Tagged: Banks

Busts are not ‘inevitable’

There are those who can display a solid grasp of the oft–misunderstood mechanics of credit and money generation by banks and who are also well aware of the episodes of endemic mistakes this entrains in in our system. Yet, perhaps because they possess a certain ideological bent, many such commentators cannot seem to steel themselves to take the next step and admit that very little of this has anything to do with a free market, or that those mistakes are decidely not an intrinsic feature of what they like to call ‘capitalism’.

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Banks DO Create Money

For those who will not take my word for it that banks do create deposits by lending money, let me quote you a little Roepke from a footnote (p113) to his 1936 work, ‘Crises & Cycles’:

“The process [of credit creation] is now clearly explained in any text-book on economics, banking or money (especially recommendable is Hartley Withers’ Meaning of Money). A fuller treatment may be found in the following books: R. G. Hawtrey, op. cit.; J. M. Keynes, A Treatise on Money, pp. 23-49 : C. A. Philips, Bank Credit, New York, 1920; W. F. Crick, “The Genesis of Bank Deposits,” Economica, June 1927, and F. A. von Hayek, Monetary Theory and the Trade Cycle, London,1933.”

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Flawed Fractions

First published 5th July, 2013 as ‘Free, Fractioned & Flawed’  by the Cobden Centre

It is unsound to distinguish between circulating and idle money. It is no less faulty to distinguish between circulating money and hoarded money. What is called hoarding is a height of cash holding which–according to the personal opinion of an observer–exceeds what is deemed normal and adequate. However, hoarding is cash holding. Hoarded money is still money and it serves in the hoards the same purposes which it serves in cash holdings called normal. He who hoards money believes that some special conditions make it expedient to accumulate a cash holding which exceeds the amount he himself would keep under different conditions, or other people keep, or an economist censuring his action considers appropriate. That he acts in this way influences the configuration of the demand for money in the same way in which every “normal” demand influences it.

Ludwig von Mises, ‘Human Action’, 1949

Of late, there has been a vigorous renewal of the old debate regarding the advisability or otherwise of allowing free banking institutions – otherwise unanimously preferred to that ubiquitous, illiberal cartel which operates with enormous legal and political privilege under central-bank tutelage – the right to issue their own ‘inside money’ in the form of ‘fiduciary media’ which have less than a 100% backing in whatever form of ‘outside money’ (e.g., precious metal bullion or specie) has come to form the fundamental basis for the currency.

Recasting this question in less esoteric terms, the argument is one of whether free banks should be allowed to increase their stock of demand liabilities (their ‘inside’ or self-created money) – namely, deposit book entries subject to cheque or immediate electronic transfer and their own proprietary issue of bank-notes and E-cards – beyond the sums representative of the stores of – let us say, for the sake of example – silver residing in their vaults (their share of ‘outside’ or exogenously-arisen money).

Though the Fractional Free Bankers (hereafter, the FFBs) generally concede that the stock of outside (or, as we might say, ‘hard’) money should be fixed so as to limit the generation of an undesirable degree of instability in the economy, they have no such scruples about permitting the sum of ‘inside’ monies from varying to a degree determined only by the narrow, actuarial calculus of the individual free bank.

Anything else, they say, is not only an unwarranted intrusion into the voluntary relations conducted between each free bank and its customers – who should have the right to agree even to a contract which the 100% reservists unwaveringly argue is logically inadmissible – but it is actually a sub-optimal economic solution, too.

The reasoning they apply goes something like the following. The ideal money is one whose use does not impair economic calculation because of changes emanating from the money ‘side’ rather than from the goods ‘side’ of each transaction undertaken with it.

Implicit in this asymmetry is the idea that while variations in people’s expressed valuation of a single good – as reflected in its price – send useful, specific packets of information about that one good’s relative scarcity (loosely, the balance between its available supply and the demand it experiences from all those aiming to buy it) and hence about the expense and effort to which people should go in making more of it, money changes affect all goods indiscriminately (since money, the generally accepted medium of exchange has no price of its own, per se) and hence these latter sow as much confusion as they bring disruption into the marketplace.

Running through this discussion are two intertwined sub-debates: firstly, whether money is a good in its own right, or whether it is itself merely a token, a ‘place-holder’, or accounting entry which records some prior contribution to production and, secondly, whether there exists a genuine distinction between that saving which is accomplished by a co-incident act of passing the saved command over present goods to another (i.e., investing it, for however short a time) and that brought about by that simple abstention usually scorned as ‘hoarding’ (which we shall hereafter refer to as the much less emotively-charged business of ‘sparing’).

In fact, one of the arguments the FFB team frequently advances is that since money is indeed ‘just another good’, there are no grounds for erecting a hindrance to entrepreneurs – i.e., fractional free-bankers – if they seek to meet evidence for an increased demand for it with a suitably increased supply.

Yet, this line itself entails both a paradox and something of a non sequitur. The first arises from the fact that, as we were earlier assured, changes deemed to emanate from a differently expressed demand for money were not supposed to be equivalent to those emanating from fluctuations on the goods’ side (perhaps, in this context, we should say the other goods’ side), which somewhat belies this opposing and treacherously bland denial of money’s special role in the economy.

The second failure of logic is the bound up with the idea that if money is just another good then presumably its multiplication cannot be as nearly costless to accomplish as one continues to suspect its grant to be, notwithstanding the FFB advocates’ rhetoric about the burden of such intangibles as establishing and maintaining the issuing bank’s reputation, or of protecting its liquidity, in addition to the firm’s further outlays on buildings, labour, equipment, and marketing, all means by which it promotes public acceptance of its brand and hence earns its lucrative contribution to the overall supply of money. Even if we do concede the fact that the replication of such monies is not completely free, they certainly are among the most easily reproduced of all goods, at least within a wide range of successive, marginal additions to the stock of fractionally-uncovered, ‘inside’ money.

The FFB school further suggests that, absent today’s statist interventions, each bank would not only be stopped from growing disproportionately to its peers – for fear of being presented with more net claims than it can redeem in outside money – but that banks collectively would still be precluded from expanding in concert because the width of the illiquid tail in the distribution of their mutual clearings would grow faster than the height of its expected zero-net mean and hence the costs of prudence would eventually outstrip the benefits of enlargement.

Even if we accept this rather arcane statistical hypothesis, this in itself, however, would still seem to rest largely upon the implicit assumption that a bank caught in that position would not have either formal or informal borrowing arrangements with its peers upon which to fall back in the event of such a statistical misfortune befalling it.

Although we must be of course exercise care in appealing too closely to a system which is perverted by the presence of fiat money, a central bank, state-subsidized deposit insurance, and the moral hazard of ‘Too Big To Fail’, it is nonetheless hard to say that banks have felt unduly cognisant of their basic liquidity needs during these past two decades of reckless hypertrophy. Much as often happened in Victorian banking crises, modern financial institutions – at least prior to 2008’s little embarrassment – came to rely upon the market itself to keep them out of difficulty – banking upon being covered by the highly efficient clearing house, stock lending, and securities repo markets which carry out some $1.5 quadrillion’s worth of annual transactions (some with a 99% netting success rate, in the US alone).

Lulled into a false sense of security by this mirage of systemic liquidity, leverage grew alarmingly, even without counting the mountainous contingent liabilities each bank tried to conceal among the footnotes to its quarterly reports.

Nor can one argue that they spent much time restricting one another’s activities too much by refusing each other credit or dealing lines. In fact, a glance at their aggregate balance sheet shows that, even now, as mistrust has grown and the potential capital costs of the new Basle III regime loom large in their calculations, two-thirds of the entries are made up of bank-bank transactions while in the enormous, off-balance sheet, derivative iceberg which lurks treacherously in the financial shipping lane, more than 90% of the more than half-quadrillion dollars of notionals outstanding involves another financial counterpart.

Be that as it may, the FFB’s reasoning is then often reinforced with an approach which openly relies upon the opposite interpretation of the nature of money – which is to say that it is no more than a datum of economic input, comprised of the counters which some all-seeing recording angel transfers to each individual’s credit whenever he or she sells something they have made, practices their skills, expends their sweat, or lends out their property for use by another.

Now, the argument runs, when a man is struck with a suddenly elevated sense of risk he sells but does not buy – when he ‘spares’ and does not invest what he thereby saves – he has ‘deactivated’ his small share of the medium of exchange and has thus served to make it unreasonably difficult for all his fellows to trade their goods and services with one another, in their turn.

Passing by the implicit aggregatism of much of what follows, we are told that, by not passing the money he has earned immediately back to another he is acting to reduce the ‘carrying capacity’ of the economic network much as if he were selfishly tapping into the electricity grid and draining off much-needed kilowatts simply to charge up his precautionary stack of batteries.

However, this argument only really holds if we also hew to the idea that to avoid a cascade of harmful side-effects, the quantity of utilised ‘money capital’ must correspond one-for-one with the actual physical goods available for purchase (especially where these are destined for purposes of reproductive, rather than exhaustive, consumption) and that it must do so at broadly unchanged prices, into the bargain.

To be fair to our FFB friends, we can perhaps resolve some of this inherent contradiction by an appeal to the overriding importance of the subjective over the concrete in much economic analysis, that is to say, by a much more accurate definition of what we mean by that very overworked, but often ill-defined term, ‘capital’.

As Richard Strigl (among others) made very plain, the mental image we usually conjure up when we hear the phrase is that of some actual capital good – usually a piece of long-lived machinery, but also a tool, a component, a building, and so forth – but it is crucial to realise that this explicitly physical entity only comprises actual economic capital to the extent that it is properly integrated into the structure of and participates in the processes inherent to ongoing production – a test it will meet by routinely generating sufficient net income to maintain itself in operation.

Indeed, the prevalent fetishism attached to such substantial forms and the corresponding lack of attention paid to the manner of their current or prospective employment is a major source of error in matters, not just economic, but investment-related, too.

Similarly, ‘spared’ money – if kept back as a precautionary reserve – may still, therefore, be a good, but it may no longer be considered a capital good. Its withdrawal – or we might better say, its reclassification – may, of course, have wider consequences, much as would a similar alteration in the status or employment of any other entity, since capital formation and, alas, capital consumption are part and parcel of any dynamic economy.

Bah! Humbug!

That having hopefully been clarified, let us look at the alleged difference between saving-investing and sparing to see if we can discover any irrefutable reason why we should favour – indeed, facilitate – the one and yet fight to neutralise the other.

If I save, the first thing I do is abstain from immediate (exhaustive) consumption and, in seeking a home for my increased funds, I may well transfer my potential command over the foregone goods to a third party, via the purchase of a financial claim. Regardless of whether this investment is conducted in the ‘primary’ (or fund raising) or the ‘secondary’ (title transfer) market, it will serve to furnish the claim’s seller with a ready means of purchase in my place.

Alternatively, I may simply leave the balance on deposit at the bank (or at one of that bank’s regular correspondents) which had earlier granted a loan to the man for the very purpose of buying whatever it was I sold to him in order to raise this money. Effectively, via the intermediation of the bank, I have unconsciously lent my customer the means to enjoy current goods which he previously did not possess.

