Unlimited QE is, according to Münchau, the result of new theories of how central banking works. You see, with open-ended QE the Fed “has become much more determined in guiding future expectations,” which is supposedly what the economy needs: bureaucrats who centrally and administratively guide expectations. Strangely, though, this does not sound all that modern to me.

There is no denying that, of late, things have not been going according to plan but this is no reason for Münchau to question the role of central banks in this crisis, let alone the very concept of monetary central planning, of the idea that some ‘wise men and women’ in Frankfurt, Washington or London, fix the supply of base money and certain prices (interest rates) in order to control, guide and manage overall economic performance. Like many of his FT colleagues, Münchau is in awe of the power elite that supposedly runs our economies and our societies to our benefit. Difficult times only seem to require more determined politicians and more determined central bankers. And when central planning fails, the central planners simply need a new plan. Or a new target.

Not surprisingly, Münchau is an advocate of nominal GDP targeting, the new fad in monetary central planning. There is allegedly nothing wrong with monetary policy. The central bankers only need a new target, and, naturally, a more comprehensive one. The trained mathematician Münchau lectures us how this works:

“This is a debate about nominal income targeting, where a central bank no longer stabilises the inflation rate directly but focuses instead on stabilising nominal gross domestic product. You can think of nominal GDP as the sum of real GDP and inflation. If real growth falls, the central bank would thus have to drive up inflation. Conversely, if real growth rises, the central bank would have to bear down on inflation much harder than it would do under the pure inflation targeting regime used by central banks such as the ECB.”

There is a dangerous naivete about all of this, a blindness toward real-life complexity. There is also a kind of narrow-mindedness, of which Münchau accuses the central bank critics, but of which he himself is the prime example. Münchau and other advocates of GDP-targeting are consistent macro-economists, which means they necessarily ignore many important micro-economic phenomena.

Here is the prime fallacy behind the nominal GDP target and, in fact, all of Münchaus’ argument: It tacitly assumes that money is neutral, which money never is. Let me explain.

The idea that central banks should target nominal GDP presupposes firstly, that stability in nominal GDP is in fact desirable and possible, and that we can ascertain what the ‘right’ level of nominal GDP should be, and what the appropriate relationship between inflation and real GDP is. Such stability rarely exists in human affairs and in particular in economic phenomena, and such a static and non-dynamic view of the economy strikes me as rather – well, not modern. Secondly, and even more importantly, it presupposes that there are direct and stable links between the quantities that the central bank does indeed control directly – that is the monetary base, bank reserves, and certain interest rates – and the macro-economic variables, growth and inflation, which are the ultimate target of its policies. This relationship – between base money and inflation and growth – is, however, very complex and far from stable, and many things can and must happen on the way from changing one to changing the other. And not all of these things are pretty.

Let us assume the central bank fears that real GDP is running too low and that the central bank now has to, according to Münchau, ‘drive up inflation’. How does the central bank do it? – The answer is, it does what it always does, just more of it. The central bank buys certain financial assets from the banks and credits the banks’ accounts at the central bank with newly created bank reserves. Thus, the banks have more – and, we can assume, cheaper – reserves than before, which means they now have an incentive to lend more money. Loan rates on credit markets should drop as more credit gets extended. Investment projects that were previously shunned due to relatively high costs of funding are now profitable. New lending and new borrowing occurs. This may indeed lift real GDP – although only temporarily – and ultimately lift the average of prices, the price level, an effect that, in contrast to the GDP boost, is usually permanent. However, it is clear that many other things must have changed as well as a consequence of what the central bank just did: certain financial assets will have gone up in price and down in yield; bank balance sheets will have expanded; financial leverage will have increased; capital has been reallocated; the relationship between voluntary saving and investment in the economy has been altered; relative prices have changed; income and wealth distribution have changed. It takes either incredible naivete to assume that all these changes are so benign that we can safely ignore them, or childlike optimism in the wisdom and farsightedness of central bankers to assume that all these effects can be anticipated and incorporated in the design of these policies.

The macroeconomic fallacy is to believe that an expansion of the money supply has two effects and two effects only: it lifts growth (good) and it lifts inflation (sometimes good, sometimes bad, sometimes unimportant). That this is too narrow a view, we know since Richard Cantillon invented modern economics. Cantillon lived 300 years ago, so Münchau may object that he did not understand the ‘modern economy’, and besides, Cantillon did not obtain a PhD from MIT, as did Bernanke and Draghi, Münchau’s heros. But in Cantillon’s defense we may say that he experienced first-hand – and indeed actively participated in – one of the most remarkable experiments with paper money in all of history. I am talking about the famous John Law scheme in France from 1716 to 1720. Cantillon knew Law and invested in his paper money scheme. In fact, Cantillon achieved what most modern hedge fund managers dream about. He rode the bubble – the famous Mississippi bubble – to its peak and took his profits before the bubble collapsed. In contrast to Law who ended impoverished and had to flee France, Cantillon retired a wealthy man and recorded his astute observations about the effects of monetary expansion. One of his most notable discoveries was the fundamental non-neutrality of money. As Cantillon stated, when new money is injected into the economy, it does not raise all prices simultaneously and to the same degree but some faster than others, and some more than others.

This is important and has far-reaching consequences. ‘Easy money’ does not just directly affect growth and inflation, or any desired combination of the two. It does not just affect the statistical average of prices, the price level, or the statistical aggregate of economic transactions, real GDP, or any other statistical macro-variable. ‘Easy money’ always means changes in relative prices, changes in resource allocation, and changes in income and wealth distribution. In particular, ‘easy money’ lowers interest rates, which are crucial in a market economy for coordinating investment activity with the public’s time preference, i.e. the public’s propensity to save and thereby support and sustain the capital stock. Monetary expansion means distorted interest rate signals and thus necessarily capital misallocation. This fundamental insight is the basis of all monetary theories of the business cycle, that is, of the insight that monetary expansion leads to booms that must be followed by busts. Every monetary expansion creates distortions, the liquidation of which cause the next recession. Every monetary expansion creates economic instability. This was already the basis of the business cycle theories of the British Classical economists of the Currency School in the 19^th century, but more importantly, it was the basis of the so far most convincing business cycle theory, the one developed by Ludwig von Mises in 1912 and 1924, a theory that is now widely known as the Austrian Theory of the Business Cycle.

This theory explains why modern fiat money central banks can never be a source of ‘stability’, whether that means the stability of the inflation rate or the stability of nominal GDP. Central banking, whether old fashioned or modern, is always a source of instability. This theory also explains why modern central banking has now maneuvered us into a veritable economic cul de sac. Repeated attempts over the past decades to buy near-term economic growth at the price of persistent marginal debasement of money has now left us with such a distorted and over-indebted economy that any further monetary expansion has to be ever more scarily aggressive to even cut through the thicket of accumulated imbalances and have any effect on inflation and GDP, whether real or nominal. This policy will ultimately end in hyperinflation when the public loses confidence in this charade.

I don’t know if those German ECB critics who get Münchau all riled up know anything about Cantillon or Mises. For all I know, they may suffer from the same macroeconomic tunnel-vision that afflicts Münchau. The difference is this: In the final assessment they are correct and Münchau is wrong. The road to economic hell is paved with easy money.

In the meantime, the debasement of paper money continues.

Fed Chairman Ben Bernanke

There was a beautiful symmetry to last week’s policy announcement by the Fed. Precisely a week after the ECB had pledged its commitment to unlimited purchases of Euro Zone government bonds, the Fed declared that its new round of debt monetization – ‘quantitative easing’ or QE3 – would be open-ended.

Unlimited, open-ended. The concept of stimulus has certainly evolved since the crisis started.

This should give us reason to pause. ‘Unlimited’ is not a word that is used much in economics or in business-life. The only thing that is really unlimited is peoples’ wishes and desires. Everything else is very limited indeed. That is why we have markets and prices and competitive enterprise, in short, that is why we have capitalism: to make the best use of limited resources in the face of essentially unlimited demands on such resources. The market is all about allocating scarce means to chosen ends (chosen by the consumer), all about relative prices, about trade-offs. And the beauty of private enterprise is precisely that when things go wrong the losses are private and limited. Every businessman, every investor, even every gambler, knows that sometimes you have to cut your losses if you want to survive.

Not so in politics – and now central banking – where the stop-loss limit is evidently seen as an indication of lack of commitment. “We will do whatever it takes” was a phrase that was much used in the early part of this crisis, around 2008. No doubt it was meant to instil confidence, yet it is one of the scariest things a policymaker can say. If policies go wrong – or have unintended consequences, as they always do – the costs are born by society. We should be concerned if those who are entrusted with the privileges of state power declare that they will use these powers without limits – the power to tax, the power to regulate, the power to legislate, and the power to print money. On Thursday Bernanke declared that he would not stop his policy until it has the results that he believes it should have.

Increasing frustration

The FT, a reliable cheerleader for policy-activism and firmly in the don’t-just-stand-there-do-something-anything school of crisis management, said the decision was bold. Well, maybe. But the decision for unlimited QE is also a sign of defeat. QE2 had not delivered what Bernanke had told us it would. In November 2010, in his famous Washington-Post op ed, he had expressed his view that the $600 billion he printed back then would kick off a ‘virtuous cycle’. Well, that didn’t work out, did it?

