I’ve recently written for Save Our Savers attempting to square the massive expansion of Britain’s monetary base since March 2009 with the fact that inflation has now been within the Bank of England’s target range of 2% (+/- 1%) since June 2012. Here I’d like to expand a little.
Since March 2009 Britain’s monetary base, also known as narrow money or M0, has increased by 321%. We can see that the majority of this is in the form of increased bank reserves, up 642% since March 2009
Source:The Bank of England, series Notes in circulation – RPWB55A, and Reserve Balances – RPWB56A
This is just what we’d expect to see following the Bank of England’s Quantitative Easing, where the Bank creates new money and uses it to purchase bonds from banks – that new money becomes bank reserves. Those banks have sat on that money (not using it as a basis for new credit creation and feeding into M4) which is why, while narrow (M0) money has exploded, broad (M4) money has barely budged, increasing by just 7.4% since March 2009.
Source:The Bank of England, series Notes in circulation (RPWB55A) and Reserve Balances (RPWB56A) (M0), and Monthly amounts outstanding of M4 (monetary financial institutions’ sterling M4 liabilities to private sector) (in sterling millions) seasonally adjusted (LPMAUYN) (M4)
This relative restraint in M4 growth explains the relative restraint in inflation. There is no great mystery as to why banks which have just seen their assets tank and ravage their balance sheets should want to hold more reserves. The key question is what happens next.
The chart above shows the ratio of M0 to M4 since May 2006; how many pounds of broad money each pound of narrow money is supporting. From 25:1 between May 2006 and March 2009, it slumped via successive bouts of Quantitative Easing to about 6:1 since September 2012.
Now, on the one hand banks might stick to this new, lower ratio. Chastened by their experiences with mortgage backed assets they might desire a permanently lower reserve to asset ratio and all QE will have been is a vast recapitalisation of banks.
On the other hand, as ‘recovery’ kicks in they might start to increase their reserve to asset ratio. They might not scale the giddy heights of 25:1 again, but they will be multiplying out from a monetary base which has tripled in size. Britain’s monetary base is now £362 billion and M4 is about six times that, £2.2 trillion. But if renewed confidence in the banking sector saw banks return to higher ratios, the resulting M4 figures would be as follows:
Here, we are told, the Bank of England will be able to ‘drain’ this liquidity from the system. It would do this by reversing QE; selling bonds to banks and effectively destroying the base money it receives in return. But a massive increase in the supply of bonds relative to the demand for them will lower their price. This is the same as raising their yield and this is the same as raising a key interest rate.
It is worth pondering for a moment the scale of bond sales and consequent rise in interest rates which might be necessary to drain this base money from the financial system. We must hope either that the economy can stand it or that banks keep holding these reserves.
Now we know: The Fed is going to purchase $75bn of assets, a reduction of $10bn a month. The two other bits of information that came from the FOMC meeting were that purchases of US Treasuries and mortgage bonds are to be cut by $5bn each, and interest rates will be held at zero for even longer. And to justify zero interest rates, the unemployment target is being shifted from 7% to 6.5%.
In my opinion the Fed showed through its FOMC statement it has little control over events, something that should dawn on markets in the coming days. To debate this we must put aside the question as to whether or not quantitative easing is sensible in the first place and only focus on this FOMC compromise. There is an argument that any reduction in QE should be confined to purchases of Treasuries, because the budget deficit is reducing and the market probably needs more of this paper for collateral purposes. If that argument had been presented it would have made sense and the Fed’s stock would have likely soared. Instead the tapering is to be split between mortgage bonds and Treasuries, which suggests a “pluck a figure out of the air” approach rather than a more reasoned one. The scale of tapering is in the lower range of expectations, so presumably was intended to be market-neutral. This tells us that the FOMC probably came to its decision based on what was expected of it rather than from a sense of conviction that the policy is correct. But the greater inconsistency is over forward interest rate guidance.
When a central bank holds interest rates below their natural market level, it stands there to provide however much liquidity is required to keep the rate suppressed. This in practice is the result of a number of factors including overall demand for money, and on the supply side changes in the quantity of narrow money, bank credit expansion and required reserves. QE is one form of this liquidity, and the extent to which QE is reduced must be compensated for by other means if interest rates are going to be kept at the target level.
This simple fact makes changes in QE meaningless in the broader monetary context, and on this vital point the Fed keeps silent. Instead it attempts to offset the deflationary implications of tapering by increasing its commitment to zero interest rate policy (ZIRP) and for longer. We are left wondering how long it will be before this contradiction is generally understood. Furthermore, those that link QE to prospective prices for gold and silver are ignoring the commitment to interest rates and are effectively pushing a one-sided argument.
It is not just precious metals that are mispriced. Government bond yields, particularly for the weaker eurozone states do not reflect credit risk. Equity markets are priced on the back of ZIRP. Fixed assets, particularly housing and motor vehicles are being financed on the back of this unreality. The important point is not tapering, but that ZIRP continues indefinitely.
This article was previously published at GoldMoney.com
There are lots of reasons why QE hasn’t yet created inflation in the rich West…
SO HEADLINE writers everywhere got to say money really does grow on trees today.
Gold, in fact, has been found in minute quantities in eucalyptus trees in Australia. Analyzing tree leaves and bark could now unearth gold deposits up to 30 metres below ground elsewhere in the world, geochemists say.
Good news perhaps for the mining sector. But unearthing that ore won’t be easy like picking a leaf. Making money is never cost-free. And not even money-printers are making as much profit as you might imagine right now.
UK firm De La Rue today gave its second profits warning of the year. Weird as it sounds, there is over-capacity in note printing worldwide, it claims. That may seem hard to believe, what with quantitative easing still rolling ahead at record levels. But money printing isn’t what it used to be, even without the US Fed daring to taper its $85 billion per month. And De La Rue is lagging profit targets set back in 2010, when asset purchases with newly-minted central bank cash was hitting its stride.
De La Rue Plc is the world’s largest independent printer of banknotes. It has printed 150 different currencies over the last 5 years, and designed two-fifths of all new banknotes issued anywhere in the world since 2008.
You might think that was (ahem) a license to print money. But volumes actually fell this year, De La Rue says, down 10% in the first half of 2013.
