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.
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.
[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.
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!
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.
When it comes to the world of international finance, Jim Rickards has quite nearly seen it all. As a young man, he worked for Citibank in Pakistan, of all places. In the 1990s, he served as General Counsel for Long-Term Capital Management, Jim Merriwether’s large, notorious hedge fund that collapsed spectacularly in 1998. In recent years, he has been a regular participant in Pentagon ‘wargames’, in particular those incorporating financial or currency warfare in some way, and he has served as an advisor to the US intelligence community.
Yet while his experiences are vast in breadth, they have all occurred within the historically narrow confines of a peculiar international monetary regime, one lacking a gold- or silver-backed international reserve currency. Yes, reserve currencies have come and gone through history, but it is the US dollar, and only the US dollar, that has ever served as an unbacked global monetary reserve.
Nevertheless, in CURRENCY WARS and THE DEATH OF MONEY, Jim does an excellent job of exploring pertinent historical parallels to the situation as it exists today, in which the international monetary regime has been critically undermined by a series of crises and flawed policy responses thereto. He also applies not only economic but also complexity theory to provide a framework and deepen understanding.
As for what happens next, he does have a few compelling ideas, as we explore in the following pages. To begin, however, we explore what it was that got him interested in international monetary relations in the first place.
BACK TO THE 1970S: THE DECADE OF DISCO AND DOLLAR CRISES
JB: Jim, you might recall the rolling crises of the 1970s, beginning with the ‘Nixon Shock’ in 1971, when the US ‘closed the gold window’, to the related oil shocks and then the de facto global ‘run on the dollar’ at the end of the decade. At the time, as a student, did you have a sense as to what was happening, or any inclination to see this as the dollar’s first real test as an unbacked global monetary reserve? Did these events have any influence on your decision to study international economics and to work in finance?
JR: I was a graduate student in international economics in 1972-74, and a law student from 1974-77, so my student years coincided exactly with the most tumultous years of the combined oil, inflation and dollar crises of the 1970s. Most observers know that Nixon closed the gold window in 1971, but that was not considered the end of the gold standard at the time. Nixon said he was ‘temporarily’ suspending convertibility, but the dollar was still officially valued at 1/35th of an ounce of gold. It was not until 1975 that the IMF officially demonitised gold although, at French insistence, gold could still be counted as part of a country’s reserve position. I was in the last class of students who were actually taught about gold as a monetary asset. Since 1975, any student who learns anything about gold as money is self-taught because it is no longer part of any economics curriculum. During the dark days of the dollar crisis in 1977, I spoke to one of my international law professors about whether the Deutschemark would replace the dollar as the global reserve currency. He smiled and said, “No, there aren’t enough of them.” That was an important lesson in the built-in resilience of the dollar and the fact that no currency could replace the dollar unless it had a sufficiently large, liquid bond market – something the euro does not yet have to this day. From law school I joined Citibank as their international tax counsel. There is no question that my academic experiences in a period of borderline hyperinflation and currency turmoil played a powerful role in my decision to pursue a career in international finance.
JB: As you argued in CURRENCY WARS and now again in THE DEATH OF MONEY, the US debt situation, public and private, is now critical. It would be exceedingly difficult for another Paul Volcker to arrive at the Federal Reserve and shore up confidence in the system with high real interest rates. But why has it come to this? Why is it that the ‘power of the printing press’ has been so abused, so corrupted? Is this due to poor federal governance, as David Stockman argues in THE GREAT DEFORMATION? Is it due to the incompetence or ignorance of the series of Federal Reserve officials who failed to appreciate the threat of global economic imbalances? Or is it due perhaps to a fundamental flaw in the US economic and monetary policy regime itself?
