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.
What is Super Mario up to?
First, he gave an unexpectedly dovish speech at the Jackson Hole conference, rather ungallantly upstaging the host, Ms Yellen, who was widely anticipated to be the most noteworthy speaker at the gathering (talking about the labor market, her favorite subject). Having thus single-handedly and without apparent provocation raised expectations for more “stimulus” at last week’s ECB meeting, he then even exceeded those expectations with another round of rate-cuts and confirmation of QE in form of central bank purchases of asset-backed securities.
These events are significant not because they are going to finally kick-start the Eurozone economy (they won’t) but because 1) they look rushed, and panicky, and 2) they must clearly alienate the Germans. The ideological rift that runs through the European Union is wide and deep, and increasingly rips the central bank apart. And the Germans are losing that battle.
As to 1), it was just three months ago that the ECB cut rates and made headlines by being the first major central bank to take a policy rate below zero. Whatever your view is on the unfolding new Eurozone recession and the apparent need for more action (more about this in a minute), the additional 0.1 percent rate reduction will hardly make a massive difference. Yet, implementing such minor rate cuts in fairly short succession looks nervous and anxious, or even headless. This hardly instils confidence.
And regarding the “unconventional” measures so vehemently requested by the economic commentariat, well, the “targeted liquidity injections” that are supposed to direct freshly printed ECB-money to cash-starved corporations, and that were announced in June as well, have not even been implemented yet. Apparently, and not entirely unreasonably, the ECB wanted to wait for the outcome of their “bank asset quality review”. So now, before these measures are even started, let alone their impact could even be assessed, additional measures are being announced. The asset purchases do not come as a complete surprise either. It was known that asset management giant BlackRock had already been hired to help the ECB prepare such a program. Maybe the process has now been accelerated.
This is Eurozone QE
This is, of course, quantitative easing (QE). Many commentators stated that the ECB shied away from full-fledged QE. This view implies that only buying sovereign debt can properly be called QE. This does not make sense. The Fed, as part of its first round of QE in 2008, also bought mortgage-backed securities only. There were no sovereign bonds in its first QE program, and everybody still called it QE. Mortgage-backed securities are, of course, a form of asset-backed security, and the ECB announced purchases of asset-backed securities at the meeting. This is QE, period. The simple fact is that the ECB expands its balance sheet by purchasing selected assets and creating additional bank reserves (for which banks will now pay the ECB a 0.2 percent p.a. “fee”).
As to 2), not only will the ECB decisions have upset the Germans (the Bundesbank’s Mr. Weidmann duly objected but was outvoted) but so will have Mr. Draghi’s new rhetoric. In Jackson Hole he used the F-word, as in “flexibility”, meaning fiscal flexibility, or more fiscal leeway for the big deficit countries. By doing so he adopted the language of the Italian and French governments, whenever they demand to be given more time for structural reform and fiscal consolidation. The German government does not like to hear this (apparently, Merkel and Schäuble both phoned Draghi after Jackson Hole and complained.)
The German strategy has been to keep the pressure on reform-resistant deficit-countries, and on France and Italy in particular, and to not allow them to shift the burden of adjustment to the ECB. Draghi has now undermined the German strategy.
The Germans fear, not quite unjustifiably, that some countries always want more time and will never implement reform. In contrast to those countries that had their backs to the wall in the crisis and had little choice but to change course in some respect, such as Greece, Ireland, and Spain, France and Italy have so far done zilch on the structural reform front. France’s competitiveness has declined ever since it adopted the 35-hour workweek in 2000 but the policy remains pretty much untouchable. In Italy, Renzi wants to loosen the country’s notoriously strict labour regulations but faces stiff opposition from the trade unions and the Left, not least in his own party. He now wants to give his government three years to implement reform, as he announced last week.
Draghi turns away from the Germans
German influence on the ECB is waning. It was this influence that kept alive the prospect of a somewhat different approach to economic challenges than the one adopted in the US, the UK and, interestingly, Japan. Of course, the differences should not be overstated. In the Eurozone, like elsewhere, we observed interest rate suppression, asset price manipulations, and massive liquidity-injections, and worse, even capital controls and arbitrary bans on short-selling. But we also saw a greater willingness to rely on restructuring, belt-tightening, liquidation, and, yes, even default, to rid the system of the deformations and imbalances that are the ultimate root causes of recessions and the impediments to healthy, sustainable growth. In the Eurozone it was not all about “stimulus” and “boosting aggregate demand”. But increasingly, the ECB looks like any other major central bank with a mandate to keep asset prices up, government borrowing costs down, and a generous stream of liquidity flowing to cover the cracks in the system, to sustain a mirage of solvency and sustainability, and to generate some artificial and short-lived headline growth. QE will not only come to the Eurozone, it will become a conventional tool, just like elsewhere.
I believe it is these two points, Draghi’s sudden hyperactivity (1) and his clear rift with the Germans and his departure from the German strategy (2) that may explain why the euro is finally weakening, and why the minor announcements of last Thursday had a more meaningful impact on markets than the similarly minor announcements in June. With German influence on the ECB waning, trashing your currency becomes official strategy more easily, and this is already official policy in Japan and in the US.
