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That G20 meeting

G20 gatherings of world leaders on the surface are all the same: they conclude with a meaningless anodyne statement that everyone can agree with. But these meetings do serve a purpose: they allow the world leaders to meet informally and exchange views.

Since the last G20 in St Petersburg in 2013 when there was a high degree of conviction that economic growth would return, the global economic outlook has instead deteriorated significantly. Instead of last time’s mutual bonhomie over the prospect of their collective success, the world’s leaders this time are almost certainly worried. They would have learned about the failure of monetary policy everywhere. They would have had this first-hand from Japan’s delegation, which is on its way to financial and currency destruction. The despair in the European delegations would have been obvious as well.

The problem is that post-war monetary theories have failed to deliver. Lower interest rates and increased quantities of money in order to promote economic growth no longer work. The abandonment of the laws of the markets in favour of stimulating consumer demand by monetary means has turned out to be a blind alley. Time will tell, but if the global economy is heading for a slump, the banking system will become overburdened with defaulting borrowers, and government deficits will rise uncontrollably, especially in the welfare nations. This cannot be permitted to happen under any circumstances. It is therefore quite likely that the alternative to monetary-driven policy, accelerated government deficit spending as a pre-emptive measure, will be tried instead. And in this respect the relative success of the British and American economies will be attributed to their large budget deficits, while the misery of austerity is identified with the problems in France and the southern Eurozone.

These are bad and confused arguments, but they will be emotionally attractive to the political class, while the central bankers probably feel it is time the politicians took responsibility for economic management. Furthermore, it is surely becoming obvious that monetary solutions only enrich the bankers. And the most effective way of countering deflation, economists will argue, will be for demand-led price rises for consumer products, which have a better chance of coming about through increased government spending. And do not be surprised if economists argue that governments need to take over the debt-creation process to kick-start the business cycle.

We might look back on Brisbane as a milestone in global economic policy, when governments and central banks changed the emphasis of economic management from monetary stimulation through the financial system towards a greater emphasis on direct government intervention. In the process two things are likely to happen: currencies will begin to lose their purchasing power with respect to everyday goods, and government bond yields are likely to rise, undermining financial asset valuations.

This will certainly puff up GDP, because government spending is a significant part of it. But the idea that controlled price inflation can be engineered flies in the face of all experience. If the emphasis does shift from monetary solutions towards more aggressive government spending the risk will also shift towards an uncontrollable decline in purchasing power for currencies. It will be very good for inflation hedges like gold.

Money

Understanding the Money Creation and Society Debate

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

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

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

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

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

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

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

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

Price Index 1750-2003

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

M4: 1982-2014

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

Sectoral lending

As I said in debate on 6 Dec 2011:

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

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

Further reading:

Money

The Future of Bitcoin

Later today, I will be speaking at this year’s Cato Annual Monetary Conference in Washington, DC. The theme of this year’s conference is positively eye-watering for proponents of private money: “Alternatives to Central Banking: Toward Free-Market Money.” I will be speaking on the first session, “The Bitcoin Revolution”. So will I be expanding on how bitcoin will revolutionise money and change the world as we know it? Well, not exactly. My topic is: Bitcoin will bite the dust. Bitcoin will collapse, and probably soon.

The core of the argument is simple. To work as intended, the Bitcoin system requires atomistic competition on the part of the ‘miners’ who validate transactions blocks in their search for newly minted bitcoins. However, the mining industry is characterized by large economies of scale. In fact, these economies of scale are so large that the industry is a natural monopoly. The problem is that atomistic competition and a natural monopoly are inconsistent: the inbuilt centralization tendencies of the natural monopoly mean that mining firms will become bigger and bigger – and eventually produce an actual monopoly unless the system collapses before then. The implication is that the Bitcoin system is not sustainable. Since what cannot go on will stop, one must conclude that the Bitcoin system will inevitably collapse. The only question is when.

I could go on at length about how this centralizing tendency will eventually destroy every single component of the Bitcoin value proposition, knocking them down like a row of dominos: the first domino to fall will be distributed trust, Bitcoin’s most notable attraction; instead, the system will come to depend on trust in the dominant player not to abuse its power. This player will become a point of failure for the system as whole, so the ‘no single point of failure’ feature of the system will also disappear. Then anonymity will go, as the dominant player will be forced to impose the usual anti-anonymity regulations justified as means to stop money laundering and such like, but in reality intended to destroy financial privacy. Even the Bitcoin protocol, the constitution of the system, will eventually be subverted. Every component of the Bitcoin value proposition will be destroyed. For bitcoin users and investors, there will be no reason to stay with the system. Plus the large mining pools, or at least one of them, are already a major threat to the system and the system has no effective way of dealing with this threat.

The whole thing is a house of cards: there will be nothing left within the system to maintain confidence in the system. If you have money invested in Bitcoin, best get out now before it collapses, because collapse it will.

Before going further, let me stress that I have not changed my support for private money one jot: researching and promoting private money has been my life’s work. Am I against Bitcoin? No. I just don’t think it is unsustainable. Am I against the alt currencies, the blockchain etc? Not at all. For the record: I support all experimentation in the private money space. My point is that some experiments will fail, and Bitcoin will be one of them.

Informal feedback on my and Martin Hutchinson’s paper on which the presentation is based leaves me in no doubt that our message will provoke outrage amongst the more extreme Bitcoiners: indeed, it already has. We have no axe to grind against Bitcoin and no desire to offend the Bitcoin lunatic fringe. However, one has to follow the logic of one’s argument as one sees it: Hier stehe ich, ich kann nicht anders. If others disagree, well, that’s just the way it is.

I would ask everyone involved in this controversy to note that Martin and I are making a prediction, made before the event: Bitcoin will bite the dust. The more extreme Bitcoiners say it won’t: they say that Bitcoin will reach the moon. They are welcome to their views, but only one side of this argument is going to be proven right. So let’s wait and see who is right and who gets egg on their face. If we have to eat humble pie afterwards, then so be it, but we don’t think so.