Hopefully, but not necessarily, the man who takes them off the market will transform them into capital – i.e., as discussed above, he will put them to use in a productive act which is intended to bring a net material addition (and an increment of value) into being in compensation for the effort and outlay involved.

Another way I may save is by using my sale proceeds to discharge an outstanding debt. If this debt was part of a book credit offered me by some non-bank entity, it is easy to see that my delivery of money to my creditor similarly promotes him to into my place as a likely customer of someone else.

If I owe the sum instead to the bank, it is true that to pay this back potentially shrinks the outstanding stock of money, though the often overlooked corollary is that this presumably liberates the lending or securities buying capacity of a bank which may now feel it has more reserves, or more capital, than is optimal. Even if the bank decides that an increase in its own prudential ratios is in fact warranted – and so does not seek to replace me as its obligor – far better to allow me to do this voluntarily than for the bank to withdraw its facilities in a summary fashion from some other whose livelihood is still reliant upon them.

However, what I might also do is take delivery of a sum of ‘outside’ money – say a quantity of silver coins – and commit them to safe keeping, whether at home or in a safe deposit box – or I may simply leave untouched the pre-existing demand deposit balance made over to my name in settlement of my unmatched sale of goods, a deposit against which the bank, of course already holds some asset and so which remains similarly passive.

Now, by ‘sparing’, I clearly make no such direct, onward provision for another to take my place in the queue for the checkout desk but – to the extent that whatever goods of my habitual uptake I chose not to consume fall in price on that account (or whatever other goods so decline because their demand was predicated upon my usual vendor’s subsequent use of his receipts from me) I still transfer real purchasing power to all other present holders of money.

Now if, as is often the case, my decision to ‘spare’ has come about because my perception of the degree of economic uncertainty has increased and if this angst is mirrored by others, it is likely that the next most eager buyer of the goods after me may also be chary of offering any lasting lien over the success of his enterprise or the strength of his balance sheet as part of their acquisition. Alternatively, the typical lender or equity investor to whom they might turn might be similarly reluctant to accommodate even those who are not so discouraged.

But if a substitute buyer does now emerge who has decided that, at this newly lowered price, the goods in question cross both the threshold of his list of subjective wants and fall within the limits of his available monetary means, he may be relieved of the need to borrow from me, or anyone else, and the one-off nature of the cost incurred in their purchase (as opposed to the ongoing, riskier one entailed in either selling a stake in his business or giving someone a continuing first charge over its earnings) may make him correspondingly more eager to proceed.

But, in either case, the fact that the goods can now be had without having to give any deeper a commitment than to hazard a diminution in his cash holding, may make their purchase all the more likely and may thus prove a swift and effective counter to any supposed ‘blockage’ in the circulation of goods and services which my actions may have caused.

The only real caveat here is that the good’s seller, disappointed at my lack of custom will not reduce them sufficiently for them to be sold to anyone else; that he resists marking them down to their new clearing price. As W. H Hutt took great pains to elucidate such a process of ‘withholding’ – whether of goods or labour or whatever – is the real cause of economic constipation, not my simple refusal to spend.

The more readily the withholder can persuade himself that some deus ex machina of the credit market will somehow provide him with a better price for his wares, the more likely he is to resist liquidating them. This leads straight to the inference that, once again, the knowledge that money may be manipulated in one’s favour only enhances the natural temptation to shy away from the immediate realisation of a loss and so, often, traps one into suffering a greater one in future. We shall return to this theme later.

To the argument that this is cold comfort to the man whose cashflow I have so callously reduced (or a similarly chilly one for those who depend on subsequent disbursements of the same), all that can be said is that such a disappointment may have occurred even had I save-invested and not spared, or paid down a bank debt since no-one in the world shares my uniquely individual, subjective, ordinal listing of wants and so, by that token, no-one is likely to be an exact replacement for me as a consumer of specific goods, in any case.

Thus, the truth is that even if I had pressed my money into the hands of the next man I bumped into in the street and bidden him to spend it, my favourite bar, or the shop where I regularly buy my groceries would still have been at risk of a drop in their takings. The economic ‘data’ – to use Mises’ somewhat dry terminology – have changed and if someone has been over-reliant on me not contributing to that change, well, they have my sympathies, but do not arouse in me any feeling of guilt, nor to they have me clamouring that either an all-knowing central bank, nor a purportedly more sensitive network of FFBs should immediately step in to compensate for my sudden lack of appetite.

Nor is it entirely clear how ‘hoarding’ money – to give it its full, pejorative flavour – is altogether different to ‘hoarding’ something else of wide-ranging economic significance like petrol or potash. The first ‘hoarder’ of these may also trigger other, precautionary acts of ‘hoarding’; this will increase the scarcity of the ‘hoarded’ entity in a manner few had foreseen; this will bring about economic disruption, plan failures, and a winnowing out of the weak and under-capitalised across the economic structure.

But, ultimately, just like money, the ‘hoarder(s)’ cannot live on fuel or fertilizer alone: they must realize some of their stockpile – albeit, on better terms than before they started (at least at first). Soon, however, it is likely to be the case that they will face the same problems in first maintaining, then liquidating their ‘corner’ that many have experienced before them, viz., that they will have (a) destroyed some of the demand for their product; (b) promoted a discovery process which may reveal a permanent means of economising on its use; (c) stimulated supply (about which more in a moment); and (d) confounded themselves with the challenge of not driving down the exchange value of their inventory, perhaps even more violently than they first elevated it.

To Catch a Falling Safe

FFB supporters will tell us that all this could be avoided if we simply cut to stage (c) by allowing their banks to increase the quantity of money smoothly, proportionately, and on a semi-automatic basis. This is where we both encounter a distinct sense of unease and fall prey to suspicions that the story is just a little too – well – Just So.

The disquiet comes because we insist that for it to be as ‘hard’ as we feel is ideal (in order to avoid the wasteful hysteresis of the business cycle) money must be a good with a cost of production at least commensurate with that of other goods. So, as Mises unequivocally proposed, let people go out and dig more metal from the ground if they really must (so as to provide us with more ‘outside’ money), but let us not allow a narrow community the power to create it with the stroke of a pen or the click of a keyboard.

Nor should we introduce a controversial means of money multiplication – with all its latent dangers of abuse during the upswing – by assuming that this virtuous elasticity will spare us the traumas of the dreaded ‘secondary depression’ and so be well worth the risk. Two aspects of this contention need a closer examination than they usually receive from the FFBers: will their banks actually do what they think they should and expand their unreserved demand liabilities at the height of a money panic rather than scrambling themselves after liquidity and so aggravating the crisis; and, absent a prior, fractionally-pyramided, money and credit bubble to over-extend men’s means, can there even be such a generalized sauve qui peut as is herein imagined?

As for the first of these, let us reiterate that, for its promulgated mechanism to work, the FFB circle implicitly assumes that at this, the point of maximum fear, the bank will quickly recognise my deposit’s likely inertia and will chance its arm to increase its earning assets by supplementing my dormant holding with a newly-created other, something it can only do by extending a new loan or buying a longer term financial claim whose rather more unquestioned marketability during the boom had gilded it with a thin sheen of ‘moneyness’ now cruelly revealed as a sham, with drastic implications for its pricing, here in the bust. Twenty-five years in both the practice and the study of financial markets persuades your author that bankers – famously known as men who offer you the use of an umbrella only when it is not raining – would ever proceed in this manner!

Turning to the second question, we confess to a feeling that if money were really ‘hard’ – and so, for us, 100% reserved and difficult of increase – the amount of credit erected upon its durable foundations would be less prone to a dangerous and even reckless top-heaviness; that the extinction of credit could not itself reduce the supply of money (as the imploding fractional process would do) and so prevent the ‘real balance’ effect from eventually stabilizing prices; and that the acquired understanding of how a hard money system works – complete with its benign, productivity-led, secular fall in prices – would bring about a gradual shift towards an ever greater reliance on equity finance and an equal-and-opposite withdrawal from our endemic inflationary gaming by which we routinely incurring ever more debt to dress up returns, to flatter our income, and to falsely bolster ‘growth’ – and Miller-Modigliani be damned!

Even if we set aside these objections and accept the FFB view, a further difficulty quickly arises regarding the implementation of any stabilization policy – i.e., one aimed at preventing a feedback between the ‘real’ and the money side of the economy whereby the decline in one exacerbates that being suffered in the other – whether this offset is centrally-directed from above or spontaneously-emergent from below.

The centrally-planned solution that we all now have to endure suffers most obviously from the classic Hayekian ‘knowledge problem’ of being ignorant of what signs to monitor, in how timely a fashion they must be gathered and interpreted, and what actions they should then induce as a corrective.

This is too big a topic with which to deal fully here – indeed, it has, in one form or another, comprised the core of the author’s commentaries over the past decade and a half! Suffice to say that many of the more enlightened (if not all the Austrian-inclined) analyses tend to converge on the idea of wondering whether we might stabilise nominal income by an appeal to the tautologous ‘equation of exchange’, MV=PT – that is, that the volume of money turned over in a given period (the product of its supply, M, with its ‘velocity’ V) necessarily equals all money transactions taking place within the economy (exchanges of physical goods, T, weighted by their money price, P).

The first thing to say is that idea of maintaining the volume or even the flux of monetary circulation should not – as some have suggested – be confused with targeting nominal GDP since this clumsy statistical artefact is far too biased towards final, exhaustive consumption (and, worse, to government spending of a fundamentally uncertain value) and to end up promoting excess exhaustive consumption in a bust is only to increase, not to diminish, the destruction of capital, a harsh truth rarely grasped by your average, pull-push hydraulics, mainstream macromancer.

But, even if we widen this to the aim of stabilising a more soundly-based measure of nominal transactions (i.e. of including all those significantly larger, intermediate exchanges largely netted out of the GDP arithmetic)– most easily proxied by non-financial business sales – there is a further caveat that what looks like a ‘hoarding’-led decline in velocity (the rate of money turnover) may, in fact, be a reflection of a monetary surplus brought about by the removal of many higher-order stages in what is, by definition, an overly-extended, far too ‘roundabout’ economic organization.

To see this, imagine that a firm which once bought the grain, milled it, baked it, and retailed it all under one roof only pays its workers and its suppliers of one input and only sells to one set of customers, requiring many fewer monetary interchanges than if each of these stages were hived off into a separate, specialist enterprise. As the over-stretched and under-capitalized layout of the boom economy snaps back into a more sustainable configuration, many such stages, erroneously laid out during the misleadingly easy money conditions of the boom, will be eliminated, reducing the number of sales and purchases as it does. Though many of these will involve only credit, there will inevitably be an extra call on money involved as well

Thus, if velocity falls – something the FFB bank is mooted to register and then counter-balance because of the palpable reduction in the clearings it must undertake – it may not be just because money is becoming immobilized in ‘hoards’ but because actual transactions volume is shrinking as it must if the adjustment is to be allowed to run on unhindered.

Conversely, if many of the boom’s dealings were undertaken outside of the banks – i.e., on the securities markets, or via the direct extension of intercompany trade credit – there may actually be a dash to make avail of those same backstop lines of credit which the fee-hungry banks typically insist its capital and money market customers take up when the skies are cloudless and their utilisation is likely to be scant, indeed.

