that central banks have somehow ‘fixed’ the problem and we were back in a self-sustaining recovery. These hopes would only be crushed as the next cyclical downturn took inflation, bond yields and equity valuations to new destructive lows. In the Ice Age, hope is the biggest enemy..
“Investors are beginning to see how impotent the Fed and ECB’s efforts are to prevent deflation. And as the scales lift from their eyes, equity, credit and other risk assets trading at extraordinarily high valuations will take their next Ice Age stride towards the final denouement.”
It is certainly staggering that even after expanding its balance sheet by $3.5 trillion, the Fed has been unable to trigger visible price inflation in anything other than financial assets. One dreads to contemplate the scale of the altogether less visible private sector deleveraging that has cancelled it out. One notes that while bonds are behaving precisely in line with the Ice Age thesis, stock markets – by and large – are not quite following the plot. But there were signs last week that they may finally have got a copy of the script.
The tragedy of our times, unfolding slowly but surely via ever-lower bond yields, is that there is a vacuum at the heart of the political process where bold action – not least to grasp the debt nettle – should reside. Since nature abhors the vacuum, central bankers have filled it. They say that to a man with a hammer, everything looks like a nail. To a central banker facing the prospect of outright deflation, the answer to everything is the printing of ex nihilo money and the manipulation of financial asset prices. The by-product of these malign trends is that it makes rational investment and asset allocation, indeed more narrowly the pursuit of real capital preservation, impossible.
Since the integrity of the debt (and currency) markets is clearly at risk, we have long sought alternatives that offer much diminished credit and counterparty risk. The time-honoured alternative has been gold. As the chart below (via Nick Laird) shows, between 2000 and 2011, gold
tracked the expansion in US debt pretty handily. In 2008 and then in 2011/2012 gold became overextended relative to US debt. Beginning in 2013 gold then decoupled in the opposite direction. As things stand today, if one expects that relationship to resume – and we do – then gold looks anomalously cheap relative to the gross level of US debt, which clearly is not going to contract any time soon.
A second rationale for holding gold takes into account the balance sheet expansion of the broader universe of central banks:
If one accepts that gold is not merely an industrial commodity but an alternative form of money (and central banks clearly do, or they would not be holding it in the form of reserves), than it clearly makes sense to favour a money whose supply is growing at 1.5% per annum over monies whose supply is growing at between 8% and 20% per annum. It then merely comes down to biding one’s time and waiting for Albert Edwards’ “final denouement” (or simply the next phase of the global financial crisis that never really went away).
Two recent tweets from George Cooper on the topic of bond investing are also worthy of republication here:
“The combination of indexing / rating agencies and syndication means that collectively the investment industry does not provide effective discipline to borrowers.”
This is a clear example of market failure brought about by institutional fund managers and the consultants that “guide” their institutional investor clients. There is simply no punishment for ill-disciplined government borrowers (i.e., all of them). To put it another way, where have the bond vigilantes gone ? And,
“The best thing the ECB could do here is state clearly that it has reached the limit of monetary policy and the rest is up to politicians.”
It is not as if politicians asleep at the wheel have gone entirely unnoticed. Two high-profile reports have been published this year drawing attention to the debt problems gnawing away at the economic vitality of the West. Perhaps the most damning response to date has come from the euro zone’s pre-eminent political cynic, Jean-Claude Juncker:
“We all know what to do, we just don’t know how to get re-elected after we’ve done it.”
No discussion of the bond market could possibly be complete without a brief mention of the defenestration of the so-called ‘Bond King’, Bill Gross, from Pimco. For the benefit of anyone living under a rock these past weeks, the manager of the world’s largest bond fund jumped ship before he could be shoved overboard. Pimco’s owners, Allianz, must surely regret having allowed so much power to be centralised in the form of one single ‘star’ manager. In a messy transfer that nobody came out of well, Janus Capital announced that Bill Gross would be joining to run a start-up bond fund, before he had even announced his resignation from Pimco (but then Janus was a two-faced god). This was deliriously tacky behaviour from within a normally staid backwater of the financial markets. Some financial media reported this as a ‘David vs Goliath’ story; in reality it is anything but. The story can be more accurately summarised as ‘Bond fund manager leaves gigantic asset gatherer for other gigantic asset gatherer’ (Janus Capital’s $178 billion in client capital being hardly small potatoes). This is barely about asset management in the truest, aspirational sense of the phrase. This writer recalls the giddy marketing of a particularly new economy-oriented growth vehicle called the ‘Janus Twenty’ fund in the UK back in 2000. Between March 2000 and September 2001, that particular growth vehicle lost 63% of its value. Faddish opportunism is clearly still alive and well. This gross behaviour may mark a market top for bonds, but probably not. But it’s difficult to shake off the suspicion that navigating the bond markets profitably over the coming months will require almost supernatural powers in second-guessing both central banks and one’s peers – especially if doing so on an indexed basis. For what it’s worth this is a game we won’t even bother playing. Our pursuit of the rational alternative – compelling deep value in equity markets – continues.
Orders for US non-military capital goods excluding aircraft rose by 0.6% in August after a 0.2% decline in July to stand at $73.2 billion. Observe that after closing at $48 billion in May 2009 capital goods orders have been trending up.
Most commentators regard this strengthening as evidence that companies are investing both in the replacement of existing capital goods and in new capital goods in order to expand their growth.
There is no doubt that an increase in the quality and the quantity of tools and machinery i.e. capital goods, is the key for the expansion of goods and services. But is it always good for economic growth? Is it always good for the wealth generation process?
Consider the case when the central bank is engaging in loose monetary policy i.e. monetary pumping and an artificial lowering of the interest rate structure. Such type of policy sets the platform for various non-productive or bubble activities.
In order to survive these activities require real funding, which is diverted to them by means of loose monetary policy. (Once loose monetary policy is set in motion this allows the emergence of various bubble activities).
Note various individuals that are employed in these activities are the early recipients of money; they can now divert to themselves various goods and services from the pool of real wealth.
These individuals are now engaging in the exchange of nothing for something. (Individuals that are engage in bubble activities don’t produce any meaningful real wealth they however by means of the pumped money take a slice from the pool of real wealth. Again note that these individuals are contributing nothing to this pool).
Now bubble activities like any non-bubble activity also require tools and machinery i.e. capital goods. So various capital goods generated for these activities is in fact a waste of real wealth. Since the tools and machinery that are generated here are going to be employed in the production of goods and services that without the monetary pumping of the central bank would never emerge. (Wrong infrastructure has emerged).
These activities do not add to the pool of real wealth, they are in fact draining it. (This amounts to economic impoverishment). The more aggressive the central bank’s loose monetary stance is the more drainage of real wealth takes place and the less real wealth left at the disposal of true wealth generators. If such policy persists for too long this could slow or even shrink the pool of real wealth and set in motion a severe economic crisis.
We suggest that the strong bounce in capital goods orders since May 2009 is on account of extremely loose monetary stance of the Fed. Note that the wild fluctuations in our monetary measure AMS after a time lag followed by sharp swings in capital goods orders.
An increase in the growth momentum of money followed by the increase in capital goods orders to support the increase in various bubble activities. Conversely, a decline in the growth momentum of money supply followed by a decline in capital goods orders.
