While the stance of monetary policy around the world has, on any conceivable measure, been extreme, by which I mean unprecedentedly accommodative, the question of whether such a policy is indeed sensible and rational has not been asked much of late. By rational I simply mean the following: is this policy likely to deliver what it is supposed to deliver? And if it does fall short of its official aim, then can we at least state with some certainty that whatever it delivers in benefits is not outweighed by its costs? I think that these are straightforward questions and that any policy that is advertised as being in ‘the interest of the general public’ should pass this test. As I will argue, the present stance of monetary policy only has a negligible chance, at best, of ever fulfilling its stated aim. Furthermore, its benefits are almost certainly outweighed by its costs if we list all negative effects of this policy and do not confine ourselves, as the present mainstream does, to just one obvious cost: official consumer price inflation, which thus far remains contained. Thus, in my view, there is no escaping the fact that this policy is not rational. It should be abandoned as soon as possible.
The policy and its aims
The key planks of this policy are super low interest rates and targeted purchases (or collateralized funding) of financial assets by central banks. While various regional differences exist in respect of the extent of these programmes and the assets chosen, all major central banks – the US Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan – have been engaged and continue to be committed to versions of this policy. Its purpose is to facilitate exceptionally cheap funding for banks and to affect the pricing of a wide range of financial assets, in particular and most directly government bonds but also mortgage bonds in the US and real-estate investment trusts and corporate securities in Japan. There is an ongoing debate in the UK and in the Euro Zone, too, about directly boosting prices of other, ‘private’ securities, that is, to have their prices manipulated upwards by direct purchases from the central banks.
To the wider public this policy is described as ‘stimulating’ growth, ‘unlocking’ the flow of credit and ‘jump-starting’ the economy. If that is indeed the aim, this policy has already failed.
We have now had almost five years of near-zero interest rates around the world. If such low interest rates were indeed the required kick-starter for the economy, we should have seen the results by now. ‘Stimulus’ is something that incites or arouses to action, a kind of ‘ignition’ that sets off processes, in this case, one assumes, a self-sustained economic recovery. But if the world economy was really fundamentally healthy and only in need of a dose of caffeine to stir it back into action, then dropping rates from around 4 to 5 percent to zero, as happened 4 or 5 years ago, should have done the trick by now.
Defenders of the policy will argue that we would all be in much more of a bind without it, but this is not the point here. This is something we can discuss when comparing costs and benefits. There is no escaping the conclusion that this policy has failed if its aim is to provide a required ignition – the stimulus – to ‘jump start’ the economy.
In support of my conclusion that this policy has failed as a ‘kick-starter’ of self-sustained growth I can quote as witnesses the very officials and experts who advocated this policy in the first place and who are still implementing it. Not a single one of the major central banks is even close to announcing the successful conclusion of these policies or is even beginning to contemplate an exit. 5 years into ‘quantitative easing’ and zero interest rates, the Fed last week began to openly consider increasing its monthly debt monetization programme. Although the week ended on a bright note, at least for the professional optimists out there, as the unemployment rate came in a tad lower than expected, manufacturing data during the week was disappointing and the US economy is evidently entering another growth dip.
Still, many argue that the roughly 2 percent growth that the US economy may achieve this year is nothing to be sniffed at. Yet, for a $15 trillion dollar economy that is just $300 billion in new goods and services. In the first quarter of 2013, the Fed expanded the monetary base by $300 billion alone, and the central bank is on course for $1 trillion in new money by Christmas, while the federal government will run a close to $1 trillion deficit despite the ‘sequester’. That is very little growth ‘bang’ for a lot of stimulus ‘buck’. Self-sustained looks different.
Last week in the Euro-Zone, the ECB cut its repo rate to 0.5%, a record low. If suppressing interest rates from 3.75% in 2007 to 0.75% by 2012, has not lead to a meaningful, let alone self-sustaining recovery, or at a minimum the type of underachieving recovery that would at least allow the ECB to sit tight and wait a bit, what will another drop to 0.5% achieve?
Shamelessly, some economists and financial commentators cite high youth unemployment in countries such as Spain as a good reason to cut rates further. The image that is projected here is evidently one of countless Spanish entrepreneurs standing at the ready with their investment projects, willing and eager to employ numerous Spanish young people if only rates were 0.25% lower. Then all their ambitious investment plans would become potentially profitable, and the long promised recovery could finally commence.
The number of young Spanish people who will find employment thanks to the ECB cutting rates close to zero cannot be known but I suggest a number equally close to zero is a reasonably good guess.
The ‘benefits’ – or are they costs?
This is not to say that this policy has no effects. It even had benefits, for some.
By suppressing market yields and boosting the prices of financial assets this policy has delivered substantial windfall profits for owners of stocks, bonds, and real estate. Those who did, for example, speculate heavily on rising property prices in the run-up to the recent crisis, then were put through the wringer by the financial meltdown, now find themselves happily resurrected and restored to their previous wealth, if not more wealth, courtesy of central bank charity.
The 0.25% rate cut from the ECB may not lift many young Spaniards into employment but it surely makes ‘owning’ financial assets on credit cheaper. For every €1 billion of assets the rate cut means a €2.5 million saving per year in cost of carry, as duly noted by the big banks, ‘investment’ banks and hedge funds. After the ECB rate cut, German Bunds reached new all-time highs as did, a few days later, Germany’s main stock index.
That we are witnessing strange and dangerous deformations of the capitalist system, if we can still even call it capitalist, and that new bubbles are being blown everywhere, is not only evident by the increasingly grotesque dichotomy between a woefully underperforming real economy perennially teetering on the brink of renewed recession and a financial system, in which almost every sector is trading at record levels, but also by the fact that the high correlation among asset classes on the way up to new records is beginning to strain the minds of the economists to come up with at least marginally plausible fundamental justifications for such uniform asset inflation. ‘Safe haven’ government bonds that would usually prosper at times of economic pain are equally ‘bid only’ as are risky equities and the grottiest of high yield bonds. The common denominator is, of course, cheap money. And if cheap money for the foreseeable future is not enough, then how about cheaper money – forever?
A conflicted conscience or outright embarrassment are now stirring some financial economists to suggest that the joys of bubble finance should be brought straight to the economic war zones in the European periphery, and that in order to have a bigger impact on the ‘real’ economy, the ECB should buy private loans and other local assets in these regions and thus more directly interfere in their pricing. The manipulations of the monetary central planners are too blunt, they need to be more fine-tuned. These suggestions are dangerously wrongheaded. Extending the addiction to the monetary crack cocaine of cheap credit beyond the financial dealing rooms of London, New York and Frankfurt and to the economy’s productive heartland is not going to solve anything, at least not in the long run, and that is a timescale that may still matter to some people, at least outside of the financial industry. There is nothing Spain needs less than a new artificially propped up real estate boom. The aforementioned Spanish youth would only swap today’s dependency on state hand-outs for dependency on never-ending cheap-credit policies from the ECB and ongoing asset-boosting price manipulations. This has nothing whatsoever to do with sustainable growth, lasting and productive employment and real wealth creation.
The fact that trained economists today seriously contemplate these policies and are willing to dress them up as ‘solutions’ only goes to show how far the new ’entitlement culture’ on Wall Street and in the City of London, where everybody now feels entitled to cheap credit and ongoing asset-boosting policy programs as the universal cure-all, has affected economic thinking. The speculating classes are beginning to feel generous: “Hey, this free cash is great. Let’s extend it to everybody.”
Would a deflationary correction be better?
Back to our cost-benefit analysis. The defenders of the present policy will argue that without it GDP in the major economies would have dropped more, that asset prices and lending would be more depressed, and that we might even be in the middle of some dreadful debt deflation. Maybe so. But to the extent that the present GDP readings are the result of central bank pump priming and not the result of renewed growth momentum, they are simply artificial and thus ultimately unsustainable. In fact, the mere suspicion that this might be so must undoubtedly depress optimism and thus the willingness to engage in the economy and put capital at risk. Nobody knows any longer what the real state of the economy is.
While the unemployed Spanish youth may not benefit – or only very marginally so – from record high German stock prices and their own government’s renewed ability to borrow yet more and yet more cheaply – they may in fact ultimately benefit from a deflationary clear-out that would cause prices on many everyday items to drop. Deflation is not such a bad thing if you have to live on your savings or a modest, nominally fixed payment stream. Additionally, reshuffling the economy’s deck of cards could also offer opportunities. Tearing down the old structures and allowing the market to price things honestly again, according to real risks and truly available savings, may at first cause some shock but ultimately bring new possibilities. The present monetary policy is inherently conservative. It bails out those who got it wrong in the recent crisis at the expense of those who didn’t even participate in the last boom. Some Schumpeterian creative destruction is urgently needed.
I am not advocating deflation or economic cleansing for the sake of deflation and contraction, or out of some sense of economic sadism, or even out of moral considerations of any kind. However, it strikes me that what ails the economy is not a lack of money or lack of a powerful ‘kick-starting’ stimulant, and it may not suffer from unduly high borrowing costs either. Wherever borrowing costs are still high in this environment of ‘all-in’ central bank accommodation they may be high for a reason, maybe even a good one. What ails the economy are the structural impediments that are well established and that had been long in the making, such as inflexible labor markets with their permanently enshrined high unit labor costs and excessive regulation that have always protected current job-holders at the expense of those out of work or entering the labor market. Overbearing welfare systems, high tax rates and outsized public sectors have long held back major economies. Easy money that, for some time, enabled high public sector borrowing and spending, and facilitated local property booms, helped cover up these structural rigidities. Now these issues simply come to the fore again. New rounds of easy money will not make these problems disappear but only create a new illusion of sustainability.