Is Draghi scared by the weak growth numbers and the prospect of deflation?
Maybe, but things should be put in perspective.
Europe has a structural growth problem as mentioned above. If the structural impediments to growth are not removed, Europe won’t grow, and no amount of central bank pump priming can fix it.
Nobody should be surprised if parts of Europe fall into technical recessions every now and then. If “no growth” is your default mode then experiencing “negative growth” occasionally, or even regularly, should not surprise anyone. Excited talk about Italy’s shocking “triple-dip” recession is hyperbole. It is simply what one should expect. Having said this, I do suspect that we are already in another broader cyclical downturn, not only in Europe but also in Asia (China, Japan) and the UK.
The deflation debate in the newspapers is bordering on the ridiculous. Here, the impression is conveyed that a drop in official inflation readings from 0.5 to 0.3 has substantial information content, and that if we drop below zero we would suddenly be caught in some dreadful deflation-death-trap, from which we may not escape for many years. This is complete hogwash. There is nothing in economic theory or in economic history that would support this. And, no, this is not what happened in Japan.
The margin of error around these numbers is substantial. For all we know, we may already have a -1 percent inflation rate in the Eurozone. Or still plus 1 percent. Either way, for any real-life economy this is broadly price-stability. To assume that modest reductions in any given price average suddenly mean economic disaster is simply a fairy tale. Many economies have experienced extended periods of deflation (moderately rising purchasing power of money on trend) in excess of what Japan has experienced over the past 20 years and have grown nicely, thank you very much.
As former Bank of Japan governor Masaaki Shirakawa has explained recently, Japan’s deflation has been “very mild” indeed, and may have had many positive effects as well. In a rapidly aging society with many savers and with slow headline growth it helped maintain consumer purchasing power and thus living standards. Japan has an official unemployment rate of below 4 percent. Japan has many problems but deflation may not be one of them.
Furthermore, the absence of inflation in the Eurozone is no surprise either. There has been no money and credit growth in aggregate in recent years as banks are still repairing their balance sheets, as the “asset quality review” is pending, and as other regulations kick in. Banks are reluctant to lend, and the private sector is careful to borrow, and neither are acting unreasonably.
Expecting Eurozone inflation to clock in at the arbitrarily chosen 2 percent is simply unrealistic.
Draghi’s new activism moves the ECB more in the direction of the US Fed and the Bank of Japan. This alienates the Germans and marginally strengthens the position of the Eurozone’s Southern periphery. This monetary policy will not reinvigorate European growth. Only proper structural reform can do this but much of Europe appears unable to reform, at least without another major crisis. Fiscal deficits will grow.
Monetary policy is not about “stimulus” but about maintaining the status quo. Super-low interest rates are meant to sustain structures that would otherwise be revealed to be obsolete, and that would, in a proper free market, be replaced. The European establishment is interested in maintaining the status quo at all cost, and ultra-easy monetary policy and QE are essentially doing just that.
Under the new scheme of buying asset-backed securities, the ECB’s balance sheet will become a dumping ground for unwanted bank assets (the Eurozone’s new “bad” bank). Like almost everything about the Euro-project, this is about shifting responsibility, obscuring accountability, and socializing the costs of bad decisions. Monetary socialism is coming. The market gets corrupted further.
The following is a commentary I wrote for The Forum section of London business-paper City A.M. The link is here.
It is now six years since the collapse of Lehman Brothers, and considering that the US economy has officially been in recovery for the past five years, that equity indexes have put in new all-time highs, and that credit markets are once again ebullient to the point of carelessness, it is worth contemplating that monetary policy remains stuck in pedal-to-the-floor stimulus mode. Granted, quantitative easing is (once again) scheduled to end, and the first rates hikes are now expected for next year, but the present policy stance certainly remains highly accommodative. A full ‘exit’ by the Fed is still merely a prospect.
Expectations appear to be for the US economy to finally emerge from its long stay in monetary intensive care healthier and fit for self-sustained, if modest, growth. I think this is unlikely. The lengthy period of monetary stimulus will have saddled the economy with new dislocations. And if central bank intervention did indeed manage to arrest the forces of liquidation that the crisis had unleashed, then some old imbalances will also still hang around.
“Easy money” is – contrary to how it is frequently portrayed – not some tonic that simply lifts the general mood and boosts all economic activity proportionally. Monetary stimulus is always a form of market intervention. It changes relative prices (as distinguished from the ‘price level’ that most economists obsess about); it alters the allocation of scarce resources and the direction of economic activity. Monetary policy always affects the structure of the economy – otherwise no impact on real activity could be generated. It is a drug with considerable side effects.
The latest crisis should provide a warning. As David Stockman pointed out, it did not arrive on a meteor from space, but had its origin in distortions in the housing market in the US – and the UK, Spain and Ireland – and in related credit markets, and therefore ultimately in the “easy money” policies of the early 2000s. Administratively suppressing short rates down to 1 percent for a prolonged period was then the “unconventional” policy du jour, and it was a success of sorts. A credit crunch and deleveraging were indeed avoided, which were then feared as a consequence of WorldCom and Enron defaulting and the dot.com-bubble bursting, but only at the price of blowing an even bigger bubble elsewhere.