We suggest that a down-trend in the growth momentum of money supply since October 2011 is currently on the verge of asserting its dominance. This means that various bubble activities are likely to come under pressure. Slower monetary growth is going to slow down the diversion of real wealth to them from wealth generating activities.
Consequently capital goods orders are going to come under pressure in the months ahead. (The build-up of a wrong infrastructure is going to slow down – a fewer pyramids will be built).
If there is one concept that illustrates the difference between a top-down macro-economic approach and the reality of everyday life it is the velocity of circulation of money. Compare the following statements:
“The collapse in velocity is testament to the substantial misallocation of capital brought about by the easy money regimes of the past 20 years.” Broker’s research note issued September 2014; and
“The mathematical economists refuse to start from the various individuals’ demand for and supply of money. They introduce instead the spurious notion of velocity of circulation according to the pattern of mechanics.” Ludwig von Mises, Human Action.
This article’s objective is not to disagree with the broker’s conclusion; rather it is to examine the basis upon which it is made.
The idea of velocity of circulation referred to arose from the quantity theory of money, which links changes in the quantity of money to changes in the general level of prices. This is set out in the equation of exchange. The basic elements are money, velocity and total spending, or GDP. The following is the simplest of a number of ways it has been expressed:
Amount of Money x Velocity of Circulation = Total Spending (or GDP)
Assuming we can quantify both money and total spending, we end up with velocity. But this does not tell us why velocity might vary: all we know is that it must vary in order to balance the equation. You could equally state that two completely unrelated quantities can be put into a mathematical equation, so long as a variable is included whose only function is to always make the equation balance. In other words the equation of exchange actually tells us nothing per se.
This gives analysts a problem, not resolved by the modern reliance on statistics and computer models. The dubious gift to us from statisticians is their so-called progress made in quantifying the economy, so much so that at the London School of Economics a machine called MONIAC (monetary national income analogue computer) used fluid mechanics to model the UK’s economy. This and other more recent computer models give unwarranted credence to the idea that the economy can be modelled, derivations such as velocity explained, and valid conclusions drawn.
Von Mises’s criticism is based on the philosopher’s logic that economics is a social and not a physical science. Therefore, mathematical relationships must be strictly confined to accounting and not be confused with economics, or as he put it human action. Unfortunately we now have the concept of velocity so ingrained in our thinking that this vital point usually escapes us. Indeed, the same is true of GDP, or the right hand side of the equation of exchange.
GDP is only an accounting identity: no more than that. It ranks gin with golf-balls by reducing them both to a monetary value. Statisticians select what’s included so it is biased in favour of consumer goods and against capital investment. Crucially it does not tell us about an ever-changing economy comprised of successes, failures, and hard-to-predict human needs and wants, which taken all together is economic progress. And because it is biased in its composition and says nothing about progress the value of this statistic is grossly exaggerated.
The only apparent certainty in the equation of exchange is the quantity of money, assuming it is all recorded. No one seems to allow for unrecorded money such as shadow banking, but we shall let that pass. If the money is sound, as it was when the quantity theory of money was devised, one could assume that an increase in its quantity would tend to raise prices. This was experienced following Spain’s importation of gold and silver from the new world in the sixteenth century, and following the gold mining booms in California and South Africa. But relating an increase in the quantity of gold to prices in general is at best a summary of a number of various factors that drive the price relationship between money and goods.
Today we no longer have sound money, whose purchasing power was regulated by human preferences across national boundaries. Instead we have fiat currencies whose purchasing power is formalised in foreign exchanges. When the Icelandic krona on 8th October 2008 halved in value, it had nothing to do with changes in the quantity of money or Iceland’s GDP. Yet if we try to interpret velocity in this case, we will find ourselves pleading a special case to explain its substantial increase as domestic prices absorbed the shock imparted through the foreign exchanges.
Iceland’s currency collapse is not an isolated event. The purchasing power of a fiat currency varies constantly, even to the point of losing it altogether. The truth of the matter is the utility of a fiat currency is entirely dependent on the subjective opinions of individuals expressed through markets, and has nothing to do with a mechanical quantity relationship. In this respect, merely the potential for unlimited currency issuance or a change in perceptions of the issuer’s financial stability, as Iceland discovered, can be enough to destabilise it.
According to the equation of exchange, this is not how things should work. The order of events is first you have an increase in the quantity of money and then prices rise, because monetarist logic states that prices rise as a result of the extra money being spent, not as a result of money yet to be spent. With a mechanical theory there can be no room for subjectivity.
It is therefore nonsense to conclude that velocity is a vital signal of some sort. Monetarism is at the very least still work-in-progress until monetarists finally discover velocity is no more than a factor to make their equation balance. The broker’s analyst quoted above would have been better to confine his statement to the easy money regimes of the past 20 years being responsible for the substantial misallocation of capital, and leaving out the bit about velocity entirely.
A small slip perhaps on the way to a sensible conclusion; but it is indicative of the false mechanisation of human behaviour by modern macro-economists. However it should also be noted that is impossible to square the concept of velocity of circulation with one simple fact of everyday life: we earn our salaries once and we dispose of it. That’s a constant velocity of roughly one.
The US Federal Reserve can keep stimulating the US economy because inflation is posing little threat, Federal Reserve Bank of Minneapolis President Kocherlakota said. “I am expecting an inflation rate to run below 2% for the next four years, through 2018”, he said. “That means there is more room for monetary policy to be helpful in terms of … boosting demand without running up against generating too much inflation”.
The yearly rate of growth of the consumer price index (CPI) stood at 1.7% in August against 2% in July and the official target of 2%. According to our estimate the yearly rate of growth of the CPI could close at 1.4% by December. By December next year we forecast the yearly rate of growth of 0.6%.
It seems that the Minneapolis Fed President holds that by boosting the demand for goods and services by means of an additional monetary pumping it is possible to strengthen the economic growth. He believes that by means of strengthening the demand for goods and services the production of goods and services will follow suit. But why should it be so?
If by means of monetary pumping one could strengthen the economic growth then it would imply that by means of monetary pumping it is possible to create real wealth and generate an everlasting economic prosperity.
This would also mean that world wide poverty should have been erased a long time ago, after all most countries today have central banks that possess the skills of how to pump money. Yet world poverty remains intact.
Despite the massive monetary pumping since 2008 and the policy interest rate of around zero Fed policy makers seem to be unhappy with the so-called economic recovery. Note that the Fed’s balance sheet, which stood at $0.86 trillion in January 2007 jumped to $4.4 trillion by September this year – a monetary pumping of almost $4 trillion.
We suggest that there is no such thing as an independent category called demand. Before an individual can exercise demand for goods and services he/she must produce some other useful goods and services. Once these goods and services are produced individuals can exercise their demand for the goods they desire. This is achieved by exchanging things that were produced for money, which in turn can be exchanged for goods that are desired. Note that money serves here as the medium of the exchange – it produces absolutely nothing. It permits the exchange of something for something. Any policy that results in monetary pumping leads to an exchange of nothing for something. This amounts to a weakening of the pool of real wealth – and hence to reduced prospects for the expansion of this pool.
