Thursday, June 25, 2009

Quantitative Easing - Monetizing UK Government Debt

It is a long time since I have taken a look at quantitative easing (QE -printing money). Long term readers of the blog will know that I have have offered objections to the policy from the outset, and I have seen it as a barely hidden method of 'monetizing' government debt (printing money to pay the government bills). I have also warned of the potential risk for hyper-inflation that is inherent in the policy.

I have written this many times, but it is worth repeating what inflation actually is. If you have an output of 100 units, and 100 units of currency and increase the units of currency to 110 units, the only outcome is that there are more units of currency chasing the 100 units of output. That is inflation. In the case of the UK at present, there is a fall in output at the same time as an increase in currency issuance, thereby making the currency issuance more potent. This is a simplistic explanation, and there are complications that I discuss here. However, those complications do not directly impact on what is being discussed in this post, which is related to the mechanism of QE.

Before moving forwards, is QE the same as printing money? One of the most amusing things I have seen regarding the policy of QE is the attempt by Charles Bean, Deputy Governor for monetary policy of the Bank of England, to try to suggest that QE is not the same as printing money:
Quantitative easing has been described in some quarters as “printing money”, though it is not literally that. It is more akin to us buying the asset with a cheque drawn on the Bank of England, which the seller then deposits with his own bank. As a consequence, the quantity of bank deposits in the economy goes up, while the claims that the banks hold on the Bank of England also increase.
This is simply disingenuous. The method of QE is as follows, and this is from a Bank of England paper:
The aim of quantitative easing is to inject money into the economy in order to revive nominal spending. The Bank is doing that by purchasing financial assets from the private sector. When it pays for those assets with new central bank money, in addition to boosting the amount of central bank money held by banks, it is also likely to boost the amount of deposits held by firms and households. This additional money then works through a number of channels, discussed later, to increase spending.
You will note the term 'new central bank money'. Whilst there is no physical printing press, the Bank of England literally creates the money. Any suggestion that this is not 'printing money' is disingenuous nonsense. It is exactly the same effect as running a printing press to create new £50 notes.

For those unfamiliar with the mechanism of QE, the Bank of England buys an asset such as a government bond and credits the institution from whom they buy the asset with the value of the asset, by 'creating' the credit in the account of the seller. They have literally just created the money, and that money now sits in the account of the seller, ready to be used in the market.

As an illustration of the underlying principle, if you were to imagine that the Bank of England decided to buy your house for £250,000, it is doing the equivalent of printing enough notes for the £250,000 and giving you the notes fresh off the printing press. You could then go and spend that money as legal tender, and the amount of money in the economy has increased by £250,000. To reverse the increase in money, the Bank of England could then sell your house. Once they received the £250,000 they would then put the notes in a furnace and burn them. As such the £250,000 of additional money would disappear. This is the way in which the Bank of England can try to control the money supply, but they simply 'credit' the account of a bank rather than actually physically printing the money.

If we use the house example, in the modern sense of printing money, rather than getting cash, you would find that £250,000 appeared in your bank account from the issuance of a credit from the Bank of England.

The most interesting point is that the QE policy was justified as a fight against deflation, and that this justification is still being trotted out. I will quote from Mervyn King at the February select committee just to confirm that the excuse for QE is fight deflation and maintain inflation:
The reason we are doing that is because our judgment is that since last autumn, with the remarkable change in conditions last autumn, the amount of money in the economy is simply not growingfast enough to enable us to reach a sustainable growth rate with inflation close to the target. [question 11]
This from the Bank of England website on why they are implementing QE, as it is even more explicit:
The instrument of monetary policy shifted towards the quantity of money provided rather than its price (Bank Rate). But the objective of policy is unchanged – to meet the inflation target of 2 per cent on the CPI measure of consumer prices. Influencing the quantity of money directly is essentially a different means of reaching the same end.
It is worth just briefly noting the actual nature of the inflation policy, and the parameters within which the Bank of England works. This is from the Bank of England website:
If the inflation target is missed by more than 1 percentage point on either side - in other words, if the annual rate of CPI inflation is more than 3.0% or less than 1.0% - the Governor of the Bank, as Chairman of the MPC, must write an open letter to the Chancellor explaining the reasons why inflation has increased or fallen to such an extent and what the Bank proposes to do to ensure inflation comes back to the target. This does not mean that the Bank has a target of 1.0 - 3.0%. The target is 2.0%. But if inflation varies by more than 1 percentage point from the target, the Bank has to explain why.
In the meantime, the CPI measure of inflation (the one that the Bank of England is targeting), has not dropped below 2% in the entire period of the QE policy, has not required a letter to be written, and the current rate is a fraction above 2%.

