I have been reading many views from an endless number of commentators on the potential roll on effects of a Euro break-up; a new language has sprung up around the Euro crisis, such as the now widely used Grexit, and even less pleasant sounding Spexit (which does not seem to have caught on). What to make of all these scenarios that are being trotted out?
My answer makes this a relatively (and unusually) short post; the answer is that nobody really has any idea at all, and if they say they do, then they are genuinely geniuses, have an outstanding set of tarot cards, or they are just plain guessing. The reason why I argue this is very straightforward. As I argued in my last post, we are entering a special set of circumstances. In particular, the drivers of the world economy long ago ceased to be about market fundamentals, and is instead dominated by state action; whether fiscal or monetary policy. This is largely the result of what I termed as extreme policy making setting up a dynamic in which the extreme policy enacted in economy x, sends ripples out into the markets, leading to a further extreme policy response from country y, which in turn washes back onto economy x, which reacts with further extreme policy.....and so it continues with all of the major economies now acting with increasingly extreme policy to a point where markets are now 'nationalised'.
There are therefore some very basic reasons why it is not possible to predict the roll on effects of a Grexit, or any other exit, from the Eurozone. The only certainty is that, as and when these events take place, the economic policymakers will not stand back, but will again intervene in an even more dramatic fashion, in an attempt to 'save' the world economy. Here I am assuming that the coming Euro-calamity will actually take place in the coming month/s. Quite suprisingly, I am in rare agreement with Paul Krugman that there is currently no plausible avenue out of the current path to crisis in Europe. However, I put a small caveat that there just might be a new action from policymakers, and not just those in Europe, and these might still hold back the tide a little longer.
Like many commentators, I am tempted to hazard a guess at possible outcomes, but keep on trying to grab hold of any scenario which is driven by clear principles, theory or the market. However, as I argued in my last post, any theory or generalisation from past events has been torn up along with the economic textbooks.
Instead of finding any clear scenario, I simply finding myself contemplating what will be done as a large ditch attempt to turn back the tide, and how this will set up even more unpredictable outcomes. One obvious answer will be that the printing presses will roll, and not just in Europe. We might even see concerted and coordinated central bank responses, including the Euro area, Japan, China, the US and the UK. In all events, the central banks will continue to at least try to stand behind the banks, perhaps producing something like an LTRO on steroids.
Perhaps the most interesing question will be the timing of action. At what point will policymakers act; before Grexit, during Grexit, or once the consequences of Grexit are apparent. Also, although Grexit is often seen as the forthcoming trigger for crisis, it may be that the trigger will emerge in one of the larger Euro economies, with Spain, Italy, Portugal, Ireland, and even France, all looking fragile. There is a real risk of events overtaking the current 'magic' date of the Greek elections.
Regardless of the 'trigger', if my guess is right, and that there will be a coordinated response, there will likely be a positive spike upwards, as relief grips the market. Commodities and stocks will likely briefly soar in so-called safe haven markets. As with previous state interventions, eventually the markets will fall back down, or even crash. Alternatively, if policy is uncoordinated, then there is likely to be a series of small market rallies, which will extinguish themselves as quickly as they started. This might encourage yet further extreme policy responses. Running to gold is another possibility, as gold in some respects is
entirely irrational and that very irrationality is also gold's strength.
It just feels safe when all else feels unsafe*.
Nevertheless, this is all speculation, and the only certainty in the policy response is that there absolutely will be a policy response, and it will almost certainly be extreme. As such, the ripples of the actions of each of the policymakers will ripple out and interact in the global economy, and will likely further swamp any market signals that might remain. It is for this reason that I emphasise that my commentary is nothing more than speculation; I am guessing.
As such, we are now in the uncomfortable position that, come what may, the world economy now no longer sits in the hands of markets, firms, banks and individual actions of economic actors. Instead, we now wait upon the action of states to determine the next steps in this economic crisis. The track record of states at managing the crisis is not encouraging. They have tugged and heaved on both fiscal and monetary policy levers, and still the situation in the world economy swings back towards negative outcomes. With each swing back to negative from each policy response, the stakes are being raised ever further. Again, in my last post, I discussed how the LTRO has compounded the problems in Spain, albeit giving both the Spanish banks and state a very, very brief reprieve.
My final guess is to suggest that, at the very least, the economic ride of the coming months will be a turbulent one. In this, I think I am in agreement with everyone. For the rest, and my own comments, treat is all with a big pinch of salt.
* I do not believe that gold is some kind of 'special' form of 'money', but its history as money is what I believe gives it the feeling of safety.
Note: For my next post, I will try to get away from the Euro crisis and instead take a more analytical look at China or the US going forwards. The European crisis is not the only issue of interest. However, for all my good intention, I keep being distracted by Europe and, for obvious reasons, may be pulled back to Europe. If I do return to the European situation, rather than a very general post such as this one, I will try to focus on some of the detail of the situation (country/market/institution etc.).
Showing posts with label Central Banks. Show all posts
Showing posts with label Central Banks. Show all posts
Monday, June 4, 2012
Tuesday, August 30, 2011
An Agenda for Gold?
For those familiar with this blog, they will know that I am not overly supportive of a gold standard currency, but that I think that it is better than the current fiat money system (see here for my alternative). As things stand, we can now see the dangers in the current fiat system, which is the ongoing debasement of many currencies through money printing (QE- Quantitative Easing).
It never does any harm to emphasise the point that so-called QE is absolutely no different from running a physical printing press, even though there are occasional commentators who try to suggest it is different. Creating money by electronically crediting a bank with previously non-existent money is no different from running a printing press and shipping the newly printed money into the bank's vault. In both cases, money is created and an asset is purchased. It is just that the former does so without the bothersome necessity of running a physical printing press. I suspect that, if the central banks were to be undertaking the old-fashioned printing press method, there would be greater outcry against the policy of QE. Trucks filled with newly printed money arriving at banks would focus minds and attention on what is taking place. As it is, the modern method of money printing is just abstract enough to obscure the reality of what is taking place.
However, it seems that commentators are now starting to see that there is something wrong with the new policy of printing our way out of troubles, and the gold standard is moving up the agenda. This from Forbes:
It seems that there is a growing divide in mainstream commentary on the policy of printing money, with some expressing fear about the consequence of the policy and moving back to the idea of a gold standard, and others supporting the policy as a magic bullet for the economic woes that are assailing so many economies. At the heart of the debate is the question of inflation, with those who are anti-QE arguing that it is inflationary, and those in favour suggesting that the lack of massive inflation following early QE demonstrates that the fears of inflation are exaggerated. A good explanation comes from Liam Halligan:
For the proponents of QE, the lack of massive inflation is used as a justification for continuation of the policy. For those who are arguing for a return to gold, they can see that somehow, at some point in time, the massive expansion of the monetary base in QE countries must eventually see a rise in inflation. For the latter, they are not always clear in their understanding/explanation of why massive inflation has not taken place. However, their instinct that QE must eventually have a price is correct. Furthermore, the price is already being paid around the world as easy money has flooded into other economies. That in turn is creating distortions in markets, and those distortions will ripple back towards the countries that caused the problem in the first place. Again in TFR, this is what I had to say about 'extreme policy' in the context of the 'carry trade':
One way or another, the effects of extreme policies such as QE ripple out into the global economy, only to eventually wash back in unpredictable forms. The great conceit of the policymakers is that they think that they know what they are doing. In the end, the call for a return to a gold standard is really a call for the policymakers to take their hands off the levers of monetary policy, as they do not really understand what happens when they pull on the levers.
It never does any harm to emphasise the point that so-called QE is absolutely no different from running a physical printing press, even though there are occasional commentators who try to suggest it is different. Creating money by electronically crediting a bank with previously non-existent money is no different from running a printing press and shipping the newly printed money into the bank's vault. In both cases, money is created and an asset is purchased. It is just that the former does so without the bothersome necessity of running a physical printing press. I suspect that, if the central banks were to be undertaking the old-fashioned printing press method, there would be greater outcry against the policy of QE. Trucks filled with newly printed money arriving at banks would focus minds and attention on what is taking place. As it is, the modern method of money printing is just abstract enough to obscure the reality of what is taking place.
However, it seems that commentators are now starting to see that there is something wrong with the new policy of printing our way out of troubles, and the gold standard is moving up the agenda. This from Forbes:
There is nowhere left to hide. America’s governing elites begin to internalize the magnitude of their failure to generate jobs. CBO now predicts worse than 8% unemployment until 2014. America begins to engage, seriously, with the implications of the faltering dollar and reconsider the appeal of the gold standard. From The New Yorker to The National Interest to The Washington Monthly to The Nixon Foundation, thoughts turn to gold.The linkage between returning to a gold standard and the urge to print money is obviously related. Once again, there is talk of printing money in the US, or QE3:
As Wall Street parses the message the Federal Reserve chairman sent in his speech Friday from Jackson Hole, the narrative that has taken hold includes, on one level or another, more action to help boost the markets and the economy.The UK is also flirting with another round of money printing, with this from the Guardian:
That was supported Monday with key endorsements from Fed presidents Charles Evans and Narayana Kocherlokota, who both said they either would support further monetary measures or a continuation of the ones already in place.Whether future moves come in the form of traditional quantitative easing or something else is what Bernanke and other Fed officials must decide between now and the next Open Markets Committee meeting on Sept. 20. The expectation for easing was heightened when Bernanke said the meeting would be extended from one to two days, indicating that serious consideration would be given to additional monetary measures.