Thus, the hypothetical negative feedback of lowered money transmission and lesser bank clearings leading to an equilibrating expansion in money liabilities may prove a chimera, since the link between the first and second may not only be broken, but rewired with an opposite polarity.

All in all, we hope we shown that we have sufficient reservations – both in theory and practice – not to cast our lot in with the FFBers on this issue.

No Compensation

Perhaps we should give the last word on the foregoing not to Mises and Rothbard – who were, of course, just as vehemently opposed to fractionalism as they were avidly in favour of free banking – nor to such ‘stabilizers’ as Roepke, or the more Wieserian Hayek (who seemed to become ever more woolly-minded and impractical on this issue as time went on) but to Richard Strigl, a less well-known member of the Pantheon, but one who provided us with one of the most detailed and clearly-worded expositions of the structure of production, the nature of capital, and the business cycle in his 1934 work, fittingly – if unimaginatively – entitled, ‘Capital and Production’.

It is true that in the relevant Chapter 3, section 3, Strigl deals with the standard framework, i.e., one which is dominated by a central bank, but nonetheless his unequivocal distinction between what might happen and what will happen if we attempt to offset hoarding remains, I think, decisive, even when we relax that constraint.

Firstly he makes a case which I think today’s primary FFBers such as George Selgin and Steven Horwitz would share as to why such a move might be desirable.

“… An elasticity in the volume of credit can be demanded without the adaptability of the money supply [thanks to ‘hoarding’], thereby leading to an interference of money in the structure of roundabout methods of production… If the central bank could completely oversee the conditions which require the expansion or the contraction of credit from the point of view of the ‘neutrality’ of money… it could [do so].”

“’Additional credit’ that the central bank grants in order to compensate for the effects of hoarding are not ‘genuine additional credit’, but ‘compensatory credit’ and [ditto] restrictions… However, the central bank has no reliable indicator for such a policy; there is nothing in the economy that can directly inform [it] whether the supply of credit is greater or smaller than the supply of ‘real savings capital’.”

In the money and credit economy there is no market on which the ‘artificial’ influencing of the supply of credit would immediately lead to a disruption. Here, the rule holds that the influence on the capital market from the side of money can only be recognised by the effects which [genuine] expansions or… restrictions have.”

“…As a consequence, an ideal functioning of money in the sense of a neutral money can probably never be expected.”

Our contention, argued above, is that this lack of what Strigl terms an ‘omniscient institution’ cannot just be assumed to be made good by its substitution with a multiplicity of FFBs, each concerned only with maximising profit under the constraints holding of the lowest possible reserve consistent with statistical safety, as indicated by their expectations of likely clearing conditions.

Strigl further goes on to warn explicitly of the purely theoretical validity of this business of a neutral money, pointing out in a footnote to the above that:-

“… In the stationary economy, monetary influences lead to ‘disturbances’; hence there is a question under which circumstances these… do not occur, i.e., that money is ‘neutral’. Here the question regarding the neutrality of money is hence a question regarding the monetary conditions of the stationary course of a money economy.’

The crucial point here is that the concept of a ‘stationary economy’ is an abstraction of the economist’s mind, adopted so as to hold at least a few of the ceterises briefly paribus in a way that the real world denies him the chance to do. Strigl is thus making clear that what seems logically unimpeachable in this Gedanken experiment should not imply a prescription for how to order matters amid the messy dynamism of the real world.

Strigl further questions the practicality of such measures in a lengthy appendix, ‘On the Problems of Business Cycles’. After dealing here in more detail with the progression of the downturn, we reach the point where “…a withdrawal of money capital from the circulatory flow of the turnover of capital” – our accursed itch to hoard – takes place, implying that “a compensation without damage” – such as the FFBers presuppose – “would seem conceivable here”

But, says Strigl convincingly, this will be just the point where the only ones willing to take up this newly-available credit will be those who, otherwise, “…are forced to liquidate, to make emergency sales or to cease production due to a lack of capital…” for whom “…any credit means at least the monetary avoidance of losses and perhaps even the potential for later improvements.”

However,” he goes on, “satisfying this demand implies delaying the liquidation of the crisis, lengthening and strengthening it. For it is essential that a significant demand for credit by those who would like to work towards continuing the boom, that is, an ‘unhealthy’ demand for credit, exists along wit a significantly reduced demand for new, sound investments.”

Here we are back to Hutt’ s insights on how voluntary ‘withholding’ – which we could even term, speculative denial – means Say’s Law breaks down and markets no longer clear, perpetuating and propagating the misery of the bust.

To be sure,” Strigl continues, “ these explanations are highly schematic. However, they can show that the chance of a compensating expansion of credit in the recessive phase of the cycle is in practice very small; that there is hardly any chance of financing production processes which can be lastingly continued: and that the danger, instead, that additional credit prolongs and makes the crisis more severe is very large.”

As for that other canard of modern ‘re-inflation’, i.e., boosting consumer expenditures, our sage is also very forthright about its malign effects:-

“…a cycle policy is also conceivable which, by enlarging consumption would try to avoid those effects of ‘decapitalization’ which consist of the loss of demand for consumer goods. Here, additional money would function such that it would replace the money withdrawn from circulation and would demand consumer goods for pure consumption in its place. The movement of goods would thus be the same as if the money withdrawn… had served consumption.”

We have already pointed out that withdrawing money from investment and using it for consumption is the same as consuming capital” – a quantity of which, you will recall, the higher orders we are trying to prop up is already suffering a desperate lack.

In addition, some effect on relationships for cost prices must also surface in the form of support for cost prices…” – are you watching, Mr. Bernanke? – “Thus, the policy of financing consumption must in the end cause the emergence of price relationships that make an improvement in the potential for new investments more difficult… The ‘artificially’ created demand for consumer goods will ultimately also create an increased need of for operating capital (sort-term investments) and will make these… increasingly profitable. This, too, must serve to weaken the forces that work in the direction of removing the obstacles which stand between short-term investments and long-term capital markets.”

In conclusion, let it be said that a guideline for determining the extent of credit that should operate in this way does not exist.”

We insist that neither does it exist when Fractional Free Bankers, rather than the central bank, are doling out that credit, even if we stretch our credulity to believe they would be so inclined to do, just at the moment when the economic prospects were at their bleakest and the cause of their own survival was therefore paramount.

So, in banking, by all means give us freedom, but also give us freedom from fractions, for we believe that the benefits of their permitting their use within an otherwise demonstrably superior framework to be too largely illusory and their potential drawbacks all too threatening to make the experiment of their introduction a rational one to conduct.


The Beggar’s Opera

The Beggar’s Opera

First published 2nd February 2009

“Today, with the exception of a dozen or two reasonable individuals, the whole world is in complete agreement on two points: debts should remain unpaid, and the economy should be stimulated through strong inflation.”

Mises to Fritz Georg Steiner, letter dated January 29, 1932, Mises Archive 71: 11.             

A good deal of our writing over the past year and a half has concentrated on analysing the course the downturn would take, once it emerged; how deep it might become; and how widespread would be the pain felt as the latest of all too many New Era runaway trains crashed headlong into the unchanging economic realities it had long sought to deny.

Naturally, our attempts at prognostication were necessarily less than perfect. The emerging market currency crisis of the latter months of 2008 escaped us, to name one big miss, as we committed the cardinal sin of failing to disaggregate the data pertaining to dollar-based assets and liabilities in Asia, Russia, and Brazil and so spoiled the fact that we had come early to the conclusion that the ‘decoupling’ thesis was sheer economic charlatanry by failing to consider how an external liquidity crunch would exacerbate the collapse of exports in a whole slew of foreign exchange-rich – and, hence, theoretically not funding-constrained – countries.

Nor, of course, were we able to directly specify the timing, nor the exact sequence of events as the calamity unfolded. While being among the most committed and consistent sceptics of the merits of government activism, even we could not have suspected that Hank’n’Ben, surely the greatest paired buffoons since Abbot and Costello, would – through sheer, vacillatory incompetence – contrive to undo the supposedly salutary effect of all the hundreds of billions of dollars they obtained under false pretences – or which they simply printed up – in order to shower them without overmuch in the way of either solid legal sanction or well-tested precedent on their best Wall St. buddies.

Neither could we have imagined that, within the space of a few short months, these two clowns would eradicate all grounds for rational calculation by counterparties, claimants, and would-be purchasers by:-

  • first shoehorning Bear Stearns and WaMu into JPM and Merrill into BoA (bemoaning all the while that institutions grown even more gargantuan as a result were already ‘too big to fail’);
  • then violently switching tack to proffer establishment poster-boys such as GS and Morgan Stanley the shelter of the Fed’s ever-spreading comfort blanket of liquidity;
  • next brutally throwing fellow investment bank Lehman to the wolves  – pour encourager les autres;
  • even as they near-simultaneously issued a blank cheque of unprecedented scale to that mission creep-blighted un-insurer, AIG?

Apart from greatly increasing counterparty risk, this also threatened to trigger CDS-related cash-payouts on an incalculable scale. In turn, this forced the Big 3 central banks not only to slash rates and to monetize all sorts of highly unsuitable assets, but to offer foreign currency swaps to the tune of $650 billion and, further, to allow banks to build up a veritable mountain of superfluous re-deposits with them of no less than $1.3 trillion – undermining what was left of the interbank lending market as they did.

Hence, we have moved swiftly from a problem of localized stress in the automotive and residential real estate markets to a general constriction of even the most basic of trade flows as working capital has evaporated, leading to a classic ‘struggle for liquidity’ (albeit one partly masked in terms of its effect on, say, the yield curve, by the extraordinary actions being undertaken by the central banks in their role as cartel welfarists).

Toccata and Fugue

Though much of our approach has involved a direct application of our teachers’ traditional precepts, any extra skill we may have displayed in relation to the unthinking Herd, has also arisen from today’s adapting the analysis to take account of the peculiar political, institutional, and social framework in which unchanging economic laws may express themselves in greatly varying specific outcomes.

To take an example of the general case, Mises wrote perhaps THE classic exposition of what has broadly befallen us in his Meisterwerk, Human Action, Chapter XX –  a piece of writing so percipient that it merits an extended quotation:-

‘Deflation and credit restriction never played a noticeable role in economic history. The outstanding examples were provided by Great Britain’s return, both after the wartime inflation of the Napoleonic wars and after that of the first World War, to the prewar gold parity of the sterling. In each case Parliament and Cabinet adopted the deflationist policy without having weighed the pros and cons of the two methods open for a return to the gold standard. In the second decade of the nineteenth century they could be exonerated, as at that time monetary theory had not yet clarified the problems involved. More than a hundred years later it was simply a display of inexcusable ignorance of economics as well as of monetary history.

‘Ignorance manifests itself also in the confusion of deflation and contraction and of the process of readjustment into which every expansionist boom must lead. It depends on the institutional structure of the credit system which created the boom whether or not the crisis brings about a restriction in the amount of fiduciary media. Such a restriction may occur when the crisis results in the bankruptcy of banks granting circulation credit and the falling off is not counterpoised by a corresponding expansion on the part of the remaining banks. But it is not necessarily an attendant phenomenon of the depression; it is beyond doubt that it has not appeared in the last eighty years in Europe and that the extent to which it occurred in the United States under the Federal Reserve Act of 1913 has been grossly exaggerated.