What is required to boost the economic growth – the production of real wealth – is to remove all the factors that undermine the wealth generation process. One of the major negative factors that undermine the real wealth generation is loose monetary policy of the central bank, which boosts demand without the prior production of wealth. (Once the loopholes for the money creation out of “thin air” are closed off the diversion of wealth from wealth generators towards non-productive bubble activities is arrested. This leaves more real funding in the hands of wealth generators – permitting them to strengthen the process of wealth generation i.e. permitting them to grow the economy).
Now, the artificial boosting of the demand by means of monetary pumping leads to the depletion of the pool of real wealth. It amounts to adding more individuals that take from the pool of real wealth without adding anything in return –an economic impoverishment.
The longer the reckless loose policy of the Fed stays in force the harder it gets for wealth generators to generate real wealth and prevent the pool of real wealth from shrinking.
Finally, the fact that the yearly rate of growth of the CPI is declining doesn’t mean that the Fed’s monetary pumping is going to be harmless. Regardless of price inflation monetary pumping results in an exchange of nothing for something i.e. an economic impoverishment.
The Democratic Party has made “income inequality” a signature issue for the 2014 (and, presumably, 2016) election cycle. Democrats, en masse, shout “J’accuse!” at Republicans. There is a very different story to tell.
“Income inequality” is a crude, and twisted, heuristic for stagnant median family income. “Income inequality” does not really resonate with voters, asnoted by the Washington Post‘s own Catherine Rampell, with a mountain of evidence showing that Americans don’t begrudge the wealthy their wealth, just are frustrated at the lack of widespread economic opportunity.
So let’s get down to cases. Stagnant median family income is not the GOP’s fault. It’s the Fed who done it.
The Atlantic Media Company’s Quartz recently claimed that the Fed has been intentionally keeping a lid on wages. This has potentially major political implications. Among other things, this view would allow the Republicans to push the discourse back toward the real problem, wage stagnation. It can serve to refocus the Congress on the real solution, restoring real, rule-based, integrity to monetary policy as a way to get America moving again.
A culpable Fed gives irony to the fact that it is the Democrats that protect the Fed as if it were the Holy of Holies of the Temple. What if, as asserted inQuartz, the Fed, by policy, and not the GOP, is the source of wage stagnation? This opens an opportunity for the GOP to parry the political narrative of “income inequality” and feature the real issue on the mind of the voters and forthrightly to address its core cause, poor monetary policy.
This has been slow to happen because Federal Reserve has exalted prestige. The elite media has a propensity to canonize the Chair of the Fed. Media adulation has obscured the prime source of the stagnation besetting American wage earners for the past 43 years.
Paul Volcker’s life was exalted (with some real justification), for instance by New York Times prize-winning journalist Joseph B. Treaster as The Making of a Financial Legend. Downhill from there…
Official picture of Janet Yellen from FRBSF web site
. (Photo credit: Wikipedia)
Chairman Greenspan was featured on the cover of Time Magazine’s February 15, 1999 issue as the most prominent member of “The Committee To Save The World.” One of the greatest investigative journalists of our era, Bob Woodward, wrote a deeply in-the-tank hagiography of Alan Greenspan, entitled Maestro. In retrospect, the halo the media bestowed was faux.
The Atlantic Monthly, in its February 12, 2012 issue, featured Fed Chairman Ben Bernanke on its cover as The Hero. (Hedging its bets, The Atlantic ran a duplicate inside cover referencing him as The Villain.) Author Roger Lowenstein wrote: “Ben Bernanke saved the economy—and has navigated masterfully through the most trying of times.” The adulation for Chairman Bernanke, in retrospect, seems overdone. Even President Obama, at the end of Bernanke’s final term, gave him a not-so-subtle push out the door, as reported by CNN: “He’s already stayed a lot longer than he wanted, or he was supposed to….”
It’s Janet Yellen’s turn for media canonization. This is premature.
Madame Yellen’s institutional loyalty and obvious decency command this columnist’s respect. Her intentions present as — profoundly — good. That said, the road to a well-known, notorious, destination is said to be paved with good intentions. Moreover, canonization demands that a miracle be proven. None yet is in evidence.
The canonization of Madame Yellen began in earnest with an August 24 article in Politico by Michael Hirsch, The Mystery Woman Who Runs Our Economy. The process was taken up to the next level the very next day in an article by Matt Phillips in Quartz, Janet Yellen’s Fed is more revolutionary than Ben Bernanke’s ever was.
Hirsch tees it up in Politico nicely:
As has been written, Yellen is clearly passionate about the employment problem. It was no accident that the theme of this year’s Jackson Hole meeting was “labor market dynamics,” and the AFL-CIO’s chief economist, Bill Spriggs, was invited while Wall Street economists were not.
Yellen is also very cagey about whether that’s happening or not: She’s playing her own private game of chicken with inflation, indicating that she wants to see more wage growth for workers (another thing that’s hard to track ahead of time) before she raises rates. Beneath the careful analysis and the caveat-freighted sentences, the bottom line seems to be: “We’re making this up as we go along.”
Phillips, in Quartz, observes that it has been Fed policy to suppress wages for two generations. Phillips:
From her position as the world’s single most powerful economic voice, the chair of the US Federal Reserve, Janet Yellen, is forcing the financial markets to rethink assumptions that have dominated economic thinking for nearly 40 years. Essentially, Yellen is arguing that fast-rising wages, viewed for decades as an inflationary red flag and a reason to hike rates, should instead be welcomed, at least for now.
It might sound surprising to most people who work for a living, but for decades the most powerful people in economics have seen strong real wage growth—that is, growth above and beyond the rate of inflation—as a big problem.
Phillips then gets to the point, providing what passes for economic wisdom among the enablers of the Fed’s growth-sapping (including wage-enervating) interventions.
Since the end of the Great Inflation, the Fed—and most of the world’s important central banks—have gone out of their way to avoid a replay of the wage-price spiral. They’ve done this by tapping on the economic brakes—raising interest rates to make borrowing more expensive and discourage companies from hiring—as wages started to show strong growth.
Phillips provides this exaltation of Janet Yellen:
If she’s right, and American paychecks can improve without setting off an inflationary spiral, it could upend the clubby world of monetary policy, reshape financial markets, and have profound implications for everything ….
Higher real wages, without exacerbating inflation, indeed would be something to cheer. That, demonstrably, is possible. The devil is in the details.
There’s persuasive, even compelling, evidence that the international monetary system is better governed by, and working people benefit from, a smart rule rather than the discretion of career civil servants, however elite. An important Bank of England paper in 2011, Financial Stability Paper No. 13, contrasts the poor performance, since 1971, of the freelancing Fed with the precursor Bretton Woods, and with classical gold standard, rules. This paper materially advances the proposition of exploring “a move towards an explicit rules-based framework.”
A rule-based system would represent a profound transformation of how the Fed currently does its business. House Financial Services Committee Chairman Jeb Hensarling (R-Tx) said, in a recent hearing, that “The overwhelming weight of evidence is that monetary policy is at its best in maintaining stable prices and maximum employment when it follows a clear, predictable monetary policy rule.”