The European Central Bank (ECB) is more constrained, with an inbuilt philosophical opposition to printing money:Hopes of a fresh round of quantitative easing in the UK increased on Thursday after Martin Weale, of the Bank of England's monetary policy committee (MPC), used a speech in Doncaster to say there is "undoubtedly scope" for the radical recession-busting policy to be extended.
Weale, who was one of two hawks advocating an increase in interest rates until he changed his vote at this month's meeting, said the Bank could restart quantitative easing if oil prices continue to fall and the sovereign debt crisis in the eurozone worsens.
Warning that events on the continent are a greater threat to the UK economy than the slowdown in America, Weale said: "There is undoubtedly scope for further asset purchases to trigger further reductions in yields on government debt should the need arise."
Notwithstanding the growing discussion of a gold standard, one of the great curiosities about QE is how it has now entered into mainstream commentary as if it were a perfectly reasonable thing to do. There are all sorts of justifications given for the policy, but the lack of any remit for central banks to undertake the policy is quietly ignored or forgotten. The most obvious case of this is the Bank of England, which is supposed to use monetary policy to target inflation. Despite several years of overshooting the inflation target, as can be seen from the earlier quote, QE is back on the agenda in the UK. How is it that the Bank of England's remit is forgotten by so many commentators?
New York professor Nouriel Roubini called on the ECB to reverse monetary tightening immediately given the darkening global picture. "It should reduce rates to zero, and make big purchases of government bonds," he said.
Frankfurt is unlikely to heed the advice. The bank's president Jean-Claude Trichet, last week stuck to his anti-inflation script and said "we do not do QE".The ECB began buying Spanish and Italian bonds for the first time yesterday, causing 10-year yields to plunge by 90 basis points. However, an ECB statement over the weekend came with too many strings to satisfy investors. The bank is likely to be tested over coming weeks.
David Marsh, co-chairman of OMFIF, said the statement was "half-hearted" and suggested that dissenting German hawks were imposing limits. "The ECB is clearly not going in with all guns blazing," he said.
It seems that there is a growing divide in mainstream commentary on the policy of printing money, with some expressing fear about the consequence of the policy and moving back to the idea of a gold standard, and others supporting the policy as a magic bullet for the economic woes that are assailing so many economies. At the heart of the debate is the question of inflation, with those who are anti-QE arguing that it is inflationary, and those in favour suggesting that the lack of massive inflation following early QE demonstrates that the fears of inflation are exaggerated. A good explanation comes from Liam Halligan:
Liam Halligan has captured one element of the reason for the lack of inflation, and another is the exporting of inflation through the 'carry trade', as the Wall Street Journal reports:The reality is QE has already done an awful lot of damage. America has expanded its base money supply three-fold in two and a half years – from 6pc to 18pc of national income. But even this jaw-dropping measure hasn't led to much of an expansion in monetary measures, such as M2 that include bank lending, precisely because the banks, for all the propaganda to the contrary, are still determined not to lend. They can make more money simply channelling QE money into stocks and other investments.
Crucially, the banks also remain petrified of counter-party risk in the inter-bank market. Many of them, disgracefully, are still concealing vast sub-prime losses in off-balance-sheet vehicles. So they assume other banks are doing the same. Such mistrust between the banks – "we're lying, so they must be lying" – gums up the wheels of finance and starves even creditworthy firms of the funds needed to invest and create jobs.
That's why M2 has remained flat, despite a massive expansion of base money. The way to break the deadlock, though, isn't to do more QE, but to end inter-bank torpor by forcing "full disclosure" of bank losses. Such disclosure is barely happening, on either side of the Atlantic. The UK's monetary base has also tripled, while producing – for the same non-disclosure reasons as in the US – only minimal growth in M2.
For much of the past two years global investors borrowed dollars and Japanese yen at the rock-bottom interest rates set by the U.S. Federal Reserve and the Bank of Japan and then poured that cheap money into currencies like the Australian dollar and Mexican peso to earn much higher interest rates.The problems of the carry trade for the recipients has led to reactions to try to prevent the inflows of 'cheap' money, such as Brazil establishing capital controls:Now, those popular "carry trades," which profited from a difference in interest rates as high as 12 percentage points in Brazil's case, are starting to unwind as investors lose faith in the outlook for global growth and fret over financial turmoil. If it continues, it will bring an end to a rally in emerging market and commodity-based currencies that began shortly after the Fed slashed rates to near zero at the end of 2008 and it could drive up borrowing costs for banks, companies and even households in those countries.
That unwinding could be cut short if the Fed's announcement Tuesday that it would keep its target interest rates at "exceptionally low" levels "at least through mid-2013" makes carry trades attractive again. But the problem with the strategy is that it is only profitable if currencies are either stable or if the funding currency is falling against the investing currency. And if the past week's bout of global financial turmoil persists and puts emerging market and commodity currencies under more pressure, many investors will be forced to throw in the towel and buy back dollars.
Brazil has been vocal on one of the themes put on the table by France as G-20 chair: how to better police capital flows globally. Several emerging countries, including Brazil, have been faced with buoyant capital flows in search of higher yields, which have put upward pressure on their currencies and hurt their exports.This is what I had to say in TFR magazine in December 2009:Countries have reacted by imposing capital controls or intervening on their currency in a unilateral way. This has prompted the G-20 to try and coordinate capital controls better, so as to avoid adverse impact on growth from disorderly moves.
What we can see in Liam Halligan's analysis and my own explanation is the reason why it is that we do not currently see massive (or hyper) inflation in the money printing economies. However, what we can also see is the potential for inflation to start a rapid upwards climb in the QE economies. The only way that the money supply might be reduced is to reverse the QE, which would mean selling the government bonds that have already been purchased and destroying the proceeds of the sale. Could markets absorb such a sale when government debt is already flooding the markets? It seems improbable.But there is also another factor, there is increasing talk of a US dollar ‘carry trade’, as a result of dramatically increased liquidity combined with near zero interest rates.
The idea is simply that a good return on investment can be made by borrowing at a low interest rate in one country, and investing in another that has a higher interest rate. In doing so, the inflationary effects of printing money are exported to the country that is the destination for the carry trade.
This was what happened when Japan resorted to quantitative easing, with the printed money going west in the yen carry trade, acting as one of the sources of excess liquidity for the credit bubbles that burst in 2007 and 2008. There is less talk of a sterling carry trade, but it’s fair to assume that, with monetary circumstances similar to the US, something similar may be taking place there (albeit on a much smaller scale).
The interesting point here is that, as a result of the carry trade, Japan itself did not experience the inflationary effects of printing money. The case of Japan is cited as the reason why inflation will not take place in the UK and US. However, there is a fundamental difference between the UK, the US and Japan.
During the period of the carry trade, Japan was generating a large current account surplus, so the flood of yen onto the market did not result in significant currency weakness. By contrast, both the UK and US have been (and continue) to run large current account deficits. In both cases the currency is already sitting on weak foundations and, therefore, export of the dollar and sterling into the carry trade will simply put more pressure on the value of those currencies. They are flooding the market with currencies for which there is already a potential over-supply.
What we can see is a problem looming on the horizon. Output in both the UK and US has fallen (and is still falling in the UK), which means that some of the effects of the reduction in credit are already ‘eaten up’.
Furthermore, the governments of both countries are stepping in to fill the void of private credit contraction with government borrowing. If the money sitting in central banks were to enter into the economy, there would be a real increase in the money supply and this would cause rapid inflation. On the other hand, if the money exits the economy via the carry trade, it will severely weaken both nations’ currencies and re-enter the economy through the back door of import-price inflation.
At the moment, the increase in money has not entered into the real economy, but it will do at some point. I suspect that it will be through the back door of the carry trade.
For the proponents of QE, the lack of massive inflation is used as a justification for continuation of the policy. For those who are arguing for a return to gold, they can see that somehow, at some point in time, the massive expansion of the monetary base in QE countries must eventually see a rise in inflation. For the latter, they are not always clear in their understanding/explanation of why massive inflation has not taken place. However, their instinct that QE must eventually have a price is correct. Furthermore, the price is already being paid around the world as easy money has flooded into other economies. That in turn is creating distortions in markets, and those distortions will ripple back towards the countries that caused the problem in the first place. Again in TFR, this is what I had to say about 'extreme policy' in the context of the 'carry trade':
We can see this instability taking place. We see, for example, the Swiss taking ever more radical measures to try to lower the value of their currency in the face of the 'safe haven' purchases of their currency. We can see the instability in the surge in the gold price. We can see the instability in the on-off panics in markets. Every day we see more examples of the instability.From enactment to (unpredictable) result, there is a period during which the effects of the policy build and interact with the results of other policies and the markets, both domestic and international.
It can therefore often take a long time before the full effects become apparent. As they do become apparent, the other actors respond with their own policy provision, and the effects of that policy will again take time to impact.
Among all of the major economies, the responses to the economic crisis have been extreme policy making. We are only now seeing the full impacts of those policies, and the reactions to those policies are building. The underlying problem is that, the more extreme the policy of one actor, the more likely that the response of another actor will be extreme. The world economy is a dynamic system, and the actions of each policy will, in the end, lead to a response from other actors in the world economy.