This is the problem with our modern fiat money system. With the supply of money no longer constrained by a nature-given, scarce commodity (gold or silver), but now fully elastic, essentially unlimited, and under the control of a lender of last resort central bank, the parameters of risk-taking are forever altered.
Allegedly, we can now stop bank-runs and ignite short-term growth spurts, or keep the overall “price level” advancing on some arbitrarily chosen path of 2 percent. But we can achieve all of this only through monetary manipulations that must create imbalances in the economy. And as the overwhelming temptation is now to use “easy money” to avoid or shorten any period of liquidation, to go for all growth and no correction, distortions will accumulate over time.
As we move from cycle to cycle, the imbalances get bigger, asset valuations become more stretched, the debt load rises, and central banks take policy to new extremes to arrest the market’s growing desire for a much needed cleansing. That policy rates around the world have converged on zero is not a cyclical but a structural phenomenon.
Central bank stimulus is not leading to virtuous circles but to vicious ones. How can we get out? – Only by changing our attitudes to monetary interventions fundamentally. Only if we accept that interest rates are market prices, not policy levers. Only if we accept that the growth we generate through cheap credit and interest-rate suppression is always fleeting, and always comes at the price of new capital misallocations.
The prospect for such a change looks dim at present. Last year’s feverish excitement about Abenomics and this year’s urgent demands for Eurozone QE show that the belief in central bank activism is unbroken, and I remain sceptical as to whether the Fed and the Bank of England can achieve a proper and lasting “exit” from ultra-loose policy in this environment. The near-term outlook is for more heavy-handed interventions everywhere, and the endgame is probably inflation. This will end badly.
The data was not really surprising and neither was the response from the commentariat. After a run of weak reports from Germany over recent months, last week’s release of GDP data for the eurozone confirmed that the economy had been flatlining in the second quarter. Predictably, this led to new calls for ECB action. “Europe now needs full-blown QE” diagnosed the leader writer of the Financial Times, and in its main report on page one the paper quoted Richard Barwell, European economist at Royal Bank of Scotland with “It’s time the ECB took control and we got the real deal, instead of the weaker measure unveiled in June.”
I wonder if calls for more ‘stimulus’ are now simply knee-jerk reactions, mere Pavlovian reflexes imbued by five years of near relentless policy easing. Do these economists and leader writers still really think about their suggestions? If so, what do they think Europe’s ills are that easy money and cheap credit are going to cure them? Is pumping ever more freshly printed money into the banking system really the answer to every economic problem? And has QE been a success where it has been pursued?
The fact is that money has hardly been tight in years – at least not at the central bank level, at the core of the system. Granted, banks have not been falling over one another to extend new loans but that is surely not surprising given that they still lick their wounds from 2008. The ongoing “asset quality review” and tighter regulation are doing their bit, too, and if these are needed to make finance safer, as their proponents claim, then abandoning them for the sake of a quick – and ultimately short-lived – GDP rebound doesn’t seem advisable. The simple fact is that lenders are reluctant to lend and borrowers reluctant to borrow, and both may have good reasons for their reluctance.
Do we really think that Italian, French, and German companies have drawers full of exciting investment projects that would instantly be put to work if only rates were lower? I think it is a fairly safe bet that whatever investment project Siemens, BMW, Total and Fiat can be cajoled into via the lure of easy money will by now have been realized. The easy-money drug has a rapidly diminishing marginal return.
In most major economies, rates have been close to zero for more than five years and various additional stimulus measures have been taken, including some by the ECB, even if they fell short of outright QE. Yet, the global economy is hardly buzzing. The advocates of central bank activism will point to the US and the UK. Growth there has recently been stronger and many expect a rise in interest rates in the not too distant future. Yet, even if we take the US’ latest quarterly GDP data of an annualized 4 percent at face value (it was a powerful snap-back from a contraction in Q1), the present recovery, having started in 2009, still is the slowest in the post-World-War-II period, and by some margin. The Fed is not done with its bond-buying program yet, fading it out ever so slowly and carefully, fearful that the economy, or at any rate overstretched financial markets, could buckle under a more ‘normal’ policy environment, if anybody still knows what that may look like. We will see how much spring is left in the economy’s step once stimulus has been removed fully and interest rates begin to rise — if that will ever happen.
Then there is Japan, under Abe and Kuroda firmly committed to QE-square and thus the new poster-boy of the growth-through-money-printing movement. Here the economy contracted in Q2 by a staggering 6.8% annualized, mimicking its performance from when it was hit by a tsunami in 2011. This time economic contraction appears to have been mainly driven by an increase in the country’s sale tax (I guess the government has to rein in its deficit at some stage, even in Japan), which had initially caused a strong Q1, as consumers front-loaded purchases in anticipation of the tax hike. Now it was pay-back time. Still, looking through the two quarters, the Wall Street Journal speaks of “Japan’s slow recovery despite heavy stimulus”.