Surely quantitative easing means there’s more money around? Near-zero interest rates are also bringing more credit and spending to the economy, right? And what about the revival of real estate prices, most notably in UK housing but also worrying German politicians as even Berlin rents soar?
All that money, however, is electronic, not physical paper. Indeed, the central banks’ printing presses are today an “electronic equivalent” as current Fed chair Ben Bernanke put it way back in 2002. Urging the Japanese to debauch the Yen just as he’s since attacked the Dollar, Bernanke only used “printing” as analogy, however. Whereas it was paper money, not photons blinking on a bank-account balance, which fired inflation in the basket-case economy of Zimbabwe when Bernanke spoke a decade ago, and in Argentina today.
Digitized cash, in contrast, is now the real thing, as military strategist, historian and consultant Edward Luttwak noted this month in an aside on Italian gangsters. Starting in the 1990s, says Luttwak, the Calabrian family gangs pushing cocaine north into Europe as far as the new markets of the old Soviet states found their “Colombian [cocaine] suppliers refused to accept cash, because it was no good for investing in Miami real estate or local hotels or restaurants. The Calabrians needed real money: not bundles of paper but deposits in bank accounts that could be wired.”
Fact is, legitimate businesses cannot use cash. And worldwide, reckons Mastercard (with a vested interest, of course), business transactions now account for 89% of the value of payments. Consumers, meantime, are also moving away from cash (at least, outside the black economy they are; and those immoral earnings still need laundering into the “real money” of digitized bank databases in the end). As a proportion of retail transactions by number, cashless payments now make up 80% in the United States, 89% in the UK, and all but 7% in Belgium according to Mastercard. Even ignoring the plastic PR team, nearly half of UK consumer transactions are now done without cash, with currency payments sinking almost 10% by value in 2012 from the year before, according to the British Retail Consortium. The bulk of non-cash growth came from “alternative” methods, notably PayPal, with “new ways to pay and new ways to shop shaping the retail landscape like never before.”
Might this explain why consumer price inflation hasn’t taken off in the developed West? Yes, there’s lots more money around. Yes, people keep buying gold as protection. Because basic economics says this should push the general price level higher, as the value of each monetary unit is shrunk. But all this extra money sits on hard drives, servers and in the cloud, rather than in purses and wallets. That’s where money is transacted too, in intangible code. Lacking a physical presence, perhaps this wall of money loses its impact.
There are lots of other reasons you could give for why inflation hasn’t surged with the money supply. It’s all locked up in banking reserves, for instance, instead of reaching the “real” economy. Increased spending power since 2008 has gone almost entirely to the richest households, who use it to buy shares, property and fine art rather than Doritos and donuts. Or perhaps central bankers really have kept that credibility which they fought to attain after the 1970s’ inflation. Western households are now sure that the cost of living will never be let loose again.
But the birth of physical money back in ancient Greece changed our brains and our world. Coins made kings of anyone holding them, with the “universal equivalent” marking the beginning of the end of feudal society just as it created an independent yard-stick for all values – mercantile, religious and personal. This is what the myth of King Midas is about, after all.
The human brain and how it conceives of the world is being changed again by digitization today. Just ask a 20-year old (go on, ask them. Ask them anything, and see if they can answer without checking online. Ask a 45-year old come to that). Plenty of people worry that it’s all changing us for the worse, twiddling their fears about the internet by writing, of course, on the internet. Plenty of other idiots think the posthuman world will prove a new joy, with the internet’s jibber-jabber of lies, confusion and stupidity taking us back to some forgotten Eden where everyone’s views are equal. Like, y’know, in the way opinions were freely allowed to medieval peasants who couldn’t read? Today’s infotainment and readers’ comments let knowledge morph and shift just like knowledge was shared and communal pre-Gutenberg. Who needs the Enlightenment?!
Either way, perhaps our brave new digital world also revokes the iron law of money. Perhaps our flood of new cash will never end in higher living costs in the way it always has – always has – in the past. Because money we cannot touch cannot in turn touch prices as surely as paper or metal did.
Yeah right. And money really does grow on trees.
This article was previously published at BullionVault.com.
We use the term “reserve currency” when referring to the common use of the dollar by other countries when settling their international trade accounts. For example, if Canada buys goods from China, it may pay China in US dollars rather than Canadian dollars, and vice versa. However, the foundation from which the term originated no longer exists, and today the dollar is called a “reserve currency” simply because foreign countries hold it in great quantity to facilitate trade.
The first reserve currency was the British pound sterling. Because the pound was “good as gold,” many countries found it more convenient to hold pounds rather than gold itself during the age of the gold standard. The world’s great trading nations settled their trade in gold, but they might hold pounds rather than gold, with the confidence that the Bank of England would hand over the gold at a fixed exchange rate upon presentment. Toward the end of World War II the US dollar was given this status by international treaty following the Bretton Woods Agreement. The International Monetary Fund (IMF) was formed with the express purpose of monitoring the Federal Reserve’s commitment to Bretton Woods by ensuring that the Fed did not inflate the dollar and stood ready to exchange dollars for gold at $35 per ounce. Thusly, countries had confidence that their dollars held for trading purposes were as “good as gold,” as had been the Pound Sterling at one time.
However, the Fed did not maintain its commitment to the Bretton Woods Agreement and the IMF did not attempt to force it to hold enough gold to honor all its outstanding currency in gold at $35 per ounce. The Fed was called to account in the late 1960s, first by France and then by others, until its gold reserves were so low that it had no choice but to revalue the dollar at some higher exchange rate or abrogate its responsibilities to honor dollars for gold entirely. To it everlasting shame, the US chose the latter and “went off the gold standard” in September 1971.
Nevertheless, the dollar was still held by the great trading nations, because it still performed the useful function of settling international trading accounts. There was no other currency that could match the dollar, despite the fact that it was “delinked” from gold.
There are two characteristics of a currency that make it useful in international trade: one, it is issued by a large trading nation itself, and, two, the currency holds its value vis-à-vis other commodities over time. These two factors create a demand for holding a currency in reserve. Although the dollar was being inflated by the Fed, thusly losing its value vis-à-vis other commodities over time, there was no real competition. The German Deutsche mark held its value better, but German trade was a fraction of US trade, meaning that holders of marks would find less to buy in Germany than holders of dollars would find in the US. So demand for the mark was lower than demand for the dollar. Of course, psychological factors entered the demand for dollars, too, since the US was seen as the military protector of all the Western nations against the communist countries for much of the post-war period.