You will also note that the RPI measure of inflation has dropped, but RPI includes housing costs, which are dropping due to low interest rates. I explain the circularity of consideration of the RPI measure as a driver of interest rates (or QE) in more depth here and the problem of the circularity is presumably why it is not used for Bank of England policy guidance. In any case, RPI is not the inflation measure that the bank uses.

As such, under the terms of inflation targeting, it is apparent that the Bank of England is undertaking a policy which is 'unconventional' at a time when they have not even come close to the point where the bank needs to even report any concern over inflation rates. It is evident that there has been, and still is, no justification for the policy of QE if the policy is based upon CPI inflation. However, the policy has been justified on the possibility of future deflation. Again, an answer from Mervyn King from February:
The aim at present, with the concern about inflation being below the target in the medium term, is we are trying to bring the future outlook for inflation back up to the target. That is why we are engaging in the quantitative easing, but we have absolutely no interest or wish to see inflation go above that. [Question 12]
The quote dates from February and, as yet, there is still no evidence of the CPI falling in any way that might justify such an unconventional and untested policy. As I have said, the CPI has not even moved out of the boundaries that require a letter of explanation.

The next interesting point to consider is the method of QE. The official policy of QE allows for purchase of commercial assets or government debt (gilts). However, the implementation of the policy has seen gilts being the asset that is being purchased in (by far) the majority of the cases. The following chart makes the point (from the Bank of England here):

Why purchase government debt? This is the argument presented by Mervyn King:
In order to ease policy, therefore, we have adopted what is a relatively standard approach, which is to buy government securities [gilts] in the market. That way we do not distort private sector yields or take a judgment on which private sector assets we should buy, and this increases the amount of money in the economy. [Question 11]
Contrary to the assertion that buying gilts will not 'distort private sector yields', it is clear that this will not be the case. If people have a choice of investments, the condition of one asset will have an impact upon the other investment, and the Bank's purchase of gilts is specifically designed to make private assets more attractive (or that is the official view) than gilts.

With regards to the argument about which private sector assets to buy, this has been exactly what the Bank of England has been doing with the Special Liquidity Scheme - buying private sector assets. It is not apparent therefore that there is not any squeamishness over buying private sector assets. Also, as you will note, despite this statement, they are still buying a token number of bonds, indicating that it is indeed 'do-able' to buy private assets. In any event, as has been admitted by the Bank of England, this is not a conventional policy, and therefore there are no boundaries to what might be purchased.

A further explanation from the Bank of England is that if they buy gilts, then the sellers will have money to buy other assets (see here, page 96). However, in order to increase the money supply, it really does not matter what the bank spends the money on. Whatever it is used to purchase, the money supply has increased in the economy, as it will land in the hands of someone or some organisation. They will then have a new reserve of cash to use to spend or save. Bearing in mind that the aim of the bank is to prevent deflation, it really does not matter what the money is used for. If we take the earlier imagined example of the Bank of England buying your house, then it is apparent why this is the case.