JR: It is still possible to strengthen the dollar and cement its position as the keystone of the international financial system, but not without costs. Reducing money printing and raising interest rates would strengthen the dollar, but they would pop the asset bubbles in stocks and housing that have been re-created since 2009. This would also put the policy problem in the laps of Congress and the White House where it belongs. The problems in the economy today are structural, not liquidity-related. The Fed is trying to solve structural problems with liquidity solutions. That will never work, but it might destroy confidence in the dollar in the process. Federal Reserve officials have misperceived the problem and misapprehend the statistical properties of risk. They are using equilbirium models in a complex system. (Ed note: Complexity Theory explores the fundamental properties of dynamic rather than equilibrium systems and how they react and adapt to exogenous or endogenous stimuli.) That is also bound to fail. Fiat money can work but only if money issuance is rule-based and designed to maintain confidence. Today’s Fed has no rule and is destroying confidence. Based on present policy, a complete loss of confidence in the dollar and a global currency crisis is just a matter of time.
JB: Thinking more internationally, the dollar is in quite good company. ‘Abenomics’ in Japan appears to have failed to confer any meaningful, lasting benefits and has further undermined what little confidence was left in the yen; China’s bursting credit and investment bubble threatens the yuan; the other BRICS have similar if less dramatic credit excess to work off; and while the European Central Bank and most EU fiscal authorities have been highly restrained for domestic political reasons in the past few years, there are signs that this may be about to change. Clearly this is not a situation in which countries can easily trust one another in monetary matters. But as monetary trust supports trust in trade and commerce generally, isn’t it just a matter of time before the currency wars of today morph into the trade wars of tomorrow? And wouldn’t a modern-day Smoot-Hawley be an unparalleled disaster for today’s globalised, highly-integrated economy?
JR: Currency wars can turn into trade wars as happened in the 1920s and 1930s. Such an outcome is certainly possible today. The root cause is lack of growth on a global basis. When growth is robust, large countries don’t care if smaller trading partners grab some temporary advantage by devaluing their currencies. But when global growth in anemic, as it is now, a positive sum game becomes a zero-sum game and trading partners fight for every scrap of growth. Cheapening your currency, which simultaneously promotes exports and imports inflation via the cross rate mechanism, is a tempting strategy when there’s not enough growth to go around. We are already seeing a twenty-first century version of Smoot-Hawley in the form of economic sanctions imposed on major countries like Iran and Russia by the United States. This has more to do with geopolitics than economics, but the result is the same – reduced global growth that makes the existing depression even worse.
JB: You may recall that, in my book, THE GOLDEN REVOLUTION, I borrow your scenario of how Russia could, conceivably, undermine the remaining international trust in the dollar with a pre-emptive ‘monetary strike’ by backing the rouble with gold. Do you regard the escalating situation in Ukraine, as well as US policies in much of the Black Sea/Caucasus/Caspian region generally, as a potential trigger for such a move?
JR: There is almost no possibility that either the Russian rouble or the Chinese yuan can be a global reserve currency in the next ten years. This is because both Russia and China lack a good rule or law and a well-developed liquid bond market. Both things are required for reserve curreny status. The reason Russia and China are acquiring gold and will continue to do so is not to launch a new gold-backed currency, but rather to hedge their dollar positions and reduce their dependence on dollar reserves. If there is a replacement for the dollar as the leading reserve currency, it will either be the euro, the special drawing right (SDRs), or perhaps a new currency devised by the BRICS.
JB: Leaving geo-politics aside for the moment, you mention right at the start of THE DEATH OF MONEY, citing the classic financial thriller ROLLOVER, that even non-state actors could, perhaps for a variety of reasons, spontaneously begin to act in ways that, given the fragility of the current global monetary order, cascade into a run on the dollar and rush to accumulate gold. If you were to do a remake of ROLLOVER today, how would you structure the plot? Who could be the first to begin selling dollars and accumulating gold? Who might join them? What would be the trigger that turned a trickle of dollar selling into a flood? How might the US government respond?
