The “Transmission Mechanism” Is Broken.
As the Fed debates what form of QE to launch on the world and whatever new communication strategies they are going to employ, maybe they should sit back and figure out why their policies seem to be doing so little.
The Fed is clearly trying to stimulate the economy. As much as I disagree with many of their policies, I do believe their intentions were to boost the economy and not just help banks make easy money. In spite of their intentions, they have failed and I think it is because they are clinging to two flawed assumptions.
The Wealth Effect
The Fed seems to have an unwavering belief in the wealth effect. They believe that if they can just increase stock prices, people will feel better and spend more. This may have been the case at one time, but there are several reasons why it isn’t working. The most obvious flaw (which has been reported on www.zerohedge.com) is that the wealth is now far too concentrated to benefit the economy as a whole. Relatively few people own most of the shares. The benefit of an increasing stock market just goes to too few people. We are just off record highs of food stamp recipients, but the number is shocking. Somewhere around 45 million people are getting food stamps. It doesn’t take a PhD in economics to figure out that people using food stamps to survive are unlikely to get too excited about stocks being up 15% or even 30%.
So the poor don’t care about the wealth effect.
What about the middle class? Maybe in 2000 people would have been impressed by the wealth effect and spent more, but things have changed. The middle class is worried about their homes. They are not comfortable that they have much equity (if any) in their homes and that has created risk aversion that will outweigh any wealth effect. But the wealth effect is further eroded since much of the “savings” and stock investments are held in IRA’s. The middle class remains concerned not only about their jobs, but also about what they will be forced to pay for in the future. Even those people lucky enough to have defined benefit plans are concerned that those pensions and benefits will be cut back. The likelihood of receiving significant support from governments in the future (state, local, or federal) is being questioned. So the gains in IRA are offset by fears that other promises will be broken. The wealth effect may allow the middle class to consume at a reasonable level, but there are too many other concerns for this wealth effect to have much of an impact.
What about the rich? Certainly at the extreme end, going from 100 million to 110 million probably doesn’t do much for your ability or willingness to consume. Even at a lower wealth level, the change may not be enough to offset future earnings concerns – especially if you work on Wall Street. The “rich” have a lot of their wealth in restricted shares of their companies. That value will have increased, but the willingness to spend money based on an increased valuation of restricted shares is greatly diminished. Enron was treated as an isolated case, but since 2007, people are being much more careful treating “restricted shares or options” as true savings.
Then there is the psychology of the rich. Many of the rich got rich because they were smart or hard working or figure out what someone needed. They made money because they found opportunities and took advantage of those opportunities. They are smart enough to see that this “wealth effect” is being created by artificial stimulus and not real true demand. The Fed is creating demand for “risk assets” but not for products. The rich will find ways to accumulate and sell “risk assets” because that is where the Fed has been able to stimulate demand. That doesn’t generate longer term growth for the economy, but why would the rich spend money to build factories or create new products when the actual demand for products hasn’t changed? They won’t. The fact that the rich know QE just creates demand for risk assets is one of the biggest (and least discussed) reasons for the failure of QE programs to generate growth in the real economy.
At least the Fed does seem to be trying to target housing now. They must realize that attempting to generate “wealth effect” growth via the stock market is hopeless.
Low Rates for Banks means Low Rates for Banks’ Customers
Somehow the Fed believes that providing low cost funds for banks will translate into low cost funds for the clients of the banks. It just isn’t happening. Liquidity remains a key concern of banks. They are willing to sacrifice margin for liquidity and perceived safety. Why lend to a consumer when you can buy corporate bonds or treasuries. Those have much greater liquidity and require much less effort to accumulate a large portfolio then making loans a few hundred thousand dollars at a time.
The Fed has not only underestimated how much value the banks place on liquidity, they have encouraged it, as capital rules benefit banks with more liquid assets. Lending to small companies and individuals requires lots of work (costs) and results in relatively illiquid assets. The banks are placing a high value on liquidity and are extremely cost conscious, so the cheap money they get is not making it down to the lower levels of the economy. Microsoft, on the other hand, can add to their cash stash with one quick call to the syndicate desk at any big bank.
Not only have the regulations encouraged banks to concentrate on liquid assets, the Fed has given them extra reasons to focus on the lowest risk products. By becoming a bid of last resort (as far as I know there have been no details on the prices paid by the Fed for its POMO purchases) the Fed was able to help banks generate easy profits (notice how almost no bank lost money on any day when QE2 was active). Banks focused on the assets where they know there is always a bid, and not exactly the most price sensitive bid. Operation twist has failed to help get cheap mortgages into the average consumer, but it did manage to teach banks that they should continue to stick to assets where there was easy money to be made and where positions could be closed quickly.
These extremely cheap loans were like free money. Somehow the Fed thought bankers would stand in line, take the cheap money and then do something constructive for the economy with it. Instead, the banks take the free money and then do what any intelligent human being would do, they go to the back of the line to get more free money.
When a theory doesn’t work, it is often because the assumptions are flawed. The Fed should be going back and figuring out how to address the failure of the stock market wealth effect and of the bottleneck of the banks. Maybe the Fed should just make mortgage loans directly to individuals? Probably a stupid idea, but at least it would impact homes which is where the wealth effect would really be felt across the board, and it would ensure the cheap money was making it to the people the Fed wants to see getting cheap money.
Economists: A Profession at Sea
January 19, 2012 | By Robert Johnson | 14
After the financial crisis of 2008, the Queen of England asked economists, “Why did no one see the credit crunch coming?” Three years later, a group of Harvard undergraduate students walked out of introductory economics and wrote, “Today, we are walking out of your class, Economics 101, in order to express our discontent with the bias inherent in this introductory economics course. We are deeply concerned about the way that this bias affects students, the University, and our greater society.”