I haven’t even touched upon the growing risk that never-ending monetary accommodation will end in inflation and monetary chaos but it is apparent already that this policy has no convincing claim on rationality. Nevertheless, it is almost certain that it will be continued.
It’s official: global economic policy is now firmly in the hands of money cranks.
The lesson from the events of 2007-2008 should have been clear: boosting GDP with loose money – as the Greenspan Fed did repeatedly between 1987 and 2005 and most damagingly between 2001 and 2005 when in order to shorten a minor recession it inflated a massive housing bubble – can only lead to short term booms followed by severe busts. A policy of artificially cheapened credit cannot but cause mispricing of risk, misallocation of capital and a deeply dislocated financial infrastructure, all of which will ultimately conspire to bring the fake boom to a screeching halt. The ‘good times’ of the cheap money expansion, largely characterized by windfall profits for the financial industry and the faux prosperity of propped-up financial assets and real estate (largely to be enjoyed by the ‘1 percent’), necessarily end in an almighty hangover.
The crisis that commenced in 2007 was therefore a massive opportunity: an opportunity to allow the market to liquidate the accumulated dislocations and to bring the economy back into balance; an opportunity to reflect on the inherent instability that central bank activism and manipulation of interest rates must generate; an opportunity to cut off a bloated financial industry from the subsidy of cheap money; and an opportunity to return to sound money and, well, to capitalism. Because for all the thoughtless talk of this being a ‘crisis of capitalism’, a nonsense concocted on the facile assumption that anything that is noisily supported by bankers must be representative of free market ideology, the modern system of ‘bubble finance’, cheap fiat money and excessive debt has precious little to do with true free-market capitalism.
That opportunity was not taken and is now lost – maybe until the next crisis comes along, which won’t be long. It has become clear in recent years – and even more so in recent months and weeks – that we are moving with increasing speed in the opposite direction: ever more money, cheaper credit, and manipulated markets (there is one notable exception to which I come later). Policy makers have learned nothing. The same mistakes are being repeated and the consequences are going to make 2007/8 look like a picnic.
From ‘saving the world’ to blowing new bubbles
Of course, I was never very optimistic that the route back to the free market and sound money would be taken. At the time I left my job in finance in 2009 and began to write Paper Money Collapse, the authorities had already decided that to deal with the consequences of easy-money-induced bubbles we needed more easy money. ‘Quantitative easing’, massive bank bailouts, deficit spending and ultra-low policy rates had become the policy of choice globally. But at least the pretence was upheld for a while that these were temporary measures – ugly and unprincipled but required under the dreadful conditions of 2008 to save ‘the system’. The first round of debt monetization after the Lehman collapse – the exchange of $1 trillion of mortgage-backed securities on bloated bank balance sheets for freshly minted bank reserves from Bernanke’s printing press under ‘quantitative easing 1.0’ (QE1) – was presented as an emergency measure to avoid bank collapses and a systemic crisis.
I never thought that this was a convincing rationale as it was clear to me that whatever the accumulated dislocations were, there was ultimately no alternative to allowing the market to identify and liquidate them. Aborting, delaying and sabotaging this essential process of economic cleansing and rebalancing would only cause new problems. Even on the assumption that these were measures to deal with extreme ‘tail events’, I could not then and cannot now support them. But it is becoming abundantly clear that these measures are neither temporary nor restricted to avoiding bank runs or systemic chaos but that now, after the public has become sufficiently accustomed to them and a cheap-money-addicted financial industry has begun to incorporate them into their business models, they constitute the ‘new normal’, that they are now the accepted ‘modern’ tool kit of central bankers. Zero interest rates, trillion-dollar open-market operations to manipulate asset prices and to ‘manage’ the yield curve are now just another day in the modern fiat money economy. Nobody talks of restraining central bank activism. Rather, the temptation is growing to use these tools to kick-start another artificial boom.
In his excellent new book The Great Deformation – The Corruption of Capitalism in America, David Stockman provides a fascinating account of how the principles of sound money, balanced budgets and small government have progressively been weakened, betrayed, undermined and ultimately completely abandoned in American politics (often by Republican politicians and even some of the alleged ‘free market heroes’ of Republican folklore), and how today’s cocktail of bubble finance and trillion-dollar deficits represents the delayed but inevitable blossoming of destructive seeds that were sown with Roosevelt’s New Deal and Nixon’s default on the Bretton Woods gold exchange standard. In a chapter on the recent crisis, Stockman argues convincingly that the shameful bailout of Wall Street in 2008, in particular of Goldman Sachs, Morgan Stanley, and a few other highly leveraged entities via the bailout of ‘insurance’ giant AIG, were sold to Congress and the wider public with exaggerated claims that the nation’s real economy was at imminent risk of collapse. From my position as an economist and a market participant at the time of these events, Stockman’s analysis and interpretation strike me as entirely consistent and correct. But even if we were willing to give more credit to the claims of the ‘bailsters’ and interventionists that the fallout for Main Street would have been substantial, that would only further underline how far the Fed’s preceding easy money policies had destabilized the economy, and the question would still remain whether it could ever be a reasonable objective of policy to sustain these large-scale dislocations against market forces.
Be that as it may, the dislocations were largely sustained and plenty of new ones added. Talk of ‘exit strategies’ – that is, of a ‘normalization’ of interest rates and shrinking of central bank balance sheets – has now pretty much died down. Super-low interest rates are now a permanent tonic for the financial industry. In fact, the nature of the debate has shifted markedly over the past 15 months as the idea is progressively gaining adherents that the new hyper-interventionist tool-kit of the central bankers that was slipped in under the cloak of avoiding financial Armageddon in 2008 should now be used pro-actively to start a new easy-money-induced credit boom, that aggressive money printing and debt monetization should be employed to generate a new growth cycle. Many economists are de facto demanding a new bubble.
In America, QE2 was already targeted at boosting the prices of government debt and thereby lowering interest rates and encouraging more lending – which naturally means more borrowing and more debt, the opposite of deleveraging and rebalancing. And QE3 – which is an open-ended $85-billion-a-month price-fixing exercise for selected mortgage- and government- securities – is even targeted officially at lowering the unemployment rate, meaning Fed officials seriously claim that they can create (profitable and lasting?) jobs by cleverly manipulating asset prices.
The resurgence of the money cranks
Rising real wealth is always and everywhere the result of the accumulation of productive capital, which means real resources saved through the non-consumption of real income, and its employment by entrepreneurs in competitive markets under the guidance of uninhibited price formation. This process requires apolitical, hard and international money. Monetary debasement always hinders real wealth creation; it does not aid it. Easy money leads to boom and bust, never to lasting prosperity. Easy money is not a positive-sum game and not even a zero-sum game. It is always and everywhere a negative-sum game.
To claim, instead, that an economy’s performance and society’s wealth is lastingly enhanced by pumping more fiat money through its financial system requires a considerable degree of economic illiteracy and, in the wake of the recent crisis, selective amnesia. Not too long ago, such assertions as to the benefit of inflation and money printing would have clearly marked its proponent as a money crank. But the cranks are now manning the monetary policy ships everywhere, and the international commentariat is either willingly complicit in spreading economic nonsense or intellectually challenged when it comes to exposing the naivete and recklessness of these policies.
Nothing confirms the renewed dominance of money crankism more than the present sad spectacle of Japan, a country that became a post-WWII economic powerhouse in no small measure thanks to the old capitalist virtues of hard work, high savings rates, strong capital accumulation, and innovative and international-minded entrepreneurship, now taking a leaf out of the policy book of Argentina and embarking on a mission of aggressive money printing, currency debasement, asset price manipulation and inflationism. Japanese savers are already losing international purchasing power by the bucket load as the Yen keeps plummeting in international markets.
The idea that currency debasement will result in lasting, self-sustained growth and rising prosperity is positively laughable. I do not doubt that Japan’s new initiative of aggressive monetization has the potential to improve the headline numbers on a number of corporate earning reports and to even give a near-term boost to GDP. Like most drugs, easy money tempts its users with the promise of an immediate but short-lived high. What is, however, absolutely certain is that whatever ‘stimulus’ is generated in the short term is bought at the price of more imbalances (most certainly higher indebtedness) that will weigh down severely on the Japanese population in the future. What is even more worrying is that Japan’s gigantic pool of government debt – held to a large extent by an aging population as a ‘pension nest egg’ and by domestic banks on highly levered balance sheets – is a veritable powder keg, and the Bank of Japan’s new inflation strategy is tantamount to playing with fire.
The deflation myth
It has become commonplace to justify Japan’s monetary ‘experimentation’ with reference to the country’s long suffering under supposedly ‘crippling’ deflation. Even otherwise respectable financial newspapers and journals lazily repeat this standard refrain. It is complete and utter nonsense. Whatever Japan’s problems are, and I am sure they are numerous and sizable, deflation is not one of them.
Firstly, there is no economic rationale for assuming that the type of moderate and ongoing deflation (secular deflation) that analysts suspect in Japan and that is the result of stable money and marginal improvements in productivity could constitute a problem for the economy’s performance. Why such deflation is harmless (and even preferable to moderate inflation) I explain in detail in chapter 5 ofPaper Money Collapse. I make no claim to originality here, as this insight was widely accepted among most serious mainstream economists up to and including the first third of the twentieth century when it became sadly ‘forgotten’ rather than refuted. But if you don’t want to take my word for it or go through the argument in my book, or if you want to have ‘empirical evidence’, then you might want to listen to Milton Friedman, hardly an advocate of the gold standard, who (together with Anna Schwartz) analyzed the late 19th century economy of the United States which had both stronger growth and much more deflation (in particular after the fiat money episode of the Civil War had ended) than Japan had over the past 20-odd years, and who concluded that U.S. data “casts serious doubts on the validity of the now (1963) widely held view that secular price deflation and rapid economic growth are incompatible.”
