The following text is from the notes I made of a talk that I gave to the “End of The World Club” at the Institute of Economic Affairs on 18 April 2014.
If there is one feature of human society that makes it successful, it is the capacity that human beings have of choosing to satisfy short-term appetites or to defer gratification. This ability to distinguish between short term and long term interests is at the heart of economics.
But why defer consumption? Why save at all?
One reason is the transmission of wealth from one generation to the next. Another is to ensure security in hard times.
A complaint of American academics about French savings in the 19th century is that they were too conservative. Easy for them to say.
The population of France grew more slowly than any other industrialising nation in the 19th century (0.2% per year from 1870 to 1913, compared with 1.1% for Germany and 0.9% for Great Britain). The figures would be even worse if emigration from the British Isles were added to the headcount.
This slower rate of population growth would tend to mean a slower rate of economic growth: smaller local markets, fewer opportunities for mass production. This was well known to be a problem in France. In fact Jean-Baptiste Say was sent to England in 1815 to study the growth of English cities such as Birmingham and its effect on the economy (here in French).
The causes of low investment must surely include political and social instability.
Here are the changes of regime in France during the 19th century: 1800-1804: The Consulate
1804-1814: The Empire
1814: The First Restoration
1814-1815: The Return of Napoleon
1815-1830: The Return of the Restoration
1830-1848: The British Experiment
1848-1851: The Second Republic
1851-1852: The military coup-d’état
1852-1859: The Empire Strikes Back
1860-1870: The Free Trade Experiment (supported by Richard Cobden)
1870-1871: Three sieges of Paris, two civil wars, one foreign occupation
1870-1879: The State Which Dare Not Speak Its Name (retrospectively declared to be a republic)
1879-1914: La Belle Epoque (including the anarchist bombings 1892-1894 and the Dreyfus Affair 1894-1906)
If instability discourages savings, it is remarkable how much there actually was.
Five billion francs in gold, raised by public subscription to pay for the German army of occupation to leave France after the Franco-Prussian War. The amount was supposed to be impossible to pay and designed to provide an excuse for a prolonged German occupation. It was paid in full in two years. 80% of the money (equivalent to over two and half times the national government’s total annual spending, was raised in one day).
What the modern academics decried was that these sorts of sums weren’t invested in industry or agricultural technology. In 1880, French private investments amounted to 7.3 billion Francs, but this was less than half of all investments (48%), versus 52% for government bonds.
You can’t pick up your factory machines and run away from the Uhlans, or the Communards.
Gold was one preferred wealth storage option. It still is in France.
Government bonds were generally considered a good deal: backed by the power of taxation, and, unlike gold, they earned interest.
One constant concern of French governments in the 19th century was the diplomatic isolation enforced by the 1815 Congress of Vienna. Various attempts were made to break this, some successful like the split of Belgium from the Netherlands in 1830, the Crimean War (co-operation with the British), others failed (Napoleon III’s Mexican adventure, the Franco-Prussian War).
By 1882, Germany looked like getting economic and military supremacy in Europe, with an Triple Alliance with Austria-Hungary and Italy. With the British playing neutral, the best bet was to build up Russia.
The first Russian bonds sold in France were in 1867 to finance a railroad. Others followed, notably in 1888. At this point the French government decided on a policy of alliance with Russia and the encouragement of French savers to invest in Russian infrastructure. From 1887 to 1913, 3.5% of the French Gross National Product is invested in Russia alone. This amounted to a quarter of all foreign investment by French private citizens. That’s a savings ratio (14% in external investment alone) we wouldn’t mind seeing in the UK today!
A massive media campaign promoting Russia as a future economic giant (a bit like China in recent years) was pushed by politicians. Meanwhile French banks found they could make enormous amounts of commission from Russian bonds: in this period, the Credit Lyonnais makes 30% of its profits from it’s commission for selling the bonds.
In 1897, the ruble is linked to gold. The French government guarantees its citizens against any default. The Paris Stock Exchange takes listings for, among others: Banque russo-asiatique, la Banque de commerce de Sibérie, les usines Stoll, les Wagons de Petrograd.
The first signs of trouble come in 1905, with the post-Russo-Japanese War revolution. A provisional government announced a default of foreign bonds, but this isn’t reported in the French mainstream media or the French banks that continue to sell (mis-sell?).
During the First World War, the French government issued zero interest bonds to cover the Russian government’s loan repayment, with an agreement to sort out the problem after the war. However, in December 1917, Lenin announced the repudiation of Tsarist debts.
The gold standard was abolished, allowing the debasement of the currency, private citizens were required to turn over their gold for government bonds.
Income tax was introduced (with a top rate of 2%) after the assassination in Sarajevo of the Archduke Ferdinand and his wife.
In 1923, a French parliamentary commission established that 9 billion Francs had effectively been stolen from French savers in the Russian bonds affair. Bribes had been paid to bankers and news outlets to promote the impression of massive economic growth in Russia. Many of the later bonds were merely issued to repay the interest on earlier debt.
For the next 70 years, protest groups attempted to obtain compensation, either from the Russian government or from the French government that had provided “guarantees”. You won’t be surprised to know that some banks managed to sell their bonds to private investors after 1917, having spread false rumours that the Soviets would honour the bonds.
Successive French governments found themselves caught between the requirements of “normal” relations with the USSR and the clamour of dispossessed savers and their relatives.
In November 1996, the post-Soviet Yelstin government agreed a deal to settle the Russian bonds for $400 million. The deal covered less than 10% of the families demanding compensation. Despite this, 316,000 people are thought to have received some compensation, suggesting that over 3 million families were affected by the Russian bonds scandal.
There are similarities with the present day but also significant differences.
First, the role of government guarantees and links with favoured banks, ensuring savers were complacent.
Second the manipulation of economic data by the Russian government, which looks a lot like what’s been happening in China.
Third the fragility of the situation: war can break out. All sorts of assumptions we can make about safe investments go out of the window.
One specifically French response to all this is something I would like to see an academic study of. What changes to consumption and savings would follow from growing up in a family where savings have been wiped out by government action (Russian or one’s own)? If three million people were directly involved, most French people would have known someone who had deferred consumption and been robbed. To what extent does the post-1945 explosion in mass consumption in France reflect a view that deferring consumption is foolish when savings can be stolen with the connivance or lack of concern of one’s own government?
Still unnoticed by a large part of the population is that we have been living through a period of relative impoverishment. Money has been squandered in welfare spending, bailing out banks or even — as in Europe — of fellow governments. But many people still do not feel the pain.
However, malinvestments have destroyed an immense amount of real wealth. Government spending for welfare programs and military ventures has caused increasing public debts and deficits in the Western world. These debts will never be paid back in real terms.
The welfare-warfare state is the biggest malinvestment today. It does not satisfy the preferences of freely interacting individuals and would be liquidated immediately if it were not continuously propped up by taxpayer money collected under the threat of violence.
Another source of malinvestment has been the business cycle triggered by the credit expansion of the semi-public fractional reserve banking system. After the financial crisis of 2008, malinvestments were only partially liquidated. The investors that had financed the malinvestments such as overextended car producers and mortgage lenders were bailed out by governments; be it directly through capital infusions or indirectly through subsidies and public works. The bursting of the housing bubble caused losses for the banking system, but the banking system did not assume these losses in full because it was bailed out by governments worldwide. Consequently, bad debts were shifted from the private to the public sector, but they did not disappear. In time, new bad debts were created through an increase in public welfare spending such as unemployment benefits and a myriad of “stimulus” programs. Government debt exploded.
In other words, the losses resulting from the malinvestments of the past cycle have been shifted to an important degree onto the balance sheets of governments and their central banks. Neither the original investors, nor bank shareholders, nor bank creditors, nor holders of public debt have assumed these losses. Shifting bad debts around cannot recreate the lost wealth, however, and the debt remains.
To illustrate, let us consider Robinson Crusoe and the younger Friday on their island. Robinson works hard for decades and saves for retirement. He invests in bonds issued by Friday. Friday invests in a project. He starts constructing a fishing boat that will produce enough fish to feed both of them when Robinson retires and stops working.
At retirement Robinson wants to start consuming his capital. He wants to sell his bonds and buy goods (the fish) that Friday produces. But the plan will not work if the capital has been squandered in malinvestments. Friday may be unable to pay back the bonds in real terms, because he simply has consumed Robinson’s savings without working or because the investment project financed with Robinson’s savings has failed.
For instance, imagine that the boat is constructed badly and sinks; or that Friday never builds the boat because he prefers partying. The wealth that Robinson thought to own is simply not there. Of course, for some time Robinson may maintain the illusion that he is wealthy. In fact, he still owns the bonds.
Let us imagine that there is a government with its central bank on the island. To “fix” the situation, the island’s government buys and nationalizes Friday’s failed company (and the sunken boat). Or the government could bail Friday out by transferring money to him through the issuance of new government debt that is bought by the central bank. Friday may then pay back Robinson with newly printed money. Alternatively the central banks may also just print paper money to buy the bonds directly from Robinson. The bad assets (represented by the bonds) are shifted onto the balance sheet of the central bank or the government.
As a consequence, Robinson Crusoe may have the illusion that he is still rich because he owns government bonds, paper money, or the bonds issued by a nationalized or subsidized company. In a similar way, people feel rich today because they own savings accounts, government bonds, mutual funds, or a life insurance policy (with the banks, the funds, and the life insurance companies being heavily invested in government bonds). However, the wealth destruction (the sinking of the boat) cannot be undone. At the end of the day, Robinson cannot eat the bonds, paper, or other entitlements he owns. There is simply no real wealth backing them. No one is actually catching fish, so there will simply not be enough fishes to feed both Robinson and Friday.
Something similar is true today. Many people believe they own real wealth that does not exist. Their capital has been squandered by government malinvestments directly and indirectly. Governments have spent resources in welfare programs and have issued promises for public pension schemes; they have bailed out companies by creating artificial markets, through subsidies or capital injections. Government debt has exploded.