Our best guess is that we are facing a mass extinction in the cryptocurrency ecosystem. However, the competition for market share will continue and we expect that that ecosystem will soon repopulate. If the experience of life on earth offers any guide, we could expect to see such cycles of proliferation and extinction occurring again and again. For all we know, cryptocurrencies might still be in their Ediacaran Period, when a wonderful diversity of multicellular life had first colonized the seas, but many of these organisms are about to become extinct. No, correction: many of the alts have already bitten the dust – the mass extinction is well under way.

The undeniable achievement of Bitcoin is that it demonstrates the practical possibility of fully decentralized monetary systems based on the principle of distributed trust rather than central authority: it shows that they can fly, but the problem is that it does not demonstrate that they can stay in the air for too long. Where Bitcoin falls short is that its model is not sustainable thanks to the contradiction between the decentralization on which it depends to work properly and its inbuilt tendencies toward centralization. I therefore regard Bitcoin as an instructive creative failure, but I am hopeful that the lessons to be drawn from its impending demise will lead to superior cryptocurrencies that are free of its major design flaws. Designing such systems would be a challenge worthy of a new Satoshi Nakamoto – or possibly the old one if he is still out there somewhere and looking to complete the project that he didn’t quite get right the first time.

Pity about the conference date though. Had the conference been yesterday, I could have gone dressed as Guy Fawkes or a Catherine wheel.

Money

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become ‘profiteers,’ who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. … Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.

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

Originating at Forbes.com: http://www.forbes.com/sites/ralphbenko/2014/09/30/the-rise-and-fall-and-rise-and-fall-of-king-dollar-part-2/

Money

The Rise And Fall And Rise And Fall Of King Dollar, Part 1

The Wall Street Journal, recently, in The Return of the Greenback, observed that “the resurgent dollar has logged its longest winning streak in 17 years, rising against a broad basket of currencies for nine straight weeks.”  This has led to, perhaps irrational, exuberance from supply side titans Larry Kudlow and Steve Moore.

Cheapening the dollar is a bad thing, unequivocally.  It does not necessarily follow that making the dollar dearer is a good thing.  And there is a frequently unnoticed factor at work: the dollar’s status as the world reserve currency.  Dr. Jared Bernstein, senior fellow with the Center on Budget and Policy Priorities, and, previously, chief economist to Vice President Biden and executive director of the White House Task Force on the Middle Class, boldly claims that the dollar’s reserve currency status has cost America 6 million jobs.  This is a startling, and potentially important, claim.

We live in a world monetary system that makes the U.S. dollar its official reserve currency.  About 60%  of international central bank reserves are Yankee dollars. Some, both right and left, in America and abroad, consider the reserve currency status of the dollar a bug in the software of our world monetary system. Getting this fixed is, in the opinion of some consequential thinkers, of capital importance for the generation of quality jobs, and equitable prosperity, in America and the world.

The reserve currency status of the dollar, particularly as a potential factor in wage stagnation, has profound political implications.  Dispirited voters yearn for leadership that actually understands how to get the economic tide to lift all boats again.  Notwithstanding his promotion of some marked policy differences with this columnist, this columnist says three cheers for Dr. Bernstein for squarely pushing the reserve currency question into play.

Dr. Bernstein stirred up a healthy argument in an August New York Times op-ed entitled Dethrone ‘King Dollar.’  Bernstein:

[T]he new research reveals that what was once a privilege is now a burden, undermining job growth, pumping up budget and trade deficits and inflating financial bubbles. To get the American economy on track, the government needs to drop its commitment to maintaining the dollar’s reserve-currency status.

Bernstein draws on an interesting, and thoughtful, paper by economist Kenneth Austin in The Journal of Post Keynesian Economics. Austin dramatically illustrates the explosion of international dollar reserves and explores the possible significance to our economy.  Bernstein performs a signal public service by placing this into the policy discourse. Bernstein:

Mr. Austin argues convincingly that the correct metric for estimating the cost in jobs is the dollar value of reserve sales to foreign buyers. By his estimation, that amounted to six million jobs in 2008, and these would tend to be the sort of high-wage manufacturing jobs that are most vulnerable to changes in exports.

Bernstein’s proposal drew a tart riposte at Café Hayek from Don Boudreaux and another from the Heritage Foundation’s Daily Signal by Bryan Riley and William Wilson. 

Shortly after Bernstein’s proposed dethroning of ‘King Dollar’ Larry Kudlow and Steve Moore, in their NRO column, joyfully celebrated The Return of King Dollar:

[W]hen the dollar crashed in the 1970s — especially relative to gold — the economy collapsed into a crippling stagflation. From 1999 to 2009, the dollar index dropped by almost 40 percent, with only a brief surge between 2004 and 2006. The economy and wages were sluggish at best.

The relationship between a strong currency and prosperity is lost on the many nations that adhere to the mercantilist model whereby a devalued currency supposedly gives a country a competitive edge by making exports cheaper. …

Kudlow and Moore deserve praise for their opposition to cheapening the dollar.  That said, cheering on a “strong” dollar intellectually is akin to calling for a longer inch or a heavier ounce as a recipe to — magically — make us richer.

No.  What is needed is a high integrity, meticulously defined, dollar.

A dollar at the mercy of a freelancing Fed, subject to being whipsawed in value, up or down, is a barrier to commerce.  Money, by definition, is a medium of exchange, a store of value and — not be overlooked — a unit of account.  There are many empirical data tending to show that only by meticulously maintaining the definition of the unit — for example, by defining the dollar by grains of gold and making it legally convertible thereunto — can good job creation, and equitable prosperity, consistently be achieved.

There is a deep, fascinating, historical context.  It extends even to the use of the regal metaphor.  Therein rests an irony wrapped in a controversy inside some history.

