Parliamentary committees are not especially noted for entertainment, but the November Treasury Select Committee hearing on the Bank of England’s Inflation Report is a refreshing exception. The fun starts on p. 30 of the transcript of the hearings with Steve Baker MP and Bank of England Governor Mark Carney light-heartedly jousting with each other.
Steve begins by asking Dr. Carney if the Bank is all model-driven. To quote from the transcript:
Dr Carney: No. If we were all model driven, then you would not need an MPC.
Q81 Steve Baker: All right. But we do have plenty of models floating around.
Dr Carney: I presume you feel we do need an MPC, Mr Baker?
Steve Baker: I think you know I think we don’t.
Dr Carney: I just thought we would get that read into the record.
[KD: First goal to Dr. Carney, but looks to me like it went into the wrong net.]
Steve Baker: I want to turn to a criticism by Chris Giles in The Financial Times of the model for labour market slack, which called it a nonsense. If I may I will just share a couple of quotes with you. He said that, according to a chart in the inflation report, the average-hours gap hit a standard deviation of -6, and this is something we would expect to happen once in 254 million years. He also said that the Bank of England is again implying the recent recession, as far as labour market participation is concerned, was worse than any moment in 800 times the period in which homo sapiens have walked on the earth. How will the Bank reply to a criticism as strident as this one?
[KD: The article referred to is Chris Giles, “Money Supply: Why the BoE is talking nonsense”, Nov 17 2014: http://ftalphaville.ft.com/2014/11/17/2045002/moneysupply-why-the-boe-is-talking-nonsense/#]
Dr Carney: Since you asked, let me reply objectively. Calculations such as that presume that there is a normal distribution around the equilibrium rate. Let me make it clear. First off, what is the point of the chart? The chart is to show a deviation relative to historic averages. It is an illustrative chart that serves the purpose of showing where the slack is relative to average equilibrium rates, just to give a sense of relative degrees of slack. That is the first point. The second point is that the calculation erroneously, perhaps on purpose to make the point but erroneously, assumes that there is a normal distribution around that equilibrium rate. So in other words to say that there is a normal distribution of unemployment outcomes around a medium-term equilibrium rate of 5.5%. So it is just as likely that something would be down in the twos as it would be up in the eights. Well, who really believes that? Certainly not the MPC and I suspect not the author of that article. It also ignores that the period of time was during the great moderation for all of these variables as well, so it is a relatively short period. These are not normal distributions. You would not expect them. You would expect a skew with quite a fat tail. So using normal calculations to extrapolate from a chart that is there for illustrative purposes is—I will not apply an adjective to it—misleading and I am not sure it is a productive use of our time.
Q82 Steve Baker: That is a fantastic answer. I am much encouraged by it, because it does seem to me it has been known for a long time that it is not reasonable to use normal distributions to model market events and yet so much mathematical economics is based on it.
[KD: Carney’s is an excellent answer: one should not “read in” a normal distribution to this chart, and the Bank explicitly rejects normality in this context.
Slight issue, however: didn’t the Bank’s economists use the normality assumption to represent the noise processes in the models they used to generate the chart? I am sure they did. One wonders how the charts would look if they used more suitable noise processes instead? And just how robust is the chart to the modelling assumptions on which it is based?]
Dr Carney: People do it because it is simple—it is the one thing they understand—and then they apply it without thinking, which is not what the MPC does.
Steve Baker: That is great. I can move on quickly. But I will just say congratulations to the Bank on deciding to commission anti-orthodox research because I think this is going to be critical to drilling into some of these problems.
Dr Carney: Thank you.
[KD: Incredulous chair then intervenes.]
Q83 Chair: To be clear, the conclusion that we should draw from this is that we should look at all economic models with a very high degree of scepticism indeed.
Dr Carney: Absolutely.
[KD: So you heard it from the horse’s mouth: don’t trust those any of those damn models. Still incredulous, the chair then intervenes again to seek confirmation of what he has just heard.]
Chair: Can I just add that it is an astonishing conclusion? I do not want to cut into Steve Baker’s questions, but is that the right conclusion?
Dr Carney: Absolutely. Models are tools. You should use multiple ones. You have to have judgment, you have to understand how the models work and particularly, if I may underscore, dynamic stochastic general equilibrium forecasting models, which are the workhorse models of central banks. What they are useful for is looking at the dynamics around shocks in the short term. What they are not useful for is the dynamics further out where—
[KD: Dr. Carney reiterates the point so there can be no confusion about it. So let me pull his points together: (1) He “absolutely” agrees that “we should look at all economic models with a very high degree of scepticism.” (2) He suggests “You should use multiple [models]”, presumably to safeguard against model risk, i.e., the risks that any individual model might be wrong. (3) He endorses one particular – and controversial – class of models, Dynamic Stochastic General Equilibrium (DSGE) models as the “workhorse models” of central banks, whilst acknowledging that they are of no use for longer-term forecasting or policy projections.
I certainly agree that none of the models is of any longer-term term use, but what I don’t understand is how (1), (2) and (3) fit together. In particular, if we are to be skeptical of all models, then why should we rely on one particular and highly controversial, if fashionable, class of models, never mind – and perhaps I should say, especially – when that class of models is regarded as the central banks’ workhorse. After all, the models’ forecast performance hasn’t been very good, has it?
The discussion then goes from the ridiculous to the sublime:]
Chair: I am just thinking about all those economists out there whose jobs have been put at risk.
Dr Carney: No, we have enhanced their jobs to further improve DSG models.
Steve Baker: We are all Austrians now.
[A little later, Steve asks Sir Jon Cunliffe about the risk models used by banks.]
Q84 Steve Baker: Sir Jon, before I move too much further down this path, can I ask you what would be the implications for financial stability and bank capital if risk modelling moved away from using normal distributions?
Sir Jon Cunliffe: Maybe I will answer the question another way. It is because of some of the risks around modelling, the risk-weighted approach within bank capital, that we brought forward our proposals on the leverage ratio. So you have to look at bank capital through a number of lenses. One way of doing is to have a standardised risk model for everyone and there is a standardised approach and it works on, if you like, data for everybody that does not suit any particular institution and the bigger institutions run their own models, which tend to have these risks in them. Then you have a leverage ratio that is not risk-weighted, and therefore takes no account of these models, and that forms a check. So with banks, the best way to look at their capital is through a number of different lenses.
[KD: Sir Humphrey is clearly a very good civil servant: he responds to the question by offering to answer it in a different way, but does not actually answer it. The answer is that we do not use a non-normal distribution because doing so would lead to higher capital requirements but that would never do as the banks would not be happy with it: they would then lobby like crazy and we can’t have that. Instead, he evades the question and says that there are different approaches with pros and cons etc. etc. – straight out of “Yes, Minister”.
However, notwithstanding that Sir Jon didn’t answer the question on the dangers of the normal distribution, I would also ask him a number of other (im)pertinent questions relating to bad practices in bank risk management and bank risk regulation:
1. Why does the Bank continue to allow banks to use the discredited Value-at-Risk (or VaR) risk measure to help determine their regulatory capital requirements, a measure which is known to grossly under-estimate banks true risk exposures?
The answer, of course, is obvious: the banks are allowed to use the VaR risk measure because it grossly under-estimates their exposures and no-one in the regulatory system is willing to stand up to the banks on this issue.
2. Given the abundant evidence – much of it published by the Bank itself – that complex risk-models have much worse forecast performance than simple models (such as those based on leverage ratios), then why does the Bank continue to allow banks to use complex and effectively useless risk models to determine their regulatory capital requirements?