Many people believe the paper wealth they own in the form of government bonds, investment funds, insurance policies, bank deposits, and entitlements will provide them with nice sunset years. However, at retirement they will only be able to consume what is produced by the real economy. But the economy’s real production capacity has been severely distorted and reduced by government intervention. The paper wealth is backed to a great extent by hot air. The ongoing transfer of bad debts onto the balance sheets of governments and central banks cannot undo the destruction of wealth. Savers and pensioners will at some point find out that the real value of their wealth is much less than they expected. In which way, exactly, the illusion will be destroyed remains to be seen.
This article was previously published at Mises.org.
It was not too surprising that there is going to be no tapering for some very good reasons. The commencement of tapering would have led deliberately to bond yields rising, triggered by an increase in sales of government bonds to the public and at the same time escalating sales by foreign governments as they attempt to retain control over their own currencies and interest rates. This was the important lesson from floating the rumour of tapering in recent months.
The reason tapering was not going to happen is summarised as follows:
1. Monetarists and therefore central bankers believe that rising bond yields and interest rates will strangle economic recovery. They want to see more robust evidence of recovery before permitting that to happen.
2. Rising bond yields would have required the Fed to raise interest rates sooner rather than later to stem the flight of bank deposits from the Fed’s own balance sheet held as excess reserves, which only earn 0.25%.
3. Importantly, the global banking system has too much of its collective balance sheet invested in fixed-interest bonds, and is also exposed to rising interest rates through interest rate swap derivatives. Tapering would almost certainly have precipitated a second bank crisis starting at the system’s weakest point.
4. The cost of funding the US Government’s deficit would have risen, difficult when the debt ceiling has to be renegotiated yet again.
5. Rising US interest rates will most probably destabilise emerging market currencies, risking a new Asian crisis.
6. It is a bad time to shift the burden of government funding back into the markets, because foreign holders have shown they will sell into rising yields.
The Fed has reaffirmed that zero interest rates will be with us for some time to come. It simply has no choice: it has to play down the risk of inflation. The result will be more price inflation, which is bad for the dollar and good for gold. This was reflected in the US Treasury yield curve, where prices of long maturities fell yesterday relative to the short end.
The markets had wrongly talked themselves into believing that tapering was going to happen, when the rumour was no more than an experiment. In the process precious metals were sold, driven by increasingly bearish technical talk every time a support level was breached. It is hardly surprising therefore that the recovery in gold and silver prices last night was dramatic, with gold moving up $70 and silver by $2 from intra-day lows. It looks like a significant second bottom is now in place above the June lows and the bear position, coupled with the shortage of physical metal will drive prices in the coming weeks.
The implications of the Fed not going ahead with tapering are bad for the dollar and won’t stop bond yields at the long end from rising. It shows that the whole US economy is in a massive debt trap that cannot be addressed for powerful reasons. The reality is the expansion of cash and deposits in the US banking system is tending towards hyperinflation and is proving impossible to stop. That is the message from this week’s FOMC meeting, and I expect it to gradually dawn on investors world-wide in the coming weeks.
The purpose of this essay is to put the latest crisis in the context of longer-term debt trends in the US and to attempt some predictions in respect to the US economy and financial markets.
Statistics are records of past events. Analyzing statistics means interpreting history, and this can only be done on the basis of theory. We must first have some theoretical notions to be able to render past events intelligible. Of course, historic data cannot be in conflict with the theory used, as that would put the validity of the latter in doubt. But we can neither use statistics to prove the correctness of a theory nor directly discover new theories (although history may give us ideas about potential theories). Before we look at the data I should give a brief outline of my theory, which readers of my bookPaper Money Collapse will be familiar with.
The theory – short version
Paper Money Collapse challenges the prevailing consensus on money. This consensus holds that it is good to have something called ‘monetary policy’. Most mainstream economists today, while accepting the superiority of markets when it comes to allocating scarce resources to their most urgent uses, also maintain that in the field of money state involvement is desirable, and that a smoothly functioning economy requires a constantly expanding supply of state paper money and the guidance (manipulation) of certain market prices (interest rates) by a central bureaucracy, i.e. the central bank. More precisely, this bureaucracy should keep expanding the supply of money in such a way that money’s purchasing power declines continuously (moderate, controlled inflation) and that, whenever the economy is weak, it should use its powers to ‘stimulate’ the economy towards faster growth, usually through accelerated base money production and administratively lowered interest rates.
Paper Money Collapse argues that all these notions are erroneous and dangerous. Constant monetary expansion is not needed (not even in a growing economy) and is always highly disruptive. The continuous expansion of fiat money, naturally via financial markets, systematically distorts interest rates, which must lead to capital misallocations and other economic imbalances that will make recessionary corrections at a later stage inevitable. The recessions that ‘easy’ monetary policy is then supposed to shorten or ease are thus nothing but the result of previous monetary expansion.
Recessions can only be avoided by avoiding artificial booms through credit expansion. Once monetary expansion has led to sizable economic distortions the recession becomes unavoidable – and even necessary to cleanse the economy of dislocations. But to make matters worse, in our present system of unconstrained fiat money creation, recessions are – whenever they occur – countered by accelerated money creation (usually via new bank reserves from the central bank) and further cuts in interest rates. Imbalances are thus not being purged from the economy. Instead they accumulate over time making the financial system and the economy overall progressively more unstable. The system is moving towards a point of catharsis: either a complete purge is finally allowed to unfold (painful) or ever more fiat money is created until the public loses confidence in fiat money itself and a hyperinflationary currency collapse occurs (more painful).
I maintain that this theory is logically consistent and not in conflict with past events.
Clearly identifying, let alone quantifying, imbalances is exceedingly difficult if not impossible. It is usually during crises that imbalances become visible as such. Consequently, analyzing data requires a considerable degree of judgement. In the following I look at ‘excessive indebtedness’ as a major dislocation caused by fiat money expansion.
The present monetary system naturally encourages the excessive accumulation of debt, and discourages deleveraging and disinflation, although at certain points in time these may be difficult to avoid altogether. During the financial crisis deflationary and recessionary forces briefly gained the upper hand. To what extent have they purged the system of money-induced imbalances? Has a meaningful ‘cleansing’ of imbalances taken place? If so, has the economy ‘healed’?
Over the 31 years from 1981 to the end of 2012, total debt outstanding in the US economy grew from $5,255 billion to $56,280 billion. The debt load has increased continuously from year to year – with only one single exception: 2009, when total debt declined by just 0.2%. Debt has grown faster than nominal GDP in 27 out of 31 years. The average growth rate in total debt was 8% per annum, compared to 5.4% for nominal GDP. In 1981, total debt outstanding was 168% of GDP, today it is 359% of GDP.
In 1981, total debt broke down as follows: household debt was about 48% of GDP; business debt was about 53% of GDP; the public sector owed about 38% of GDP and the financial sector 29% of GDP. Note that of the four major sectors, the public sector and the financial sector were the two smaller ones. Debt of the financial sector was only slightly more than half of corporate debt.
Things looked very different by the end of 2012: Household debt had ballooned to 82% of GDP and corporate debt to 81%. Public sector debt now stood at 93% of GDP and financial sector debt at 103% of GDP. The public and financial sector had become the largest debtors.
While corporate debt was about 7.5 times larger in absolute terms at the end of 2012 than at the end of 1981, financial sector debt was 17 times larger. Over the 26 years from 1981 to the eve of the current financial crisis in 2007, financial sector debt grew at an average clip of more than 12% per annum compared to about 6% for nominal GDP over the same period. When we entered the present financial crisis in 2007, financial sector debt stood at an all-time high for any sector in US financial history, at 131% of GDP.
I maintain that such a dramatic growth in overall indebtedness, as well as the specific breakdown of that growth by sector, is symptomatic of our unconstrained fiat money system with its constant money growth and lender-of-last-resort central banks that encourage debt accumulation and promote high-leverage strategies in the financial sector. That this has led to substantial economic instability is now self-evident.
Has the US economy deleveraged since 2007?
The two sectors that were most exposed in 2007 were households (via the residential mortgage market) and the financial sector. Both sectors have shed debt since 2007. Both have deleveraged. Households reduced their debt from a record $13,712 billion in 2007 to $12,831 billion at the end of 2012. These $881 billion mean a reduction of 6.4%. The financial sector was forced to cut debt even more: From 2007 to 2012, total outstanding debt of the financial sector was reduced by more than $2,100 billion, a reduction of 12%.
Such reductions in debt were unprecedented in the 31-year history we are looking at here. At no point before had household debt and financial sector debt declined on a year-over-year basis. In this respect, the events of the recent crisis were indeed unique. ‘Cleansing’ has occurred. But how meaningful are these reductions? In absolute terms – total amounts of debt outstanding – both sectors are roughly back to where they were …..in Q3 of 2006, barely a year before the crisis started! Not much has happened in absolute terms. However, in recent years, the economy has continued to grow moderately, so as a percentage of GDP, household debt is today roughly where it was in 2002/3, and financial sector debt is about where it was in 2001/2. In relative terms, a decade of excess has thus been unwound.
Nevertheless, as mentioned above, the total debt load has continued to grow and stands at an all-time record today. The reason for this is mainly the explosion in public sector debt. While households and financial firms have cut debt by $3 trillion since 2007, the state has taken on an additional $6.6 trillion in new debt over the same period– almost all of it at the federal level! In fact, outstanding debt of the federal government has more than doubled since 2007!
The trend of ever-rising overall debt has thus continued. The deleveraging in the household and financial sector has, however, resulted in a reduced pace of debt accumulation overall, despite heavy borrowing from the federal government. In 2010, for the first time since 1992, the economy has grown faster than total debt, and this has continued in 2011 and in 2012, if at a slowing pace. Consequently, total debt stands at 359% of GDP today, slightly down from its peak of 381% in 2009. At 359% debt-to-GDP is back to where it was at in early 2007. Again, not much deleveraging has occurred in total.
Conclusion and outlook
I cannot see that the recent crisis has already brought about some kind of fundamental healing of the US economy, some much needed purge of monetary excesses. Yes, households and the financial industry have trimmed back and are now probably in better shape than a few years ago. Household debt numbers now seem to be stabilizing, meaning deleveraging could be coming to an end, while there is no sign yet that financial deleveraging has concluded. Of course, given the prevailing belief system, those who control the levers of the fiat money system are doing what they can to discourage further deleveraging. Zero interest rates and open-ended QE are hardly conducive to debt reduction.