As such, when actor ‘A’ pulls on policy lever ‘X’, they really cannot see the outcome of their own actions. The larger the actor, and the more extreme the policy, the greater the chance that the reaction of other actors will also be extreme. The greater the reaction of these actors, the greater the reaction that will be forthcoming in response.
And so it continues, creating an ever more unstable system; the more the levers are pulled, and the harder that they pull on them, the greater the potential for the policy intentions to be confounded, and the greater the general instability.
One way or another, the effects of extreme policies such as QE ripple out into the global economy, only to eventually wash back in unpredictable forms. The great conceit of the policymakers is that they think that they know what they are doing. In the end, the call for a return to a gold standard is really a call for the policymakers to take their hands off the levers of monetary policy, as they do not really understand what happens when they pull on the levers.
Tuesday, February 10, 2009
'Yes' the bankers bear responsibility, but now they are scapegoats..
Before getting on to the main subject, please accept my apologies for the lack of posts recently, but 'real life' sometimes has to take a priority. As I still have demands on my time, a quick post today, and one which is a commentary on news, rather than a particular theme.
Perhaps the most important point I would like to make follows from an article in the Telegraph in which the commentator was discussing a bleak picture for the world economy. He refers to the huge US borrowing needs that are emerging.
In the meantime, for those who are probably already spooked in the bond market, the sheer scale of the continuing growth in US government commitments must be rapidly eroding what little confidence there may be left in the $US. On the one hand, Obama's 'stimulus' package looks set to progress through government, and on the other hand there is the latest bailout announcements for the banking system in the US. With each month that passes, the numbers, the massive and horrendous scale of the commitments of the US government, are moving beyond belief.
For those who look at these numbers, they are still comparing these numbers with notional and shrinking measures of GDP. However, for overseas holders of the $US there will be an increasingly frightening question that will by now be crossing their minds. In order for the US to repay this borrowing, at some point they must sell more goods and services than they import, must have a positive current account balance. In order for these monstrous sums of money to be repaid, this means not only reversing a massive trade and current account deficit, but turning these massive deficits into massive surpluses. Quite simply, it is not going to be possible to achieve this if the US government continues the massive borrowing, and attempts to support their economy through ever more borrowing.
In all of the measures, there is not one single measure that addresses fundamental structural reform of the US economy. As such, the holders of $US assets are going to very worried indeed. For those of you who still doubt the potential for a complete $US collapse, I will refer you to a link here, in which it is revealed that there was an electronic run on the US banking system in September, revealed in a C-span broadcast:
Overall, the process of the unravelling of the $US appears to be going very much as I expected/predicted. The continuing desperate attempts of the US government to support ever larger parts of their economy is just adding fuel to the fire.
Meanwhile, as this is all going on, the world and the media are increasingly distracted with what can only be described as a media circus. The particular circus I am referring to is the question of executive pay, which has served as a handy distraction in which huge numbers of commentators and politicians can indulge in self-righteousness. The reality of the situation is that, whilst the bankers played a part in this crisis, they were not alone, but aided and abetted by government, regulators, and central banks.
However, with their cap in hand for ever more bailout money, one of the prices that the bankers have to pay is to take the full measure of blame on their own shoulders. They are not in a position to point their fingers at the others who have been complicit in the mess that has been created. The price is that blame is doled out to them, and they must bend over and take the beating on behalf of all of those who are responsible. Perhaps one of the more moronic variants in the media can be found in the Telegraph, regarding the enquiry into the crisis. I recommend reading this, if only to illustrate how puerile the whole business has become.
These enquiries also serve a more immediate distraction, which is to shift focus away from why so much money is being poured into an insolvent banking system. This is a matter of importance, not the pay rates of the bankers who are benefiting from the bailout. Whilst their remuneration should be a matter of public concern when they are being bailed out, it is insignificant when compared with the actual bailout overall (over some of my recent posts, I have been building towards a further discussion of the bailouts, but have not yet had the time to address this).
I can not help but think that all of this talk of evil bankers is simply a distraction which serves the politicians by diverting our attention from what really matters, which is that all of their plans and schemes are doing nothing to reverse the current economic crisis, and are already leading to the ultimate collapse of the $US in the case of the US, and £GB in the case of the UK. It only serves to direct all the blame onto a group who are unable to defend themselves, and who are therefore convenient scapegoats.
I will re-emphasise that I am not saying that the bankers did not play a part in the crisis, that they should not be getting large salaries at taxpayers expense, but the way that all of the blame is being heaped upon them is pure scapegoating. This is not a trivial matter, as it means that the others that were responsible for creating the mess are the very same people who are supposed to be resolving the mess, and often with policy that just replicates the original problem in new forms - in other words, the government borrows more as a stand in for the fall in consumer borrowing.
Without the economists, politicians and central bankers taking their blame, they can continue in their positions in which they can continue to cause so much damage.....
Note 1: For those who might mention that Obama is a new pair of hands......take a look at his economic team and policy....
Note 2: A rushed post, so I am sorry that I can not respond to the many good comments on my last post. I will try to catch up....
Perhaps the most important point I would like to make follows from an article in the Telegraph in which the commentator was discussing a bleak picture for the world economy. He refers to the huge US borrowing needs that are emerging.
Where is the money to come from? China, the Pacific tigers and the commodity powers are no longer amassing foreign reserves ($7.6 trillion). Their exports have collapsed. Instead of buying a trillion dollars of extra bonds each year, they have become net sellers. In aggregate, they dumped $190bn over the last fifteen weeks.For regular readers, they will remember that I proposed that China would have to start selling US assets to fund their own stimulus, and that in doing so they risked a collapse of the $US. I noted that the Chinese would have to strike a balance in the volume of sales of these assets, such that they pulled in as much value as possible before the whole market collapses, leaving them with piles of useless paper. It looks very much like they are following this course, and the question that therefore looms in my mind is to ask how long before all the other $US holders follow suit?
In the meantime, for those who are probably already spooked in the bond market, the sheer scale of the continuing growth in US government commitments must be rapidly eroding what little confidence there may be left in the $US. On the one hand, Obama's 'stimulus' package looks set to progress through government, and on the other hand there is the latest bailout announcements for the banking system in the US. With each month that passes, the numbers, the massive and horrendous scale of the commitments of the US government, are moving beyond belief.
For those who look at these numbers, they are still comparing these numbers with notional and shrinking measures of GDP. However, for overseas holders of the $US there will be an increasingly frightening question that will by now be crossing their minds. In order for the US to repay this borrowing, at some point they must sell more goods and services than they import, must have a positive current account balance. In order for these monstrous sums of money to be repaid, this means not only reversing a massive trade and current account deficit, but turning these massive deficits into massive surpluses. Quite simply, it is not going to be possible to achieve this if the US government continues the massive borrowing, and attempts to support their economy through ever more borrowing.
In all of the measures, there is not one single measure that addresses fundamental structural reform of the US economy. As such, the holders of $US assets are going to very worried indeed. For those of you who still doubt the potential for a complete $US collapse, I will refer you to a link here, in which it is revealed that there was an electronic run on the US banking system in September, revealed in a C-span broadcast:
At 2 minutes, 20 seconds into this C-Span video clip, Kanjorski reports on a "tremendous draw-down of money market accounts in the United States, to the tune of $550 billion dollars." According to Kanjorski, this electronic transfer occurred over the period of an hour or twoI suggest that watching this will correct any misconceptions that the $US and world economy is not currently in a position of extreme fragility. The really odd thing about this is that the media have not grabbed hold of it yet.
Overall, the process of the unravelling of the $US appears to be going very much as I expected/predicted. The continuing desperate attempts of the US government to support ever larger parts of their economy is just adding fuel to the fire.
Meanwhile, as this is all going on, the world and the media are increasingly distracted with what can only be described as a media circus. The particular circus I am referring to is the question of executive pay, which has served as a handy distraction in which huge numbers of commentators and politicians can indulge in self-righteousness. The reality of the situation is that, whilst the bankers played a part in this crisis, they were not alone, but aided and abetted by government, regulators, and central banks.
However, with their cap in hand for ever more bailout money, one of the prices that the bankers have to pay is to take the full measure of blame on their own shoulders. They are not in a position to point their fingers at the others who have been complicit in the mess that has been created. The price is that blame is doled out to them, and they must bend over and take the beating on behalf of all of those who are responsible. Perhaps one of the more moronic variants in the media can be found in the Telegraph, regarding the enquiry into the crisis. I recommend reading this, if only to illustrate how puerile the whole business has become.
These enquiries also serve a more immediate distraction, which is to shift focus away from why so much money is being poured into an insolvent banking system. This is a matter of importance, not the pay rates of the bankers who are benefiting from the bailout. Whilst their remuneration should be a matter of public concern when they are being bailed out, it is insignificant when compared with the actual bailout overall (over some of my recent posts, I have been building towards a further discussion of the bailouts, but have not yet had the time to address this).
I can not help but think that all of this talk of evil bankers is simply a distraction which serves the politicians by diverting our attention from what really matters, which is that all of their plans and schemes are doing nothing to reverse the current economic crisis, and are already leading to the ultimate collapse of the $US in the case of the US, and £GB in the case of the UK. It only serves to direct all the blame onto a group who are unable to defend themselves, and who are therefore convenient scapegoats.
