Quote of the Day

That we are witnessing strange and dangerous deformations of the capitalist system, if we can still even call it capitalist, and that new bubbles are being blown everywhere, is not only evident by the increasingly grotesque dichotomy between a woefully underperforming real economy perennially teetering on the brink of renewed recession and a financial system, in which almost every sector is trading at record levels, but also by the fact that the high correlation among asset classes on the way up to new records is beginning to strain the minds of the economists to come up with at least marginally plausible fundamental justifications for such uniform asset inflation. ‘Safe haven’ government bonds that would usually prosper at times of economic pain are equally ‘bid only’ as are risky equities and the grottiest of high yield bonds. The common denominator is, of course, cheap money. And if cheap money for the foreseeable future is not enough, then how about cheaper money – forever?

Detlev Schlichter

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The Monarchs of Money

An interesting look at the role of central bankers from the CBC, Canada’s public broadcaster:

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George Osborne warning us about the Bank of England?

In 1997, the Bank supposedly went independent. Of course, a central bank by its very nature is anything but independent. Ask Goldman Sachs.

However the Chancellor of the Exchequer is still required by law to give advice to the Bank – so what is it? Give  “due weight to the impact of its actions on the near-term economic recovery”, and “sustain growth”. Not really the warning I was hoping for.

The implications are simple enough: stop asking banks to shore up capital (and by proxy, lend less he says) and get on with building the economy. By saying this Osborne flies in the face of Basel III, public opinion, and common sense. It is time for politicians to grow some spine and stop thinking of the near-term, as Osborne calls it (most would call it short term), and focus on the real problems that banks face – in particular one on Threadneedle Street.

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Quote of the Day

The Fed is the elephant in the living room that everyone pretends not to notice. Even many of those who blame government for the current mess leave the Fed out of the picture altogether. The free market, meanwhile, takes the blame for the destructive consequences of what it does. This charade has gone on long enough. It’s time to consider the possibility that maybe the elephant, and not little Johnny, is the one breaking all the furniture.

Thomas Woods, Meltdown

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The Head of the ECB has “No plan B”

The head of the ECB, Mario Draghi, was asked if there was a plan if countries such as Cyprus decided to leave the Euro:

Well you really are asking questions that are so hypothetical that I don’t have an answer to them. Well, I may have a partial answer. These questions are formulated by people who vastly underestimate what the Euro means for the Europeans, for the Euro area. They vastly underestimate the amount of political capital that has been invested in the Euro. And so they keep on asking questions like: “If the Euro breaks down, and if a country leaves the Euro, it’s not like a sliding door. It’s a very important thing. It’s a project in the European Union. That’s why you have a very hard time asking people like me “what would happened if.” No Plan B.

To mangle a phrase from Instapundit, the Euro’s in the very best of hands. It’s not like this wasn’t predicted by numerous economists prior to the creation of the eurozone or anything…


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Dangerous experimentation

“Since we decided a few weeks ago to adopt the leaf as legal tender, we have, of course, all become immensely rich.”

The Restaurant At The End of The Universe, Douglas Adams

Post World War II, there was a system known as Bretton Woods, which was the last remains of the pre-war gold standard. Under this system, US dollars were convertible into gold, and the dollar acted as the worlds reserve currency. Bretton Woods had many flaws, not least the greater inflation it allowed compared to the pre-war standard, but it could be argued that at least it was planned before being implemented. The current system we have has no such defence.

Over time, the US gold reserves dwindled, and selling them at the agreed fixed price of $35 an ounce was no longer possible.  The date 15th August 1971 isn’t one that is terribly well known, but it’s a key date in the economic history of the world. On this date, Richard Nixon effectively ended the Bretton Woods system by declaring that the US would no longer honour the agreements and stopped selling the gold. Despite all the focus on the Watergate scandal,  this act of Nixon’s administration has had far wider and longer-lasting consequences.

Fiat currency is now global – there is nothing backing up the money supply, and central banks can inflate to their hearts content. Individual countries had experimented with fiat currencies in the past but this has never happened before on a global scale. Economists now love to talk about how we can’t go back to the gold standard – but our current system wasn’t planned or debated, it wasn’t voted on by politicians nor by the people in a referendum. The fundamental basis of our economy, money, was decided by an executive decision.

As Detlev Schlichter explains in Paper Money Collapse, no fiat (or “paper” money) system has ever been successful long term. They have either collapsed in chaos, or a decision was taken to revert to some form of commodity based money before things got out of hand. Throughout nearly all of human history, gold or silver has been used as money. Are we arrogant enough to think that our worldwide experiment with fiat money will last? In the 42 years it has so far lasted, we have had many financial crises, an ever growing pile of debt (both private and government), and the highest sustained inflation ever seen.