Elsewhere the debate has moved on
In the Anglo-Saxon countries the debate about the negative side-effects of ultra-easy money seems to be intensifying. Last week Martin Feldstein and Robert Rubin, in an editorial for the Wall Street Journal, warned of risks to financial stability from the Fed’s long-standing policy stimulus, pointing towards high asset values and tight risk premiums, stressing that monetary policy was asked to do too much. Paul Singer, founder of the Elliott Management hedge fund and the nemesis of Argentina’s Cristina Fernandez de Kirchner, was reported as saying that ultra-easy monetary policy had failed and that structural reforms and a more business-friendly regulatory environment were needed instead. All of this even before you consider my case (the Austrian School case) that every form of monetary stimulus is ultimately disruptive because it can at best buy some growth near term at the price of distorting capital markets and sowing the seeds of a correction in the future. No monetary stimulus can ever lead to lasting growth.
None of this seems to faze the enthusiasts for more monetary intervention in Europe. When data is soft, the inevitable response is to ask the ECB to print more money.
The ECB’s critics are correct when they claim that the ECB has recently been less accommodative than some of its cousins, namely the Fed and the Bank of Japan. So the eurozone economy stands in front of us naked and without much monetary make-up. If we do not like what we see then the blame should go to Europe’s ineffectual political elite, to France’s socialist president Hollande, whose eat-the-rich tax policies and out-of-control state bureaucracy cripple the country; to Ms Merkel, who not only has failed to enact a single pro-growth reform program since becoming Germany’s chancellor (how long can the country rest on the Schroeder reforms of 2002?) but now embraces a national minimum wage and a lower retirement age of 63, positions she previously objected to; to Italy’s sunny-boy Renzi who talks the talk but has so far failed to walk the walk. But then it has been argued that under democracy the people get the rulers they deserve. Europe’s structural impediments to growth often appear to enjoy great public support.
Calls for yet easier monetary conditions and more cheap credit are a sign of intellectual bankruptcy and political incompetence. They will probably be heeded.
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.
“I am definitely concerned. When was [the cyclically adjusted P/E ratio or CAPE] higher than it is now? I can tell you: 1929, 2000 and 2007. Very low interest rates help to explain the high CAPE. That doesn’t mean that the high CAPE isn’t a forecast of bad performance. When I look at interest rates in a forecasting regression with the CAPE, I don’t get much additional benefit from looking at interest rates… We don’t know what it’s going to do. There could be a massive crash, like we saw in 2000 and 2007, the last two times it looked like this. But I don’t know. I think, realistically, stocks should be in someone’s portfolio. Maybe lighten up… One thing though, I don’t know how many people look at plots of the market. If you just look at a plot of one of the major averages in the U.S., you’ll see what look like three peaks – 2000, 2007 and now – it just looks to me like a peak. I’m not saying it is. I would think that there are people thinking – way – it’s gone way up since 2009. It’s likely to turn down again, just like it did the last two times.”
“Paid promoters have helped push CYNK [CYNK Technology Corp] market cap to $655 million after a 3,650% increase in the share price on Tuesday.
“CYNK had assets of just $39 (no zeroes omitted) as of March 31, 2014 and a cumulative net loss of $1.5 million. The “company” has no revenue.
“CYNK claims that it is “a development stage company focused on social media.” However, the “company” does not even have a website and has just one employee [who acts as President, Chief Executive Officer, Chief Financial Officer, Treasurer and Company Secretary].
“With no assets, no revenue and no product, CYNK has no value. Author expects that CYNK shares are worthless.”
Lord Overstone said it best. “No warning can save people determined to grow suddenly rich.” But there is clearly a yawning chasm between the likes of those folk cheerfully bidding up the share price of CYNK, and prudent investors simply trying to keep their heads above water. What has effectively united these two otherwise disparate communities is today’s central banker. Andy Haldane, the chief economist for the Bank of England, speaking at an FT conference last week, conceded that ultra-accommodative monetary policy had “aided and abetted risk-taking” by investors and that policy makers had wanted to use higher asset prices to try and stimulate the wider economy (that is to say, the economy) into a more robust recovery: “That is how [monetary policy] is meant to work. That’s why we did it.” If the Bank of England had not slashed interest rates and created £375 billion out of thin air, “the UK economy would have been at least 6 per cent smaller than it is today.” A curiously precise figure, given the absence of any counterfactual. But regardless of the economic “benefits” of quantitative easing, Haldane did have the grace to admit that
“That will mean, on average, that financial market volatility will be somewhat greater than in the past. I think it will mean, on average, that those greed and fear cycles in financial markets will be somewhat more exaggerated than in the past. That, for me, is the corollary of the risk migration.”
Which is a bit like an arsonist torching a wooden building and then shrugging his shoulders and saying,
“Well, wood will burn.”
Our central bankers, of course, will not be held accountable when the crash finally hits, even if the accumulated dry tinder of the boom was almost entirely of their own creation. Last week the Bank for International Settlements, the central banker’s central bank, issued an altogether more circumspect analysis of the world’s current financial situation, in their annual report. It concluded, with an entirely welcome sense of caution, that
“The [monetary] policy response needs to carefully consider the nature and persistence of the forces at work as well as policy’s diminished effectiveness and side effects. Finally, looking forward, the issue of how best to calibrate the timing and pace of policy normalisation looms large. Navigating the transition is likely to be complex and bumpy, regardless of communication efforts. And the risk of normalising too late and too gradually should not be underestimated.” (Emphasis ours.)