What has happened? Rebellion from both above and below suggests that economists, who were recently at the core of power and social leadership in our society, are no longer trusted. Not long ago, the principal theories of economics appeared to be the secular religion of society. Today, economics is a discipline in disrepute. It’s as if our ship of state broke from its stable mooring and unexpectedly slammed into the rocks. How could things have gone so spectacularly wrong? And what can be done to repair economics so economists can play a productive role in helping society?
As the Oscar-winning documentary Inside Job illustrated, there is a very lucrative market for false visions of financial-market behavior that legitimate the desires of participants to be unshackled and make more money. But good policy prescriptions are public goods that represent the social good and not just the concentrated financial interests. Unfortunately, as economists beginning with the work of Adam Smith have repeatedly shown, public goods are underprovided in the marketplace. In addition, the reputation of the economics profession is itself a collective good, and those who have tarnished it are not adequately penalized for the damage they do to their fellow professionals when they accept large sums of money in return for marketing a perspective that benefits vested interests.
These are problems that some within economics have been aware of for a long time, but the discipline as a whole has been unable to address them. The onus is on the profession to face these challenges and help lead society off the rocks.
How to Save Economics
first, economists should resist overstating what they actually know. The quest for certainty, as philosopher John Dewey called it in 1929, is a dangerous temptress. In anxious times like the present, experts can gain great favor in society by offering a false resolution of uncertainty. Of course when the falseness is later unmasked as snake oil, the heroic reputation of the expert is shattered. But that tends to happen only after the damage is done.
Second, economists have to recognize the shortcomings of high-powered mathematical models, which are not substitutes for vigilant observation. Nobel laureate Kenneth Arrow saw this danger years ago when he exclaimed, “The math takes on a life of its own because the mathematics pushed toward a tendency to prove theories of mathematical, rather than scientific, interest.”
Financial-market models, for instance, tend to be constructed with building blocks that assume stable and anchored expectations. But the long history of financial crises over the past 200 years belies that notion. As far back as 1921, Frank Knight of the University of Chicago made the useful distinction between measurable risk and “unknown unknowns,” which he called radical uncertainty. Knight’s point was that in a period of radical uncertainty, expectations couldn’t be anchored because they have nothing to latch onto. Financial theories and regulatory designs that hinge on the assumption of stable and anchored expectations are not resilient enough to meet the challenges presented by real financial markets in radically uncertain times.
The third remedy for repairing economics is to reintroduce context. More research on economic history and evidence-based studies are needed to understand the economy and overcome the mechanistic bare-bones models the students at Harvard objected to being taught.
But the economic orthodoxy continues its romance with the Enlightenment tradition of Cartesian “universal laws.” This began after the Thirty Years’ War, when society demanded both a method of investigation that did not antagonize religious factions and universal abstract laws and principles that could be objectively proven. Lost to the traumas of religious and social turmoil were the humble and pragmatic humanistic approaches of Francis Bacon and Michel de Montaigne and the suppleness of William Shakespeare. Reorienting economics away from the Enlightenment glamour of high theory and returning it to focusing on real problems, in the same way a clinical physician does, would make economics more relevant.
The profession needs to realign the incentives for doing reputable research in order to protect its integrity as a whole, as is done in medicine. Recent policies announced by the American Economic Association on disclosing conflicts of interest are a step in a healthy direction. Faculty members should also be forced to step down from consulting at the time they receive tenure.
Fourth, we must acknowledge the intimate, inseparable relationship between politics and economics. Modern debates about who caused the financial crisis—government or the private financial sector—are almost nonsensical. We are living in an era of money politics and large powerful interests that influence the laws and regulations and their enforcement. In order to catalyze the evolution of economics, research teams would benefit from multidisciplinary interaction with politics, psychology, anthropology, sociology and history.
Such interdisciplinary communication would also benefit another neglected area of economics: the study of macroeconomic systems. Psychologists mock what economists call the microfoundations of consumer behavior—a set of assumptions based on the idea that isolated individuals behave with clear knowledge of the future. That this framework is suitable for aggregate systems in a globalized economy simply because the tribe called economics has agreed to adhere to these ad hoc assumptions makes no sense. Increased interactions with disciplines that economists have often mocked as unscientific would greatly improve economists’ understanding of the real world and would be more truly scientific.
Many of these suggestions have been argued within the profession as far back as the formation of the American Economic Association in the late 19th century. Its committee on graduate economics education, a panel created in the early 1990s to take stock of the field, as well as the work of economist David Colander and others, has repeatedly illuminated these concerns with economic method and education. It is only now, with the force of recent events so damaging to societies everywhere on earth, and with the rise of developing countries that see the shortcomings of the economic orthodoxy’s prescriptions, that the resistance to renewing the economics profession may be overcome. Until then, we are really at sea without an anchor.
“By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”
~John Maynard Keynes
This year will mark my 32nd year in the business. I began my career in 1980 after spending several years in corporate life, which I did not find to my liking. I had too much of an independent streak and eventually came to the realization that I’d be much better off starting my own business. When I entered the financial world interest rates were beginning to peak, as the long upward climb in inflation was coming to an end under the leadership of Paul Volker at the Fed. It is hard to believe today that interest rates on treasuries were as high as 15.7%. The yields on money market funds were over 18%. Inflation rates were over 14%, with oil prices at $40 a barrel. Gold and silver would eventually peak at $850 and $50 an ounce, respectively.
Where the Debt Supercycle Begins
I spent my first decade in the business as a broker before transforming my business to a fee-based money management firm. All I sold in the 1980’s was fixed income. Who wanted to invest in stocks when you could get double digit returns in guaranteed deposits at a bank or by investing in government debt? I still remember one of my first trades—a 10-year treasury note paying a 15% interest rate.