The pound sterling has lost 90% of its value since 1971. And this is the system economists tell us is the best one?

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Quote of the Day

The central banking branch of the state remains hostage to Wall Street speculators who threaten a hissy fit sell-off unless they are juiced again and again. Monetary policy has thus become an engine of reverse Robin Hood redistribution; it flails about implementing quasi-Keynesian demand–pumping theories that punish Main Street savers, workers, and businessmen while creating endless opportunities for speculative gain in the Wall Street casino.

David Stockman

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The central bankers’ Catch-22

Governments and central banks have manoeuvred themselves into a financial mess that shows no sign of getting better. Debt to GDP ratios continue to climb, with many industrialised nations over 100% (and Japan has gone well over 200%). It normally takes a major war to raise levels this high! Meanwhile central banks are now purchasing more and more government debt, typically with newly created money. This won’t end well, and I’ll try to explain why.

Central bank purchasing of government debt helps to keep yields lower than they would otherwise be. This is because they can buy debt with newly created money, at no cost to them. The rest of the market has to use real money, and hence is more concerned with risk and a decent rate of return, if for nothing else to cover the rate of inflation. The only reason central banks start buying government debt is because of the inability of the government to place debt on the market at the rates the government wants. So while a investment bank might be willing to buy debt at 3%, a central bank would be happy to undercut this.

Today, large portions of government debt are being funded by quantitative easing programs. If central banks cease buying government debt, then yields will rise as the market will demand higher prices. If central banks continue to buy government debt, this will lead to price inflation (especially in assets) as most debt is bought with newly created money. While central bank buying initially helps to keep yields down, overtime the resulting inflation causes the market to demand higher yields on the debt in order to compensate for the debt being paid back with devalued money. So any new debt that is still bought by the market demands a higher price. This puts further pressure on the central bank to intervene and buy more debt.

So regardless of what central banks do, yields on government debt are set to rise higher than they currently are. This means governments have to divert more tax revenue and borrowing to pay interest rather than paying for public services. This leads the government to either borrow more or print more to make up the difference, setting in place a viscous circle.

This puts governments in the position of an ever greater proportion of spending being used to service the debt. The more money is printed, the higher interest rates in the market will go (note this is different to the official central bank rate, which would almost certainly be kept as low as possible). This is the great irony of inflation – money is printed in order to keep interest rates low, but over time the price inflation forces interest rates to rise.

There comes a point where only the central bank will buy government debt – all private actors are demanding too high a price. What options does a government now have?

1. Keep printing money, ultimating end in hyperinflation (default in all but name), followed by a depression. Many of the 20th century hyperinflations were the result of out of control government debt.
2. Openly default – refuse to pay back the debt. Any banks holding large amounts of government debt go bust, as they don’t have enough capital to protect against such a loss – and they can’t be bailed out this time, as the government doesn’t have the money either. Massive deflation and depression.
3. See the catch22 coming up, and make drastic cuts in public spending to not just balance the budget, but to generate a surplus that can begin to pay off the debt. While and until the economy adjusts (which it will), there will be a recession/depression. Even in this scenario, it may require default on any debt which matures soon.

So whatever happens, we have a recession or depression. There is no way out without one. So, we either choose when and how it it happens, or we allow our creditors to do it for us when the proverbial hits the fan.

And by the way, what the UK coalition government is doing is not #3:

JPhelangraph1source – including inflation adjustments

As the author of the linked article, John Phelan, has said:

The British economy is walking a tightrope. On the one hand it has deficits the size of Greece; on the other it has interest rates as low as Germany.

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Banks to do the impossible

The “advice” being given to major UK banks by the government and the Bank of England is  akin to telling someone to walk in two directions at once.

On the one hand, banks are being encouraged to lend money, to both businesses and consumers, to stimulate the economy. The unprecedented low interest rates at the Bank are part of this.

On the other hand, banks are also being told to recapitalise, as many banks are over leveraged and at risk of going bust (again) if there is another major crisis. This process would happen naturally if interest rates were higher, as that would encourage individuals to save more money, and discourage borrowing.

Joined up government anyone?

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Quote of the day

In other news, it would appear that the “Conservative” party believes that the housing market in the U.K. is insufficiently distorted and in danger of reverting to market principles. To prevent that, the new budget contains provisions to assure that there will be malinvestment, bank bailouts, and direct state losses from mortgage defaults for years to come.

I confess to being impressed. It is normal for politicians to fail to learn from history, but here they’ve managed to forget even 2008. Well done, gentlemen, well done!

Perry Metzger


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