‘The dearth of credit which marks the crisis is caused not by contraction, but by the abstention from further credit expansion. It hurts all enterprises–not only those which are doomed at any rate, but no less those whose business is sound and could flourish if appropriate credit were available. As the outstanding debts are not paid back, the banks lack the means to grant credits even to the most solid firms. The crisis becomes general and forces all branches of business and all firms to restrict the scope of their activities. But there is no means of avoiding these secondary consequences of the preceding boom.

‘As soon as the depression appears, there is a general lament over deflation and people clamour for a continuation of the expansionist policy. Now, it is true that even with no restrictions in the supply of money proper and fiduciary media available, the depression brings about a cash-induced tendency toward an increase in the purchasing power of the monetary unit. Every firm is intent upon increasing its cash holdings, and these endeavours affect the ratio between the supply of money (in the broader sense) and the demand for money (in the broader sense) for cash holding. This may be properly called deflation.’

As he went on to explain:-

‘But it is a serious blunder to believe that the fall in commodity prices is caused by this striving after greater cash holding. The causation is the other way around. Prices of the factors of production–both material and human–have reached an excessive height in the boom period. They must come down before business can become profitable again. The entrepreneurs enlarge their cash holding because they abstain from buying goods and hiring workers as long as the structure of prices and wages is not adjusted to the real state of the market data. Thus any attempt of the government or the labour unions to prevent or to delay this adjustment merely prolongs the stagnation.

‘…Under a credit expansion which first affects the loan market… the inflationary effects are multiplied by the consequences of capital malinvestment and overconsumption. Overbidding one another in the struggle for a greater share in the limited supply of capital goods and labour, the entrepreneurs push prices to a height at which they can remain only as long as the credit expansion goes on at an accelerated pace. A sharp drop in the prices of all commodities and services is unavoidable as soon as the further inflow of additional fiduciary media stops.

‘While the boom is in progress, there prevails a general tendency to buy as much as one can buy because a further rise in prices is anticipated. In the depression, on the other hand, people abstain from buying because they expect that prices will continue to drop. The recovery and the return to “normalcy” can only begin when prices and wage rates are so low that a sufficient number of people assume that they will not drop still more. Therefore the only means to shorten the period of bad business is to avoid any attempts to delay or to check the fall in prices and wage rates.

‘Only when the recovery begins to take shape does the change in the money relation, as effected by the increase in the quantity of fiduciary media, begin to manifest itself in the structure of prices.’

Variations on a Theme

But the time for unalloyed diagnosis is past: what we must now attempt is the much trickier task of prognosis. In attempting this, the questions we, as commodity investors, must try to face up to are threefold; just when the recovery will ‘begin to take shape’, what sort of ‘shape’ that might be, and broadly how will the ‘structure of prices’ be ‘manifest’ when it does.

Here, having cited Mises as an authority on how the archetypal business cycle breakdown comes about we must briefly digress to consider a number of key differences between today’s economy and the one he was analysing in the first half of last century.

The first of these lies in the fact that the malign effects of credit expansion used to be largely the result of giving exclusively producers greater means with which to purchase inputs (whether relatively long-lived machinery, stocks of semi-processed goods, or labour itself) beyond the levels which could be funded out of their own profits and at interest rates below those at which they could attract into their schemes other sources of genuine savings.

By definition, we take these latter to mean those money sums which represent a voluntary abstinence from exhaustive consumption. The twin significance of this is that not only do these savings’ very genesis demonstrate that a limited satiety has arisen with respect to current output (and hence that something new on the menu might be welcomed from entrepreneurs in future), but also that a tangible pool of unutilized goods must now exist; goods which can therefore be reallocated from a marginally over-supplied end-consumption to serve as inputs (direct or otherwise) in the newly re-organized or expanded productive processes for which the businessman is seeking the funds in the first place.

The principal virtue of insisting upon such a correspondence is that it greatly limits the scope for the development of the sort of systemic entrepreneurial error which so plagues us today, a phenomenon which can only arise under conditions of unbacked credit expansion (so-called ‘forced saving’), and the frustration of true market mechanisms (which categorically do NOT include state-sponsored fractional-reserve banking or the maintenance of ‘managed’ currencies either within, or across, borders).

That such a blight pertains today, should by now be undeniable, but, overlaid upon this, trillions of dollars of additional credit has also been made available to serve no obvious productive end, but merely as a means of providing instant gratification on dangerously stretched and under-discounted payment terms to end-consumers (private or public) who were either unable to afford it out of current income, or by issuing claims against the earning assets already in their possession.

For far too long, the games has been to push all reckoning off up an ever-mounting hill of sand, all the time trying to pretend the present value of each grain of obligation is a reasonable one. Alas! Once the force of economic gravity at last won out over the illusions of investment bank ingenuity, it triggered a power-law avalanche, burying one of the millions of easy-terms Sisyphuses under the weight of a burden each thought he should never again have to shoulder.

It is true that some of this credit had a counterpart in a real desire to save, but such a transfer of resources to exhaustive- (rather than to constructive-) users has largely vitiated the savers’ benign impulse to make provision for their future. Moreover, two contemporary elements have served further to reinforce this baneful financing of unproductive (and hence, in essence, destructive) consumption – the two phenomena tritely labelled ‘globalisation’ and ‘securitization’, respectively.

By the former we mean the fact of separating the functions of an increasingly feckless, home-bred cadre of the takers of instant material pleasures from those of a well-motivated (if often only semi-skilled) overseas workforce of the makers such delights – an unfortunate apartheid often reinforced by a one-sided policy of currency (mis)management on the part of the latter’s government and by abject irresponsibility on the part of the formers’ overlords (herein lies another difference with the classical tale of the business cycle, though not necessarily with the experience of the intra-war years themselves)

Like much in economics, we must be careful not to drown the individual in the anonymous swamp of the mass, for we may all – at one time or another – find ourselves on either side of the divides which fall between borrower and lender, producer and consumer (a split which we must therefore be careful not to moralize about too monotonously).

However, as individuals, there are certain obvious boundaries over which we would not overstep unless these were hidden from us by means of either financial manipulation or political intervention. Sadly, few such limits have been in evidence in a world in which rampant inflationism has been encouraged, in great measure, by central banks desperate to forestall the consequences of a series of preceding busts and oblivious to the fact that a modest rise in their favoured index of consumer goods prices is far from being the sole litmus test of economic well-being.

Compounding this, those charged with directing the emergent nations have been all too happy to build the Potemkin village of pseudo-prosperity out of the straw of unrealizable promises to pay being liberally issued by richer foreigners with far too few material goods, but only a plethora of suspect IOUs, to offer in exchange for the poorer citizens’ sweat. The foreigners’ suzerains, for their part, were even more willing to close their eyes as thrift disappeared and investment withered under the twin pestilences of chronic credit expansion and a creeping government encroachment on free association. Instead, they were content to fool themselves that a Never-Never land profusion of flat-screen TVs and dockside dining establishments – largely charged to plastic or parlayed out of an ephemeral gain in home values – had somehow offset the latent impoverishment and progressive demoralisation which was insidiously eroding their societies’ long-held competitive advantage.

This is not to suggest – as both the right-wing autarkists and the left-green Savonarolas are equally wont to do – that a greater international division of labour is bad, per se. Far from it: the whole history of human civilisation is one of a greater specialization of function and of the evolution of higher levels of mutual co-operation which it instils. Not only are these the conditions for more rapid material progress, but they also tend to be conducive to the maintenance of peaceful relations, too, given that such fruitful interdependence means the dubious benefits of war become more and more paltry in prospect when compared to the ongoing bounties of commercial interaction which must perforce be sacrificed upon the bloody altar of Mars.

What IS needed, however, is to adhere faithfully to a monetary-financial system which promotes such an impetus, rather than prostitutes it. To abandon the semi-automatic regulation of a proper gold standard and the self-correcting tendencies of the price-specie mechanism it transmits for a world of chicanery in which central banks routinely aim to force interest rates to artificially low levels and finance ministries seek to defend unrealistic currency parities vis-à-vis their trading partners is no less heinous a method of false accounting than is the sophisticated sham of the bankers’ ‘Level 3’ assets or the crude deceit of a Madoff.

The crux of the second named influence is that not only does securitization break down the bounds of mutual responsibility and prudence between counterparties; not only does it encourage the sorcerer’s apprentices to introduce a dangerous degree of over-ingenuity into the associated repackaging, but that it inherently mirrors the psychology of the indulgent borrower by providing the lender with his own form of après moi le déluge instant gratification. This is realised when the originator books – and promptly re-leverages – a notional profit long years ahead of the receipt of what he has, in fact, ensured is an ever more protracted stream of smaller and smaller quanta of payments, each predicated upon an ever more dubious ability to generate the necessary cash when it falls due.

Moreover, when our securitizer then lends the purchase price to those to whom he sells the resulting security (and sometimes even capitalizes the fees due from this as part of another securitization), we can see that a great deal of undesirable leverage can become obfuscated by the layers of seductively lucrative pyramiding being piled on top of what is, at root, a very basic – if often a highly suspect – transaction.

Institutionally, this has been made worse by the fact that finance has become the master, not the servant of the economy, a reversal which has seen star-struck politicians compete away their powers of oversight in this explicitly non-market area, in order to have the greatest number of free-spending financiers come settle in their own particular fiefdom.

The result has been that of allowing the bankers to determine their own risk limits with the same disastrously predictable consequences of enjoining teenage hot-rodders only to ease off the gas pedal once they, themselves, felt they were driving a little too fast for comfort.

Battle Hymn of the Republic

To return to our larger theme, the second major disparity between conditions today and those which obtained when the traditional business cycle theory was being teased out is that, in the interim, even the peace-time state has gone from inflicting the incidental annoyances of a worthy, but over-officious nightwatchman to marshalling a swelling roster of Gauleiter and commissars, each charged with implementing a Petri-dish profusion of bureaucratic and penal Do’s and Don’t’s in every nook and cranny of the citizen’s life. It is therefore able to commandeer scarce resources to a degree unheard in more self-reliant times.

To take but one measure of this, in the America of 1929, private sector income – wages, proprietors’ earnings, dividends and interest – was reckoned at more than twelve times the size of the public sector wages and welfare payments being doled out. Even at the height of the New Deal (and hence at the depths of the Depression) this ratio stood at five to one. In stark contrast, in today’s much-touted ‘free market’, the proportion has lately languished – even amid 2006’s  boom-time conditions – at around 3:1, below that recorded even in the final years of WWII.

If we stop for a moment to make an additional adjustment for all those ostensibly ‘private’ businesses whose sole or major client is the state (and whose totals should therefore be transferred from numerator to denominator), we can see that what has lately fallen apart is anything but Darwinian ‘capitalism’ and that it is not so much the red staining the tooth and claw of the marketeer about which we should be concerned, but rather the one staining the banner of the International which flutters above us all.

The point here is that if government is a dead weight in good times – especially with regard to the enormous costs incurred as its legions of pen-pushers, inspectors, and collectors earn a nice living, thank you, making up arbitrary rules and shuffling resources from Peter (who is not THAT electorally important to their masters) to Paul (who currently happens to be) – it can be equally a decelerant in the bad ones. Even here, though, we should harbour no illusions about whether this attribute simply prolongs the patient’ s agony, rather than being of any identifiable therapeutic value to him.