If you decide to spend the money given to you by the Bank of England for purchase of your house, then the money will be used for the purchase of goods and services, thereby increasing demand for goods and services by £250,000. The amount of goods and services have more money chasing them than before the bank made the purchase and created money, and that is quite literally inflation. Once you have spent the money, the money will either be spent by the recipients or the money or will be deposited as savings in a bank. The money supply in relation to the total output of the economy has increased.

Alternatively, if you decide to save the £250,000, then you will deposit it in the bank. The bank will then likely use that money for fresh lending, which will means somebody else will use it for the purchase of a good or service, thereby again increasing the amount of money chasing goods or services. Even if the money is used to buy government debt (gilts) directly, the government will spend the money and the same thing will occur. The money will be used to pay nurses, who will spend the money on goods or services, or pay for a new road which will mean more expenditure on goods and services.

In other words, whatever the Bank of England purchases, one way or another, it will end up being used to purchase goods or services, and will create inflation in the goods or services for which it has been used. The Bank of England would not buy your house or bother with such a small amount of new currency issuance, but the principle is illustrated in this example.

The point about why it is not important how the money enters the economy is made clearly by Ben Bernanke, with his quote of the idea of using a helicopter to drop freshly printed money into an economy:
In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money.
In short, however money enters the economy, it will still have the effect of arriving in the hand of somebody and will be available for spending, thereby increasing the supply of money in relation to goods and services.

So why is the Bank of England buying government debt?

When the policy was first proposed, it was at a time when markets were looking at the UK debt issuance with increasing concern, due to the exploding size of the debt. It would also have been evident to the UK government that they were not alone in issuing so much debt, as this process was being replicated around the OECD. In this situation, it was likely that the market for government debt issuance was about to be far more competitive, with the market flooded with debt. As a result, the possibility of lack of sufficient demand for the massive issuance of UK debt was being discussed by some analysts (and in this blog), which would translate into UK bankruptcy and a visit to the IMF. If the UK debt was not sold, the result would be a run on the £GB and national insolvency.

If we look at the nature of the problem, it is apparent that using QE to buy government debt simply does not make sense on any level, except that it is being enacted because it is the only way that government borrowing might be paid for. It is clearly unnecessary to buy gilts, but the purchase of gilts raises exactly the kind of worries that I am expressing here. It will, at the very least, raise concerns that the policy is the monetization of government debt (e.g. Warren Buffet on QE), and that will shake confidence in the economy overall. If it was the only method of increasing the money supply, then it might just make sense, but the problem is that all asset purchases will have the same effect.

Whilst I have presented (I hope) a logical argument against the use of QE for purchase of government debt, it might be argued that the Bank of England is just misguided. They genuinely believe in the threat of deflation, and genuinely believe that buying gilts is the best way to enact QE. However, it is when we view the latest thinking on the so called 'exit strategy' that such a suggestion becomes questionable.

When using the example of purchasing your house, I pointed out that the reversal of a policy would be for the bank to sell the house, and then burn the money to take it out of the money supply. This is a very important point, as the Bank of England will need an exit strategy, and the logical strategy would be to do the equivalent of selling the house - sell the gilts back on to the market. However, it is now apparent that this is not the strategy. This from the Bank of England Quarterly Bulletin for 2009 Q2 for the 'exit strategy':
As the economy recovers, the medium-term outlook for inflation will improve. As in normal times, the Committee will be guided by the medium-term outlook for inflation relative to the inflation target. Given that the inflation target is symmetric, if inflation looks set to rise above the 2% target, then the Committee will want to tighten monetary policy to slow spending and reduce inflation.

