Who made this very sound statement two years ago in relation to QE I?
The last resort of desperate governments when all other policies have failed
Answer: George Osborne, our Chancellor.
Sometime soon it will have to stop because in the end printing money leads to inflation.
Answer: our Prime Minister.
Both of these statements were made in 2009 when the first round of QE unfolded.
If people are spending less, it follows that the money unit is being used less. Indeed corporate balance sheets are paying down debt and chalking up healthy cash balances. Coupled with this, in a fractional reserve system, when money gets repaid and not relent, as we know, it came from nothing, and it goes back to nothing.
Personal savings are at their highest for many years as households do the same, pay off debt and replenish cash balances.
Bank reserves are the highest they have been for a long time in relation to overall bank balance sheet size.
God help us if people do start to spend again in the fashion of old as there will be the mother of all inflations.
By the way, many empirical studies, most notably by Friedman, show us that the demand for money is very stable.
As we have discussed here before, regime policy uncertainty will cause people to hold precautionary balances, but only for a short period of time.
With the first round of QE of £200bn and now the second of £75bn we have nearly added 15% to the money supply.
They way out for the Bank of England is to massively raise interest rates as part of a very tight money policy. Either way, this is bad news for us.
Hoping a mild inflation will reduce our real debts over time is a very dangerous game. As soon as the inflation genie is out of the bottle, and we all realise that our money is depreciating, we will spend it, retailers will reprice to take into account the new demand, and prices will soar.
They are hoping not only for a mild inflation, but also for those in receipt of the new money, the people who have had their gilts bought with the new money, to then go and spend it and get those “animal spirits” working again.
So the bankers once again win. More expensive houses, more fast cars and boats, with their bonuses for organizing the buying of the gilts.
The banks get the new money deposited with them and can then shore up their balance sheets even further, as I suspect they are still concerned about all the wonky property loans and dodgy sovereign debt they need to wipe off their books. Thus, giving effectively £75bn of money out of the ether to the banks will not have the desired effect of increasing lending or spending (besides the bankers’ toys already mentioned). We all just have our purchasing power diminished while that of the banking system is raised. They get the new wealth effect, not you!
As most of these institutions are replete with failed corporate executives, still in the same jobs, who will more than likely repeat the same mistakes, who are regulated by the same people in differently named organizations, we have once more a recipe for disaster.
As we always say on this site, the creditors get fleeced . A pensioner buying an annuity today with a £300k pension would have got £22,500 pa and now will get £18,500, should the yields go down to where they want it. The ongoing war on the poor is relentless. Pensioners just have to swallow a 30% pay cut. Forget looters in Tottenham, we will have geriatrics in the streets of green and leafy middle class suburbia smashing the place up if they are not careful. They will suffer for the mistakes of past governments who in partnership with the banks created the mother of all credit booms, which has led to the largest misallocation of resources since the 30s.
As blame for the artificial boom does not lie with the Conservative Party, but with the Blair and Brown money regimes, I can’t fathom why the current government keeps trying to repeat the policy mistakes of the previous one, especially when they condemned this approach to money policy back in 2009.
One further thing, if they do pull yields down on gilts, this may well make borrowing costs marginally cheaper, but lets face it: if 50 basis points means you live or die in business, you are kidding yourself that you have a viable business anyway.
Likewise, if you are a home owner who is so close to the wire that a fraction of a interest rate move wipes you out, then you are a renter of a home, not an owner. The quicker you default, then better for you and your family. Release your burden, rent, and feed your family. No one will be saying at your funeral “he was a great man, he honoured his mortgage. Even though he never should have taken it out because he could not afford it, he was advised by the bank to do so. What’s more, they were so kind that they gave him a mortgage worth more than the house, so he could buy his furniture. Failing to feed his kids and getting divorced did not trouble this honorable man; for the rest of his life he toiled for the bank.”
Embrace default and let’s get this correction over and done with, so we can carry on and rebuild our lives in peace.
This is the problem with politics. If there’s a clash between the right thing to do and the most politically advantageous thing to do then the latter will always be picked. We know the govt knows it’s the wrong thing to do, they’ve already said as much when the last govt did it, so what other explanation could there be for their actions?