The history? Keynes employed a regal metaphor (applied to gold rather than currency) in his 1930 tract Auri Sacra Fames in which he writes

… gold, originally stationed in heaven with his consort silver, as Sun and Moon, having first doffed his sacred attributes and come to earth as an autocrat, may next descend to the sober status of a constitutional king with a cabinet of Banks….

The irony? Keynes explicitly mistrusted the Fed.  Keynes did not wish to endow the U.S. Federal Reserve with the power that, under then-prevailing circumstances which no longer need apply, a return to the gold standard would have entailed.  Keynes, in his 1923 essay, Alternative Aims In Monetary Policy:

It would be rash in present circumstances to surrender our freedom of action to the Federal Reserve Board of the United States. We do not yet possess sufficient experience of its capacity to act in times of stress with courage and independence. The Federal Reserve Board is striving to free itself from the pressure of sectional interests; but we are not yet certain that it will wholly succeed. It is still liable to be overwhelmed by the impetuosity of a cheap money campaign.

Keynes expressed wariness of the risk of currency depreciation (better known as inflation). Sure enough, eventually the Federal Reserve indeed became “overwhelmed by the impetuosity of a cheap money campaign.”  The Fed cheapened its product — Federal Reserve Notes — by 85% since 1971 (and by about 95% since the Fed’s inception).

A dollar today is worth a 1913 nickel and a 1971 nickel and dime.  This gives a whole new meaning to the phrase “nickeled and dimed to death.”

Cheapening of money is very bad for business.  It is really, really, terrible for labor.  Ron Paul, call your office: Keynes proved quite right to be dubious about the Fed.

Why do so few of the economists who exalt Keynes share his tough-mindedness toward the Fed?  Why do so few grasp the irony of their mesmerized adulation of an institution with such a mediocre (and sometimes catastrophic) track record? Many acorns have fallen far from the tree.

One of the factors in play involves one of the standard tropes of mercantilism, to which Kudlow and Moore allude: the intentional depreciation of a national currency to gain unfair trade advantage.  This is what classically was called a “beggar-thy-neighbor” policy.  The neighbor, in this instance, is America. Forbes Media chairman, and Editor-in-Chief, Steve Forbes, and Forbes.com columnist Nathan Lewis, both gold standard advocates, are zealous critics of mercantilism (as is this columnist).

Steve Forbes (with Elizabeth Ames) in their recent book Money: How the Destruction of the Dollar Threatens the Global Economy and What We Can Do About It observes:

The neo-mercantilists of the twentieth century may have thought that floating exchange rates would allow countries to correct perceived imbalances with their rivals and bolster their domestic economies.  But the monetary system they created was more volatile than the one they had destroyed, with balance harder than ever to achieve.

The turmoil of the post-Bretton Woods era is what sent European nations scurrying for the shelter of a stable currency, setting the stage for the euro.  The explosion of currency trading it has wrought has become a huge source of fees for banks.  It has helped produce the market swings and giant windfalls so decried by Occupy Wall Street and others.  In this dangerous world, monetary policy is deployed as a frequent weapon, nearly always with destructive consequences.”

Nathan Lewis writes, in his Forbes.com column Keynes and Rothbard Agree: Today’s Economics is Mercantilism:

All of today’s premier economic policies, notably monetary manipulation and floating fiat currencies, attempts to “manage the economy” via government deficit spending, and the never-ending concern over “imbalances” in trade, are straight-up Mercantilism.

We really won’t make much progress in our economic understanding until this is recognized. The entirety of today’s Mercantilist agenda should be discarded; first, at an intellectual level, and then at the level of public policy. Britain did this, and went from an economic backwater overshadowed by tiny Holland, to the birthplace of the Industrial Revolution and the center of the largest empire of the nineteenth century.

Forbes and Lewis are skeptical about the power of manipulating currency to achieve trading advantage.  The intramural dispute among gold standard advocates around the current account, however, is of mostly academic significance.  The respective camps respectfully agree as to most of the disorders caused by paper money.  They agree that the remedy to our “Little Dark Age” of wage stagnation lies in the definition of the dollar by gold.

Businessman/scholar Lewis E. Lehrman, founder and chairman of the Lehrman Institute (whose monetary policy website this columnist professionally edits) too is an outspoken critic of mercantilism.  Lehrman is the leader of a group of thinkers influenced by the works of his mentor Jacques Rueff, influential French monetary official, public intellectual (Mont Pelerin society member), and iconic classical gold standard advocate.

As for the unjustly obscure Rueff, keen monetary observer Robert Pringle, author of The Money Trap states in his influential blog of the same name:

[Rueff] would have predicted the Global Financial Crisis and economic catastrophe of the past seven years – and would certainly have attributed it to the absence of an international monetary system worth the name. He would have been equally critical of the flawed construction of the euro.

He saw that the globalizing trading regime was fundamentally at odds with mercantilist monetary and exchange rate policies: one aspired to universality and openness, the other pointed to particularization and separation.

More generally, monetary nationalism, unleashed by the absence of a global standard for money, is inconsistent with a liberal order.

Reserve currency status of the dollar, the more emphatically when the dollar is not defined by and redeemable in a fixed weight of gold, is a form of monetary nationalism inconsistent with a liberal order.  And according to Bernstein reserve currency status also is costing millions of jobs.

What are some of the costs of the “exorbitant privilege” as the dollar’s reserve currency status was called by then finance minister of France Valery Giscard d’Estaing?  Ought now America to give the exorbitant privilege a gold watch and send it into retirement?

To be continued.

Originating at Forbes.com: http://www.forbes.com/sites/ralphbenko/2014/09/29/the-rise-and-fall-and-rise-and-fall-of-king-dollar-part-1/

Money

End the Fed’s War on Paychecks

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…

English: Official picture of Janet Yellen from...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 QuartzJanet 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.

Money

The end of tapering and government funding

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.