Here are my present forecasts, and they are necessarily highly speculative:
Super-easy monetary policy will continue as far as I can see. The Fed has declared that it wants to use monetary policy to boost employment (the hubris of the bureaucrat!). But deleveraging in the financial sector, if it persists, would be a problem for the Fed’s strategy. The financial sector is crucial in transmitting easy policy. The Fed can thus reasonably be expected to continue leaning against deleveraging with all its might. And if and when deleveraging turns into re-leveraging, the Fed will probably nurture it for some time.
Public sector profligacy is not a crisis phenomenon but has been in full bloom since 2002 and is now in large part structural. A political solution looks unlikely any time soon. The state will thus continue to be the main driver behind the overall growth in debt. Funding this debt accumulation is not a problem with the Fed now the biggest marginal buyer of Treasury securities and the Fed unlikely to abandon super-easy policy anytime soon.
The corporate sector has not been a major driver in this story so far. Recently, corporate debt has begun to expand again. It is not unreasonable to assume that this will continue.
In aggregate, the picture could be the following: outstanding debt of the public sector will continue to grow rapidly, corporate debt mildly to maybe strongly; household indebtedness might stagnate. The wild card remains the financial sector. My guess is that what little overall deleveraging we experienced – measured as a modest decline in total debt in relation to the economy’s capacity for income-generation, i.e. GDP – is in the process of being reversed. The interventionists (i.e. the mainstream) will hail this as a success of policy. ‘Debt-deflation’ has been avoided – for now. A more realistic assessment is that the economy is as much on financial steroids as a few years ago, and – in aggregate – as fragile. Expanding debt levels further from here will require interest rates that are continuously depressed through policy and an even more activist and interventionist central bank. The Fed is fully on board with this.
Deflation is very unlikely from here. The debasement of paper money continues. Inflation rates should begin to move higher.
Debt-GDP-ratios of 359% (now) or 381% (2009) are unusual historically. The ratio was below 200% at the start of the Great Depression and it peaked at a touch above 300% in 1933, when nominal GDP collapsed. The current debt load is unprecedented. But then, countries such as Japan and the UK have total debt in excess of 500 percent of GDP. Disaster still looks inevitable but maybe not imminent.
…a final word on the bond market.
It so happens that the start year of the above analysis – 1981 – also marked the peak in bond yields in the US. 10-year Treasury notes reached 15% back in 1981 and went on a downward path from there that lasts to this day. We have had an almost uninterrupted, 31-year bull market in bonds. Not only Treasuries but also corporate and mortgage debt are presently trading at or near historic lows in yield. Although the US economy never had to carry more debt – certainly never more in absolute terms and almost never more relative to GDP – the compensation that investors get for holding all this debt has never been lower!
Sure, inflation was still high in the early 1980s but the structural drop in inflation was over by 1992. CPI inflation has broadly moved sideways in a stable range since the early 1990s without any additional disinflationary momentum.
It seems that over the past three decades the debtors were encouraged to take out ever more debt because the lenders – the bond buyers – were happy to hold ever more debt at ever lower yields. A market in which demand for assets keeps rising at persistently rising prices (persistently falling yields) has all the ingredients of a bubble. I think the US bond market – and by extension, international bond markets – could be the greatest bubble in history.
With the halls no longer decked with boughs of holly and the wassailers at last stuffed full of figgy pudding, we have all reluctantly begun to struggle back to our desks, turn on our Bloomberg screens, and wearily face up to the long slog ahead towards the annual profit target.
Even though the New Year is still wrapped in its swaddling clothes, it is hard to avoid the jaded feeling that the market has already arrived at an all too cosy consensus about how events will unfold in 2013 and where the money is to be made as they do.
The Yen will continue to fall and fall under the maniacal compulsion of the new Japanese government; bond yields will finally cease their three-decade decline; and stocks will (of course) rally, probably dragging industrial commodities with them. In Europe, the worst is widely held to be behind us – even though nothing much has been done there beyond persuading traders that the line of least resistance lies in not calling Mario Draghi’s bluff when he insists that sovereign spreads must not widen. China’s typically sagacious new central planners will somehow ‘rebalance’ the ailing giant that is their fiefdom by pouring yet more concrete and digging yet more holes without this time stumbling into a further mindless duplication of capacity, sparking a divisive property rush, or re-igniting a socially disquieting round of consumer price rises. Perched high above, in the crow’s nest which sways alarmingly above this Ship of Fools, the Bernanke Fed will keep on buying however many of the obligations of an incurably profligate government it feels like monetizing, thereby hoping to prise the prudent out of their more passive habits of saving by means of the insidious, corrosive, time decay which negative real interest rates visit on the thrifty and, in doing so, it will seek to insure us against all possibility of renewed recession.
Easy, isn’t it?
Well, perhaps. But before we start spending our bonuses before we have truly earned them, let us first pause to consider whether any or all of these suppositions are really imbued with the full hue of inevitability or whether instead an all too typical mass disappointment will set in, either around the start of February (as has traditionally been the tendency when the last winning trade of the old year is carried too eagerly on into the new) or sometime in the Spring (as has been the case in the last three years of policy undulation and Risk-On/Off hysteresis).
Take the US, for example. Just like the Mayan fiasco of prophecy, the budgetary apocalypse of the so-called ‘fiscal cliff’ (a hackneyed phrase whose overuse grates on the ears almost as much as that damnable cliché relating to metallic containers, public highways, and coups de pieds) has been partly averted, even if we can all look forward, in the coming weeks, to another round of facile political posturing ahead of the near-inevitable debt ceiling extension.
Rather than cheer, however, any rational investor would find this procrastination a mater of deep anxiety for, as Laurence Kotlikoff points out, it is not so much the minor contour change of the ‘cliff’ which should be exercising our concerns, but the terrifying, Miltonian ‘abyss’ which lies beyond it in a country where the accelerated transmutation of ageing Baby Boom tax payers into voracious entitlement eating retirees is adding no less that $11 trillion a year to the unpayable $222 trillion NPV of the nation’s overall sum of actual and contingent liabilities.
For now, though, even if the recovery is a deal more anaemic than anyone seeking votes might hope, America has managed to avoid slipping back into the mire in the way so many of its peers have done, where, that is, these latter have been fortunate enough to free themselves from the choking quagmire of unresolved crisis in the first place.
By all accounts, the economy – and by extension, a stock market flattered by the artificially exiguous discount factors applied to its prospective earnings stream – has much going for it: corporate profits are elevated, cash flow is at record highs, wages are subdued, the buying-back of equities is proceeding apace, that last aided greatly by a booming market in corporate debt . Capital expenditures are on the rise (if not so impressive in inflation-adjusted, net – rather than nominal, gross – terms) and payrolls are indeed expanding if not as rapidly as some might wish.
Moreover, the broad brush of the overall jobs numbers has been obscuring the heartening detail that the country’s more productive sectors are making their contribution to re-employment (manufacturing and the extractive industries have, between them, added almost 600,000 to the roster since the trough), while the bulk of the retrenchments have come in the non-productive, if not parasitical, sectors of finance (mea culpa!) and government.
The main concern here is that, despite the Fed’s ongoing efforts to force everyone to swim by flooding the land in liquidity, overall business revenues have undergone something of a deceleration in recent months and regular surveys of small businesses are obstinately throwing off readings typical of a slump, while claims of rediscovered vigour in the enfeebled construction sector seem to be belied by the trifling gains in headcount and hours worked in the field, not to mention the refusal of mortgage purchase applications to shake off their post-crash sloth, or of office vacancy rates to decline in any meaningful manner.
In Europe, politics may yet play an unexpected part, not least in Italy where Il Caviliere seems to have found a way to manoeuvre himself back to the centre of things in the form of the partial self-denial of ambition encapsulated in his faction’s deal with its erstwhile allies of the Northern League, under the terms of which he would settle for the finance minister’s job. However that particular gambit pays out, it seems certain that the hustings everywhere will resound to cries of repudiation for anything associated with the slow grind of Orient Express Austerity (i.e., that pernicious assault on the commonwealth which seeks to keep an overgrown and intrusive state as large as possible, no matter what the cost to that enterprising and self-reliant middle which is otherwise most likely to spark a renaissance).
Even in Germany, the cracks have begun to appear as the Merkel coalition has already delivered a sackful of costly pre-election sweeteners to keep the electorate onside in this, the key year for the coalition. As one perceptive acquaintance put it, we should expect little else when the struggle for power will be conducted between what he sourly called the red socialists, the green socialists, the yellow socialists, and the black socialists.
For our part, it has always been the contention that the true test of Germany’s avowed resolve to insist upon budgetary discipline and at least the pretence of monetary rectitude would arrive if and when the country’s recent good fortune began to run out and its own mighty engines of growth were heard, at last, to sputter and cough.
With business revenues now falling in all sectors, except that of what are probably inflation-boosted consumer non-durables (making the MDAX, if not yet its larger sibling the DAX, seem historically expensive by comparison) and with industrial production and exports each having suffered a three-month retracement of a magnitude not seen outside either 2008’s global ‘sudden stop’ or the post-Reunification hangover, we’ll see the test of our thesis that the Bundesbank may soon pass from a show of Schlesinger-like sternness to its polar opposite of Welteke-like vacillation.
Curiously, this slowdown seems to be taking form despite an intensification of the Eurozone’s dysfunctional ‘biflation’, a sharp divergence in monetary trends between the core and the periphery which has seen the key aggregate grow at accelerating double digit rates in the Eastern Frankish Realm and barely growing (if not actively deflating) in the Western half of New Carolingia.
Some of this inconsistency is largely to be explained by the transfer of deposits from the PIIGS – where they run a risk, however vanishing one is meant to believe it is, of not only being lost in a local banking collapse, but of being summarily redenominated in a devalued numeraire – to the perceived safe havens of Germany, Luxembourg, Finland, and the Netherlands. When such monies come to rest in banks north and east of the Rhine, they are not immediately intended for spending on the output of the Mittelstand: their ‘velocity of circulation’ is preternaturally low, if you will.
