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?
Two Bloomberg correspondents reported on August 8 that the US Government’s unfunded liabilities rose by $11 trillion last year, “ten times larger than the official deficit”, and are now at an estimated $222 trillion. The authors base their estimates on figures supplied by the Congressional Budget Office. This makes talk about the “fiscal cliff”, as the Bush tax cuts come to an end, a secondary issue. Meanwhile in Germany the Constitutional Court will be told on 12 September that the bailout costs faced by Germany are €2 trillion with a further €1.7 trillion in the pipeline, compared with only €170 billion a year ago.
In contrast with these accelerating deficits, the gold price has fallen from over $1,900 to recent lows under $1,600. Admittedly this move has been accompanied by growing apathy in the market, matched perhaps by complacency in bond markets over the state of the government finances quoted above. Furthermore similar budgetary problems, particularly those welfare-related, afflict all advanced economies. And these liabilities are not just rising; they are accelerating and are unlikely to remain hidden for much longer.
While the general public is aware that the eurozone, for example, has difficulties and that world economic conditions are far from blissful, it is unaware of the enormous scale of the global sovereign debt crisis. Even economists who should know better ignore it; however, they are gradually beginning to realise, contrary to what their text-books tell them, that stuffing new money into an economy is not leading to recovery and underwriting future tax revenues. This being the case, unfunded liabilities will emerge at the same time tax revenues diminish.
Waking up to this reality will create its own financial shock, made worse perhaps because it has been the intention of governments to hide the truth. They have pursued this deception with zero interest rates, which have artificially cut the cost of government borrowing and kept stock markets from falling. At the same time they have fostered the myth that government spending can make a positive difference to the economic outcome. Contrast this with Spain and Italy, who are unable to conceal their financial difficulties any longer. Their problems are a foretaste for what the rest of us will eventually face.
Do recent stirrings in precious metal prices indicate an end to this complacency, or is it just a speculative bounce? Time will tell, but given the rapid deterioration of government finances, gold and silver have been left a long way behind. But summer’s lease hath all too short a date. In the next few months we will think less about outdoor activities and more about what’s ahead of us. Some of our future pre-occupations are easy to anticipate, such as the growing risk of the eurozone disintegrating. Others are less visible, but could this winter see us waking up to the consequences of governments’ off-balance sheet liabilities turning into actual deficits?
If this is the case gold and silver – having dallied for a year – have a lot of catching up to do, and the recent rise should be the start of a major move upwards.
“Toby Baxendale is an entrepreneur who built up, amongst other things, the UK's largest fresh fish supplier to the Food Service sector, see www.directseafoods.co.uk, and recently sold it. Toby is dedicated to furthering the teaching of the Austrian school of economics. He established and funded the 1st Distinguished Hayek Visiting Teaching Fellowship Program at the LSE in Honour of the Nobel Laureate F A Hayek. Toby is Chairman of The Cobden Centre. Richard Cobden's timeless principles of the abolition of legal privilege of the few at the expense of the many are worthy in this day and age to promote. | Contact us
12 August 12 | Tags: Keynesianism, Sovereign Debt | Category: Economics | Leave a comment
Economists and journalists often point to the danger of external public debts — in contrast to internal debts, which are regarded as less troublesome. Japan is a case in point. Japan has an enormous public-debt-to-GDP ratio of more than 200 percent. It is argued that the high ratio is not a problem, because the Japanese save a lot and government bonds are held mostly by Japanese citizens; it is internal debt.
In contrast, Spain with a much lower public-debt-to-GDP ratio (expected to be at 80 percent at the end of this year) is regarded as more unstable by many investors. One reason given for the Spanish fragility is that about half of Spanish government bonds are held by foreigners.
At first sight, one may doubt this line of reasoning. In fact, as an individual living in Spain, I do not care if I get a loan from a Spanish or a German friend. Why would the Spanish government be different? Why care if loans come from Spaniards or from Germans?
Governments are ultimately based on physical violence or the threat of physical violence. The state is the monopolist of violence in a given territory. And in violence lies the difference. Internally held debts generate income for citizens, which can be taxed by the threat of violence. This implies that part of the interest paid on internal debt flows back to the government through taxes. Interest paid on external debt, in contrast, is taxed by foreign countries.
There is another, even more compelling, reason why the monopoly of violence is important: I can force neither my Spanish nor my German friend to roll over his loan to me when it comes due. While the government cannot force individuals outside its territory to roll over loans, it can force citizens and institutions within its jurisdiction to do so. In a more subtle form, governments can pressure their traditional financiers, the banks, to roll over public debts.