I would put it to him that the answer is the same as the answer to the previous question.
3. Why does the Bank continue to rely on regulatory stress tests in view of their record of repeated failure to identify the build-up of subsequently important stress events? Or, put it differently, can the Bank identify even a single instance where a regulatory stress test correctly identified a subsequent major problem?
Answer: The Northern Rock ‘war game’. But even that stress test turned out to be of no use at all, because none of the UK regulatory authorities did anything to act on it.
In the meantime, perhaps I can interest readers in my Cato Institute Policy Analysis “Math Gone Mad”, which provides a deeper – if not exactly exhaustive but certainly exhausting – analysis of these issues:
Economists have always been envious of the practitioners of the natural and exact sciences. They have thought that introducing the methods of natural sciences such as laboratory where experiments could be conducted could lead to a major break-through in our understanding of the world of economics.
But while a laboratory is a valid way of doing things in the natural sciences, it is not so in economics. Why is that so?
A laboratory is a must in physics, for there a scientist can isolate various factors relating to the object of inquiry.
Although the scientist can isolate various factors he doesn’t, however, know the laws that govern these factors.
All that he can do is hypothesize regarding the “true law” that governs the behaviour of the various particles identified.
He can never be certain regarding the “true” laws of nature. On this Murray Rothbard wrote,
The laws may only be hypothecated. Their validity can only be determined by logically deducing consequents from them, which can be verified by appeal to the laboratory facts. Even if the laws explain the facts, however, and their inferences are consistent with them, the laws of physics can never be absolutely established. For some other law may prove more elegant or capable of explaining a wider range of facts. In physics, therefore, postulated explanations have to be hypothecated in such a way that they or their consequents can be empirically tested. Even then, the laws are only tentatively rather than absolutely valid.1
Contrary to the natural sciences, the factors pertaining to human action cannot be isolated and broken into their simple elements.
However, in economics we have certain knowledge about certain things, which in turn could help us to understand the world of economics.
For instance, we know that an increase in money supply results in an exchange of nothing for something. It leads to a diversion of wealth from wealth generators to non wealth generating activities. This is certain knowledge and doesn’t need to be verified.
We also know that for a given amount of goods an increase in money supply all other things being equal must lead to more money paid for a unit of a good –an increase in the prices of goods. (Remember a price is the amount of money per unit of a good).
We also know that if in the country A money supply grows at a faster pace than money supply in the country B then over time, all other things being equal, the currency of A must depreciate versus the currency of B. This knowledge emanates from the law of scarcity.
Hence for something that is certain knowledge, there is no requirement for any empirical testing.
How this certain knowledge can be applied?
For instance, if we observe an increase in money supply – we can conclude that this resulted in a diversion of real wealth from wealth generators to non-wealth generating activities. It has resulted in the weakening of the wealth generating process.
This knowledge however, cannot tell us about the state of the pool of real wealth and when the so-called economy is going to crumble.
Whilst we can derive certain conclusions from some factors, however, the complex interaction of various factors means that there is no way for us to know the importance of each factor at any given point in time.
Some factors such as money supply – because it operates with a time lag, could provide us with useful information about the future events – such as boom-bust cycles and price inflation.
(Note that a change in money supply doesn’t affect all the markets instantly. It goes from one individual to another individual – from one market to another market. It is this that causes the time lag from changes in money and its effect on various markets).
Contrary to the natural sciences, in economics, by means of the knowledge that every effect must have a cause and by means of the law of scarcity (the more we have of something the less valuable it becomes), we can derive the entire body of economics knowledge.
This knowledge, once derived, is certain and doesn’t need to be verified by some kind of laboratory.
1. Murray N. Rothbard, “Towards a Reconstruction of Utility and Welfare Economics”, On Freedom and Free Enterprise: The Economics of Free Enterprise, May Sennholz, ed. (Princeton, N.J.: D.Van Nostrand, 1956), p3.
Frenchman Jean Tirole of the University of Toulouse won the 2014 Nobel Prize in Economic Sciences for devising methods to improve regulation of industries dominated by a few large firms. According to Tirole large firms undermine the efficient functioning of the market economy by being able to influence the prices and the quantity of products.
Consequently, this undermines the well being of individuals in the economy. On this way of thinking the inefficiency emerges as a result of the deviation from the ideal state of the market as depicted by the “perfect competition” framework.
In the world of perfect competition a market is characterized by the following features:
There are many buyers and sellers in the market
Homogeneous products are traded
Buyers and sellers are perfectly informed
No obstacles or barriers to enter the market
In the world of perfect competition buyers and sellers have no control over the price of the product. They are price takers.
The assumption of perfect information and thus absolute certainty implies that there is no room left for entrepreneurial activity. For in the world of certainty there are no risks and therefore no need for entrepreneurs.
If this is so, who then introduces new products and how? According to the proponents of the perfect competition model any real situation in a market that deviates from this model is regarded as sub-optimal to consumers’ well being. It is then recommended that the government intervene whenever such deviation occurs.
Contrary to this way of thinking, competition is not on account of a large number of participants as such, but as a result of a large variety of products.
The greater the variety is, the greater the competition will be and therefore more benefits for consumer.
Once an entrepreneur introduces a product—- the outcome of his intellectual effort–he acquires 100 per cent of the newly established market.
Following, however, the logic of the popular way of thinking, this situation must not be allowed for it will undermine consumers’ well being. If this way of thinking (perfect competition model) were to be strictly adhered to no new products would ever emerge. In such an environment people would struggle to stay alive.
Once an entrepreneur successfully introduces a product and makes a profit he attracts competition. Notice that what gives rise to the competition is that consumers have endorsed the new product. Now the producers of older products must come with new ideas and new products to catch the attention of consumers.
The popular view that a producer that dominates a market could exploit his position by raising the price above the truly competitive level is erroneous.
The goal of every business is to make profits. This, however, cannot be achieved without offering consumers a suitable price.
It is in the interest of every businessman to secure a price where the quantity that is produced can be sold at a profit.
In setting this price the producer entrepreneur will have to consider how much money consumers are likely to spend on the product. He will have to consider the prices of various competitive products. He will also have to consider his production costs.
Any attempt on behalf of the alleged dominant producer to disregard these facts will cause him to suffer losses.
Further to this, how can government officials establish whether the price of a product charged by a dominant producer is above the so-called competitive price level? How can they know what the competitive price is supposed to be?
If government officials attempt to enforce a lower price this price could wipe out the incentive to produce the product.
So rather than improving consumers’ well being government policies will only make things much worse. (On this, no mathematical methods no matter how sophisticated could tell us what the competitive price level is. Those who hold that game theories could do the trick are on the wrong path).
Again, contrary to the perfect competition model, what gives rise to a greater competitive environment is not a large number of participants in a particular market but rather a large variety of competitive products. Government policies, in the spirit of the perfect competition model, are however destroying product differentiation and therefore competition.
The whole idea that various suppliers can offer a homogeneous product is not tenable. For if this was the case why would a buyer prefer one seller to another? (The whole idea to enforce product homogeneity in order to emulate the perfect competition model will lead to no competition at all).
Since product differentiation is what free market competition is all about it means that every supplier of a product has 100 per cent control as far as the product is concerned. In other words, he is a monopolist.
What gives rise to product differentiation is that every entrepreneur has different ideas and talents. This difference in ideas and talents is manifested in the way the product is made the way it is packaged, the place in which it is sold, the way it is offered to the client etc.