Fed Asset Purchase

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.

Economics

A difficult question

In a radio interview recently* I was asked a question to which I could not easily give a satisfactory reply: if the gold market is rigged, why does it matter?
I have no problem delivering a comprehensive answer based on a sound aprioristic analysis of how rigging markets distorts the basis of economic calculation and why a properly functioning gold market is central to all other financial prices. The difficulty is in answering the question in terms the listeners understand, bearing in mind I was told to assume they have very little comprehension of finance or economics.
I did not as they say, want to go there. But it behoves those of us who argue the economics of sound money to try to make the answer as intelligible as possible without sounding like a committed capitalist and a conspiracy theorist to boot, so here goes.

Manipulating the price of gold ultimately destabilises the financial system because it is the highest form of money. This is why nearly all central banks retain a holding. The fact we don’t use it as money in our daily business does not invalidate its status. Rather, gold is subject to Gresham’s Law, which famously states bad money drives out the good. We would rather pay for things in government-issue paper currency and hang on to gold for a rainy day.

As money, it is on the other side of all asset prices. In other words stocks, bonds and property prices can be expected to rise measured in gold when the gold price falls and vice-versa. This relationship is often muddled by other factors, the most obvious one being changing levels of confidence in paper currencies against which gold is normally priced. However, with bond yields today at record lows and equities at record highs this relationship is apparent today.

Another way to describe this relationship is in terms of risk. Banks which dominate asset markets become complacent about risk because they are greedy for profit. This leads to banks competing with one another until they end up ignoring risk entirely. It happened very obviously with the American banking crisis six years ago until house prices suddenly collapsed, threatening to take the whole financial system down. In common with all financial bubbles everyone ignored risk. History provides many other examples.

Therefore, gold is unlike other assets because a rising gold price reflects an increasing perception of general financial risk, ensuring downward pressure on other financial asset prices. So while the big banks are making easy money ignoring risks in equity and bond markets, they will not want their party spoiled by warning signs from a rising gold price.

This is a long way from proof that the gold market is manipulated. But the big banks, and we must include central banks which are obviously keen to maintain financial confidence, have the motive and the means. And if they have these they can be expected to take the opportunity.

So why does it matter if the gold price is rigged? A freely-determined gold price is central to ensuring that reality and not financial bubbles guides us in our financial and economic activities. Suppressing the gold price is rather like turning off a fire alarm because you can’t stand the noise.

*File on 4: BBC Radio4 due to be broadcast on 23 September at 8.00pm UK-time and repeated on 28 September at 5.00pm.

Economics

Bank Run Incentive, Central Bank Bankruptcy, and The Fallacy of the Credit Theory of Money

[Editor’s Note: this is from the World Dollar Foundation, and can be found here]
Part 1: The Bank Run Incentive

There is an incentive to start bank runs due to a) the fallacy of fractional-reserve banking, and b) the fallacy of deposit “guarantees”.

A. The Fallacy of Fractional-reserve banking

A fractional-reserve bank issues more property titles than there is actual underlying property. The total value of property titles cannot exceed the total value of actual underlying property. Therefore, holders of property titles have an incentive to act quickest in withdrawing the actual underlying property. Those who act slowest are the losers, as they fail to withdraw any of the actual underlying property.

B. The Fallacy of Deposit “Guarantees”

In the event of a systemic run on fractional-reserve banks, all of the actual underlying property is withdrawn. Therefore, no actual underlying property exists with which the government could fulfil deposit “guarantees”, unless new underlying property is created.

However, the government does not create new underlying property at will. Only the central bank can create new underlying property, doing so on the expectation that it is to be repaid, for its subsequent destruction. Therefore, the central bank will not issue the government with the new underlying property to fulfil the deposit “guarantees” with, unless it believes the government can credibly repay it. In other words, the deposits are not “guaranteed” at all by the party that actually has the power to create new underlying property.

If the central bank determines that the government cannot credibly repay, it is a concession that the risk is too high that the central bank cannot meet its own liability to destroy the property (upon its intended repayment). Therefore, the government that forces the central bank (against its wishes) to issue it with new underlying property can perceivably drive the central bank into declaring bankruptcy, jeopardising the entire monetary system.

However, even if we reject the idea that deposit “guarantees” are a fallacy, there is still a big problem. The entire monetary system is jeopardised by the reality that the business model of the central bank is, in fact, bankrupt. This fact is seemingly unbeknownst to even the central bankers themselves, and is covered next in Part 2.

Part 2: The Bankrupt Business Model of the Central Bank

The business model of the central bank is bankrupt due to a) the impossibility of making a profit in the long run, b) the virtual certainty of making a loss in the long run.

A. The Impossibility of Making a Profit in the Long Run

The central bank lends money into existence, and destroys it upon its repayment. It is impossible for more money to be repaid than is lent into existence. Therefore, it is impossible for the central bank to make a profit in the long run.

B. The Virtual Certainty of Making a Loss in the Long Run

All money lent into existence carries the risk of not being repaid. Therefore, it is virtually impossible for the central bank to recover 100% of the money it lends into existence. Therefore, it is virtually guaranteed that the central bank makes a loss in the long run.

In terms of the balance sheet (a “snapshot” of the present affairs) of the central bank, it must be the case that it its liabilities always exceed its assets, provided that the provision for doubtful debts is correctly factored in.

However, in order for the central bank not to be declared bankrupt, it must be held that there is no virtual certainty of making a loss in the long run. Therefore, it must be held that the central bank can recover 100% of the money it lends into existence (with virtual certainty). This incorrect belief is based on a fallacy called the credit theory of money, covered next in Part 3.

Part 3: The Fallacy of the Credit Theory of Money

According to the credit theory of money, the value of money ultimately rests on the obligation of the debtor to pay his debt. It is held that money must, in the long run, return to the creator of the money, for the money keeps being chased by those debtors who have an obligation to pay their debt to the creator of the money.