JR: If Rollover were re-made today, it would not be a simple Arab v. US monetary plot. The action would be multilateral including Russia, China, Iran, the Arabs and others. Massive dumping of dollars might be the consequence but it would not be the cause of the panic. A more likely scenario is something entirely unexpected such as a failure to deliver physical gold by a major gold exchange or dealer. That would start panic buying of gold and dumping of dollars. Another scenario might begin with a real estate collapse and credit crash in China. That could cause a demand shock for gold among ordinary Chinese investors, which would cause a hyperbolic price spike in gold. A rising gold price is just the flip side of a collapsing dollar.
JB: This entire discussion all follows from the fragility of the current international monetary system. Were the system more robust, we could leave the dollar crisis topic to Hollywood for entertainment rather than to treat it with utmost concern for personal, national or even international security. But what is it that makes systems fragile? Authors ranging from George Gilder (KNOWLEDGE AND POWER), to Joseph Tainter (THE COLLAPSE OF COMPLEX SOCIETIES) and even Edward Gibbon (THE RISE AND FALL OF THE ROMAN EMPIRE) have applied such thinking to ancient and modern economies and societies. They all conclude that, beyond a certain point, centralisation of power is destabilising. Does this mean that a robust monetary system would ‘de-centralise’ monetary power? Isn’t this incompatible with any attempt by the G20 and IMF to transform the Special Drawing Right (SDR) from a unit of account into a centrally-managed, global reserve currency?
JR: Yes. Complex systems collapse because increases in complexity require exponential increases in energy to maintain the system. Energy can take many forms including money, which can be thought of as a form of stored energy. We are already past the point where there is enough real money to support the complexity of the financial system. Elites are now resorting to psuedo-money such as deriviatives and other forms of leverage to keep the system going but even that will collapse in time. The proper solution is to reduce the complexity of the system and restore the energy/money inputs to a sustainable level. This means reducing leverage, banning most derivatives and breaking up big banks. None of this is very likely because it cuts against the financial interests of the power elites who run the system. Therefore a continued path toward near-term collapse is the most likely outcome.
JB: In CURRENCY WARS you make plain that, although you are highly critical of the current economic policy mainstream for a variety of reasons, you are an agnostic when it comes to economic theory. Yet clearly you draw heavily on economists of the Austrian School (eg Hayek) and in THE DEATH OF MONEY you even mention the pre-classicist and proto-Austrian Richard Cantillon. While I doubt you are a closet convert to the Austrian School, could you perhaps describe what it is about it that you do find compelling, vis-à-vis the increasingly obvious flaws of current, mainstream economic thinking?
JR: There is much to admire in Austrian economics. Austrians are correct that central planning is bound to fail and free markets produce optimal solutions to the problem of scarce resources. Complexity Theory as applied to capital markets is just an extension of that thinking with a more rigorous scientific foundation. Computers have allowed complexity theorists to conduct experiments that were beyond the capabilities of early Austrians. The results verify the intuition of the Austrians, but frame the issue in formal mathematical models that are useful in risk management and portfolio allocation. If Ludwig von Mises were alive today he would be a complexity theorist.
JB: You may have heard the old Irish adage of the young man, lost in the countryside, who happens across an older man and asks him for directions to Dublin, to which the old man replies, unhelpfully, “Well I wouldn’t start from here.” If you were tasked with trying, as best you could, to restore monetary stability to the United States and by extension the global economy, how would you go about it? You have suggested devaluing the dollar (or other currencies) versus gold to a point that would make the existing debt burdens, public and private, credibly serviceable. But does this solve the fundamental systemic problem? What is to stop the US and global economy from printing excessive money and leveraging up all over again, and in a decade or two facing the same issues, only on a grander scale? Is there a better system? Could a proper remonetisation of gold a la the classical gold standard do the trick? Might there be a role for new monetary technology such as cryptocurrency?