However, that this is not the full story can be seen from the fact that, since Draghi quelled the incipient panic last summer when he issued his resounding boast to ‘do whatever it takes’, the tell-tale TARGET2 balances which reflect this twin-sided process of credit withdrawal and flight-to-quality have undergone a partial decline which we can quantify roughly either by way of the shrinkage of the joint Spanish-Italian total (or of that of its De-Fin-Nl-Lux counterpart) of some €110 billion seen between August and November. Alongside this, non-currency portion of the money supply in the former has shrunk by €6.2 billion (-1.8% annualized), while that in the latter has shot up by €77 billion (a massive 19.4% annualized which stretches to 26.0% in Germany alone).
If these funds, too, are not being spent with quite the abandon they were a few short months ago, it might be taken to indicate that conditions are worsening and sentiment darkening more drastically than the superficial optimism of the securities markets would have us infer.
The one place where things do seem to have taken a decided downward lurch is in France. After coming back broadly into balance, its T2 debits jumped back up to €43 billion in October (the last period for which the BdF has seen fit to publish its balance sheet). Alongside this, there has been a sharp, €15 billion, -10.5% annualized decline in non-currency money supply which has served to take the annual rate of change close to zero in real terms and hence very much back into the danger zone.
It can hardly be a coincidence that this mini-run occurred in the context of the spat over the possible nationalization of Arcelor Mittal’s steel works; the implosion into internecine strife of the UMP opposition; and the disarray so evident at the heart of Hollande’s administration – not least regarding the status of the soak-the-rich tax – which led to the international embarrassment of Gerard Depardieu’s very public defection to the Russians.
The country, which has seen debt/GDP jump 20 points since the crisis (and with ongoing deficits of ~€2 billion a day do add to the tally) and which has a €40-45 billion structural–looking current account gap to fill, is not entirely securely placed in the affection of the world’s investing public even if the implicit support of the rest of the European mechanism makes a full-blown flight an unlikely prospect just yet. Nonetheless, all this bears watching.
Just across the channel, the fall of the services sector PMI to a 3 1/2 –year low, coupled with a dip in the construction analogue the bottom reaches of its last two years’ range, has raised the spectre of a ‘triple dip’ recession. Notwithstanding this, the UK manages to run a record trade gap in goods, clearly in excess of £100 billion a year, leaving the overall trade deficit of £36 billion a bare £3.8 billion less deep than it was at the peak of the boom and a current account which is beginning to push into a zone which heralded the last two sterling crisis – in the mid-1970s and during the first ERM break-up.
Ironically, this has come about as the BOE’s latest efforts at QE have finally had some purchase on the nation’s stock of usable money. Between February and November last year, the Old Lady’s balance sheet expanded by £90-odd billion and money supply rebounded from its post-Crisis lows, climbing £70.6 billion at an annualized rate of no less than 10%.
Loose money, loose fiscal policy (the shortfall is still running at some £10 billion a month), low competitiveness, and a weak leadership unable to steel itself to do anything to address the issue. This all sounds horribly familiar to this particular seed of Albion.
All of which brings us to China (sigh!).
No-one can surely need to be told that the last few months have seen a modest improvement in the Middle Kingdom’s fortunes which has auspiciously coincided with the induction of the new leadership. In part, this was grounded on the usual year-end orgy of spending undisbursed government budgets, in part on the typical fourth quarter acceleration which took place in the money supply. This last quickened to a 34% annualized rate from the third quarter’s unchanged pace – impressive enough, perhaps, but still the slowest closing burst in four years. Furthermore, the volume of new loans granted – seemingly hamstrung by lacklustre deposit formation – touched a 3-year low, with the important medium-long term sub-category dipping to a 4-year nadir.
But if the banks were not officially in the game, the ‘shadow system’- including Xiao Gang’s Ponzi component – certainly came up trumps!
‘Total Social Financing’, as it is called (and less equity issuance), outstripped boring old bank loans by a factor or 1.7:1 in the final quarter of the year and constituted no less than 72% of all new credit extended in December. Compared with the same month in 2011, new, official, on-balance sheet bank loans declined 38% from CNY733 billion to CNY453 billion, while all other forms of credit rose 112% from CNY538 billion to CNY1, 139 billion.
Now some of this shift is probably not entirely a retrograde step, at least not to the extent that it represents a genuine entrepreneurial attempt to circumvent China’s antediluvian, financially-repressed, SOE-favouring, bank-coddling regulatory framework and instead tries to put people’s savings to work at a suitable rate of interest, funding genuine productive undertakings.
The problem is that some sizeable – if necessarily unquantifiable – fraction also comprises local government boondoggling, loan sharking, and outright fraud. No wonder the central authorities moved last week to clamp down on the activities of the lower tiers of government in this regard.
To put all of this in come kind of context, it looks as though every extra renminbi of incremental GDP in 2011 was ‘bought’ with around CNY1.76 in new credit: last year the ratio was 3:1. Capital efficiency, anyone?
Moreover, when we look at liquidity, matters become even more pressing. In 2011, the system was already pyramiding Y5.50 on top of every new Y1 of actual new money created (2.54:1 for the shadow component). Last year the overall ratio was 8.22:1 and the shadow one stretched to 3.87:1.
And what is all this moolah being used for? For moving away from a malinvestment-led graveyard of capital such as has been constructed over the past decade of SOE princeling dominance? It certainly doesn’t look like it.
‘Urbanization’ may be the new buzz word (and one about whose exact meaning we still maintain certain caveats), but this just means that instead of crushing returns at home and abroad (and piling up zombie loans on the books of the pliant state-owned banks) in such sectors as aluminium, steel, ship-building, photo-voltaic, etc., China now seems to wish to emulate post-bubble 1990s Japan with a whole host of non-paying propositions aimed at the domestic, rather than the international, market.
Take commercial real estate. Forced to cut back on their residential excesses, developers have been parlaying a good part of those new funds into building shopping malls wherever they can cut a deal with those paragons of municipal virtue, their buddies at the local land office. And, typically, they have not done things by halves for, as a recent press report made known, between now and 2015, if all goes according to schedule, China will add no less than 600 million square metres of mall floor space (around 120,000 football pitches’ worth). For comparison the ICSC estimate of the existing stock of US shopping malls comes in at around 650 million, around half the nations’ overall retail area.
Then there are the subways. All well and good in principle to reduce congestion, increase safety and convenience and lower logistic costs, but they are hardly going to pay even their maintenance charges, much less their construction costs if the present economics are anything to go by.
As the China Daily reported in what was – for the sensitive tenor of the times – an unusually critical article, doubts are already surfacing about the sustainability of the current programme.
Keen to spare the new bosses the loss of face of a soggy end to a soft year, in September, the NDRC suddenly approved 25 subway projects in 18 cities, for a total investment of more than CNY800 billion. Still furiously pump-priming, by November they had authorised four more cities — Beijing, Nanchang, Fuzhou, and Urumqi — to commit to plans requiring another CNY135 billion even though 35 cities had already broken ground on such projects in 2012, for an estimated ante of CNY260 billion, said the paper, citing a report of the Comprehensive Transport Research Institute of the commission.
Among the doubters, was one Wang Mengshu of the Chinese Academy of Engineering who told the interviewer that:-
A city is eligible to build subways only if it has an urban population of more than 3 million, an annual GDP that exceeds 100 billion yuan, and a local government budget higher than 10 billion yuan. In addition, the one-way traffic flow must reach 38,000 people at peak time, according to the National Development and Reform Commission…
“However, some less developed cities in inland China have manipulated the figures to meet the requirement,”he concluded.
One other thing to note is that, despite running a trade surplus of $235 billion and attracting FDI inflows of what will turn out to be around $95 billion over the 10 months since the last lunar holiday, the official count of foreign exchange reserve holdings shows zero net gain for the period. Subtracting outward FDI of an estimated $70 billion (and noting that euro and sterling parities versus the US did not undergo any significant changes in the interim), that leaves a cool $260 billion unaccounted for.
No wonder the North American and Australasian press is rife with tales of Chinese visitors getting stopped at customs for not declaring $10s of 1000s of bills stuffed into their luggage, or of their less than discreet presence at housing auctions in their destination countries. All well and good, you may say, if the external surpluses are being recycled into the hands of private individuals, rather than being directed, via purchases of government securities, to the dead hand of the state, but it nonetheless speaks volumes about how the insiders view the prospects for wealth preservation, much less further capital gain, at home.
It is presumably on such grounds as these that Bernard Connolly recently compared present day China to 1830s America – an era your author dealt with in the fifth chapter of ‘Santayana’s Revenge’. Glancing back at this today, we can see where the similarities lie: a vast orgy of infrastructure spending taking place in a wildly uncontrolled manner by eager local governments; a febrile property market in denationalized land, rampant speculation in commodities – all financed by pliable, politically-controlled banks and their shadow market counterparts.
Tick…tock… tick… tock!
So, as we started by saying, we are uneasy regarding the consensus, but, for all the whispers that the Fed is about to become a deal less accommodative—and frankly, we’ll believe it when we see it—it doesn’t look as though anyone is short of anything out at the back end, even if that bear market dog-with-fleas, the 5-year, has seen specs switch to the other side of the trade in the past few weeks That said, a number of the key interest rate charts are showing some signs of stress, with a number of trend breaks to be found here and there, not least in the US.
Hardly the calamity of 1994 as yet then, though the one area which does bear watching is the Japanese bond market.
It may be too much to hope that Abe and his coterie of economic illiterates can grasp the fact that by trying to favour his export lobby, he is raising Japanese input prices across the whole economy, and so not only potentially eroding margins but reducing real incomes and hence possibly hurting both the supply and the demand side of a system which hardly needs to be inflicted with any further disadvantages. But what he might take cognisance of is that any lack of trust he engenders in the value of both the currency and the mountain of government debt which, in the main, provides its backing—not least on the balance sheets of the banking system—might begin to cost him more than he can possibly hope to gain by stimulating ’consumption’ like the good little Keynesian he is.