Madame Yellen stated that “It would be a grave mistake for the Fed to commit to conduct monetary policy according to a mathematical rule.” Contrast Madame Yellen’s protest with a recent speech by Paul Volcker in which he forthrightly stated: “By now I think we can agree that the absence of an official, rules-based cooperatively managed, monetary system has not been a great success. In fact, international financial crises seem at least as frequent and more destructive in impeding economic stability and growth. … Not a pretty picture.”
Madame Yellen’s ability to achieve her (postulated) goal of rising real wages in a non-inflationary environment likely depends on who is right here, Yellen or Volcker. It is a key issue of the day. The threshold issue currently is framed as between “a clear, predictable monetary policy rule” and the discretion of the Federal Open Market Committee. The available rules are not limited to mathematical ones but, to achieve real wage growth and equitable prosperity, the evidence fully supports the proposition that a rule is imperative.
Returning America to consistently higher real wage growth is a Holy Grail for this columnist. Equitable prosperity, very much including the end of wage stagnation, is a driving objective for most advocates of a rule-based system, very much including advocates of “the golden rule.”
Getting real wages growing is a laudable, and virtuous, proposition. Premature canonization, however, is a flattering injustice to Madame Yellen … and to the Fed itself. The Federal Reserve is lost in a wilderness — “uncharted territory” — partly, perhaps mainly, of its own (well-intended) concoction.
The road to the declaration of sainthood requires, according to this writer’s Catholic friends, documentation of miracles. If this writer may be permitted to play the role of advocatus diaboli for a moment … no American Economic Miracle — akin to the Ludwig Erhard’s German “Economic Miracle,” the Wirtschaftswunder, driven by currency reform — yet appears in evidence.
Expertise, which Chair Yellen certainly possesses in abundance, can lead to hubris … and hubris in disaster as it did in 2008. Good technique is necessary but not sufficient.
As this writer elsewhere has noted,
Journalist Edwin Hartrich tells the following story about Erhard …. In July 1948, after Erhard, on his own initiative, abolished rationing of food and ended all price controls, Clay confronted him:
Clay: “Herr Erhard, my advisers tell me what you have done is a terrible mistake. What do you say to that?”
Erhard: “Herr General, pay no attention to them! My advisers tell me the same thing.”
Erhard, famously, proved right, his experts, wrong.
Madame Yellen by dint of her decency and intellect may yet prove capable of restoring the Great Moderation … and the real wage growth, with low inflation, that went with that. Yet, at best, Great Moderation 2.0 would be, as was its predecessor, a temporary, rather than sustainable, solution. “Making it up as you go along” is a proposition fraught with peril.
At worst, if Madam Yellen has, as observers such as Forbes.com‘s John Tamny detect, a proclivity for cheapening the dollar as a path to real wage growth she easily could throw working people out of the frying pan and into the fires of inflation. Moreover, the Fed’s proclivities toward central planning may be one of the most atavistic relics of a bygone era. Central planning, by its very nature, even if well meant, always suppresses prosperity. As the sardonic statement from the Soviet Union went, “So long as the bosses continue to pretend to pay us we will pretend to work.”
Some who should know better ignorantly, and passionately, still are stuck in William Jennings Bryan’s rhetorically stirring but intellectually vacuous 1896 declaration, “You shall not press down upon the brow of labor this crown of thorns, you shall not crucify mankind upon a cross of gold.” This is a plank that won Bryan his party’s nomination and cost him the presidency… three times. The electorate knows that cheapening the money is the problem, not the solution.
The Fed, not the gold standard, pressed down the crown of thorns upon labor’s brow. The GOP, rather than playing rope-a-dope on “income inequality,” would do well to dig down to find the monetary rule with which to restore a climate of equitable prosperity and real wage growth. Results, not intentions, are what counts.
There is abundant evidence that the right rule-based system would not be a “grave mistake” but a smart exit ramp back to growth of real wages. Anything the Fed does that departs from a dollar price rule is anti-equitable-prosperity. Anything else hurts all, labor and capital. The Congress, under the leadership of Chairmen Garrett (R-NJ) and Hensarling (R-Tx), whose committee has in front of it the Federal Reserve Accountability and Transparency Act and Joint Economic Committee Chairman Kevin Brady’s (R-Tx) Centennial Monetary Commission, at long last, is bestirring itself. Now is the right time to amp up the crucial debate over monetary policy … by enacting both of these pieces of legislation.
Last year markets behaved nervously on rumours that QE3 would be tapered; this year we have lived with the fact. It turned out that there has been little or no damage to markets, with bond yields at historic lows and equity markets hitting new highs.
This contrasts with the ending of QE1 and QE2, which were marked by falls in the S&P 500 Index of 9% and 11.6% respectively. Presumably the introduction of twist followed by QE3 was designed at least in part to return financial assets to a rising price trend, and tapering has been consistent with this strategy.
From a monetary point of view there is only a loose correlation between the growth of fiat money as measured by the Fiat Money Quantity, and monthly bond-buying by the Fed. FMQ is unique in that it specifically seeks to measure the quantity of fiat money created on the back of gold originally given to the commercial banks by our forebears in return for money substitutes and deposit guarantees. This gold, in the case of Americans’ forebears, was then handed to the Fed by these commercial banks after the Federal Reserve System was created. Subsequently gold has always been acquired by the Fed in return for fiat dollars. FMQ is therefore the sum of cash plus instant access bank accounts and commercial bank assets held at the Fed.
The chart below shows monthly increases in the Fed’s asset purchases and of changes in FMQ.
The reason I take twice the monthly Fed purchases is that they are recorded twice in FMQ. The chart shows that the creation of fiat money continues without QE. That being the case, QE has less to do with stimulating the economy (which it has failed to do) and is more about funding government borrowing.
Thanks to the Fed’s monetary policies, which have encouraged an increase in demand for US Treasuries, the Federal government no longer has a problem funding its deficit. QE is therefore redundant, and has been since tapering was first mooted. This does not mean that QE is going to be abandoned forever: its re-introduction will depend on the relationship between the government’s borrowing needs and market demand for its debt.
This analysis is confirmed by Japan’s current situation. There, QE coincides with an economy that is deteriorating by the day. One cannot argue that QE has been good for the Japanese economy. The reality behind “abenomics” is that Japan’s government is funding a massive deficit at the same time as savers are drawing down capital to cover their day-to-day living requirements. In short, the funding gap is being covered by printing money. And now the collapsing yen, which is the inevitable consequence of monetary inflation, threatens to expose this folly.
On a final note, there appears to be complacency in capital markets about government deficits. A correction in bond markets will inevitably occur at some point and severely disrupt government fund-raising. If and when this occurs, and given that it is now obvious to everyone that QE does nothing for economic growth, it will be hard to re-introduce it as a disguised funding mechanism for governments without undermining market confidence.
After closing at 3.03% in December 2013 the yield on the 10-year US T-Note has been trending down, closing at 2.34% by August this year. Many commentators are puzzled by this given the optimistic forecasts for economic activity by Fed policy makers.
According to mainstream thinking the Central Bank is the key factor in determining interest rates. By setting short-term interest rates the Central Bank, it is argued, through expectations about the future course of its interest rate policy influences the entire interest rate structure.