The notion behind the term ‘stimulus’ had always been the one-off kick-starter, the policy-induced ignition that would simply set the economic engine in motion again. In Paper Money Collapse I explain why this image is false and the word ‘stimulus’ misleading and why every stimulus necessarily changes the economy, why it must create winners and losers, change income distribution and resource use. Stimulus sounds harmless but every stimulus is intervention. And the iron law of intervention is that once you intervened you have to intervene again, you cannot just stop the intervention without undoing the results of previous interventions. QE is state intervention in the market. There is no natural end to it. Bernanke de facto admitted that much last week. If QE3 had been limited, it would have ended at some point, and if the economy had then not been much healthier, and that is obviously now a valid concern for the Printmaster-in-Chief, he would have had to announce QE4, and so forth. With the decision last week, Bernanke saved himself the embarrassment of adding bigger numbers to this, his last-ditch policy tool.

If QE was supposed to be a form of medicine for the economy as its advocates claim, then Bernanke conceded now that the patient, after 4 years of treatment, has not recovered but is now addicted to the medicine. “We can’t turn off the monetary morphine unless the patient gets better.”

What does ‘get better’ mean? – Bernanke says a substantially improved labour market. Well, I wonder how many Americans will find employment as a result of the various asset price manipulations that are the central bank’s stock in trade and that – mind you – were instrumental in creating the crisis in the first place. But even if we were to believe it, wouldn’t that mean that these Americans are forthwith dependent on ongoing Fed largesse? I mean if Americans find jobs that evidently depend on artificially cheap credit from the Fed, will these jobs not disappear when the artificial cheapening stops? – Oh, I forgot, there is no end to the Fed’s easy money stance. Silly me.

The Fed – like all other central banks – is increasingly boxed in. They know – or begin to suspect – that their policies are not kick-starting the economy but they cannot admit it. ‘Unlimited’ and ‘open-ended’ have a ring of machismo about them but they also indicate frustration and desperation.

Impatient policymakers

We cannot say we haven’t been warned. Bernanke’s affinity for ‘unlimited money printing’ was well documented by this famous statement of his:

“The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost…We conclude that under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”

But the speech that this quote is taken from, before the National Economics Club in Washington in November 2002, was all about the risk of deflation. Today, there is no (imminent) risk of deflation in the US. And the risk of banking system collapse is, from all we know, not any bigger today than it has been at any point over the past 12 months when the Fed did not expand its balance sheet at all. I therefore agree with those analysts who say the Fed is doing something different, although I believe that this was already the case with QE2. It is not using QE as an extreme measure to avoid banking collapse or the onset of a deflationary spiral (a hugely overblown fear anyway, in my opinion) but because it is getting frustrated with the speed of growth. Avoiding the collapse of the financial house of cards has been one objective of monetary policy in recent years, but simply maintaining the financial system in a state of arrested collapse is not enough. We need growth. And the Fed has only one means of creating growth, that is, by artificially cheapening credit and massaging various asset prices up and their yields down with the help of the printing press. That is obviously the same policy that got us into the crisis in the first place but never mind.

Having said all this, there is no reason to expect any fireworks soon. Let’s be honest, in today’s world of trillion-dollar deficits $40 billion a month is not that much. At that pace, it will take the Fed until Christmas 2013 to inject the same kind of money into system that it did within 6 months during QE2, when it did not kick-start a ‘virtuous cycle’.

The Wall Street Journal reported that economists had estimated that another $500 billion of QE would boost GDP by 0.2 percent and lower the unemployment rate by 0.1 percent. Or, was it GDP by 0.1 percent and the unemployment rate by 0.2 percent? – I forgot. The Wall Street Journal did not report if the economists were sniggering.

It will take the Fed a year to get $500 billion newly printed cash into the system. I suspect the Fed economists expect a bigger impact as all the money is targeted for the mortgage market. I also think the monthly amounts will soon be lifted to more meaningful sums.

The bottom line is this: QE is no longer unconventional. It is the new normality. The central bank not only manipulates – persistently and systematically – short term interest rates and the supply of bank reserves so that credit remains constantly cheap, it now also manipulates the shape of the government yield curve, the cost of state borrowing, and risk premiums in the mortgage market. All of this requires ongoing balance sheet expansion at the Fed and open-ended money printing. And there is no exit strategy.

This will end badly.

Yesterday, the ECB pronounced itself the official lender-of-last resort to all Euro-Zone governments. To assure that the state can always borrow at conveniently low rates has been declared an essential component of ‘maintaining financial stability’ and thus a standard plank of modern central banking. Despite all their professed differences and divergent legal frameworks, all major central banks have now become their respective governments’ inexhaustible ATMs. – Coincidence?

At the press conference yesterday Draghi declared that unlimited bond buying was really par for the course of what a central bank should do to make sure that those ‘transmission channels of monetary policy’ don’t get clogged. It is all well within the ECB’s original mandate, although Draghi thought it still necessary to blame the need for his new initiative on somebody, namely the investors who, with their ‘unfounded fears’, create ‘severe distortions’ in government bond markets.

He was evidently talking of the ‘unfounded fears’ of a breakup of the euro when what is really at the heart of the Euro Zone sovereign debt crisis is the fear of various states going bust, and that fear is anything but unfounded. The inability of most governments to reign in public spending and to end their dependence on continuous borrowing is the real reason for ‘severe distortions’ in sovereign debt markets.

The politicians and central bankers could have separated the issue of default and Euro-exit by making it clear that default is an option within the single currency. That was indeed the idea behind the original no-bailout clause. Let Greece go bust, and Spain as well, but don’t kick them out of the euro. Default is a problem between creditor and debtor, that’s all. As I said before, under the Classical Gold Standard, a government could have defaulted and nobody would have ceased to use gold as money, not even the citizens of the defaulted state. Similarly, the Californians will not be asked to leave the dollar-zone if (or when) the Californian government defaults.

Euro-exit is a political decision, not an economic necessity. The idea is to get your own central bank back, print lots of money and, that way, keep borrowing and spending. Yesterday, the ECB made it clear that exit is unnecessary as the ECB will now do all the printing for the weaker states itself.

 There is no surprise here. This was all expected and it was sooner or later inevitable. Yet it does constitute a further step toward the nationalization of money and credit and the death of free markets. Here is why:

It is a matter of logic that anybody who habitually spends more than he earns and borrows the difference puts himself at the mercy of his creditors. When those lose faith in him, he will be unable to roll over his debt or borrow more, or may only be able to do so at punitively high rates. That is the flipside of living constantly beyond your means, of going ever more into debt. You need somebody to fund such extravagance. When your lenders lose trust in your ability to repay, it is ‘game over’.

But in our system of unlimited fiat money this does no longer apply to banks and governments. For these two entities it doesn’t matter what the investors and depositors  – ‘the market’ – think or feel. In these cases, the central bank bureaucracy assumes the role of ultimate decision-maker. As long as the banks and the governments can convince the central bank bureaucracy that they should stay in business and keep borrowing, they will stay in business and keep borrowing, preferably straight from the printing press and without the involvement of those pesky investors with their ‘unfounded fears’. And these days it is not hard to convince the central bank.

From LTRO  to OMT

The members of the political-financial complex have certainly been sticking together: bankrupt banks have been buying the bonds of bankrupt governments so that the governments could continue bailing out the bankrupt banks, and the ECB provided the cash for this charade. It used to be called LTRO – long-term refinancing operation.

Under LTRO, the ECB could pretend that it was only supporting the banks and not spendthrift governments at the same time. Supporting the banks was accepted according to the then reigning central banking orthodoxy, funding the state not so much. Late last year and earlier this year, the ECB printed €1,000 billion of new money and gave it to the banks, mainly banks in the Euro Zone periphery. These banks then used the money to buy the bonds of their governments.

LTRO had two flaws: €1,000 billion may sound like a lot of money to you and me but even €1,000 billion is not, well, unlimited. And because LTRO was not unlimited, it ran out at some stage, and the dire state of public finances came to the surface again. All the newly acquired government bonds were suddenly burning a new hole in the balance sheets of the already weakened periphery banks.

The central bank bureaucracy has now come up with OMT – outright monetary transactions – to address LTRO’s two weaknesses: OMT is not only unlimited, it doesn’t burden the balance sheets of the banks any longer. This is money printing from the central bank directly for the benefit of the state (even if it is conducted in the secondary market).

Of course, OMT comes with a whole range of pious promises, such as that it will only benefit governments that receive support from the ESM or EFSF, and that subject themselves to the tough conditions of these programs. The valiant efforts at fiscal consolidation will continue.

Yeah, right.

We heard this many times before. The Eurocracy is very good at imposing tough limits and restrictions on itself, only to ignore them shamelessly at the first hurdle. Remember the Maastricht treaty? The limits on government debt and budget deficits? The no-bailout clause? Every single promise has been broken by now. Besides, we have no guarantees. The ECB may change any of these conditions at the drop of a hat. All of this is entirely arbitrary. The elite is making up its own rules as it goes along.