JR: The classic definition of money involves three functions: store of value, medium of exchange and unit of account. Of these, store of value is the most important. If users have confidence in value then they will accept the money as a medium of exchange. The unit of account function is trivial. The store of value is maintained by trust and confidence. Gold is an excellent store of value because it is scarce and no trust in third parties is required since gold is an asset that is not simultaneously the liability of another party. Fiat money can also be a store of value if confidence is maintained in the party issuing the money. The best way to do that is to use a monetary rule. Such rules can take many forms including gold backing or a mathematical formula linked to inflation. The problem today is that there is no monetary rule of any kind. Also, trust is being abused in the effort to create inflation, which is form of theft. As knowledge of this abuse of trust becomes more widespread, confidence will be lost and the currency will collapse. Cryptocurrencies offer some technological advantages but they also rely on confidence to mainatin value and, in that sense, they are not an improvement on traditional fiat currencies. Confidence in cryptocurrencies is also fragile and can easily be lost. It is true that stable systems have failed repeatedly and may do so again. The solution for individual investors is to go on a personal gold standard by acquiring physical gold. That way, they will preserve wealth regardless of the monetary rule or lack thereof pursued by monetary authorities.
JB: Thanks Jim for your time. I’m sure it is greatly appreciated by all readers of the Amphora Report many of whom have probably already acquired a copy of THE DEATH OF MONEY.
In a world of rapidly escalating crises in several regions, all of which have a clear economic or financial dimension, Jim’s answers to the various questions above are immensely helpful. The world is changing rapidly, arguably more rapidly that at any time since the implosion of the Soviet Union in the early 1990s. Yet back then, the changes had the near-term effect of strengthening rather than weakening the dominant US position in global geopolitical, economic and monetary affairs. Today, the trend is clearly the opposite.
Jim’s use of Complexity Theory specifically is particularly helpful, as the balance of power now shifts away from the US, destabilising the entire system. Were the US economy more robust and resilient, perhaps a general global rebalancing could be a gradual and entirely peaceful affair. But with the single most powerful actor weakening not only in relative but arguably in absolute terms, for structural reasons Jim explains above, the risks of a disorderly rebalancing are commensurately greater.
The more disorderly the transition, however, the less trust will exist between countries, at least for a time, and as Jim points out it is just not realistic for either the Russian rouble or Chinese yuan to replace the dollar any time soon. As I argue in THE GOLDEN REVOLUTION, this makes it highly likely that as the dollar’s share of global trade declines, not only will other currencies be competing with the dollar; all currencies, including the dollar, will increasingly be competing with gold. There is simply nothing to prevent one or more countries lacking trust in the system to demand gold or gold-backed securities of some kind in exchange for exports, such as oil, gas or other vital commodities.
Jim puts the IMF’s SDR forward as a possible alternative, but here, too, he is sceptical there is sufficient global cooperation at present to turn the SDR into a functioning global reserve currency. The world may indeed be on the path to monetary collapse, as Jim fears, but history demonstrates that collapse leads to reset and renewal, and in this case it seems more likely that not that gold will provide part of the necessary global monetary foundation, at least during the collapse, reset and renewal period. Once trust in the new system is sufficient, perhaps the world will once again drift away from gold, and perhaps toward unbacked cryptocurrencies such as bitcoin, but it seems unlikely that a great leap forward into the monetary unknown would occur prior to a falling-back onto what is known to have provided for the relative monetary and economic stability that prevailed prior to the catastrophic First World War, which as readers may note began 100 years ago this month.
[Editor's note: the following piece was originally published by World Dollar at zerohedge.com]
In 2003, Jörg Guido Hülsmann, a senior fellow of the Mises Institute, published the essay “Has Fractional-Reserve Banking Really Passed the Market Test?” in a Winter edition of The Independent Review. The key conclusion drawn was that it is the obfuscation of the difference between fractional-reserve IOUs and genuine money titles which preserves the the practice of fractional-reserve banking.