For instance, a hamburger that is sold in a beautiful restaurant is a different product from a hamburger sold in a takeaway shop. So if the owner of a restaurant gains dominance in the sales of hamburgers should he then be restrained for this? Should he then alter his mode of operation and convert his restaurant into a takeaway shop in order to comply with the perfect competition model?
All that has happened here is that consumers have expressed a greater preference to dine in the restaurant rather than buying from the takeaway shop. So what is wrong with this?
Let us now assume that consumers have completely abandoned takeaway shops and buying hamburgers only from the restaurant, does this mean that the government must step in and intervene?
The whole issue of a harmful monopoly has no relevancy in the free-market environment. A harmful monopolist is likely to emerge when the government, by means of licenses, restricts the variety of products in a particular market. (The government bureaucrats decide what products should be supplied in the market).
By imposing restrictions and thus limiting the variety of goods and services offered to consumers, government curtails consumers’ choices thereby lowering their well being.
Summary and conclusion
We suggest that the whole idea of government regulating large firms in order to promote competition and defend people’s well being is a fallacy. If anything, such intervention only stifles market competition and lowers living standards.
This year’s Nobel prize in economics awarded to Jean Tirole for developing better regulations to control markets runs against the spirit of the Nobel award.
The idea of Alfred Nobel was to reward a scientist whose invention and discovery bettered people’s lives and well being. Better government controls of markets runs, however, contrary to the spirit of Nobel.
Deposit insurance is one of the most misunderstood – and also most dangerous – forms of government intervention into the financial system.
Let’s start with the common misconception that deposit insurance is an industry-operated affair independent of the government.
In the UK, deposit insurance is provided by the Financial Services Compensation Scheme (FSCS). To quote from its website:
“The FSCS is the UK’s statutory fund of last resort for customers of financial services firms. This means that FSCS can pay compensation to consumers if a financial services firm is unable, or likely to be unable, to pay claims against it. The FSCS is an independent body, set up under the Financial Services & Markets Act 2000 (FSMA).”
It also explains that the FSCS is funded by levies on firms authorised to operate by either of the Prudential Regulation Authority or the Financial Conduct Authority.
So the FSCS is notionally independent and the guarantees are financed by levies on participating firms.
However, this does not mean that deposit insurance is in any way a free-market phenomenon: it is explicitly the creature of legislation and participating firms are compelled not just to join, but to join on dictated terms. This is rather like having a system of compulsory car insurance and, moreover, a compulsory system that mandates the exact terms (including the pricing) of the car insurance itself – compulsory one-size-fits-all.
This should set off alarm bells that there might be something wrong with it.
And how do we know that its designers designed it properly? We don’t.
In fact, we know that they couldn’t possibly have designed it properly, as any rational insurance system would tailor the charges to the riskiness of clients, include co-insurance features and other incentives to moderate risk-taking, have charges that would evolve over time in response to changing market conditions, and so forth. This is insurance 101.
This is not how deposit insurance works, however.
Most of all, any rational system would have the product delivered by the market, not by some jerry-built contraption dreamt up by committees of legislators and regulators who have neither the knowledge nor the incentive to get it right. One also might add few if any of these people have any experience in or understanding of the industry they are meddling with, but let’s move on.
It then occurred to me that perhaps my kids are right and I am too cynical – maybe Father Christmas and the fairies do exist: one should keep an open mind – so I checked out the FSCS website to have a closer look at their system. What I found was a masterpiece of gobbledegook that I highly recommend to other connoisseurs of regulatory gibberish:
Backward ran sentences until reeled the mind. My favourite bit is the explanation of the levy calculation that does not explain how the levy is actually calculated.
All this said, the banks rather like deposit insurance because it gives them a great marketing tool: bank with us and your money is safe because we are members of the deposit guarantee scheme, and you will get your money back even if we happen to fail.
They also like it because they can game the system – taking extra risks and offering higher deposit rates than they would otherwise be able to get away with – in effect, exploiting the risk-taking subsidy created by deposit insurance and passing the extra risks to the fund itself.
But surely, if the banks like the system, they would create one themselves if the government didn’t create it for them? No. Were this true, the banks would have done exactly that many years ago, and there would have been no ‘need’ for the state to have intervened to do it for them. The fact is that they didn’t.
The reason they didn’t is because the service that deposit insurance provides to the retail customer – reassurance or confidence – is better provided in other ways, most notably, by pursuing conservative lending policies and maintaining high levels of capital. And the reason for this is simply that deposit insurance introduces an additional layer of moral hazard and governance headaches that can be avoided if the banks self-insure via moderate risk-taking and high levels of capital.
This should come as no surprise. True confidence does not come from “you can trust us if we screw up because someone else will bail you out” but from “you can trust us because it is demonstrably in our interest to make sure we don’t screw up”. Deposit insurance is an inferior confidence product – one might even say, a confidence trick.
We can also look at this another way. Suppose that a group of banks attempted to set up a scheme similar to the current one, of their own free will and with no government intervention. They would soon realise that the scheme was not viable – no bank would want to be liable for the risks the others were taking, with no means of controlling those risks. So it would never get off the ground – and the current system only got off the ground because the state imposed it.
In short, deposit insurance is not a creature of the market but a creature of the state, and a decidedly inferior one at that. It is, indeed, a classic instance of that regulatory Gresham’s Law by which state intervention causes the bad to drive out the good. Where have we seen that before?
“I say to all those who bet against Greece and against Europe: You lost and Greece won. You lost and Europe won.” –Jean-Claude Juncker, former prime minister of Luxembourg and president of the Eurogroup of EU Finance Ministers, 2014
“We have indeed at the moment little cause for pride: As a profession we have made a mess of things.” –Friedrich Hayek, Nobel Laureate in Economic Science, 1974
Jean-Claude Juncker is a prominent exception to the recent trend of economic and monetary officials openly expressing doubt that their interventionist policies are producing the desired results. In recent months, central bankers, the International Monetary Fund, the Bank for International Settlements, and a number of prestigious academic economists have expressed serious concern that their policies are not working and that, if anything, the risks of another 2008-esque global financial crisis are building. Thus we have arrived at a ‘Crisis of Interventionism’ as the consequences of unprecedented monetary and fiscal stimulus become evident, fuelling a surge in economic nationalism around the world, threatening the end of globalisation and the outbreak of trade wars. Indeed, a tech trade war may already have started. This is is perhaps the least appreciated risk to financial markets at present. How should investors prepare?
THE FATAL CONCEIT
Friedrich Hayek was the first Austrian School economist to win the Nobel Memorial Prize in Economic Science. Yet Hayek took issue with the characterisation of modern economics as a ‘science’ in the conventional sense. This is because the scientific method requires theories to be falsifiable and repeatable under stable conditions. Hayek knew this to be impossible in the real world in which dynamic, spontaneous human action takes place in response to an incalculable number of exogenous and endogenous variables.
Moreover, Hayek believed that, due to the complexity of a modern economy, the very idea that someone can possibly understand how it works to the point of justifying trying to influence or distort prices is nonsensical in theory and dangerous in practise. Thus he termed such hubris in economic theory ‘The Pretence of Knowledge’ and, in economic policy, ‘The Fatal Conceit’.
History provides much evidence that Hayek was correct. Interventionism has consistently failed either to produce the desired results or has caused new, unanticipated problems, such as in the 1920s and 1930s, for example, an age of particularly active economic policy activism in most of the world. Indeed, as Hayek wrote in his most famous work, The Road to Serfdom, economic officials tend to respond to the unintended consequences of their failed interventions with ever more interventionism, eventually leading to severe restrictions of economic liberty, such as those observed under socialist or communist regimes.