There is no magic at work here, only a suspension of accounting conventions. Any sprawling organisation able to siphon off the wealth of others by diktat can endure even the most sizable mismatches between income and outgo for a considerable time, especially when the Maynard-in-Wonderland orthodoxy positively encourages it to abandon any pretence of living within its means (effectively, within those of the subjects from whom it levies them) whenever storm clouds gather in the vicinity.

With the cargo-cult of Keynesian ‘spending’ dominating the collective consciousness, Depression may be the sickness of the citizen, but it is assuredly the health of the State no less than is War (to recall Randolph Bourne’s trenchant phrase). Thus, the enormous, bloated girth of Leviathan is bound to expand relatively – and probably in an outright fashion, as well. As it does, GDP – which is biased to the sort of end-expenditure at which government excels and which largely ignores questions of the sustainability of such flows – can be temporarily boosted and payrolls kept artificially inflated, even if the ongoing loss of wealth is increasing.

Given the socio-political tenor of our times it is pointless to pretend that one can make many converts to the viewpoint that what the economy needs now is not more meddling, but instead the greatest entrepreneurial flexibility in adapting to drastically altered conditions; the maximum facility in matching costs to falling revenues; and the utmost capacity in altering the composition of its capital base.

Conversely, in the purely dispassionate attempt to formulate an investment strategy it would be equally naïve not to allow for the fact that, well-intentioned or not, the perverse incentives attaching to interventionism (which, sui generis, must involve a policy of not allowing many of the necessary adjustments to proceed) and to the general substitution of narrow political preference for the market-based expression of individual will may well cushion some of the most violent effects of the down wave, but only at the cost of seriously impairing both the speed and quality of the subsequent recovery.

Remember that, for all the unheard-of billions thrown at the problem, for all the monetary debasement so cynically practiced, even Roosevelt’s most ardent apologists will tend to subscribe to the misconception that it took the forcible enslavement of six million young men in the armed forces and the institution of a rigid command economy to ‘put and end to’ the downturn.

Effectively, this is to admit that only by a tyrannical diversion of the labour of a significant portion of the workforce to the least constructive ends imaginable could a Keynesian programme keep everybody occupied – albeit for the scantest of material rewards to those so made to toil! No surprise then, that many of FDR’s Brain Trust openly admired Mussolini, or that JMK himself notoriously prefaced the German edition of his General Theory with a wistful encomium to the totalitarian system under which he imagined the machinations laid out therein best working. 

Be that as it may, it is clear we must resign ourselves to a repeat of the experiment, for each passing day brings us yet more activism – much of it sweatily reactive; little of it showing signs of reflection or the pursuit of a considered strategy; most of it adding to uncertainty and thus spreading paralysis rather than acting as a palliative.

But if it is a military maxim never to reinforce failure, it is equal a principle of politics that if one billion fails, then two billions must be required, or, indeed tow hundred billions. Switching metaphors, the quacks into whose tender mercies we have been committed consider that, if the patient has become anaemic and run-down as a result of long years of dissipation, he must be bled and, should he not recover from his swoon, he must be purged and bled some more.

Pomp & Circumstance

Of course, it just m-i-g-h-t be that something in the seemingly endless barrage of new measures accidentally delivers one of those ‘Yes, we can’ moments for which all President Obama’s many worshippers are so fervently praying, but there are also three far less benign outcomes which we would argue lie much higher up the list of likelihoods, namely:-

  • that what remains of the market mechanism will wither and die as the incalculability of the regime changes saps its last vestige of vitality and so allows the slump to intensify disastrously;
  • that the advance of government, far from being an auxiliary source of strength, simply provides a cover for the private sector to withdraw from the fray, clamping down on its own expenditures and snuffing out the embers of investment as its members retreat from a world in which they can foresee no realistic chance of turning a profit – something Mises himself was already talking about as early as 1931;
  • that the crazed moves to slash interest rates, to monetize an increasingly unlikely basket of shaky claims, and to balloon public deficits might yet trigger a series of currency collapses or unleash a wild Weimar, wheelbarrow ride to the poor house.

The first of these scenarios needs only a little exposition. Perhaps the most pressing danger in this regard is that an unstoppable death spiral emerges from the current fiasco over the banking bail-out, especially in countries where the relevant scale of contingent fiscal support is clearly beyond the bounds of possible delivery.

Promptly liquidating bad banks, like liquidating any other failed enterprise, would have served to reduce the horrendous degree of over-capacity all too apparent in an business where ever more insane levels of risk and leverage – as well as ever more sly regulatory prevarication – have had to be accepted in order to make the expected return on capital.

But rather than encouraging full and early disclosure of each entity’s true status and then applying a rigorous practice of triage – thereby making room for the remaining healthy banks to continue to serve sound borrowers at an economic rate of interest – the authorities have so contrived it that almost the entire industry has now come to be dependent upon the public purse and/or the central bank printing press, with regulators also conniving in a relaxation of reporting standards and capital adequacy testing at precisely the moment when the cancer of distrust – of discredit, if you will – is poisoning the system, to the detriment of all. The only purpose this seems to be serving is that of keeping the plague victims alive for just long enough to pass the infection on to the healthy.

Be that as it may, we are now almost irreparably committed to the very opposite course – thanks to the incomprehension of some leaders and to the vainglory of others. In this context, we had previously argued that in major countries with relatively little foreign currency debt, the constraints on the monetization of assets, on central-commercial bank support for even long- term government debt, and therefore on unbalancing the budget were perhaps further away than was generally imagined. However, on reflection, that might have been a little too glib and it occurs to us that there are two main caveats to be borne in mind – one general and one more specific.

In the round, the mistake we made regarding EMs last quarter tells us to be wary of over-aggregation here, too. One could well expect that the sharp drop in a given currency which such extreme measures tend to provoke (viz., the UK) might initially be welcomed as an aid in ‘rebalancing’ activity away from the external sector, but, even where overall foreign currency debt levels suggest the side effects should be muted, we must always be wary that certain sectors – or even individual bellwether companies – might, nonetheless, find themselves driven onto the rocks, dragging down their counterparties with them as they founder (Russia is a case in point here).

Even were this not to occur, one cannot entirely allay the nagging suspicion that a sharp fall in the reserve currency, for one, might actually be broadly deflationary, as was sterling’s abandonment of gold in 1931. Though this might seem a perverse judgement to those conditioned to see a sickly greenback as the world’s main inflationary driver, just imagine what would happen to world trade flows, to real income, and to foreign balance sheets – packed as they are with paper denominated in it – if the dollar were suddenly devalued 50% overnight and so prompted widespread write-downs and bought fewer imports (and also, in such credit-straitened times, gave others the means to buy fewer US exports, too).

Turning to the more specific problem we can envisage, the rub is that for such extraordinary steps to be taken, the central bank must be a full and active participant in them – in the jargon, the demarcation between fiscal and monetary policy must be removed. This, however, may be easier to achieve in, say, Japan, the US, or China than it is ever likely to be the case in the Eurozone.

If even Germany has struggled to get its paper away in recent auctions, what price a Greece or a Portugal if bond spreads widen and CDS quotations climb further? To deal with the inevitable fiscal strain of a deep recession is one thing, but to have to resuscitate the entire financial circulatory system at the same time is a prospect which is already beginning to spook the horses.

It is true that the same government bonds with which a polity may intend to support an ailing bank – or use to extend finance directly to a cash-strapped local business – are the ideal balance sheet fodder for that same bank (being zero risk-weighted, earning assets), a fact which sets up the possibility of pulling off a neat little round-robin of accounting trickery.

As we have long said, in extremis, the state could become the lender and spender of first resort, with credit institutions relegated to becoming rump depositories of the proceeds of what would effectively be ‘war-bonds’. Moreover, since these bonds would also be eligible collateral for the ECB, even in the Zone, the central bank could be inveigled into playing a supporting role without formally having to announce its willingness to do so.

Nonetheless, there is clearly much more scope inside the fractious EU for political schism – especially across the historic divider of the Rhine – than exists within, other more homogeneous sovereignties and those who argue that the case of a Spain is no different to that of a California clearly forget that the last time American states signalled their wish to exercise their constitutional right to secede in the face of unsupportable economic policies, a certain high-tariff, corporate-welfarist from Illinois ‘unleashed the fateful lightning of His terrible swift sword’, leaving a million of his compatriots to share his own, premature obsequies.

Beyond the purely financial angle, a further possible route to the abyss which might lead from the adoption of unlimited fiscal support for too many zombies would be constructed amid a resurgence of antagonistic protectionism. The worry here is that as each state acts to prop up more and more of its ailing domestic industries, it will be tempted to try to secure them a market share of which their own efforts have been all too undeserving. Furthermore, State A is likely to become even more bellicose about its new ward’s foreign (non-voting) competitors if it can persuade itself that they are only able to pose a threat to its protégé because their home State B is supporting them in their turn.

An outright repeat of the Smoot-Hawley debacle is probably not to be looked for, but a creeping erection of barriers to trade (whether or not dressed up in the cant of ‘ethical’ or ‘ecological’ rhetoric) – and hence a curtailment of the means by which the indebted can pay down their obligations – is not to be lightly dismissed. Worryingly, both the backlash against immigrant workers seen in Europe, the ‘national champion’ policy emanating from the Elysée and the insidious moves by the US steel lobby to tie Washington hand-outs to preferential use of its products show how rapidly things could degenerate as stresses mount.

The Farewell Symphony

Assuming we do avoid such pitfalls, we must next consider whether government can actually stimulate business or merely substitute for it and the lesson of 1930s America is salutary in this regard.

For example, real, private net domestic investment was negative throughout all of the six years from 1930 to 1935, inclusive, strongly suggestive of the inference that the very business-to-business component of spending which is largely cancelled out in the GDP methodology, but which is crucial to the maintenance – much less the elevation of – material prosperity, was withering on the vine.

With overall retained earnings negative for these same six years – as even non-financial companies sought to maintain some level of dividend payment in the face of a plunge into negative aggregate profitability unique in the statistical record, renewed investment – and hence a re-employment of displaced workers – was all the more reliant on access to funding (and, conversely, to the willingness to take the accompanying risk). A look at the trajectory of aggregate debt levels is therefore instructive here, as the following table highlights.


TABLE 1: ‘Crowding out’ 1930s-style

From this, it is evident that, by 1938/9, though FDR’s regime had increased its indebtedness to no less than 2 ½ times the levels which had prevailed on the eve of the slump in 1929/30, the private sector total provided more than an offset, by contracting 23% from a much larger starting base.

Thus, while government debt outstanding rose some $27 billion (equivalent to a third of average nominal GNP over the period), private balance sheets shed nearly $38 billion, led by a $16 billion drop in corporate liabilities, a $12 billion decline in commercial & financial loans (only partly a result of the $2.3 billion fall in brokers’ loans), and a $7 billion fall in non-farm mortgages. Not shown here, net new issuance of corporate securities declined more than 90% from a 1928-9 combined peak of $13.3 billion to a 1939/40 nadir of only $1.2 billion.