Secondly, there is not even any deflation in Japan that deserves the name. The data (which is here) does not support it. I am sure the economists at the Bank of Japan employ massive magnifying glasses to detect deflation in their data series. What Japan has is, by any rational standard, price stability.
In February 2013, the consumer price index (CPI) stood at 99.3. Ten years earlier, in February 2003, it stood at 100.3, and ten years before that, in February 1993, at 99.6. Apart from the fact that, as with any price-index data, the methodology, accuracy and relevance of these statistics is always highly debatable, it is clear that if we do take the data at face value we see an economy that has roughly enjoyed stable prices for two decades. In fact, prices rose marginally in the late 1990s, remained stable for a few years, and have recently declined marginally.
In February of this year, the inflation rate was -0.6 percent year over year. Would any of the commentators who lament Japan’s ‘crippling deflation’ claim that an inflation rate of +0.6 percent year over year would constitute worrying inflation, or even deserve the label ‘inflation’ at all? Would it not simply be called a rounding error? – By comparison, official UK inflation stood at +2.8 percent year over year in February 2013 and has fluctuated between +1.1 percent and +5 percent over the past 4 years alone. What monetary system is more conducive to rational economic calculation and planning – Japan’s or Britain’s? (It should be worth noting that over those 4 years the British economy has NOT outperformed Japan, despite its ‘wonderful’ inflation.)
Those commentators who tell us that this ‘crippling deflation’ is hurting the economy because people postpone spending decisions in anticipation of lower prices, want us to believe that Mr. and Mrs. Watanabe don’t buy a new popup toaster for ¥3,930 this year because – at a 0.6 percent p.a. deflation rate – they can reasonably assume that it will only cost ¥3,906 to buy the same toaster next year. And they won’t even buy it next year at ¥3,906 because the year after that it will only cost ¥3,883. The Watanabes would thus be able to save ¥47 over two years by not eating any toast (and it goes without saying that they may save considerably more by never eating toast!). This is a saving of – wait for it! – $0.47 or £0.31 (at present exchange rates) for postponing the purchase of a standard consumption item for two years – 730 mornings without toast! The notion that this ‘crippling’ deflation is holding back Japanese growth is simply beyond ridiculous, yet you can hardly open a newspaper these days without seeing such nonsense presented as economic analysis. (I would recommend that these experts on consumer psychology call the people at Apple, Samsung and other providers of tablets, smartphones and various consumer technology items and tell them that they are missing a trick: it is evidently rising prices that get people buying, not falling prices!)
Funding the state
The deflation argument is so flimsy that one can only assume it is a convenient scapegoat for a different agenda: securing printing-press funding for the state. Under Japan’s new monetary debasement plan, the Bank of Japan will practically buy the entire annual issuance of new government debt and thus fund excessive public sector spending directly via the printing press. Japan is famously the world’s most highly indebted state at 230% of GDP and runs an annual budget deficit of around 10% of GDP. Even the most troubled members of EMU enjoy better funding stats.
The often-heard argument that such profligacy has evidently not been punished by markets for years and decades, so why should the day of reckoning be any nearer now, is unconvincing. For years, the Japanese public has in fact saved and has faithfully handed its private savings over to the state, which immediately wasted them on Keynesian ‘stimulus’ projects that will never bring a meaningful return (bridges and roads to nowhere, public pools, agricultural subsidies). For a long time it was to a considerable degree private frugality that funded public excess. But now the savings rate has collapsed to 2 percent and given the shrinking workforce and aging population is unlikely to ever recover. Private savings are thus no longer sufficient to fund the state’s recklessness, so now it is up to the Bank of Japan to keep the state in business and maintain a mirage of solvency. The inflationary implications of funding massive government waste through money-printing rather than voluntary savings are, of course, considerable.
The risk here is not that the policy of monetary debasement will again amount to ‘pushing on a string’ and fail to raise inflation and inflation expectations. The much riskier and likelier outcome is that this policy will ultimately ‘succeed’. The aging Japanese population sits on a massive pile of government debt that is not backed by productive capital but that the population still considers its ‘pension assets’. Debasing the purchasing power of fixed income streams that Japanese pensioners draw from this pool will ultimately dampen domestic consumption – the very component of GDP that the inflationists claim to boost with their monetary debasement. If inflation only rises from -0.6 percent to +1 percent, the entire Japanese yield curve is ‘under water’. Only very long maturity bonds will still provide a positive real yield. This will also hurt the banks which are massive (leveraged) owners of government debt. And of course, a meaningful sell-off in the bond market would quickly wipe out bank capital.
Such a sell-off may still not occur anytime soon. At the present UK inflation-rate of +2.8 percent, most of the UK’s government bonds are also trading at negative real yields. In fact, in recent months many bond investors around the world have exhibited a remarkable willingness to hold bonds at negative real returns. It appears as if many of these securities have become, in the eyes of their holders, ‘cash equivalents’, i.e. instruments that are held for reasons of safety and liquidity, not for reasons of income generation. How far the central banks can exploit this phenomenon is uncertain. Central banks cannot turn water into wine but almost any asset into (fiat) money by ‘monetizing’ them. The only limit to this operation is the willingness of the public to hold these new ‘monetized’ assets, and frankly I doubt that there is money demand in Japan to the tune of 230 percent of GDP. – We shall find out.
Money crankism will spread
‘Abenomics’ will not solve Japan’s problems; it will make the Japanese worse off and it has the potential to trigger a mighty financial crisis. Yet, what is surely inevitable might not be imminent. During the early honeymoon between ‘Abenomics’ and financial reality, the idea of printing yourself to prosperity is likely to have imitators, with the UK being a prime candidate. In terms of total indebtedness, the UK is the one industrialized country that can compete with Japan, meaning it is in the same supersized debt-pickle. Even the timid attempts by Chancellor Osborne to lower the speed at which Her Majesty’s government goes further into debt are being attacked as savage ‘austerity’ by the opposition and large parts of the media. In his latest budget he put the remaining taxpayer-chips on another housing bubble and gave the Bank of England more room to ignore inflation. Over at Thredneedle Street, the Deputy Governor of the Bank of England, Paul Tucker, openly fantasized about negative interest rates recently, outgoing Governor Mervyn King voted for more QE (overruled), and Governor-elect Mark Carney promises to be, well, – flexible. Bottom line: desperation is spreading. Watch this place! Chances are the Old Lady is the next to throw any remaining caution and remaining vestiges of monetary sanity to the wind and – go ‘all in’.
This will end badly.
P.S.: As to ‘the exception’, the only place where money crankism is not the order of the day yet is – the Euro Zone!– Yes, I am serious. – I know, I know. This is an amalgamation of semi-socialist, semi-bankrupt welfare states that share the same politicized paper currency issued by a central bank that has already bailed out too many banks, has manipulated various government bond markets and whose balance sheet as a percent of GDP is larger than the Fed’s. However: in a global sea of monetary madness there are at least a few remaining signs of sanity and orthodox monetary discipline on display in the much derided EMU. Greece was allowed or encouraged to default on part of its debt, which meant that bond-holders had to eat losses. Cyprus’ biggest bank is being wound down, which means depositors are going to eat losses, too. There is a persistent push towards ‘austerity’. On the fiscal front, the Euro Zone easily outperforms the US, the UK and, of course, Japan. While the Fed has increased its balance sheet girth by almost $300 billion in the first three months of 2013 alone, the ECB has reduced its own by almost €400 billion over the same time. My rule is this: the more Professor Krugman is foaming at the mouth and the more apoplectic the commentary from the strategists, analysts and economists in the bailout-addicted financial industry get, the more it seems that Mrs Merkel & Co are getting a few things right.
We recently looked at the Federal Reserve’s 2012 results. In particular, we pointed to some positive and negative developments. On a positive note, the Fed managed to shrink down the size of its balance sheet by approximately one-third of a percent. (Hey, it’s a start.) On a negative note, this decrease occurred because banks shifted their holdings of reserves into cash, thus forcing the Fed to sell off some of its assets. I explained that this is a potentially negative result, as the shift into cash brings with it inflationary pressure on prices.
In this article I want to point out who has benefited from the Fed’s operations over the past year.
There has been a lot of discussion about the large increase in reserves, and especially excess reserves, held by the banking system. Mostly this discussion is couched in terms of the increase in the money supply. While the increase in excess reserves—less than $2bn in August 2008 to almost $1.5 trillion at the end of 2012—does represent an increase in the money supply, some rule changes accompanying the crisis also signify that they are part of a bailout. One aspect of the Fed’s crisis response was to commence paying interest on required and excess reserve balances. (The required reserve is the amount of money banks must hold to meet the minimum reserve requirement on deposits, and excess reserves are any amount held in excess of this minimum.)
Interest on reserves is set at 0.25 percent, and is paid from the Fed’s operating revenues to its member banks. As we can see in Figure 1 below, the Fed has paid the banking system nearly $4bn each month for the last two years to hold on to their reserves.
Figure 1: Interest paid on reserve balances (monthly, $bn) Source: Federal Reserve Bank of St. Louis
One way to think of this payment is as a sort of bailout. Since the payments on reserves are paid out from the Fed’s operating revenues, it reduces its end of year profits by the same amount. Since these profits would normally be remitted to the Treasury, the policy of paying interest on reserves has been, in effect, a fiscal policy involving a transfer from the Treasury to the banking sector. Interest on reserves redirects taxpayer money to the banking system, over $45bn during 2012. This transfer from the Fed to the banking system is larger than any single year transfer from the Fed to the Treasury prior to 2009.