Translation: ZIRP (Zero Interest Rate Policy – and in the case of the ECB, which has taken rates negative, NIRP) is no longer working – if it ever did. Hyper-aggressive monetary policy has side effects. Getting out of this mess is not going to be easy, and it’s going to be messy. Forward guidance, which was meant to simplify the message, has instead hopelessly confused it. And there are big risks that central banks will lose the requisite confidence to tighten policy when it is most urgently needed, and allow an inflationary genie entirely out of the bottle.
The impact of central banks’ unprecedented monetary stimulus on financial markets is so overwhelming that it utterly negates any sensible analysis of likely macro-economic developments. On the basis that sometimes it’s simply best not to play some games, we no longer try. What should inform investors’ preferences, however, is bottom-up asset allocation and stock selection. The US equity market is clearly poor value at present. That doesn’t mean that it can’t get even more expensive, and the rally might yet have some serious legs. But overvaluation at an index level doesn’t preclude the existence of undervalued stocks well away from the braying herd. (We think the most compelling macro value is in Asia and, if we had to single out any one country, Japan.)
“The central thesis among investors at present is that they have no other choice but to hold stocks, given the alternative of zero short-term interest rates and long-term interest rates well below the level of recent decades..”
“Investment decisions driven primarily by the question “What other choice do I have ?” are likely to prove regrettable. What we now have is a market that has been driven to one of the four most extreme points of overvaluation in history. We know how three of them ended.”
The conclusion seems clear to us. If one chooses to invest at all, invest on the basis of valuation and not on indexation (the world’s largest stock market, that of the US, is one of the most seemingly conspicuously overvalued). As an example of the sort of valuations currently available away from the herd, consider the following. You can buy the US S&P 500 index today with the following metrics:
Price / earnings: 18.2
Price / book: 2.76
Dividend yield: 1.89%
Meanwhile, Greg Fisher in his Halley Asian Prosperity Fund (albeit currently closed) is buying quality businesses throughout Asia on somewhat more attractive valuations. (By geography, the fund’s largest allocations are to Japan, Vietnam and Malaysia.) The fund’s current metrics are as follows:
Average price / earnings: 7
Average price / book: 0.8
Average dividend yield: 4.5%.
But the realistic prospect of growth is also on the table. The fund’s average historic return on equity stands at 15%.
Pay money. Take choice.
Incoming from Tom Paterson, chief economist at “Gold Made Simple”:
I’m currently travelling around Europe in my VW campervan with my my wife and 9 month old daughter! Well, why not!
I’ve picked up a gig at the Daily Express making short videos about the UK economy – the first one can be found here [video]:
I’ve filmed another 5 (covering the UK debt, Deficit, Govt Spending and BoE money printing)… and a new one will go live every Monday…
The Walls sausage advertisement threw me for a moment before the proper video started. Looks like a good series to watch out for.
Tom Paterson can be contacted by email here.
One of the interesting things that happened at the End of the World Club on Monday evening, was a teaser of what’s new about Detlev Schlichter‘s Paper Money Collapse (2nd edition). We are promised some discussion about Bitcoin (which really got going about the time PMC first appeared on bookshelves).
Also promised is an update of Detlev’s views and he hopes to include discussions that have taken place in various forums (such as on his blog).
Further updates as we get them.
Editor’s note: this article, under the title “No end to central bank meddling as ECB embraces ‘quantitative easing’, faulty logic” appears on Detlev Schlichter’s site. It is reprinted with kind permission.
The 2nd edition of his excellent Paper Money Collapse is available for pre-order.
“Who can print money, will print money” is how my friend Patrick Barron put it succinctly the other day. This adage is worth remembering particularly for those periods when central bankers occasionally take the foot off the gas, either because they genuinely believe they solved the problem, or because they want to make a show of appearing careful and measured.
The US Federal Reserve is a case in point. Last year the Fed announced that it was beginning to ‘taper’, that is, carefully reduce its debt monetization program (‘quantitative easing’, QE), and this policy, now enacted, is widely considered the beginning of policy normalization and part of an ‘exit strategy’. But as Jim Rickards pointed out, the Fed already fully tapered twice – after QE1 and after QE2 – only to feel obliged to ‘qe’ again some time later. Whether Ms Yellen is going to see the present ‘taper’ through to its conclusion and whether the whole project will in future be remembered as an ‘exit strategy’ remains to be seen.
So far none of the big central banks has achieved the ‘exit’ despite occasional noises to the contrary. Since the start of the financial crisis in the summer of 2007, the global trend has been in one direction and one direction only: From easy money we moved to easier money. QE has been followed by more QE. As I mentioned before, the Fed’s most generous year in its 100-year history was 2013, any talk of ‘tapering’ notwithstanding.