However, the credit theory of money is a fallacy. The value of money ultimately rests on its use as a medium of exchange, eliminating the inefficient “double coincidence of wants” present in barter. Money can circulate among members of the trading public (in perpetuity) for precisely this reason.

There is no rule that money must eventually return to those who have debts to pay, and indeed this is a highly unrealistic assumption, due to a) market forces in the supply of goods and services, b) market forces in the supply of money.

A. Market forces in the supply of goods and services

In the market economy, there is no rule that those who receive a greater amount of loans must outcompete those who receive a lesser amount of loans. Those who who receive a lesser amount of loans can win in market competition by being more efficient in meeting the demands of the trading public.

In addition, when investment is financed by credit not backed by true saving, it is termed “malinvestment”, as it tends to be inconsistent with the tastes and preferences of consumers and producers, and of the availability of scarce resources, thus increasing the likelihood of defaults.

B. Market forces in the supply of money

By having a (credit) money creator, winners and losers are created as a result of artificial barriers or prejudices or preferences. The recipients of greater amounts of loans tend to be benefitted, but the key winner is, of course, the (credit) money creator itself, as it canperpetually misappropriate wealth from the rest of society.

This fundamentally unfair system means there can be legitimate demand for heterogeneity to be introduced into the money supply. For instance, if in a given time period, the (credit) money creator expands the supply of money by a disproportionately large amount, the market could decide to scale down the value of these monetary units, as it amounts toexpropriation of the existing holders of money. Alternatively, new monetary units could be rejected entirely. There is simply no need to have a growing supply of money in order to have a growing economy. Instances such as these would make it highly challenging for the money to assuredly go back to the debtors of the (credit) money creator.

Another strong market incentive is to switch to an alternative monetary system, such as one with the use of precious metals such as gold or silver, or one with the use of World Dollar, a new currency based on the idea that the ultimate basis for money, a social convention, is for it to be issued to everyone, equally. If the market does switch, the (credit) money risks declining rapidly in value, even to the extent of becoming entirely worthless.

Economics

Money, Macro & Markets

First it was the government’s miraculous ability to deliver on-target GDP growth that got the permabulls bellowing again, then it was the striking (world-beating, one might even say), 12% currency-adjusted rally in its stock market that got them triumphantly pawing the ground. Nor did the drop in interest rates serve in any way to dampen the eternal hope that China was once again deferring meaningful structural reform in the face of a threat to near-term output.

 

Quite what was actually behind the equity rally is not easy to say. There were whispers that the Russians (who else?) were piling in, now that their assets were subject to arbitrary seizure as part of Nova Roma’s vilification of their leader and proxy war against their homeland. There was also talk that the imminent linkage of the Shanghai and HK bourses was driving an arbitrage between the unusually-discounted mainland A-shares and their offshore H-share equivalents. Finally, in a typically neat piece of circular reasoning, the imminent rebound in the economy which we have even seen some brave (or foolhardy, according to preference) souls project at a startling 8.5% (sic) early next year was held to be at work to push up what was an otherwise under-owned and thus optically ‘cheap’ emerging market.

 

On the face of it, news that, over the first seven months of the year, the increase in SOE earnings had accelerated from June’s 8.9% YOY to July’s 9.2% – well up on the first quarter’s paltry 3.3% pace – may have seemed to have offered some much-needed confirmation of this optimistic thesis. However, a closer glance at the figures would not have proven quite so reassuring, had anyone bothered to actually take one.

 

Over the past, supposedly brighter three months, revenues advanced a modest 6.2% compared to the like period in 2013, though with as-reported profits up an ostensibly more creditable 12.1%. There, all grounds for positive spin, alas, were exhausted. For one, operating profits were, in fact, only up 4.0% like-for-like (a wide discrepancy which can only excite suspicion as to the nature of the headline surplus) while financing costs vaulted a fifth higher.

 

Worse still, in eking out even this degree of improvement since May, liabilities have soared by an incredible CNY2.320 trillion (around $125 billion a month) – an increment fully half as big again as that registered twelve months ago and a sum which is actually greater than the entire reported sum of ‘total social finance’ over the trimester (that latter ‘only’ managed CNY 2.240 trillion after last month’s thoroughly unexpected swoon).

 

And what did our proud commanders of the economic heights achieve for shouldering such a hefty weight of obligations? An addition to revenues of CNY719 billion (extra debt to extra ‘sales’ therefore coming in at a ratio of 3.2:1); a pick-up in ‘profit’ of CNY76 billion (d[Debt]:d[Income] = 30:1); and a blip up in operating profit of just CNY16 billion (at a truly staggering ratio of 144 to 1).

Reversing these latter relationships, we can see that while swallowing up all of the nation’s available new credit since the spring, China’s SOEs added 31 fen per one renminbi in sales, 3.3 fen in reported profit, and a bare 0.7 fen in the operating version of income. Just the sort of performance on which to base expectations of a significant coming rise in growth and prosperity!

 

Armed with such an underwhelming use of resources – both physical and financial – it is perhaps no wonder that MIIT is again trying to shut down swathes of superfluous capacity, issuing what are effectively cease-and-desist orders against 132 firms in a whole range of heavy industries – iron, steel, coke, ferroalloy, calcium carbide, aluminium, copper and lead smelting, cement, flat glass, paper, leather, printing and dyeing, chemical fibres, and lead-acid batteries. Shipbuilding may not be far behind, either, given that it formed the main topic of discussion at a meeting of the National Committee of the CPPCC this week.

 

The language used was, in some cases, pretty uncompromising, too: “Total industrial capacity in cement and plate glass is still growing, but the industry-wide sales rate is in decline and accounts receivable are increasing… there are to be no new projects in the sector for any reason,” thundered the MIIT communique.