The Fed estimates that it will remit to the Treasury $88.9bn from its 2012 operations, a record-breaking year. As we can see in Figure 2, there has been a steady increase in the amounts of remittances to the Treasury over the past decade, and especially since 2009.
Figure 2: Federal Reserve annual remittances to U.S. Treasury ($bn)
The sharp increase after 2008 was the result of the quantitative easing policies. By increasing the money supply, the Fed had to purchase assets from the banking system. Some of these assets were U.S. Treasuries, some were riskier mortgage-backed securities, and some were guaranteed Federal agency debt. All of these newly purchased assets paid an interest rate, which contributed to the increase in Fed operating revenues and profits as it increased the money supply.
The $91bn of net income came almost wholly from interest earned on the securities the Fed holds ($80.5bn).
The U.S. Treasury issues bonds which are bought by the Federal Reserve. (We should note that the Fed doesn’t buy these bonds directly from the Treasury, but only on the secondary market from favored dealers.) Interest paid on these bonds accumulates at the Fed as income, and at the end of the year the Fed distributes it back to the Treasury, less its operating expenses. Since the Fed held, give or take, about $1.6 trillion of U.S. Treasury securities over 2012, the government was essentially able to get a free lunch—any interest paid on these securities was an accounting fiction, as it was remitted back at the end of the year (less expenses).
Normally the Fed only operates at the short end of the yield curve. This means that as a general rule the Fed only purchases short-term U.S. Treasury debt. Since short-term debt is also the lowest yielding, some might say that the Fed is not really providing much of a free lunch.
The big news during 2012 for Fed watchers was the expansion of its “Operation Twist.” With an increased focus on the long end of the yield curve, the Fed started purchasing bonds of longer maturity to keep long-term borrowing costs low. This was a savvy move that would help shield the Treasury from the effects of some of the Fed’s own policies. The Fed has the potential to increase inflationary pressures on prices through its monetary expansion. Since this inflation is not occurring now, but almost certainly will at some future date, only longer-dated securities will see their yields rise to account for their lost purchasing power. This would spell disaster for a Treasury that finances itself in part with longer-dated securities. By pledging to buy longer-term bonds, the Fed will artificially reduce their yields and thus mask the inflation premium building on their yields.
Jan. 1, 2012
Jan. 1, 2013
Change
Within 15 days
17,847
0
-17,847
16 to 90 days
25,506
5
-25,501
91 days to 1 year
87,285
16
-87,269
1 to 5 years
650,378
378,474
-271,904
5 to 10 years
660,486
862,403
201,917
Table 1: Maturity distribution of U.S. Treasury holdings of the Fed ($m)
While the Fed has slightly decreased the total amount of Treasuries held, Operation Twist has increased the average maturity of these holdings. The Fed currently holds almost no Treasuries with maturities under 1 year and has increased its holdings dated longer than 5 years by over $200bn. Even though the total amount of Treasury debt held has decreased, the total distribution to the Treasury has increased because of this maturity shift. By holding higher interest rate bonds of longer maturities, the Fed earns more interest, which results in more profit to remit to the Treasury at year end.
As we review the Fed’s operations in 2012 we see the usual outcomes. The banking sector has benefited from its operations (unusually so, thanks to the continued interest on reserve policy) and the government has received a free lunch by having a ready buyer for its ever-increasing debt, especially long-term debt, which might otherwise be susceptible to inflationary pressures increasing its interest yield. Let’s see what surprises the Fed has in store for us in 2013.
Episode 68: GoldMoney’s Andy Duncan speaks to Steve Baker MP, a Conservative backbencher who represents the constituency of Wycombe in the United Kingdom’s House of Commons. A supporter of the Austrian School of economics, Mr Baker has launched several private member’s bills in parliament – with the support of his colleague Douglas Carswell MP – aimed at advancing dialogue on the subject of sound money. In this podcast Steve Baker discusses these bills, along with his views on quantitative easing, the post-Bretton Woods monetary order, and the chances of a future monetary reset. Mr Baker also touches upon the future of the euro, Britain’s membership of the European Union, and his co-founding of The Cobden Centre. He also discusses a possible future political initiative to launch a British gold pound project.
Blue-chip mystique still clings to it but you can feel the reputational parabola slowly gathering momentum on the downside. Its projects are too large and diffuse, the resources to achieve them too crude and there are mounting signs of unhappiness and confusion at the top.
Given their long-standing rock star status, pity the central banker; the fall from grace may be vertiginous.
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The Governor of the Old Lady seems more attuned to this unfolding trend than most. On my reading, he metaphorically ran up the white flag in a recent speech. It was the oddest mixture of explanations, implicit apologies and rationalisations imaginable from such an august perch. Do have a look; it’s not long.
King finished with an amusing touch: “As for the MPC [Monetary Policy Committee], you can be sure we shall be looking for as much guidance as we can find, divine or otherwise. What better inspiration than the memory of those children on Rhossili beach singing Cwm Rhondda.”
Perhaps the South Wales Chamber of Commerce seemed a forgiving place to lay out some of central banking’s many puzzles.
Put simply, his message was: I know what we’re doing seems a bit crazy, and I know all the fundamental problems are still out there waiting to be solved, but what else can we do?
What’s even scarier is that I understand what he means. After all, most of the really important stuff, like correcting the monstrous accumulated imbalances of recent decades and setting a more sensible course for the future, isn’t within the Bank of England’s remit. And yet, because the magic wand is in their hands, everyone looks to them to do something. Anything.
Which, as we know, they did. Cumulative QE (so far) of £375 billion, or 25% of GDP, enough for top spot amongst its Western institutional colleagues. As King suggested, the market is well and truly sated:
During the crisis central banks have provided liquidity to banks on a truly extraordinary scale, so much so that there were no takers for additional liquidity in our latest auction. It is still useful to keep their auction facility as an insurance policy. But banks are now overflowing with liquid assets.
Insurance policy indeed. Any more QE would seem in danger of plunging the whole business into farce.
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King, as he often does, got to the nub of the matter early on in his speech:
In the long run, we will need to rebalance our economy away from domestic spending and towards exports, to reduce the trade deficit, to repay our debts, and to raise the rate of national saving and investment. So you are probably puzzled by the fact that we seem to be doing exactly the opposite of that today. Almost 4 years ago now, I called this the “paradox of policy” – policy measures that are desirable in the short term appear diametrically opposite to those needed in the long term. Although we cannot avoid long-term adjustment to our economy, we can try to slow the pace of the adjustment in order to limit the immediate damage to output and employment.
He’d be only too aware, I’m sure, that our current intolerable mess is the result of giving in to a long succession of apparently desirable short-term policy measures. In each of the would-be and actual recessions of recent decades, politicians and central bankers strove to “limit the immediate damage to output and employment.” And, for the most part, succeeded. Trouble is, of course, in doing so earlier excesses were never allowed to sort themselves out; instead, they were carried forward with compound interest and then added to afresh.
How does one ever decide that now, finally, is the moment to pay the piper?
Thing is, even if King thought the time was now (or, quite possibly, a few years ago), it’s out of his hands. He can advise, plead, cajole, threaten to resign, but he can’t decide. So too with his compatriots elsewhere, many of whom have also been delicately (and sometimes not so delicately) pointing out the limits of of monetary policy and pleading for deeper structural reform.
As King said immediately after his comment about banks now overflowing with liquid assets:
Their problem remains insufficient capital. Just as in 2008, there is a deep reluctance to admit the extent of the undercapitalisation of the banking system in many parts of the industrialised world. The verdict of the market is clear – without central banks support banks still find it expensive to borrow.
What’s true of the banking system is no less true for the economy more generally. There’s way too much debt and not enough equity. Until that imbalance is dealt with (together with all the real world distortions it fostered) there’s no chance of organic growth, just the hyped up, artificial variant produced by great bouts of fiscal and monetary stimulus.
Central bankers are burdened with a kind of original sin. After all, without their unfailing support and encouragement (together with the very nature of the fiat fractional reserve banking systems over which they preside), the credit excesses of recent decades would have been quite impossible. Can any of them coolly and dispassionately disentangle and measure the system in which they’re so deeply embedded?
I don’t know, but it’s not hard to imagine King lying awake in the early hours of the morning.
♦ ♦ ♦
So what’s the endgame?
With overall debt levels rising (still), rates pinned to the floor and vast amounts of excess liquidity sloshing about (thank you Mervyn, Ben, Mario et al), a private sector busily trying to repair its collective balance sheet and economies everywhere in the doldrums because of massive imbalances, anyone who says they know the answer is dreaming.
What we can say is that policy is distinctly, perhaps even irretrievably, assymmetrical. Central bankers are conditioned to leap into action at the merest hint of renewed weakness, much less deflation. As with both fiscal and monetary stimulus in recent decades, the political incentives all run one way. In the absence of sustained, reassuring economic growth, it’s hard to see what might change this bias.
Right now, all the resulting excess liquidity is mostly languishing in reserves at various central banks, collecting a paltry return and seemingly doing no harm. There’s a bit of fresh lending going on here and there, but demand is low and the banks, generally, remain relatively cautious. Fact is, central bankers are tearing their hair out because of the financial system’s lack of responsiveness.
Careful what you wish for, perhaps? According to Ashwin Parameswaran, the market’s current willingness to hold unusually large quantities of money because of the crisis induced desire for safety and liquidity may not hold if “real rates turn significantly negative”:
Once real rates become sufficiently negative, credit growth explodes and the positive feedback loop of ever higher inflation fuelled not just by currency repudiation but by active exploitation of the banking and central bank discount window to access essentially free loans is set in motion. In other words, hyperinflation in modern capitalist economies is characterised not just by a collapse in the demand for deposits but an explosion in demand for loans at the free lunch level of nominal interest rates enforced by the central bank.