Only the prospect of instant default and a complete cut-off from new borrowing will ever force politicians to shrink the state apparatus that is the source of their power. The political class hates ‘austerity’. So do the majority of voters. With the backstop from the printing press in place, the appetite for fiscal reform will most certainly fade. The chances that ‘austerity’ will die a quiet death have increased.

Market response

The markets’ initial response is somewhat silly, in my opinion, albeit not entirely surprising. Equities are rallying hard, in particular bank stocks. So does government debt. The euro is stronger versus other paper currencies because the risk of breakup has allegedly receded. But breakup looked unlikely even before.

In fact, no response was needed. Nothing material has changed. Like the central banks in Britain and the US, the ECB will now actively and directly support government debt with the printing press but this was sooner or later inevitable anyway. I do not see any basis for a marked divergence of any of these currencies. In all these economies the printing press is quickly becoming the last line of defense for an unsustainable system.

And the ECB’s OMT will end the depression as little as QE in the US and Britain has ended the depression there. I expect the asset rallies to peter out quickly but asset prices to remain elevated because of cheap money everywhere.

In the meantime, the debasement of paper money continues.

]]> http://detlevschlichter.com/2012/09/draghi-ecb-to-counter-unfounded-fears-with-unlimited-cash/feed/ 18 http://detlevschlichter.com/2012/09/u-s-republicans-introduce-gold-standard-debate-mainstream-media-go-mental/ http://detlevschlichter.com/2012/09/u-s-republicans-introduce-gold-standard-debate-mainstream-media-go-mental/#comments Mon, 03 Sep 2012 18:10:08 +0000 Detlev Schlichter http://papermoneycollapse.com/?p=2340

America's new money? (photo by Swiss Banker)

I am not holding my breath over the Republicans’ plans for another gold commission to investigate the possibility of returning the USA to a gold standard in the case of the Romney-Ryan ticket winning.

Of course, I like the Classical Gold Standard, which existed from about 1880 to 1914, and I am convinced it was a humongous mistake to do away with it, a mistake that was further compounded by the abandonment of its weak successor, Bretton Woods, in 1971. And you know what I think of our present unconstrained fiat money system: It is suboptimal, unstable and unsustainable. It is fundamentally incompatible with capitalism, and it has now amassed so many colossal imbalances, from overstretched banks to a gigantic and never to be repaid public debt load, that it is firmly beyond repair. It is in its endgame.

But I don’t believe the best solution would be to go back to a government-run gold standard. We should not trust politicians and bureaucrats with money, certainly never again with entirely unconstrained fiat money, but probably not even with a monetary system that comes with the strait jacket of an official gold standard. I would argue instead for the complete separation of money and state, and for an entirely private monetary system. Let the market decide what should be money and how much there should be of it. I do strongly believe that gold would again play an important role in such a system. After all, gold and silver have been chosen forms of money for thousands of years, in all cultures and societies. That is what the trading public always went for when it was free to choose.

Nevertheless, I would agree that even an ‘official gold standard’, such as the US had before 1933, and in particular before the Federal Reserve was established in 1913, would still be much better than anything we have today. But the chances of such a system being reintroduced are slim.

Political obstacles are immense

Remember, there already was a gold commission under Ronald Reagan in the early 1980s, and it rejected the idea. And I think the chances for a return to gold through the established political process were considerably better 30 years ago than they are today.

For all his faults, Reagan was a much more libertarian politician than Romney, with incomparably better free market credentials, a stronger philosophical core, and a superior talent for communication. I don’t trust today’s Republican Party implementing a truly libertarian program.

Also, in the early 1980s, it would have been much easier to transition to a gold standard. Constant fiat money expansion had not yet created the massive imbalances and the illusions of prosperity that characterize our economies today. Back then the total debt of the US government was less than  $1,000 billion. Today, the annual budget deficit is bigger than that. Today, the withdrawal symptoms would be considerably larger for the state, the financial industry and the distorted and hugely inflated asset markets, all of which are now thoroughly addicted to the crack cocaine of a never-ceasing flow of super-easy money. In the early 1980s, then-Fed chairman Paul Volcker had in fact stopped the printing press for a while and allowed higher interest rates to cleanse the system of some of the accumulated distortions. There was in fact a discernible political will to implement hard money. Compare that to the situation today!

So if Romney wins the election (a very big if), then it is still likely that the commission will reject the idea, in my opinion. Nobody wants to take the short-term pain of turning off the monetary tab, even if the long run benefits are considerable. Wall Street, the media, academia, and, of course the Fed, are strongly on the side of fiat money. I don’t see any commission overruling these powerful factions.

In many ways, the worst outcome would be some watered down, pseudo-gold standard under the management of the Fed. If the crisis then persisted, which it would, the easy-money advocates would blame everything on the ‘gold standard’ tying the hands of ‘our saviour, the central bank’. This is also a problem for a Romney-win in general, which is unlikely to bring the pro-market changes America needs although his policies will be branded ‘free market’ by the statist media. If Obama remains in office, at least nobody will call his program ‘capitalism’.

Media and academia are mainly pro-state, pro-politics, anti-gold

So I guess, we hard-money nutcases will have to wait for the crisis to get worse, while the advocates of fiat money and central banking can relax and happily cheer on the Printmaster-in-chief as he creates good and lasting jobs with QE5 and QE6. What has, however, been interesting in recent days has been the response in the mainstream media. Commentators have been in a state of apoplectic fit over the gold commission, writing dismissive pieces against gold that are as full of hysterical rage as they are void of economic reasoning.

I am fully aware, of course, that the present easy-money system controlled by educated bureaucrats has its adherents, in particular among people who perceive every problem in society to be best solved by politicians and the state. But the extent of economic nonsense and disinformation that was disseminated in these tirades, and the strenuous, laboured defence of the present system, I still found remarkable.

Bloomberg diagnosed that the critics of Fed activism, zero-interest rates and unlimited QE, suffer from an “anti-inflation obsession” that borders on “derangement”, while Robin Banerji in a piece for the BBC website remarks that advocating the gold standard had been the domain of “economic eccentrics” and followers of “folksy” libertarian Ron Paul, in short, ill-adjusted people who have not gone with the times, who are nostalgic, longing “for a simpler age”. You see, if you are an advocate of the gold standard you may suffer from psychological problems. Fittingly, Banerji’s article for the BBC is titled: Gold standard: Could it return in the US?, which make it sound like a disease. Cholera: Could it return in the US?

Unfortunately, Mr. Banerji’s article does not give the economic layman a clear comparison of the key features of the two systems, fiat money and gold standard. Instead, the reader is left with the vague sense that a gold standard would either collapse instantly or lead to grave instability. The present system is, by comparison, described as successful and inherently stable.

To this effect, the article quotes three mainstream economists – Kenneth Rogoff, Anil Kashyap (return to gold “incredibly crazy”) and Charles Wyplosz – all opponents of a return to gold. Wyplosz provides this remarkable insight:

“There has been no significant inflation in the advanced economies for the last 25 years, so the need for gold to defeat inflation seems unnecessary.”

Hmmm. From 1997 to 2007, that is, the ten years that preceded the start of the present crisis, house prices in the US appreciated 3 times faster then in the preceding 100 years. We had drastic asset price inflations and various asset price bubbles around the world over the past 25 years, plus explosions in general indebtedness and massive bank balance sheet expansions, and these inflations set us up for the present crisis. Real estate booms that ended in banking crises occurred in Japan, Scandinavia, South East Asia, the US, the UK, Ireland and Spain, to name just the examples that come to mind immediately. But I guess, as long as a pint of milk in the supermarket only goes up by 3 percent a year, there is ‘no significant inflation’ for Mr. Wyplosz. Remarkable.

“Stable paper money versus unstable gold money.” – Really?

While the present system is supposedly doing swell, the gold standard is a source on instability. Harvard-man Rogoff has this to say:

“The price of gold fluctuates a lot and therefore the price of your currency would fluctuate a lot.”

This is a popular fear about the gold standard, and it is without any foundation in economic theory or history. Today’s gold price is volatile because gold has been (partially) demonetized and is now fluctuating against state-issued paper money, and the resulting price movements tell us more about the instability of fiat money than of gold.

Throughout history, gold provided a reasonably stable form of money, while paper money systems have, without exception, led to drastic reductions in money’s value, have always created major economic instability and always ended in complete currency disaster if a return to commodity money was not achieved in time. Indeed, economists only began to systematically study major, lasting changes in money’s purchasing power as a macro-economic phenomenon – and disturbance – in Britain in the early 19th century, when the pound was off gold for a considerable time to make it easier to fund the war with France, and an unprecedented inflation occurred.

As I explain in detail in Paper Money Collapse, complete stability in money’s purchasing power is an unobtainable goal. The purchasing power of money will always be subject to fluctuations, in either system. But major, lasting changes in money’s value are the prerogative of fiat money systems. It is fiat money systems that have always produced inflation, often followed by corrective deflation when fiat money production finally ceased. If you look at long-dated charts of the purchasing power of the world’s oldest currencies – the British pound and the US dollar – you can spot easily when these currencies were taken off gold or silver, and when they were later put back on gold or silver.

Gold has been relatively stable money, while paper money has always been – without exception – unstable money. Abandoning commodity money always increased uncertainty over money’s purchasing power for the money-user.