What I did not realize at the time was the U.S., and the western world in general, was about to embark on what we now refer to as the “Debt Supercycle”—a theory articulated by the investment strategists at Bank Credit Analyst out of Canada. The Debt Supercycle is a description of the long-term decline in U.S. balance sheet liquidity and the rise in indebtedness during the WWII period. Economic expansions in the post WWII world were associated with the buildup in debt as western governments introduced automatic stabilizers through entitlements such as unemployment benefits, Social Security, Medicare, and deposit insurance at financial institutions. During the early stages of debt buildup, government policies were successful in preventing the frequent depressions that plagued the pre-WWII economy. Western economies would experience periodic corrections during recessions, but these recessions did not reverse the long-term trend of debt buildup that continued to grow with each successive decade.
These trends would lead to growing illiquidity making our financial markets more fragile and susceptible to the threat of a deflationary event like we experienced recently in the great credit crisis of 2008-2009. These periodic recessions were fought by governments with more deficit spending and credit creation. Thus, the bigger balance sheet excesses became, the more painful the eventual corrective process would be. The financial stakes became higher in each new economic cycle, putting ever-increasing pressure on governments to reflate demand, by whatever means were available.
According to the Bank Credit Analyst the Debt Supercycle reached an important inflection point in the recent economic meltdown of 2008-2009. Authorities reached the limit of their ability to get consumers to take on more credit. The result is that it forced governments to leverage up instead. This is where we are today as authorities spend, borrow and print money to fight off the deflationary impact of private sector deleveraging. Welcome to the final chapter of the Debt Supercycle—a period of trillion dollar deficits that are being monetized by trillion dollar expansions of central bank balance sheets, otherwise known as money printing. Once fiscal policy is pushed to the limits of sustainability, the Debt Supercycle will come to a violent end. This is exactly what is happening to Europe now.
A graphic depiction of this Debt Supercycle can be seen below. As of this writing, outstanding U.S. federal debt is close to $15.3 trillion dollars. For the first time in my lifetime US federal debt now exceeds U.S. GDP. In personal terms each U.S. citizen now owes $180,559.1
Our politicians have been acting irresponsibly, paying only lip service to the nation’s rapidly growing debt burden. It has been argued that our debt is not as bad as it appears and we have plenty of options and time to resolve this issue. Some argue for higher taxes, others for dramatic spending cuts. The truth is that neither will work alone. There aren’t enough taxpayers to pay the bill, even if we raise tax rates to 100% on the rich. Spending cuts will also not solve our problems unless we eliminate all forms of entitlements and drastically reduce the size of our military. In the end, our only option will be to pursue a combination of tax increases, entitlement and spending reductions, and a steady dose of inflation. This is the policy we pursued after WWII and it is now the official policy of the U.S. government, a term referred to as financial repression.
“I do not think it is an exaggeration to say history is largely a history of inflation, usually inflations engineered by governments for the gain of governments.”
~Friedrich August von Hayek
I would like to address the unusual phenomenon of the Debt Supercycle and why it has gone on for well over three decades without a major crisis until recently. Politicians, and the Keynesian economists who support them, have long argued that debt imbalances don’t matter. What matters is the economy’s ability to grow and it is government’s job to make sure it grows through whatever means necessary. On the surface this argument seems plausible. The two graphs below illustrate the popularity of this view.
From 1978 to today, the U.S was able to grow its total debt from $719 billion to $56 trillion, an annualized growth rate of 13.7%.2 While U.S. debt was growing during this period of time the interest rate paid on that debt steadily declined. This confounded experts who would have predicted higher rates of inflation and certainly higher rates of interest. This can be explained. At the end of the 1970’s inflation rates were hovering over 14%, bond yields on U.S. treasuries had risen to over 15%. The US. Government had been financing its growing deficits by urging the Fed to monetize its debt by printing money to buy U.S. treasuries. This is what led to the rising inflation rates during the 1970’s. This philosophy came to an end with President Carter’s appointment of Paul Volcker to head up the Federal Reserve.
From Printing Presses to the Bond Market
Volcker and other central bankers convinced their respective governments that they could tame the inflation monster by financing deficits through the bond market rather than the current practice of monetizing (printing money to pay off) the debt. Stung by a wave of rising inflation, governments turned to their central banks for advice. The advice given had three components: one, raise short-term interest rates in order to restrain bank borrowing by individuals and businesses; two, cut government borrowing; and three, use the bond market to finance budget deficits by selling bonds to domestic and overseas investors.
It was argued, and rightly so, that when a government taps the bond market it is drawing from the existing stock of savings—no new money is created. Large institutions such as insurance companies, pension funds, mutual funds, and individual investors would supply the necessary capital to finance government deficits. The inducement to supply this capital was high real interest rates, an interest rate that was well above the inflation rate. It worked. The migration of credit expansion from within the monetary sector to outside it was the single biggest reason why OECD government inflation fell below five percent throughout the 80’s, 90’s, and the 2000’s. As shown in the graphs above, it led to rising debt levels and falling interest rates.
Another process that occurred during this period that facilitated government debt financing was the revolution that was occurring in the capital markets. Peter Warburton described this process in his seminal work “Debt and Delusion,” from which I now quote:
The capital markets’ revolution of the late 1980’s and the 1990’s was facilitated by several parallel developments, of which five stand out. First, the incapacity of the banks, due to non-performing loans; second, the adoption of liberal credit policies by governments; third, the displacement of discretionary consumer borrowing by obligatory government borrowing (to finance budget deficits); fourth, the concentration of management of private wealth in the hands of large funds; and fifth, the increased use and acceptance of financial derivatives….
If this powerful shift from traditional bank borrowing towards the capital markets in North America and Western Europe had not taken place, it is most probable that there would have been a much longer period of recession and consolidation in the aftermath of the late 1980’s property bust….
Deprived of the easy option of selling bonds to investment funds and individuals, the government would probably have resorted to greater monetization of their borrowing….