 

This time around, given Chairman Xi’s rigorous ‘anti-corruption’ campaign, there might well be a little less of the back-sliding and wilful defiance which has greeted such edicts in the past. The emperor is no longer quite so fare away, nor the mountain quite so high, if you are a recalcitrant local cadre these days!

 

Even before this, the signs were there for those with eyes to see. Despite the much-bruited pick-up in activity, Chinese power use, excluding the residential component, SLOWED to 4.5% YOY in the three months to July from 8.1% in the preceding three months. Nor did this come without a significant deceleration in so-called ‘tertiary’ industry sector (loosely, that encompassing services and light indstry) which is henceforth supposed to be the torchbearer for growth and employment. Here, consumption dropped from the spring’s 10%-plus rates to just 7.4% YOY last month. Added buring of lights and turning of lathes in the secondary industry category – essentially manufacturing – was a tardy 4.2% even though growth in industrial production, we were told, had averaged 9.0% in that same period.

 

Hmmmm. No wonder the PMI seems to be shedding some of its recent, rather inexplicable exuberance.

 

Round and round the circle of vicious consequences swirls. As Wang Xianzheng, President of the China Coal Industry Association, admitted: ‘Currently, more than 50 percent of enterprises are in payment arrears and have delayed paying wages.’ Of 26 large companies spread across nine provinces, he revealed that 20 are making losses, only 9 are still in the black, and the remainder are hovering uneasily between (commercial) life and death.

 

Other obvious signs of distress are to be had among the loan guarantee networks which had everywhere come into being with the then-laudable aim of persuading constitutionally reluctant banks to lend to customers other than SOEs when times were good. Now trapped in flagging businesses which are more correlated than perhaps the participants had realised – and often having succumbed to the diversion of funds to less commendable ends in the interim – they are all going sour together and the same interconnectedness which was once their mainstay is proving instead a sheet anchor with which to drag them all under.

 

As Zhou Dewen, president of Zhejiang Federation of Private Enterprise Investment, told the Global Times, the rash of bankruptcies in Zhejiang and Jiangsu provinces has disrupted production and led to lay-offs, with 80% of all sour loans in the area associated with such mutual guarantee schemes. So elevated is the level of distrust, as bad debts have risen at an annualized 30% pace this year, that banks are now trying to call loans in early and obtaining court orders to freeze the assets of those firms that are unable to comply with their demands.

 

The banks themselves are beginning to accelerate write-offs dramatically – even though the official NPL ratios still look woefully understated. They are also drawing heavily upon the markets in order to bolster their capital as a precaution. As the WSJ reported, the four largest state-owned lenders have started raising a planned $73 billion in debt and equity this year – a call which is expected to jump to more than $300bn in the next five years, according to the banking regulator.

 

In addition, five local governments in the south and east of the country are setting up so-called ‘asset-management companies’ – effectively state-sponsored ‘bad banks’ – in a mirror of the system used by Zhu Rongji in the 1990s to shuffle the more toxic stuff off its originators’ balance sheets and thus allow them to continue to lend while the bitter fruits of their previous mistakes were hidden away elsewhere.

 

Though this only disguises and does not in any way alleviate the economic waste spawned by the boom, it might at least allow banks to issue new equity-like capital – perhaps to the insurers who are themselves being heavily promoted by Beijing as the next battalion of systemic saviours – at above notional book value and hence to enable them to remain a viable source of new credit. Note that the last time this was done, the losses were essentially fiscalized: banks simply swapped the bad loans on their books for what have since proven to be irredeemable – but nonetheless fully par-valued – loans to the state entities which, in turn, financed the obliging AMCs. Balance sheets will not shrink, therefore, only become sanitised, by the operation of this mechanism.

 

Here, however, is where it all gets fraught once more, because the same local governments who are being marshalled to assume the banks’ bad debts (many of them ensuing from extending credit to LGFPs) are themselves becoming desperate for funds given that all too many of their own, sure-fire investment gambits are turning out to be the dampest of damp squibs.

 

As the Economic Information Daily reported, an audit of 448 eastern township platform companies found that two-fifths of them were curently loss making, while a further thirty percent barely broke even. With these bodies so heavily dependent on land sales to generate the revenues needed to cover their current outlays, much less their ambitious capital expansion plans and ongoing debt service costs – and with such ‘sales’ only being possible in large part if the authorities extend the credit to the purchasers in the first place – a decidedly negative feedback loop has begun to tighten around their necks as the property market itself enters a slump.

 

Indeed, according to research conducted by brokerage company Centaline Property Agency, twenty major developers have between them spent CNY182.5 billion yuan so far this year to purchase new sites – a drastic 38% down on the like period last year.

 

‘Worsening property sales have undercut the willingness of developers to buy land. Their focus now is on raising cash from the sales of what they’ve already built. Few are in the mood to buy more,’ said Zhang Dawei who headed up the company’s research team.

 

In July alone, aggregate land sales revenue for 300 Chinese cities was off by a half from the same month in 2013, as reported by the China Index Academy. Sales in the four largest cities of Beijing, Shanghai, Guangzhou, and Shenzhen – normally a slam-dunk – sank by a staggering 70%.

 

‘The downturn means that the scale of land sales for the remainder of this year could continue to contract. Developers have pushed the “conservative” button,’ said Zhang with commendable understatement.

 

And quite right, too, as anecdotal evidence grows that formerly avid house-buyers are beginning to adopt that age-old American practice of ‘jingle mail’ – that is, they are simply walking away from properties they either cannot afford or do not believe will again appreciate in price.

 

At one end of the scale, one Nanjing online estate agent recorded a growing back-log of such defalcations and referred to the ‘unspeakable pain’ in the local market – an agony apparently shared in at least six other of the districts neighbouring his.

Despite the widespread belief that Chinese buyers are sitting on a typical equity cushion of 30-40% of the property value – and hence, unlike their less well-endowed US, Irish, and Spanish cousins, are impervious to all bar the most extreme events in the market – the scary truth is that much of the real estate to which they do hold title has been, how shall we say, ‘rehypothecated’ – i.e., pledged as collateral for a range of business loans as well as for the more speculative use of funds.