Today we are seeing the beginnings of a change. The Fed has been inflating the dollar massively, reducing its purchasing power in relation to other commodities, causing many of the world’s great trading nations to use other monies upon occasion. I have it on good authority, for example, that DuPont settles many of its international accounts in Chinese yuan and European euros. There may be other currencies that are in demand for trade settlement by other international companies as well. In spite of all this, one factor that has helped the dollar retain its reserve currency demand is that the other currencies have been inflated, too. For example, Japan has inflated the yen to a greater extent than the dollar in its foolish attempt to revive its stagnant economy by cheapening its currency. So the monetary destruction disease is not limited to the US alone.
The dollar is very susceptible to losing its vaunted reserve currency position by the first major trading country that stops inflating its currency. There is evidence that China understands what is at stake; it has increased its gold holdings and has instituted controls to prevent gold from leaving China. Should the world’s second largest economy and one of the world’s greatest trading nations tie its currency to gold, demand for the yuan would increase and demand for the dollar would decrease. In practical terms this means that the world’s great trading nations would reduce their holdings of dollars, and dollars held overseas would flow back into the US economy, causing prices to increase. How much would they increase? It is hard to say, but keep in mind that there is an equal amount of dollars held outside the US as inside the US.
President Obama’s imminent appointment of career bureaucrat Janet Yellen as Chairman of the Federal Reserve Board is evidence that the US policy of continuing to cheapen the dollar via Quantitative Easing will continue. Her appointment increases the likelihood that demand for dollars will decline even further, raising the likelihood of much higher prices in America as demand by trading nations to hold other currencies as reserves for trade settlement increase. Perhaps only such non-coercive pressure from a sovereign country like China can wake up the Fed to the consequences of its actions and force it to end its Quantitative Easing policy.
This article was previously published at Mises.org.
We are now into a second week of a partial Federal Government shut-down, which is causing considerable concern, centred on the Government’s ability to finance its debt and pay interest without a budget agreed for the new fiscal year. Should this continue into next week and beyond, the Fed will have to enter damage-limitation mode if the Treasury cannot issue any more bonds because of the separate problem of the debt ceiling.
Most likely, QE will have to be switched from financing the government to buying Treasuries already owned by the private sector. Any attempt to reduce the monthly addition of raw money will simply result in bond yields and then interest rates rising. And indeed, already this week we have seen yields on short-term T-bills rise in anticipation of a possible default. The market is naturally beginning to discount the possibility that the Fed may not be able to control the situation.
The T-bill issue is very serious, because they are the most liquid collateral for the $70 trillion shadow banking system. And without the liquidity they provide securities and derivative markets, we can say that Round Two of the banking crisis could make Lehman look like a picnic in the park.
This is the sort of event deflationists have long been expecting. According to their analysis there comes a point where debt liquidation is triggered and there is a dash for cash as assets collapse. But they reckon without allowing for the fact that deposits can only be encashed at the margin; otherwise they are merely transferred, and only destroyed when banks go under. This is the risk the Fed anticipates, and we can be certain it will move heaven and earth to avoid bank insolvencies.
Furthermore the deflationists do not have a satisfactory argument for the effect on currency exchange rates. Iceland went through a similar deflationary event to that risked in the US today when its banking system collapsed and the currency halved overnight. Today a dollar collapse on the back of a banking crisis would also disrupt all other fiat currencies, forcing central banks to coordinate intervention to conceal the currency effect. This leaves gold as the only true reflector of loss of confidence in the dollar and therefore all other fiat currencies.
Those worrying about deflation ignore the fact that it is the fiat currency that takes it on the chin while gold rises – every time without exception. This was even the experience of the 1930s, when Roosevelt suspended convertibility, increased the price of gold by 40% to $35 per ounce, and the banking crisis was contained.
Of course there is likely to be some short-term uncertainty; but against the Fiat Money Quantity (FMQ) gold is down 30% compared with the price pre-Lehman crisis. This is shown in the chart below.
With gold at an extreme low in valuation terms, current events, whichever way they go, seem unlikely to drive it much lower. A wise man perhaps should copy the Asians, who know a thing or two about paper currencies, and are buying gold in ever-increasing quantities.
This article was previously published at GoldMoney.com.
“The goods and services traded on the semi-secretive website Silk Road since February 2011 with the virtual currency Bitcoins were so varied that the Federal Bureau of Investigation described it as “the most sophisticated and extensive criminal marketplace on the internet today”.
￼Its philosophical underpinnings, however, were not solely a desire to get rich quick but, according to the FBI complaint published on Wednesday after the site was shut down, “Austrian economic theory” and the works of Ludwig von Mises and Murray Rothbard, economists closely associated with the Mises Institute, in the US state of Alabama.”
- More obnoxious anti-Austrian School slurs from the Financial Times, on this occasion by John Aglionby and Tracy Alloway.
The Daily Mail no longer has a monopoly on libelling the dead: the Financial Times is also doing a pretty good job. John Aglionby’s story this week (‘Libertarian economics underpinned Silk Road Bitcoin drug website’) was, even by the standards of a paper coloured pink that should really be coloured yellow, an extraordinary piece of character assassination. You do not have to be a believer in Austrian business cycle theory to find the linkage between an apparently criminal website and two widely respected economic theorists to be utterly objectionable. Those FT readers who were moved to respond on the paper’s website tended to think similarly:
“the lowest of lows..”
“FT trying to discredit Ludwig von Mises, the Austrian business cycle theory and Bitcoins all in one go.. for god’s sake, you do not have any decency left..”
“childish, glib and misleading.. a new low for the FT.. Disgusting, to say the least”
“Another shining example of the death of journalism”
“The goods and services traded on the semi-secretive website Silk Road since February 2011 with the virtual currency Bitcoins were so varied that the Federal Bureau of Investigation described it as “the most sophisticated and extensive criminal marketplace on the internet today”.