Toby, you still seem convinced that price inflation is going to take off, which goes against all the evidence. Money supply is falling, even by the Austrian measures. The market clearly doesn’t think there is much risk of high inflation in the future, or it wouldn’t be buying 10 year bonds at low interest rates. Wages are pretty much flatlining, again showing a lack of inflation expectations.
You seem to be only looking at a very small part of the puzzle to form your view – the increase in size of the monetary base – rather than the bigger picture.
Hello Dan
The market is only buying 10 year bonds at low interest rates because it is a rigged market. With 0.5 per cent interest rates set for the banks there is a big juicy “carry trade” to be had on government bonds. The 10 year is currently trading at 2.44 per cent. If a bank borrows at 0.5 per cent then there is 1.94 per cent of pure profit there. This is the essence of the central bank created bubble in government bonds. When this bubble bursts and the bond markets collapse, there will be a massive rush from government paper into real assets and we will then see what von Mises refers to as a crack up boom.
This is the bigger picture. Governments, via their central banks, can only suppress the market for so long. When reality bites home and the final debacle arrives the entire monetary system will be swept away in a tsunami of valueless digital fiat currency.
Evening Simon,
Why is it a rigged market? The interest rate on government bonds is determined by the market and the demand for those bonds. And as to the “carry trade” that you refer to, there are a few issues with that. Firstly, you mention 1.94% of “pure profit”. But with inflation running at around 5%, anyone buying those bonds is currently making a real loss. Secondly, if investors were expecting higher inflation in the future, then they would be charging the government higher interest rates for those 10 year bonds to make up for the expected inflation; otherwise they would be losing a lot of money.
You say that “the entire monetary system will be swept away in a tsunami of valueless digital fiat currency”. Those are quite strong words, and you seem remarkably confident that this is what will happen in the future. I would say that there is a small chance that you are right, but a high probability that you will be proved wrong. In my view, it is always best to try and look back at similar situations that have occurred historically when making predictions about the future. For example, the situation that Japan found itself in from the early 90s has many parallels with the current crisis. They printed huge amounts of money, and got into huge amounts of debt which did not result in inflation or high interest rates.
Evening Dan
It is a rigged market because the central bank sets interest rates and prints money: in a real market these functions are performed by real people digging up gold, saving money, investing and borrowing in the real world, and not by central planners tinkering with the money supply and interest rates. It is also a rigged market because banks are allowed to trade insolvently (i.e. the fractional reserve banking system).
You bring up my point about 1.94 per cent of pure profit. Clearly this doesn’t appear to be much. However, when the banks lever up their capital by a factor of 10-40 times then this becomes a really healthy profit even with inflation rates way above those that are currently reported.
You say investors expect higher returns if they expect higher inflation. This is true if the investors aren’t part of the rigged system, but the real players in the market are banks and so the normal rules do not apply to them because of the reasons stated above. Who do you think has been buying Greek government debt? I don’t know anyone who has apart from the banks. Also, as soon as bond prices start falling and interest rates start to rise, central banks just print more money, buy up piles of the bonds and thereby drive the interest rate down. How is this not a rigged system?
The reason I am so confident that the monetary system will collapse is because all fiat monetary systems in the past have collapsed. Looking at the current system, the amount of debt, the size of the derivatives market and the sheer inability of any part of the system to withstand proper market discipline without threatening the entire system with complete and utter destruction all make it look to me as an inevitability.
I am no fan of fractional reserve banking because I think it is a fundamentally flawed and unstable system. However, the only way it can continue to limp along is if busts are allowed to purge the malinvestments built up during the boom phases. However, governments and central banks have absolutely refused to allow this purging to take place which is making the problem worse and worse. We can still avoid a complete collapse of the fiat currencies (for a while at least) if the market is allowed to purge itself of bad debt and fraud through bank failures, defaults and bankruptcies. However, this will be even more painful now than it would have been in 2008 if world leaders had done what they should have done then. This is why I am so sure that all fiat currencies are doomed.
Simon,
My point on the 1.94% of pure profit was that, with inflation near 5%, the banks would actually be making a real loss on this investment. No amount of levering will change this.
Banks are not the only actors buying government bonds. But irrespective of this, they are rational investors in the market and would not be buying 10 year bonds at low yields if they thought that inflation was going to mean a huge loss on this investment; this would hardly be good for their business and their shareholders.