 

‘In the past few years, many small business owners blindly invested in real estate, mining and other industries. These industries are now suffering from overcapacity and falling asset prices, so business owners are unable to pay their debts,’ said one general manager of a Wenzhou microfinance company.

 

‘Many [of these] use the house as collateral when business loans go wrong,‘ Ge Ningbo, a county bank manager, told a journalist.

 

To get a feel for the scale of the problem, consider press reports that in Wenzhou, 1,000 homes were abandoned as a result of the decline, homes with an ostensible market value of more than Y6.4 Billion – or roughly $1 million a pop! No scrabbling rural migrants, these, but possibly members of an increasingly scrutiny–shy party apparatus! Clearly, the banks will need to suck in even more money from their gullible preference shareholders if this phenomenon starts to spread and, in the meanwhile, it is hard to see how they will be empowered to make sufficient revenue-positive new loans to keep the whirligig in motion in such a climate of confusion and disabusal.

 

Sadly, we have not finished our tale of woe there because there are also stories circulating in the official media that those same local governments, who are in many ways the lynchpins of the whole merry-go-round, may be far deeper into the mire than has been recognised to date.

 

As the articles detail, a member of the relevant NPC standing committee confided to a press contact that when hidden liabilities are taken into account alongside those uncovered in a recent audit, the true total of LG debt almost doubles to a wince-inducing Y30 trillion. Just for sheer size – some 50% of national GDP – this would be a matter of concern, but it also should not be overlooked that far too much of that monstrous total is comprised of short-term obligations against which are held long-term, illiquid, and often economically redundant ‘assets’.

 

Given that the last NAO study showed that are some 3,700 governmental bodies across various categories which had debts in excess of 100% of their local GDP, something patently needs to be done if the mad Chinese juggler is to keep his profusion of balls bobbing in the air.

 

So, welcome to local scrip issues. Yes, it seems that ingenious local cadres have dusted off their depression-era news clippings and revisited the age of the mediaeval mint and simply started using their own IOUs as media of exchange wherever their writ may run.

 

Economic Information Daily reported that in Hubei, Hunan and Guangdong, among others, government IOUs have become a ‘discount currency.’ In fact, commentary on Caijing suggests that not only are even small, rural communities now doing likewise, but that some companies, too, are paying their workers in scrip – just as in the early days of the Western factory age when resort by employers to what was called the ‘truck’ or ‘Tommy’ system was widespread.

 

As the early 19th century English radical, William Cobbett noted, ‘… when this tommy system… makes its appearance where money has for ages been the medium of exchange, and of payments for labour; when this system makes its appearance in such a state of society, there is something wrong; things are out of joint; and it becomes us to inquire into the real cause of its being resorted to…’

 

His answer? The state of economic depression brought about by the costs imposed upon entrepreneurs by the dead-weight of government:-

 

‘It is not the fault of the masters, who can have no pleasure in making profit in this way: it is the fault of the taxes, which, by lowering the [net] price of their goods, have compelled them to resort to this means of diminishing their expenses, or to quit their business altogether, which a great part of them cannot do without being left without a penny… Everything was on the decline… I was assured that shop-keepers in general did not now sell half the quantity of goods in a month that they did in that space of time four or five years ago… need we then wonder that the iron in Staffordshire has fallen, within these five years, from thirteen pounds to five pounds a ton [metal-bashers were similarly bearing the brunt, it appears]… and need we wonder that the iron-masters, who have the same rent and taxes to pay that they had to pay before, have resorted to the tommy system, in order to assist in saving themselves from ruin!’

 

‘Here is the real cause of the tommy system; and if [we wish] to put an end to it… prevail upon the Parliament to take off taxes to the amount of forty millions a year.’

 

Caijing devoted quite some space to ‘netizen’ comments on this state of affairs, several of which reflected a considerable degree of awareness that this had come about because of the unbridled spending and lavish self-indulgence of the relevant officials, while some were also aware that such an emission of fiat money was a direct parallel of the official money-creation process and further that it could only persist for so long as some minimal degree of trust resided in the councils’ ability one day to redeem the claims. Moreover, it was noted that since people ultimately expect the discount between township paper and that issued by the PBOC to widen, they were using the former preferentially to buy and sell and clinging on to the latter – a classic, Gresham’s Law example of bad money driving out good.

 

If the localities are in such dire straits as these, then it is hard to resist the temptation to believe that we are approaching some sort of end-game. But what, we should ask ourselves, might be the trigger for its no-doubt jarring denouement?

 

Well, here we come full circle with the latest act of Xi Jinping’s grand ‘anti-corruption’ drive. For, as well as Our Glorious Leader’s insistence at last week’s Leading Group get-together that everyone must ‘truly push forward reform with real guns and knives’ (ulp!), news has come out that the National Audit Commission will next conduct a full, ‘rigorous’ check of all land sales and related transactions carried out between 2008-13 and that, moreover, the results will be to hand when the top men convene for their next Plenum this coming October.

 

One can only imagine the consternation in the ranks which this announcement has unleashed. After all, there is unlikely to be overmuch evidence that any of these deals were conducted transparently, competitively, honestly, and legally, in the absence of any and all inducements, kickbacks, or displays of favouritism, not only since such was the accepted practice during the reign of Wen and Hu – especially during the infamous, no questions asked, frenzy of post-Crash stimulus – but also because this is a sphere notoriously subject to peculation in what we fondly imagine to be our more enlightened polities, too.

 

We can therefore not only expect the bodycount to rise substantially as officials fearful of censure seek to avoid their imminent disgrace and subsequent punishment, but we should also be prepared for the possibility that when this most capacious of all cylindrical metallic containers of vermiform invertebrae is opened, it will be accompanied by a blast of sufficient megatonnage to bring the whole flawed edifice crashing to the ground.