The pound and the dollar have, in their very long history, never lost as much purchasing power as quickly as they have since 1971, when Nixon closed the gold window.

To imply that gold would be unstable money while fiat money can guarantee stability is putting the historical record on its head. If we judge the two monetary alternatives, fiat money and gold standard, purely on purchasing power stability, there can be no question that the gold standard wins easily. To my knowledge, at no point in history was gold or silver replaced with fiat money, because the public demanded an end to ‘unstable commodity money’ and craved ‘stable fiat money’. But on the other hand, monetary systems have repeatedly gone back from paper money to commodity money, such as gold, in an effort to restore economic stability. Britain did it in 1821 and the US in 1879. I find it hard to believe that Rogoff does not know this. Why he is happy to portray it otherwise, I can only guess. And the journalist Banerji is evidently uninterested in checking the facts.

In a similar direction go statements like these, again from Rogoff:

“[The effect on the US economy of a return to a gold standard] could either be inflationary or deflationary depending on the initial rate.”

Again this is highly misleading as it falsely associates the gold standard with uncertainty and instability. Based on history and economic theory, we can predict with reasonable certainty that a return to a gold standard would be deflationary in the near-term – almost regardless of the initial rate – as the preceding inflationary boom is unwound, but provide monetary stability in the long run. Under a gold standard the supply of (core) money would be essentially fixed or could only be expanded very slowly. There would be no longer any monetary policy, and banks would no longer enjoy the privilege of a “lender of last resort”. These are the key differences to the present system. Because of our fiat money system, the relative prices of many assets are distorted by constant monetary expansion, which does not – contrary to widespread misperception – lift all prices uniformly but some prices more than others. Additionally, banks are running low capital and reserve ratios because of the safety net provided by the printing press. The change of monetary regime would cause many prices to adjust, many probably to decline, and many banks to shrink their balance sheets to protect reserves. Once we are through this deflationary adjustment – which is, in my view, unavoidable at some stage anyway – we can expect the gold standard to give us money of superior purchasing power stability, as I explained above.

Over time, a proper gold standard can be expected, on conceptual grounds, to even deliver moderate deflation. Prices would have a slight tendency to decline over time. Statistically and historically, this phenomenon has been very minor, indeed, and such secular deflation, if it occurs at all, is never an obstacle to strong growth.

The problems of transition

 Rogoff is, however, correct to highlight the general importance of the initial dollar-gold rate established by the new gold standard. The US has a sizable gold hoard but at the present gold price it is worth ‘only’ about $440 billion when years and decades of paper money creation have caused the monetary base to balloon to $2,600 billion, and M2 to more than $10,000 billion. For the official gold stock to back the entire monetary base the dollar would have to be devalued versus gold to a new price of $10,000 per once of gold, compared to $1,690 per ounce now; and if M2 was to be backed completely with gold, the new gold price would have to be $38,000 per ounce! Such a drastic revaluation of the dollar could have various knock-on effects, certainly in the international gold and commodity markets but probably elsewhere. Rogoff is right to point this out.

However, these are problems with the transition from one system to another. I am the first to admit that after 40 years of unrestricted fiat money creation a smooth and friction-free transition back to sound money is anything but straightforward. This is also my biggest criticism of present-day easy-money policies: They create illusions of stability by creating more imbalances and making a return to a stable system more difficult. But such a return will one day be necessary and unavoidable.

None of these objections mean that a transition to sound money is ultimately not possible and the long run benefits of it not highly desirable. Remember that transitions from paper systems back to gold were achieved repeatedly throughout history. More importantly, these points say little about the workings of a gold standard versus the operation of a fiat money system. The reader must wonder why anybody in his right mind would even contemplate going back to gold when all a gold standard could ever give us was volatility, uncertainty and chaos.

 Well, in fairness to Banerji, he had this to say about the gold standard:

“From 1945-1971, the period of the “gold exchange standard”, the US fixed the dollar to gold at $35 an ounce. Growth rates were higher and rises in wealth were more equitably shared across society than in the years that followed. Unemployment has been higher, growth lower, and wealth more unevenly distributed since the US dollar came off gold in 1971.”

 But then he hastens to add: “This could have been coincidence, however.”

 What are the effects of money creation?

 The Bloomberg opinion piece is equally hostile to the gold standard idea but it is less confusing and misleading, and instead provides the reader with a clear and rousing endorsement – incredibly naive and misguided, in my opinion – of fiat money and central bank activism, an apparently wonderful system that we would have to do without if the mad Republicans brought the gold standard back.

“Contrary to what gold bugs and other Fed-bashers say, the Fed’s dual mandate and its policy of quantitative easing — buying bonds to nudge down interest rates– have been vital strengths, not weaknesses. They have helped to support demand and bring unemployment down, albeit slowly. Fiscal paralysis in Washington made the Fed’s unorthodox measures all the more necessary. Far from being reckless, the Fed has been too timid and needs to embark on the third round of QE that Chairman Ben S. Bernanke keeps hinting is on the way.”

The key argument is a familiar one, and it goes something like this: Economic crises occur, they just happen, gold standard or no gold standard, but under our present system we at least have a central bank that can lower interest rates and print lots of money to stimulate demand and get us out of the crisis.

Behind it lies a dangerous simplification, namely that fiat money creation has two effects and two effects only: all else being equal, injections of money lift the price level (i.e. they cause inflation) and lift GDP. Rising prices are sometimes good and sometimes bad. You can, of course, have too much inflation. But the growth-boosting effect of more money is always welcome. So, whenever inflation is not a problem (or when there is even a risk of deflation) the printing of money is an unequivocal positive. Who can be against it?

But injections of new money into the economy have many other effects than just lifting two entities of national account statistics. Have those who hold this simplistic macro-economic view ever thought about how the micro-economic act of injecting a certain amount of new money into the economy at a specific point, namely the banking sector, is supposed to translate directly, smoothly, and instantly into the macro-economic phenomena of higher prices all around and more economic activity all around? Alas, the whole thing is slightly more complicated.

Thankfully, but still unbeknown to the folks at Bloomberg, for centuries many high-caliber economists have worked hard to understand and explain the full range of effects of money injections. Indeed, one of the very first economists ever, Richard Cantillon, already made it an important aspect of his work, and his insights – almost 300 years ago – were already superior to what you can read in most financial market commentary today. For Cantillon already stressed that an inflow of new money will not lift all prices simultaneously and by the same extent but some prices more than others and some sooner than others. And that is as true today as it was in the early 18^th century.

An inflow of new money into the economy must always change relative prices. Therefore, it must affect the use of scarce resources, the structure of production, and the distribution of income. Every inflow of new money must therefore create winners and losers. As a rule, the early recipients of the money (today, those are mainly to be found in the financial industry) benefit at the expense of the later recipients.

Inflows of new money tend to lower interest rates and also change the structure of interest rates, which in turn will affect the extent of investment and the structure of investment in the economy. In short, the delicate co-ordination between voluntary saving and capital investment that, in a free market, is conducted by market interest rates, is systematically distorted. The artificial cheapening of credit through money injections leads to capital misallocations and mal-investment.

For 200 years, many economists have blamed the business cycle on monetary expansion, usually as a result of artificial bank credit creation, often encouraged by the abandonment of a commodity anchor. The effects of money inflows listed above tend to create near-term booms that must be followed by corrective recessions later on. This phenomenon has to date been analyzed most comprehensively and convincingly by the Austrian School economists Ludwig von Mises and F.A. Hayek.

Mises called it the fundamental non-neutrality of money. Money can never be neutral. This means that any monetary economy, including a gold standard economy, will be subject to occasional disruptions emanating from the use of money, but the more elastic the supply of money is, and the more the supply of money is constantly expanded, the more severe these disruptions must be. Elastic money is also unstable and destabilizing money.

The crisis that the Fed is fighting today with easy money is the result of a housing bubble that the Fed itself inflated when it provided easy money to fight the previous recession, and that recession was the result of the collapse of the internet-bubble in 2001 which had previously been inflated by the Fed itself when it provided easy money to fight the consequences of the Asian debt crisis and the collapse of the hedge fund, LTCM, in 1999, which….you get the idea.

Fact is, our unrestricted fiat money system is moving us progressively away from monetary stability and economic sanity. The Fed and other central banks have become serial bubble-blowers, and they have now created such vast imbalances that they are all on zero interest rates and repeated rounds of asset purchases to keep the system from collapsing. It requires such a naïve and simplistic macro-economic viewpoint as the one espoused by the Bloomberg editors to not see that this system is simply unsustainable.

I do not think that the US Republican Party will bring us back to a gold standard anytime soon. Sadly, I think the crisis will have to get much worse before this will be achieved. But there can be no question that we will have to transition to a hard money system eventually. The future of capitalism and a free society depends on it.

As Ludwig von Mises wrote in 1965:

“If our civilization will not in the next years or decades completely collapse, the gold standard will be restored.”