￼￼“Sorry to say, but you all seem to fail to understand that the FT is making a heroic attempt to switch from factual financial reporting to a top position in entertainment of the masses. Don’t you think they are doing well? I most certainly do.”
That the Austrian business cycle theory should be held in such low esteem by such a prominent financial journal might be taken as an admission of guilt for not having noticed the credit bubble while it was inflating, and for then having continually defended the (neo-Keynesian) establishment line rather than debate the practical value of any alternative policy course.
In Austrian business cycle theory, the central bank is the culprit responsible for every boom and bust, firstly in fuelling excessive bank credit growth and maintaining interest rates at overly stimulative lows; then in prolonging the inevitable recession by propping up asset prices, bailing out insolvent banks, and attempting to stimulate the economy via the mechanism of deficit spending. It is difficult to see why the theory is so problematic given that the US Federal Reserve, for example, is not an agency of the US government per se but rather a private banking cartel. When push comes to shove, whose interests will the Fed ultimately protect – those of the banks, or those of the rest of the productive population?
But in any discussion of the ‘long emergency’ enduring throughout the insolvent West, the role of politicians should not be ignored. If politicians had moderated their tendencies to make unaffordable promises to their electorates, western fiscal disasters and the attendant debt mountains would now be less dramatic. And if politicians were not slaves to the electoral calendar, it is fair to assume that difficult choices might even have been taken in the long term interests of their respective economies.
The current gridlock in the US political system (first over the shutdown and latterly over the debt ceiling) is a perfect example of grandstanding politicians abdicating all responsibility for the electorate they claim to serve. And as a glaring example of cognitive dissonance, Treasury bond investors’ responses to fears over a looming default really do take some beating. That beating should, of course, be reserved for investors stupid enough to believe that debt issued by the world’s largest debtor country should be somehow treated as risk-free, especially when the possibility of formal default is only a matter of days away.
Treasury bond defenders will no doubt point out that in a fiat currency world where the central bank has the freedom to print ex nihilo money to its heart’s content, the very idea of default is absurd. But that is to confuse nominal returns with real ones. Yes, the Fed can expand its balance sheet indefinitely beyond the $3 trillion they have already conjured out of nowhere. The world need not fear a shortage of dollars. But in real terms, that’s precisely the point. The Fed can control the supply of dollars, but it cannot control their value on the foreign exchanges. The only reason that US QE hasn’t led to a dramatic erosion in the value of the dollar is that every other major economic bloc is up to the same tricks. This makes the rational analysis of international investments virtually impossible. It is also why we own gold – because it is a currency that cannot be printed by the Fed or anybody else.
On the topic of gold, the indefatigable Ronni Stoeferle of Incrementum in Liechtenstein has published his latest magisterial gold chartbook. (FT: if you’re reading, Ronni is an Austrian, so you’ll probably want to start the character assassinating now.) Set against the correction in the gold price 1974-1976, the current sell-off (September 2011 – ?) is nothing new. The question is really whether our financial (and in particular debt) circumstances today are better than they were in the 1970s. We would merely suggest that they are objectively worse.
Trying to establish a fair price for gold is obviously difficult, but treating it as a commodity like any other suggests that the current sell-off is not markedly different from any previous correction during its bull run:
To cut to the chase, it makes sense to own gold because currencies are being printed to destruction; the long term downtrend in paper money (as expressed in terms of gold) remains absolutely intact:
And we cannot discuss the merits of gold as money insurance over the medium term without acknowledging the scale of the problem in (US) government debt:
Whatever happens in the absurd and increasingly dangerous debate over raising the US debt ceiling, the fundamental problem remains throughout the western economic system. Governments have lived beyond their means for decades and must tighten their belts. Taxes are certain to rise, and welfare systems certain to contract. Even if western governments manage to rein in their morbidly obese consumption patterns without a disorderly market crisis, their legacy will be felt by generations yet to come. The debt mountain cannot and will not resolve itself. (Why, again, we own gold; because we think there is a non-trivial chance of a gigantic financial system reset.) The piper must, at some point, be paid. Western economic policy can be distilled down into just four words: the unborn cannot vote.
This article was previously published at The price of everything.
Now that there is growing evidence of GDP growth, we must consider a new topic: the likely effect on central bank balance sheets, using the US Fed as an example.
Since the banking crisis the Fed has acquired substantial quantities of securities as a result of the assistance it gave to too-big-to-fail banks and subsequently through quantitative easing, most of the assistance to the banks, the Maiden Lane and TALF securitisations, has been repaid. But since then, QE has swelled the Fed’s balance sheet to $3.6 trillion. The financing of this expansion is reflected mainly in excess reserves, which are deposits in favour of depository institutions, in excess of their required reserves.
As bond yields rise, it is obvious that the Fed will have to absorb portfolio losses, currently amounting to about $20bn for each one per cent fall in the value of its US Treasuries and $13bn on its mortgage securities (though these are likely to be more stable in price due to their self-liquidating nature). So far, 10-year Treasuries have fallen about 12% since end-April, and the Fed has $522bn of Treasuries with a maturity of over 10 years. In very rough terms the losses on its Treasuries of all maturities are likely to be about $200bn since April, larger than the Fed’s own capital by a very wide margin.
On the face of it, it doesn’t matter if the Fed’s capital is wiped out because it can easily magic up some more. But another problem will come when it has to raise interest rates: what will it do to stop banks withdrawing their excess reserve deposits? Presumably raise the interest rate paid on them. But it will probably appear to the wider public that the Fed is paying the banks not to lend money to businesses and people. At the moment interest on reserve deposits is only ¼%, but what if it has to be raised to 3% or 4% or even more to control bank credit? The banks will be earning between them $60-80bn per annum by leaving their excess reserves at the Fed.
It can be seen that rising bond yields and interest rates will play havoc with central bank accounts. It wasn’t meant to be like this: economic recovery was going to allow the Fed to taper its QE, and government deficits would disappear as tax revenues recover, giving the space for the Fed to unwind its purchases of Treasury debt. Instead, rising interest rates are likely to make it very difficult for the Fed to reduce its holdings of Treasuries, eliminating all those inflationary excess reserves at the same time.