Yes, the country needs, once again to re-orient itself, as it did in the wake of each of the major busts of the past 20 years. Further, it can probably not rely so heavily from here on upon supplying China’s vast, subsidized processing trade with high value-added inputs for incorporation into mass consumer products and transhipment to a West not so willing or able to indenture itself so as to buy them. This would have been the case even before the casus belli of the Diaoyu/Senkaku island dispute put business relations between the two prickly neighbours into the deep freeze. No one suggests that this will be swift or simple to effect, but given that the country has done it several times before, there is no prima facie case to suggest it will prove unable to do so again.
If Abe really wants to help, he should get someone to pull up a chart of what happened during the term of office of his predecessor Koizumi. Government shrank and a re-invigorated private sector expanded into the gap. Even if the aggregate GDP numbers recorded this as at best a minor victory, the quality of the whole was improved and hope of something greater briefly flickered into life before the experiment was prematurely abandoned.
The state and its pampered banks have everywhere reduced private initiative to near impotence, if not to outright Randian insurrection. It’s about time it quit its infernal meddling and let the wealth creators at the problem once again.
I suspect they’d be more than happy to have the opportunity to show what they can do, if asked.
Episode 73: GoldMoney’s Andy Duncan talks to Godfrey Bloom, who represents Yorkshire and North Lincolnshire in the European Parliament, and who is a member of the parliament’s Committee on Economic and Monetary Affairs. They talk about the possibility of Germany instituting a gold-backed Deutschmark, and broader issues to do with European monetary and fiscal policy.
In a recent Mises.org daily article co-authored with Patrick Barron, Mr Bloom states that Germany now has a “Golden Opportunity” to get back to sound money by pulling out of the euro and introducing a gold-backed Deutschmark. However, given the lack of a comprehensive audit, suspicions about the integrity of the German gold reserves remain. Bloom therefore advocates that Germany should repatriate its physical gold from the storage locations abroad.
They also talk about monetary policies of the European Union, the errors of European politicians and whether or not the eurozone can be sustained. In addition, they also discuss Britain’s relationship with the EU and Britain’s own precarious financial position, particularly in relation to its welfare state and deficit spending.
This podcast was recorded on 21 November 2012 and previously published at GoldMoney.com.
It might seem like yesterday to some but it was already in 2009 that politicians in Europe began to talk about ‘austerity’, a concept that quickly became the new black in European political fashion. In brief, austerity in Europe is based on the idea that the accumulated sovereign debts are now dangerously large and need to be reduced by some combination of temporary (so they claim) tax increases and spending cuts. Once the debt is reduced to a more manageable level, so the thinking goes, taxes can be cut and spending restored to the previous level.
Sounds oh-so reasonable now, doesn’t it? The problem is, however, it isn’t working. As we approach the end of 2012, in every instance of austerity being applied, economic growth is weaker and government deficits higher than projected, the result being that the accumulated debt burdens continue to grow. Indeed, they are growing more rapidly than prior to the onset of austerity!
Now one key reason for this is that, concerned about the dire state of the economies in question, the financial markets have dramatically driven up their governments’ borrowing costs. Private sector investors seem unwilling to underwrite the risk that austerity might not work. To a small extent, the European Central Bank (ECB) has stepped in to fill the funding gap, purchasing selective clips of bonds from distressed euro-area governments, but this provides only temporary support.
The simple math of the matter is that unless borrowing costs fall substantially, austerity will fail. But how to bring down borrowing costs when private investors are not convinced austerity is going to work? Why, have the ECB take a much larger role. Hence the showdown between the German Bundesbank, opposed to open-ended bank and sovereign bail-outs, and, well, just about every euro-area politician, policy maker and Eurocrat involved. Let’s briefly explore this important tangent.
AUFTRITT DER UNBEUGSAME WEIDMANN
(ENTER THE UNYIELDING WEIDMANN)
To outside observers, this situation may seem rather odd. Following the introduction of the euro, the Bundesbank ceded power over German monetary policy and, by extension of the German mark’s previous role as anchor currency, over euro-area monetary policy as well. (The Bundesbank retains an important regulatory and supervisory role with respect to German financial institutions.) So how is it, exactly, that the Bundesbank is somehow in a position to resist what has now become a near universal euro-area march toward some form of debt monetisation?
Well, as it happens, the German public hold the Bundesbank in rather high regard. Most Germans recall how the Bundesbank long presided over Europe’s largest economy, maintaining price stability and fostering a sustained relative economic outperformance. Many Germans probably recall how, on multiple occasions, the Bundesbank successfully resisted inflationary government policy initiatives. Older Germans recall how the Bundesbank contributed to the Wirtschaftswunder (economic miracle) of the 1950s and 1960s. And Germans know that the ECB was supposedly modelled on the Bundesbank and the euro on the German mark.
So when the Bundesbank speaks, Germans listen. And when the Bundesbank voices concern over ECB or German government policy, Germans become concerned. And so it is today. It has been widely reported in the German press that Bundesbank President Jens Weidmann has threatened to resign at least once in protest over potential German government participation in inflationary bail outs of distressed euro-area banks and governments. Apparently Chancellor Merkel has pleaded for Weidmann to remain at the helm and so far she has succeeded. 
But what if she should fail? What if Weidmann does indeed resign in protest at some point? His former colleagues Axel Weber and Juergen Stark have already done so (In Stark’s case, from the ECB, not the Bundesbank). What if some of his Bundesbank board colleagues join him?
I can’t emphasise this point enough: The institution of the Bundesbank is held in such high regard among the German public that should Weidmann and any portion of his colleagues resign in formal protest of bailouts in whatever form, it may well bring down the German government, throw any bailout arrangement into complete chaos, spark a huge rout in distressed euro-area sovereign and bank debt and quite possibly result in a partial or even complete breakup of the euro-area. The Bundesbank thus represents the normally unseen foundation on which the entire euro project rests. Should it remove its support, it may all come crashing down.
But why would the Bundesbank ever do such a thing? Isn’t it just a bureaucracy like any other, expected to serve the government? Well, no. Consider the unique role of the Bundesbank under German Law. It is not answerable to the government. It is its own regulator. Its board members are appointed by the president—the head of state—not the chancellor, the head of the government. Its employees are sworn to secrecy during both their active service and in retirement. The Bundesbank alone determines whether its employees have infringed its code of conduct and determines what disciplinary actions, if any, should be taken.
Weidmann’s intransigence is thus entirely in line with German law and tradition. The Bundesbank, by design, will confront the government if it believes that such action is necessary to carry out its mandate. And what is that mandate? As per the original Bundesbank Act, “The preservation of the value of German currency.” Previously the mark, the euro is now the German currency and the Bundesbank’s mandate is to preserve its value. Needless to say, open-ended bailouts of euro-area banks and sovereign countries would, without question, threaten that value.
You can be certain that when President Weidmann said earlier this year that what was being proposed by the ECB “violated its mandate,” he chose his words very, very carefully. In a subsequent speech on the same topic, he quoted from Goethe’s Faust, arguably the most famous play in German literature and a classic warning against hubris and temptation. You don’t do that if you are not deadly serious. The implication, no doubt, is that Weidmann is sending a message that the Bundesbank is independent of the ECB with respect to determining whether or not ECB policies are consistent with “the preservation of the value of German currency,” which now happens to be the euro. The Bundesbank has thus re-assumed this dormant but ultimate power over German monetary policy. Under just what circumstances it will choose to exercise it, I don’t know, but if the German and other euro-area governments continue along the road to bailouts, it will almost certainly happen at some point, presenting the greatest challenge yet to the sustainability of EMU in its current form.
WHY ‘AUSTERITY’ DOESN’T WORK
As mentioned earlier, austerity isn’t working, in many countries largely because borrowing costs are not declining. But if austerity were credible, they would. What is it about austerity as implemented that is failing to win over bond investors?
I have some ideas. First, note that, so far at least, austerity in practice is more about tax increases than spending cuts. However, the countries in question are already among the most highly taxed in the world. As Arthur Laffer and others have suggested in theory and has often been observed in practice, beyond a certain point, tax increases not only fail to generate additional revenue but actually reduce it. (It so happens that the Scandinavian debt crisis of the early 1990s was addressed not with tax increases but with tax cuts, as well as spending cuts. Rapid growth followed, although for a variety of reasons including substantial currency devaluation.)
Second, consider that the countries in question have enormous accumulated debt burdens, in some cases previously disguised and underreported. Cooking the books does not instill investor confidence. Yet paying down such a large debt mountain is going to take a long, long time. Today’s investors need to trust not only today’s politicians, but their successors down the road, to make good on promises that will remain subject to political opportunism and expedience for many years.
Third, governments may talk a good game but can they walk the walk? A close look at European ‘austerity’ legislation reveals that actual spending cuts are few and far between. What is being proposed in most cases is that the rate of spending increases declines. But an increase is still an increase and absent healthy economic growth needs to be financed with, you guessed it, more debt. Investors may want to see real rather than ‘faux’ austerity before accepting lower debt yields.
Fourth, let’s consider the possibility that what investors are really interested in is not some accounting plan that looks nice on paper, assuming governments can rein in runaway spending, but rather a more comprehensive plan that fundamentally reforms economies, making them more flexible and competitive. If growth is not to be provided by deficit spending—the traditional welfare state model—it must be provided by an unsubsidised private sector. If an economy lacks capital or skilled workers, or taxes either labour or capital at too high a rate, it is not going to be able to grow and pay down debt. Such fundamental reform remains essentially off the table in the austerity plans discussed to date.
Finally, let’s turn to a technical but extremely important point, namely, how austerity as observed in practice adds further evidence to the already substantial pile demonstrating that the dominant neo-Keynesian paradigm held by the economic policy mainstream is itself deeply flawed.
INCONVENIENT MULTIPLIER MATHS
The difficulties with austerity go beyond merely placating the bond markets. The fact is, a large debt burden is a huge economic problem. Sure it is preferable to be able to finance the debt at low rates, but if you want to pay it down you must divert resources from elsewhere. That is going to be painful at any interest rate. But such are the political pressures on the modern welfare state that the accumulation of an excessive, unserviceable debt over time is a near certainty.
Why should this be so? Well, back in the days before the modern welfare, or ‘nanny’ state, politicians didn’t pretend to have solutions for everything. If you were overweight, it was your problem. If your kids didn’t learn basic reading, writing and numeracy, at home or at school, it was their problem. With the growth of the welfare state, however, more of your problems become politicians’ problems and, by extension, those of the taxpayers who must provide the funds for the ‘solutions’.