You mention Greek debt; the reason that yields are so high on this debt is that the market has priced in the possibility of default. If the market investors thought that the UK was at risk of inflation or default, they would be charging high interest rates to buy our debt too.
The reason you give for your confidence that the current monetary system will collapse is that all fiat money systems in the past have collapsed. But so have all previous commodity standards, free banking systems etc. I would agree with your criticism of fractional reserve banking, but I don’t think that full reserve banks will emerge as governments have found ways to deal with the instabilities of fractional reserve systems.
I’d be interested to know what would change your mind with respect to your view that there is going to be a rush from government paper and a ‘crack up boom’. What would change my view is if inflation began to really pick up into the levels we saw in the 70s, and 10 year bond yields started to drastically ramp up from their current very low levels, with the economy still in a depressed state.
Dan
All previous gold standards have failed because they were not 100 per cent reserve systems. The instability emanated from fractional reserve banking practices and not from gold which bears no counter party risk.
Inflation is not rising prices, it is an expansion of the money supply. Rising prices, or price inflation, comes later. Inflation has already happened, we now need to see whether this inflation is demolished with some bank failures, bankruptcies and defaults, or whether it is added to with further QE and zirp for an extended period of time. The choices made by governments and central banks with respect to this monetary expansion will determine whether and when the fiat system collapses.
Simon, as I pointed out earlier, the broad money supply, which is the amount of money in the real economy and hence the measure that matters, has actually decreased in the UK over the past year. So we’ve had a contraction, not an expansion, of the money supply.
See http://www.ft.com/cms/s/0/74258ef0-e3a8-11e0-bd3d-00144feabdc0.html#axzz1YrdEq5gf
Yes Dan broad money has contracted but base money has ballooned, this is a time bomb waiting to go off. When banks lever up this money by lending into the real economy that is when TSHTF!
Simon,
I don’t think that it is a time bomb waiting to go off. As I said above, the closest parallel with our current situation is Japan, 2000 – 2006. They carried out a large QE programme which didn’t work too well, in the sense that the extra money just piled up in bank vaults as excess reserves and so didn’t result in price inflation. They then unwinded the QE and raised interest rates slightly in 2006 -see my post to Toby below.
This provides some real world evidence towards the view that QE isn’t going to accomplish much (but may be better than nothing).
Dan
One last question for you: please enlighten me on the “ways that governments have found to deal with the instabilities of fractional reserve systems”. It is these instabilities that have caused all the booms and busts we have experienced over the last few hundred years. The latest shambles also arises from this fundamentally flawed and dishonest practice. If the government does in fact have these “ways”, why on earth didn’t they deploy them and thus prevent this deplorable situation from ever arising?
Simon,
Deposit insurance for one. The recent Vickers report suggests higher capital ratios, bail in mechanisms to convert debt into equity, and separation of retail and investment banking. These recommendations should minimise taxpayer exposure to future crises. As a last resort, there is always nationalising the banks (wiping out shareholders and creditors but keeping the payments system going, as per Iceland) or providing them with unlimited liquidity from the central bank. All of these mechanisms have their problems, but they will allow fractional reserve banking in pretty much its current form to continue.
Dan
None of these schemes prevents credit expansion which is the root of the problem, therefore they will always fail. All these schemes are sticking plasters used to fix a gaping and fatal wound. Also, nationalising banks is what will be the cause of the final debacle, since it is through this mechanism that the taxpayer is placed on the hook for massive debts which have no way of ever being paid off.
Simon,
You are right that nationalising banks can be crippling for a country. An extreme case is Ireland, which is saddled with massive sovreign debt after guaranteeing all the debts of its banking system.
However, the counter example to this is Iceland, which could not bail out its banks as their debts were too large relative to Iceland’s GDP. So Iceland kept the payments system going by taking over the banks and guaranteeing deposits, but wiped out all other creditors and foreign depositors.
As a result, Iceland has emerged from the crisis with a small sovreign debt, and has experienced much faster gowth than Ireland (its banks have now been privatised again).
The option of nationalising banks will always have to be available as a last resort, but this does not necessarily mean putting the taxpayer on the hook for massive debts.