The other major central banks face the same problem, having expanded their balance sheets in the wake of the banking crisis. They will be expected to stabilise the banking system and ensure undercapitalised banks are not wiped out by rising bond yields, or wrong-footed by interest-rate swap exposures. If, at the same time, the central banks are forced to recapitalise themselves to appear solvent, one wonders what the effect will be on the currencies concerned.
We might be about to discover how sound they and their currencies really are.
“This took guts.”
- Comment by Steven Ricchiuto of Mizuho Securities in response to the Federal Reserve’s surprise decision to refrain from “tapering” its $85 billion monthly bond purchase programme, as reported by the Financial Times, 19 September.
Human beings are suckers for a story. The story peddled by mainstream economic commentators goes that the US Federal Reserve and its international cousins have acted boldly to prevent a second Great Depression by stepping in to support the banks (and not coincidentally the government bond markets) by printing trillions of dollars of ex nihilo money which, through the mechanism of quantitative easing, will mysteriously reflate the economy. It’s a story alright, but more akin to a fairy story. We favour an alternative narrative, namely that with politicians abdicating all real responsibility in addressing the financial and economic crisis (see this article), the heavy lifting has been left to central bankers, who have run out of conventional policy options and are now stoking the fire for the next financial crisis by attempting to rig prices throughout the financial system, notably in property markets, but having a grave impact on volatility across credit markets, government bond markets, equities, commodities.. As politicians might have told either them, or Steven Ricchiuto of Mizuho Securities, it’s quite easy to be brave when you’re spending other people’s money.
Before we get back to the Fed, it’s worth a minute recapping why it was created, namely as a private banking cartel with a monopoly over the country’s financial resources and the facility to shift losses when they occur to the taxpayers. Satire goes a long way here (not least because the reality is so depressing) – here is Punch’s take on the banks from April 1957*:
Q: What are banks for?
A: To make money.
Q: For the customers?
A: For the banks.
Q: Why doesn’t bank advertising mention this ?
A: It wouldn’t be in good taste. But it is mentioned by implication in references to reserves of $249,000,000 or thereabouts. That is the money they have made.
Q: Out of the customers?
A: I suppose so.
Q: They also mention Assets of $500,000,000 or thereabouts. Have they made that too ? A: Not exactly. That is the money they use to make money.
Q: I see. And they keep it in a safe somewhere?
A: Not at all. They lend it to customers.
Q: Then they haven’t got it?
Q: Then how is it Assets?
A: They maintain that it would be if they got it back.
Q: But they must have some money in a safe somewhere?
A: Yes, usually $500,000,000 or thereabouts. This is called Liabilities.
Q: But if they’ve got it, how can they be liable for it?
A: Because it isn’t theirs.
Q: Then why do they have it?
A: It has been lent to them by customers.
Q: You mean customers lend banks money?
A: In effect. They put money into their accounts, so it is really lent to the banks.
Q: And what do the banks do with it?
A: Lend it to other customers.
Q: But you said that money they lent to other people was Assets?
Q: Then Assets and Liabilities must be the same thing.
A: You can’t really say that.
Q: But you’ve just said it. If I put $100 into my account the bank is liable to have to pay it back, so it’s Liabilities. But they go and lend it to someone else, and he is liable to pay it back, so it’s Assets. It’s the same $100, isn’t it?
A: Yes, but..
Q: Then it cancels out. It means, doesn’t it, that banks don’t really have any money at all?
Q: Never mind theoretically. And if they haven’t any money, where do they get their Reserves of $249,000,000 or thereabouts?
A: I told you. That is the money they’ve made.
A: Well, when they lend your $100 to someone they charge him interest.
Q: How much?
A: It depends on the Bank rate. Say five and a half percent. That’s their profit.
Q: Why isn’t it my profit ? Isn’t it my money ?
A: It’s the theory of banking practice that..
Q: When I lend them my $100 why don’t I charge them interest?
A: You do.
Q: You don’t say. How much?
A: It depends on the Bank rate. Say half a percent.
Q: Grasping of me, rather?
A: But that’s only if you’re not going to draw the money out again.
Q: But of course I’m going to draw it out again. If I hadn’t wanted to draw it out again I could have buried it in the garden, couldn’t I ?
A: They wouldn’t like you to draw it out again.
Q: Why not? If I keep it there you say it’s a Liability. Wouldn’t they be glad if I reduced their Liabilities by removing it?
A: No. Because if you remove it they can’t lend it to anyone else.
Q: But if I wanted to remove it they’d have to let me?
Q: But suppose they’ve already lent it to another customer?
A: Then they’ll let you have someone else’s money.
Q: But suppose he wants his too.. and they’ve let me have it?
A: You’re being purposely obtuse.
Q: I think I’m being acute. What if everyone wanted their money at once?
A: It’s the theory of banking practice that they never would.
Q: So what banks bank on is not having to meet their commitments?
A: I wouldn’t say that.
Q: Naturally. Well, if there’s nothing else you think you can tell me..
A: Quite so. Now you can go off and open a banking account.
Q: Just one last question.
A: Of course.
Q: Wouldn’t I do better to go off and open up a bank?
*Cited in G. Edward Griffin’s history of the Fed, ‘The Creature From Jekyll Island’.
If only. In defending an insolvent banking system, central banks have now created a more absurd situation than Punch could ever have dreamed of. This commentator, for example, has a meaningful cash deposit with a UK commercial bank that is currently earning 0.0% interest (let’s say minus 3% in real terms). To put it another way, we have 100% counterparty and credit risk with a minus 3% annual return. Is it any wonder the UK savings rate is not higher ? Is it any wonder that savers are stampeding into risk assets ? But the likes of the Fed have muddied the pond further by attempting a policy of “forward guidance” that is little more than a sick joke, given the recent sell-off in government bond markets and the resultant rise in government bond yields, on fears of “tapering”. The Fed has lost control of the bond market. As Swiss investor Marc Faber puts it,
The question is when will it lose control of the stock market.