If this traditional course of action had been followed, then there is little doubt that inflationary fires would have been rekindled in the western economies during the 1990’s by pressing additional liquidity (cash and bank deposits) into the hands of consumers and firms, the demand for goods, services and assets would have increased relative to their available supplies. After a couple of years or so, the outcome of excessive money creation would have been a resurgence of consumer price inflation, following the pattern of the 1970’s and early 1980’s.
This process worked for an extended period of time with occasional hiccups and financial failures: the bankruptcy of Orange County, the Mexican peso crisis in late 1994, the collapse of Barings Bank in 1995, the Asian currency crisis in 1997, and the Russian debt default and the bankruptcy of Long Term Capital Management in 1998.
The Rise of Derivatives
Overtime, a new pattern was beginning to emerge by the 1990’s and continues on to this day: an increasing frequency of rogue waves or black swan events.3With the increasing role of large financial institutions as intermediaries within the financial system a large important part of capital transfers were being done in secret through the derivatives market. Transactions between investment banks and mega funds such as hedge funds were increasingly being transacted in secret in the OTC derivatives market far from the public gaze.
Derivatives were the ultimate leverage tool used by hedge funds and the proprietary trading desks of large banks in gearing up the financial system. The use of derivatives enabled these financial entities the ability to gain control of a larger asset portfolio with a smaller commitment of capital. Derivatives in effect gave artificial support to both the bond and equity markets. It also facilitated the massive leveraging of the financial system with debt-to-asset ratios rising from 12-1 to 40-1 by the time of the 2008 financial crisis. Most importantly, the synthetic support given the bond and equity markets by these leveraged instruments were critically dependent on the downward progression of interest rates and the shape of the yield curve. A small tremor in the structure of interest rates would undermine the profitability of these leveraged trades leading to forced selling in the bond, equity, and commodity markets, which explains much of what happened during 2007-2009.
Risk On/Risk Off and the “Paranormal” Market
The fact remains that our financial system still remains highly leveraged. As Bill Gross recently wrote in his 2012 investment outlook, “most developed economies have not, in fact, delevered since 2008…credit as a whole remains resilient or at least static because of a multitude of quantitative easings (QE) in the U.S., U.K., and Japan…and now Euroland countries.”4
Because interest rates are now zero bound, according to Gross, it raises the possibility of a fat left-tailed possibility of unforeseen delevering or the fat right-tailed possibility of central bank inflationary expansion. The result is we face a number of years in the future where economies will exhibit different aspects of the New Normal which Gross describes as “Sub,” ”Ab,” or “Paranormal” (to be explained below).5
The global financial system is still leveraging up. However, this time it is governments that are doing the leveraging. Today, sovereign debt is being issued in copious quantities. The vast majority of this debt is being used to finance non-productive consumption. All of the world’s major governments are spending and living well beyond their means leaving central banks to return once again towards aggressive debt monetization to desperately ensure interest rates remain subdued and the financial system abundantly liquid. As Grant Williams explained with the following image below, “currently the central banks of the top three developed world entities: the Eurozone, the US and Japan have balance sheets that amount to roughly $8 trillion…What does this mean? It means that nearly $8 trillion in world economic growth is artificial and exists only courtesy of central bank intervention…It also means that central banks will never unwind their ‘assets’…It also means that in this age of ongoing consumer and corporate deleveraging, central banks will have no choice but to continue monetizing.”
This creates an unstable dynamic whereby market participants focus their attention on divining opaque and unpredictabie moves by “the powers that be” rather than the real and economic value of various assets. This anticipation by highly leveraged financial players of policy reflation is what underpins the highly speculative nature of our current global marketplace. When reflationary policies are delayed or not forthcoming, the markets deleverage and go into “risk off” mode. This drives the dollar higher and treasury yields lower. When the monetary bazookas are unleashed the “risk on” trade is executed and stocks and commodities rise universally. This “risk on/risk off “ trade is now part of the new Paranormal that Gross describes in his 2012 investment outlook.
When Markets Rebel
The question as to which fat tail risk (left or right) the markets experience boils down to a game of confidence that governments and their respective central banks are playing with the bond markets. The risk to government is that because of zero bound interest rates, governments have been financing a good portion of their debt short-term. The rate of interest is low which helps to reduce deficits. The danger is that since a good majority of debt is short-term it will have to be rolled over. As long as confidence is maintained debt will continue to roll over at existing low interest rates. The real danger is when the markets lose confidence in policymakers. That is, if the markets rebel and demand higher rates of return. It is a rise in interest rates which now directly threatens the solvency of many governments. Record debt levels are not a burden to government as long as interest rates remain low. It is when confidence is lost and rates rise that the solvency issue comes into question. This is the nightmare scenario that keeps central bankers up at night; a warning Sidney Homer wrote in his “A History of Interest Rates”:
Many besides the government have been encouraged to borrow at short who in an earlier age would have borrowed at long term just to be sure the funds would be available if needed. The dangers of this procedure became sadly evident in the 1970’s, when certain borrowers, such as Penn Central and New York City, suddenly found the refunding market closed to them.6
We now live in a new era of uncertainty—Pimco’s new “paranormal,” if you will. Our financial system continues to leverage up as governments replace the private sector in gearing up their balance sheets. Central banks are now embarked on a policy of reflation, monetizing a major portion of rising government deficits. The ECB’s balance sheet expanded by $947B (euro 727B), or 36% last year, to a record $3.5T. The Fed expanded its balance sheet by $513B to $2.92T, an increase of 21%.
We are now at a state where the sovereign bond market has grown to become the largest financial bubble in history; a bubble that could succumb to three potential market shocks. The first type of shock would come from a spike in commodity prices triggered by additional rounds of quantitative easing. It could be as simple as an “act of God” such as an earthquake, tsunami, or the failure of an important agricultural crop. The bond market would react in fear that higher commodity prices would be absorbed in the price of goods and services via loose monetary policy.