Whether these huge reserves might one day wreak unexpected havoc is something I’ve long wondered about too. What I hadn’t realised until I read Ashwin’s links was how critically important explosive private credit growth has often been in earlier hyperinflations.
It makes perfect sense, of course. Once the incentives are strong enough (and what could be stronger than seriously negative real rates?) the whole machinery of credit and money creation is unleashed. One shudders to think how silly things could get.
Could it really happen today, in the US, the UK, or Japan? Could central bankers miscalculate or lose control so badly as to set this particular doomsday machine in motion?
Cassandra though I often am in these matters, I struggle to see it. After all, there’s no shortage of historical horror stories at hand. Still, like armies, central bankers are inclined to fight the last war, and after the 1930s they’re understandably paranoid about letting debt deflation get the upper hand. As Bernanke said at a conference honouring Milton Friedman on his 90th birthday: “Regarding the great depression. You’re right, we [the Fed] did it. We’re very sorry. But thanks to you, we won’t do it again.”
So it’s not inconceivable. It just needs inflation to get away enough to generate juicy negative real rates. With so much dry tinder already around and central banks all leaning one way, that’s not inconceivable either. Remember too that while individual banks can get rid of reserves through making loans or purchasing investments, overall, banks can’t. What one loses, another gains. One can therefore imagine an accelerating rush by individual banks to deploy reserves, all of it, at a systemic level, entirely fruitless and on the other side newly hungry demand intent on exploiting negative real rates. While the notion of hyperinflation still seems . . . well, a bit hyper, it doesn’t strike me as an easy beast to rein in if it bolts.
To bring it under control, central banks would either have to vaporise sufficient reserves through sales from their portfolio to give banks pause, or, raise the rate they pay on reserves high enough to discourage the process. Neither seems attractive. Brave indeed would be the central banker who embarked on the former in these bone china delicate times. As for the latter, with reserves so high (and still growing) it sure wouldn’t be cheap.
“Giarre, a town in eastern Sicily, sits above the sea on the slopes of Mount Etna. It was once a collection point for the wine produced on the hills above, which was rolled down its main street in barrels to the port below. Today, Giarre bears a far more dubious distinction. The city of 27,000 hosts the largest number of uncompleted public projects in the country: 25 of them, nearly one for every 1,000 inhabitants. So spectacular is the waste that some locals have proposed promoting Giarre’s excess as a tourist attraction.
On an afternoon in September, I toured some of Giarre’s most notorious eyesores with Turi Caggegi, a journalist who has been writing about government waste since the 1990s. Caggegi showed off a partly built, graffiti-covered theater where work has started and stopped 12 times. It has yet to host a show. Not far away stood a hospital that took 30 years to build and was outdated before it was ready to open. Later, Caggegi drove past an Olympic-size swimming pool that was sunk but never completed. “So much money wasted,” he said. “And it wasn’t that they were spending it on productive investments. They were buying votes.
In 2011 the Sicilian regional government ran a €5.3 billion ($6.8 billion) deficit on a €27 billion ($34.8 billion) budget. This year, with the island’s credit rating hovering just above junk status and Italian Prime Minister Mario Monti cutting subsidies to the regions in an effort to shore up the national budget, Sicily has reached the breaking point.
…
“Bread and circuses,” said Caggegi. “That’s what the Romans used to say.” Italians are discovering what happens when the bread runs out.””
“Riot police were out in force in Tehran’s main squares yesterday as merchants kept their shops shut in protest at the falling rial, despite threats of prosecution.. The rial has fallen 30 percent in the past week, raising questions about Iran’s economic health in the face of tightening international sanctions. Wednesday’s strike by bazaar merchants in the capital, accompanied by unexpected protests by currency traders, led to clashes between riot police and demonstrators..”
- From the Financial Times, ‘Iran riot police on alert as merchants step up protest’, 5.10.2012.
That roaring sound you hear is the noise of chickens coming home to roost across the western world. We have had four decades since President Nixon took the US dollar off gold in 1971, during which time our politicians have happily promised us the earth and made up for the inevitable shortfall by borrowing from the bond markets, and therefore from the future. But even governments cannot live beyond their (taxpayers’) means indefinitely. As the likes of Greece and Sicily are now discovering, the future has caught up with us.
There is a thesis, with which we agree, that suggests that the world now requires constant economic growth solely to service its mountain of outstanding debts. So what happens when that constant economic growth starts to turn into a synchronised slowdown – or worse? So far, with private sector borrowers furiously deleveraging (even at near zero interest rates: NOBODY WANTS TO BORROW – see Japan, last 20 years), the major central banks have aggressively taken the other side of the trade, and pumped money into the banks through the magical money-creation Ponzi scheme known as quantitative easing. The banks aren’t particularly keen on lending it out. That may be because they’re predominantly insolvent, but let’s not go there. So we have a stand-off, of sorts. On the one hand, individuals and corporates, having binged on easy credit for far too long, are now mostly sickened by the stuff. On the other hand, central bank governors don’t want to take the credit for Great Depression II. They’ll get it anyway, because the markets cannot be fooled indefinitely either. Meanwhile, the price signals that would ordinarily be a guide to entrepreneurs and other risk-takers are being hopelessly distorted by money-printing.
One side-effect of QE is that increasingly dangerous sovereign debt (as a shorthand: G7 government debt) optically resembles high quality debt in that the miserly yields available seem to reflect some form of ‘flight to quality’. What those miserly yields actually reflect is financial repression – namely that the government and its regulators are effectively forcing captive investors (not least pension funds) to invest almost exclusively in this garbage. In the process, by happy coincidence, heavily indebted governments are able to fund themselves. The private sector has a word for this policy: extortion.
Another side-effect of QE is that the perception of value in the variously affected currencies swings even more wildly than usual. Somebody intelligent once wrote that paper currencies don’t float, they just sink against each other at different rates. Since 1971 this has undoubtedly been the case. But since the Fed and the ECB went all-in in their pursuit of QE ad absurdum, the risk of disorderly currency collapse has risen markedly.
Don’t just take our word for it. CLSA’s Christopher Wood in his recent ‘Greed and Fear’ commentary writes as follows:
While the central banks have undoubtedly bought some time by creating the newsflow to allow most world stock markets to rally last quarter after the Eurozone-driven risk-aversion seen in the previous quarter, the decision by the Fed to adopt “open-ended” QE, and the overwhelming reaction of the investor consensus to support that decision, has re-enforced the base case long argued by Greed & Fear. That is that the “capitalist” world is on the path to the collapse of the fiat paper system. For once the “open-ended” principle is established, as it now has been, it can be expanded ad infinitum.
..the game will be up when investors cease viewing the relevant sovereign bond as a safe haven and that government bond yields spike as a result of supply concerns. At the point when such turmoil hits the reserve currency of the world, namely the US dollar and its government bond market, quantitative easing will be discredited, and most likely the modern fiat paper monetary system along with it, as well as of course monetarist and Keynesian orthodoxies.
Nor is Christopher Wood alone in a financial wilderness in this bleak prognosis. SocGen’s Dylan Grice in last week’s ‘Popular Delusions’ commentary cited Bernd Widdig and his analysis of Germany’s inflation crisis (‘Culture and Inflation in Weimar Germany’):
Next to language, money is the most important medium through which modern societies communicate.
As Dylan Grice indicates,
His may be an abstract observation, but it has the commendable merit of being true.. all economic activity requires the cooperation of strangers and therefore, a degree of trust between cooperating strangers. Since money is the agent of such mutual trust, debasing money implies debasing the trust upon which social cohesion rests.
And he adds,
I feel queasy about the enthusiasm with which our wise economists play games with something about which we have such a poor understanding.
For students of markets and economics this recalls a quotation by Keynes himself:
But to-day we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time — perhaps for a long time.
Keynes also once wrote that he worked for a government he despised for ends he considered criminal. We would adopt that phrase and direct it to the leading neo-Keynesian economists – overzealous believers in a false science – who are even now leading the delicate mechanism of the western economies into a fatal experiment with unsound money, egged on by bankers whose ethical compass has already been shown to be hopelessly compromised.
Today the currency of Iran. Tomorrow ..?
This argument happens to transcend the mundane and partially subjective business of shepherding pounds, shillings and pence to the safest havens; it touches on issues of fundamental morality. If we are debating with the ignorant, ignorance can ultimately be addressed, given an open mind. If we are debating with the profoundly stupid, that stupidity may admittedly be a barrier to full resolution of the debate. But if we are debating with people who are going to do harm, whether deliberately or inadvertently, the debate should be conducted at the fullest volume and with the widest number of engaged participants.
I am delighted that Fraser Nelson and the Spectator have picked up something we have been saying all the time for our nearly three years in existence: that QE is a regressive tax that transfers from the poor to the rich and should be stopped with immediate effect.
This of course should not be the only reason why it should be stopped, the principal one being that no new amount of money units created causes more goods and services to be made — more things that people want at cheaper prices (yes, deflated prices!), served in a more timely fashion to suit the most urgent consumer needs. Only entrepreneurs, by refraining from consumption — i.e., doing that most terrible of things according to the mainstream economist, saving — can they deploy their wealth to invest in more intensive, better combinations of factors of production. In short, to invest further in the capital structure of their business to produce these better goods and services.
I recommend this article and welcome that even the mainstream media are now starting to pick up on these points. There may be hope for sound economic reasoning yet!
Around the start of the year, in the course of a routine set of market overviews which we have to set out twice a year for one of our clients, we laid down two themes and a thesis.