Banks and governments live in a relationship akin to a symbiosis. Governments have granted banks the privilege to hold fractional reserve and have given them implicit and explicit bailout guarantees. Further support is provided through a government’s controlled central bank, which may help out in times of liquidity problems. In addition, governments control the banking system through a myriad of regulations. In return for the privilege to create money out of thin air, banks use this power to finance governments buying their bonds.
Due to this intensive relationship and the government’s monopoly of violence, the Japanese government can pressure its banks to roll over outstanding debt. It can also pressure them to abstain from abrupt selling and encourage them to take even more debt onto their books. Yet the Japanese government cannot force foreigners to abstain from selling its debt or to accumulate more of it. Here lies the danger for governments with external public debts such as the Spanish one.
While Spanish banks and investment funds will not flush the market with Spanish government bonds, foreign institutions may well do so. The Spanish government cannot “persuade” or force them not to do so as they are located in other jurisdictions. The only thing that the Spanish government can do — and the peripheral governments are actually doing — is to pressure politicians in fellow countries to pressure their own banks to keep bonds on their books and roll them over.
External public debts also pose a danger for the US government. Foreign central banks such as the Bank of China or the Bank of Japan hold important sums of US government bonds. The threat, credible or not, to throw these bonds on the market may give their governments, especially the Chinese one, some political leverage.
What about a Trade Deficit?
In regard to the stability of a currency or the sustainability of government debts, the balance of trade (the difference between exports and imports of goods and services) is also important.
An export surplus (abstracting from factor income and transfer payments) implies that a country accumulates foreign assets. As foreign assets are accumulated, the currency tends to be stronger. Foreign assets can be used in times of crisis to pay for damages. Japan again is a case in point. After the earthquake in March 2011, foreign assets were repatriated into Japan, paying for necessary imports. Japanese citizens sold their dollars and euros to repair damage at home. There was no need to ask for loans denominated in foreign currencies, thereby putting pressure on the yen.
Japan’s export surpluses manifest themselves also on the balance sheet of the Bank of Japan. The Bank of Japan has bought foreign currencies from Japanese exporters. These reserves could be used in a crisis situation to reduce public debts or defend the value of the currency on foreign exchange markets. In fact, the net level of Japan’s public debts falls 20 percent taking into account the foreign exchange reserve holdings of the Bank of Japan (over $1 trillion). Thus, export surpluses tend to strengthen a currency and the sustainability of public debts.
On the contrary, import surpluses (abstracting from factor income or transfers) result in net foreign debts. More goods are imported than exported. The difference is paid for by new debts. These debts are often held in the form of government bonds. A country with years of import deficits is likely to be exposed to large holdings of external public debts that may pose problems for the government in the future as we have discussed above.
The balance of trade may also be an indicator for the competitiveness of an economy, and, indirectly, for the quality of a currency. The more competitive an economy, the more likely the government can support its fiat currency by expropriating the real wealth created by this competitive economy and will not get into public-debt problems. Further, the more competitive the economy, the less likely that public-debt problems are solved by the production of money.
While an export surplus is a sign of competitiveness, an import surplus may be a sign of a lack thereof. Indeed, long-lasting import deficits may be the sign of a lack of competitiveness, and often go hand in hand with high public debts, exacerbating the lack of competitiveness.
Economies with high and inflexible wages — as in southern Europe — may be uncompetitive, running a trade deficit. The uncompetitiveness is maintained and made possible by high government spending. Southern eurozone governments hired people into huge public sectors, arranged generous and early retirement schemes, and offered unemployment subsidies, thereby alleviating the consequence of the unemployment caused by inflexible labor markets. The result of the government spending was therefore not only a lack of competitiveness and a trade deficit but also a government deficit. Therefore, large trade and government deficits often go hand in hand.
In the European periphery, imports were paid with loans. The import surplus cannot go on forever, as public debts would rise forever. A situation of persisting import surpluses such as in Greece can be interpreted as a lack of political will to reform labor markets and to regain competitiveness. Therefore, persisting import surpluses may cause a currency or public-debt sell-off. In this sense, the German export surplus supports the value of the euro, while the periphery’s import surplus dilutes its value.
In sum, high public (external) debts and persisting import surpluses are signs of a weak currency. The government may well have to default or to print its way out of its problems. Low public (external) debts and persisting export surpluses, in contrast, strengthen a currency.
 Another important reason is that the Spanish government cannot use the printing press at its will, because it is shared by other Eurozone governments that might protest. Japan, however, controlls its central bank and thereby the printing press.