A second shock could be triggered as a result of political instability and loss of confidence in government policy. An example is what is occurring right now in Europe regarding an attempt toward a fiscal union or the debt ceiling debate in the U.S. The bond market would view negatively a failure by governments to rein in spending and control their deficits.
The third shock would emanate from a potential default or restructuring of a sovereign debt that would lead to a domino effect in the banking system. A large international bank or group of banks might not be able to meet their obligations which would lead to a rise in fear of uninsurable losses among the banks or their counterparties.
As the bond market continues to expand through sovereign debt expansion and central bank monetization, it is moving further away from reality as a result of speculative activity. This makes sovereign debt extremely sensitive to any unanticipated event. The probability of another black swan or rogue wave is beginning to multiply; from a failed bond auction, to larger than expected deficits, to political rancor over spending cuts. Sovereign debt can no longer be looked upon as a risk free asset. For the reasons cited above I continue to avoid U.S. treasury debt as the rates of return bear no resemblance to reality or are commensurate with the risk they entail. Caveat emptor!
Inflation: An Expansion of Counterfeit Credit
By Keith Weiner
The Keynesians and Monetarists have fooled people with a clever sleight of hand. They have convinced people to look at prices (especially consumer prices) to understand what’s happening in the monetary system.
Anyone who has ever been at a magic act performance is familiar with how sleight of hand often works. With a huge flourish of the cape, often accompanied by a loud sound, the right hand attracts all eyes in the audience. The left hand of the illusionist then quickly and subtly takes a rabbit out of a hat, or a dove out of someone’s pocket.
Watching a performer is just harmless entertainment, and everyone knows that it’s just a series of clever tricks. In contrast, the monetary illusions created by central banks, and the evil acts they conceal, can cause serious pain and suffering. This is a topic that needs more exposure.
The commonly accepted definition of inflation is “an increase in consumer prices”, and deflation is “a decrease in consumer prices.” A corollary is a myth that stubbornly persists: “today, a fine suit costs the same in gold terms as it did in 1911, about one ounce.” Why should that be? Surely it takes less land today to raise enough sheep to produce the wool for a suit, due to improvements in agricultural efficiency. I assume that sheep farmers have been breeding sheep to maximize wool production too. And doesn’t it take less labor to shear a sheep, not to mention card the wool, clean it, bleach it, spin it into yarn, weave the yarn into fabric, and cut and stitch the fabric into a suit?
Consumer prices are affected by a myriad of factors. Increasing efficiency in production is a force for lower prices. Changing consumer demand is another force. In 1911, any man who had any money wore a suit. Today, fewer and fewer professions require one to be dressed in a suit, and so the suit has transitioned from being a mainstream product to more of a specialty market. This would tend to be a force for higher prices.
I don’t know if a decent suit cost $20 (i.e. one ounce of gold) in 1911. Today, one can certainly get a decent suit for far less than $1600 (i.e. one ounce), and one could pay 3 or 4 ounces too for a high-end suit.
My point is that consumer prices are a red herring. Increased production efficiency tends to push prices down, and monetary debasement tends to push prices up. If those forces balance in any given year, the monetary authorities claim that there is no inflation.
This is a lie.
Inflation is not rising consumer prices. One can’t understand much about the monetary system from inside this box. I offer a different definition.
Inflation is an expansion of counterfeit credit.
Most Austrian School economists realize that inflation is a monetary phenomenon. But simply plotting the money supply is not sufficient. In a gold standard, does gold mining create inflation? How about private lending? Bank lending? What about Real Bills of Exchange?
As I will show, these processes do not create inflation under a gold standard. Thus I contend the focus should be on counterfeit credit. By definition and by nature, gold production is never counterfeit. Gold is gold, it is divisible and every piece is equivalent to any other piece of the same weight.
Gold mining is arbitrage: when the cost of mining an ounce of gold is less than one ounce of gold, miners will act to profit from this opportunity. This is how the market signals that it needs more money. Gold, of course, has non-declining marginal utility, which is what makes it money in the first place, so incremental changes in its supply cause no harm to anyone.
Similarly, if Joe works hard, saves his money, and gives a loan of 100 ounces to John, this is an expansion of credit. But it is not counterfeit or illegitimate or inflation by any useable definition of the term.
By extension, it does not matter whether there are market makers or other intermediaries in between the saver and the borrower. This is because such middlemen have no power to expand credit beyond what the source—the saver—willingly provides. And thus bank lending is not inflation.
Below, I will discuss various kinds of credit in light of my definition of inflation.
In all legitimate credit, at least two factors distinguish it from counterfeit credit. First, someone has produced more than he has consumed. Second, this producer knowingly and willingly extends credit. He understands exactly when, and on what terms, with what risks he will be paid in full. He realizes that in the meantime he does not have the use of his money.
Let’s look at the case of fractional reserve banking. I have written on this topic before. To summarize: if a bank takes in a deposit and lends for a longer duration than the deposit, that is duration mismatch. This is fraud and the source of banking system instability and crashes. If a bank lends deposits only for the same or shorter duration, then the bank is perfectly stable and perfectly honest with its depositors. Such banks can expand credit by lending, (though they cannot expand money, i.e. gold), but it is real credit. It is not counterfeit.
Legitimate lending begins with someone who has worked to save money. That person goes to a bank, and based on the bank’s offer of different interest rates for different durations, chooses how long he is willing to lock up his money. He lends to the bank under a contract of that duration. The bank then lends it out for that same duration (or less).
The saver knows he must do without his money for the duration. And the borrower has the use of the money. The borrower typically spends it on a capital purchase of some sort. The seller of that good receives the money free and clear. The seller is not aware of, nor concerned with, the duration of the original saver’s deposit. He may deposit the money on demand, or on a time deposit of whatever duration.
There is no counterfeiting here; this process is perfectly honest and fair to all parties. This is not inflation!