The first of these was that the then-rapid pace of growth of money supply proper in the US – already becoming something of an exception on a global perspective – would continue to favour the maintenance of a pace of recovery there, above all in corporate revenues and hence, in all likelihood, in corporate profitability.
Such developments, we said, typically lead not only to an appreciation of stock market valuations, but also lend support to wider economic measures, such as employment and investment, however cautious CEOs and CFOs may be in padding out their balance sheets with cash.
So it proved to be, with the S&P putting in its best first quarter since the rebound from the depths of the 1997/8 Asian Crisis. Lending a certain (if possibly temporary) corroboration to this, operating margins also reached or approached record highs (depending upon whether you take data for the S&P, for all non-financial corporations, or just the domestic subset), as did reported EPS. Given the plain accounting intertwining of profits and investment on the consolidated balance sheet – as well as the motivational nexus on the individual one – it was perhaps no wonder that, even if coming from relatively depressed levels, the growth in capex outstripped that of GDP as a whole, or that manufacturing payrolls enjoyed their fastest percentage gain (subject to later revisions) in almost three decades.
Sadly, there is reason to believe that this creditable performance may have represented a high-water mark. Certainly, since spring turned into summer, there have been signs of a deceleration. Revenue growth has dipped to a two-year low – and in nominal terms has all but stalled – new orders have mostly turned lower, employment gains have dwindled and the rise in the real ‘wage fund’ become suddenly snail-like. This sudden shift to a lower gear was brought home dramatically by the shocking 12.3 unit drop in the ISM index of new orders, a plunge which was both the greatest suffered since 9-11 and the second largest since the second oil shock and which took the measure into contractionary territory for the first time in over three years. Adding to the gloom, this was followed by the steepest fall in two year in the NFIB small business index, suggesting the malaise is becoming widespread – perhaps, in the latter instance, due to the costs associated with Obamacare.
Again, no-one who pays attention to the marked deceleration of money growth these last six months should be too surprised at this. If not yet by any means a tailwind, the raging gale which filled the economy’s spinnaker in the run-up to year-end has lessened to the gentlest of zephyrs since then. With the economy vulnerable to a further deterioration of offshore conditions, it is hard to see the rate of progress doing anything other than diminish while this less extravagantly favourable monetary situation persists domestically.
As Dallas Fed President Richard Fisher so colourfully puts it, the US may well be the ‘best nag in the glue factory’, but that does not mean it is about to earn a place in the winners’ enclosure at the Kentucky Derby any time soon.
Meanwhile, in Asia, our second theme was predicated upon our very Austrian perceptions of the likelihood of anyone being able to engineer an instance of that semi-mythical beast, the ‘soft landing’, in a system as overly dependent on credit-fed, fixed capital spending as is China’s – much less in one where real money supply crashed from a monstrous 38% rate of climb (where it stood 5.7 sigmas above the previous 13 years’ average) to a petrifying minus 1.4% (3.6 sigmas beneath it) in the space of a year!
Those within the policy apparatus can perhaps be forgiven for assuming that they (and they alone) could manage a manoeuvre which has classically proven to lie beyond the compass of their Occidental rivals. Had not, after all, they ‘succeeded’ beyond compare in bringing about a QE-fuelled boom far beyond the envy of a Bernanke, a King, or a Trichet when the world first fell apart in 2008/9? Besides, were their armies of Western apologists and the even more serried divisions of mainstream macro dullards not almost unanimous in declaring that either the slow-down would conform to a gentle glide path or that, conversely, at the first sign the descent was indeed quickening, the afterburners would be lit, the stick pulled back, and the whole, ponderous, creaking, billion-man flying-boat would go round again for another pass in, oh say, 2014 or 2015?
That the first of these assumptions would prove to be amiss was an easy call to make for those with a more established pedigree of economic reasoning: the bet that the second would not even be attempted until far too late in the day was a less certain failure, predicated as it was upon what little we outsiders really know about the political imperatives at work within the confines of the Forbidden City, but it was still where the smart money piled its chips.
To understand why this was the case, consider the phrase a very senior member of the Chinese Communist Party recently employed: ‘the only two things that can threaten the regime are inflation and corruption’. So has it ever been, throughout China’s long history.
Given that, the observation that the 2009-10 stimulus delivered a massive, socially-imperilling dose of both these evils, it did not require too much nerve to hold to the idea that the relief of the monetary stringency gradually imposed (in the official markets for money and credit, at least) last year would be maintained until the fear of an imminent implosion rebalanced the scales of political calculus – above all, in this, a leadership transition year and doubly, trebly so when the Party apparat’s inner schisms were revealed with the dramatic purge of Bo Xilai and his Chongqing henchmen.
Thus, it is that, wherever you look, you see signs of distress in China. Shipbuilding, steel making, aluminium smelting, textiles, construction – even sectors such as these, which are dominated by the privileged oligopolies of the state-owned enterprises, are palpably struggling. Meanwhile, stockpiles of raw materials continue to mount on the wharfsides and in the warehouses, entailing who knows what dangers for those who have raised grey-market funding by using them as collateral and who thus owe monies both at home (in loan-sharked yuan) and abroad in an inconveniently appreciating dollar. Meanwhile, accounts receivable pile up on balance sheets at rates greatly in advance of those at which reported revenues advance and the spreading stench of fraud poisons the waters for those looking to plug the gaps with gullible gweilo money.
The authorities’ response? To insist that the Big 4 accounting firms do not co-operate with the SEC in investigating any such accusations and to issue a media directive that no bad news may be reported without prior approval in the run up to the autumn’s Politburo handover.
Indeed, there are clear signs that some of these dangers are beginning to be realised. Taking the difference between the reported size of China’s forex reserves and the sum of trade and FDI inflows (and making some best-guess reckoning of the effects of reval changes and interest gains), one gets an estimate of hot money movements being diffused across the porous barrier of capital controls – most famously via the metals L/C rehypothecation scam. Between March’09 and February of this year, such ‘unexplained’ flows amounted to no less than $560 billion – roughly two-fifths of China’s total reserve accumulation and a third of its coincident increase in M1.
The last four months of increasing angst about the state of the ‘landing’ have seen a dramatic reversal of these flows, to the point that the discrepancy in the books suggests that China may have lost no less than $128 billion – a flight which exceeds that suffered during the worst of the Lehman crisis. Taken at face value, this implies further, self-reinforcing pressure for the renminbi to weaken, for the Dim Sum bond bubble to deflate, and for commodity loans to be unwound, either suddenly – by means of re-exporting some of the swelling inventories of copper, et al – or gradually – by cutting back on new imports until the excess has worn off and the bills settled.
Either way, a chilling prospect, even if this does not trigger a new financial crisis among China’s complex and shadowy interweaving of ‘loan guarantee’ companies and off-balance sheet ‘wealth management products’
It should go without saying that China is not the be-all and end-all of this story, for it is also the nexus whereat much of the value-added is booked, if not strictly accrued, from the embodiment into the consumer goods we Europeans and Americans so avidly buy off the higher-tech component marvels of its more sophisticated neighbours, especially Japan, South Korea, and Taiwan. Nor is China’s fate a matter of indifference to its suppliers and fellow users of less rarefied inputs, whether directly – e.g., Australia, Brazil, South Africa, and the Gulf – or indirectly, wherever similar goods have their prices boosted by means of China’s disproportionate take-off from world market supply.
China has now begun to react, of course, cutting the effective bellwether, one-year lending rate from 5.9% (6.55% official less the permitted discount of 10%) to 4.2% (6.0% less the widened 30% rebate) in the space of a month. As Wang Shuo, Managing Editor of the influential and highly-regarded Caixin Magazine blogged at once on his Weibo page: “This is an admission that the hard landing is already here.” In this, he only anticipated his sovereign overlord, President Hu, by a few hours, for this latter worthy soon thereafter started bleating that the economy faces ‘severe downwards pressure’.
You bet it does! Take a range of key indicators – from electricity usage, to Shanghai container throughput, to nationwide rail freight ton-miles, to steel output – and you will notice that none of these shows a rate of growth during the second quarter of more than 4% from 2011, and some are as low as 1%. Whatever fictive GDP number we are presented with this week, the message is clear: “Brace! Brace! Brace!”
The trick will now be to avoid re-inflating the property bubble – and information suggesting 125% of June’s overall loan total was comprised of household credit offers little reassurance on that score. It is also imperative that the regime acts to assuage the fears of a populace who were already, in the aftermath of the first rate reduction, responding to official survey questions in a high and increasing proportion that they feared an imminent ‘surge’ in consumer goods prices. Good luck with that, Comrades!
Last of all we come to Europe and here is where, six months ago, we only had a thesis, or rather a litmus test, for, when we last wrote the report in question, we said that the key issue was whether or not the massive LTRO operations then just being enacted would actually stimulate a long-awaited increase in money supply in the Zone.
We know now that the answer was a qualified negative since the bulk of the impact of the operation went towards providing a mechanism through which credit withdrawal and outright capital flight into the core could occur, without collapsing the banking systems of the periphery, there and then. Thus the qualification on the above negative: money supply has continued to shrink in the Olive Belt debtor nations (especially after deducting the wastage due to CPI price rises), while it has begun to accelerate in what is not far from becoming an alarming manner in the creditor nations of the north, thanks to the arcane wonders of the TARGET2 apparatus.
A cynic might point out that such a sub-alpine price and wage suppression, coupled with the converse trends among the supra-alpine elite is exactly what is needed to ‘rebalance’ the Eurozone without breaking the single currency apart.