I will re-emphasise that I am not saying that the bankers did not play a part in the crisis, that they should not be getting large salaries at taxpayers expense, but the way that all of the blame is being heaped upon them is pure scapegoating. This is not a trivial matter, as it means that the others that were responsible for creating the mess are the very same people who are supposed to be resolving the mess, and often with policy that just replicates the original problem in new forms - in other words, the government borrows more as a stand in for the fall in consumer borrowing.
Without the economists, politicians and central bankers taking their blame, they can continue in their positions in which they can continue to cause so much damage.....
Note 1: For those who might mention that Obama is a new pair of hands......take a look at his economic team and policy....
Note 2: A rushed post, so I am sorry that I can not respond to the many good comments on my last post. I will try to catch up....
Tuesday, February 3, 2009
Central Banks and Their Role in the Crash
As many readers will be aware, central banks are playing a central role in the management of the current economic crisis. As such, I thought that it may be worth reviewing their role in the creation of the crisis itself. After all, if they contributed to the crisis, it might be reasonable to question what role they may be playing in the attempts to fix the crisis.
Before starting , I had better start with a brief description of the role of central banks, and exactly what they are (for conspiracy theorists see note 1). As an example, the Bank of England (BoE) gives its core purposes as financial and monetary stability and similar explanations for other central banks can be given. In order to allow them to achieve their purpose, they are normally given a monopoly on the issue of currency so that they are able to control the supply of money in the economy. To these, I would also add that they have a secondary and perhaps just as important purposes. This is to support government borrowing (not an overtly stated purpose), as well as being the banker's bank. I am simplifying here, but that is the basics.
For the purposes of this post I want to focus on central bank targeting of interest rates. If I have time I will post a couple of notes at the end to explain the process, but suffice to say that an underlying purpose of interest rates is controlling the amount of money in the economy, meaning that the central banks either 'create' money, or 'destroy' money'. One of the key measures that drives interest rate targeting is the rate of inflation - too high and they reduce the money supply. It is here that we come to the first problem.
We have all come to accept the official rate of inflation as being a relatively uncontroversial measure of the change in the cost of living, but this acceptance of the official rate is very questionable. An excellent explanation of why this is the case can be found in an article which details the many manipulations of the method of calculation of inflation. I strongly recommend reading the article in full, as it shows an excellent case study of how it is in the interest of governments to manipulate official rates of inflation.
One point of particular note in the calculation of inflation (e.g. in the UK) is what it does not measure, and that is property prices. This is a most curious omission, as a house is one of the largest items of expenditure for most individuals, whether renting or through buying a house. As we are all very aware, we went through a period of massive house price inflation, and the problem is that this did not show up in the statistics.
It should be recognised that arguments against including house prices might be put forward, such as the idea that the cost of owning a house is in part dependent on the interest rates charged on mortgages, and that is a valid measure. However, this becomes a circular argument as, if house prices are inflating and are not measured in inflation, interest rates will remain low despite the actual inflation, thereby keeping the cost of the mortgage repayments relatively low whilst the asset price inflates. However you look at it, having to borrow £200,000 this year to by a house, and having to borrow £300,000 next year is inflation. The day to day cost of servicing the loan may change, but the cost of the good has still inflated.
You will find the UK Office of National Statistics personal inflation calculator here. You will note that they do not calculate the rate of inflation by the interest rate paid on borrowing when buying, for example, household goods. They measure it against the price of the good itself. It seems that they have not noticed that a house is a 'good', or more likely they have decided that the inflation of house prices is something they would rather not measure.
In consideration of inflation, it is important to move away from the official figures, and actually understand what inflation really is. It is actually very simple. Inflation is a an increase in prices resultant from an increase in the amount of money chasing a particular good or service. The causes of inflation can come from an increase in the supply of money, changes in the demand for a good or service, a reduction in the supply of a good, or a combination of these.
In the case of house prices, one of the primary factors in the inflation was an increase in the supply of money, which can be seen in the mortgage markets with increased multiples of income being considered, 'ninja' mortgages, self-certification and many other means of softening lending criteria. In other words, there was a significant increase in the money supply creating inflation. This, even by the self-defined purpose of central banks, should have been a matter which would be of concern to them. Instead, they merely looked at the official inflation and ignored the reality of real inflation 'on the ground'.
To this problem of the measurement of inflation, I should also add another problem with one of the measures used by central bankers which is GDP. However I will not discuss this again, as I have done so in some depth in other posts (e.g. here).
As such we have a situation in which, for example, central banks in the UK and US showed negligence. However, it is not just these central banks that are to blame, and I will give the rather curious example of the influence of the Japanese central bank in the housing bubbles of the UK and US. Japan's central bank is just one central bank that played a role, but it is a very interesting example.
As many readers may be aware, Japan had its own property crash in 1990 as a result of its own bubble. The result of this crash was to see a period of economic contraction in Japan, with the Japanese central bank eventually responding with a long period in which interest rates were virtually zero, and also with the Japanese central bank following a policy of quantitative easing, or printing money.
As regular readers know, I warn of the danger of hyper-inflation when central banks print money. Printing money has two impacts; on the one hand it transfers the value of the existing money supply onto the new money, such that the value of each unit of money is reduced (inflation), which has the effect of more money chasing the same goods (inflation). So why did Japan not have a bout of hyper-inflation?
The answer is rather odd. As fast as the Japanese central bank pumped out newly printed money, Japanese banks also pumped money out of Japan into Western banks. Having reduced inflation to virtually zero, any holdings of the currency were moved into countries with higher interest rates in what was known as 'the carry trade'. In other words, the lack of the ability to earn interest in Japan drove Japan into diverting lending outside of Japan.
In this trade, what was happening was that you could borrow at no cost in Japan, drop the money into a Western economy, and be paid interest on money that you borrowed for nothing. In doing so, even though the money was being devalued by the government printing more money, you could offset the devaluation by the interest you gained through investing it in Western countries. The following is a (grossly) simplified explanation:
If you are printing money such that the base money supply increases by 5% per year, and interest rates are zero, you can borrow that money, invest in a country offering 7% interest, and actually make a currency whose value should be falling, increase in value. In investing the money overseas, you are actually creating an improvement to your current account that offsets the impact of the increase in units of your currency. You are creating greater foreign reserves as a result of the return on that overseas lending, such that you are accumulating ever more foreign reserves, thereby strengthening your currency. If you look at a chart for the value of the JPY against the $US, you will see that the rate fluctuated but has only recently fallen significantly.
The story is not as simple as I paint it here, as Japan also has a large trade surplus and considerable savings, other countries were inflating their money supply and so forth.... The reason for pointing this out is that we have in principle is a system in which it is possible for a central bank to print money, flood that currency into another market, and still retain the relative value of the currency. It is quite an extraordinary notion and I therefore find it hard to believe myself and, as such, comments on this are welcome.
As an aside, the only problem in such a scheme is currency risk, where you expose the lending to fluctuations between your home currency and that of the destination currency. i.e. if the destination currency falls in value, then you risk your money.
What we then have is a situation where there are several results. The first is that, as fast as the money is printed, it is pumped out such that the money supply in the economy never expands, and the country remains in a situation of deflation or very low inflation. By keeping the interest rate so low in Japan, the central bank defeated its own purpose. The second result is that an ever larger 'wall' of money leaves Japan for the Western economies in the carry trade.
A good example of the results of the carry trade in the destination economy is provided by New Zealand, whose size makes the effects more apparent. The curious thing about New Zealand is that, unlike the US or UK, New Zealand kept interest rates relatively high and still created a house price bubble. When we think about the carry trade, it is apparent why this would be the case. In particular, the New Zealand central bank was between a rock and a hard place....
If the central bank increased interest rates, it would encourage the carry trade, and the carry trade means an injection of more money into the economy. However, if the bank reduced interest rates, thereby discouraging the carry trade, then you have a situation in which the central bank is itself increasing the supply of money into the economy. In other words, whichever way the central bank jumped, it would not reduce the money supply. It is almost enough to make you feel sorry for the central bankers (almost).
What I am trying to paint here is a picture in which central bankers are pulling their various levers to control the economy, but the measures that they use to guide their lever pulling are actually faulty. Furthermore, the problem that arises is that, even as they are pulling their own levers, other central banks might be pulling levers that will confound their own actions. In essence, you have a situation in which there is an illusion of control, but a reality of very little control.
At the heart of the problems is that the central banks have control over the monetary supply, and that money supply is therefore subject to their manipulations. In particular, the problem is that they are able to create money, and in creation of money they create ripples of distortion both in their local economy and in the wider world economy. It is perhaps for this reason that the central bankers are calling for ever more co-ordination between the central banks.
However, co-ordination between the central banks creates even greater risks than the current system. If we remember that the central bankers have made basic mistakes in the management of their local economies, and that these have contributed to the current crisis, it is more than likely that co-ordination will make the mistakes systemic, and create even greater distortions in the world economy. A good example of international co-ordination creating systemic risk can be seen in the Basel banking regulation frameworks, which have played a major part in the development of the current crisis (see posts here and here for how).
The only real solution to the endless and distorting tinkering of these central banks is to actually remove from them their facility to create money from nothing. In practical terms, that means to go back to a commodity based standard - whether gold, platinum or silver really does not matter. I have explained the benefits of such a system, and why it is better than a fiat currency in another post.