Monetary policy could be tightened in a number of ways. It could involve some combination of increases in Bank Rate and sales of assets in order to reduce the supply of money in the economy. Alternatively, the supply of reserves could be reduced without asset sales, through the issuance of short-term Bank of England bills. The MPC will decide on the most appropriate way to withdraw the policy stimulus based on the circumstances prevailing at the time.
You will note here that there is no commitment to sell the gilts back into the market, and instead a suggestion to use Bank of England bills. The Bank of England's description of the short-term Bank of England bills is as follows:
The Bills will constitute direct, unsecured, unconditional and general obligations of the Bank of England and will rank pari passu with all other unsecured and unsubordinated indebtedness of the Bank of England from time to time outstanding and without any preference one over the other, by reason of priority of date of sale or otherwise. "Indebtedness" means all indebtedness of the Bank of England in respect of moneys borrowed by the Bank of England and guarantees given by the Bank of England for moneys borrowed by others. The Bills will not be obligations of any person other than the Bank of England.
In other words, the Bank of England is proposing issuance of its own debt in place of selling the gilts. Whilst this might have the effect of reducing the money supply, the question that arises is to the reason why they would not just sell the gilts, and therefore restore the bank balance sheet to something like normality? Why would they want to hang on to the gilts?

The answer quite simply is that the market is already being flooded with gilts, and any move to sell the gilts held by the Bank of England would result in even greater supply, and an even greater risk of a failed bond auction.

What we therefore have is a highly unconventional policy in QE, with no rules or boundaries or precedent, resulting in the purchase of government debt (albeit through intermediaries). The purpose given is to fight a deflation that has not taken place. The method of enactment of the policy is of no consequence to the final result, but nevertheless the Bank of England has gone to considerable lengths to justify why buying government debt is the best way to enact the policy. As Bernanke recognises, a helicopter drop of money would achieve the same impact in fighting deflation. Furthermore, the exit strategy potentially leaves the gilts in the hands of the Bank of England even once the policy is abandoned.

None of this adds up. The only logical conclusion is that the government is being financed through the printing press, and such funding has unhappy precedent. In light of this, I do wonder how Mervyn King and the other officials at the Bank of England might justify this policy. I can only imagine how the discussions might have played out at the outset of the policy. I would guess that the conversations involved expressions from the government such as 'for the good of the country' and 'temporary measures in extreme circumstances'. At the time of implementation of QE, it is easy to see how such action might have momentarily seemed to be essential.

I am also guessing that the officials at the Bank of England are now having sleepless nights. I can not believe that they can not see where this policy is leading. As such, it can only be hoped that they will have the courage of their convictions and refuse to cooperate further. I am hoping that they will see that prolonging the idiocy of current government policy is wrong, and is taking the country towards economic disaster.

It is apparent now that Mervyn King is having severe doubts about the government fiscal policy, and it is to be hoped that this will see him resisting any further extensions of QE. As such, I am hoping the Bank of England has the leadership with the courage to call an end to this.

Mervyn King Identifies the Problem, then Avoids the Solution...

Some of the readers may have seen a Telegraph article that summarises some of the key points from Mervyn King, the Bank of England Governor, from the May Inflation Report. His thinking is very much in accord with much of the mainstream in supporting the efforts of governments and central banks to support their economies. However, there are some contradictions in his points that suggest that he is having grave doubts about what is taking place. In effect he is trying to square a circle. I will quote at some length from his comments:
The scale of the deficit is truly extraordinary. 12.5pc of GDP is not something that anybody would have anticipated even a year or two ago and this reflects the scale of the global downturn. But it also reflects the fact that we came into this crisis with fiscal policy itself on a path that wasn't itself sustainable and a correction was needed.

The speed of which the fiscal stimulus should be withdrawn has to depend on the state of the eocnomy. There is no point in presenting a profile for the reduction of deficits that is independent of the state of the economy.

There will certainly need to be a plan for the lifetime of the next parliament, contingent on the state of the economy, to show how those deficits will be brought down if the economy recovers to reach levels of deficits below those which were shown in the budget figures.

In other words the deficit is very worryingly large, but it has to be endured, and action needs to be taken in the medium term to shrink the deficit. So far, so conventional. However, it is in his later discussion that the underlying contradiction becomes apparent:

To ensure a sustainable recovery and prevent a repetition of the crisis we must reform the international monetary system. The United Kingdom and other deficit countries will now be aiming at more sustainable levels of domestic demand.