Following the expectations theory (ET), which is popular with most mainstream economists, the long-term rate is an average of the current and expected short-term interest rates. If today’s one-year rate is 4% and next year’s one-year rate is expected to be 5%, the two-year rate today should be (4%+5%)/2 = 4.5%.
Note that interest rates in this way of thinking is set by the Central Bank whilst individuals in all this have almost nothing to do and just form mechanically expectations about the future policy of the Central Bank. (Individuals here are passively responding to the possible policy of the Central Bank).
Based on the ET and following the optimistic view of Fed’s policy makers on the economy some commentators hold that the market is wrong and long-term rates should actually follow an up-trend and not a down-trend.
According to a study by researchers at the Federal Reserve Bank of San Francisco (FRBSF Economic Letter – Assessing Expectations of Monetary Policy, 8 of September 2014) market players are wrongly interpreting the intentions of Fed policy makers. Market players have been underestimating the likelihood of the Fed tightening its interest rate stance much sooner than is commonly accepted given Fed officials’ optimistic view on economic activity.
It is held that a disconnect between public expectations and the expectations of central bank policy makers presents a challenge for Fed monetary policy as far as the prevention of disruptive side effects on the economy is concerned on account of a future tightening in the interest rate stance of the Fed.
We suggest that what matters for the determination of interest rates are individuals’ time preferences, which are manifested through the interaction of the supply and the demand for money and not expectations regarding short-term interest rates. Here is why.
The essence of interest rate determination
Following the writings of Carl Menger and Ludwig von Mises we suggest that the driving force of interest rate determination is individual’s time preferences and not the Central Bank.
As a rule people assign a higher valuation to present goods versus future goods. This means that present goods are valued at a premium to future goods.
This stems from the fact that a lender or an investor gives up some benefits at present. Hence the essence of the phenomenon of interest is the cost that a lender or an investor endures. On this Mises wrote,
That which is abandoned is called the price paid for the attainment of the end sought. The value of the price paid is called cost. Costs are equal to the value attached to the satisfaction which one must forego in order to attain the end aimed at.
According to Carl Menger:
To the extent that the maintenance of our lives depends on the satisfaction of our needs, guaranteeing the satisfaction of earlier needs must necessarily precede attention to later ones. And even where not our lives but merely our continuing well-being (above all our health) is dependent on command of a quantity of goods, the attainment of well-being in a nearer period is, as a rule, a prerequisite of well being in a later period……..All experience teaches that a present enjoyment or one in the near future usually appears more important to men than one of equal intensity at a more remote time in the future
Likewise according to Mises,
Satisfaction of a want in the nearer future is, other things being equal, preferred to that in the farther distant future. Present goods are more valuable than future goods.
Hence according to Mises,
The postponement of an act of consumption means that the individual prefers the satisfaction which later consumption will provide to the satisfaction which immediate consumption could provide.
For instance, an individual who has just enough resources to keep him alive is unlikely to lend or invest his paltry means.
The cost of lending, or investing, to him is likely to be very high – it might even cost him his life if he were to consider lending part of his means. So under this condition he is unlikely to lend, or invest even if offered a very high interest rate.
Once his wealth starts to expand the cost of lending, or investing, starts to diminish. Allocating some of his wealth towards lending or investment is going to undermine to a lesser extent our individual’s life and well being at present.
From this we can infer, all other things being equal, that anything that leads to an expansion in the real wealth of individuals gives rise to a decline in the interest rate i.e. the lowering of the premium of present goods versus future goods.
Conversely factors that undermine real wealth expansion lead to a higher rate of interest rate.
Time preference and supply demand for money
In the money economy individuals’ time preferences are realized through the supply and the demand for money.
The lowering of time preferences, i.e. lowering the premium of present goods versus future goods, on account of real wealth expansion, will become manifest in a greater eagerness to lend and invest money and thus lowering of the demand for money.
This means that for a given stock of money there will be now a monetary surplus.
To get rid of this monetary surplus people start buying various assets and in the process raise asset prices and lower their yields, all other things being equal.
Hence, the increase in the pool of real wealth will be associated with a lowering in the interest rate structure.
The converse will take place with a fall in real wealth. People will be less eager to lend and invest thus raising their demand for money relative to the previous situation.
This for a given money supply reduces monetary liquidity – a decline in monetary surplus. Consequently, all other things being equal this lowers the demand for assets and thus lowers their prices and raises their yields.
What will happen to interest rates as a result of an increase in money supply? An increase in the supply of money, all other things being equal, means that those individuals whose money stock has increased are now much wealthier.
Hence this sets in motion a greater willingness to invest and lend money.
The increase in lending and investment means the lowering of the demand for money by the lender and by the investor.
Consequently, an increase in the supply of money coupled with a fall in the demand for money leads to a monetary surplus, which in turn bids the prices of assets higher and lowers their yields.
As time goes by the rise in price inflation on account of the increase in money supply starts to undermine the well being of individuals and this leads to a general rise in time preferences.
This lowers individuals’ tendency for investments and lending i.e. raises the demand for money and works to lower the monetary surplus – this puts an upward pressure on interest rates.
We can thus conclude that a general increase in price inflation on account of an increase in money supply and a consequent fall in real wealth is a factor that sets in motion a general rise in interest rates whilst a general fall in price inflation in response to a fall in money supply and a rise in real wealth sets in motion a general fall in interest rates.
Explaining the fall in long-term interest rates
We suggest that an uptrend in the yearly rate of growth of our monetary measure AMS since October 2013 was instrumental in the increase in the monetary surplus. The yearly rate of growth of AMS jumped from 5.9% in October 2013 to 10.6% by March and 10.3% by June this year before closing at 7.6% in July.
Furthermore, the average of the yearly rate of growth of the consumer price index (CPI) since the end of 2013 to July this year has been following sideways trend and stood at 1.6%, which means a neutral effect on long-term yields from the price inflation perspective. Also the average of the yearly rate of growth of real GDP, which stood at 2.2% since 2013, has been following a sideways movement – a neutral effect on long term rates from this perspective.
Hence we can conclude that the rising trend in the growth momentum of money supply since October last year was instrumental in the decline in long-term rates.
Summary and conclusions
Since December 2013 the yields on long-term US Treasuries have been trending down. Many commentators are puzzled by this given the optimistic forecasts for economic activity by Fed policy makers. Consequently, some experts have suggested that market players have been underestimating the likelihood of the Fed tightening its interest rate stance much sooner than is commonly accepted. We hold that regardless of expectations what ultimately matters for the long-term interest rate determination are individuals’ time preferences, which is manifested through the interaction of the supply and the demand for money. We suggest that an up-trend in the yearly rate of growth of our monetary measure AMS since October 2013 has been instrumental in the increase in the monetary surplus. This in turn was the key factor in setting the decline in trend in long-term interest rates.
[Editor's note, this piece, by Richard Ebeling, is from EpicTimes]
It is an old adage that there are lies, damn lies and then there are statistics. Nowhere is this truer that in the government’s monthly Consumer Price Index (CPI) that tracks the prices for a selected “basket” of goods to determine changes in people’s cost-of-living and, therefore, the degree of price inflation in the American economy.