Now let’s look at Real Bills of Exchange, a controversial topic among members of the Austrian School. In brief, here is how Real Bills worked under the gold standard of the 19th century. A business buys merchandise from its supplier and agrees to pay on Net 90 terms. If this merchandise is in urgent consumer demand, then the signed invoice, or Bill of Exchange, can circulate as a kind of money. It is accepted by most people, at a discount from the face value based on the time to maturity and the prevailing discount rate.
This is a kind of credit that is not debt. The Real Bill and its market act as a clearing mechanism. The end consumer will buy the final goods with his gold coin. In the meantime, every business in the entire supply chain does not necessarily have the cash gold to pay at time of delivery.
This problem of having gold to pay at time of delivery would become worse as business and technology improved to allow additional specialization and thus extend the supply chain with additional value-added businesses. And it would become worse as certain goods went into high demand seasonally (e.g. at Christmas).
The Real Bill does not come about via saving and lending. It is commercial credit that is extended based on expectations of the consumer’s purchases. It is credit that arises from consumption, and it is self-liquidating. It is another kind of legitimate credit.
For more discussion of Real Bills, see the series of pieces by Professor Antal Fekete (starting with Lecture 4).
Now let’s look at counterfeit credit. By the criteria I offered above, it is counterfeit because there is no one who has produced more than he has consumed, or he does not knowingly or willing forego the use of his savings to extend credit.
First, is the example where no one has produced a surplus. A good example of this is when the Federal Reserve creates currency to buy a Treasury bond. On their books, they create a liability for the currency issued and an asset for the corresponding bond purchase. Fed monetization of bonds is counterfeit credit, by its very nature. Every time the Fed expands its balance sheet, it is inflation.
It is no exaggeration to say that the very purpose of the Fed is to create inflation. When real capital becomes more scarce, and thus its owners become more reluctant to lend it (especially at low interest rates), the Fed’s official role is to be the “lender of last resort”. Their goal is to continue to expand credit against the ever-increasing market forces that demand credit contraction.
And of course, all counterfeit credit would go to default, unless the creditor has strong collateral or another lever to force the debtor to repay. Thus the Fed must act to continue to extend and pretend. Counterfeit credit must never end up where it’s “pay or else”. It must be “rolled”. Debtors must be able to borrow anew to repay the old debts—forever. The job of the Fed is to make this possible (for as long as possible).
Next, let’s look at duration mismatch in the financial system. It begins in the same way as the previous example of non-counterfeit credit—with a saver who has produced more than he has consumed. So far, so good. He deposits money in a bank, and this is where the counterfeiting occurs. Perhaps he deposits money on demand and the bank lends it out. Or perhaps he deposits money in a 1-year time account and the bank lends it for 5 years. Both cases are the same. The saver is not knowingly foregoing the use of his money, nor lending it out on such terms and length.
This, in a nutshell, is the common complaint that is erroneously levied against all fractionally reserved banks. The saver thinks he has his money, but yet there is another party who actually has it. The saver holds a paper credit instrument, which is redeemable on demand. The bank relies on the fact that on most days, they will not face too many withdrawal demands. However, it is a mathematical certainty that eventually the bank will default in the face a large crowd all trying to withdraw their money at once. And other banks will be in a similar position. And the collapsing banking system causes a plunge into a depression.
There are also instances where the saver is not willingly extending credit. The worker who foregoes 16% of his wage to Social Security definitely knows that he is not getting the use of his money. He is extending credit, by force—i.e. unwillingly. The government promises him that in exchange, they will pay him a monthly stipend after he reaches the age of retirement, plus most of his medical expenses. Anyone who does the math will see that this is a bad deal. The amount the government promises to pay is less than one would expect for lending money for so long, especially considering that the money is forfeit when you die.
But it’s worse than it first seems, because the amount of the monthly stipend, the age of retirement, and the amount they pay towards medical expenses are unknown and unknowable in advance, when the person is working. They are subject to a political process. Politics can shift suddenly with each new election.
Social Security is counterfeit credit.
With legitimate credit, there is a risk of not being repaid. However, one has a rational expectation of being repaid, and typically one is repaid. On the contrary, counterfeit credit is mathematically certain not to be repaid in the ordinary course. This is because the borrower is without the intent or means of ever repaying the loan. Then it is a matter of time before it defaults, or in some circumstances forces the borrower to repay under duress.
Above, I offered two factors distinguishing legitimate credit:
1. The creditor has produced more than he has consumed
2. He knowingly and willingly extends credit
Now, let’s complete this definition with the third factor:
3. The borrower has the means and the intent to repay
Every instance of counterfeit credit also fails on the third factor. If the borrower had both the means and the intent to repay, he could obtain legitimate credit in the market.
A corollary to this is that the dealers in counterfeit credit, by nature and design, must work constantly to extend it, postpone it, “roll” it, and generally maintain the confidence game. Counterfeit credit cannot be liquidated the way legitimate credit can be: by paying it back normally. Sooner, or later, it inevitably becomes a crisis that either hurts the creditor by default or the debtor by threatening or seizing his collateral.
I repeat my definition of inflation and add my definition of deflation:
Inflation is an expansion of counterfeit credit.
Deflation is a forcible contraction of counterfeit credit.
Inflation is only possible by the initiation of the use of physical force or fraud by the government, the central bank, and the privileged banks they enfranchise. Deflation is only possible from, and is indeed the inevitable outcome of, inflation. Whenever credit is extended with no means or ability to repay, that credit is certain to eventually become a crisis that threatens to harm the creditor. That the creditor may have collateral or other means to force the debtor to take the pain and hold the creditor harmless does not change the nature of deflation.
Submitted by Brandon Smith of Alt Market
New Jersey Will Pay You $1000 To Destroy The 2nd Amendment
There is nothing more disgusting or detestable than a citizen informant. Without citizen informants, tyrants could never retain the kind of power they wield. In fact, without citizen informants, totalitarian movements would never gain traction. This is why EVERY functional oligarchy throughout history has implemented programs designed to encourage the development of common spies, using the promise of monetary reward, or collective recognition.