If we look at the earlier comment and this comment, it is apparent that there is a contradiction in the argument. On the one hand the suggestion is that the fiscal stimulus is necessary, and on the other that there needs to be a change to 'more sustainable levels of domestic demand'. If we actually view the nature of the objectives of the stimuli, and the underlying reason for the government deficit spending, it is exactly the opposite of sustainable domestic demand.

From this document of the Treasury Select Committee in February, we can find the following quote from Mervyn King (key section highlighted):
I think this goes back to what I call the paradox of policy. I think it does not make sense to engage on a national campaign to raise savings rates in the very short run; we will need to do so once we get out of the crisis. In the short run we have to engage in measures to ensure that spending returns to more normal levels in order to prevent significant falls in output and rises in unemployment. Once we have got through that immediate problem, then the challenge will, indeed, be to raise the national savings rate, both public and private. [answer to question 5]
The question here is the question of what normal might be. Is it debt fuelled spending, which is unsustainable, or is it the reduced spending indicative of sustainability? It does not matter whether the deficit is originating in consumer spending or government spending, the current domestic demand is not sustainable. In both cases, the country is in aggregate consuming more than it produces, and this is not sustainable. Why delay the shift to sustainable demand? Why not make the shift now?

What we are seeing here is a recognition of the underlying problem, but a refusal to act to rectify the problem. It can not be put more simply than this. If we are consuming too much now, we surely need to stop. Now.

To use a metaphor, Mervyn King has diagnosed the illness, but does not have the courage to suggest taking the unpleasant medicine now. Instead, he is proposing letting the illness run on even longer, even though it will do even more damage to the body in the meantime. I just hope that he goes further, and actually has the courage to call a halt. He may actually be in a position to have the influence to actually achieve this.....

More on the Bond Smuggling

I have been keeping an eye on the bond smuggling story (see here and here), and have noted that absolutely nothing is being added to the story. There is still no official word from the US, other than stories repeating the comment that, from pictures seen on the Internet (???), an official suggested that they were fake. As yet, no official report on the authenticity of the bonds. Nothing has come out of Italy.

This story is surprising in the respect of the complete lack of any definitive information from official sources. Bearing in mind the level of speculation about the story, it would be reasonable to expect that some kind of official statement would be made.

I have also been thinking about the breaking of the story. I do not know how the Italian police operate, but usually, whenever there is a major 'bust' the police arrange a press conference. I can think of no larger bust than foiling a $134.5 billion counterfeiting plot. What I would normally expect from such a story is a crowded press room, the chief of police smiling at the press and introducing those who caught the criminals, followed by a sample bond (in a plastic bag) held aloft for the photographers. In short, the bust should have been presented as a triumph. The police are not normally so shy of promoting their success....instead, nothing....

In short, I keep coming back to this story as it is all very odd. I find the ongoing silence to be a continuation of the oddness. In particular, why nothing from the Italian authorities? The only explanation, and it is quite a reasonable explanation in principle, is that there is an ongoing investigation. However, how does that fit with the story of the smugglers being released?

I will continue to update you if there are any developments. However, if there are no developments, then I think that we might conclude that there really is more to this story than meets the eye. After all, why would there be such silence on the largest counterfeiting operation ever?


You may have noted that I have not been very responsive to comments of late. It is, unfortunately, one of those times when real life is rather busy, and I am therefore extremely short on time. I have also been trying to devote time to the fixed fiat currency idea, which is very long and complex, and have also been preparing a post on QE (hopefully to follow shortly). Apologies for this, and I hope that I will be able to devote more time after a week or so.

Wednesday, June 17, 2009

Smuggled US Bonds in Italy - An Update

The Smuggled Bonds

I am getting a considerable amount of traffic to my post on the smuggled bonds in Italy, and you may wish to read the original and the comments at the end if you have not already done so (post here).