On August 19th, the Bureau of Labor Statistics (BLS) released its Consumer Price Index report for the month of July 2014. The BLS said that prices in general for all urban consumers only rose one-tenth of one percent for the month. And overall, for the last twelve months the CPI has only gone up by 2 percent.
A basket of goods that had cost, say, $100 to buy in June 2014 only cost you $100.10 in July of this year. And for the last twelve months as a whole, what cost you $100 to buy in August 2013, only increased in expense to $102 in July 2014.
By this measure, price inflation seems rather tame. Janet Yellen and most of the other monetary central planners at the Federal Reserve seem to have concluded, therefore, that they have plenty of breathing space to continue their aggressive monetary expansion when looking at the CPI and related price indices as part of the guide in deciding upon their money and interest rate manipulation policies.
Overall vs. “Core” Price Inflation
The government’s CPI statisticians distinguish between two numbers: the change in the overall CPI, which rose that 2 percent for the last year, and “core” inflation, which is the rate of change in the CPI minus food and energy prices. Leaving these out, “core” price inflation went up even less over the last twelve months, by only 1.9 percent.
The government statisticians make this distinction because they argue that food and energy prices are more “volatile” than many others. Fluctuating more frequently and to a greater degree than most other commonly purchased goods and services, they can create a distorted view, it is said, about the magnitude of price inflation during any period of time.
The problem is that food and energy costs may seem like irritating extraneous “noise” to the government number crunchers. But to most of the rest of us what we have to pay to heat our homes and put gas in our cars, as well as buying groceries to feed our families, is far from being a bothersome distraction from the statistical problem of calculating price inflation’s impact on our everyday lives.
Constructing the Consumer Price Index
How do the government statisticians construct the CPI? Month-by-month, the BLS tracks the purchases of 6,100 households across the country, which are taken to be “representative” of the approximately 320 million people living in the United States. The statisticians then construct a representative “basket” of goods reflecting the relative amounts of various consumer items these 6,100 households regularly purchase based on a survey of their buying patterns. They record changes in the prices of these goods in 24,000 retail outlets out of the estimated 3.6 million retail establishments across the whole country.
And this is, then, taken to be a fair and reasonable estimate – to the decimal point! – about the cost of living and the rate of price inflation for all the people of the United States.
Due to the costs of doing detailed consumer surveys and the desire to have an unchanging benchmark for comparison, this consumer basket of goods is only significantly revised about every ten years or so.
This means that over the intervening time it is assumed that consumers continue to buy the same goods and in the same relative amounts, even though in the real world new goods come on the market, other older goods are no longer sold, the quality of many goods are improved over the years, and changes in relative prices often result in people modifying their buying patterns.
The CPI vs. the Diversity of Real People’s Choices
The fact is there is no “average” American family. The individuals in each household (moms and dads, sons and daughters, and sometimes grandparents or aunts and uncles) all have their own unique tastes and preferences. This means that your household basket of goods is different in various ways from mine, and our respective baskets are different from everyone else’s.
Some of us are avid book readers, and others just relax in front of the television. There are those who spend money on regularly going to live sports events, others go out every weekend to the movies and dinner, while some save their money for an exotic vacation.
A sizable minority of Americans still smoke, while others are devoted to health foods and herbal remedies. Some of us are lucky to be “fit-as-a-fiddle,” while others unfortunately may have chronic illnesses. There are about 320 million people in the United States, and that’s how diverse are our tastes, circumstances and buying patterns.
Looking Inside the Consumer Price Index
This means that when there is price inflation those rising prices impact on each of us in different ways. Let’s look at a somewhat detailed breakdown of some of the different price categories hidden beneath the CPI aggregate of prices as a whole.
In the twelve-month period ending in July 2014, food prices in general rose 2.5 percent. A seemingly modest amount. However, meat, poultry, fish and egg prices increased, together, by 7.6 percent. But when we break this aggregate down, we find that beef and veal prices increased by 10.4 percent and frankfurters went up 6.9 percent, but lamb rose by only by 1.7 percent. Chicken prices increased more moderately at 2.7 percent, but fresh fish and seafood were 8.8 percent higher than a year earlier.
Milk was up 5.4 percent in price, but ice cream products decreased in price by minus 1.4 percent over the period. Fruits increased by 5.7 percent at the same time that fresh vegetable prices declined by minus 0.5 percent.
Under the general energy commodity heading, prices went up by 1.2 percent, but propane increased by 7.3 percent in price over the twelve-month period, while electricity prices, on the other hand, increased by 4 percent.
So why does the overall average of the Consumer Price Index seem so moderate at a measured 2 percent, given the higher prices of these individual categories of goods? Because furniture and bedding prices decreased by minus 3.1 percent, and major appliances declined in price over the period by minus 6.2. New televisions went down a significant minus15 percent
In addition, men’s apparel went down a minus 0.2 percent over the twelve months, but women’s outerwear rose a dramatic 12.3 percent in the same time frame. And boys and girls footwear went up, on average, by 8.2 percent.
Medical care services, in general, rose by 2.5 percent, but inpatient and outpatient hospital services increased, respectively, by 6.8 percent and 5.6 percent.
Smoke and Mirrors of “Core” Inflation
These subcategories of individual price changes highlight the smoke and mirrors of the government statisticians’ distinction between overall and “core” inflation. We all occasionally enter the market and purchase a new stove or a new couch or a new bedroom set. And if the prices for these goods happen to be going down we may sense that our dollar is going further than in the past as we make these particular purchases.
But buying goods like these is an infrequent event for virtually all of us. On the other hand, every one of us, each and every day, week or month are in the marketplace buying food for our family, filling our car with gas, and paying the heating and electricity bill. The prices of these goods and other regularly purchased commodities and services, in the types and combinations that we as individuals and separate households choose to buy, are what we personally experience as a change in the cost-of-living and a rate of price inflation (or price deflation).
The Consumer Price Index is an artificial statistical creation from an arithmetic adding, summing and averaging of thousands of individual prices, a statistical composite that only exists in the statistician’s calculations.
Individual Prices Influence Choices, Not the CPI
It is the individual goods in the subcategories of goods that we the buying public actually confront and pay when we shop as individuals in the market place. It is these individual prices for the tens of thousands of actual goods and services we find and decide between when we enter the retail places of business in our daily lives. And these monetary expenses determines for each of us, as individuals and particular households, the discovered change in the cost-of-living and the degree of price inflation we each experience.
The vegetarian male who is single without children, and never buys any types of meat, has a very different type of consumer basket of goods than the married male-female couple who have meat on the table every night and shop regularly for clothes and shoes for themselves and their growing kids.
The individual or couple who have moved into a new home for which they have had to purchase a lot of new furniture and appliances will feel that their income has gone pretty far this past twelve months compared to the person who lives in a furnished apartment and has no need to buy a new chair or a dishwasher but eats beef or veal three times a week.
If the government were to impose a significant increase in the price of gasoline in the name of “saving the planet” from carbon emissions, it will impact people very differently depending up whether an individual is a traveling salesman or a truck driver who has to log hundreds or thousands of miles a year, compared to a New Yorker who takes the subway to work each day, or walks to his place of business.