As the tax burden grows over time, however, taxpayers gradually begin to resist tax increases. In practice, this has resulted in the welfare states steadily accumulating debt, as taxpayers have repeatedly refused to pay the high rates of tax up front to finance the welfare policies in question.
In many welfare states, the average taxpayer is a major receiver of benefits, including publicly provided heathcare and education. Taxpayers in welfare states are suffering a collective ‘tragedy of the commons’, in which each tries to extract maximum benefit for minimum cost. The result is a steadily accumulating debt, representing that portion of welfare not covered by current tax revenues.
The dangers of an accumulating debt can be disguised, however, as long as economic growth appears healthy enough to service the debt. This is where the so-called ‘multiplier’ comes in. As the debt grows, it adds to GDP growth via the multiplier effect: for each unit of deficit spending, the economy will in fact grow by some multiple of that. (This is because deficit spending creates money through borrowing that would not otherwise have been created and this new money flows out into the economy where it stimulates growth generally). This process can go on for many years, as we have seen.
The neo-Keynesian economic mainstream doesn’t see anything wrong with this in principle, as long as debts don’t become excessive relative to GDP. But welfare politics being what they are, they do. (It is a rare welfare state indeed that can rein itself in as debts swell. Indeed, the exceptions that prove the rule here are few and far between and are explained primarily by natural economic advantages.) When a welfare state finally reaches the limits of debt accumulation, as the bond markets refuse to finance any further increase in debt at serviceable rates, some form of austerity would seem to be required.
No so fast. 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 particularly, 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.
Speaking of not noticing, one could be forgiven for wondering whether this IMF paper was not in fact written with precisely this agenda, that is, to provide an expedient justification for easing off the austerity brakes for awhile. Why? Well as it happens, the IMF’s analysis is not particularly robust. First, they use a data set with a rather short history. Second, their claim to have generated robust statistical results seems questionable. How so? Well, have a look at the following chart:
Now the slope of the line through the data is meant to show the forecast error based on the old multiplier assumptions, in other words, the extent to which the IMF has got things wrong. Note Greece in the lower right corner, representing the unanticipated negative effects of a rather extreme fiscal tightening, and Germany in the upper left, representing the forecast error associated with a moderate fiscal expansion. But if you eliminate these two extreme observations from the sample—something any good statistician would do as a reality check—guess what? You are left with a statistically insignificant ‘blot’ of observations from which you can’t really conclude anything. In other words, the IMF is jumping to conclusions. Now why might that be?
I have an idea. Consider: some of the more outspoken Keynesians wasted no time touting these findings as ‘proof’ that austerity can’t work; that what is really needed is more stimulus, not less; that their arch-Keynesian views have now been vindicated!
Among this group are Paul Krugman, who never saw a stimulus he didn’t like; and former Fed economist Richard Koo of Nomura, who shows a bit more discretion in his views. But in this case they are on the same page: the IMF data are clear, unambiguous evidence, in their view, that the problems created by excessive debt are best addressed with more debt, rather than less. Logic, apparently, is mere inconvenience for those with a PhD in Keynesian economics, as are questionable, cursory statistical analyses, normally referred to pejoratively as ‘data-mining’.
MULTIPLIER REALITY CHECK
Now that we have seen how two prominent Keynesians have responded with applause to an unabashedly Keynesian-inspired IMF study, let’s step back and consider the broader implications for a moment. As is the case with many policy papers, this one is perhaps more notable for what it doesn’t say than for what it does.
Consider: even if the IMF paper is correct in its questionable statistical observations, why, exactly, might the multiplier be larger on the downside than on the upside? Could it be that the net economic benefits of borrowing and consuming through the years are more than outweighed by the eventual requirement that the accumulated debts are paid down? Could it be that borrowing and consuming your way to prosperity doesn’t actually work? Or, conversely, that good, old-fashioned saving and investing your way to prosperity does?
The IMF does not ask and thus does not even begin to answer these common-sense questions. If it did, it might come to some rather common-sense conclusions. That they just perform a data-mining exercise, apparently to serve an agenda, rather than ask and answer the real questions, is yet more evidence that the dominant neo-Keynesian paradigm is being exploited by self-serving policymakers seeking any excuse they need to keep borrowing, spending and consuming, so that the inevitable, unavoidable hard choices need not be made on their watch. Leave it rather to their successors or, better yet, the next generation, or the generation after. After all, isn’t it just human nature for parents and grandparents to expect their children and grandchildren to take care of them in their old, infirm age? In any case, it takes hard work and some sacrifice to actually provide for the next generation to have a higher standard of living. But hey, we’re rich enough as it is, aren’t we? Isn’t poverty a thing of the past? And don’t we aspire to higher things these days like economic equality, political correctness, or ‘nanny’ rules and regulations to keep us from smoking, or drinking, or gambling, or whatever other immoral, reprehensible, irresponsible behaviours? Worrying about debts and budgets is just so passé!
Well, ask the Greeks or the Spanish how they feel about political correctness these days. Or ‘nannystate’ rules on personal behaviour. Something tells me they might be rather more concerned with putting food on the table. And something tells me that the theoretical future of the welfare state, long predicted by von Hayek, von Mises, Friedman, Buchanan and other notable, non-Keynesian economists, is rapidly colliding with the actual present, in a list of countries that continues to grow.
Before we move to the next topic, some readers might be asking themselves, if neither ‘austerity’ nor stimulus is the answer, what on earth is? My answer to this question is that the ‘faux austerity’ I mentioned earlier isn’t really austerity at all. Tightening the screws on a failing welfare state without fundamental reform is not going to convince investors to hold additional debt. Corporations that are fundamentally uneconomic need to do more than cut a few costs here and there if they want to rollover their debts. They need to engage in some ‘creative destruction’ of their operations. Anything less, and bond investors will walk away and leave them to their fate.
Unfortunately, the political processes of the modern welfare state, entrenched as they are in administering entitlements of various kinds, do not lend themselves to fundamental economic reform. Thatcher’s near-bankrupt Britain is a rare exception, in which a highly charismatic politician, against all political odds, took a principled stance against the relentless growth of the welfare state and managed to slow its growth for a time. She didn’t stop it, however, something that the present British government, soon to face near-bankruptcy yet again, no doubt regrets.
While Keynesians prefer to ignore relevant examples, the fact is, real austerity is possible. Look at the Baltic States of Estonia, Latvia and Lithuania. Look at Bulgaria, or Slovakia, or Iceland. Look at South Korea, Thailand, Malaysia and other Asian countries hit hard by their collective debt crisis in the late 1990s. It can be done. But it implies real economic hardship for a period of time and it goes right to the heart of the government, which must shrink relative to the private sector. Many career politicians and bureaucrats will simply find that they are out of work and that they must seek private sector jobs, without guaranteed state pensions and other benefits, like most ordinary folks.
THE IMF RESURRECTS THE ‘CHICAGO PLAN’
The reality of contemporary welfare state politics being what it is, I would argue that there is essentially zero chance that the Keynesians in charge are going to do an about-face. Sure, they might have realised that their policies are not working, but this just means that they are going to raise the stakes. As some are now beginning to argue, there is in fact no reason to worry. Austerity might not work once you are stuck in a debt trap, but so what? What if you could just wave a magic wand and make the debt disappear? Now that would solve all our problems, wouldn’t it?
We know intuitively that this is nonsense. But just because something is nonsense doesn’t stop policymakers from spouting it when expedient. As I wrote in an Amphora Report back in 2010, as the euro-area debt crisis was escalating:
Just as there is no free lunch in economics generally, there is no magic wand in economic policy. Policymakers who claim otherwise are like magicians distracting their audience. As is the case in the physical world, in which there is conservation of energy–the first law of thermodynamics–there is also conservation of economic risk. It cannot be eliminated by waving a magic wand. It can, however, be transformed from one type of risk to another.
As it happens, such sleight-of-hand risk transfer forms the core of the sophistic argument put forth in a superficially scholarly paper published recently by the IMF. The authors, Jaromir Benes and Michael Kumhof, resurrect the long-forgotten ‘Chicago Plan’ of the 1930s, first proposed by Irving Fisher, an early exponent of the Monetarist economic school associated with the University of Chicago. In brief, the Chicago Plan proposes changing the nature of money and money creation in the economy from a nominally private-sector affair, in which commercial banks serve as the engines of money growth, to an exclusively public sector one. Somehow, replacing private sector assets and liabilities with public sector ones is supposed to reduce or eliminate the various problems associated with the current system, in which money creation is supposedly a ‘private’ affair.
While I could have a go at pointing out in detail just how hideously flawed this paper is, fortunately I don’t need to. My friend and fellow financial writer Detlev Schlichter recently penned a devastating critique and I highly recommend reading it in its entirety. For our purposes here, a few particularly relevant quotes follow:
[T]he paper sets up an entirely new and I believe bogus problem based on the premise that in our monetary system money is supposedly provided ‘privately’, that is, by ‘private’ banks, and ‘state-issued’ money only plays a minor role. From this rather confused observation, the paper derives its key allegation that ‘state-issued money’ ensures stability, while ‘privately-issued money’ leads to instability. This claim is not supported by economic theory… Monetary theory does not distinguish between ‘state-controlled money’ and ‘privately produced’ money, it is a nonsensical distinction for any monetary theorist. An attempt to give credence to this distinction and its alleged importance is made in a later chapter in the Benes/Kumhof paper but, tellingly, this attempt is not based on monetary theory but on an ambitious, if not to say bizarre, re-writing of the historical record.
Detlev then goes on to point out precisely why this ‘public’ vs ‘private’ money distinction is all but meaningless not only in theory but in practice:
In recent decades, the global banking system found itself on numerous occasions in a position in which it felt that it had taken on too much financial risk and that a deleveraging and a shrinking of its balance sheet was advisable. I would suggest that this was the case in 1987, 1992/3, 1998, 2001/2, and certainly 2007/8. Yet, on each of these occasions, the broader economic fallout from such a de-risking strategy was deemed unwanted or even unacceptable for political reasons, and the central banks offered ample new bank reserves at very low cost in order to discourage money contraction and encourage further money expansion, i.e. additional fractional-reserve banking. It is any wonder that banks continued to produce vast amounts of deposit money – profitably, of course? Can the result really be blamed on ‘private’ initiative?