]]> http://detlevschlichter.com/2012/09/u-s-republicans-introduce-gold-standard-debate-mainstream-media-go-mental/feed/ 11 http://detlevschlichter.com/2012/08/paper-money-collapse-nominated-for-international-book-award/ http://detlevschlichter.com/2012/08/paper-money-collapse-nominated-for-international-book-award/#comments Fri, 31 Aug 2012 12:58:14 +0000 Detlev Schlichter http://papermoneycollapse.com/?p=2335 I am very happy and proud to announce that Paper Money Collapse – The Folly of Elastic Money and the Coming Monetary Breakdown has been shortlisted for the 2012 getAbstract book award. Previous winners include Nassim Nicholas Taleb, Niall Ferguson, Robert Shiller, Bill Bonner, Thomas Sowell and Peter Schiff. The award ceremony will be held at the International Frankfurt Book Fair in Frankfurt, Germany, on October 10. Yours truly will, of course, be there. Keep your fingers crossed!

Below is the press announcement from getAbstract and the list of nominees:

getAbstract’s 12th Annual International Book Award Ceremony

The awards ceremony takes place on October 10, 2012, at the Frankfurt Book Fair

Lucerne, Switzerland – July 30, 2012 – Albert Einstein once said, “Any intelligent fool can make things bigger, more complex and more violent. It takes a touch of genius – and a lot of courage – to move in the opposite direction.” getAbstract concurs. Good authors recognize problems and break them down to their basic elements. Moreover, the very best writers even have some ideas about how to solve these inextricable dilemmas.

For the 12th time since 2001, getAbstract is proud to award a prize for the best business books of 2012 at the opening of the Frankfurt Book Fair, on October 10, 2012. getAbstract (www.getAbstract.com) assessed more than 10,000 English and German business books in the fields of leadership and management, strategy, sales and marketing, human resources, economics and politics, finance, and career development, and we have selected 10 finalists. The 2012 nominees are:

GERMAN

- App-Economy by Ansgar Mayer – mi-Wirtschaftsbuch/Münchner Verlagsgruppe
- Ausgegeizt by Uli Burchardt – Campus Verlag
- Data Unser by Björn Bloching, Lars Luck, Thomas Ramge – Redline/Münchner Verlagsgruppe
- Der amerikanische Patient by Josef Braml – Siedler/Random House Verlagsgruppe
- Zerschlagt die Banken by Rudolf Hickel – Econ/Ullstein Verlage

ENGLISH

- Inside Apple by Adam Lashinsky – Business Plus/Hachette Group
- Paper Money Collapse by Detlev S. Schlichter – John Wiley & Sons
- Reverse Innovation by Vijay Govindarajan, Chris Trimble – Harvard Business Review Press
- Thinking, Fast and Slow by Daniel Kahneman – Farrar, Straus & Giroux
- Too Big to Know by David Weinberger – Basic Books/Perseus Books Group

Two of the nominated titles from each language category will receive this well-established and, in the international publishing world, coveted business book award. The official awards ceremony will take place on October 10, 2012, from 4:00 p.m. to 5:00 p.m., at Frankfurt Book Fair’s “Lesezelt” in Frankfurt am Main.

About the getAbstract International Book Award

This year, the award celebrates its 12th anniversary. When getAbstract launched its business book award in 2001, it was the first international award of its kind. Since then, getAbstract has presented the prize to such esteemed authors as George A. Akerlof, Robert J. Shiller, Nassim Nicholas Taleb, Ian Morris, Benoît Mandelbrot, Malcolm Gladwell, Niall Ferguson, Joseph Stiglitz, Thomas Sowell, Chris Anderson, Peter Sloterdijk, Gunter Dueck, Uwe Jean Heuser, Wolfgang Münchau and Hans-Werner Sinn.

For more details about previous award winners, please go to:

http://www.getAbstract.com/Bookaward.

http://en.wikipedia.org/wiki/GetAbstract_International_Book_Award

Dear readers, first of all, apologies seem in order. An unusual gap between blog posts has appeared on the Schlichter Files this summer. The reason is that I was travelling with my family in East Africa through most of August, enjoying the spectacular landscapes and the fascinating wildlife there, and meeting some very interesting people. Although, admittedly, I travelled in considerable comfort, and East Africa offers today reasonably good internet connections, often even in fairly remote areas, I decided not to read any newspapers, websites or even my emails for a few weeks, and instead tried to take my mind off the depressing subject of monetary meltdown and the destruction of capitalism and the free society at the hands of politicians and central bankers. So here I am, back in London after almost a month in the relative wilderness, slowly and reluctantly catching up with events in the strange world of 21^st century finance. My first impression is that I have not missed much in terms of the unfolding crisis. None of the dynamics have changed. If anything, I feel my dire predictions and gloomy outlook again confirmed by recent events.

Where we are

Last month we entered the sixth year of this crisis, although parts of the media seem determined to continue calling it a ‘recovery’. Wishful thinking. We have been in continuous crisis for half a decade. Doses of Valium and Prozac – called QE among central bankers – have calmed nerves occasionally and given the false impression of healing.

QE, or ‘quantitative easing’, is, of course, the creation of massive new quantities of monetary units and their targeted injection into financial markets for the purpose of manipulating asset prices and interest rates, and of flooding the banks with extra free reserves. QE is a dangerous drug. It is a hallucinogen. It can make you feel better for a while but it won’t cure the disease. In fact, it makes you sick. The global economy suffers from grave distortions that are the result of years and decades of artificially cheapened credit: Overstretched banks, too much debt, inflated asset prices, misallocated capital. Cheapening credit further – and manipulating asset prices further – is, however, the MO of QE. QE encourages additional borrowing and further balance sheet expansion.

QE – and zero interest rates – is the policy equivalent of crack cocaine. It makes addictive. There is no end to it.

I was reminded of this when I opened the newspapers last Thursday for the first time in almost a month, and learned that the Fed might be on the cusp of another round of QE.

“Fed Minutes Signal Action Likely”, headlined the Wall Street Journal, “Fed shows a strong consensus for action”, the Financial Times.

Whenever the policy elite is promising more action you should get very concerned.

QE – to the bitter end

When compared to their peers among the global oligopoly of state money printers, the Fed bureaucracy has had a rather quiet spell over the past 12 months. The Fed only conducted some balance-sheet neutral bond price manipulations (‘Operation Twist’) but refrained from any money-printing worth mentioning. Since the crisis started in July of 2007, when the bottom fell out from under the US subprime market, the Fed has, of course, created a cool $1,900 billion in new money in the form of bank reserves. Its balance sheet has more than tripled. But most of this money was created during QE1 – after the collapse of Lehman in 2008, when the Fed bailed out the US banking system by taking over more than $1,000 billion of its mortgage exposure – and then during QE2 – when the Fed created another $600 billion to manipulate the prices of US Treasury securities. But in year 5 of the crisis – July 2011 to July 2012 – the monetary base has remained unchanged, for the first time in any one-year spell since July 2007.

Such impassivity is not becoming for the most powerful central bank in the world, in particular when the Bank of England is already on QE3, and the ECB has just expanded its balance sheet by more than 50 percent. (Incidentally, the ECB, the pantomime villain among international QE-enthusiasts because of its supposedly Bundesbank-inspired hard-money line, created more money, at least exchange-rate adjusted, since 2007 than the Fed: €1,800 billion. As I keep saying, when I look at the world’s major central banks, I see sameness, not divergence.)

Bureaucrats can, of course, not sit still for long. People might get the idea that they are useless and that we don’t need them, or, heaven forbid, that their work is even positively harmful. The bureaucrat cannot allow these concerns to emerge. Through ‘action’ he has to remind the public of his vital importance to society. By contrast, private companies are ventures that are ultimately controlled by consumer demand, and that are therefore usually limited in time. They emerge, grow and prosper, decline and die when consumer tastes change or better competitors come onto the scene. Not so the monopolistic state bureaucracy. It is built for eternity. Regardless of how disruptive, harmful and distortive the central banks’ ongoing money injections and cheap credit policies have been over the years and decades, and how culpable the Fed (among others) has been in creating and maintaining vast imbalances, the central bank bureaucrat has to go on with his work. He can’t question his mission without questioning his own existence.

Part of the Fed’s official mission is, famously, to boost employment. The notion behind this task – namely that lasting private sector employment can be enhanced through constant money injections and manipulations of interest rates – is utter economic nonsense. However, it is the very raison d’etre of the Fed. That is their line and they are sticking to it.

That QE3 would ultimately come was clear from the moment that QE2 had been concluded. It was only a matter of time. Yet, from the point of view of the central banker, it would be a mistake to simply resume QE without orchestrating first a protracted and well-publicised internal debate. Otherwise, the public could get the idea that modern central banking was simply ‘money printing’ rather than a difficult, complicated, and intricate affair that requires countless economic analysis and careful fine-tuning.

The Fed’s present deliberations seem to go something like this:  There is a ‘recovery’ out there, but it does not look ‘substantial and sustainable’ enough. Some higher asset prices, lower interest rates, tighter risk premiums, or more generous bank reserves – preferably, all of the above – could help the economy and make sure that the ‘strengthening’ is ‘substantial and sustainable’. Let’s print more money!

What to expect

I have no insights in what precisely the Fed is up to, and frankly, I find the expert-discussions among analysts on CNBC or elsewhere on the topic slightly degrading and cringe-inducing, akin to watching an episode of ‘I am a celebrity, get me out of here’. Do these experts realize how much we have moved away from capitalism? These financial analysts often call themselves ‘economists’ when what they are doing resembles much more the work of the Soviet-era Kremlin watchers who tried to read between the lines of policy pronouncements and the tea leaves of the Politburo.