For several years we have been warning of the dangers of central banks becoming increasingly interventionist in the capital markets. We are old school free market libertarians: if bankers make bad decisions, let their banks fail. This is essentially the same perspective taken by Michael Lewis, recently interviewed in Bloomberg Businessweek. On the fifth anniversary of its bankruptcy, Lewis was asked whether he thought Lehman Brothers had been unfairly singled out when it was allowed to fail (given that every other investment bank was quickly rescued, courtesy of the US taxpayer). His response:
Lehman Brothers was the only one that experienced justice. They should’ve all been left to the mercy of the marketplace. I don’t feel, oh, how sad that Lehman went down. I feel, how sad that Goldman Sachs and Morgan Stanley didn’t follow. I would’ve liked to have seen the crisis play itself out more. The problem is, we would’ve all paid the price. It’s a close call, but I think the long-term effects would’ve been better.
But that is not what happened. We didn’t get runs on investment banks. We got bank bailouts, taxpayer rescues, QE1, QE2, QE3 and now QE-Infinity. The impact on the real economy has been questionable, to say the least:
But the impact on financial markets has been demonstrably beneficial to investment banks and their largest clients.
As Stanley Druckenmiller points out, the Fed didn’t act bravely, they bottled it. They had the opportunity to start, ever so gently, to reverse a policy of monstrous intervention in the capital markets, and they blew it. That makes it all the harder for them to “taper” next time round. When do capital markets free themselves from the baleful manipulation of the state? Marc Faber was similarly unimpressed:
The endgame is a total collapse, but from a higher diving board. The Fed will continue to print and if the stock market goes down 10% they will print even more. And they don’t know anything else to do. And quite frankly, they have boxed themselves into a corner where they are now kind of desperate.
The Fed may be desperate, but we’re not. We have our client assets carefully corralled into four separate asset classes. High quality debt (not US Treasuries or UK Gilts) offers income and a degree of capital protection given that the central banks have demolished deposit rates. Defensive equities give us some skin in the game given central bank bubble-blowing in the stock market – but this game ends in tears. Uncorrelated, systematic trend-followers give us a “market neutral” way of prospectively benefiting from any disorderly market panic. And real assets give us some major skin in the game in the event of an inflationary disaster. Since pretty much all of these assets can be marked to market on a daily basis, they are not free of volatility, but we are more concerned with avoiding the risk of permanent loss of capital, Cypriot bank-style. We have, in other words, Fed-proofed our portfolios to the best of our ability. And on the topic of gold alone, Marc Faber again:
I always buy gold and I own gold. I don’t even value it. I regard it as an insurance policy. I think responsible citizens should own gold, period.
Now that the Fed has blinked in the face of market resistance, it seems inevitable to us, as it does to people like Marc Faber, that at some point, possibly in the near future, traditional assets are at risk of loudly going bang. How close are you going to be to the explosion?
This article was previously published at The price of everything.
“Sir, Martin Sandbu writes: “We should not worry about inflation – if we strip out volatile or policy-driven elements, it stands at 1.5%, according to Citigroup”, (“Carney has not yet bent the markets to his will”, August 14.)
“Please arrange for Mr Sandbu to cancel the policies concerned and to prevent the volatile situations encountered. When was the last time inflation was 1.5% ? This comment is as meaningless as my saying: “If savings rates were 5%, then I could afford two more holidays a year.” They aren’t, and I can’t.”
- Letter to the editor of the Financial Times, from Mr Charles Kiddle, Gateshead, UK.
King Cnut The Great, more commonly known as Canute, was a king of Denmark, England, Norway and parts of Sweden (thanks Wikipedia !). He is likely to be known to any English schoolchildren still being educated for two specific things: extracting Danegeld – a form of protection racket – from the citizenry, and for the possibly apocryphal story that once, from the shoreline, he ordered back the sea. Over to Wikipedia:
Henry of Huntingdon, the 12th-century chronicler, tells how Cnut set his throne by the sea shore and commanded the tide to halt and not wet his feet and robes. Yet “continuing to rise as usual [the tide] dashed over his feet and legs without respect to his royal person. Then the king leapt backwards, saying: ‘Let all men know how empty and worthless is the power of kings, for there is none worthy of the name, but He whom heaven, earth, and sea obey by eternal laws.’ He then hung his gold crown on a crucifix and never wore it again “to the honour of God the almighty King”. This incident is usually misrepresented by popular commentators and politicians as an example of Cnut’s arrogance.
This story may be apocryphal. While the contemporary Encomium Emmae has no mention of it, it would seem that so pious a dedication might have been recorded there, since the same source gives an “eye-witness account of his lavish gifts to the monasteries and poor of St Omer when on the way to Rome, and of the tears and breast-beating which accompanied them”. Goscelin, writing later in the 11th century, instead has Cnut place his crown on a crucifix at Winchester one Easter, with no mention of the sea, and “with the explanation that the king of kings was more worthy of it than he”. Nevertheless, there may be a “basis of fact, in a planned act of piety” behind this story, and Henry of Huntingdon cites it as an example of the king’s “nobleness and greatness of mind.” Later historians repeated the story, most of them adjusting it to have Cnut more clearly aware that the tides would not obey him, and staging the scene to rebuke the flattery of his courtiers; and there are earlier Celtic parallels in stories of men who commanded the tides..
The encounter with the waves is said to have taken place at Thorn-eye (Thorn Island), or Southampton in Hampshire. There were and are numerous islands so named, including at Westminster and Bosham in West Sussex, both places closely associated with Cnut. According to the House of Commons Information Office, Cnut set up a royal palace during his reign on Thorney Island (later to become known as Westminster) as the area was sufficiently far away from the busy settlement to the east known as London. It is believed that, on this site, Cnut tried to command the tide of the river to prove to his courtiers that they were fools to think that he could command the waves. Conflictingly, a sign on Southampton city centre’s Canute Road reads, “Near this spot AD 1028 Canute reproved his courtiers”.
Cnut did exist, even if his mythologised battle with Nature was a fabrication. And for anyone who thinks that politicians are capable of learning from disastrous policy failures, the following lesson from history is also instructive. Explicitly linking economic policy and monetary policy rates to unemployment rates is not an innovation of either Ben Bernanke’s Fed or Mark Carney’s Bank of England. As Ferdinand Lips points out in his ‘Gold Wars’ (hat-tip to The Real Asset Company’s Will Bancroft):
With the passage of [the US Employment Act of 1946], the US government officially declared war on unemployment and promised to maintain full employment regardless of cost. Thus, it hoped to eliminate the business cycle and to prevent the country from ever sinking to the economic depths of the 1930s.