To answer Detlev’s rhetorical question: of course not! Just because commercial banks are legally private entities does not in any way imply that they are not de facto agencies of the government. Fannie Mae and Freddie Mac were private sector entities too, prior to being placed into official government ‘conservatorship’, albeit ones engaged in even narrower, more heavily regulated activities than ordinary commercial banks.
Perhaps the best way to think about how banking institutions have operated in recent decades is as private utility companies, with their activities heavily regulated and subsidised by the central bank and a handful of government agencies. Or, to use another industry as an example, consider defence contractors. Sure, they might be private firms in the legal sense, but the business in which they are engaged—defence—is so intertwined with the activities of government that it is essentially impossible to distinguish just where the public role ends and the private role begins.
No doubt the legal grey area that exists between public and private activities in any industry is fertile ground for corruption and abuse. In finance, however, this grey area reaches right into the heart of the money and credit creation process and, thereby, has an insidious if largely unseen impact on the entire economy. To blame ‘private sector’ money and credit growth for the mess we are in, as Messrs Benes and Kumhof do in their paper, demonstrates either colossal ignorance or disingenuousness. I leave it to the reader to decide which.
MONETISATION BY ANY OTHER NAME
If while reading the above you thought that what in effect is being proposed is a massive monetisation of debt, you are right. That is exactly what it is. All but the most radical of Keynesian economists, however, refrain from using the ‘m’ word. They prefer wonkish terms like ‘quantitative easing’ for example. Or, when there is natural downward pressure on prices, they say extreme measures are called for due to ‘inflation targeting’. When they get really desperate, they do occasionally refer to things like the ‘printing press’ or even ‘helicopters’, but somehow the ‘m’ word is something only ever contemplated by two-bit dictators, be they fascist, communist or some combination of the two. After all, monetisation is blatant, in-your-face wealth confiscation from private sector savers to public and financial sector borrowers. Modern, enlightened welfare state democracies would never contemplate such a thing now, would they?
Perhaps this is one reason why the German Weimar hyperinflation is regarded with such horror in the modern economics profession, even though it is but one of many fiat money hyperinflations of the past century. How could a reasonably free and open democracy—indeed, the one in which the idea for the modern welfare state originated—possibly resort to monetisation to solve its excessive debt problem, a legacy of WWI? How irresponsible! Had they just done as Krugman, Koo or other modern Keynesians recommend, and stuck to QE and double-digit fiscal deficits, why, they would have been just fine!
Yes, I’m being faceitious yet again. But come on folks, the idea that somehow, by calling ‘monetisation’ something else makes it so, is just another example of the intellectual sophistry being practiced at the IMF and elsewhere in Keynesian policy circles. They are playing a semantics game while trying desperately to get governments the world over to get on with outright debt monetisation, assuming that this would never morph into a hyperinflation or other such economic calamity.
Ah, but it might. Sorry to sound alarmist, but at some point it might. Reality is a harsh mistress. The future has a way of arriving now and again, sometimes when you least expect it. Responsible folks need to take a sober look at the road we are on. Ignore the can being kicked along the road and focus instead on where the road leads. In this case, it leads to some combination of currency debasement, devaluation and debt default (with the latter substantially less likely, in my opinion, although I would not rule it out in certain cases). It might, just might, lead to a hyperinflation.
So what is a defensive investor, interested primarily in wealth preservation, to do? My advice in this matter has changed little since the first Amphora Report went out in early 2010. Diversify out of financial and into real assets that cannot be debased, devalued or defaulted on. Within financial assets, overweight income-generating stocks in industries with pricing power, that is, those more easily able to pass cost increases through to consumers. Within real assets, acquire some physical, allocated gold and silver but note that these are already trading somewhat expensive relative to most other commodities.
One important lesson of the Great Depression and other periods of severe economic deleveraging is that the prices of less fashionable commodities such as agricultural products can become extremely depressed from time to time and that they tend to outperform precious metals once they cheapen (in relative terms) to a certain point. I would argue that we are at or near that point already.
The Amphora mantra has always been and remains to diversify. Diversification is the only ‘free-lunch’ in economics, frequent Keynesian claims to the contrary notwithstanding, and it is the best form of financial insurance there is. Better than gold. Better than silver, or any single commodity. Better than any one stock, or stock market for that matter. Better than any one bond market, or any one currency. In a world of not just known unknowns, but even unknown unknowns, it would be imprudent to place any number of eggs in just one basket. Even golden ones.
 ECB President Mario Draghi affirmed this policy at today’s monthly ECB press conference and also suggested strongly that the ECB is likely to purchase substantially more debt in future.
 Among other German publications, Der Spiegel reported on this. The link to the article is here.
 Weidmann’s specific words, in German, for those interested, were the following: “Die Bundesbank steht hinter dem Euro. Und gerade deshalb setzen wir uns mit Verve dafür ein, dass der Euro eine stabile Währung bleibt und die Währungsunion eine Stabilitätsunion. Es gibt verschiedene Wege, dieses Ziel zu erreichen. Sicherlich nicht erreichen werden wir dieses Ziel aber, wenn die europäische Geldpolitik in zunehmendem Maße für Zwecke eingespannt wird, die ihrem Mandat nicht entsprechen. The link to this speech is here. His reference in a subsequent speech to Goethe’s Faust can be found at the link here.
 Those welfare states with manageable debt burdens tend to be endowed with plentiful natural resources, such as Norway, Sweden Finland, or Canada, for example. This makes them natural exporters and enables them to finance a certain degree of domestic welfare without resorting to chronic debt accumulation.
 The IMF World Economic Outlook can be found here.
 For more on the concept of a ‘debt trap’, please see “Caught in a Debt Trap”, Amphora Report vol 3 (July 2012). The link is here.
 I have written at length about the critical yet commonly overlooked role that Schumpeterian ‘creative destruction’ plays in a healthy economy. For a recent example, please see “Why Banktuptcy is the New Black,” Amphora Report vol. 3 (April 2012). The link is here.
 “There May Be No Free Lunch, but Is There a Magic Wand?” Amphora Report vol. 1 (September 2010). The link is here.
 The entire paper, The Chicago Plan Revisited, can be found on the IMF’s website here.
 Detlev’s paper is posted to his blog, linked here. I also highly recommend Detlev’s book, Paper Money Collapse, details of which you can also find on his blog.
 For those curious, German chancellor Bismarck introduced the first European pay-as-you-go state pension in the 19th century. It has served as the original model for state pensions subsequently introduced in most of Europe and North America. Germany was also an early adopter of compulsory public education.
 You can find the inaugural Amphora Report here.
Currently serving as the Chief Investment Officer of a commodities
fund, John was previously Managing Director and Head of the Index Strategies Group at Deutsche Bank in London, where he was responsible for the development and marketing of proprietary, systematic quantitative strategies for global interest rate markets.
A cum laude graduate of Occidental College in California, John holds a Masters Degree in International Finance and Economics from the Fletcher School of Law and Diplomacy, associated with Harvard and Tufts Universities.
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13 November 12 | Tags: Bundesbank, Chicago Plan, ECB, Euro, Hyperinflation, Inflation, Irving Fisher, Keynesianism, Laffer Curve, Richard Koo, Sovereign Debt | Category: Economics | One comment
“Giarre, a town in eastern Sicily, sits above the sea on the slopes of Mount Etna. It was once a collection point for the wine produced on the hills above, which was rolled down its main street in barrels to the port below. Today, Giarre bears a far more dubious distinction. The city of 27,000 hosts the largest number of uncompleted public projects in the country: 25 of them, nearly one for every 1,000 inhabitants. So spectacular is the waste that some locals have proposed promoting Giarre’s excess as a tourist attraction.
On an afternoon in September, I toured some of Giarre’s most notorious eyesores with Turi Caggegi, a journalist who has been writing about government waste since the 1990s. Caggegi showed off a partly built, graffiti-covered theater where work has started and stopped 12 times. It has yet to host a show. Not far away stood a hospital that took 30 years to build and was outdated before it was ready to open. Later, Caggegi drove past an Olympic-size swimming pool that was sunk but never completed. “So much money wasted,” he said. “And it wasn’t that they were spending it on productive investments. They were buying votes.
In 2011 the Sicilian regional government ran a €5.3 billion ($6.8 billion) deficit on a €27 billion ($34.8 billion) budget. This year, with the island’s credit rating hovering just above junk status and Italian Prime Minister Mario Monti cutting subsidies to the regions in an effort to shore up the national budget, Sicily has reached the breaking point.
“Bread and circuses,” said Caggegi. “That’s what the Romans used to say.” Italians are discovering what happens when the bread runs out.””
“Riot police were out in force in Tehran’s main squares yesterday as merchants kept their shops shut in protest at the falling rial, despite threats of prosecution.. The rial has fallen 30 percent in the past week, raising questions about Iran’s economic health in the face of tightening international sanctions. Wednesday’s strike by bazaar merchants in the capital, accompanied by unexpected protests by currency traders, led to clashes between riot police and demonstrators..”
– From the Financial Times, ‘Iran riot police on alert as merchants step up protest’, 5.10.2012.
That roaring sound you hear is the noise of chickens coming home to roost across the western world. We have had four decades since President Nixon took the US dollar off gold in 1971, during which time our politicians have happily promised us the earth and made up for the inevitable shortfall by borrowing from the bond markets, and therefore from the future. But even governments cannot live beyond their (taxpayers’) means indefinitely. As the likes of Greece and Sicily are now discovering, the future has caught up with us.