ECB mistrusted by Keynesian consensus
Whenever the European Central Bank reduces its money printing and scales back its market rigging, it invariably unleashes the fury of the Keynesian and inflationist commentariat. In the eyes of its numerous critics, the ECB lacks the proper money-printing credentials of the more pro-active and allegedly more ‘modern’ central banks. It still has a whiff of the old Bundesbank about it, although a few years back, when the ECB flooded the European banking system with cheap liquidity, its balance sheet was larger as a share of GDP than those of its comrades, the Fed and the Bank of England.
The ECB went through two periods of restraint since the crisis: In early 2011 it began to hike interest rates, and in 2013, after the eurozone debt crisis died down, the ECB allowed its balance sheet to shrink by more than €700 billion as banks repaid cheap loans from the central bank. This stood in stark contrast to the Fed’s balance sheet expansion of about $1,000 billion over the same period. The first episode of restraint came to an end in 2012 when the ECB reversed its rate hikes and then cut rates further, ultimately to a new low of just 0.25 percent. Presently, we are still in the second period of restraint, although it too appears to be about to end soon as the ECB’s boss Mario Draghi hinted in his press conference last week at a newfound willingness to embrace unconventional policies to combat ‘deflation’ or even ‘long periods of low inflation’. (The ECB’s harmonized index of consumer prices stood probably at just 0.5% last month.) This means the ECB is likely to cut rates to zero or below soon, or to start asset purchases (‘QE’), or probably both.
This move is hardly surprising in the big scheme of things as outlined above, and the ECB will explain it officially with its mandate to keep inflation below but close to 2 percent, from which it does not want to deviate in either direction. This target itself is silly as it assumes that inflation of 1.8 percent is inherently better than inflation of zero (true price stability, if it ever was attainable), or inflation of minus 1.8 percent (deflation). This is, of course, precisely the argument that has been relentlessly and noisily trumpeted by the easy-money advocates in the media, the likes of Martin Wolf and Wolfgang Münchau in the Financial Times, and the reliably shrill Ambrose Evans-Pritchard in The Daily Telegraph, among others. A certain measure of inflation is deemed good, very low inflation is bad, and anything below zero, even mild deflation, potentially a disaster. But why should this be the case?
Moderate deflation, that is, slowly declining money prices, may or may not be a symptom of problems elsewhere in the economy, but that slowly declining money prices as such constitute an economic problem lacks any foundation in economics and can easily and quickly be refuted by even a cursory look at economic history. In the 19th century we find extended periods of ongoing, moderate deflation in many economies that simultaneously experienced solid growth in output and substantial rises in living standards, a “coincidence”, wrote Milton Friedman and Anna Schwartz in their influential A Monetary History of the United States, 1867 – 1960, that “casts serious doubts on the validity of the now widely held view that secular price deflation and rapid economic growth are incompatible.”
Many commentators advance the argument that falling prices depress consumption as purchases get constantly deferred. Even the usually more sober FT-writer John Authers seems to have succumbed to this argument as he explained to his readers last Saturday that prices “fall, thanks to sluggish economic activity. Consumers do not buy now, as goods will be cheaper in future. This lack of consumption slows growth further, and pushes prices down even further.” (John Authers, “Draghi has to back his QE words with action” Financial Times, Saturday April 5/ Sunday April 6 2014, page 24)
This argument, constantly regurgitated by the cheerleaders of money-printing, is weak. First of all, it is certainly no argument in the present environment of close to zero but still positive inflation. If the ECB plans to fight even very low inflation, as Draghi stated at the ECB press conference, than this argument does nothing to support that policy. Certainly, no one defers any purchases when prices are just stable. However, and more importantly, even in a mildly deflationary environment of let’s say 1 to 2 percent per annum, the argument does appear to be a stretch.
Argument ignores time preference
Consumers only contemplate buying something that they consider an economic good, that is, that they consider useful, that they want because it expends some (subjective) use-value to them. In deferring a purchase they can, in a deflationary environment, save money but at the cost of not enjoying the possession of what they want for some time. By not buying a toaster now you may be able to buy it 1 or 2 percent cheaper in a year’s time, or 2 to 4 percent cheaper in two years’ time (always assuming, of course, that the mild deflation persists that long, which nobody can guarantee), but even these small monetary gains come at the expense of not enjoying ownership of the toaster for two years. The small monetary gain obtained by delaying purchases is not for free, as the argument seems to assume, but comes at the cost of waiting. I suggest that only a very small number of items, and only those for which there is very marginal demand indeed, would be affected.
Time preference is not a concept of psychology, it is a constituting element of human action. It is a priori to human action, which means it exists independent of experience or of personal circumstances as it is already entailed in the very concept of what constitutes an ‘economic good’.
If you experienced no time preference in relation to a specific good you would be indifferent as to whether you enjoyed the possession of that good today or tomorrow. And tomorrow you would be indifferent as to whether you enjoyed it that day or the next, and so forth. Logically, you would be indifferent as to whether you enjoyed possession of it at all, and this means that the good in question is not an economic good for you. You do not care for it.
As George Reisman put is succinctly: To want something means, all else being equal, to want it sooner rather than later.
Be honest, how many purchases over the past 12 months would you not have made had you had a reasonable chance of obtaining the item in question at a 1 or 2 percent discount if you waited a year?
That the prospect of falling prices does not usually deter consumption can be readily seen today in the market for consumer electronics (mobile phones, computers), which has been in deflation – and considerable deflation – for quite some time.