Since my post the US has finally confirmed that the bonds are fake:

WASHINGTON, June 19 (Reuters) - A purported $134 billion in U.S. government bearer bond certificates seized by police near the Italian-Swiss border are fake, the U.S. Treasury said on Friday.

"Based on the photograph we've seen online, they are clearly fake. And not even good fakes," said Stephen Meyerhardt, a spokesman for the Treasury's Bureau of the Public Debt.

However, the actual details on this story remain very patchy and contradictory which is still giving me pause for thought. Who are the two individuals, why did the confirmation that they were fake take so long, what were the forgers trying to achieve with such apparently useless bonds? Just to add fuel to the conspiracy fires, it transpires that the two individuals with the bonds have been released from custody without charge! The reason given is that they did not try to pass off the bonds as genuine.....

This seems very odd.

Another concern is that the original reason for my belief that the bonds were forged was an article detailing a bond forgery operation in the Philippines, which appeared to match the bonds that were found. This from the FT:

Whether the men are really Japanese, as their passports declare, is not entirely clear, but Italian and US secret services working together soon concluded that the bills and accompanying bank documents were most probably counterfeit, the latest handiwork of the Italian Mafia.

Few details have been revealed beyond a June 4 statement by the Italian finance police announcing the seizure of 249 US Treasury bills, each of $500m, and 10 "Kennedy" bonds, used as inter-government payments, of $1bn each. The men were apparently tailed by the Italian authorities.

Yesterday the mystery deepened as an Italian blog quoted Colonel Rodolfo Mecarelli of the Como provincial finance police as saying the two men had been released. The colonel and police headquarters in Rome both declined to respond to questions from the Financial Times.

In the story above, it is apparent that the 'authorities' were tailing the men, but the original story proposed that they were stopped in a random check. This is a very different story to how the men were intercepted to that which was previously released. Of course, it is possible that this is just more details being released, but the original stories appeared to be quite clear.

The article above goes on to detail another related scam, involving $1 billion in bonds in relation to the Venezuelan central bank. The scale and nature of the fraud detailed looks very different from the case in question. This is rather odd:

Italian officials, while pointing out that hauls of counterfeit money and Treasury bills were not unusual, were stunned by the amount involved. Investigators are looking into the origin and destination of the fakes.

Last month Italian prosecutors revealed they had cracked a $1bn bond scam run by the Sicilian Mafia, with the alleged aid of corrupt officials in Venezuela's central bank. Twenty people were arrested in four countries.

The fake bonds were to have been used as collateral to open credit lines with banks, Reuters news agency reported. The Venezuelan central bank denied the accusations.By FT staff in Rome, Tokyo, New York and Washington

Not only are they not connecting the bonds in this case to the Philippines forgeries, they are proposing the mafia are responsible. This seems highly unlikely. I really can not believe that the mafia are that idiotic. According to one unnamed US official, the bonds included a picture of the space shuttle, even though they are dated from a time long before the space shuttle. And the mafia were involved in such stupidity???

In the last two years, Italian authorities have seized some $800 million of U.S. bonds in the Como area in northern Italy.

Meyerhardt said U.S. government investigators believe that the seized bond forgeries were made using commercial photo enhancement software to alter the image of a $100 bill to increase the amount into millions or billions and add what appear to be interest coupons.

Another U.S. official said the seized bonds were purported to be issued during the Kennedy administration in the early 1960s, but the certificates showed a picture of a space shuttle on it -- a spacecraft that first flew in 1981. Some of the bonds were purportedly issued in a $500 billion denomination that never existed.

This really does not sound like a mafia operation....

Had the news simply confirmed the identity of the individuals, and linked them to the Philippines forgery operation, I would have quietly accepted the story as a simple piece of idiocy. However, the muddying of the waters does give me some concern. I am not inclined to conspiracy theory but, as one commentator pointed out, governments do indulge in skulduggery. I am still not convinced that there is something amiss here, but there is also nagging sense that all is not as it appears. I can not quite convince myself either way. The FT Alphaville article on the latest news also appears to share this sense of unease.