There is a thesis, with which we agree, that suggests that the world now requires constant economic growth solely to service its mountain of outstanding debts. So what happens when that constant economic growth starts to turn into a synchronised slowdown – or worse? So far, with private sector borrowers furiously deleveraging (even at near zero interest rates: NOBODY WANTS TO BORROW – see Japan, last 20 years), the major central banks have aggressively taken the other side of the trade, and pumped money into the banks through the magical money-creation Ponzi scheme known as quantitative easing. The banks aren’t particularly keen on lending it out. That may be because they’re predominantly insolvent, but let’s not go there. So we have a stand-off, of sorts. On the one hand, individuals and corporates, having binged on easy credit for far too long, are now mostly sickened by the stuff. On the other hand, central bank governors don’t want to take the credit for Great Depression II. They’ll get it anyway, because the markets cannot be fooled indefinitely either. Meanwhile, the price signals that would ordinarily be a guide to entrepreneurs and other risk-takers are being hopelessly distorted by money-printing.
One side-effect of QE is that increasingly dangerous sovereign debt (as a shorthand: G7 government debt) optically resembles high quality debt in that the miserly yields available seem to reflect some form of ‘flight to quality’. What those miserly yields actually reflect is financial repression – namely that the government and its regulators are effectively forcing captive investors (not least pension funds) to invest almost exclusively in this garbage. In the process, by happy coincidence, heavily indebted governments are able to fund themselves. The private sector has a word for this policy: extortion.
Another side-effect of QE is that the perception of value in the variously affected currencies swings even more wildly than usual. Somebody intelligent once wrote that paper currencies don’t float, they just sink against each other at different rates. Since 1971 this has undoubtedly been the case. But since the Fed and the ECB went all-in in their pursuit of QE ad absurdum, the risk of disorderly currency collapse has risen markedly.
Don’t just take our word for it. CLSA’s Christopher Wood in his recent ‘Greed and Fear’ commentary writes as follows:
While the central banks have undoubtedly bought some time by creating the newsflow to allow most world stock markets to rally last quarter after the Eurozone-driven risk-aversion seen in the previous quarter, the decision by the Fed to adopt “open-ended” QE, and the overwhelming reaction of the investor consensus to support that decision, has re-enforced the base case long argued by Greed & Fear. That is that the “capitalist” world is on the path to the collapse of the fiat paper system. For once the “open-ended” principle is established, as it now has been, it can be expanded ad infinitum.
..the game will be up when investors cease viewing the relevant sovereign bond as a safe haven and that government bond yields spike as a result of supply concerns. At the point when such turmoil hits the reserve currency of the world, namely the US dollar and its government bond market, quantitative easing will be discredited, and most likely the modern fiat paper monetary system along with it, as well as of course monetarist and Keynesian orthodoxies.
Nor is Christopher Wood alone in a financial wilderness in this bleak prognosis. SocGen’s Dylan Grice in last week’s ‘Popular Delusions’ commentary cited Bernd Widdig and his analysis of Germany’s inflation crisis (‘Culture and Inflation in Weimar Germany’):
Next to language, money is the most important medium through which modern societies communicate.
As Dylan Grice indicates,
His may be an abstract observation, but it has the commendable merit of being true.. all economic activity requires the cooperation of strangers and therefore, a degree of trust between cooperating strangers. Since money is the agent of such mutual trust, debasing money implies debasing the trust upon which social cohesion rests.
And he adds,
I feel queasy about the enthusiasm with which our wise economists play games with something about which we have such a poor understanding.
For students of markets and economics this recalls a quotation by Keynes himself:
But to-day we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time — perhaps for a long time.
Keynes also once wrote that he worked for a government he despised for ends he considered criminal. We would adopt that phrase and direct it to the leading neo-Keynesian economists – overzealous believers in a false science – who are even now leading the delicate mechanism of the western economies into a fatal experiment with unsound money, egged on by bankers whose ethical compass has already been shown to be hopelessly compromised.
Today the currency of Iran. Tomorrow ..?
This argument happens to transcend the mundane and partially subjective business of shepherding pounds, shillings and pence to the safest havens; it touches on issues of fundamental morality. If we are debating with the ignorant, ignorance can ultimately be addressed, given an open mind. If we are debating with the profoundly stupid, that stupidity may admittedly be a barrier to full resolution of the debate. But if we are debating with people who are going to do harm, whether deliberately or inadvertently, the debate should be conducted at the fullest volume and with the widest number of engaged participants.
“I believe in an America where millions of Americans believe in an America that’s the America millions of Americans believe in. That’s the America I love.”
– US Presidential Candidate Mitt Romney.
Never try to teach a pig to sing, advised Robert Heinlein. It wastes your time and it annoys the pig. We try to shy away from overmuch coverage of politics in this commentary for similar reasons – it’s probably a waste of time, and many readers hate it. But trying to avoid politics in the financial world is easier said than done. Five years of enduring crisis have gifted more and more power both to the politicians whose easy spending helped cause the crisis, and to their appointees in central banks who have run out of conventional policy options and are now busily stacking up unintended but nevertheless vast and intractable problems for the future. Market prices are no longer determined by the considered assessment of independent investors acting rationally (if indeed they ever were), but simply by expectations of further monetary stimulus. So far, those expectations have not been disappointed. The Fed, the ECB and lately even the BoJ have gone “all-in” in their fight to ensure that after a grotesque explosion in credit, insolvent governments and private sector banks will be defended to the very last taxpayer.
Mitt Romney was widely derided as having “gaffed” when he spoke of the now infamous 47%
who are with [the President], who are dependent upon government, who believe that they are victims, who believe the government has a responsibility to care for them, who believe that they are entitled to healthcare, to food, to housing, to you-name-it. That that’s an entitlement. And the government should give it to them.
Romney may have been “inelegant” in his choice of words. But at least he had the guts to voice what many silent millions must surely be thinking across the ailing western economies. It takes many things to bring errant government finances under control. Simply pledging to squeeze the rich (and casually conflating tax avoidance – which is legal – with tax evasion – which isn’t) is an aggravating diversion for wealthier voters. As any hole-digger knows, the very first policy response on recognition of the hole should be to stop digging. For a heavily indebted government, the equivalent of stopping digging is cutting spending. And yet we have a coalition government allegedly focused on austerity and deficit reduction which is content, for example, to keep giving hundreds of millions of pounds of development aid to wealthy countries.
Just as government-led austerity is something of a myth in the UK, deleveraging would seem to be a myth of comparable standing in the US. The consistently excellent Doug Noland points out the absurdity of the US deleveraging myth:
US non-financial credit market debt grew by 5% in the second quarter, its strongest expansion since Q4 2008;
Corporate credit market borrowing grew by 6.9%;
Consumer credit grew by 6.2%;
Federal borrowing grew by 10.9%;
While household debt has declined by $800 billion since the end of 2007, to $13.5 trillion, federal debt has expanded by more than seven times that decline: total non-financial debt ended Q2 at a record $38.9 trillion, having expanded by $6.5 trillion over 16 quarters;
As a percentage of GDP, total non-financial debt has grown from 124% of GDP in June 2008 to 249% of GDP as at the end of the second quarter.
As Noland suggests, a genuine deleveraging would see price levels and market-based incentives adjust across the economy in a manner that would support business investment. Genuine deleveraging would see a change in economic emphasis from credit-fuelled consumption towards savings and productive investment. Central bankers, on the other hand, having driven interest rates to the zero bound, seem determined to destroy savers. Genuine deleveraging would see a meaningful reduction in non-productive debt. Genuine deleveraging would see market prices determined by fundamental forces and not by government intervention, manipulation and inflationism. Instead, we get a profound form of ‘mission creep’ by central banks like the Fed, which in the words of veteran analyst Jim Grant has evolved well beyond its origins as a lender of last resort and not much else, and now is fully engaged in
the business of steering, guiding, directing, manipulating the economy, financial markets, the yield curve; it manipulates and pegs interest rates – it is all over the joint, doing what so signally failed in the old eastern bloc.
And so it is that the government agencies that have given themselves the mission of economic oversight are now working to destroy the very same economies they are nominally tasked with protecting. It is a wholly specious argument to suggest that the creation of trillions of dollars / pounds / euros / yen out of thin air will not ultimately be inflationary; like saying that storing an infinite amount of tinder next to an open flame does not constitute a fire hazard. Admittedly, the explicit inflationary impact of historically unmatched monetary stimulus will not be fully visible until those trillions are circulating in the economy in private exchanges between buyers and sellers – rather than squatting ineffectively in insolvent banks’ reserves. But financial markets are nothing if not capable of anticipating future trends. Investors, traders, speculators – call them what you will – are already weighing up the probability of a reduction in future purchasing power driven by open- ended commitments to money printing today, and the prices of alternative money such as gold and silver, as denominated in unbacked fiat currency, are already responding.
Financial repression, of course, is all about wealth transfer. Inflationism is the textbook response to a crisis of too much debt (even if you were the over-borrowed entity that triggered the crisis in the first place). Many constituents (pensioners in traditional schemes and on fixed incomes, annuity holders, depositors) will be more or less powerless to avoid the looming inflationary wave. But it is not too late for savers and investors less constrained by circumstance. Brent Johnson of Santiago Capital has a nice line in telling it how it is. With one eye on ‘The Usual Suspects’ he indicates that
the greatest trick central bankers ever pulled was convincing the world that they work for the public and not for the banks.
His advice, which we fully endorse, is to move away from the realm of paper assets and towards the world of real ones. Anticipating that inflationary tsunami is not a precise science because market confidence in intangible paper currency does not persist in a linear fashion. It lasts until it doesn’t last any more, and then it runs the risk of shattering instantaneously, along with faith in most G7 government debt. Like Hemingway’s bankrupt we go broke slowly, and then all at once. But one of the most grotesque ironies of our time is that the asset class that is objectively the least attractive as well as the proximate cause of the world’s financial problems – western market government debt – is also the most expensive. Just because sheep-like bond fund managers are providing a real time lesson in the perils of agency risk does not mean we have to follow them down the primrose path. Cash, most forms of bonds, and fixed annuities all look like poor prospects for the years ahead. Productive real estate, defensive equities of businesses with pricing power, gold and silver all look like better alternatives.
The last Fed chairman with the guts to do the right thing for the economy rather than just its banks, Paul Volcker, has rightly observed that “monetary policy is about as easy as it can get”. Another round of QE “will fail to fix the problem”. That is in part because the Fed, along with its international peer group, now is the problem. The sooner voters come to appreciate the dangers inherent in modern central banking and its unlimited powers to manipulate the financial system, the better. Are there any politicians out there who can rise to the challenge?