For what it is worth, my guess is the Fed will have to do more than the lame $600 billion they did last time. And at some point they will have to also stop paying interest on the massive excess reserves at the Fed to push more money into the economy.

What will the consequences be? Will this be the straw that breaks the camel’s back? Will it push the financial system over the edge? Will it finally undermine confidence in the system? Will this trigger sell-offs in bonds and trigger currency meltdown? – I doubt it. Not yet. We may have to wait a tad longer for this. But it will undoubtedly add to the grave distortions in our financial system. The Fed’s chosen assets will get a temporary boost, some well-connected financial firms will make handsome windfall profits, and some of the economic data might improve for a while. I also think that the deflationists out there, who expect balance sheet shrinkage and drops in asset prices, will again be disappointed. Another dose of Valium will probably keep asset prices supported and also consumer and producer prices on an upward trend. All this new cash has to go somewhere. The debasement of paper money will continue. Gold could do well.

Naturally, none of this will end the crisis. It will certainly not kick off a ‘virtuous cycle’ of growth and prosperity such as Bernanke foolishly promised back in 2010 when he last engaged in QE. That this is the one ‘stimulus’ that will finally put the economy on self-sustaining growth, on the ‘substantial and sustainable strengthening’ the Fed demands, is grotesque and simply laughable. This policy will simply cement the dislocations and add more debt to our economies. It could inflate the government bond bubble – the most dangerous of all bubbles – further, and allow the US government to run even larger deficits for even longer (although, admittedly, the bond bubble continued to inflate even in the absence of QE, due to private sector ‘safe haven’ flows, although the bubble has also been supported continuously through zero interest rates and ample bank reserves, both provided by the Fed). The financial system will, on the margin, become even more dependent on ongoing Fed support and ultra-low policy rates. This will make it impossible for the Fed to ever reverse course.

The idea that all this monetary madness is only temporary, only to help us get out of the crisis, and that the central banks have an ‘exit strategy’ –a term that I have not heard or seen in any discussion of central bank policy since spring of 2011! – is getting less tenable by the day. There is no exit strategy. Not in the US, not in the UK, not in the Euro Zone.

In Britain, the ex-central bankers Blanchflower and Posen are demanding that the Bank of England, the global QE champion, drops its ‘anguished religious ethics’ over QE and finally buys a wider range of financial assets, and not just government bonds. Germany’s Spiegel-magazine this month reported that the ECB might establish upper yield spreads for non-German government bonds and then defend them through its own open-market bond-buying. Wherever you look, the same story: More money has to be printed in order for the central bank bureaucracy to influence, distort and manipulate an ever wider range of asset prices.

One day a sufficiently large section of the public will realize that the central bank and the government have no alternative to printing ever more money and taking on ever more debt. The only way they know of how to ‘stimulate’ the economy is via cheapening credit and encouraging more lending and borrowing. At some point, confidence will evaporate, people will disengage from bonds and paper money, inflation will rise (as money becomes a hot potato) and real interest rates rise even faster (as bonds become hot potatoes, too). Nobody knows when that will be. But we know one thing: the policy bureaucracy remains relentless in its efforts to make the widespread price distortions, capital misallocations and the gargantuan debt pile bigger. More interventions and market manipulations are on the way. All of them are designed to discourage the liquidation of imbalances and instead encourage more debt accumulation. The goal seems to be to make the endgame as catastrophic as possible.

That is the one thing the central bank bureaucrats and politicians will succeed in.

"Don't worry. Trust me." -- President Nixon - photo White House Photo Office

On August 15, 1971, President Richard Nixon declared that the United States would no longer honour its promise to exchange US dollars held by foreign central banks for gold at a fixed price of $35 an ounce. The innocuous term ‘Nixon closed the gold window’ that is now widely used to describe this act does not quite convey its significance. (Was something to be stopped from going out or from coming in through the window? Can the window be reopened again?)

What Nixon did was cut the last remaining official link between the world’s leading reserve currency and gold and thus remove the last constraint on fiat money creation.

Was this a big deal? – It was very big deal. In fact, we are only now beginning to realize the full consequences of it. In fact, the present crisis is nothing but the endgame of this system, or non-system, of this, mankind’s latest and so far most ambitious, experiment with unrestricted fiat money. The first truly global paper standard.

Nixon knew that it was big. On TV that day he felt compelled to reassure the American public that this was only temporary and that the purchasing power of the dollar was secure. Forty-one years later we are still on the same system (or non-system), and the dollar has lost eighty percent of its purchasing power.

But, the mainstream economists, who weren’t even involved in designing this system (or non-system), as nobody designed it, it was simply the result of political opportunism — these economists today tell us that this system is great, it is to our advantage. We should be grateful for it.

Because the eighty percent drop in purchasing power quoted above, isn’t the whole story, that is only CPI, the consumer price index. For the past thirty years, a lot of the newly created money was channeled predominantly not into the markets for consumer goods but into the stock market, the bond market, the real estate market, and again the bond market. This created illusions of wealth. It also created a lot of debt, overstretched banks, a gigantic financial industry, various bubbles, and yet more debt. It did so around the world. And whenever this house of cards looks like it could come crashing down on us – we print more money!

Simple. What can go wrong?

Of course, there was also real economic progress over those forty-one years. Entrepreneurship, trade, innovation, saving, and all that old fashioned stuff that modern, enlightened economists don’t talk about any more. But on top of that real prosperity an ever thicker layer of make-believe prosperity accumulated. And our economists have adapted to this new reality – a reality created not by them, or their theories, but simply borne out of cynical political expediency – and become experts in the various techniques of governments to create illusionary prosperity and short-term growth spurts. Stimulus. Growth through low interest rates. Growth through more debt. Growth through currency debasement. Growth through fiscal policy. Growth through monetary policy.

Modern economists don’t know capitalism. They certainly don’t care about it. If the economy grows it is because of good policy, which means low interest rates and stimulus. If the economy doesn’t grow, it is because of bad policy, which means interest rates are too high (even if they are zero) or the central bank does not print enough money. Since Nixon ‘closed the gold window’, we have progressively replaced savings with cheap credit, the market with policy, and entrepreneurs and innovation with the FOMC and the G20.

Since 1971, the number and intensity of banking crises around the world has gone up markedly, according to Carmen Reinhart and Kenneth Rogoff, hardly anti-establishment economists. Debt levels exploded. The ten years up to the start of this crisis in July 2007 have seen house prices in the US rise ten times faster than over the previous one hundred years.

Look around the world today. Is it a coincidence that all major central banks are at zero interest rates to support bankrupt banks and bankrupt governments the world over?

Bizarrely, it is today the advocates of sound and hard money who are made to explain their atavistic ideas. — Gold standard? To establishment figures like Lord Skidelsky, the advocates of a gold anchor are like druids who dress in strange clothes and worship ancient gods – rather than, as befits the enlightened modern economist, worship at the altar of Keynes, the IMF, and big government. And ex-central banker DeAnne Julius simply knows that it would be foolish to return to a gold standard. All power to the bureaucracy!

What I find fascinating is how many intelligent people are willing, even feel urged, to provide intellectual support for a system that is not the result of intellectual discourse but came about – rather non-intellectually – through sheer power politics, opportunism and hubris, and that is evidently failing. Our financial system (or non-system) offers a great example of Nietzsche’s dictum that investigating the true origin and the true motivation behind things most often leads to surprising results. The purpose and the clever design that most people later believe to be behind various institutions are often only projected onto them with hindsight.

Even more bizarre is the willingness to absolve the political class of their responsibility for the disaster they have inflicted on us, and to even look to the political class to now save us from this ever-growing mess. There is something disturbing and sickening about the pathetic reverence of commentators, analysts and economists for the policy bureaucracy, the central bankers, the G20, the finance ministers; how every word they say is scrutinized for any hint of another clever scheme, another policy initiative that could make all our past mistakes go away and that could make the status quo operable again. “The weak labour market could force the Fed into action,” as if the Fed had the key to the solution in some drawer, as if all that was needed now was another round of QE, another rate cut, another twisty price manipulation.

I wonder if forty years of paper money have made the politicians bolder and the economists dumber. But maybe at this stage they are both simply getting more desperate.

And nothing is more dangerous to your personal and material wellbeing, and your liberty, than desperate politicians. Desperate politicians think that the end justifies the means. No constraints on their ad hoc decision-making can be tolerated. Laws must be changed if they stand in the way.

On October 27, 2010, Chancellor Angela Merkel promised the German parliament that the bailout fund EFSF (European Financial Stability Facility – you couldn’t make this stuff up!) was a temporary thing. As temporary as Nixon’s closed window, one assumes. In February of 2010, Greece had already been bailed out the first time – in contravention of the no-bailout clause in European treaties. Now a bailout fund was needed. But not to worry. This is only temporary. And we know what we are doing.

Of course, as more bailouts were needed, the EFSF grew bigger. It will now be replaced with the ESM – the European Stability Mechanism, no sniggering please. And this thing is, of course, permanent. (The German Constitutional Court will rubber-stamp it soon. Not to worry.)

What do our commentators and mainstream economists have to say about it? – Great! We need a big bazooka! Merkel should do more!