In the 1950s and the 1960s a weekly column in Barron’s called “The Trader” was written by a certain Mr. Nelson. Week after week, he untiringly drew readers’ attention to the consequences the Employment Act had on the purchasing power of the currency..
One would have thought that economic central planning would have been somewhat discredited after the Soviet empire collapsed in 1989, in favour of free markets. That message has yet to get to the US Federal Reserve or the Bank of England. But the Soviet experience is doubly instructive, in that it shows just how long a fatally dysfunctional system can last in the face of its obvious, existential, contradictions and absurdities.
Our thesis is that we are perilously close to the disorderly end-stage of a 40 year experiment in money and unfettered credit. That experiment started when US President Nixon took the US dollar off gold in 1971, and in the process created a global unbacked fiat currency system for the first time in world history. The history of paper currencies is instructive, too. Not one has ever lasted. Fast forward 40 years.. Texan fund manager Kyle Bass points out that total credit market debt now stands at some 360% of global GDP. For an individual country to maintain a debt to GDP ratio of 250% is consistent with that country deficit-spending its way through a war – such as was the position for the UK in 1945. For the entire world (read: notably the western world) to be loaded with such an untenable debt burden today suggests that something has gone catastrophically wrong with our banking and credit system.
We don’t know what the future holds but, crucially, our investment process does not explicitly require us to, and we have engineered it such that our process carries a degree of insurance against our own overconfidence as asset management fiduciaries. The market can be directed, coerced, bribed, manipulated, distorted and pummelled, but we don’t believe it can ever be completely destroyed – despite the best efforts of central bankers. There is early evidence that bond market vigilantes have had enough with QE and other desperate policy manoeuvrings, and are voting with their feet. If bond yields continue to rise, think very carefully about your exposure to market risk in all its other forms. We have, and are positioned accordingly.
In the current context, if Cnut did ever order back the tide, whether he did so to instruct his courtiers or to display his arrogance over the forces of nature is somewhat moot. The great physicist Richard Feynman made a similar admonition to NASA after the 1986 space shuttle disaster ending up killing seven crew members. In his infamous warning to a bureaucracy seemingly overtaken by ‘spin’, he said in his conclusion to the Challenger report,
For a successful technology, reality must take precedence over public relations, for Nature cannot be fooled.
For Feynman, and for Cnut, it was Nature. For us, it is the markets. Modern critics of the central banks, like ourselves, would suggest that we now have a modern equivalent of Cnut’s Danegeld, in the form of punitively low interest rates, rates which are being kept artificially low to try and resurrect a borderline insolvent banking system which is still content to pay significant executive bonuses and, in some instances, even dividends (to shareholders foolish enough to own common stock issued by banks whose fundamental value cannot be remotely assessed on any sensible economic basis). The economy, in other words, is being held hostage to cater to narrow and largely unreconstructed banking interests. At the same time, the farce of “forward guidance” – the pledge to keep interest rates unchanged until there is tangible evidence of economic recovery, almost irrespective of the latent inflationary pressure being stoked up – is being revealed as farce by Gilt yields that have risen by over 100 basis points since May (and the same holds for US Treasuries). Despite the king’s orders, in other words, the tide continues to come in.
A version of this article was previously published at The price of everything.
Over the past four decades the global economy has largely experienced prolonged imbalances, with countries running large current account deficits in symbiotic relationships with those running large surpluses. In our recent HindeSight Investor Letter – Top of the BoPs we revisit our long held belief that the current monetary order as defined by a constellation of exchange rate arrangements between the major global currencies, and which maintained these imbalances artificially, has led to excessive global liquidity and credit creation. This in turn drove a litany of asset price bubbles.
The bursting of these asset bubbles has continued in a series these past two decades, each one’s demise leading to more disruptive policy responses which have only succeeded in igniting yet more bubbles, only for those too to fail.
Finally in 2008 we witnessed the finale of decades of credit creation, rising in what appeared to be a crescendo of credit excess and widespread asset booms. We saw this event as the death throes of an unstable monetary regime, only then to see an unprecedented global reaction by policymakers in a coordinated fashion to keep the global system alive. For a moment here today, there are those who dare to believe they have succeeded, with rising equity markets a testimony to a reviving global economy. Nothing could be further from reality.
We stand by our assessment that the disproportionate reaction of central bankers and policymakers alike has merely succeeded in compounding and exacerbating the error of this highly imbalanced monetary system. Recent events in emerging countries are a manifestation of the continuing unravelling of our monetary order.
In another recent HindeSight letter we described how the world is faced with a binary situation of global deflation or hyperinflation. We believe the odds have tilted firmly towards deflation. It would appear the unwinding of the global imbalances that led to the 2008 crisis is continuing unabashed, irrespective of the recent monetary excess used to abate them.
Large current account deficits led to unsustainable debt creation and as a consequence the trade deficit countries were the first to experience a severe financial crisis, but now on the other side of the equation the surplus countries are experiencing their reaction to the crisis. For balance of payments have two components to the equation both the financiers and the borrowers, so by definition changes in savings and investments in one such country has a profound impact on those of another.
The recent instability in emerging market economies and especially China is a direct consequence of these global imbalances which became stymied briefly by global bail-outs only to have been left in a more vulnerable economic position. The deleveraging process which began in 2008 has been a slow burner but is likely now in full swing. The deflationary risks are very high.
Top of the Pops was a legendary British music chart television show which began weekly broadcasts on the BBC in 1964, and finally wound down its music decks in July 2006. The show comprised performances from leading selling music artists and always culminated with an airing of the number one best selling single of the week, after a rundown of the top 30 singles. So popular was the show that it became a major UK export franchise, with its iconic logo emblazoned over TV screens globally.
Like all great cultural institutions the music was both a representation and manifestation of its ages, shaping popular culture and generations alike. No more emblematic of its age were the Punk rock bands of the 70s, both here in the UK and the US; the ‘Sex Pistols’ and ‘The Clash’, the UK vanguard, and across the Atlantic the ‘Television’ and the ‘Ramones’. Hard-edged, shouted vocals amongst a cacophony of relentless drumming, heavy bass and repetitive electric guitar chords, they bore witness to an anti-establishment movement seemingly disenfranchised with the economic misery of the time.