As it is, we can see that these tinkerers are not really to be trusted, and that their current tinkering in each individual economy can only set up new ripples and distortions in the world economy, whilst all the while the ripples and distortions of the activities of other central banks will only serve to confound their own plans.
Note 1:
First of all, despite what conspiracy theorists suggest, they are not institutions that are in the hands of a few wicked and clever individuals with huge power to shape the world. Instead, they are rather mundane institutions that have an illusion of power...
I watched one of the conspiracy theorist videos listed in Google, and they presented a picture in which the federal reserve was run and owned by a group of shadowy international bankers. However, I noted that they never actually revealed who the shadowy owners actually are, or that many central banks have been nationalised. If you have any doubts, take a look at this site, which details the ownership of the federal reserve......and how much money goes to the shareholders, and how much to the government. They are not part of an international secretive bankers conspiracy. A two minute search on Google found a paper that revealed the structure and ownership of the federal reserve, and it seems funny that this was excluded from the three and a half hour video....
Note 2:
For those who wonder how a central bank creates money, the process is shockingly simple. If they decide they want to increase the money supply they simply buy something (normally some kind of government securities), and do this by simply doing the equivalent of writing a cheque for it. This means that a credit appears in an account of whoever accepted the cheque and money has appeared. The trouble is that central bank has not actually used anything to pay for the securities - it just creates the credit, and the money supply has increased by the amount of that credit. Money from thin air....if a central bank wants to decrease the money supply, it simply sells the asset, and the money simply disappears...
I was tempted to go into a more comprehensive explanation, but hope this serves the purpose for this post.
Note 3:
It occurred to me that, with the explanation of the Japanese money printing, some might think this offers a justification for printing money. It should be noted that this system only worked due to the differential available in the interest rates, and the ability for Western countries to soak up the money in their asset bubbles. In the current climate, the only place for money to go is into lending to governments. Lo and behold, governments throughout the OECD are on a borrowing binge of epic proportions. Not only that, but every country central bank in the OECD is targeting low interest rates, the US is printing money, the UK is printing money....In other words, around the world there is a massive inflation in the money supply.
The problem here is that, unlike the past, there are no assets that are going to soak up the excess of money. Although the house price bubble represented real inflation, it did not 'feel' like inflation because people believed that they held an asset that offset the inflation. I am misusing the term, but the housing bubble partially sterilised the money that was entering the economy. However, as the governments start to absorb and utilise the massive increases in the monetary base, this money will start flooding into activity in the economy that is measured by official inflation, and that is when hyper-inflation kicks in. The increase in the money supply has nowhere to go but into the purchase of goods and services.
Note 4:
I must be a little careful about the use of the word inflation in general. The problem is that there is a situation of real inflation, and official inflation. For example, right now, there is real deflation if house prices are included, as the cost of this good is dropping very rapidly. I will try to ensure I make a distinction in future posts, but it is easy to use the word without thinking whilst meaning 'official' inflation.
Note 5:
With regards to using measures like inflation and GDP I should add that any such measures are of themselves subject to problems, regardless of whether they are correctly applied/understood. A couple of years ago, I read a very good illustration of this (I think the author's name was Neeley), in which a visitor to an airport saw a very strange sight. A plane came to a halt, the baggage handlers opened the hold and one of the baggage handlers then grabbed a bag, ran across the runway at breakneck speed, before depositing the bag on a carousel, and then starting the carousel. It turned out the performance measure for baggage was a measurement of the time that it took from the plane coming to a halt, to the first bag arriving at the carousel, and the carousel starting....the figures looked good, but the underlying real performance remained very poor.
The point here is that if you focus on a particular measure, you will end up distorting behaviour to meet the outcome of what is being measured. As such, in the case of GDP, the focus of so much attention, nobody stopped to think about the underlying meaning of the measure, such that debt driven activity was encouraged - after all, such activity increased GDP.... in other words, the way the measure was used was no different from the principle of the baggage handlers...
Note 6:
I have hesitated to hit the publish button on this post, whilst I have tried to think through the issue of the Japanese money printing.
However I look at it, it appears that it really is possible for a central bank to print more money and see the value of the currency increase (even if only in the short term). Eventually such a system is unsustainable, as it must lead to some kind of inflation, even if it is not in the domestic market. In this case, in the end the lenders lose, as they have accepted IOUs in return for their money which are actually of equally dubious value as the money that was lent, and this is due to the inflation created in the source of the IOUs. In other words, they exchanged debased currency for debased IOUs. I hope this makes sense and, as I have mentioned before, comments are welcome, in particular any challenges to the idea that I have put forward.
Note 7:
I am re-reading The Wealth of Nations again, and for those of you who find economics a puzzle, I can not recommend this book enough. It is clearly written, free of jargon, and just makes excellent sense. The language is a little archaic in places but, as you read it, you find that you stop noticing as you are so absorbed by what he is saying. It really is an outstanding book. Perhaps a copy posted to all of the OECD leaders might help?
Before starting , I had better start with a brief description of the role of central banks, and exactly what they are (for conspiracy theorists see note 1). As an example, the Bank of England (BoE) gives its core purposes as financial and monetary stability and similar explanations for other central banks can be given. In order to allow them to achieve their purpose, they are normally given a monopoly on the issue of currency so that they are able to control the supply of money in the economy. To these, I would also add that they have a secondary and perhaps just as important purposes. This is to support government borrowing (not an overtly stated purpose), as well as being the banker's bank. I am simplifying here, but that is the basics.
For the purposes of this post I want to focus on central bank targeting of interest rates. If I have time I will post a couple of notes at the end to explain the process, but suffice to say that an underlying purpose of interest rates is controlling the amount of money in the economy, meaning that the central banks either 'create' money, or 'destroy' money'. One of the key measures that drives interest rate targeting is the rate of inflation - too high and they reduce the money supply. It is here that we come to the first problem.
We have all come to accept the official rate of inflation as being a relatively uncontroversial measure of the change in the cost of living, but this acceptance of the official rate is very questionable. An excellent explanation of why this is the case can be found in an article which details the many manipulations of the method of calculation of inflation. I strongly recommend reading the article in full, as it shows an excellent case study of how it is in the interest of governments to manipulate official rates of inflation.
One point of particular note in the calculation of inflation (e.g. in the UK) is what it does not measure, and that is property prices. This is a most curious omission, as a house is one of the largest items of expenditure for most individuals, whether renting or through buying a house. As we are all very aware, we went through a period of massive house price inflation, and the problem is that this did not show up in the statistics.
It should be recognised that arguments against including house prices might be put forward, such as the idea that the cost of owning a house is in part dependent on the interest rates charged on mortgages, and that is a valid measure. However, this becomes a circular argument as, if house prices are inflating and are not measured in inflation, interest rates will remain low despite the actual inflation, thereby keeping the cost of the mortgage repayments relatively low whilst the asset price inflates. However you look at it, having to borrow £200,000 this year to by a house, and having to borrow £300,000 next year is inflation. The day to day cost of servicing the loan may change, but the cost of the good has still inflated.
You will find the UK Office of National Statistics personal inflation calculator here. You will note that they do not calculate the rate of inflation by the interest rate paid on borrowing when buying, for example, household goods. They measure it against the price of the good itself. It seems that they have not noticed that a house is a 'good', or more likely they have decided that the inflation of house prices is something they would rather not measure.
In consideration of inflation, it is important to move away from the official figures, and actually understand what inflation really is. It is actually very simple. Inflation is a an increase in prices resultant from an increase in the amount of money chasing a particular good or service. The causes of inflation can come from an increase in the supply of money, changes in the demand for a good or service, a reduction in the supply of a good, or a combination of these.
In the case of house prices, one of the primary factors in the inflation was an increase in the supply of money, which can be seen in the mortgage markets with increased multiples of income being considered, 'ninja' mortgages, self-certification and many other means of softening lending criteria. In other words, there was a significant increase in the money supply creating inflation. This, even by the self-defined purpose of central banks, should have been a matter which would be of concern to them. Instead, they merely looked at the official inflation and ignored the reality of real inflation 'on the ground'.
To this problem of the measurement of inflation, I should also add another problem with one of the measures used by central bankers which is GDP. However I will not discuss this again, as I have done so in some depth in other posts (e.g. here).
As such we have a situation in which, for example, central banks in the UK and US showed negligence. However, it is not just these central banks that are to blame, and I will give the rather curious example of the influence of the Japanese central bank in the housing bubbles of the UK and US. Japan's central bank is just one central bank that played a role, but it is a very interesting example.
As many readers may be aware, Japan had its own property crash in 1990 as a result of its own bubble. The result of this crash was to see a period of economic contraction in Japan, with the Japanese central bank eventually responding with a long period in which interest rates were virtually zero, and also with the Japanese central bank following a policy of quantitative easing, or printing money.
As regular readers know, I warn of the danger of hyper-inflation when central banks print money. Printing money has two impacts; on the one hand it transfers the value of the existing money supply onto the new money, such that the value of each unit of money is reduced (inflation), which has the effect of more money chasing the same goods (inflation). So why did Japan not have a bout of hyper-inflation?