EVERY law, regulation and restriction that was part of the original set-up of EMU has now been broken.

The limits on budget deficits and overall public debt limits (Maastricht Criteria)? –Ignored.

The no-bail out provision? – Ignored.

The ban on ECB buying sovereign bonds to support fiscal policy? – Circumvented with the flimsiest of excuses.

Let’s face it. There is no master plan here. The political class is losing control. There is not even a conspiracy. There is a lack of control, of direction and of design. One quick-fix after another, and every one brings us a step closer to a very nasty endgame.

For the final option is always the same, not only in the Euro Zone, where new ‘hope’ just arrived in the form of Mario Draghi’s apparent willingness to buy more government debt, but also in the US, the UK, Japan, and China: print more money.

If you have no (or little) debt, if you are a productive citizen and if you have saved a bit, you are already in the crosshairs of the policy bureaucracy. Either your property will get taxed away or inflated away. Probably both.

The biggest threat to your property and to your individual liberty does not come from markets and not even from the bankers. It comes from politics.

Confiscation in the olden days: Brueghel's 'Paying the Tax' (wikimedia)

 Last week, the Deutsches Institut für Wirtschaftsforschung (DIW), or German Institute for Economic Research, an influential think tank, proposed an ingenious solution to the Euro Zone debt crisis. The German government should issue a Zwangsanleihe, a compulsory bond that every German with savings of €250,000 or more should be compelled to underwrite with 10 percent of his or her own money. Such measures could help the German state grab another €230 billion in resources from the private sector to support its bailout commitments, the DIW economists announced with apparent satisfaction.

Didn’t economists once use to explain the importance of clearly delineated and legally protected private property, of free and voluntary exchange, and of true market prices? By explaining how capitalism works, these economists also demonstrated the limits and dangers of state interference, which is the reason why those who rather put their faith in strong political leadership and governmental design than the spontaneous order of free markets called economics – after Thomas Carlyle – the ‘dismal science’.

Maybe this is a somewhat romanticized definition of the term ‘economist’. Many statists, socialists and cranks have also adopted the label over the past 300 years. Yet, the history of economics shows that its greatest and most enduring contributions have come from those social scientists who explained how the voluntary, contractual interaction of independent, self-interested individuals creates a system that works to the advantage of society overall, and I may be forgiven for having assumed – or hoped – that in the early 21^st century certain insights would have been so completely accepted that they could function as some kind of common ground for civilized discussion. I am fully aware that as an Austrian School economist I am at the ‘extreme’ free market end of the spectrum of economic opinion but I had thought – again naively, I guess – that certain principles would be unquestioned even by those who are happy to assign a larger role to the state. After all, in most cases these economists still claim to be advocates of the market economy, at least in some broader definition of the term, and given this position I had assumed that they, too, must assign at least a certain importance to the concept of ‘private property’, and that any blatant violation of private property by the state must at least give them a moment’s pause.

Well, it could be said that if all these economists took private property really seriously, they would have already become ‘Austrians’, so maybe I should not be surprised by the willingness of ‘mainstream’ economists to sacrifice the private property of third parties. But surprised I am. Surprised at what seems to be a growing enthusiasm for government-friendly quick fixes that come with little regard for the principles of capitalism and the free society, and with no consideration for the long run consequences.

Dismal no more

Since the start of the ‘global financial crisis’, or ‘the great endgame of the global fiat money experiment’, as I like to call it, we have witnessed a merry anything-goes of economic interventionism, an increasingly desperate and shameless struggle by the bureaucracy to sustain the unsustainable. And simultaneously, what I consider to be an intellectual shift among the economics profession. Eager to no longer be ‘dismal scientists’ but to be politically relevant and pragmatic instead, the economists have quickly taken to devising ever more audacious policies to help the state escape the consequences of decades of habitual overspending, reckless borrowing, and artificial cheapening of credit. The end seems to justify the means, and the end is to maintain the status quo, regardless of how bizarrely unbalanced it has become.

That economists are still advocates of free markets and defenders of justly acquired private property is a myth, at least when we consider the economists who dominate the policy debate. Apart from those at think tanks, such as the DIW, this includes economists at the central banks, the IMF, the OECD, and in the nominally ‘private’ banking sector that has by now become a state protectorate. Here, nobody likes to hear about spontaneous interaction, voluntary exchange, and true market prices, but almost everybody seems to love debt monetization (‘quantitative easing’), the manipulation of specific asset prices (‘operation twist’ or ECB-imposed yield caps on sovereign bonds), substantial government ‘stimulus’ spending, ‘fiscal transfers’, and various other forms of market distortions and bureaucratic interference.

Take the alleged beauty of currency debasement. I find it remarkable how many economists claim that it would be preferable for Greece (and by implication for other countries) to be able to print her own local money and debase it to her heart’s content. Sure, devaluing the monetary unit may provide a shot in the arm to the local export industry and create a very short-lived illusion of competitiveness. These ‘benefits’ are fleeting and the group of beneficiaries is small. But debasement will make many people poorer. All those who save by holding domestic money balances will see their purchasing power diminished.

That this is in the interest of ‘The Greeks’ has been amply refuted by the very actions of Greek savers. They are shifting deposits to banks in the Euro Zone core not only out of concern over local banks, but also in an attempt to protect the purchasing power of their savings, i.e. their property, from confiscation through inflation.

Failure is an option

The central problem in the present crisis – in Europe and elsewhere – is that states have assumed obligations they are unable to meet. So have many banks. In principle, this should only be of concern to the two parties to the contract – debtor and creditor. Ultimately, any entity can go bankrupt, including sovereign states, and there is no need to drag an ever larger group of innocent bystanders into this calamity. Specifically, there is no reason why a defaulted state would have to force its citizens to adopt a new currency. There is as little need for all Greeks to stop using the euro after the bankruptcy of the Greek government as there is for all Californians to stop using the dollar after the bankruptcy of the Californian government.

It is, of course, to be expected that a defaulted government would find it difficult to borrow again and that it, therefore, would have to live within the confines of its income from taxation. This is precisely why the political and bureaucratic class doesn’t like it – and why their intellectual handmaidens, the economists, come up with schemes to rather make everybody else pay. They happily impose an inflation tax on all money-users as long as it keeps the state borrowing and spending and living high on the hog on confiscated wealth, and as long as it keeps the banks from shrinking and asset prices from falling. The status quo must be protected at all cost.

All these interventions are inherently conservative in nature (they conserve the prices and structures of the preceding boom) and, without exception, they protect the reckless from the consequences of their mistakes, and they punish the prudent. Those who did not allow themselves to get seduced by ‘easy money’ during the ‘bubble’ years and who managed their finances conservatively and saved would – in a truly capitalist system – now be the beneficiaries of the ‘bust’ – and thus provide the raw material for a real recovery. They could pick up assets ‘on the cheap’ were it not for the various policies (zero interest rates, unlimited bank funding, QE) designed to keep the prices of such asset at artificially high levels for the benefit of their present owners, often the banks. As savers are thus barred from buying assets at appropriately lower prices, they have no choice but to stay on the sidelines, holding saving deposits in which their capital gets whittled away by negative real interest rates, another policy designed to protect banks and a debt-addicted public sector.

One of the advantages of basing an economy on private property is that the success and failure of actions can be (reasonably) clearly attributed and that responsibility is specific and limited, and not communal and open-ended. This requires that the failure of institutions and policies must be clearly visible and not hidden, and that the market must be allowed to liquidate failure. In the present debate, however, most economists seem to be of the view that what is to be avoided at all costs is the recognition of failure, the liquidation of imbalances, and the shrinkage of certain entities, regardless of the sheer silliness of their outsized liabilities.

Flooding the economy with new money is an attempt to mask the failure of various institutions and policies and to socialize the effects of such failure. Here is the dirty little secret of monetary policy: Printing limitless fiat money may be costless to the central banks but it is not costless to society.

“Hooray, we are inflating the debt away!”

But it is likely to get worse. The present stalemate is not making anybody happy. The economy is not being cleansed of its dislocations and neither is any sustainable growth momentum developing. Frustration and impatience are likely to rise. My concern is that most establishment economists are now intellectually prepared to embrace even more aggressive intervention, including a no holds barred monetary über ‘stimulus’ to break the gridlock and try and ‘inflate the imbalances away’. This is the final insult to anybody who believes in private property as it involves the wholesale expropriation of the saving classes. Such policies will require additional draconian market interventions. Large parts of the ‘private’ sector will have to be turned into captive holders of bonds, in particular government bonds. Highly regulated entities, such as banks, insurance companies and pension funds, are the obvious candidates, and they are already being lined up for this. Capital controls will be reintroduced. All of this will have disastrous consequences for the economy. Attempts to ‘inflate the debt away’ are a recipe for economic Armageddon. They do not lead to a balanced, deleveraged and cured economy but to total currency collapse, which tends to decimate the middle class. That such policies are even being contemplated now, I find shocking.

Such an outcome is, of course, not inevitable. Our future is not predetermined. There is always a chance that those in power will simple ignore these economists.

But maybe I am just being naïve again.