It is the diversity of our individual consumer preferences, choices and decisions about which goods and services to buy now and over time under constantly changing market conditions that determines how each of us are influenced by changes in prices, and therefore how and by what degree price inflation or price deflation may affect each of us.
Monetary Expansion Distorts Prices in Different Ways
An additional misunderstanding created by the obsessive focus on the Consumer Price Index is the deceptive impression that increases in the money supply due to central bank monetary expansion tend to bring about a uniform and near simultaneous rise in prices throughout the economy, encapsulated in that single monthly CPI number.
In fact, prices do not all tend to rise at the same time and by the same degree during a period of monetary expansion. Governments and their central banks do not randomly drop newly created money from helicopters, more or less proportionally increasing the amount of spending power in every citizen’s pockets at the same time.
Newly created money is “injected” into the economy at some one or few particular points reflecting into whose hands that new money goes first. In the past, governments might simply print up more banknotes to cover their wartime expenditures, and use the money to buy armaments, purchase other military supplies, and pay the salaries of their soldiers.
The new money would pass into the hands of those selling those armaments or military supplies or offering their services as warriors. These people would spend the new money on the particular goods and services they found desirable or profitable to buy, raising the demands and prices for a second group of prices in the economy. The money would now pass to another group of hands, people who in turn would now spend it on the market goods they wanted to demand.
Step-by-step, first some demands and some prices, and then other demands and prices, and then still other demands and prices would be pushed up in a particular time-sequence reflecting who got the money next and spent in on specific goods, until finally more or less all prices of goods in the economy would be impacted and increased, but in a very uneven way over time.
But all of these real and influencing changes on the patterns of market demands and relative prices during the inflationary process are hidden from clear and obvious view when the government focuses the attention of the citizenry and its own policy-makers on the superficial and simplistic Consumer Price Index.
Money Creation and the Boom-Bust Cycle
Today, of course, virtually all governments and central banks inject new money into the economy through the banking system, making more loanable funds available to financial institutions to increase their lending ability to interested borrowers.
The new money first passes into the economy in the form of investment and other loans, with the affect of distorting the demands and prices for resources and labor used in capital projects that might not have been undertaken if not for the false investment signals the monetary expansion generates in the banking and financial sectors of the economy. This process sets in motion the process that eventually leads to the bust that follows the inflationary bubbles.
Thus, the real distortions and imbalances that are the truly destabilizing effects from central banking inflationary monetary policies are hidden from the public’s view and understanding by heralding every month the conceptually shallow and mostly superficial Consumer Price Index.
What is Super Mario up to?
First, he gave an unexpectedly dovish speech at the Jackson Hole conference, rather ungallantly upstaging the host, Ms Yellen, who was widely anticipated to be the most noteworthy speaker at the gathering (talking about the labor market, her favorite subject). Having thus single-handedly and without apparent provocation raised expectations for more “stimulus” at last week’s ECB meeting, he then even exceeded those expectations with another round of rate-cuts and confirmation of QE in form of central bank purchases of asset-backed securities.
These events are significant not because they are going to finally kick-start the Eurozone economy (they won’t) but because 1) they look rushed, and panicky, and 2) they must clearly alienate the Germans. The ideological rift that runs through the European Union is wide and deep, and increasingly rips the central bank apart. And the Germans are losing that battle.
As to 1), it was just three months ago that the ECB cut rates and made headlines by being the first major central bank to take a policy rate below zero. Whatever your view is on the unfolding new Eurozone recession and the apparent need for more action (more about this in a minute), the additional 0.1 percent rate reduction will hardly make a massive difference. Yet, implementing such minor rate cuts in fairly short succession looks nervous and anxious, or even headless. This hardly instils confidence.
And regarding the “unconventional” measures so vehemently requested by the economic commentariat, well, the “targeted liquidity injections” that are supposed to direct freshly printed ECB-money to cash-starved corporations, and that were announced in June as well, have not even been implemented yet. Apparently, and not entirely unreasonably, the ECB wanted to wait for the outcome of their “bank asset quality review”. So now, before these measures are even started, let alone their impact could even be assessed, additional measures are being announced. The asset purchases do not come as a complete surprise either. It was known that asset management giant BlackRock had already been hired to help the ECB prepare such a program. Maybe the process has now been accelerated.
This is Eurozone QE
This is, of course, quantitative easing (QE). Many commentators stated that the ECB shied away from full-fledged QE. This view implies that only buying sovereign debt can properly be called QE. This does not make sense. The Fed, as part of its first round of QE in 2008, also bought mortgage-backed securities only. There were no sovereign bonds in its first QE program, and everybody still called it QE. Mortgage-backed securities are, of course, a form of asset-backed security, and the ECB announced purchases of asset-backed securities at the meeting. This is QE, period. The simple fact is that the ECB expands its balance sheet by purchasing selected assets and creating additional bank reserves (for which banks will now pay the ECB a 0.2 percent p.a. “fee”).
As to 2), not only will the ECB decisions have upset the Germans (the Bundesbank’s Mr. Weidmann duly objected but was outvoted) but so will have Mr. Draghi’s new rhetoric. In Jackson Hole he used the F-word, as in “flexibility”, meaning fiscal flexibility, or more fiscal leeway for the big deficit countries. By doing so he adopted the language of the Italian and French governments, whenever they demand to be given more time for structural reform and fiscal consolidation. The German government does not like to hear this (apparently, Merkel and Schäuble both phoned Draghi after Jackson Hole and complained.)
The German strategy has been to keep the pressure on reform-resistant deficit-countries, and on France and Italy in particular, and to not allow them to shift the burden of adjustment to the ECB. Draghi has now undermined the German strategy.
The Germans fear, not quite unjustifiably, that some countries always want more time and will never implement reform. In contrast to those countries that had their backs to the wall in the crisis and had little choice but to change course in some respect, such as Greece, Ireland, and Spain, France and Italy have so far done zilch on the structural reform front. France’s competitiveness has declined ever since it adopted the 35-hour workweek in 2000 but the policy remains pretty much untouchable. In Italy, Renzi wants to loosen the country’s notoriously strict labour regulations but faces stiff opposition from the trade unions and the Left, not least in his own party. He now wants to give his government three years to implement reform, as he announced last week.
Draghi turns away from the Germans
German influence on the ECB is waning. It was this influence that kept alive the prospect of a somewhat different approach to economic challenges than the one adopted in the US, the UK and, interestingly, Japan. Of course, the differences should not be overstated. In the Eurozone, like elsewhere, we observed interest rate suppression, asset price manipulations, and massive liquidity-injections, and worse, even capital controls and arbitrary bans on short-selling. But we also saw a greater willingness to rely on restructuring, belt-tightening, liquidation, and, yes, even default, to rid the system of the deformations and imbalances that are the ultimate root causes of recessions and the impediments to healthy, sustainable growth. In the Eurozone it was not all about “stimulus” and “boosting aggregate demand”. But increasingly, the ECB looks like any other major central bank with a mandate to keep asset prices up, government borrowing costs down, and a generous stream of liquidity flowing to cover the cracks in the system, to sustain a mirage of solvency and sustainability, and to generate some artificial and short-lived headline growth. QE will not only come to the Eurozone, it will become a conventional tool, just like elsewhere.