That the net shrinkage in the combined debt stock of $10.5 billion almost exactly matched the $9.5 billion decline in GNP, or the $11 billion drop in disposable personal income is almost too perfect a coincidence, but nevertheless shows up a very real causative chain.

This ‘passing of the baton’ was a major reason why, despite the appearance – after years of Coolidge frugality – budget deficits of exceeding a then-shocking 5% of GDP, a 40% devaluation of the currency, and a tangled lunacy of producer subsidy and supply destruction, ‘only’ took the average change in CPI to the abnormally high peace-time level of 3.4% between 1933 and 1937, but did not entirely realise the contemporary fears of those who fretted over the ramifications of this concerted display of voodoo economics.

Japan of the 1990s offered a repeat version of the trend. From taking up 80% of household savings around the bubble peak (i.e., in the five years 1987-91), private, non-financial corporations switched dramatically to being net lenders of funds, adding to the pool a sum almost three times that set aside by householders. Put another way, from borrowing 9.2% of total private domestic demand, they ended up saving 7.2%, thereby largely offsetting the vast expansion of the government’s contribution.


Figure 1: Leaving the field of play

Indeed, so counter-productive was this latter, that it was only after the Koizumi reforms started to reduce its footprint – from around 2002 – that private sector demand showed any signs of revival. Shortly, thereafter, in 2003, gross corporate expenditures finally pulled out of a six-year, 14% nominal-yen slump (where they had hit a level first seen way back in 1990) and embarked upon their most rapid and sustained advance since the bubble itself burst, more than a decade before.

So, today – where left to themselves – many businesses have already begun to taking tough, but rational, steps aimed at coping with a radically changed environment. Such an adaptation is, after all, what constitutes the recession itself and this, it should never be forgotten, is a healing process.

Certainly, for some while, fewer capital goods will be needed (or, at least, fewer of last year’s hot-ticket items), fewer workers will be hired, and fewer productive inputs – such as fuel and other raw materials – will find a use. Though one can have a sincere degree of compassion for those individuals blamelessly caught up in the dislocation which must ensue, the shortest route back to gainful employment for them all is for entrepreneurs to be given every encouragement to do what they do best and to be provided with all possible means to identify new opportunities and to suffer no let or hindrance in taking advantage of the temporary slack in resources as they move to exploit them and so act to restore a more durable form of prosperity.

If governments r-e-a-l-l-y wanted to do some good, therefore, they would desist from monetary quackery and strictly limit assistance to that which temporarily alleviates genuine hardship. They would drastically reduce business taxes – as well as those levied on all forms of private savings. They would simplify planning protocols and cut loose the onerous burden of largely pointless regulations being mindful of the fact that building a better framework within which the state-dependent legal nonsense of fractional reserve banking is one thing, but telling entrepreneurs how many threads per inch must be on each screw they use or insisting upon written confirmation of the maximum capacity of each fire bucket is quite another.

Above all, governments should desist from spending much beyond their now-reduced incomes. Though anathema to the tenets of modern macroeconomics (the same ones, you will recall, which were of such help in both predicting and, hence, avoiding our present woes, much less in helping rectify them), this would both reduce business costs directly – hence helping restore profitability – and make the least charge on the sorely-depleted pool of useful existing resources. Such minimalism would therefore greatly facilitate the entrepreneurial shift we so urgently need to take place.

Capriccio Espagnol

But, to re-iterate, it is a forlorn hope to look for an outbreak of collective sanity to occur, so we have to assume that frictions will be increased, not alleviated and that recovery – in the main scenario, at least – will be shallower and more enfeebled than it need be.

In essence, those residing in the inveterate deficit nations (see the accompanying graphic) need to borrow and spend less and save and produce more of almost everything but domestic real estate! If necessary, some reflection of this could be seen in altered foreign exchange rates – ideally as a one-off movement recognising the falsity of the existing parity and its distortive effects on economic calculation – but only where this is not frittered away by renewed credit expansion and the sort of self-defeating short-termism reported by the Bank of England agents last month when they revealed that UK exporters had tried to use the fall in sterling to try to increase prices, only to wonder why orders were not then sufficiently forthcoming in a world already cutting back on outlays of all kinds.


Figure 2: Neither a borrower, nor a lender be

In the language of Boehm-Bawerk, such nations need to lengthen their structure of production – something not best achieved by mindlessly promoting end-consumption, whatever the Krugmans and Kaletskys of this world may think. As Hayek replied to R. F. Kahn’s disbelieving question on the occasion of delivering his seminal ‘Prices and Production’’ lectures at the LSE, in 1931, if everyone went out and bought a new overcoat (i.e., if excessive end-consumer demand were stimulated), it would make the problems worse, not better for enfeebled higher-order businesses by bidding inputs away from them.

As far back as John Stuart Mill, it was recognised that the demand for end-consumer goods does not constitute a demand for labour, per se – only a vote as to how labour should be employed. It is the pairing of the saver and the productive redeployer of the saved resources which puts others to work, not the hedonistic depleter of the existing stock of goods. But even such a simple, two-step analysis eluded the mathematical meddler who was Keynes, however, leading him down some ludicrous blind alleys, indeed.

As Mises recalled (quoted in Marxism Unmasked, San Francisco, 1952)

“An American friend published an article dealing with his personal friendship with Lord Keynes. He tells a story about visiting Keynes in a Washington hotel. In washing his hands, the friend was very careful not to soil more than a single towel. Keynes then crumpled all of the towels and said in that way he was making more jobs for American chambermaids. From this point of view, the best way to increase employment would be to destroy as much as possible. I would have thought that idea had been demolished once and for all by Frédéric Bastiat in his broken window story. But evidently Keynes didn’t understand this tale of Bastiat’s.” 

Nor do all too many commentators today, one would add.

Conversely, the chronic surplus nations have to ward off the curse of what has seemed like their own success. They need to curtail investment in more export capacity and, in future, those that have resisted it should allow their currencies to appreciate gradually, limiting the possibilities for a future over-reliance to emerge. Rather than acquiring ever more claims against those abroad who are unlikely ever to repay them in full, they would be well advised to eat a little more of their own cooking than has lately been their practice.

In some cases – loosely, that of Allemanic Europe – the expansion has been much more horizontal (an extra car assembly line, an extra shift at the turbine casting works), rather than longitudinal (whole new layers of long-duration, deferred-amortization, interlinked productive stages) and the response should therefore simply be to reduce that capacity which has only served to deliver goods to those inveterate over-borrowers no longer in a position to take them up.

As many commentators have noted, one inevitable and rather unpalatable consequence of the present mess is the striking disparity between the situation in the Teutonic core of Europe and that found in the Latino-Celtic fringe – one which must be faced – assuming the European project itself is not jeopardised without the panacea of a currency adjustment to help bridge the gap in productivity and the cost base.

Self- evidently, Spain, Greece, and their peers need to hunker down and live far more within their means, while Germany and the Netherlands must, in turn, generate far more of their wealth internally than has been their practice, or else they must seek out counterparts able to pay for their shipments machine tools and mining equipment with useful merchandise of their own, not kited cheques.

Patently, the days are long past when it might have seemed sensible to squander such a high proportion of savings in offering ‘vendor finance’ to foreign customers – for that has only been to swap hard-won real resources and human toil for the pixilated promises of a prodigal. Note that this is not to endorse the standard ‘rebalancing’ argument that the surplus nations should simply resolve to spend more, willy-nilly, as an offset for the deficit nations’ retrenchment, for the former, too, have significant losses to make good while the partial re-orientation of their mighty engine of exports will take a great deal of savings-backed capital to accomplish.

In some of the surplus nation a further difficulty arises since here the mountain of export receipts has been used to further swell the domestic monetary base, enabling the ensuing credit influx to foster a true, producer-style boom – China, India, Russia, the Gulf nations, spring to mind. These countries need to shorten their productive structures as well. The irony here is that though individually laudable for their industry and thrift, people in the surplus nations face the much more difficult task in coming to terms with the new order (especially where they were foolish enough to borrow short in foreign currency in order to finance long-term schemes at home). This is something perhaps not still entirely understood by the mainstream

It may be unpleasant to forego the luxuries to which one has become accustomed until one has worked to earn the means to afford them – as the debtors may now have to do – but is usually a great deal harder to accept that the towering superstructure of machinery and plant one has built with the sweat of one’s brow to provide them now needs to be idled, retooled, or scrapped completely. The temptation must surely be to muddle along, high grading mines, skipping maintenance and deferring replacement schedules in factories, seeking for funding (where accessible) to tide oneself over, all in the hope that conditions may one day improve as mysteriously as they seem (to the average business executive) to have deteriorated.

Unfortunately, that is only a choice which serves to increase the consumption of capital and which will thereby add to the impoverishment one is currently seeking to avoid. There is no denying the harsh truth that the overcapacity which has been so painfully revealed these past few quarters is nothing less than a colossal physical reflection of the wastefulness engendered by the worldwide credit expansion. Whether or not those who commissioned the building of the excess were any more than passive participants in a monetary laxity often generated elsewhere and insidiously transmitted to their shores is utterly beside the point: capital has been misguidedly lavished upon it and workers hired to man it. Sadly, the implosion of the boom has left both unable to generate sufficient revenues to justify their continued engagement on anything like the scale envisaged when illusion still reigned supreme.

In the Hall of the Mountain King

We have often remarked that much of what has passed for the exceptional levels of profitability enjoyed by many companies in the upswing was as much as facet of financial engineering (again, much of it associated with securitizing customer receivables, lease payments, etc.) as it was anything to do with improved technique. (It is also salutary to note that, according to the US FoF data, no less than three-fifths of the whole $6.3 trillion, 63% rise in non-financial corporate net worth recorded during the five year upswing, 2003-08, can be attributed to notional gains in the value of real estate holdings, while the remainder can be ascribed to an increase in the balance sheet total of ‘miscellaneous’ financial assets).

Ultimately, aggregate nominal profits in a given country can only improve if a greater proportion or revenues do not have a corresponding cost item immediately to offset them and this can come about only because there has been: (a) more saving-based investment (thoroughly commendable); (b) higher overseas demand (fine, subject to all the qualifications voiced above); (c) or through credit expansion – this latter, of course, the root of all evil.

If any confirmation were needed that this indeed played a very large role in the last cycle, consider what  Richard Dobbs, et al, of McKinsey wrote in March 2008:-

‘Gauged either by earnings as a share of GDP or by returns on equity, US companies apparently fared better than they ever had, at least during the 45 years of our data. Between 2004 and 2007, the earnings of S&P 500 companies as a proportion of GDP expanded to around 6 percent, compared with a long-run average of around 3 percent, with the increase most acute in the financial and energy sectors. At the heart of this widely enjoyed earnings growth was a sales-driven expansion of net income rather than improved overall operating margins, growth in investments, or invested capital, each of which grew only slightly. In effect, companies increased their capital efficiency by selling more without making proportionate investments. In the nonfinancial sector, this meant squeezing greater capital efficiency from plants and working capital, so that returns on capital employed rose some 40 percent above the long-run US trend. Credit-driven consumer expenditures provided much of this revenue boost.’ [Our emphasis]

If we accept that, here among the rubble of the Western banking model, those days are long gone, this has significant consequences for both the top line and the bottom line (not to mention for the balance sheet) as many those same consumers fail to meet their past obligations, much less opt to expand them so incautiously in future.