Hayek thus took advantage of his Nobel award to warn the economics profession that, by embracing a flawed, ‘pseudo-scientific method’ to justify interventionism, it was doing itself and society at large a great disservice:
The conflict between what in its present mood the public expects science to achieve in satisfaction of popular hopes and what is really in its power is a serious matter because, even if the true scientists should all recognize the limitations of what they can do in the field of human affairs, so long as the public expects more there will always be some who will pretend, and perhaps honestly believe, that they can do more to meet popular demands than is really in their power. It is often difficult enough for the expert, and certainly in many instances impossible for the layman, to distinguish between legitimate and illegitimate claims advanced in the name of science…
If we are to safeguard the reputation of economic science, and to prevent the arrogation of knowledge based on a superficial similarity of procedure with that of the physical sciences, much effort will have to be directed toward debunking such arrogations, some of which have by now become the vested interests of established university departments.
Hayek made these comments in 1974. If only the economics profession had listened. Instead, it continued with the pseudo-science, full-steam ahead. That said, by 1974 a backlash against traditional Keynesian-style intervention had already begun, led by, among others, Milton Friedman. But Friedman too, brilliant as he no doubt was, was seduced also by the culture of pseudo-science and, in his monetary theories, for which he won his Nobel prize in 1976, he replaced a Keynesian set of unscientific, non-falsifiable, intervention-justifying equations with a Monetarist set instead.
Economic interventionism did, however, fall out of intellectual favour following the disastrous late-1970s stagflation and subsequent deep recession of the early 1980s—in the US, the worst since WWII. It never really fell out of policy, however. The US Federal Reserve, for example, facilitated one bubble after another in US stock and/or property prices in the period 1987-2007 by employing an increasingly activist monetary policy. As we know, this culminated in the spectacular events of 2008, which unleased a global wave of intervention unparalleled in modern economic history.
THE KEYNESIANS’ NEW CLOTHES
Long out of fashion, Keynesian theory and practice returned to the fore as the 2008 crisis unfolded. Some boldly claimed at the time that “we are all Keynesians now.” Activist economic interventionism became the norm across most developed and developing economies. In some countries, this has taken a more fiscal policy form; in others the emphasis has been more on monetary policy. Now six years on, with most countries still running historically large fiscal deficits and with interest rates almost universally at or near record lows, it is entirely understandable that the economics profession is beginning to ask itself whether the interventions it recommended are working as expected or desired.
While there have always been disputes around the margins of post-2008 interventionist policies, beginning in 2012 these became considerably more significant and frequent. In a previous report, THE KEYNESIANS’ NEW CLOTHES, I focused on precisely this development:
In its most recent World Economic Outlook, the International Monetary Fund (IMF) surveys the evidence of austerity in practice and does not like what it finds. In particular, the IMF notes that the multiplier associated with fiscal tightening seems to be rather larger than they had previously assumed. That is, for each unit of fiscal tightening, there is a greater economic contraction than anticipated. This results in a larger shrinkage of the economy and has the unfortunate result of pushing up the government debt/GDP ratio, the exact opposite of what was expected and desired.
While the IMF might not prefer to use the term, what I have just described above is a ‘debt trap’. Beyond a certain point an economy has simply accumulated more debt than it can pay back without resort to currency devaluation. (In the event that a country has borrowed in a foreign currency, even devaluation won’t work and some form of restructuring or default will be required to liquidate the debt.)
The IMF is thus tacitly admitting that those economies in the euro-area struggling, and so far failing, to implement austerity are in debt traps. Austerity, as previously recommended by the IMF, is just not going to work. The question that naturally follows is, what will work?
Well, the IMF isn’t exactly sure. The paper does not draw such conclusions. But no matter. If austerity doesn’t work because the negative fiscal multiplier is larger than previously assumed, well then for now, just ease off austerity while policymakers consider other options. In other words, buy time. Kick the can. And hope that the bond markets don’t notice.
Now, nearly two years later, the IMF has been joined in its doubts by a chorus of economic officials and academics from all over the world increasingly concerned that their interventions are failing and, in some cases, putting forth proposals of what should be done.
Let’s start with the Bank of England. Arguably the most activist central bank post-2008, as measured by the expansion of its balance sheet, several members of the Banks’ Monetary Policy Committee have expressed concern about the risks to financial stability posed by soaring UK property prices, a lack of household savings and a financial sector that remains highly leveraged. In a recent speech, BoE Chief Economist Charlie Bean stated that:
[T]he experience of the past few years does appear to suggest that monetary policy ought to take greater account of financial stability concerns. Ahead of the crisis, Bill White and colleagues at the Bank for International Settlements consistently argued that when leverage was becoming excessive and/or asset prices misaligned, central bankers ought to ‘lean against the wind’ by keeping interest rates higher than necessary to meet the price stability objective in the short run. Just as central banks are willing to accept temporary deviations from their inflation targets to limit output volatility, so they should also be willing to accept temporary deviations to attenuate the credit cycle. Essentially it is worth accepting a little more volatility in output and inflation in the short run if one can thereby reduce the size or frequency of asset-price busts and credit crunches.
In other words, perhaps central bank policy should change focus from inflation targeting, which demonstrably failed to prevent 2008, and instead to focus on money and credit growth. This is clearly an anti-Kenyesian view in principle, although one wonders how it might actually work in practice. In closing, he offered these thoughts:
I opened my remarks tonight by observing that my time at the Bank has neatly fallen into two halves. Seven years of unparalleled macroeconomic stability have been followed by seven years characterised by financial instability and a deep recession. It was a salutary lesson for those, like me, who thought we had successfully cracked the problem of steering the economy, and highlighted the need to put in place an effective prudential framework to complement monetary policy. Policy making today consequently looks a much more complex problem than it did fourteen years ago.
Indeed. Policy making does look increasingly complex. And not only to the staff of the IMF and to Mr Bean, but also to the staff at the Bank for International Settlements, to which Mr Bean referred in his comments. In a recent speech, General Manager of the BIS, Jaime Caruana, taking a global view, expressed fresh concern that:
There is considerable evidence that, for the world as a whole, policy interest rates have been persistently below traditional benchmarks, fostering unbalanced expansions. Policy rates are comparatively low regardless of the benchmarks – be these trend growth rates or more refined ones that capture the influence of output and inflation… Moreover, there is clear evidence that US monetary policy helps explain these deviations, especially for small open and emerging market economies. This, together with the large accumulation of foreign exchange reserves, is consistent with the view that these countries find it hard, economically or politically, to operate with rates that are considerably higher than those in core advanced economies. And, alongside such low rates, several of these economies, including some large ones, have been exhibiting signs of a build-up of financial imbalances worryingly reminiscent of that observed in the economies that were later hit by the crisis. Importantly, some of the financial imbalances have been building up in current account surplus countries, such as China, which can ill afford to use traditional policies to boost domestic demand further. This is by no means new: historically, some of the most disruptive financial booms have occurred in current account surplus countries. The United States in the 1920s and Japan in the 1980s immediately spring to mind.
The above might not sound terribly controversial from a common-sense perspective but to those familiar with the core precepts of the neo-Keynesian mainstream, this borders on economic heresy. Mr Caruana is implying that the Great Depression was not caused primarily by the policy failures of the early 1930s but by the boom preceeding it and that the stagnation of Japan in recent decades also has its roots in an unsustainable investment boom. In both cases, these booms were the product of economic interventions in the form of inappropriately easy monetary policy. And whence does current inappropriate policy originate? Why, from the US Federal Reserve! Mr Caruana is placing the blame for the renewed, dangerous buildup of substantial global imbalances and associated asset bubbles specifically on the Fed!