I believe it is these two points, Draghi’s sudden hyperactivity (1) and his clear rift with the Germans and his departure from the German strategy (2) that may explain why the euro is finally weakening, and why the minor announcements of last Thursday had a more meaningful impact on markets than the similarly minor announcements in June. With German influence on the ECB waning, trashing your currency becomes official strategy more easily, and this is already official policy in Japan and in the US.
Is Draghi scared by the weak growth numbers and the prospect of deflation?
Maybe, but things should be put in perspective.
Europe has a structural growth problem as mentioned above. If the structural impediments to growth are not removed, Europe won’t grow, and no amount of central bank pump priming can fix it.
Nobody should be surprised if parts of Europe fall into technical recessions every now and then. If “no growth” is your default mode then experiencing “negative growth” occasionally, or even regularly, should not surprise anyone. Excited talk about Italy’s shocking “triple-dip” recession is hyperbole. It is simply what one should expect. Having said this, I do suspect that we are already in another broader cyclical downturn, not only in Europe but also in Asia (China, Japan) and the UK.
The deflation debate in the newspapers is bordering on the ridiculous. Here, the impression is conveyed that a drop in official inflation readings from 0.5 to 0.3 has substantial information content, and that if we drop below zero we would suddenly be caught in some dreadful deflation-death-trap, from which we may not escape for many years. This is complete hogwash. There is nothing in economic theory or in economic history that would support this. And, no, this is not what happened in Japan.
The margin of error around these numbers is substantial. For all we know, we may already have a -1 percent inflation rate in the Eurozone. Or still plus 1 percent. Either way, for any real-life economy this is broadly price-stability. To assume that modest reductions in any given price average suddenly mean economic disaster is simply a fairy tale. Many economies have experienced extended periods of deflation (moderately rising purchasing power of money on trend) in excess of what Japan has experienced over the past 20 years and have grown nicely, thank you very much.
As former Bank of Japan governor Masaaki Shirakawa has explained recently, Japan’s deflation has been “very mild” indeed, and may have had many positive effects as well. In a rapidly aging society with many savers and with slow headline growth it helped maintain consumer purchasing power and thus living standards. Japan has an official unemployment rate of below 4 percent. Japan has many problems but deflation may not be one of them.
Furthermore, the absence of inflation in the Eurozone is no surprise either. There has been no money and credit growth in aggregate in recent years as banks are still repairing their balance sheets, as the “asset quality review” is pending, and as other regulations kick in. Banks are reluctant to lend, and the private sector is careful to borrow, and neither are acting unreasonably.
Expecting Eurozone inflation to clock in at the arbitrarily chosen 2 percent is simply unrealistic.
Draghi’s new activism moves the ECB more in the direction of the US Fed and the Bank of Japan. This alienates the Germans and marginally strengthens the position of the Eurozone’s Southern periphery. This monetary policy will not reinvigorate European growth. Only proper structural reform can do this but much of Europe appears unable to reform, at least without another major crisis. Fiscal deficits will grow.
Monetary policy is not about “stimulus” but about maintaining the status quo. Super-low interest rates are meant to sustain structures that would otherwise be revealed to be obsolete, and that would, in a proper free market, be replaced. The European establishment is interested in maintaining the status quo at all cost, and ultra-easy monetary policy and QE are essentially doing just that.
Under the new scheme of buying asset-backed securities, the ECB’s balance sheet will become a dumping ground for unwanted bank assets (the Eurozone’s new “bad” bank). Like almost everything about the Euro-project, this is about shifting responsibility, obscuring accountability, and socializing the costs of bad decisions. Monetary socialism is coming. The market gets corrupted further.
The following is a commentary I wrote for The Forum section of London business-paper City A.M. The link is here.
It is now six years since the collapse of Lehman Brothers, and considering that the US economy has officially been in recovery for the past five years, that equity indexes have put in new all-time highs, and that credit markets are once again ebullient to the point of carelessness, it is worth contemplating that monetary policy remains stuck in pedal-to-the-floor stimulus mode. Granted, quantitative easing is (once again) scheduled to end, and the first rates hikes are now expected for next year, but the present policy stance certainly remains highly accommodative. A full ‘exit’ by the Fed is still merely a prospect.
Expectations appear to be for the US economy to finally emerge from its long stay in monetary intensive care healthier and fit for self-sustained, if modest, growth. I think this is unlikely. The lengthy period of monetary stimulus will have saddled the economy with new dislocations. And if central bank intervention did indeed manage to arrest the forces of liquidation that the crisis had unleashed, then some old imbalances will also still hang around.
“Easy money” is – contrary to how it is frequently portrayed – not some tonic that simply lifts the general mood and boosts all economic activity proportionally. Monetary stimulus is always a form of market intervention. It changes relative prices (as distinguished from the ‘price level’ that most economists obsess about); it alters the allocation of scarce resources and the direction of economic activity. Monetary policy always affects the structure of the economy – otherwise no impact on real activity could be generated. It is a drug with considerable side effects.
The latest crisis should provide a warning. As David Stockman pointed out, it did not arrive on a meteor from space, but had its origin in distortions in the housing market in the US – and the UK, Spain and Ireland – and in related credit markets, and therefore ultimately in the “easy money” policies of the early 2000s. Administratively suppressing short rates down to 1 percent for a prolonged period was then the “unconventional” policy du jour, and it was a success of sorts. A credit crunch and deleveraging were indeed avoided, which were then feared as a consequence of WorldCom and Enron defaulting and the dot.com-bubble bursting, but only at the price of blowing an even bigger bubble elsewhere.
This is the problem with our modern fiat money system. With the supply of money no longer constrained by a nature-given, scarce commodity (gold or silver), but now fully elastic, essentially unlimited, and under the control of a lender of last resort central bank, the parameters of risk-taking are forever altered.
Allegedly, we can now stop bank-runs and ignite short-term growth spurts, or keep the overall “price level” advancing on some arbitrarily chosen path of 2 percent. But we can achieve all of this only through monetary manipulations that must create imbalances in the economy. And as the overwhelming temptation is now to use “easy money” to avoid or shorten any period of liquidation, to go for all growth and no correction, distortions will accumulate over time.
As we move from cycle to cycle, the imbalances get bigger, asset valuations become more stretched, the debt load rises, and central banks take policy to new extremes to arrest the market’s growing desire for a much needed cleansing. That policy rates around the world have converged on zero is not a cyclical but a structural phenomenon.
Central bank stimulus is not leading to virtuous circles but to vicious ones. How can we get out? – Only by changing our attitudes to monetary interventions fundamentally. Only if we accept that interest rates are market prices, not policy levers. Only if we accept that the growth we generate through cheap credit and interest-rate suppression is always fleeting, and always comes at the price of new capital misallocations.
The prospect for such a change looks dim at present. Last year’s feverish excitement about Abenomics and this year’s urgent demands for Eurozone QE show that the belief in central bank activism is unbroken, and I remain sceptical as to whether the Fed and the Bank of England can achieve a proper and lasting “exit” from ultra-loose policy in this environment. The near-term outlook is for more heavy-handed interventions everywhere, and the endgame is probably inflation. This will end badly.