 It should be noted that ever more new Spanish debt is held exclusively by Spanish banks, because other investors are progressively less interested in financing a government that simply refuses to enact real and effective austerity measures.
This article was previously published at Mises.org.
Throughout the European debt crises, Germany and its allies in the austerity camp have been urged by financial commentators, particularly in the United Kingdom and the United States, to show more “flexibility” to help the high-debt countries in the periphery of the single currency union.
Such flexibility first took the form of a bailout for Greece when it teetered on the brink of sovereign default in 2010. When that failed to stem the crisis, European leaders were urged to create a bailout fund for in case other nations would find it difficult to borrow on financial markets as well. They did. Ireland and Portugal subsequently tapped into that bailout fund, the European Financial Stability Facility.
When that failed to stem the crisis, the prevailing wisdom became that the bailout fund was too small and only temporary, raising concern about Germany’s willingness to bankroll peripheral eurozone nations in the long term. So Europe’s leaders devised a bigger, permanent bailout fund, the European Stability Mechanism.
Yet the crisis goes on and the new solution floated by commentators is the pooling of sovereign debt in the eurozone in the form of eurobonds. As with the Greek bailout and the erection of the bailout funds, Germany is hesitant. It fears that financial support for troubled eurozone economies removes the incentive on their part to improve their competitiveness relative to stronger European economies which Germany sees as the way to ensure long term stability in the euro area.
Moreover, there has been growing weariness in core eurozone countries like Germany and the Netherlands to bailing out weaker euro states. The political leaders of these countries can ill afford electorally to advance schemes for further European integration, which is increasingly unpopular.
This has been seized upon by those favouring, for instance, eurobonds as proof that their solutions to Europe’s debt woes are perfectly valid. The only reason they aren’t implemented—even if, so far, they usually have been, only maybe not very fast—is that Europe’s leaders are afraid of their voters who stop them from doing what’s right.
It turns out, the proponents of further European integration are quite afraid of the European electorate as well. Writes Martin Wolf, the Financial Times‘ chief economics commentator, in a recent blog post:
I fear that austerity without end will bring about a return to the unstable populist politics the European Union was designed to prevent. That could shatter the eurozone and, with it, the EU, thereby ending the most successful attempt to build peace and prosperity in Europe since the fall of the Roman Empire.
Wolf even invokes the rise of Adolf Hitler which he claims had nothing to do with hyperinflation during the Weimar Republic but was entirely due to the economic hardships of the 1930s Depression. “Deep economic collapses are dangerous.”
Indeed they are, as they often lead policy makers to experiment with unconventional economic policies because they haven’t the patience to let the market correct itself, which is exactly what should have happened after the credit crunch of 2008. Instead, by repeated government interventions in the private economy, the recession has been prolonged and the sort of creative destruction that has to take place before there can be a true and sustainable recovery has not been allowed to occur.
Notice the panic that arises whenever a single bank is about to go under. Tens of billions of euros doled out to Spain so the country can save its troubled banks. There can be no failures because the financial industry is so interconnected — it is feared that the collapse of one bank will drag others down with it, resulting in widespread financial panic.
So we have malaise instead until Germany pulls out the “bazooka” and makes clear that it will pay everyone’s bills. That is what Wolf means when he writes that “the creditworthy country has to lend freely if a fixed exchange rate system (or in this case a currency union) is to survive.”
If Chancellor Angela Merkel announces next week that she wants to quadruple the bailout fund, that she’s willing to underwrite every bad loan both German and peripheral banks ever made, will it end the crisis?
Maybe. Or maybe markets will come to their senses soon thereafter and wonder whether the German voters wouldn’t tear up such a commitment in the next election?
Maybe they’ll even realize that it doesn’t matter as long as Greece, Italy and Spain don’t change their ways and implement the sort of regulatory, labour market and entitlement reforms that are needed to move their economies away from clientalism and protectionism toward entrepreneurship and free trade.
Wolf doesn’t seem to particularly care about the longer term imperatives. He ominously writes of “populist politics” unless a short term solution is found. Without one, he believes, “the eurozone may never reach the long term”. It’s not so much an argument as it is a threat — integrate now or the “populists” win!
In fact, the push for European integration in spite of the clear wishes of voters in core eurozone countries is exactly what fuels the anti-European sentiment that Wolf despises.
But what’s more concerning is that Wolf apparently seeks deeper European integration for political reasons, not economic ones. Which raises the question: does he want want an even bigger bailout fund, does he want eurobonds and does he want to keep the euro together because it makes economic sense for Germany and the other countries in the euro, or because he wants this political project to succeed?