Yet Mr Caruana doesn’t stop there. He concludes by noting that:
[T]he implication is that there has been too much emphasis since the crisis on stimulating demand and not enough on balance sheet repair and structural reforms to boost productivity. Looking forward, policy frameworks need to ensure that policies are more symmetrical over the financial cycle, so as to avoid the risks of entrenching instability and eventually running out of policy ammunition.
So now we have had the IMF observing that traditional policies aren’t working as expected; BoE Chief Economist Bean noting how policy-making has become ‘complex’; and BIS GM Caruana implying this is primarily due to the boom/bust policies of the US Federal Reserve. So what of the Fed itself? What have Fed officials had to say of late?
Arguably the most outspoken recent dissent of the policy mainstream from within the Fed is that from Jeffrey Lacker, President of the regional Richmond branch. In a recent speech, he voiced his clear opposition to growing central bank interventionism:
There are some who praise the Fed’s credit market interventions and advocate an expansive role for the Fed in promoting financial stability and mitigating financial system disruptions. They construe the founders of the Federal Reserve System as motivated by a broad desire to minimize and prevent financial panics, even beyond simply satisfying increased demand for currency. My own view, which I must note may not be shared by all my colleagues in the Federal Reserve System, favors a narrower and more restrained role, focused on the critical core function of managing the monetary liabilities of the central bank. Ambitious use of a central bank’s balance sheet to channel credit to particular economic sectors or entities threatens to entangle the central bank in distributional politics and place the bank’s independence at risk. Moreover, the use of central bank credit to rescue creditors boosts moral hazard and encourages vulnerability to financial shocks.
By explicitly referencing moral hazard, Mr Lacker is taking on the current leadership of the Federal Reserve, now headed by Janet Yellen, which denies that easy money policies have had anything to do with fostering financial instability. But as discussed earlier in this report, the historical evidence is clear that Fed activism is behind the escalating boom-bust cycles of recent decades. And as Mr Caruana further suggests, this has been a global phenomenon, with the Fed at the de facto helm of the international monetary system due to the dollar’s global reserve currency role.
EURO ‘MISSION ACCOMPLISHED’? UH, NO
As quoted at the start of this report, Jean-Claude Juncker, prominent Eurocrat and politician, recently claimed victory in the euro-crisis. “Greece and Europe won.” And who lost? Why, those who bet against them in the financial markets by selling their debt and other associated assets.
But is it really ‘mission accomplished’ in Europe? No, and not by a long shot. Yes, so-called ‘austerity’ was absolutely necessary. Finances in many EU countries were clearly on an unsustainable course. But other than to have bought time through lower borrowing costs, have EU or ECB officials actually achieved anything of note with respect to restoring economic competitiveness?
There is some evidence to this effect, for example in Ireland, Portugal and Spain, comprising some 15% of the euro-area economy. However, there is also evidence to the contrary, most clearly seen in France, comprising some 20% of the euro-area. So while those countries under the most pressure from the crisis have made perhaps some progress, the second-largest euro member country is slipping at an accelerating rate into the uncompetitive abyss. Italy, for many years a relative economic underperformer, is not necessarily doing worse than before, but it is hard to argue it is doing better. (Indeed, Italy’s recent decision to distort its GDP data by including estimates for non-taxable black-market activities smacks of a desperate campaign to trick investors into believing its public debt burden is more manageable than it really is.)
There is also a surge in economic nationalism throughout the EU, as demonstrated by the remarkable surge in support for anti-EU politicians and parties. It is thus far too early for Mr Juncker to claim victory, although politicians are naturally given to such rhetoric. The crisis of interventionism in the euro-area may is not dissipating; rather, it is crossing borders, where it will re-escalate before long.
THE SHORT HONEYMOON OF ‘ABENOMICS’
Turning to developments in Japan, so-called ‘Abenomics’, the unabashedly interventionist economic policy set implemented by Prime Minister Abe following his election in late 2012, has already resulted in tremendous disappointment. Yes, the yen plummeted in late 2012 and early 2013, something that supposedly would restore economic competitiveness. But something happened on the way, namely a surge in import prices, including energy. Now Japan is facing not just economic stagnation but rising inflation, a nasty cocktail of ‘stagflation’. Not that this should be any surprise: Devaluing your way to prosperity has never worked, regardless of when or where tried, yet doing so in the face of structural economic headwinds is guaranteed to produce rising price inflation, just as it did in the US and UK during the 1970s.
With reality now having arrived, it will be interesting to see what Mr Abe does next. Will he go ‘all-in’ with even more aggressive yen devaluation? Or will he consider focusing on structural reform instead? Although I am hardly a Japan expert, I have travelled to the country regularly since the late 1990s and my sense is that the country is likely to slip right back into the ‘muddle through’ that characterised the economy during most of the past decade. Of course, in the event that another major global financial crisis unfolds, as I regard as inevitable in some form, Japan will be unable to avoid it, highly integrated as it is.
THE BUCK STOPS HERE: A ‘BRIC’ WALL
In my book, THE GOLDEN REVOLUTION, I document how the BRIC economies (Brazil, Russia, India, China, now joined by South Africa to make the BRICS) have been working together for years to try and reorient themselves away from mercantilist, dollar-centric, export-led economic development, in favour of a more balanced approach. Certainly they have good reasons to do so, as I described in a 2012 report, THE BUCK STOPS HERE: A BRIC WALL:
[T]he BRICS are laying the appropriate groundwork for their own monetary system: Bilateral currency arrangements and their own IMF/World Bank. The latter could, in principle, form the basis for a common currency and monetary policy. At a minimum it will allow them to buy much global influence, by extending some portion of their massive cumulative savings to other aspiring developing economies or, intriguingly, to ‘advanced’ economies in need of a helping hand and willing to return the favour in some way.
In my new book, I posit the possibility that the BRICS, amid growing global monetary instability, might choose to back their currencies with gold. While that might seem far-fetched to some, consider that, were the BRICS to reduce their dependence on the dollar without sufficient domestic currency credibility, they would merely replace one source of instability with another. Gold provides a tried, tested, off-the-shelf solution for any country or group of countries seeking greater monetary credibility and the implied stability it provides.
Now consider the foreign policy angle: The Delhi Declaration makes clear that the BRICS are not at all pleased with the new wave of interventionism in Syria and Iran. While the BRICS may be unable to pose an effective military opposition to combined US and NATO military power in either of those two countries, they could nevertheless make it much more difficult for the US and NATO to finance themselves going forward. To challenge the dollar is to challenge the Fed to raise interest rates in response. If the Fed refuses to raise rates, the dollar will plummet. If the Fed does raise interest rates, it will choke off growth and tax revenue. In either case, the US will find it suddenly much more expensive, perhaps prohibitively so, to carry out further military adventures in the Middle East or elsewhere.
While the ongoing US confrontations with Iran and Syria have been of concern to the BRICS for some time, of acute concern to member Russia of late has been the escalating crisis in Ukraine. The recent ‘Maidan’ coup, clearly supported by the US and possibly some EU countries, is regarded with grave concern by Russia, which has already taken action to protect its naval base and other military assets in the Crimea. Now several other Russian-majority Ukrainian regions are seeking either autonomy or independence. The street fighting has been intense at times. The election this past weekend confirming what Russia regards as an illegitimate, NATO-puppet government changes and solves nothing; it merely renders the dipute more intractable and a further escalation appears likely. (Russia is pressing Kiev as I write to allow it to begin providing humanitarian assistance to the rebellious regions, something likely to be denied.)