 

Under such circumstances, we find it very hard to shake off the presentiment that, on the one side, some commentators’ touching faith in an incipient re-acceleration are horribly misplaced while, on the other, the tired old ‘Goldilocks’ scenario whereby all bad news is good because it presages the launch of another round of sustained, indiscriminate ‘stimulus’ seems equally out of key with what Xi tells us he is trying to achieve.

 

 

Having dealt at such length with China, let us try and dispose of the rest of the globe in as short a space as possible.

 

Japan: Abenomics is still a horrible failure as drooping machine orders, frozen store sales, and exports back at 4 ½ year (currency-adjusted), one-quarter-from-the-peak lows reveal. So, guess what? As the PM’s approval ratings slip, another ‘stimulus’ package is said to be in the offing (sigh!)

 

Europe: Even one of Hollande’s own ministers confided to the press a couple of weeks back, ‘the truth is, he thinks we don’t have a chance’ – who are we to disagree? Meanwhile, the chap at the head of the other Sick Man, Matteo Renzi, has undergone a moment of almost Caligulan delusion, assuring supporters that the hour had come for Italy ‘to tow Europe out of the crisis’ and ‘to assume… the leadership’ of the Continent.

 

And what of his first steps to make good on such a vaunting claim? Why, in an Onion-like act of farce, to insist that ISTAT no longer releases the GDP numbers a week ahead of its peers and thereby afford underemployed analysts and commentators more opportunity to be critical of the country’s performance! And then there’s the Neocon-inspired catastrophe unfolding on the bloc’s eastern fringe from which the emergence of a bout of renewed economic difficulty is the very least of our worries.

 

USA: Chairperson Yellen is currently holding court at Jackson Hole as the US numbers continue their rebound from the winter’s retardation. What a moment for her to take the stage. Non-financials (large cap-led) are at new records, Tech at new, post-Bubble highs; junk spreads have narrowed sharply; vol has again crashed, correlations fallen, and put-call ratios evaporated. With the Bund-UST spread at a 15-year high and equities outperforming, the USD stands on the verge of a break out and up from what is already its best level in a year. The cycle is still running in favour of the States on a comparison basis, no matter how ninety-Nth percentile many of its valuations are when considered in isolation.

 

With money supply still swelling rapidly – and amid hints that it is being more actively utilised than of late—it is hard to see quite what will bring that run to an end in the near term. Were we to really be critical, one of the few clouds ‘no bigger than a man’s hand’ is that the growth of both inventories and payroll expenses are outstripping sales in the durable goods sector. Thus, while US assets are hardly ‘investible’ in the Benjamin Graham sense, they are also a tough short in the Sell’em Ben Smith one.

 

Britain: While MPC member David Miles saw fit to describe the EU as ‘dead in the water’ as a trade partner, closer to home some of the gloss is finally coming off the reputation of one of the country’s most expensive recent imports, its egregious Bank governor.

 

No doubt, dear reader, you too were shocked – shocked! – to hear local Tory Mark Field, the Honourable Member for the Cities of London and Westminster, opine to his mates in Grub Street that “…from the moment Mark Carney became governor in July 2013, it was pretty clear forward guidance was an indication rates would not rise this side of the election – for all the talk of Bank of England independence, there was a clear bargain between him and George Osborne.” Be that as it may, it is surely not too cynical to note that Fred Carney’s Army will not want to contibute to a possible defeat by Alex the Bruce’s forces in the coming Scottish independence vote.

 

You can just hear it now, that ringing oration:-

 

‘Aye, vote ‘Yes’ and interest rates may rise. Vote ‘No’ and they’ll stay as is … at least a while. And dying in your beds, many years from now, would you be willin’ to trade ALL the days, from this day to that, for one chance, just one chance, to come back here and tell our neighbours that they may take our pound and their nuclear subs, but they’ll never take… OUR FREEDOM!

 

Commodity Corner

 

Truth be told, it has not been the kindest of summers for commodities. Since reaching their late June peak, returns have suffered a 7.5% slump to touch six month lows even as US equities have added 2%. For the record, in that crumbling eight week stretch EM stocks put on 4.7%, US bonds were up 1% and junk was flat.

 

Within commodities themselves, what some commentators have been calling a ‘Garden of Eden’ summer in the US grain belt has ensured that the corn is as high as an elephant’s eye almost everywhere you look, while oilseeds and wheat have been similarly profuse. A loss of 11.3% and, in fact, the casting into jeopardy of the entire cyclical bull market in prices has been the result.

 

Energy, too, has suffered, as the record longs in oil finally began to liquidate, triggering the biggest 6-week sell-off of positions in WTI on record. IN notional value terms, net spec longs in Brent and WTI combined crashed from close to $97 billion worth of contracts to $59 billion. It is possible to read the charts to declare that this swoon has violated the uptrend in place for the last five years, as well as breaking all major MAs. Against that, we are arguably a touch oversold and the last four years’ sideways stationary, Arab Spring range remains intact. Tacticians, Faites vos jeux!

 

Dollar strength, the subsidence of financial market anxieties alluded to above, and the cessation of labour unrest in SA have hardly been conducive to higher PM prices (palladium — and Russia—excepted). Gold has also broken 200, 100, 50-day MAs and is threatening the uptrend drawn from the June 30-Dec 31 $1180 double bottom and June 3rd’s $1240 probe. Lease rates remain positive and net specs—at 43% of total O/I – as long as they have been on average throughout the last 12 years’ bull market.

 

Only Base metals seem to offer any hope (they rallied 4.2% while everything else was collapsing). Strength has partly been predicated upon what we think are decidedly ephemeral signs of a Chinese renaissance, but also on evidence of dwindling stockpiles and the litany of capex cuts and asset disposals emanating from the mining industry. They appear, therefore, to offer the least dirty shirt in the laundry basket.