It adds weight to our view that the last business cycle was one supercharged by easy credit – arguably on a scale never seen before. The inescapable inference is that the Bubble was not so much in real estate, or emerging market stocks, or modern art daubings, or vintage Bordeaux, or hedge funds, or crude oil – or whatever you care to name – these were all symptoms, not causes. No, the Bubble was the whole warped continuum of a monetary-financial system primed for disaster and propelled there by the utter incomprehension of what they had wrought which was so evident among its principal architects and overseers (the men, you will note, who are now charged with the task of ‘mopping up’ in its calamitous aftermath).

Absent such a bubble, even once the long, weary work of recovery is underway, we should set aside all thoughts of seeing such growth rates again for a very long while to come. That is, unless the third and final scenario comes to pass.

This, of course, is the one in which the opening of the Pandora’s Box of fiscal radicalism and monetary overkill lets fly the demons of currency debasement and floods the world – as is the central bankers’ unconcealed desire – with so much cash that people’s main concern becomes no longer how they can get hold of it, but how they can disembarrass themselves of the stuff.

Given that the finances of the populist Provider State are to be tested to levels not seen in peacetime, and given that the explosion in central bank balance sheets are likewise extra-ordinary – not least for the amount of sheer junk contained therein – the world has definitely taken the Tiger by the Tail. Absent the necessary degree of retrenchment and redeployment of resources, it seems the economy will become progressively more sickly and ever more politicised and will be prone to swoon every time the fiscal or monetary valves are opened less than fully, or every time a neighbour devalues his currency faster than one does one’s own.

Already, there are rumblings in Europe about the effects of sterling’s plunge, while the Swiss National Bank, no less, has brazenly warned that, if it deems the circumstances require, it could ‘sell an unlimited amount of Swiss francs…in order to prevent an appreciation…or even to bring about a substantial devaluation of the national currency.’ While the Singaporeans are trying, for the moment, to slow the rate of decline of their currency, the Russians are happy to oversee a rapid one of theirs. For their part, the Japanese are said to be concerned about he appreciation of the Yen, while the nominee for the position of US Treasury Secretary has been telling Congress that it is ‘important’ that America’s trading partners have ‘flexible currencies’ – transparent code for ‘we want a lower dollar’.

In such a world, it will be hard to imagine that the same central bankers who could not normalize interest rates in Japan for thirteen long years after pushing them below 1%, and who took far too long to restore a modicum of sanity in the aftermath of the Tech bust (itself a legacy of the Asian Contagion, which stemmed from efforts to mitigate the Tequila Crisis, which had its roots in the Japanese Bubble, which came about because of the S&L crisis, and the Occidental property bust which arose from the ’87 Crash, which came about thanks to the LDC debt crisis, which could trace its lineage back to the oil shock and hence to the break up of Bretton Woods…) will act pre-emptively and aggressively to withdraw the stimulus once the worst is past.

If that great student of the Depression, Chairman Bernanke has already apologized publicly on behalf of the 1929 Fed for easing too late, do we really think he will risk repeating the mistake they are deemed to have made when they tightened prematurely in 1937?  Does it not disconcert you, just a little, to hear Secretary Timothy Geithner telling the WSJ that: “…There (will be) a huge temptation to see the light at the end of the tunnel before it’s really there and therefore to kind of shift back to restraint before you have recovery fully established…”?

Nor can we really envisage the politicians willingly surrendering a degree of influence, vote-grubbing, and patronage which had successively eluded close to three decades’ worth of their predecessors in office. A speedy return to small(er) government and budgetary continence once the worst is past? Forget it!

So, one cannot fail to reckon without a third scenario – the one we have long espoused (though not without a few doubts in recent months as the bungling has continued). This is that – as Charles Goodhart notoriously put it in 2005 – ‘Deflation in a fiat money system is a self-imposed injury’. The only point is that, at some point, the people who use the money have also to come to believe it is the case and to switch to fearing that the cure may soon become worse than the disease.

Nor should we worry about there being enough ‘willing borrowers’ to effect the necessary bursting of the levees. If, for example, the government cut taxes to zero, while maintaining or even increasing its disbursements and simply issued T-bills to the central bank to make up the difference, a spendable, lendable surfeit of money would quickly find its way into people’s pockets, even absent a functioning private credit system. Likewise, if the central bank offered to swap unlimited quantities of bank notes or reserve balances for any identifiable claim to property, or against any verifiable promise of deferred payment presented to it, a shortage of currency would not long be felt to be a constraint.

Long-term private investment might well find little comfort under such conditions, so wealth creation might be moot, but a feverish struggle to exchange money for such goods as are available might mislead the monetary cranks into thinking they have succeeded in restoring some vitality to the system.

Given the intemperance with which those in power are acting, given the pride which they – closet Jacobins, to a man –  take in being wildly ‘unconventional’ in all things, a rebound from falling to sharply rising prices is eminently possible. The larger the government deficits incurred along the way, the more engrained the  habits of economic dictatorship, and the more entrenched the fiefdoms so created, the greater the overhang of outstanding debt which will result and hence the more intense the incentives to monetize it away in real terms.

Bamboozled by our Bloomberg screens and quickened in our impatience in a world of iPhones and Instant Messaging, we should not lose sight of the fact that we are still at a relatively early stage in the game – it is only eight short months, after all, since the ECB was last raising rates, while even the BoE only started cutting aggressively in September. Do not rule out the possibility that we are already putting in place the means for a destruction of wealth and values in a wholly opposite manner to the one everyone presently fears.

Figure 4: Heat Death, Snowball Earth & the Little Ice Age

MMM Approach

At root, MMM is based on the belief that the Credit Cycle is the Business Cycle; that fluctuations in money and credit are what give rise to instabilities in economies. It is our lot to live in a period where the checks and balances on such turbulence are much less robust than ever before; one where the deliberate violation of such restraint as does remain has become the very goal of active policy. To try to understand the interplay between money, asset markets, and the real world is the crux of what we do.

There is not much here that is a dull repetition of the mainstream economics practised so widely today. It may be a strange confession for the author of a publication called ‘Money, Macro & Markets’, but we like to start thinking about things from the individual perspective before working upwards to the collective – from micro to macro as it were. No spurious pseudo-science, just the rigorous application of logic tempered in the forge of experience.

For more detail, please download the Intro:-

16-04-28 MMM Approach

MMM Archive

Regular readers will know that the articles published here are but a small subset of the detailed work I undertake to analyse economic and political developments and their effects on markets. In order to give some idea of the scope of this, presented below is an archive of past issues of the Austrian School-informed, in-depth monthly publication, ‘Money, Macro & Markets’ in addition to which I compile twice monthly updates as the ‘Midweek Macro Musings’ which are also made available on a complimentary basis to subscribers to the former letter.

September 2016 – US equity (over)valuation: Eurozone policy overkill: Japan’s dire fiscal status

16-09-29 MMM Sept Issue

July 2016 – Liquidity traps: Post-Brexit UK: Chinese credit

16-07-20 MMM July Issue

June 2016 – US Labour Market: Productivity Unpuzzled

16-06-20 MMM June Issue

May 2016 – IMF Ship of Fools: China the Next Sucker

16-05-12 MMM May-Issue

April 2016 – UK deficit – Fred Karney’s Circus: China’s Drain: US – All in Order

16-04-11 MMM Apr Issue

March 2016 – ECB Overkill: The Farm Patch goes Oil Patch: Beijing Fingers in the Dam: Drilling Down

16-03-10 MMM Mar Issue

February 2016 – China Hopium Wars: USA Top-end Teetering: Saudi’s Empty Quarters: Is Cheap Oil Good?

16-02-10 MMM Feb Issue

January 2016 – China promises reform (again): The Fed finally does it: Carney sees no signal: ECB running out of debtors

16-01-12 MMM Jan Issue

November 2015 – Hocus Pocus: UK Sells the Family Silver to Europe: USA ABCT: China JIitters

15-11-11 MMM Nov Issue

October 2015 – Against Stupidity: Tail-chasing at the Fed: Lipstick on the Chinese Pig: Stocks (& Bonds) for the Long Run

15-10-12 MMM Oct Issue

September 2015 – Mississippi Bubble Chinese-style: Reserves & Repos Cheatsheet: Shuddup, already!

15-09-01 MMM Sep Issue

August 2015 – China’s Fake Boom: FRB Wash, Spin, Repeat: UK World per capita Deficit Champs: Euro Money Explosion: Real Commodities still not cheap

15-07-30 MMM Aug Issue

July 2015 – China & the Water(ed) Margin: Spending the Swiss Hoards: Behind the Fed Curve: CPI Mania goes Global: US Equity Valuations

15-07-30 MMM July Issue

June 2015 – China Running to Stand Still: USA Fewer Grasshoppers per Ant: UK New Regime, Old problems: Europe’s Rational(ized) Bubble

15-07-30 MMM June Issue

For subscription details, please refer to the HindeSight Letters page.

Money, Macro & Markets – The Archive

Regular readers will know that the articles published here are but a small subset of the detailed work I undertake to analyse economic and political developments and their effects on markets. In order to give some idea of the scope of this, presented below is an archive of past issues of the Austrian School-informed, in-depth monthly publication, ‘Money, Macro & Markets’ in addition to which I compile twice monthly updates as the ‘Midweek Macro Musings’ which are also made available on a complimentary basis to subscribers to the former letter.

Continue reading

The Road to Canossa

That the artificial interest rates in evidence in our hugely distorted capital and money markets can be made negative in nominal as well as in real terms is, alas, the curse of the modern age. Though entirely at odds with natural order – as we have repeatedly tried to make plain – they are also a curse that we are unlikely to have lifted any time soon, especially not in a Europe where there is no effective restraint to be had upon the exercise of his awful powers by the likes of a fanatic like Draghi.

Continue reading

Read the Book

Financial markets and human folly are clear cases of ‘deja vu all over again’ – an observation which raises the question: if only we knew a little more history, might we be able to draw lessons from the mistakes of our predecessors rather than being doomed to learn the hard way by repeatedly making our own?

Might we be also able to use what the past teaches us to construct a theoretical framework which gives us the hope we might understand our modern world a bit better than did those of the Good and the Great whom the British Queen famously asked, ‘Why did nobody see it coming?’

Oh – and did good, old Walter Bagehot really stand in favour of central banks in principle, and would his shade be likely to endorse the sort of policies they pursue in his name today?

‘Santayana’s Curse’ is the book to read to find out – and please forgive the cringeworthy corporate puffery jammed in as a preface. To adapt the usual disclaimer, the author insists the views are entirely his own – but only once the book proper begins.

Available on Amazon here http://tinyurl.com/santayanascurse

15-02-23 Book Cover


Turning Points

Note to a Client at the Height of the Crisis – Dec 15, 2008; expanded macro rationale added January 2009

Reinvestment Check List

So let us sum up and try to derive some practical pointers from all this theorising. The first premise under which we are working is that the credit cycle IS the business cycle; the second is that, no matter where it starts, higher-order goods suffer the heaviest, consumer staples the least, in the downturn; the last is that viable production must precede consumption but must also be in tune with what consumers want and can afford.