The problem with the adoption of such a sanguine view comes in two parts. The first is the quibble that a suitable capital base through which to make this shift in relative prices immediately effective is sorely lacking: unemployed Greek school teachers are not going to pose a threat to Dutch petrochemical engineers, nor Spanish carpet-layers to Mittelstand machine tool assemblers, any time soon. The second is that while the debt overhang persists – and, indeed, while it is being made progressively more onerous by the ongoing deflation – any Northern man of affluence or entrepreneurial daring tempted to speed the process through taking up productive assets or property in the afflicted zones will be greatly inhibited both by the knowledge that some highly arbitrary credit revision still lies ahead and by the fear – justified only last week by M. Hollande’s ill-judged razzia – that the state’s roving marauders will be happy to seize any gains made from such investments, however inequitable and retrospective – not to mention ultimately self-defeating – the deed might be.
In contrast to their policy-making peers elsewhere, by continuing to cite the need for ‘structural reform’, much of the European political elite is at least paying lip service to the principles contained in our oft-repeated mantra that there are no macro-economic issues which can be solved other than by micro-economic means (though, for us, that also includes case-by-case debt renegotiation, write-down, and transmutation into equity).
Sadly, while their mouths may be making such pious utterances unto the Gods, their hands – as M. Carmignac so forcefully pointed out in the European press a few days ago – are reaching ever more boldly into the pockets of those who still have reserves of capital and a viable means of support, thus bleeding the healthy in the forlorn attempt to palliate the sick. A case in point here is the latest brainwave of resurrecting the time-dishonoured method of forcing the rich to subscribe to state ‘loans’ – a levy on what might otherwise be productive capital last practiced by arbitrary princes of the ancien régime, as well as by the bellicose proto-republics with whom they were often at war.
With markets showing less and less response to the same, wearily repeated prescription of longer-lowered interest rates and more intrusions into the markets – LIBOR rigging on a universal scale, we cannot refrain from adding – the worry is that the piecemeal expenditure of the wrong sort of ammunition in pursuit of ill-counselled operational objectives will yet see the whole Grande Armée of bureaucrats, technocrats, and corporocrats arrive at its very own Berezina just in time to celebrate the two-hundredth anniversary of the utter dissolution on those pitilessly icy banks of the once-proud remnants of the first.
On page two of today’s Wall Street Journal Europe you will find the result of a readers’ poll from last Friday; Question: will the ECB’s rate cut help restore confidence in the bloc’s economy? Answer: 81 percent of readers say no; 19 percent yes.
Last week’s round of global monetary easing – another ECB rate cut, another round of debt monetization from the BoE, another rate cut from the People’s Printing Press of China – is, of course, more of the same old same old. It has a discernible touch of desperation about it and this is not lost on the public. Monetary policy is ineffective. Or, to be precise, it is only effective in delaying a bit further the much-needed liquidation of the massive imbalances that previous monetary policy helped create, and thereby is contributing, on the margin, towards making the inevitable endgame even more painful. It is counterproductive and destructive. It is certainly not restoring confidence.
Yet, many commentators and many of the establishment economists out there are not giving up. If only the ECB had cut by 0.5 percent instead of 0.25 percent, the equity market could have responded more optimistically. Maybe this would then have restored confidence? — Really? We are now below 1 percent in official interest rates, having cut by a full 400 basis points since the crisis started. How realistic is it to assume that another 0.25 percent is the difference between confidence-enhancing monetary stimulus and dread-inducing disappointment?
The advocates of ever more ‘stimulus’ are grasping at straws. What else can they do? Their pretty little world-view according to which, in a system of unlimited fiat money, the central bank can always create some additional ‘aggregate demand’ by giving a bit more artificially cheap funding to the banks lies in tatters.
Money is never neutral
That monetary policy would finally end in this cul-de-sac is no surprise. It only surprises those who share the mainstream’s simplistic view of monetary stimulus. Phrases such as “the ECB is attempting to unlock the flow of credit in the Eurozone”, are masking the complexity of the true effects of money creation and interest rate manipulation, and they make ongoing monetary stimulus look unduly harmless and straightforwardly positive. Who could object to unlocking credit, to liquefying markets or stimulating activity?
One of the major contributions of Ludwig von Mises’s monetary theory was his proof of the categorical non-neutrality of money. He demonstrated “that changes in purchasing power of money cause prices of different commodities and services to change neither simultaneously nor evenly, and that it is incorrect to maintain that changes in the quantity of money, yield simultaneous and proportional changes in the ‘level’ of prices.” (Ludwig von Mises, Memoirs, page 47).
A monetary stimulus never affects GDP and inflation directly and exclusively, these two statistical aggregates to which the mainstream assigns overwhelming importance. Every monetary stimulus affects and changes many other things as well, and these other effects have often more far-reaching consequences: monetary policy always changes relative prices, it always alters the allocation and the use of scarce resources, and it changes income and wealth distribution. Every monetary stimulus creates winners and losers.
This is being ignored by the mainstream. In his defence of QE, Martin Wolf argues in the FT that the central banks print money in the public interest. The assumption is that we all benefit from the boost to growth, short-lived as it must be, and that we all suffer the effects of higher inflation – if higher inflation materializes at all. But the new money does not reach everybody in the economy at the same time, and therefore does not affect prices ‘evenly and simultaneously’. As a general rule, the early recipients of the newly printed money benefit at the expense of the later recipients. Those who, in the chain of money distribution, are located closest to the money producer (the central bank) are always the winners. These are usually the banks and other financial market participants. They can spend the new money before it has dispersed through the economy and lifted a whole range of prices, and before the new money’s purchasing power has thus been impaired. At the present stage of the credit mega-cycle, more monetary accommodation helps the banks fund overpriced assets and bad loans on their balance sheets. Various ‘bubbles’ – which are uniformly the result of past monetary expansion – are thus sustained and even inflated further. Market forces that would adjust prices, reallocate assets and bring the economy back to balance are thus weakened or impaired completely.
Moreover, accommodative monetary policy can only lead to more economic activity by encouraging somebody to take out more loans, to take on more debt. The mechanisms by which ‘easy money’ leads to more GDP-growth is through the lengthening of balance sheets of banks and of more financial risk-taking, generally. We are in the present pickle precisely because this kind of stimulus policy has been conducted – on and off – for decades. That is what brought us to the point of a banking and debt crisis. Presently, authorities are fighting a debt crisis by encouraging more debt accumulation. They are fighting a banking crisis by encouraging the banks to take more risk. You do not lower interest rates and conduct QE and then realistically expect deleveraging and balance sheet repair.
In this context, I find it particularly bizarre that some economists argue that an even bolder intervention by the ECB, such as a deeper rate cut, another LTRO (funding operation for banks), or a commitment to more purchases of sovereign bonds, would have restored confidence. Do these experts really believe that the public will feel more confident if overstretched banks grow even more quickly with the help of the printing press? Will uncertainty over excessive government debt be laid to rest if the central bank promises to support these governments with essentially unlimited money-printing and bond purchases, thus making it easier for these governments to run deficits? Will that be seen as a solution or just a politically convenient postponement of the day of reckoning?
What causes loss of confidence is this: people do not know any longer what is and can be funded privately and voluntarily, and what is simply propped up by central bank intervention. They do not know the true prices of assets and the sustainable level of interest rates because everything is massively distorted through various central bank policies. Printing yet more money will not make anybody feel more confident.
Unintended consequences
Monetary accommodation is a form of market intervention, and like every other form of intervention it creates a whole range of unintended consequences, many of which are difficult to identify clearly and even more difficult to quantify but they are nevertheless real. My colleague at the Cobden Centre, Gordon Kerr, provided a good example during a recent discussion:
In supermarkets in London there is a trend towards replacing personnel at the check-out counters with new self-service machines that allow customers to scan their purchases and handle the payment process themselves. It is another incident of human labour being replaced with machines. We may say that this is a sign of the times, a consequence of technological progress, and thus inevitable. But such a development is, in each case, not only a consequence of what is doable technologically. It is also a result of economic calculation by the entrepreneur, in this case the owners and managers of the supermarkets. The expenditure for the machines, the capital they tie up and the interest charges that are associated with them, and any potential future losses from inappropriate handling by customers or even theft of produce due to reduced oversight will have to be compared with the cost savings from employing fewer personnel in the check-out area.
In modern-day Britain this calculation seems to work in favour of the machines but would it do so in a free market? The short answer is we do not know. But we do know that the supermarket workers and the check-out machines do currently not compete in a free market. Through the country’s numerous welfare-state regulations, among them minimum wages, social insurance, maternity- and paternity leave, health-and-safety legislation and other rules to ‘protect the worker’, the government has lifted the cost of employing people, it has made human labour expensive, while at the same time, the country’s monetary policy in favour of super-low interest rates and more bank lending has made capital cheap. From both angles, the worker is being squeezed out of the market. Legislation to protect him makes his work expensive; efforts to cheapen credit make capital investment a much easier alternative.
Do not get me wrong: our high standard of living is the result of a high ratio of productive capital to worker. If we want to increase our standard of living further we will have to keep increasing this ratio. This is the only way to enhance human productivity. But there is a right way of going about this, and there is a wrong way. The right way is to save, to put real resources aside, to redirect real resources from forms of employment that are close to present consumption and transform them into capital for future-oriented investment. How much we invest should not be the result of the decisions of central bank bureaucrats and their monetary manipulations but the result of voluntary saving decisions. That may well set a lower speed limit on capital investment but such a lower speed limit would be entirely appropriate. The resulting capital structure would be much more stable and sustainable, while investment that is funded by money creation rather than saving must lead to capital misallocations, which remains the primary source of boom-bust cycles. The apparent need of large parts of our present capital structure for near-zero interest rates and further doses of monetary stimulus simply to be sustained in their current size is a clear indication that accommodative monetary policy has already created grave dislocations. How much more of these do we want? How much more of these can the system live with?