Argument ignores opportunity costs of holding money
The argument also seems to ignore that holding one’s wealth in the form of money involves opportunity costs. Rather than sitting on cash you could enjoy the things you could buy with it. In a deflationary environment, your cash hoard’s purchasing power slowly rises and you can afford ever more nice things with your money, which means the opportunity cost of not spending it constantly goes up. (In a way, while you are waiting four years to buy your toaster at an 8 percent discount to today’s price, buying the toaster is also becoming marginally more attractive to others who are presently holding cash and who may initially not even had an interest in a toaster.)
I think that all that would follow from secular (that is ongoing, systematic but moderate) deflation is that cash would be a more meaningful competitor for other depositories of deferred consumption. Saving by simply holding money makes sense in a deflationary environment, so other vehicles to save with (bonds and shares) would have to offer a return reasonably above the expected deflation rate to attract savings. I think this is not an unreasonably high hurdle.
Furthermore, if what Authers and others describe were true for even marginal deflation, that is, if marginal deflation indeed led to more deflation and a progressively weakening economy, the reverse must logically be true for marginal inflation. Consumers would accelerate their purchases to avoid the 1 or 2 percent loss in purchasing power per annum, and this would quickly drive inflation higher. If two percent deflation led to cash hoarding and a collapse in consumption, would the 2 percent inflation advocated today as ‘price stability’ not lead to a spike in money velocity and an inflationary boom? Either scenario seems highly unrealistic.
Monetary causes versus non-monetary causes
If we use the economic terminology correctly, then inflation and deflation are always monetary phenomena, that is, they always have monetary causes. (As an aside, I here use the now standard definition of inflation as an ongoing, trending rise in the general price level, and deflation as the opposite, rather than the traditional meaning of inflation as an expansion of the money supply and deflation as a contraction.) However, the starting point of the present discussion is simply some low readings on the official inflation statistics in the eurozone. And that those could have non-monetary causes, that they could be the consequence of a crisis-driven drop in real demand in certain industries and certain countries is a realistic assumption and is in fact implied by the arguments of the QE-advocates. Outright deflation is presently being recorded in Greece, Cyprus, and Spain. And John Authers’ short statement on deflation in the FT also starts from the assumption that “prices fall thanks to sluggish economic activity.”
But to the extent that recorded deflation is not due to a general rise in money’s purchasing power (due to a general rise in money demand or an unchanged or falling money supply, to which I come soon) but the result of some producers slashing certain prices in certain industries and regions, and of those price drops not being fully compensated by rising prices somewhere else in eurozone, then this has various implications:
Consumers cannot simply assume that this is a lasting trend. The liquidation of capital misallocations and the discounting of merchandise to get it moving are crisis phenomena and cannot simply be extrapolated into the future the way consumers may have extrapolated the secular deflation of gold standard economies in the 19th century. But the straight extrapolation of very recent price changes into the future is at the core of the argument that even small deflation would be disastrous.
Furthermore, it would seem bizarre to advice merchants to not slash prices when demand drops as that would, according to the logic advanced by Authers et al, only lead to further postponement of consumption and a further drop in demand as consumers would simply expect price declines to continue. Would hiking prices be a better strategy to counter falling demand? Should we reconsider the concept of the “sale” and of “discounting” inventory to encourage buying?
To a considerable degree, the reduction in certain prices for ‘real’ economic reasons could be part of the economic healing process. It is a way for many producers, sectors of the economy, and economic regions, to regain competitiveness. It is true that falling wages in certain industries or regions make it more difficult for workers to repay mortgages and consumer loans but often the lower wage may be the only way to avoid unemployment, which would make repaying debt harder still. Behind the often-quoted headline inflation rate of presently 0.5% per annum lie numerous relative price changes by which the economy re-balances. All discussions about the ‘price index’ ignore these all-important changes in relative prices. It so happens that what goes on with the multitude of individual prices in the economy adds up, according to the techniques of the ECB statisticians, to a 0.5% harmonized inflation rate at the moment, and it may all add up to -0.5% next month or next year, or maybe even – 1 percent. To simply conclude from this one aggregate price number that the economy is getting progressively sicker would be wrong.
There is no escaping the fact that recent economic difficulties are the result of imbalances that accumulated during the credit boom that preceded the 2007/2008 financial crisis, of which the eurozone debt crisis was an after quake. Artificially cheap money created the credit boom and these imbalances. A period of liquidation, contraction, changing relative prices and occasionally falling prices is now necessary, and short-circuiting this process via renewed central bank intervention seems counterproductive and ultimately dangerous.
There is, of course, the possibility that proper monetary causes are behind the eurozone’s low inflation and soon deflation, and that those might persist. Banks still feel constrained in their ability to extend new loans and thus create new money. The growth in bank lending and thus in wider monetary aggregates may fall short of the growth in money demand. But it is an essential feature of money that any demand for it can be fully satisfied with a rise in its price. Demand for money is always demand for readily exercisable purchasing power, and by allowing the market to lift the purchasing power of money, that is, through deflation, that demand can be met. The secular, moderate and largely harmless deflation of 19th century gold standard economies had essentially the same origin. Money production did not keep pace with money demand, so money demand was satisfied via slowly falling prices.