Thus, in commodity terms, we have industrial metals   – which should include platinum and palladium, too – and rubber, cotton, and possibly sugar at one end and food crops at the other, with energy products spread between, but biased to industrial end as B2B spending is always a multiple of the kind of end-consumer numbers which show up so heavily in GDP data. Gold and silver (this a poor second) used to be a means of deflation protection since they used to BE money, but are now more of an inflation shield (hard assets vs paper) and also a credit insurance vehicle.

Recession starts when business costs get out of line with returns and recovery sets in when the converse applies (or a realistic prospect thereof takes hold) and, sadly, sacking people and scrapping capex is part of that process, so job cuts and plant shut downs are a necessary pain to be suffered the faster, the better. Like any other inputs, workers will get rehired when their (potential) contribution to profit outweighs their known cost.

The lesson of Japan’s ‘Lost Decade’ is that such earnings as are still made will be devoted for some time to repairing balance sheets, depressing corporate spending. This is key since gross business outlays are typically 2-3 times GDP, 4-6 times household consumption and 10+ times net Government spending.

In Hayekian terms, we today in the hollow of a mini ‘secondary depression’ –  i.e. one where the real-side slowdown – though brought on in the first place  by a credit-led unwind of prior credit excesses – has triggered a financial-real world negative feedback loop. Until that dynamic is broken, it will be hard to stabilize.

As and when it does, we still need to transfer as many people and as much productive capital away from zombies to seedlings as possible and while the overlap may produce negative headlines, this may still suggest healing is occurring. Anything the State does to reduce business costs is a plus, all other measures are likely to be counterproductive.

Finally, aggregate level profits can only occur arithmetically – a la Reisman – when unbacked credit is being pumped into the system (the bad way) or (by contrast, the wholly benign way) when saving (corporate or household; domestic or foreign) is being converted into below-the-line investment in saleable inventories (which are NOT therefore always a bad thing) and into fixed capital stock (each of which implies that each revenue dollar does not have a fully-realised cost dollar associated with it).

Finally, this is all very macro, top-down of course, so a fully rounded investment process would look bottom up and probably use the above only to time entry and/or to take note of threats to the entrepreneurial process at work at the individual company level, or to identify especially favourable circumstances in which the firm might be able to achieve one of the periods of ‘punctuated evolution’ which seems to characterise the genuine creation of shareholder value and not the GE ‘one penny per share every quarter’ artificial straight line kind.

One further point to note is that some of these features show up in markets first. As they do, market movements alter real world pricings so, as practitioners, we then have a two-way interplay between technicals and fundamentals which we must take into account.

The list we present is concentrated more on the business cycle itself, with some flavouring of the role commodities both as participants in it and as indicators of its status. The unanswered question is actually this: rather than ‘stronger for longer’, has the bursting of the credit bubble returned commodities to the regime of the previous twenty odd years (indeed of the previous 20,000 years!) of declining real prices – interrupted by multi-month, counter-trend evolutions – rather than holding out any chance of a repeat of the past seven years of outsized and indiscriminate gains?

If so – after a possibly sharp correction from today’s extremely oversold levels – we would thereafter see a far more oscillatory behaviour, as well as one much more differentiated between various commodities, with any gains being largely confined to nominal ones and possibly severely mitigated in practice by the prevalence of nasty contangoes which will have to be managed or at least mitigated.

The world is undeniably undergoing a major cyclical recession which we will call the ‘Little Ice Age’ – one which may last well into 2010. On top of this, the AIG-LEH fiasco – and the extreme counterparty/liquidity fears which this engendered – served to bring much of the machinery of production and the movement of trade to a juddering halt, intensifying the glaciation to a state we might dub ‘Snowball Earth’.

The working assumption is that the first signs of recovery will be associated with a reversal of this last phase and that activity and prices will show some signs of increase even if this does NOT signal and end to the adjustment process which is entailed by the wider recession.  

The world is undeniably undergoing a major cyclical recession which we will call the ‘Little Ice Age’ – one which may last well into 2010. On top of this, the AIG-LEH fiasco – and the extreme counterparty/liquidity fears which this engendered – served to bring much of the machinery of production and the movement of trade to a juddering halt, intensifying the glaciation to a state we might dub ‘Snowball Earth’.

The working assumption is that the first signs of recovery will be associated with a reversal of this last phase and that activity and prices will show some signs of increase even if this does NOT signal and end to the adjustment process which is entailed by the wider recession.

Thus, as we look for signs that either of these are beginning to improve, from my perspective, this is the provisional check list we should be running through:-


(A) Signs that Snowball Earth (capex AND working capital freeze) is thawing out, that basic flows of goods and materials have resumed, and that commodity prices can stabilize/rally:-


(1) Dollar strength ends & commercial bank redeposits at Fed/ECB decline – implying (CDS- and liquidation-related) funding hunger is finally abating;

(2) Yen weakens, especially v ‘commodity’ currencies – Japanese are again recycling offshore receipts

(3) Trade begins to pick up – maybe signalled via Baltic index, port container traffic, IATA air freight, AAR intermodal, USDA export figures, MSCI Marine equities index, etc, long before official numbers register the shift

(4) Producer metal surplus stops increasing/users restock. LME warehouse inventories fall, Shanghai ones pick up

(5) Real narrow money flows stop declining/decelerating. Money (properly defined) grows faster than credit, implying that goods are moving more readily from start to finish of the global assembly line and that sales are realised, not fictions of receivables accounting Weekly US financial data, monthlies in others

(6) Risk aversion starts to subside as captured by various spread/volatility measures, but principally led by a reversal in long T-Bond yields.

(7) The housing market begins to clear. MBAA weekly purchase index trends up

(8) Energy use stops falling. Cheaper prices encourage end-consumer use; restarted production boosts industrial use

(9) Crack/ Frac spreads improve. People actually want end-product

(10) Gold is no longer the best commodity performer

(11) Contangoes ease


(B) Signs that Little Ice Age is also ending (long term capital markets are open for business and are again being accessed) and hence that adjustment to the new world is taking place, setting the stage for further growth in future:-


(1) Non-Govt bond issuance picks up; Libors normalize, credit spreads come (selectively) in from extremes

(2) Equity markets start to rally on bad macro news days, as asset allocators rebuild exposure on dips; IPOs emerge, rights issues not so steeply discounted

(3) NAPM/Ifo/Chinese PMI-type numbers edge back towards neutral (which may merely imply things are not getting worse!)

(4) Bank assets increase, ex-CB re-deposits and government/GSE security purchases

(5) Corporate value added/cash flow starts to outstrip labour costs meaning firing is becoming less attractive than hiring once more

(6) Capex budgets are maintained/grown rather than slashed; inventories stop falling – machine tool orders rise – these two imply aggregate profits (unexpensed outlays) will begin to rise

(7) TIPS no longer price Armageddon



As you know, I have been looking at these sorts of things for some time on an informal basis, but I am here trying to be a touch more systematic. This is far from a finished product, more of a first stab.

The first premise is that the credit cycle IS the business cycle; the second is that, no matter where it starts, higher-order goods suffer the heaviest, consumer staples the least in the downturn; the last is that viable production must precede consumption but must also be in tune with what consumers want.

Thus, looking at commodities in terms of this difference between ‘higher-‘ and ‘lower-order’ goods, we have industrial metals – which, for me probably should include platinum and palladium, too – agriculture ranging from rubber and cotton at one end and food crops at the other, with energy products spread everywhere between, but biased to industrial end as B2B spending is always a multiple of the kind of end consumer numbers which show up so heavily in GDP data. Gold and silver (a poor second) used to offer a deflation protection since they WERE money and a strong shift in the preference for money over goods is what a deflation actually entails, but gold is now more of an inflation shield (as a hard asset v paper), but also credit insurance – look at how it outperforms its peers when vols and credit spreads start to rise.

Recession starts when business costs get out of line with returns and recovery when the converse applies (or a realistic prospect thereof takes hold) and, sadly, sacking people is part of that process, so job cuts are a necessary pain of our healing process and should not be hindered by diktat.

In Hayekian terms, we are here in a mini ‘secondary depression’ – i.e., in a state where the real-side slowdown – though brought on in the first place by a credit-led unwind of prior credit excesses – has triggered a financial-real world negative feedback loop. Until that is broken we cannot stabilize.

As and when it does, we still need to transfer as many people and as much productive capital away from zombies to seedlings as possible and the overlap may produce negative headlines but still suggest healing is occurring. Anything the State does to reduce business costs is a plus, all other measures are likely to be counterproductive. The latter will, alas, almost certainly dominate the former, given the prevailing paradigm.

Finally, aggregate level profits can only occur arithmetically – à la Reisman – when unbacked credit is being pumped into the system (the bad way) or conversely (this, the wholly benign way) when saving (corporate or household; domestic or foreign) is being converted into below-the-line investment in saleable inventories (whose growth is not therefore always a bad thing) and additions or improvements to fixed capital stock and hence when each top-line revenue dollar does not have a fully-realised cost dollar associated with it.

Like any other goods, workers get rehired when their (potential) contribution to profit outweighs their likely cost in the entrepreneur’s best judgement. Nothing should be done which will persuade him that this is not going to be the case.

The lesson of Japan’s ‘Lost Decade’ is that such earnings as are still made from here on will be devoted for some time to repairing balance sheets, so depressing corporate spending. This is key since gross business outlays are typically 2-3 times GDP, 4-6 times household consumption and perhaps 10 times Government spending.

As discussed, some of these features show up in markets first: sometimes market movements alter real world pricings. So, as practitioners, we then have a two-way interplay between technicals and fundamentals to consider.

Finally, this is all very macro, top-down of course, so a fully rounded investment process would look bottom up and probably use the above only to time entry and/or to take note of threats to the entrepreneurial process at work at the individual company level, or to identify especially favourable circumstances in which the firm might be able to achieve one of the periods of ‘punctuated evolution’ which seems to characterise the genuine creation of shareholder value and not the GE ‘one penny per share every quarter’ artificial straight line kind.

The list is concentrated more on the business cycle itself, with some flavouring of commodities both as participants and as indicators of its status. I’m not sure how ‘granular’ it is, over the long run.

The unanswered question is actually this: rather than ‘stronger for longer’ (as the catchword has it), has the bursting of the credit bubble returned commodities to the regime of the previous twenty odd years (indeed of the previous 20,000 years !) of declining real prices, rather than holding out any chance of a repeats of the past seven years of outsized and indiscriminate gains?

If so – after a possibly sharp correction from today’s extreme oversold levels – we would thereafter see a far more oscillatory behaviour – as well as one much more differentiated between various commodities – with any gains being largely confined to nominal ones and possibly severely mitigated in practice by the prevalence of nasty contangoes.

Ultimately, what I call I2E2S2 – Innovation, Economisation and Substitution involving Investment being directed by Entrepreneurs utilising genuine Savings – will then triumph: human ingenuity, driven by the profit motive and the ingenious being assured of the enjoyment of that profit by stable property rights, will bring better processes and new technology to bear on the problem, supply will more easily match demand, and prices will again begin to fall – in real terms, at least.


Sean Corrigan aka Wild Goose