‘Blitzkrieg Bop’ by the Ramones exemplified the mood of the era, its title inspiration coming from the German World War II tactic, blitzkrieg, which literally means ‘lightning war’. Drawing our own inspiration from Blitzkrieg Bop we echo their rally cry - ‘Hey! Ho! Let’s go’ as we re-delve into the area of global imbalances which seems to have taken a back-seat in the debate on the continuing crisis these past few years. We will observe those countries with vulnerable balance of payments in our very own version of Top of the Pops, Top of the BoPs (Balance of Payments) if you will, to see which are exhibiting financial and trade stresses.
We have found balance of payment imbalances to be a superb leading indicator of economic stress, both in the emerging and developed markets, by which we could make investment and trading decisions. They are the thermometer by which we can first observe the very real signs of a monetary system in turmoil. In keeping with our musical theme, we wanted to make reference to another iconic UK show, but this time that of BBC radio and not TV; it’s called Desert Island Discs.
Desert Island Discs marginally pre-dates the auspicious events of the Bretton Woods conference of 1944, when allied nations gathered in New Hampshire to formulate the terms of an agreement on how to regulate the international monetary system, after the likely conclusion of World War II. The show began in 1942 and endures today, each week inviting a distinguished guest to envisage that they are a castaway on a desert island; who having chosen eight pieces of music, a book and a luxury item to take with them to the island are then asked to review their life in reference to excerpts of these choices.
Although not quite existing as long as the show (according to the Telegraph it’s the longest running radio show in the UK), if we at Hinde Capital were to be castaway on a desert island, in our own version of the game Desert Island Economic Discs* – the ten macroeconomic ‘records’ we would take with us as an excerpt to a life, in this case a country, would be:
1. Current account balance as a % of GDP (and commensurate capital account)
2. Debt as % of GDP (Debt composition as % of GDP)
3. Current account balance as a % of Investment
4. Real Effective Exchange Rate
5. Stock Prices
7. M2/ reserves/ Domestic Credit
9. Short-term capital inflows/GDP
10. Real interest rate on bank deposits
The countries which make our Top of the BoPs, are mainly those of the Emerging Markets. These countries are all exhibiting the hallmarks of a classic balance of payments (BoPs) crisis which have built up over many decades.
These large and persistent trade imbalances have been caused by distortions in financial, industrial, and trade policies. These distortions have prevented adjustments for many years, but large imbalances ultimately are unsustainable because the capital flows that finance the trade imbalances can be reversed only with a reversal of trade imbalances. Eventually these imbalances will adjust in spite of policy and institutional constraints, but in this case the adjustment is often violent and can come in the form of a financial crisis.
A country that appears peaceful and stable may encounter unexpected crises. There are structural problems in China’s economy which cause unsteady, unbalanced and uncoordinated and unsustainable development
Premier Wen Jiabao (2007)
The global crisis is a financial crisis driven primarily by global trade and capital imbalances. This is the macro theme we have pursued these past 7 years. We believe the global crisis is in full swing again and asset prices are in danger of falling globally. Money is less effective at catching the falling knife.
Emerging market countries are exhibiting the signs of crisis-like price action associated with deteriorating balance of payment balances, even though many have built up significant foreign exchange reserves.
Investors and policymakers do not believe this is the beginning of a major EM contagion crisis. They are lulling themselves into a false sense of security. They see the EM market tremors, and do not fear a re-run of the EM crises of old. They are right. This is not (just) going to be an EM crisis. Recent events portend a far more serious crisis is at hand; the unravelling of our global monetary system.
The crux – the EM tremors are really signifying the demise of the credit bubble that began bursting in 2008. This is not the start of the EM crisis. It is the beginning of the end of a credit bubble collapse that began in 2008.
We have witnessed unprecedented global fiscal and monetary stimulus (QE) which was used to arrest a global credit deflation. This led to the development of a truly global bond bubble. As debt levels rose in the developed countries and monetary stimulus was exported (de facto QE) to EM countries it underpinned growth with excess credit.
Since 2003 EM countries have seen US$7 trillion of inflows into their countries and a commensurate appreciation in their currencies; ones that they have struggled to control. These are not just strong flows rather they are astronomical in size and have been achieved by this excessively loose and unconventional monetary policy.
The paradox of such inflows strengthening currency rates is that they have succeeded in stultifying EM export-led growth, despite this supply of credit. The commodity exporters amongst them have been left doubly reeling by the confluence of higher exchange rates and lower demand from a stagnating global economy and in particular China. They have all seen their commodity revenues fall precipitously.
In a re-run of the 1990s the appreciation of the dollar against a rapidly depreciating yen has begun to drag USD Asia higher. This was the trigger for the Asian Tiger currency crisis in 1997. This has been a final nail in the coffin of Sino imperialism, as their export competitiveness is lost too.
In the 1980s it was a hike by the US Fed that triggered the LatAm crisis. Today, the mere whisper of tighter monetary conditions in the US, vis-a-vis a tapering of QE has led to higher bond rates globally. Note tapering is not the same as hiking interest rates.
The consequences of multiple rounds of QE have heightened global risks as it has both exacerbated ‘currency competition’ and hot capital flows into countries seeking desperately for a return both from income and capital growth. This has created major distortions in term rates, equity and bond values, driving them artificially high in price.
These distortions have created risks far greater than the fragilities of EM countries of yesterday years. The system of credit creation has produced unstable growth underpinned with collateral which is both mobile and suspect in its integrity.
Investors have nowhere to turn, emerging market countries growth is faltering in response to export disadvantages brought about by rampant G10 currency devaluations. China is finally succumbing to its side of the global imbalance excesses. First it was the deficit nations now it’s the turn of the creditor nations to falter, primarily China.
Trade flow reversals are leading to massive capital outflows out of EMs and the question remains: will the central banks of these countries sell their FX reserves, UST- bonds and euro government bonds (bunds) to finance this surge in outflows?
It is not clear that renewed global central bank liquidity provision will even stabilise a situation we see as growing dire by the day. China is the driver. All eyes on China.