ECB, photograph by Florian K

On page two of today’s Wall Street Journal Europe you will find the result of a readers’ poll from last Friday: Question: Will the ECB’s rate cut help restore confidence in the bloc’s economy? Answer: 81 percent of readers say no, 19 percent yes.

Last week’s round of global monetary easing – another ECB rate cut, another round of debt monetization from the BoE, another rate cut from the People’s Printing Press of China – is, of course, more of the same old same old. It has a discernible touch of desperation about it and this is not lost on the public. Monetary policy is ineffective. Or, to be precise, it is only effective in delaying a bit further the much-needed liquidation of the massive imbalances that previous monetary policy helped create, and thereby is contributing, on the margin, towards making the inevitable endgame even more painful. It is counterproductive and destructive. It is certainly not restoring confidence.

Yet, many commentators and many of the establishment economists out there are not giving up. If only the ECB had cut by 0.5 percent instead of 0.25 percent, the equity market could have responded more optimistically. Maybe this would then have restored confidence? — Really? We are now below 1 percent in official interest rates, having cut by a full 400 basis points since the crisis started. How realistic is it to assume that another 0.25 percent is the difference between confidence-enhancing monetary stimulus and dread-inducing disappointment?

The advocates of ever more ‘stimulus’ are grasping at straws. What else can they do? Their pretty little world-view according to which, in a system of unlimited fiat money, the central bank can always create some additional ‘aggregate demand’ by giving a bit more artificially cheap funding to the banks lies in tatters.

Money is never neutral

That monetary policy would finally end in this cul-de-sac is no surprise. It only surprises those who share the mainstream’s simplistic view of monetary stimulus. Phrases such as “the ECB is attempting to unlock the flow of credit in the Eurozone”, are masking the complexity of the true effects of money creation and interest rate manipulation, and they make ongoing monetary stimulus look unduly harmless and straightforwardly positive. Who could object to unlocking credit, to liquefying markets or stimulating activity?

One of the major contributions of Ludwig von Mises’s monetary theory was his proof of the categorical non-neutrality of money. He demonstrated “that changes in purchasing power of money cause prices of different commodities and services to change neither simultaneously nor evenly, and that it is incorrect to maintain that changes in the quantity of money, yield simultaneous and proportional changes in the ‘level’ of prices.” (Ludwig von Mises, Memoirs, page 47).

A monetary stimulus never affects GDP and inflation directly and exclusively, these two statistical aggregates to which the mainstream assigns overwhelming importance. Every monetary stimulus affects and changes many other things as well, and these other effects have often more far-reaching consequences: monetary policy always changes relative prices, it always alters the allocation and the use of scarce resources, and it changes income and wealth distribution. Every monetary stimulus creates winners and losers.

This is being ignored by the mainstream. In his defence of QE, Martin Wolf argues in the FT that the central banks print money in the public interest. The assumption is that we all benefit from the boost to growth, short-lived as it must be, and that we all suffer the effects of higher inflation – if higher inflation materializes at all. But the new money does not reach everybody in the economy at the same time, and therefore does not affect prices ‘evenly and simultaneously’. As a general rule, the early recipients of the newly printed money benefit at the expense of the later recipients. Those who, in the chain of money distribution, are located closest to the money producer (the central bank) are always the winners. These are usually the banks and other financial market participants. They can spend the new money before it has dispersed through the economy and lifted a whole range of prices, and before the new money’s purchasing power has thus been impaired. At the present stage of the credit mega-cycle, more monetary accommodation helps the banks fund overpriced assets and bad loans on their balance sheets. Various ‘bubbles’ – which are uniformly the result of past monetary expansion – are thus sustained and even inflated further. Market forces that would adjust prices, reallocate assets and bring the economy back to balance are thus weakened or impaired completely.

Moreover, accommodative monetary policy can only lead to more economic activity by encouraging somebody to take out more loans, to take on more debt. The mechanisms by which ‘easy money’ leads to more GDP-growth is through the lengthening of balance sheets of banks and of more financial risk-taking, generally. We are in the present pickle precisely because this kind of stimulus policy has been conducted – on and off – for decades. That is what brought us to the point of a banking and debt crisis. Presently, authorities are fighting a debt crisis by encouraging more debt accumulation. They are fighting a banking crisis by encouraging the banks to take more risk. You do not lower interest rates and conduct QE and then realistically expect deleveraging and balance sheet repair.

In this context, I find it particularly bizarre that some economists argue that an even bolder intervention by the ECB, such as a deeper rate cut, another LTRO (funding operation for banks), or a commitment to more purchases of sovereign bonds, would have restored confidence. Do these experts really believe that the public will feel more confident if overstretched banks grow even more quickly with the help of the printing press? Will uncertainty over excessive government debt be laid to rest if the central bank promises to support these governments with essentially unlimited money-printing and bond purchases, thus making it easier for these governments to run deficits? Will that be seen as a solution or just a politically convenient postponement of the day of reckoning?

What causes loss of confidence is this: people do not know any longer what is and can be funded privately and voluntarily, and what is simply propped up by central bank intervention. They do not know the true prices of assets and the sustainable level of interest rates because everything is massively distorted through various central bank policies. Printing yet more money will not make anybody feel more confident.

Unintended consequences

Monetary accommodation is a form of market intervention, and like every other form of intervention it creates a whole range of unintended consequences, many of which are difficult to identify clearly and even more difficult to quantify but they are nevertheless real. My colleague at the Cobden Centre, Gordon Kerr, provided a good example during a recent discussion:

In supermarkets in London there is a trend towards replacing personnel at the check-out counters with new self-service machines that allow customers to scan their purchases and handle the payment process themselves. It is another incident of human labour being replaced with machines. We may say that this is a sign of the times, a consequence of technological progress, and thus inevitable. But such a development is, in each case, not only a consequence of what is doable technologically. It is also a result of economic calculation by the entrepreneur, in this case the owners and managers of the supermarkets. The expenditure for the machines, the capital they tie up and the interest charges that are associated with them, and any potential future losses from inappropriate handling by customers or even theft of produce due to reduced oversight will have to be compared with the cost savings from employing fewer personnel in the check-out area.

In modern-day Britain this calculation seems to work in favour of the machines but would it do so in a free market? The short answer is we do not know. But we do know that the supermarket workers and the check-out machines do currently not compete in a free market. Through the country’s numerous welfare-state regulations, among them minimum wages, social insurance, maternity- and paternity leave, health-and-safety legislation and other rules to ‘protect the worker’, the government has lifted the cost of employing people, it has made human labour expensive, while at the same time, the country’s monetary policy in favour of super-low interest rates and more bank lending has made capital cheap. From both angles, the worker is being squeezed out of the market. Legislation to protect him makes his work expensive; efforts to cheapen credit make capital investment a much easier alternative.

Do not get me wrong: Our high standard of living is the result of a high ratio of productive capital to worker. If we want to increase our standard of living further we will have to keep increasing this ratio. This is the only way to enhance human productivity. But there is a right way of going about this, and there is a wrong way. The right way is to save, to put real resources aside, to redirect real resources from forms of employment that are close to present consumption and transform them into capital for future-oriented investment. How much we invest should not be the result of the decisions of central bank bureaucrats and their monetary manipulations but the result of voluntary saving decisions. That may well set a lower speed limit on capital investment but such a lower speed limit would be entirely appropriate. The resulting capital structure would be much more stable and sustainable, while investment that is funded by money creation rather than saving must lead to capital misallocations, which remains the primary source of boom-bust cycles.  The apparent need of large parts of our present capital structure for near-zero interest rates and further doses of monetary stimulus simply to be sustained in their current size is a clear indication that accommodative monetary policy has already created grave dislocations. How many more of these do we want? How many more of these can the system live with?

The point I am making here is this: It is either naïve or a sign of incredible hubris to believe that the central bankers can anticipate the myriad of consequences their monetary interventions will have. To say that they are simply, in aggregate, in the interest of the public is simply incorrect. We are dealing here with a financial bureaucracy that has lost touch with the complexity of economic reality but that has now dug itself such a deep hole that any self-motivated turn-around can safely be ruled out.

As my friend Tim Evans says, the system has check-mated itself, and so has the mainstream and the policy bureaucracy. Their policies are failing but they cannot think the alternative, which would be a complete stop to monetary intervention and money-printing, and would mean finally allowing the market to liquidate what is unsustainable anyway. This would realign asset prices with economic reality and bring valuable assets into the hands of entrepreneurs rather than have them funded at unrealistic book-prices on bank balance sheets forever. Can they think this alternative but do they not dare to implement it? I am not so sure. I fear they may not even grasp it.

Will the ECB cut again? Will the ECB underwrite the bond purchases of the ESM via the printing press? – Yes and yes again. Of course, they will. Just give the ECB some time. Will it solve the problem? Of course, it will not.

We will see more rounds of QE, more rate cuts where this is still possible, and further expansions of central bank balance sheets. Pension funds and insurance companies will be forced by regulators to hold assets that the state wants them to hold (government bonds anyone?), and the reintroduction of capital controls appears a near certainty at this stage. Remember, a toxic mix of stubbornness and desperation rules policy making at present. It is best to be prepared for everything but the sensible solution.

Come to think of it, the title of this essay may be misleading. The central banks have reached the end of the conventional road but they will push their policies further.

This will end badly.