Sadly, there are many in our society that would gladly sell out their closest friends and family to the tortures of authoritarian bureaucracy for nothing more than a firm pat on the head and a few fiat dollars. If there was ever a more degraded lot of bottom feeding opportunist scum, the citizen informant is the very epitome.
With the implementation of the “See Something, Say Something” program, and the increasing drive by the White House to institute community watch efforts to route out “extremists”, showcased quite clearly in strategic outlines like the ‘Empowering Local Partners To Prevent Violent Extremism In The United States’:
The issue of informant networking has come to the forefront in America. My personal view is that these nauseating and diseased people should be treated as treasonous as any globalist, regardless of stated intention. That said, in an environment rife with extraneous poverty, informancy cannot be avoided. Plenty of men and women, stricken with empty wallets and bellies, are extraordinarily prone to betrayal, regardless of their inherent morality. This is the kind of world we will soon be living in, and this is the kind of environment that corrupt officials like those in New Jersey are prone to exploit. Pathetic, weak, cowardly, but ultimately dangerous sheep unknowingly serving the very men who would seek to enslave them.
In terms of 2nd Amendment rights, I find the very idea of debate rather pointless. The logic is undeniable. If you cannot defend yourself, you are a victim. Period. You become food for predators and parasites. Any state government or national government which actively seeks to disarm its citizens is suspect. I couldn’t care less about their stated rationalizations or rhetoric. In New Jersey, in Chicago, in Washington D.C., or anywhere else for that matter, an innocent man who is disarmed by law will always be victimized by an outlaw who armed through criminality. The concept of reduced crime through gun confiscation is so naïve it warrants considerable analysis. Through such efforts, good men are left defenseless, while evil men are free to wreak havoc.
The 2nd Amendment is not a negotiable or debatable pillar of the Constitution. It is absolute in its protection. Every American, regardless of the temporary circumstances of the times, is free to arm and defend himself from ANY enemy, from average criminals, to government thugs. The gun confiscation program featured in the video below, and instituted by officials in New Jersey, should not be taken lightly. The pure idiocy inherent in its premise cannot be ignored. New Jersey’s willingness to pay off potential informants could very well be a petri dish test for much more expansive programs across the country in the future. If we cannot stop the corruption and anti-constitutionalism of a pathetic state like New Jersey, then how can we expect to disrupt the same brand of corruption throughout the U.S.?
Guns are simply not the issue. An armed and educated populace is a populace safe from crime. This is a fact. New Jersey’s informant program is a travesty of justice, not only because it encourages American on American treason, but also because it ignores the very purpose behind the Second Amendment; to create a populace free from the fear of tyranny. If we do not put an end to the anti-gun tides in New Jersey, we should fully expect to see such atrocities against freedom planted at our own front doors in the near future. There are no exceptions to the Constitution. New Jersey is not outside of its jurisdiction. Every person in that state deserves the same protections as anyone else. We must disrupt the sick and perverted no questions asked buy off policies now prominent in that region, or be subject to the same in the near future…
The Great Non Debate
For five years, the writing on the wall has been crystal clear. As 2007 began, the US Foreclosure Market Report for 2006 showed that foreclosures for the year had reached 1.2 million, an increase of 42 percent over the 2005 figure. In early February 2007, in the midst of a growing rash of bankruptcies among small US sub-prime mortgage issuers, New Century Financial announced that it was “recalculating” its “profits for the previous three quarters. New Century was one of the three biggest mortgage brokers in the US. In two days, its stock price dropped 40 percent. Six months later, President Bush was calling the now obvious collapse in the US real estate market a “blip” on the US economy. Two months after that, the stock market peaked. A year after that, in September/October 2008, the global economy froze solid and was only thawed by the biggest explosion of money creation in history. Now, here we are at the start of 2012. Nothing has changed. No positive steps have been made. The symptoms have been disguised under an avalanche of palliatives but the disease continues to eat away at the substance of the system on which it feeds. The major effort of government and “mainstream” analysts everywhere has been to avoid, deflect and actively silence any nascent discussion of the root of the problem.
The root of the problem is perfectly illustrated in the fact that since August 1971, the funded debt of the US government has risen from $US 400 Billion to $US 15,236 Billion. The severity of the problem is illustrated by the fact that with Mr Obama having yet to complete his third full year as President, he has presided over $US 4,600 Billion (or almost one-third) of that increase. The root of the problem is the abandonment of money – the final legal connection between Gold and the US Dollar was ended in August 1971. The severity of the problem is the grotesque expansion of what has taken its place.
None of this has been or is being discussed because the establishment in the US and everywhere else does not want it discussed. A REAL “black swan event” – an event that deviates by 180 degrees from what is “normally expected” – would be a political debate over root causes and basic principles. The great merit of Ron Paul – and the great service he is giving to his own and every other nation – is the fact that he is doing everything he can to raise the debate to that level. That makes Dr Paul a unique politician, a man who tells people what most of them DON’T want to hear or understand.
Or at least they don’t think they want to understand it. Dr Paul’s great and merited attractiveness to a growing number of admirers has a very simple source. He is that rarest of creatures – a FREE man. He is beholden to nobody. He has developed his ideas and his convictions over a long and fruitful life of independent thinking. He does not compromise. He homes in on the fundamental issue and principle of any political issue and serves it up without salt or other “seasoning”. He says what he means and he means what he says. He is the living embodiment of the “dream” that most Americans have long since given up on as they saw it slip further and further beyond their grasp. He is the only prominent person who is doing everything he can to turn the non-debate which masquerades as the “mainstream” in the US and global political economy into something of substance. That, far more than the presidency, is his goal.