The answer is rather odd. As fast as the Japanese central bank pumped out newly printed money, Japanese banks also pumped money out of Japan into Western banks. Having reduced inflation to virtually zero, any holdings of the currency were moved into countries with higher interest rates in what was known as 'the carry trade'. In other words, the lack of the ability to earn interest in Japan drove Japan into diverting lending outside of Japan.
In this trade, what was happening was that you could borrow at no cost in Japan, drop the money into a Western economy, and be paid interest on money that you borrowed for nothing. In doing so, even though the money was being devalued by the government printing more money, you could offset the devaluation by the interest you gained through investing it in Western countries. The following is a (grossly) simplified explanation:
If you are printing money such that the base money supply increases by 5% per year, and interest rates are zero, you can borrow that money, invest in a country offering 7% interest, and actually make a currency whose value should be falling, increase in value. In investing the money overseas, you are actually creating an improvement to your current account that offsets the impact of the increase in units of your currency. You are creating greater foreign reserves as a result of the return on that overseas lending, such that you are accumulating ever more foreign reserves, thereby strengthening your currency. If you look at a chart for the value of the JPY against the $US, you will see that the rate fluctuated but has only recently fallen significantly.
The story is not as simple as I paint it here, as Japan also has a large trade surplus and considerable savings, other countries were inflating their money supply and so forth.... The reason for pointing this out is that we have in principle is a system in which it is possible for a central bank to print money, flood that currency into another market, and still retain the relative value of the currency. It is quite an extraordinary notion and I therefore find it hard to believe myself and, as such, comments on this are welcome.
As an aside, the only problem in such a scheme is currency risk, where you expose the lending to fluctuations between your home currency and that of the destination currency. i.e. if the destination currency falls in value, then you risk your money.
What we then have is a situation where there are several results. The first is that, as fast as the money is printed, it is pumped out such that the money supply in the economy never expands, and the country remains in a situation of deflation or very low inflation. By keeping the interest rate so low in Japan, the central bank defeated its own purpose. The second result is that an ever larger 'wall' of money leaves Japan for the Western economies in the carry trade.
A good example of the results of the carry trade in the destination economy is provided by New Zealand, whose size makes the effects more apparent. The curious thing about New Zealand is that, unlike the US or UK, New Zealand kept interest rates relatively high and still created a house price bubble. When we think about the carry trade, it is apparent why this would be the case. In particular, the New Zealand central bank was between a rock and a hard place....
If the central bank increased interest rates, it would encourage the carry trade, and the carry trade means an injection of more money into the economy. However, if the bank reduced interest rates, thereby discouraging the carry trade, then you have a situation in which the central bank is itself increasing the supply of money into the economy. In other words, whichever way the central bank jumped, it would not reduce the money supply. It is almost enough to make you feel sorry for the central bankers (almost).
What I am trying to paint here is a picture in which central bankers are pulling their various levers to control the economy, but the measures that they use to guide their lever pulling are actually faulty. Furthermore, the problem that arises is that, even as they are pulling their own levers, other central banks might be pulling levers that will confound their own actions. In essence, you have a situation in which there is an illusion of control, but a reality of very little control.
At the heart of the problems is that the central banks have control over the monetary supply, and that money supply is therefore subject to their manipulations. In particular, the problem is that they are able to create money, and in creation of money they create ripples of distortion both in their local economy and in the wider world economy. It is perhaps for this reason that the central bankers are calling for ever more co-ordination between the central banks.
However, co-ordination between the central banks creates even greater risks than the current system. If we remember that the central bankers have made basic mistakes in the management of their local economies, and that these have contributed to the current crisis, it is more than likely that co-ordination will make the mistakes systemic, and create even greater distortions in the world economy. A good example of international co-ordination creating systemic risk can be seen in the Basel banking regulation frameworks, which have played a major part in the development of the current crisis (see posts here and here for how).
The only real solution to the endless and distorting tinkering of these central banks is to actually remove from them their facility to create money from nothing. In practical terms, that means to go back to a commodity based standard - whether gold, platinum or silver really does not matter. I have explained the benefits of such a system, and why it is better than a fiat currency in another post.
As it is, we can see that these tinkerers are not really to be trusted, and that their current tinkering in each individual economy can only set up new ripples and distortions in the world economy, whilst all the while the ripples and distortions of the activities of other central banks will only serve to confound their own plans.
Note 1:
First of all, despite what conspiracy theorists suggest, they are not institutions that are in the hands of a few wicked and clever individuals with huge power to shape the world. Instead, they are rather mundane institutions that have an illusion of power...
I watched one of the conspiracy theorist videos listed in Google, and they presented a picture in which the federal reserve was run and owned by a group of shadowy international bankers. However, I noted that they never actually revealed who the shadowy owners actually are, or that many central banks have been nationalised. If you have any doubts, take a look at this site, which details the ownership of the federal reserve......and how much money goes to the shareholders, and how much to the government. They are not part of an international secretive bankers conspiracy. A two minute search on Google found a paper that revealed the structure and ownership of the federal reserve, and it seems funny that this was excluded from the three and a half hour video....
Note 2:
For those who wonder how a central bank creates money, the process is shockingly simple. If they decide they want to increase the money supply they simply buy something (normally some kind of government securities), and do this by simply doing the equivalent of writing a cheque for it. This means that a credit appears in an account of whoever accepted the cheque and money has appeared. The trouble is that central bank has not actually used anything to pay for the securities - it just creates the credit, and the money supply has increased by the amount of that credit. Money from thin air....if a central bank wants to decrease the money supply, it simply sells the asset, and the money simply disappears...
I was tempted to go into a more comprehensive explanation, but hope this serves the purpose for this post.
Note 3:
It occurred to me that, with the explanation of the Japanese money printing, some might think this offers a justification for printing money. It should be noted that this system only worked due to the differential available in the interest rates, and the ability for Western countries to soak up the money in their asset bubbles. In the current climate, the only place for money to go is into lending to governments. Lo and behold, governments throughout the OECD are on a borrowing binge of epic proportions. Not only that, but every country central bank in the OECD is targeting low interest rates, the US is printing money, the UK is printing money....In other words, around the world there is a massive inflation in the money supply.
The problem here is that, unlike the past, there are no assets that are going to soak up the excess of money. Although the house price bubble represented real inflation, it did not 'feel' like inflation because people believed that they held an asset that offset the inflation. I am misusing the term, but the housing bubble partially sterilised the money that was entering the economy. However, as the governments start to absorb and utilise the massive increases in the monetary base, this money will start flooding into activity in the economy that is measured by official inflation, and that is when hyper-inflation kicks in. The increase in the money supply has nowhere to go but into the purchase of goods and services.
Note 4:
I must be a little careful about the use of the word inflation in general. The problem is that there is a situation of real inflation, and official inflation. For example, right now, there is real deflation if house prices are included, as the cost of this good is dropping very rapidly. I will try to ensure I make a distinction in future posts, but it is easy to use the word without thinking whilst meaning 'official' inflation.
Note 5:
With regards to using measures like inflation and GDP I should add that any such measures are of themselves subject to problems, regardless of whether they are correctly applied/understood. A couple of years ago, I read a very good illustration of this (I think the author's name was Neeley), in which a visitor to an airport saw a very strange sight. A plane came to a halt, the baggage handlers opened the hold and one of the baggage handlers then grabbed a bag, ran across the runway at breakneck speed, before depositing the bag on a carousel, and then starting the carousel. It turned out the performance measure for baggage was a measurement of the time that it took from the plane coming to a halt, to the first bag arriving at the carousel, and the carousel starting....the figures looked good, but the underlying real performance remained very poor.
The point here is that if you focus on a particular measure, you will end up distorting behaviour to meet the outcome of what is being measured. As such, in the case of GDP, the focus of so much attention, nobody stopped to think about the underlying meaning of the measure, such that debt driven activity was encouraged - after all, such activity increased GDP.... in other words, the way the measure was used was no different from the principle of the baggage handlers...
Note 6:
I have hesitated to hit the publish button on this post, whilst I have tried to think through the issue of the Japanese money printing.
However I look at it, it appears that it really is possible for a central bank to print more money and see the value of the currency increase (even if only in the short term). Eventually such a system is unsustainable, as it must lead to some kind of inflation, even if it is not in the domestic market. In this case, in the end the lenders lose, as they have accepted IOUs in return for their money which are actually of equally dubious value as the money that was lent, and this is due to the inflation created in the source of the IOUs. In other words, they exchanged debased currency for debased IOUs. I hope this makes sense and, as I have mentioned before, comments are welcome, in particular any challenges to the idea that I have put forward.
Note 7:
I am re-reading The Wealth of Nations again, and for those of you who find economics a puzzle, I can not recommend this book enough. It is clearly written, free of jargon, and just makes excellent sense. The language is a little archaic in places but, as you read it, you find that you stop noticing as you are so absorbed by what he is saying. It really is an outstanding book. Perhaps a copy posted to all of the OECD leaders might help?
Thursday, September 18, 2008
King Canute and the Banking Crisis
I very rarely post this often, but it is an unusual point in time. I have long predicted this crisis (for new visitors to the site see the links to the left and browse the posts in the archive), knew what would happen but, somehow, now that it is here, there is a sense of unreality about it. I predicted this crisis but now we are in the situation, it seems less real than it did in my imagination and thoughts. In my imagination I did not have a sense of the panic that would ensue, but imagined the world looking on with the same dispassionate perspective that I take in considering these matters. A strange point of view with hindsight.