And here the same conclusion applies: a more restrained approach to lending, credit risk, and financial leverage, now adopted by banks and the public at large as a consequence of the crisis, may be a good thing, and for the central bank to mess with this process and to use ‘unconventional’ means to force more bank lending and money creation onto the system, out of some misguided commitment to the arbitrarily chosen statistical goal of ‘2-percent inflation’ seems foolish. If successful in raising the headline inflation rate it may succeed in creating the same imbalances (excessive leverage, misallocations of capital and distorted asset prices) that have created the recent crisis.
One commentator recently said the eurozone could ill afford deflation considering the size of its bloated banking sector. But the question is if it can afford the level of lending to attain 2 percent inflation considering the size of its bloated banking sector.
The fallacy of macroeconomics and macroeconomic policy
Let me be clear: I do not recommend a zero-inflation target or a target of moderate deflation. Moderate deflation in and of itself is a little a solution as moderate inflation in and of itself is a problem. I recommend no target as I reject the entire concept of ‘monetary policy’, of the notion that a state agency could conceivably enhance, through clever manipulation of interest rates and bank reserve policy, the coordinating powers of the market that help people realize their personal economic objectives through free trade.
We should remember that no one participates in the economy and in trade and commerce because his or her goal is that the general price level goes up by 2 percent, or that nominal GDP increases by 5 percent. People have their own personal objectives. The market is simply a powerful tool for voluntary and decentralized plan-coordination among independent individuals and groups of individuals that pursue their own goals. It is best left undisturbed. This entire project of ‘monetary policy’ is absurd in the extreme, regardless of what the target is.
It is the fallacy of macroeconomics that certain statistical aggregates, such as CPI, GDP or nominal GDP, are deemed reliable representatives of what goes on in a complex market economy, and it is dangerous hubris to believe that the state should define ‘targets’ for these statistical aggregates and then use policy intervention to achieve them. This might be an approach intellectually suitable for the ruler of a communist or fascist society. It is fundamentally at odds with free trade and a free market, and it must and will fail. That should have been a clear lesson from the financial crisis.
Instead, the mainstream consensus, deeply influenced by Keynesianism and macroeconomics, continues to embrace policy activism and intervention. I fully expect central banks to continue on their path towards more aggressive meddling and generous fiat money production. It won’t take long for the ECB to take the next step.
I’ve recently written for Save Our Savers attempting to square the massive expansion of Britain’s monetary base since March 2009 with the fact that inflation has now been within the Bank of England’s target range of 2% (+/- 1%) since June 2012. Here I’d like to expand a little.
Since March 2009 Britain’s monetary base, also known as narrow money or M0, has increased by 321%. We can see that the majority of this is in the form of increased bank reserves, up 642% since March 2009
Source:The Bank of England, series Notes in circulation – RPWB55A, and Reserve Balances – RPWB56A
This is just what we’d expect to see following the Bank of England’s Quantitative Easing, where the Bank creates new money and uses it to purchase bonds from banks – that new money becomes bank reserves. Those banks have sat on that money (not using it as a basis for new credit creation and feeding into M4) which is why, while narrow (M0) money has exploded, broad (M4) money has barely budged, increasing by just 7.4% since March 2009.
Source:The Bank of England, series Notes in circulation (RPWB55A) and Reserve Balances (RPWB56A) (M0), and Monthly amounts outstanding of M4 (monetary financial institutions’ sterling M4 liabilities to private sector) (in sterling millions) seasonally adjusted (LPMAUYN) (M4)
This relative restraint in M4 growth explains the relative restraint in inflation. There is no great mystery as to why banks which have just seen their assets tank and ravage their balance sheets should want to hold more reserves. The key question is what happens next.
The chart above shows the ratio of M0 to M4 since May 2006; how many pounds of broad money each pound of narrow money is supporting. From 25:1 between May 2006 and March 2009, it slumped via successive bouts of Quantitative Easing to about 6:1 since September 2012.
Now, on the one hand banks might stick to this new, lower ratio. Chastened by their experiences with mortgage backed assets they might desire a permanently lower reserve to asset ratio and all QE will have been is a vast recapitalisation of banks.
On the other hand, as ‘recovery’ kicks in they might start to increase their reserve to asset ratio. They might not scale the giddy heights of 25:1 again, but they will be multiplying out from a monetary base which has tripled in size. Britain’s monetary base is now £362 billion and M4 is about six times that, £2.2 trillion. But if renewed confidence in the banking sector saw banks return to higher ratios, the resulting M4 figures would be as follows:
Here, we are told, the Bank of England will be able to ‘drain’ this liquidity from the system. It would do this by reversing QE; selling bonds to banks and effectively destroying the base money it receives in return. But a massive increase in the supply of bonds relative to the demand for them will lower their price. This is the same as raising their yield and this is the same as raising a key interest rate.
It is worth pondering for a moment the scale of bond sales and consequent rise in interest rates which might be necessary to drain this base money from the financial system. We must hope either that the economy can stand it or that banks keep holding these reserves.