US economic sanctions on Russia have no doubt helped to catalyse the most recent BRICS initiative, in this case one specific to Russia and China, who have agreed a landmark 30-year gas deal while, at the same time, preparing the groundwork for the Russian banking system to handle non-dollar (eg yuan) payments for Russian gas exports. This is a specific but nevertheless essential step towards a more general de-dollarisation of intra-BRICS trade, which continues to grow rapidly.
The dollar’s international role had been in slow but steady decline for years, with 2008 serving to accelerate the process. The BRICS are now increasingly pro-active in reducing their dollar dependence. Russia has been dumping US dollar reserves all year and China is no longer accumulating them. India has recently eased restrictions on gold imports, something that is likely to reduce Indian demand for US Treasuries. (Strangely enough, and fodder for conspiracy theorists, tiny Belgium has stepped in to fill the gap, purchasing huge amounts of US Treasuries in recent months, equivalent to some $20,000 per household! Clearly that is not actually Belgian buying at all, but custodial buying on behalf of someone else. But on behalf of whom? And why?)
As I wrote in my book, amid global economic weakness, the so-called ‘currency wars’ naturally escalate. Competitive devaluations thus have continued periodically, such as the Abenomics yen devaluation of 2012-13 and the more recent devaluation of the Chinese yuan. As I have warned in previous reports, however, history strongly suggests that protracted currency wars lead to trade wars, which can be potentially disastrous in their effects, including on corporate profits and valuations.
THE END OF GLOBALISATION?
Trade wars are rarely labelled as such, at least not at first. Some other reason is normally given for erecting trade barriers. A popular such reason in recent decades has been either environmental or health concerns. For example, the EU and China, among other countries, have banned the import of certain genetically modified foods and seeds.
Rather than erect formal barriers, governments can also seek ways to subsidise domestic producers or exporters. While the World Trade Organisation (WTO) aims to prevent and police such barriers and subsidies, in practice it can take it years to effectively enforce such actions.
Well, there is now a new excuse for trade barriers, one specific to the huge global tech and telecommunications industry: Espionage. As it emerges that US-built and patented devices in widespread use around the world contain various types of ‘backdoors’ allowing the US National Security Agency to eavesdrop, countries are evaluating whether they should ban their use. Cisco’s CEO recently complained of losing market share to rivals due to such concerns. Somewhat ominously, China announced over the past week that it would prohibit public entities from using Microsoft Windows version 8 and would require banks to migrate away from IBM computer servers.
There has also been talk amongst the BRICS that they should build a parallel internet infrastructure to avoid routing information via the US, where it is now assumed to be automatically and systematically compromised. Given these concerns, it is possible that a general tech trade war is now breaking out under an espionage pretext. What a convenient excuse for protecting jobs: Protecting secrets! What do you think the WTO will have to say about that?
Imagine what a tech trade war would do to corporate profits. Name one major tech firm that does not have widely dispersed global supply chains, manufacturing operations and an international customer base. Amid rising trade barriers, tech firms will struggle to keep costs down. Beyond a certain point they will need to pass rising costs on to their customers. The general deflation of tech in recent decades will go into reverse. Imagine what that will do to consumer price inflation around the world.
Yes, a tech trade war would be devastating. Household, ‘blue-chip’ tech names might struggle to survive, much less remain highly profitable. And the surge in price inflation may limit the ability of central banks to continue with ultra-loose monetary policies, to the detriment also of non-tech corporate profits and financial health. This could lead into a vicious circle of reactionary protectionism in other industries, a historical echo of the ‘tit-for-tat’ trade wars of the 1930s that were part and parcel of what made the Great Depression such a disaster.
Given these facts, it is difficult to imagine that the outbreak of a global tech trade war would not result in a major equity market crash. Current valuations are high in a historical comparison and imply continued high profitability. Major stock markets, including the US, could easily lose half their value, even more if a general price inflation led central banks to tighten monetary conditions by more than financial markets currently expect. Of all the ‘black swans’ out there, a tech trade war is not only taking flight; it is also potentially one of the largest, short of a shooting war.
A SILVER LINING TO THE GLOOM AND DOOM
With equity valuations stretched and complacency rampant—the VIX volatility index dipped below 12 this week, a rare event indeed—now is the time to proceed with extreme caution. The possible outbreak of a tech trade war only adds to the danger. Buying the VIX (say, via an ETF) is perhaps the most straightforward way to insure an equity portfolio, but there are various ways to get defensive, as I discussed in my last report.
Where there is risk, however, there is opportunity, and right now there is a silver lining: With a couple of exceptions, metals prices are extremely depressed relative to stock market valuations. Arguably the most depressed is silver. Having slipped below $20/oz, silver has given up all of its previous, relative outperformance vs other metals from 2010-11. It thus appears cheap vs both precious and industrial metals, with silver being something of a hybrid between the two. Marginal production capacity that was brought on line following the 2010-11 price surge is now uneconomic and is shutting down. But the long slide in prices has now attracted considerable speculative short interest. If for any reason silver finds a reason to recover, the move is likely to be highly asymmetric.
Investors seeing an opportunity in silver can, of course, buy silver mining shares, either individually or through an ETF. A more aggressive play would be to combine a defensive equity market stance—say buying the VIX—with a long position in the miners or in the metal itself. My view is that such a position is likely to perform well in the coming months. (Please note that volatility of the silver price is normally roughly double that of the S&P500 index, so a market-neutral, non-directional spread trade would require shorting roughly twice as much of the S&P500 as the purchasing of silver. Also note, however, that correlations are unstable and thus must be dynamically risk-managed.)
As famed distressed-debt investor Howard Marks says, investing is about capturing asymmetry. Here at Amphora we aim to do precisely that. At present, there appears no better way to go about it than to buy silver, either outright or combined with a stock market short/underweight. From the current starting point, this could well be one of the biggest trades of 2014.
[Editor’s note: now that Steve Baker MP is on the Treasury Select Committee, it should be of interest to all Austrianists, and those interested in monetary reform in general, to re-visit Anthony Evans and Toby Baxendale’s 2008 paper on whether there is room for Austrian ideas at the top table. Within the paper they also reference William White, of the BIS, who has made several comments in the past that are sympathetic to the Austrian School. The recent BIS Annual Report, at least relative to individual, national central banks, shows some consideration of the distorting effects of monetary policy, and the cleansing effects of liquidation (note that the BIS does not face the same political pressures as supposedly independent national central banks). It will be of major importance to followers of the Austrian School around the world to follow the progress of Steve as things develop. Below is the introduction to the paper, the paper in its entirety can be downloaded here aje_2008_toptable]
At a speech in London in 2006 Fynn Kydland surveyed ‘the’ three ways in which governments can achieve credible monetary policy: the gold standard, a currency board or independent central banks. After taking minimal time to dismiss the first two as either outdated or unsuitable for a modern, prosperous economy the majority of the speech was focused on the latter, and the issue of independence. However, the hegemony of this monetary system belies the relative novelty of its use. Indeed the UK presents an especially peculiar history, given the genesis of independence with the New Labour government of 1997. A decade is a short time and two large coincidences should not be ignored. First, independence has coincided with an unprecedented period of global growth, giving the Monetary Policy Committee (MPC) a relatively easy ride. Second, the political system has been amazingly consistent with the same government in place throughout, and just two Chancellors of the Exchequer (Gordon Brown and Alistair Darling). These two conditions have meant that from its inception the UK system of central bank independence has not been properly tested.