The reason for this quick post is that I have just browsed onto the Times website and found the following news:
The reasons that the banks are not lending to each other is that they all know that they are all holding toxic debt. This is not just CDOs etc. but also fast deteriorating commercial debt, unsecured consumer debt, and old fashioned mortgage debt (held on devaluing assets with people with ever more insecure job prospects). Furthermore, the sources of liquidity from the East are drying up as confidence in the 'rich world' banking system is evaporating.
The trouble is that, government balance sheets were already looking ugly and were getting uglier by the day as revenues will have been falling like a sone. Government are now piling more toxic debt onto the balance sheets, hastening the day when governments start to default. Had they accepted the reality of the situation, then there was a real possibility that they could have cut back on expenditure, reformed structurally, and perhaps have scraped through (just). Instead they are pouring money into black holes, and daily raising the likelihood of default.
Of all of the actions that governments could take, I can not think of a worse solution. There is going to be a very, very painful period of adjustment. Governments need to hold whatever resources they can for when their economies go through restructuring. It will not be possible to reform the cost bases of the world economy overnight, and that means that there is a need for as much of a breathing space as possible. Every $ that is poured into the black hole of the banking system shortens that breathing space. Furthermore, as I have said in my previous posts, it will eventually be repaid from the healthy sectors of the economy.
I am starting to find myself repeating myself, but it also needs to be said that the current crisis is not the real crisis but the symptom of the imbalances in the world economy. The only way to address these imbalances is to actually address the structure of the Western economies such that they are once again able to compete.
As I suggested at the start of the post, what we are witnessing is blind panic - and an irrational belief that something can be done. The trouble is that what is being done will be both ineffective and costly, and can (at best) delay the adjustments. It is a tragic waste of resource just at the time when those resources will be needed most.
Note:
The Telegraph also has article on the rescue package here, and the FT offers the best summary here...
Note 2:
We are currently undergoing an experiment in seeing whether governments can hold back economic reality. It is, when you think of this, very much like Canute holding back the tide. However, in the case of Canute, he knew that he could not really do it, and that was the point. Do the central bankers think they can really hold back the economic tide?
Note 3: In my last post I answered a question on what was a safe investment, and suggested that gold was a reasonable bet (I had mentioned a similar sentiment in an earlier post). I have just noticed that gold had already been posting record gains (not surprising under the circumstances). I have never looked closely at the gold market, so have no sense of how these gains can be measured, but perhaps it is too late to buy into gold. As such I would strongly recommend a long look at the history of gold prices before jumping into the market. However, as I mentioned before, gold prices are driven by sentiment, and any positive sentiment on the latest bailout is not likely to last that long.
The reason for this quick post is that I have just browsed onto the Times website and found the following news:
'The Bank of England today joined forces with five of the world's most powerful central banks to inject up to $180 billion (£100 billion) into the world's financial system in a concerted bid to ease the funding pressure on international markets.'From the title of this post, it is probably fairly obvious what I think of this action. More to the point, how much money are governments going to keep pumping into the markets before they realise that there is no stopping the crisis. They may delay it, but nothing can alter the fact that the fundamental problems that have caused the crisis will still be there.
The reasons that the banks are not lending to each other is that they all know that they are all holding toxic debt. This is not just CDOs etc. but also fast deteriorating commercial debt, unsecured consumer debt, and old fashioned mortgage debt (held on devaluing assets with people with ever more insecure job prospects). Furthermore, the sources of liquidity from the East are drying up as confidence in the 'rich world' banking system is evaporating.
The trouble is that, government balance sheets were already looking ugly and were getting uglier by the day as revenues will have been falling like a sone. Government are now piling more toxic debt onto the balance sheets, hastening the day when governments start to default. Had they accepted the reality of the situation, then there was a real possibility that they could have cut back on expenditure, reformed structurally, and perhaps have scraped through (just). Instead they are pouring money into black holes, and daily raising the likelihood of default.
Of all of the actions that governments could take, I can not think of a worse solution. There is going to be a very, very painful period of adjustment. Governments need to hold whatever resources they can for when their economies go through restructuring. It will not be possible to reform the cost bases of the world economy overnight, and that means that there is a need for as much of a breathing space as possible. Every $ that is poured into the black hole of the banking system shortens that breathing space. Furthermore, as I have said in my previous posts, it will eventually be repaid from the healthy sectors of the economy.
I am starting to find myself repeating myself, but it also needs to be said that the current crisis is not the real crisis but the symptom of the imbalances in the world economy. The only way to address these imbalances is to actually address the structure of the Western economies such that they are once again able to compete.
As I suggested at the start of the post, what we are witnessing is blind panic - and an irrational belief that something can be done. The trouble is that what is being done will be both ineffective and costly, and can (at best) delay the adjustments. It is a tragic waste of resource just at the time when those resources will be needed most.
Note:
The Telegraph also has article on the rescue package here, and the FT offers the best summary here...
Note 2:
We are currently undergoing an experiment in seeing whether governments can hold back economic reality. It is, when you think of this, very much like Canute holding back the tide. However, in the case of Canute, he knew that he could not really do it, and that was the point. Do the central bankers think they can really hold back the economic tide?
Note 3: In my last post I answered a question on what was a safe investment, and suggested that gold was a reasonable bet (I had mentioned a similar sentiment in an earlier post). I have just noticed that gold had already been posting record gains (not surprising under the circumstances). I have never looked closely at the gold market, so have no sense of how these gains can be measured, but perhaps it is too late to buy into gold. As such I would strongly recommend a long look at the history of gold prices before jumping into the market. However, as I mentioned before, gold prices are driven by sentiment, and any positive sentiment on the latest bailout is not likely to last that long.
Monday, July 14, 2008
Government Borrowing and Interest Rates
I have posted a comment/question from a reader called 'Lemming' below, who is clearly not an ignoramus (as the poster said of him/herself - I suspect Lemming may be an economist feigning lack of knowledge):
Lemming is quite right that interest rates are set (as a target) to govern the money supply in the economy (through open market operations in the UK primarily through the London Interbank Offered Rate). The control of the money supply is managed by either buying or selling securities such as second hand government debt (e.g. bonds), or by lending to or borrowing money from banks.
However, I think Lemming is wrong to say that the 'world' doesn't care about the interest rates, as has been illustrated by the example of the 'Carry Trade' and New Zealand (see here for an academic paper which gives a useful introduction). In this case money was being borrowed in low interest countries such as Japan and being utilised in high interest New Zealand. In doing so money was flooding into New Zealand, resulting in even higher interest rates, and creating demand for the New Zealand currency, and thereby pushing up the value of the New Zealand dollar. An extreme example, but you should be aware that the UK has also been a destination for the carry trade.
Onto government borrowing....
Government borrowing results in increasing the money supply in an economy. As such, in targeting interest rates, a central bank needs to include consideration of the amount of money that a government is pumping into the economy through borrowing. The more the government borrows, the more the money supply in an economy expands. On the other hand, if a government spends revenue, the effect on the money supply is largely neutral. Instead of individuals spending the money, the government takes it from them and spends it.
If a government borrows money, it also needs to offer a yield that will exceed (expected) inflation and also be attractive against risk in changes in the value of the currency. However, as a government borrows, it will expand the money supply, raise inflation, and thereby will need to offer higher returns to compensate investors. To add to this, if there is high inflation, then a currency will devalue, further raising inflation, and creating further requirements for higher yields on government investments. The level of the impact of government borrowing will depend on how close the economy is to capacity - the closer to capacity, the greater the impact upon inflation and therefore the greater the impact on interest rates. In addition, if the government is borrowing and thereby indirectly raising interest rates, the central bank will raise interest rates restricting the money supply to business......which I will discuss for a moment..
Another reason why government borrowing is influential is best illustrated by a simplification. I am an individual investor and wish (for whatever reason) to make an investment in £GB. I will be faced with a range of choices for where I might to wish to put my money. For example, I may wish to lend into the consumer markets (e.g. putting my money into a building society account where it will be used to provide mortgages), or invest in companies (e.g. stock market), or I can lend to the government (e.g. bonds) and so forth. In each case I must make an assessment of risk and reward. If we take the example of lending of money to the government through the purchase of bonds, these kinds of bonds are considered to be 'no-risk' (a misnomer - as they do have risk) and therefore are highly competitive in the respect that they are relatively very safe investments (in some cases they even allow for inflation). By comparison non-government lending looks pretty risky.
In this situation, my investment decision would, if all investments were offering the same yield, be to go for the government bonds. Why take a risk on putting my money into unsafe instruments such as consumer lending. As such, non-government competitors must offer me a premium over lending to the government in order to give me an incentive to invest my money in their asset. As such the government becomes a formidable competitor in the market for where I invest my money, and set a benchmark on the minimum yield I will accept. In doing so, they are distorting the markets, and setting an effective minimum interest rate in the market.
So far so simple. However, life is never simple.
For example, Lemming mentions that the government wants to control inflation with interest rates. As the example of New Zealand shows , no country is a financial island, and the problems of New Zealand illustrate the problems of central banks very clearly (it is a good example because it is a small economy, and the effects can be seen more vividly as a result). On the one hand you have high interest rates to try to damp down inflation (in particular house inflation - though this is no longer an issue), but on the other hand such high interest rates are attracting the carry trade. Furthermore the carry trade is leading to the appreciation of the $NZ as there is high demand for the currency, and this means that imports are cheaper, pulling down inflation, but at the same time making New Zealand goods and services relatively expensive to imports. How can interest rates be set to manage such a situation? The answer is that it is a choice between a rock and a hard place.