It is the belief of this author that this essay has not received the acclaim that it so richly deserves. Indeed, its implications for the future of money and banking are monumentous. If those who advance the Austrian School of economics, the Mises Institute and Zero Hedge most prominently among them, were to grant its ideas a great renaissance, the worldwide return to sound money may happen far sooner than most could have believed possible.
J.G. Hülsmann explains why “in a free market with proper product differentiation, fractional-reserve banking would play virtually no monetary role” (p.403). The incisive reason given is that genuine money titles are valued at par with money proper, while fractional-reserve IOUs + RP (Redemption Promise) would be valued below par, due to default risk.
Here is the deductive argument being made:
1. Debt (IOUs + RP) is promised money.
2. A promise has the risk of not being kept (default risk).
3. Therefore, promised money, debt (IOUs + RP), is less valuable than genuine money titles (/money proper).
J.G. Hülsmann goes on to explain why the mispricing of fractional-reserve debt (IOUs + RP) persists. The reasons given include the outlawing of genuine money titles and deceptive language (“deposits”). This author would like to add one more reason, namely the myth that the government could actually “guarantee” deposits in the event of a systemic run. Systemic runs mean, by definition, most if not all money proper exiting the fractional reserve banking system, meaning the money proper with which the “guarantees” could be fulfilled doesn’t exist, short of unprecedented levels of new money printing and financial repression. This point is acknowledged on p.22 of the otherwise unexceptional “The Chicago Plan Revisited” by Jaromir Benes and Michael Kumhof.
The history of fractional reserve banking is, then, defined by informational inefficiency. Market participants have failed to reflect the price differential between fractional reserve debt (IOUs + RP) and genuine money titles.
Let us now extend the deductive argument:
4. Therefore, an arbitrage opportunity exists. All holders of Debt (IOUs + RP) have an economic incentive to make the redemption request for genuine money titles (/money proper).
Mervyn King, ex-governor of the Bank of England, once claimed that it is irrational to start a bank run, but rational to participate in one once it has started. While the second part of the claim is correct, the first is not. It is irrational not to start a bank run, due to the arbitrage opportunity that exists.
This, of course, holds the assumption that the market will become informationally efficient, and will therefore capitalise on the mispricing. But the holding of this assumption is only credible if this idea is spread. We live in a time with an unprecedented level of competing voices wanting to be heard, the unfortunate consequence of which is that we drown out the voices that are truly exceptional. It is no exaggeration to say that “Has Fractional-Reserve Banking Really Passed the Market Test?” may prove to be the most revolutionary essay in the history of monetary economics and banking, if only it receives the level of appraisal and promotion it deserves.
On this matter, the reasons given for the persistence of the mispricing of fractional-reserve debt (IOUs + RP) are unsustainable in the long run. The lack of legal protection for genuine money titles is no more than a technicality, for there is nothing in practice that can sustainably prevent the existence of full reserve banks. Awareness that “deposits” are not actually money being held for safekeeping is a matter of educating the public, as is awareness that government’s deposit “guarantees” are not actually credible in the event of a systemic run.
If we assume, then, that fractional-reserve banking will come to its logical ending, there is good reason to believe that the shock will herald the endgame for fiat money. It is in fact the case that all fiat money is the liability of the central bank, which also carries the risk of non-repayment (default risk). This, again, means an arbitrage opportunity for market participants to withdraw the fiat money from the fiat money banking system. This confirms that the original basis for fiat money is destroyed, for its repayment to the central bank is not credible.
Finally, at long last, we have a worldwide return to sound money. Will there be a new 21st century Gold Standard? Will we recourse to cryptocurrencies such as Bitcoin? Will we see the rise of the Equal Opportunity Standard, with everyone in the world being issued once with an equal amount of World dollars? Or will there be another innovation to come? What we must defend, as proud advocates of freedom, is that the free market will decide. That governments finally learn to stop their oppressive, damaging interference with the monetary system.