And in the case of the UK, we do have high levels of debt, but it is worth bearing in mind that the current government debt is a fraction of that which was built up in World War 2 (as a percentage of GDP).
Dan,
“it is worth bearing in mind that the current government debt is a fraction of that which was built up in World War 2 (as a percentage of GDP”
The more interesting statistic is our debt as a percentage of private sector GDP.
We must also consider:
– increases in unofficial public debt (pensions obligations, PFI)
– increases in corporate and household debt (reducing the ability to service public debt)
And of course there’s no peace dividend coming our way …
Hello Dan
Finally something we agree on! Iceland allowed their banks to fail and then nationalised them, that is a healthy response to banking excess and fraud and is a sound way of fixing a broken system.
Dan, you make your point well. We have to disagree. We have a 8% real inflation for the common man, once you tax tax into account . This will wipe out most peoples purchasing power under less than a decade. IF and I write IF, any of this new money put into circulation gets spent, and it will if people / business start to feel their purchasing power diminish , then we will have a bigger more pronounced inflation. This will happen very quickly and by surprise when it does and catch all people like you unawares. I for one intend to be very prepared. I hope I am very wrong!
Toby, yes I guess we will soon find out which way it will go.
The only other thing I would add is that, as I mentioned above, in my view there are many parallels between Japan’s lost decade and the current situation in the UK.
The Bank of Japan carried out a large QE programme which did not lead to price inflation. In addition, when they decided to abandon QE and raise short term interest rates in 2006, they were able to unwind all of their QE in a matter of months, without affecting bond prices. They did this mainly by letting short term securities that they had on their balance sheet mature without rolling them over. This meant that they did not have to sell a large amount of securities back to the market, which could have affected government bond yields.
So when the economy finally recovers in the UK, this would suggest that unwinding QE could be relatively pain free.
See
http://www.law.harvard.edu/programs/about/pifs/symposia/japan/2009-japan/briefing-book/van-rixtel.pdf
and
http://news.bbc.co.uk/1/hi/business/5178610.stm
Dan, I do not disagree with what you say, I just think it is more likely that our addiction to debt / consumption / not being long term savers is a salient differential point for us v Japan. Thus I am more in the “Oh heck, when it gets moving again, the genie will be out of the bottle” and I doubt very much they will be able to control it. Hence I hope I am wrong, but my analysis tells me otherwise and with regards to protecting my and my loved ones savings, I act according to my analysis.
Simon,
I agree that fractional reserve is a defective system plus I agree that lame ducks (banks or any other business) should be allowed to go bust, plus I agree that interest rates should be set by market forces, rather than central banks. However I do not see why subsidising lame ducks leads to a collapse of fiat money systems.
We provide HUGE subsidies for health and education. Where is the problem with that? Will the NHS help lead to the demise of our fiat money system? I doubt it. I’m not in favour of government continuing to subsidise incompetent and/or criminal banks, but if government chooses to do so, then as with the NHS, I don’t see why this leads to a collapse of a fiat money system.
Hello Ralph
What I think will lead to the collapse of fiat money is zirp and QE. Both of these policies force more and more money into the system which obviously thereby reduces its value. By bailing out debt ridden failed banks, trillions of pounds of toxic loans and derivatives are retained in the system creating an ever increasing burden on the real productive economy. This produces yet more debt which cannot be repaid.
This is what we are seeing all around us. Either this debt needs writing off through bank failures, bankruptcies and default or the central banks will keep the ponzi scheme afloat with yet more digital currency. It is my belief that the central banks and governments will prefer to pump ever increasing amounts of money into the system rather than allow the necessary purge to take place. This is why I think that the fiat currency system will collapse.
Comparing the NHS and the banking system is not a valid comparison. The NHS provides a service to the economy, one which we would all need to pay for privately if it wasn’t provided by us all collectively via the state. The banking system, as it is currently constituted, is an enormous cancer which is drawing ever increasing amounts of capital from the real economy to prop up its unwise lending decisions. Every trillion dollars of debt that is bailed out with a bank continues to weigh down on the real economy requiring interest payments to keep it serviced. This is why bailing out a failed bank with toxic loans and derivatives on its books is no comparison to paying money into the NHS.