Going back to government borrowing setting the minimum yield on investments. This situation means that all investments are measured relative to a baseline of lending to the government. The question to then ask is what would happen to investment decisions without such a base to measure them against. In this case each individual investment could only be measured on its merits compared with other investments.
At this point it should be noted that when lending to the government, this lending goes towards government spending. I have discussed elsewhere that we can not reasonably say that a government invests money, as there is no way of measuring the return on the investment, and no way to separate spending from investment. However, if we lend to the government, we are individually making an investment as the government provides us (as individuals) a measurable return.
As has been mentioned, an investment in the government is actually in competition for other investments. Some of these other investments might be invested into productive activities, such as company expansion and so forth. More than this, the higher the government yield offered to investors, the higher the yield needed to offer a competitive return for other investments. As such higher government yields impact across the economy. As such, if you are a company raising money, then you will need to offer a greater return than would be the case if your company were not in competition with the government. In doing so the government is indirectly raising the cost of doing business, and is also taking away sources of investment from business. With less investment finance available, this will also have the effect of raising the cost of borrowing for business, as there will be less supply of finance.
If we actually think about government borrowing, it really does not make sense. In reality there is no real justification for it, excepting in the case of national emergency (e.g. war). As soon as a government borrows, it pushes up the cost of borrowing for potentially productive uses, as well as having a whole series of effects that are indirect. As such, even in a downturn, a government borrowing will have a negative impact, as it will redirect resources away from potentially productive investments, or raise the cost of borrowing limiting the 'bang per buck' of the money borrowed (as the cost of the money will be greater).
In short, government borrowing is just a hiding place for sloppy management of the resources available to government, and represents general sloppy management of a country. It allows for government to act irresponsibly at the cost of the economy as a whole. As such, yes it is a bribe for the voters.
Note: I hope that I have not made too much of a hash of this explanation, and that it starts to illustrate the point. I have only covered some of the elements that are necessary for a full discussion, as there are so many complex interdependencies and positive and negative feedbacks in economic systems, and it is almost impossible to strip out a few isolated effects. I will welcome feedback from Lemming in particular, as I suspect that he/she may be an economist.
'I know it wasn't your intention to write an Elementary Economics course but, for ignoramuses like me, could you quickly explain how a central bank's interest rates are related to government borrowing?Sadly, there is no quick answer to this question, but I will do my best in the short time I have for this post. It really requires a long answer, so I hope I will not confuse issues in a quick review.
I had assumed that the central bank set domestic interest rates to create a feedback loop to keep the amount of money in its own economy at the 'correct' level i.e. to regulate inflation. I didn't think the rest of the world cared, as whatever happened, the exchange rate for the currency would reflect its true value.
I am a bit hazy on government borrowing. I assumed that a government could borrow 'money' on the financial markets at the cost of paying it back with interest (at a rate set by... some international committee or other) - like a business borrowing money within a country's economy. I have no idea in what currency this loan would be made (as I say I am very ignorant!)
The borrowed money would be used to boost short term cashflow, with the assumption being that it could be repaid in future due to improved economic circumstances, or when 'investments' reduced costs in the future. (And as a bribe to the electorate, no doubt.)'
Lemming is quite right that interest rates are set (as a target) to govern the money supply in the economy (through open market operations in the UK primarily through the London Interbank Offered Rate). The control of the money supply is managed by either buying or selling securities such as second hand government debt (e.g. bonds), or by lending to or borrowing money from banks.
However, I think Lemming is wrong to say that the 'world' doesn't care about the interest rates, as has been illustrated by the example of the 'Carry Trade' and New Zealand (see here for an academic paper which gives a useful introduction). In this case money was being borrowed in low interest countries such as Japan and being utilised in high interest New Zealand. In doing so money was flooding into New Zealand, resulting in even higher interest rates, and creating demand for the New Zealand currency, and thereby pushing up the value of the New Zealand dollar. An extreme example, but you should be aware that the UK has also been a destination for the carry trade.
Onto government borrowing....
Government borrowing results in increasing the money supply in an economy. As such, in targeting interest rates, a central bank needs to include consideration of the amount of money that a government is pumping into the economy through borrowing. The more the government borrows, the more the money supply in an economy expands. On the other hand, if a government spends revenue, the effect on the money supply is largely neutral. Instead of individuals spending the money, the government takes it from them and spends it.
If a government borrows money, it also needs to offer a yield that will exceed (expected) inflation and also be attractive against risk in changes in the value of the currency. However, as a government borrows, it will expand the money supply, raise inflation, and thereby will need to offer higher returns to compensate investors. To add to this, if there is high inflation, then a currency will devalue, further raising inflation, and creating further requirements for higher yields on government investments. The level of the impact of government borrowing will depend on how close the economy is to capacity - the closer to capacity, the greater the impact upon inflation and therefore the greater the impact on interest rates. In addition, if the government is borrowing and thereby indirectly raising interest rates, the central bank will raise interest rates restricting the money supply to business......which I will discuss for a moment..
Another reason why government borrowing is influential is best illustrated by a simplification. I am an individual investor and wish (for whatever reason) to make an investment in £GB. I will be faced with a range of choices for where I might to wish to put my money. For example, I may wish to lend into the consumer markets (e.g. putting my money into a building society account where it will be used to provide mortgages), or invest in companies (e.g. stock market), or I can lend to the government (e.g. bonds) and so forth. In each case I must make an assessment of risk and reward. If we take the example of lending of money to the government through the purchase of bonds, these kinds of bonds are considered to be 'no-risk' (a misnomer - as they do have risk) and therefore are highly competitive in the respect that they are relatively very safe investments (in some cases they even allow for inflation). By comparison non-government lending looks pretty risky.
In this situation, my investment decision would, if all investments were offering the same yield, be to go for the government bonds. Why take a risk on putting my money into unsafe instruments such as consumer lending. As such, non-government competitors must offer me a premium over lending to the government in order to give me an incentive to invest my money in their asset. As such the government becomes a formidable competitor in the market for where I invest my money, and set a benchmark on the minimum yield I will accept. In doing so, they are distorting the markets, and setting an effective minimum interest rate in the market.
So far so simple. However, life is never simple.
For example, Lemming mentions that the government wants to control inflation with interest rates. As the example of New Zealand shows , no country is a financial island, and the problems of New Zealand illustrate the problems of central banks very clearly (it is a good example because it is a small economy, and the effects can be seen more vividly as a result). On the one hand you have high interest rates to try to damp down inflation (in particular house inflation - though this is no longer an issue), but on the other hand such high interest rates are attracting the carry trade. Furthermore the carry trade is leading to the appreciation of the $NZ as there is high demand for the currency, and this means that imports are cheaper, pulling down inflation, but at the same time making New Zealand goods and services relatively expensive to imports. How can interest rates be set to manage such a situation? The answer is that it is a choice between a rock and a hard place.
Going back to government borrowing setting the minimum yield on investments. This situation means that all investments are measured relative to a baseline of lending to the government. The question to then ask is what would happen to investment decisions without such a base to measure them against. In this case each individual investment could only be measured on its merits compared with other investments.
At this point it should be noted that when lending to the government, this lending goes towards government spending. I have discussed elsewhere that we can not reasonably say that a government invests money, as there is no way of measuring the return on the investment, and no way to separate spending from investment. However, if we lend to the government, we are individually making an investment as the government provides us (as individuals) a measurable return.
As has been mentioned, an investment in the government is actually in competition for other investments. Some of these other investments might be invested into productive activities, such as company expansion and so forth. More than this, the higher the government yield offered to investors, the higher the yield needed to offer a competitive return for other investments. As such higher government yields impact across the economy. As such, if you are a company raising money, then you will need to offer a greater return than would be the case if your company were not in competition with the government. In doing so the government is indirectly raising the cost of doing business, and is also taking away sources of investment from business. With less investment finance available, this will also have the effect of raising the cost of borrowing for business, as there will be less supply of finance.
If we actually think about government borrowing, it really does not make sense. In reality there is no real justification for it, excepting in the case of national emergency (e.g. war). As soon as a government borrows, it pushes up the cost of borrowing for potentially productive uses, as well as having a whole series of effects that are indirect. As such, even in a downturn, a government borrowing will have a negative impact, as it will redirect resources away from potentially productive investments, or raise the cost of borrowing limiting the 'bang per buck' of the money borrowed (as the cost of the money will be greater).
In short, government borrowing is just a hiding place for sloppy management of the resources available to government, and represents general sloppy management of a country. It allows for government to act irresponsibly at the cost of the economy as a whole. As such, yes it is a bribe for the voters.
Note: I hope that I have not made too much of a hash of this explanation, and that it starts to illustrate the point. I have only covered some of the elements that are necessary for a full discussion, as there are so many complex interdependencies and positive and negative feedbacks in economic systems, and it is almost impossible to strip out a few isolated effects. I will welcome feedback from Lemming in particular, as I suspect that he/she may be an economist.
Subscribe to:
Posts (Atom)