It is common knowledge that Japan is in extreme financial difficulties, and that the currency is most likely to sink and sink. After all, Government debt to GDP is over 250%, and the rate of increase of retirees has exceeded the birth rate for some time. A combination of population demographics, escalating welfare costs, high government debt and the government’s inability in finding a solution to Japan’s ongoing crisis ensures for international speculators that going short of the yen is a no-brainer.
Almost without being noticed, the Japanese yen has already lost about 30% against the US dollar and nearly 40% against the euro over the last two years. The beneficiaries of this trend unsurprisingly are speculators borrowing yen at negligible interest rates to speculate in other markets, expecting to add the yen’s depreciation to their profits. Thank you Mr Abe for allowing us to borrow yen at 1.06 euro-cents two years ago to invest in Spanish 10-year government bonds at 7.5%. Today the bonds yield 2.65% and we can buy back yen at 0.72 euro-cents. Gearing up ten times on an original stake of $10,000,000 has made a clear profit of some $300,000,000 in just two years.
Shorting the yen has not been profitable this year so far, with the US dollar falling against the Japanese yen from 105.3 on December 31st to 101.5 at the half-year, an annualised loss of 7.2%. This gave a negative financing return on all bond carry trades, which in the case of Spanish government debt deal cited above resulted in annualised losses of over 5%, or 50% on a ten times geared position. The trader can either take the view it’s time the yen had another fall, or it’s time to cut the position.
These returns, though dependant on market timing, are by no means unique. Consequently nearly everyone in the hedge fund and investment banking communities has been playing this lucrative carry game at one time or another.
Not only has a weak yen been instrumental in lowering bond yields around the world, it has also been a vehicle for other purchases. On the sale or short side, another commonly agreed certainty has been the imminent collapse of the credit-driven Chinese economy, which will ensure metal prices continue to fall. In this case, gearing is normally obtained through derivatives.
However, things don’t seem to be going according to plan for many investment banks and hedge funds, which might presage a change of strategy. Copper, which started off as a profitable short by falling 12.5% to a low of $2.93 per pound, has recovered sharply this week to $3.26 in a sudden short-squeeze. Zinc is up 6.4% over the last six months, and aluminium up 6%. Gold is up 11%, and silver 8.5%. So anyone shorting a portfolio of metal futures is making significant losses, particularly when the position is highly geared.
It may be just coincidence, but stories about multiple rehypothecations of physical metal in China’s warehouses have emanated from sources involved with trading in these metals. These traders have had to take significant losses on the chin on a failed strategy, and may now be moving towards a more bullish stance, because China’s warehouse scandal has not played out as they expected.
So two certainties, the collapse of both the yen and of Chinese economic demand don’t seem to be happening, or at least not happening quickly enough. The pressure is building for a change of investment strategies which is likely to drive markets in new directions in the coming months.
The recent update to the MA compilation method revealed a sudden reduction in the growth rate. However this was driven by a mysterious “improvements in reporting at one institution”, which saw £85bn vanish in January 2014. I made a shadow M’ series which added this back in, but that’s not ideal.
I’ve just tried an alternative response, which is to strip MFI deposits from the measure. We can call this MAex, and here’s the series from April 1991:
If you want to see a more recent look, here it is from January 2001:
I’m continuing efforts to improve the measure.
[Editor's note: this article was originally published by the IEA here]
I would like to thank the IEA for today publishing my monograph, New Private Monies, which examines three contemporary cases of private monetary systems.
The first is the Liberty Dollar, a private mint operated by Bernard von NotHaus, whose currency became the second most widely used in the United States. It was highly successful and its precious metallic basis ensured it rose in value over time against the inflating greenback. In 2007, however, Uncle Sam shut it down, successfully charging von NotHaus with counterfeiting and sundry other offences. In reality, the Liberty Dollar was nothing like the greenback dollar. Nor could it be, as its purpose was to provide a superior dollar in open competition, not to pass itself off as the inferior dollar it was competing against, which has lost over 95 per cent of its value since the Federal Reserve was founded a century ago. For this public service of providing superior currency, Mr. von NotHaus is now potentially facing life in the federal slammer. As he put it:
‘This is the United States government. It’s got all the guns, all the surveillance, all the tanks, it has nuclear weapons, and it’s worried about some ex-surfer guy making his own money? Give me a break!’