Our main claim in this article is that monetary policy has converged into a blend of two theoretical approaches, despite there being three established schools of thought. We feel that there is room at the top table of policy debate for more explicit attention to Austrianideas, and will survey emerging and prevailing attention amongst policy commentary.
Troubling times to be a central banker
Current economic conditions are proving to be of almost universal concern. In the UK general price levels are rising (with the rise in the consumer price index (CPI) hitting 3.8% and in the retail price index reaching 4.6% in June 2008) whilst output growth is falling (with GDP growth slowing to 0.2% in quarter two 2008), raising the possibility of stagflation. This comes after a serious credit crunch that has led to the nationalisation of Northern Rock and an estimated £50 billion being used as a credit lifeline. Most of the prevailing winds are global and are related to two recent financial bubbles. From late 2000 to 2003 the NASDAQ composite index (of primarily US technology stocks) lost a fifth of its value. This was followed with a bubble in the housing market that burst in 2005/06 leading to a liquidity crisis concentrated on sub-prime mortgages. Although the UK has fewer sub-prime lendings, British banks were exposed through their US counterparts and it is now widely acknowledged that a house price bubble has occurred (the ratio of median house prices to median earnings rising steadily from 3.54 in 1997 to 7.26 in 2007) and that a fall in prices is still to come. Also worrying, we see signs that people are diverting their wealth from financial assets altogether and putting them into hard commodities such as gold or oil.
Although academic attention to developing new models is high, there seems to be a request on the part of central bankers for less formal theory building and more empirical evidence.
Alan Greenspan has ‘always argued that an up-to-date set of the most detailed estimates for the latest available quarter are far more useful for forecasting accuracy than a more sophisticated model structure’ (Greenspan, 2007), which N. Gregory Mankiw interprets to mean ‘better monetary policy . . . is more likely to follow from better data than from better models’. But despite the settled hegemony of theoretical frameworks, there is a genuine crisis in some of the fundamental principles of central bank independence. Indeed three points help to demonstrate that some of the key tenets of the independence doctrine are crumbling.
Monetary policy is not independent of political pressures
The UK government grants operational independence to the Bank of England, but sets the targets that are required to be hit. This has the potential to mask inflation by moving the goalposts, as Gordon Brown did in 1997 when he switched the target from the retail price index (RPIX) to the narrower CPI. Although the relatively harmonious macroeconomic conditions of the first decade of UK independence has created little room for conflict, the rarity of disagreement between the Bank of England and Treasury also hints at some operational alignment. On the other side of the Atlantic the distinction between de facto and de jure independence is even more evident, as Allan Meltzer says,
‘The Fed has done too much to prevent a possible recession and too little to prevent another round of inflation. Its mistake comes from responding to pressure from Congress and the financial markets. The Fed has sacrificed its independence by yielding to that pressure.’
Monetary policy is not merely a technical exercise
The point of removing monetary policy from the hands of politicians was to provide a degree of objectivity and technical competence. Whilst the Treasury is at the behest of vested interests, the Bank of England is deemed impartial and able to make purely technical decisions. In other words, the Treasury targets the destination but the Bank steers the car. But the aftermath of the Northern Rock bailout has demonstrated the failure of this philosophy. As Axel Leijonhufvud says,
‘monetary policy comes to involve choices of inflating or deflating, of favouring debtors or creditors, of selectively bailing out some and not others, of allowing or preventing banks to collude, no democratic country can leave these decisions to unelected technicians. The independence doctrine becomes impossible to uphold [italics in original].’
As these political judgments are made, there will be an increasing conflict between politicians and central bankers.
Inflation targeting is too simplistic
The key problem with the UK is that a monetary system of inflation targeting supposes that interest rates should rise to combat inflation, regardless of the source. Treating inflation as the primary target downplays conflicting signals from elsewhere in the economy. In an increasingly complex global economy it seems simplistic at best to assume such a degree of control. We have seen productivity gains and cheaper imports that should result in falling prices, but a commitment to 2% inflation forces an expansionary monetary policy. As Joseph Stiglitz has said, ‘today inflation targeting is being put to the test – and it will almost certainly fail’. He believes that rising commodity prices are importing inflation, and therefore domestic policy changes will be counterproductive. We would also point out the possibility of reverse causation, and instead of viewing rising oil prices as the cause of economic troubles, it might be a sign of capital flight from financial assets into hard commodities (Frankel, 2006). Underlying this point is a fundamental fallacy that treats aggregate demand as being the main cause of inflationary pressure. This emphasis on price inflation rather than monetary inflation neglects the overall size of the monetary footprint, which is ‘the stock of saved goods that allow entrepreneurs to invest in more roundabout production’ (Baxendale and Evans, 2008). It is actually the money supply that has generated inflationary pressures.
The current challenges have thus led to an increasingly unorthodox use of policy tools, with the British government making up the rules as it went along over Northern Rock, and the Fed going to the ‘very edge’ of its legal authority over Bear Stearns. Paul Volcker made the accusation that ‘out of perceived necessity, sweeping powers have been exercised in a manner that is neither natural nor comfortable for a central bank’, McCallum’s rule and Taylor’s rule fall by the wayside as the New York Times screams out, ‘It’s a Crisis, and Ideas Are Scarce’.
I do not doubt that the Government is sincere in its wish to make Britain “open for business” and to deliver greater life chances through reform of the welfare state. I gave some time to the Centre for Social Justice and now I see many of their ideas filtering through to public policy. I support those reforms from both a practical perspective and in view of their moral necessity.
The Prime Minister is correct to talk of the culture we have lost, particularly in respect of private shame. I am put in mind of C S Lewis’ book The Abolition of Man: there is, after all, such a thing as right and wrong. Lewis predicted humanity’s ultimate destiny on the path which embraces subjective morality: a dystopian society in which “we find the whole human race subjected to some individual men, and those individuals subjected to that in themselves which is purely ‘natural’ — to their irrational impulses.”
Some readers will recognise the problem and the dangers but reject the state’s role in finding a solution. However, we do not live in that world where the state is comprehensively rejected. There is a welfare state and it needs reform. The Government is getting on with it, and in the right direction too.
However, what the Government is not addressing is the de-civilising effects of inflation, that is, increasing the money supply.
What is commonly called “inflation” – a rise in the general price level – is an automatic consequence of debasing the currency. And currency debasement has been fierce in our lifetimes: the consequences have been and remain profound.
There is a presentation which, in one form or another, I have given many times. It shows, in a few charts:
- How the state has grown inexorably since 1900,
- How taxation reached an apparent limit at rather less than the scale of state spending, remaining there since 1971 or thereabouts.
- Where our debt projections are heading,
- How our money has been debased, particularly since 1971.
By the end of the presentation, I have explained our banking, fiscal and economic crisis. Given that what it shows is a monetary and fiscal catastrophe, people receive it surprisingly well. As far as I can tell, people can handle the truth and they want it.
One of the key slides is a price index from 1750-2003:
The grotesque debasement since 1971 – when Bretton Woods finally collapsed – hides the detail of the nineteenth century on a linear scale, so I include the same chart on a log scale. The log chart shows that, despite a number of crises and fluctuations, a pound in 1900 bought about the same basket of goods as a pound in 1800.
In contrast, money has lost almost all its value since the Second World War.
The Ethics of Money Production by Jörg Guido Hülsmann is particularly relevant at this point. Hülsmann writes:
To appreciate the disruptive nature of inflation in its full extent we must keep in mind that it springs from a violation of the fundamental rules of society. Inflation is what happens when people increase the money supply by fraud, imposition, and breach of contract. Invariably it produces three characteristic consequences: (1) it benefits the perpetrators at the expense of all other money users; (2) it allows the accumulation of debt beyond the level debts could reach on the free market; and (3) it reduces the [purchasing power of money] below the level it would have reached on the free market.