The point I am making here is this: It is either naïve or a sign of incredible hubris to believe that the central bankers can anticipate the myriad of consequences their monetary interventions will have. To say that they are simply, in aggregate, in the interest of the public is simply incorrect. We are dealing here with a financial bureaucracy that has lost touch with the complexity of economic reality but that has now dug itself such a deep hole that any self-motivated turn-around can safely be ruled out.
As my friend Tim Evans says, the system has check-mated itself, and so has the mainstream and the policy bureaucracy. Their policies are failing but they cannot consider the alternative, which would be a complete stop to monetary intervention and money-printing, and would mean finally allowing the market to liquidate what is unsustainable anyway. This would realign asset prices with economic reality and bring valuable assets into the hands of entrepreneurs rather than have them funded at unrealistic book-prices on bank balance sheets forever. Can they imagine this alternative but not dare to implement it? I am not so sure. I fear they may not even grasp it.
Will the ECB cut again? Will the ECB underwrite the bond purchases of the ESM via the printing press? – Yes and yes again. Of course, they will. Just give the ECB some time. Will it solve the problem? Of course, it will not.
We will see more rounds of QE, more rate cuts where this is still possible, and further expansions of central bank balance sheets. Pension funds and insurance companies will be forced by regulators to hold assets that the state wants them to hold (government bonds anyone?), and the reintroduction of capital controls appears a near certainty at this stage. Remember, a toxic mix of stubbornness and desperation rules policy making at present. It is best to be prepared for everything but the sensible solution.
Come to think of it, the title of this essay may be misleading. The central banks have reached the end of the conventional road but they will push their policies further.
In my view, there is no escaping the fact that things are not getting better. If anything, they are getting worse. Following the large swings in financial markets this past week and reading the commentary in the press, it strikes me that there is still a surprisingly strong belief out there that our fate is in the hands of the policymakers, who presumably still have it in their power to make things better for the economy. How can they do this? Well, expect nothing new here: Mainly by the time-worn strategy of lowering official interest rates again – where this is still possible – or by injecting more fiat money into the system through fresh loans to the banking industry or by yet another round of debt monetization. Talk about the laws of diminishing returns!
The only reason I could find in the finance commentary for why equity markets rallied last week was that the prospect of another dose of cheap money had appeared on the horizon. A week ago, on June 1, a rather dreadful employment report in the US – which, like all statistics, should not be taken at face value but treated with the utmost caution – had poured cold water over the notion of a self-sustaining recovery and instantly seemed to pull the rug from under the equity market. Then the usual pattern unfolded. Wait a minute, the markets seemed to say collectively, a weakening labour market in the US is just what is needed to tip Ben Bernanke over the edge and cause him to engage in another round of ‘quantitative easing’. And that was the basis for the rebound in global equities this week.
Please deceive me!
QE is, according to Bernanke’s own explanation, a policy tool that aims to improve the public’s sentiment and to cajole it into additional economic activity via the targeted manipulation of asset prices. For example, high equity markets usually make the economy appear healthy and are thus bound to make businessmen and women more optimistic. In a free market, low interest rates usually signal the availability of a large pool of voluntary savings that desires to be invested and to be translated into productive assets. But in the absence of a healthy economy that lifts equity markets, and in the absence of savings that can be used for true capital formation, a mirage of health and savings and capital can still be generated with the help of the printing press. QE, again by Bernanke’s own admission, is a giant placebo: It is not true medication as it evidently does not address the economy’s fundamental ills, but a tool for nationwide mass hypnosis. It is a kind-of anti-depressant, a kind of monetary Prozac.
Well, these are the policies that have been run on an unprecedented scale for a number of years now. To say they have been without effect would be wrong. As I see it, they have had numerous effects. But they certainly have not ended the crisis. What were the effects then?
Monetary accommodation has manufactured the occasional rally in ‘risk assets’ but these have usually been short-lived. After all, there still exists an unbridgeable gulf between an artificial rally created with injections of new fiat money and a re-pricing of productive assets in response to positive fundamentals. Additional effects were the following: the policy has allowed many banks to stay in business and thus hindered a recalibration of the banking industry; the policy sabotaged the redirection of scarce capital from the bubble-industries that had benefited from the credit boom toward new, productive and more sustainable employment in other sectors; it sustained an over-stretched financial industry a tad longer; it allowed governments to run big deficits and accumulate more debt; and by mis-pricing the cost of capital further it has most certainly directed entrepreneurs into areas that will prove to be disaster zones once the flow of cheap money slows.
If you believe – as I do – that large-scale mis-allocation of resources and substantial mis-pricing of assets, both the result of the extended credit boom that popped in 2007, are at the core of the present malaise then you may agree with me that monetary accommodation (QE and all that sort) will not only make the economy not better, it actively hinders the healing process. And it does so by providing a temporary placebo that seems to quickly lose its effectiveness.
Why so optimistic?
So, I ask myself, how can the prospect of another ECB rate cut or QE3 or QE4 from the Fed really make those hardened investment professionals more optimistic? I wonder, is their ostentatious enthusiasm for these deceptions genuine or is it some cynical ploy to offload ‘risk assets’ into the next artificial and short-lived rally and to then hunker down in anticipation of the unavoidable collapse? Is the apparently unfailing belief in the ultimate power of money-printing and ‘monetary stimulus’ not a sign of desperation rather than a rational assessment of a very messy situation?
Maybe they believe, with Paul Krugman, who appears very genuine in his pronouncements, that the next $2 trillion of new money from the Fed will achieve what the last $2 trillion obviously didn’t, or that the next 30% in government debt will do what the previous 30% didn’t, that is, cut through some imaginary, collective psychological knot and allow us all to be more productive. I don’t believe it but I am puzzled by the explanations and arguments that I read.
In particular, I am surprised by how much observers appear to be willing to twist the notion of the capitalist economy to be able to squeeze a modicum of optimism out of the prospect of even more blatant government intervention. I wonder if there is not some self-deception involved. Here is an interesting quote from this morning’s Financial Times, explaining why China’s surprise rate cut yesterday was a reason for optimism:
“‘We believe that the rate cut will be effective in meeting the short-term objective of getting credit and the economy moving,’ said Mark Williams at Capital Economics. ‘There could be no stronger signal that policy makers are focused on growth. That alone should prompt more activity at the large state-owned sector.’”
Well, hooray for that!
I do not know Mr. Williams and I have no intention of criticizing him personally. I only quote him here because I think that his brief statement is an excellent representation of what must be the economic belief-system of those who manage to derive optimism from these policy announcements.
Do people really believe that the ingredients for a well-functioning economy and a sustainable recovery are credit expansion based on printed money rather than savings, are interest rates that reflect the priorities of policymakers rather than the interaction of savers and borrowers on markets, and that more activity from a large state-owned sector that readily transmits the wishes of policy-makers is a good basis for a prosperous economy?
Again, I am not even implying that this is Mr. William’s view. It may well be that all he was trying to say was that these measures were bound to boost GDP statistics in the short term. And I agree with that. Chances are we will get a growth blip in China as a result. But so what? Big deal. This is no reason for real optimism, in my view. Does it mean that we have turned the corner in this crisis? I don’t think so. In fact, every component of this quote makes me bearish on China’s medium-term outlook: easy money, ‘get credit moving’, large state-owned sector. What is not to dislike about this toxic mix?
Since the financial crisis started China has expanded its money supply in the M2 definition by about 90%, or more than 13% p.a., something in which it was greatly assisted by an obedient state-controlled banking sector that understood that the policy makers were focused on growth. Such monetary stimulus is always good for one thing: blow a few bubbles. On many measures China’s real estate boom has gone further than the one in the US prior to 2006, and is more similar to the one in Japan in the 1980s. And how well that ended!
I am no expert on China but all I am saying is this: what precisely should I get optimistic for? Cheap money for the large state-owned sector?
No safe havens, sorry.
We are in a proper mess and I am sorry to say there are no painless exits, there are no cheap assets and there are no safe havens. Gold remains my favourite asset because it is something that has maintained wealth for a long time and it cannot be printed by Bernanke and not issued en masse by Geithner.
Yet, as I explained last week in detail, gold is not cheap. I believe its price already reflects the expectation that the Fed will print vast amounts of additional dollars and that an inflationary endgame to the global economic malady has a high probability. I don’t call it a bubble because so many things are actually pointing in the direction of such an outcome. Yet, any reluctance on the part of Bernanke to use the printing press more aggressively – and I believe he has good reasons to be cautious – is likely to depress the premium in the gold price over gold’s long run PPP. It is not an easy trade.
I think last week’s volatile price action in gold supports this interpretation. When the poor labour report came out on June 1, gold enjoyed its biggest one-day rally in more than 3 years, evidently in expectation of more central bank activism. But with Bernanke appearing reluctant in his testimony on Wednesday to prepare markets for another round of debt monetization, gold retreated quite sharply.
Gold is the eternal alternative to state fiat money. It is not surprising that it has now become predominantly a play on the probability of the Fed ultimately pressing the monetary nuclear button. But any gains in the so-called ‘risk assets’, such as equities, now seem to be driven not by any fundamentally justified optimism on the real economy but, too, by the prospect of another dose of monetary Prozac.
I am not sure if Warren Buffett and Charlie Munger of Berkshire Hathaway appreciate the irony here. But the ‘unproductive and uncivilised’ asset ‘gold’ that they so detest, and the ‘productive and civilised’ assets ‘equities and farm land’ that they so prefer, are presently driven by the same forces. After so much policy intervention nobody knows what the ‘real’ prices of these assets should be anyway but it seems to me that without the prospect of ongoing and constant fiat money debasement nobody can justify the nominal prices of any of them.
In the meantime, the debasement of paper money continues.