The second case is e-gold, a private digital gold transfer business – a kind of private gold standard – run by Dr Doug Jackson out of Nevis in the Caribbean. By 2005, e-gold had risen to become second only to PayPal in the online payments industry. Jackson correctly argued that it was not covered by any existing US financial regulation, not just because of its offshore status but also because it was a payment system rather than a money transmitter or bank as then-defined, and not least because gold was not legally ‘money’. Yet despite its efforts to clarify its evolving regulatory and tax status, and despite helping them to catch some of the biggest cyber criminals then in operation, US law enforcement turned on the company: they trumped up charges of illegal money transmission and blackmailed its principals into a plea bargain.
Both these cases illustrate that there is a strong demand for private money and that the market can meet that demand and outcompete government monetary systems. Unfortunately, they also illustrate the perils of private money issuers operating out in the open where they are vulnerable to attack by the government. Perhaps they should operate undercover instead…
This takes us to the third case study: Bitcoin, a new type of currency known as crypto-currency, a self-regulating and highly anonymous computer currency based on the use of strong cryptography.
To quote its designer, Satoshi Nakamoto:
‘The root problem with conventional currency is all the trust that is required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust…
‘Bitcoin’s solution is to use a peer-to-peer network to check for double-spending…the result is a distributed system with no single point of failure.’
Bitcoin is produced in a kind of electronic ‘mining’ process, in which successful ‘miners’ are rewarded with Bitcoin. The process is designed to ensure that the amounts produced are almost exactly known in advance. Since its inception in 2009, the demand for Bitcoin has skyrocketed, albeit in a very volatile way, forcing its price from 3 cents to (currently) just under $600. Perhaps the best-known use of Bitcoin has been on the dark web drugs market Silk Road, the ‘Amazon.com of illegal drugs’, but Bitcoin is increasingly popular for all manner of mundane legal uses as well.
Bitcoin is a wonderful innovation, but the pioneers in any industry are rarely the ones who last. Despite Bitcoin’s success to date, it is doubtful whether being the first mover is an advantage in the longer term: design flaws in the Bitcoin model are set in concrete and competitors can learn from them. The crypto-currency market is also an open one and a considerable number of competitors have since entered the field. Most of these will soon fail, but no-one can predict which will be best suited to the market and achieve long-run success. Most likely, Bitcoin will eventually be displaced by even better crypto-currencies.
Crypto-currencies have momentous ramifications. As one blogger put it:
‘As long as my encrypted [Bitcoin] wallet exists somewhere in the world, such as on an email account, I can walk across national borders with nothing on me and retrieve my wealth from anywhere in the world with an internet connection.’
This gives Bitcoin great potential as an internationally mobile store of value that offers a high degree of security against predatory governments. Bitcoin now fulfils the role once met by bank secrecy – the ability to protect one’s financial privacy.
There is no easy way in which the government can prevent the use of Bitcoin to evade its control. The combination of anonymity and independence means that governments cannot bring Bitcoin down by taking out particular individuals or organisations because the system has no single point of failure. They could shut down whatever sites they like, but the Bitcoin community would carry on.
Strong cryptography therefore offers the potential to swing the balance of power back from the state toward the individual. Censorship, prohibition, oppressive taxes and repression are being undermined as people increasingly escape into the cyphersphere where they can operate free from government harassment.
We now face the prospect of a peaceful crypto-anarchic society in which there is no longer any government role in the monetary system and, hopefully, no government at all.
Welcome to crypto-anarchy.
New Private Monies: A Bit-Part Player can be downloaded here.