While these three consequences are bad enough, things get much worse once inflation is encouraged and promoted by the state. The government’s fiat makes inflation perennial, and as a result we observe the formation of inflation-specific institutions and habits. Thus fiat inflation leaves a characteristic cultural and spiritual stain on human society
He goes on to write of inflation’s tendency to centralise government, to extend the length of wars, to enable the arbitrary confiscation of property, to institutionalise moral hazard and irresponsibility, to produce a race to the bottom in monetary organisation, to encourage excess credit in corporations and to yoke the population to debt. He explains how “The consequence [of inflation] is despair and the eradication of moral and social standards.”
That all sounds familiar.
Hülsmann’s work is not scripture of course, but neither are his ideas isolated. Consider Ayn Rand:
Whenever destroyers appear among men, they start by destroying money, for money is men’s protection and the base of a moral existence.
It is my firm view that inflation – the debasement of money – was the primary cause of the banking crisis. That inflation was a deliberate policy choice of welfare states. You may recall Eddie George’s remarks in 2007 and now Mervyn King has said, “Of all the many ways of organising banking, the worst is the one we have today.”
Moreover, if Hülsmann, Rand and other scholars including Mises and Hayek are to be believed, then inflation is also a major contributor to the moral and spiritual decline of our country. No amount of welfare reform alone will solve that.
All is not lost however. To return to that log-scale price index, money’s value was substantially more volatile in the first half of the nineteenth century than in the second. In 1844, the Bank Charter Act, Peel’s Act, took from the banks the privilege of extending bank notes in excess of specie (coins of inherent worth). It was recognized that this extension of candy-floss credit un-backed by prior production of real value was a systemic cause of economic and banking crises.
Unfortunately, that Act left the banks unmolested in their ability to create deposits. As our system of money and bank credit has evolved, that loophole, combined with central banking and the socialisation of risk, has delivered us into our present predicament.
It falls to our generation to solve this problem and that is why we established The Cobden Centre.
As Martin Wolf wrote in the Financial Times on 9th November 2010, “The essence of the contemporary monetary system is creation of money, out of nothing, by private banks’ often foolish lending.” And then we wonder why house prices have raced out of reach. We wonder why the basement garages in Canary Wharf are full of supercars while what was once our industrial heartland languishes in state dependency.
I admire the Prime Minister and the coming welfare reforms. I will back them gladly. But, until we end inflation as a way to fund the promises of the welfare state, we shall not have done the decent thing. We shall not have established objective morality in banking and in that lifeblood of society: money. Honest money is a prerequisite for social progress and it must be delivered if reform is to succeed.
Another classic article, brought forward. This is a speech by James Tyler to the Adam Smith Institute Next Generation Group on 6 October 2009. This speech is also available on hedgehedge.com.
I have spent the best part of the last two decades pitting my wits against the market. It’s an unforgiving game: I’ve seen ups and downs, and many of my rivals buried under an avalanche of hubris, passion, illogical thought and unchecked emotion.
I have witnessed the sheer folly of the ERM crisis, the Asian crisis, the failure of the Gods at Long Term Capital Management and the insanity of the tech boom.
I have enjoyed the ‘NICE’ decade (Non-Inflationary Constant Expansion), and scared myself silly during the credit crisis.
I am a trader.
I risk my own money and live or die by my decisions, and face the threat of personal bankruptcy every time I switch my screens on. I get no salary – indeed I turn up at the start of the month with a large office overhead – a ‘negative’ salary. I have no fancy company pension scheme, no lucrative monopoly or franchise.
I eat what I kill.
Mistakes cost me my livelihood, so, above all, my decisions have to be rooted in practical and logical decision making.
Some have called my kind parasitic, but I would have said that I bring order, efficiency, predictability, stability and deep liquidity to a crucial process: a process that makes the whole world keep ticking.
I make money work.
I make the market in interest rate derivatives: a market born out of the neo classical revolution in finance fostered in Chicago during the 1970s. I am a child of Friedman, Fisher Black, Myron Scholes and the modern international financial system.
My analysis was steeped in the neo-classical, efficient markets paradigm.
Friedman’s ideal was working. Enlightened central bankers guided the free market with gentle nudges and short term liquidity infusions, free floating currencies gently adjusted themselves to the constant flow of new information and efficient and rational markets took all in their stride.
Credit flowed, people got wealthier, economies developed and all was well.
And then the crisis struck.
Continue reading “My Journey to Austrianism via the City”
On Saturday, I spoke again to set out the scale and scope of our financial and monetary mess and again, the audience welcomed the presentation. I find this encouraging: while people are typically horrified by the true levels of debt and debasement that have been entered into by states on our behalf, generally, people are prepared to believe that reform is possible.
I was put very much in mind of two attitudes.
As Sean Corrigan has indicated, Bagehot’s classic treatise is not so much a defence of British monetary orthodoxy as a despairing attempt to show how to survive the banking crises which are inevitable under such a system. As Bagehot wrote:
I can only reply that I propose to retain this system because I am quite sure that it is of no manner of use proposing to alter it. […]
We must therefore, I think, have recourse to feeble and humble palliatives such as I have suggested. […]
This stands in contrast to the hopeful attitude shown by Jörg Guido Hülsmann in The Ethics of Money Production:
Many will object that it is impossible to bring about such a return [to a universal respect for property rights], now that we have progressed so far on the way toward a global paper money. This is a thoroughly defeatist point of view because it takes the coming disaster (hyperinflation or global tyranny) for granted. Most importantly, however, it is morally wrong. As we have argued, we face a problem of the human will; but this is after all only a problem of the will.
Now, I suppose a thoughtful person might question whether Hülsmann is engaging in hyperbole with his reference to “the coming disaster”. It seems a very reasonable question and, though I don’t propose to begin answering it here, I reflect on the trouble faced, not just by the UK, but by the Eurozone and the USA and also on the actions of their Central Banks, treasuries and legislatures: a broader range of predictions than we are accustomed to has become credible.
Denying the facts of our predicament will not do, but nor will a hopeless despair. The central, optimistic path is serious bank reform working towards honest money. As I reflect on responses to my speeches, from students, Conservatives, businessmen and others, and as I consider the increasing success of grassroots campaigns like Positive Money, I am increasingly persuaded both that Hülsmann is right to reject defeatism and that there are good reasons to believe that the will to deliver worthwhile reform may yet emerge.
You can find Andy Duncan’s review of Hülsmann here.
Antoine Clarke’s fascinating paper The Micropolitics of Free Market Money: a Proposal is also relevant.
Britain’s Trillion Pound Horror Story will be transmitted on Channel 4, tonight Thursday, 11 Nov at 9pm:
Film maker Martin Durkin explains the full extent of the financial mess we are in: an estimated £4.8 trillion of national debt and counting. It’s so big that even if every home in the UK was sold it wouldn’t raise enough cash to pay it off.
Durkin argues that to put Britain back on track we need to radically rethink the role of the state, stop politicians spending money in our name and introduce, among other measures, flat taxes to make Britain’s economy boom again.
This is a polemical film presented by Martin Durkin. The film brings economic theory to life and makes it hit home. It includes interviews with academics, economic experts, entrepreneurs and four ex-Chancellors of the Exchequer.
A number of members of the team gave interviews and we look forward to seeing the final result.