Submitted by Simon Black
Eight Simple Truths You Need To Know About 2012
Yesterday we discussed certain events that, in my view, are nearly
mathematical certainties. Things like a restructuring of public pensions
and Social Security in Europe and the US. Western governments blocking
Internet and mobile networks. War. The US government being forced to
issue debt in a foreign currency.
All of these events are underpinned by a simple premise:
1) Public and private debts included, most western nations are insolvent. Big time.
2) History shows that economic growth in such an environment is nearly impossible
when such a large percentage of GDP must be allocated solely to
interest. Most countries in this position either default or
[hyper]inflate. Both have catastrophic consequences.
3) Continued political and monetary intervention in the economy is counterproductive.
From ‘Cash for Clunkers’ to negative real interest rates, such
intervention only serves to make the problems, and their impacts, much
4) The combined ingredients of sovereign insolvency; a global
financial system based on worthless paper currency; and consumptive,
import-oriented, public entitlement economies have created conditions for an epic, long-term economic depression.
5) Deteriorating economic conditions drive social unrest. [In fact, there’s a great paper
by two European economists which defines an explicit correlation
between government budget cuts and things like rising crime rates,
riots, and even attempted revolution.]
6) Faced with a marauding population that threatens their own survival, governments will stop at nothing to maintain the status quo: their power, our expense.
Again, history shows that police states, boogeyman enemies, a total
loss of privacy, capital controls, higher taxes, etc. will all become
7) None of these delay tactics can prevent human and financial
capital from eventually migrating to where they are treated best. This
will ultimately force a complete system reset by starving the beast.
8) This is not the first time this has happened, and it won’t be the last.
This time is NOT different. Our modern society is not a unique and
special snowflake that can ward off the consequences that have plagued
empires for millennia.
Everything from the way I invest to how I allocate my time and plan
for the future is based on this view. It’s why I’m in Chile, why we
purchased a 1,000+ acre farm, and why we plan on sharing it with
I may be a bit early, but I’d much rather be early than thinking
through these implications while I’m packing my bags. After all, things
can ‘feel’ quite normal for a long time. Changes take place gradually, then faster and faster, until the decay looks like an upside-down hockey stick.
The Roman Empire, for example, began its spectacular decline shortly
after Augustus became de facto emperor in 27 BC. He was followed by a
long series of dismal failures– Tiberius, Caligula, Claudius, Nero, etc.
But Rome muddled along for hundreds of years, wavering between growth
The changes were gradual. A little currency debasement here, a bit of
excess spending there, and throw in plenty of assassinations and
foreign wars for good measure. Along the way, though, thinking people
could see the writing on the wall… and many of Rome’s citizens set sail
for greener pastures.
The gradual changes became more and more pronounced… and the more
pronounced, the more people left. As Gibbon recounts in his seminal
work, The History of the Decline and Fall of the Roman Empire, the city of Rome lost nearly 75% of its population in the Empire’s final 50-years in the 5th century.
History is full of other examples of once proud nations that, facing
problems for decades (or even centuries), completely unwound in a matter
of years. The Ottoman Empire. The Ming Dynasty. Feudal France. The Soviet Union.
Bottom line, when the real change comes, it comes very, very quickly.
Think about the pace of change these days. It’s quickening. Europe is
a great case study for this– when concerns about Greece first surfaced,
European leaders were able to contain the damage. There was disquiet,
but it soon dissipated.
Fast forward to today. We can hardly go a single day without a major,
market-rocking headline. And European politicians’ attempts to assuage
the damage have a useful half life that can be measured in days…
sometimes hours now.
Like the Ottomans, the Soviets, the Romans before them, Western civilization is entering the phase where its rate of decline will start looking like that upside-down hockey stick.
There is no crystal ball that can tell us exactly how/when it will
all go down. It stands to reason that certain events (perhaps this
year’s Presidential elections in the US, Russia, France, etc.) will be
pivotal in the decline, but suffice it to say that time is not on our side given the pace of change.
Each of us has a finite amount of resources– time, energy, capital,
etc. And I really want to encourage you to think clearly and
deliberately about how you allocate those resources… e.g. you’re better
off buying an ounce of gold than making a political campaign
2011 was a challenging year. 2012 will likely prove even more. But this isn’t anything to dread. It’s is an incredibly exciting time to be alive– change should be embraced, not feared.
Empires always run their course. Bubbles burst. But creative, thinking human beings always survive and thrive.
When it comes to the types of people in this world, there are those who say that the only way to fix the current economic catastrophe is to keep doing more of the same that got us in this condition in the first place (these are the people who say mean regression is irrelevant, and 10 men and women in an economic room can overturn the laws of math, nature, physics, and everything else and determine what is best for 7 billion people), and then there is everyone else. The former are called Keynesians. The latter are not. Only those in the former camp don’t see the lunacy of their fundamental premise, a good example of which is the following. Luckily, the world is nearing the tipping point when the camp of the former, which for the simple reason that it allowed the few to steal from the many under the guise that it is for the benefit of all, is about to be overrun, hopefully peacefully and amicable but not necessarily, and the camp of the latter finally has its day in the sun. Naturally, when that happens the status quo loses, as the entire educational and employment paradigm is one which idolizes the former and ridicules the latter even though the former has now proven beyond a shadow of a doubt it is a miserable failure (ref: $20+ trillion excess debt overhang which will, without doubt, lead to a global debt repudiation or restructuring, with some components of “odious debt”). So for all those still confused what some of the core premises of the ascendent “latter” are, below we present two one-hour lectures by Israel Kirzner. We urge readers to set aside two hours, which otherwise would be devoted to watching rubbish on TV or waiting in line for In N Out burger, and watch the two lectures below. Because, contrary to what the voodoo shamans of failure will tell you, there is a way out. It is a very painful way, but it does exist. The alternative is an assured and complete systemic collapse once the can kicking finally fails.