Altogether, this is a very, very odd story. I do feel like I am sounding a little bit like a deranged conspiracy theorist, so please feel free to comment on whether the latest news makes sense to you.

However, I do not want to just focus on the bond story, and thought I would also add some commentary on other news that is current. As such, some other points follow:


The first story that has struck me, is the 'Buy China' rules being implemented in conjunction with China's stimulus measures. As you would expect, the rules are not quite as crude as the 'Buy China' quote suggests. The Chinese government are doing implementing this policy indirectly by asking that any imports used in the stimulus must first have a government permission. In other words, there is an administrative barrier to trade that will no doubt work in conjunction with nationalist sentiment.

As one article makes clear, this appears to be (at least in part) a tit-for-tat response to the 'Buy US' policy in the US, and that this kind of trade discrimination is, in any case, not something new:

China's World Trade Organization commitments require it to treat foreign and domestic goods equally in commercial trade. But Beijing has not signed a WTO treaty that extends such requirements to government procurement, which might limit options for challenging Beijing's "Buy China" order.

Beijing has imposed similar requirements on government projects such as China's giant Three Gorges Dam to favor domestic suppliers of equipment and services.

Ambrose Evans-Pritchard in the Telegraph calls this a 'suicidal' policy, and suggests that it hints that the Chinese recovery is not as strong as has been suggested. If China were to pursue such a policy, in an attempt to protect domestic jobs, it will provide ammunition for those who have been pushing for restrictions on trade with China.

It is hard to disagree with Ambrose Evans-Pritchard, but lurking beneath this may be a reason why China has taken such a bold and inflammatory move. It might just be a signal of the confidence in China that, with their massive holdings of US debt, they hold the whip hand. It could simply be a sign that China now sees the US as impotent, and that China's position allows them to dictate the terms of trade. This is not to say that suicide thesis is wrong, as it is quite possible that China has made a miscalculation, but rather that the possibility of Chinese confidence should not be ignored. We are not privy to the meetings behind closed doors between the governments of both countries, and can only guess at how the shift in relative economic power has actually played out.

What is certain from this latest move is that a significant impetus towards wider protectionism has now taken place. How it plays out may be very significant to the outcome of the economic crisis, but this will rest in the hands of political decisions, rather than any underlying economic drivers.


A short while ago, I was discussing how there may be wild swings in sentiment, due to investors being unable to decide on a place of safety for their investments. Below is an article on treasuries over the last few days:

TOKYO, June 17 (Reuters) - U.S. Treasuries fell on Wednesday as investors took profits from a four-day rise and avoided adding positions ahead of a Federal Reserve policy meeting next week.

The benchmark 10-year yield had fallen near 3.65 percent on Tuesday, after climbing as high as 4 percent last week, helped by weaker data on manufacturing and industrial output which in part caused a two-day stock slide this week.

Still, price falls were limited as investors continued to unwind trades made on economic recovery hopes and sold stocks and commodities, and shifted some funds back into safe-haven debt.

Prospects of further Fed purchases later in the day after the central bank bought $6.45 billion of Treasury debt on Tuesday also provided some support to the debt market.

But investors were unsure about the direction for Treasuries once profit-taking runs its course, as views remain that the economy has seen the worst of the recession and before hearing the Fed's stance on bond buying at its two-day meeting next week after a spike in long-term yields this month.

I have highlighted this story, as it illustrates the nature of markets at present. They are, quite literally, in a funk of uncertainty. Nobody is entirely sure of the economic data or the economic situation.

Likewise, the roller-coaster ride of the £GB continues, with this story from Bloomberg:

June 17 (Bloomberg) -- The pound dropped by the most in almost two weeks against the euro as stocks retreated and minutes showed Bank of England policy makers voted unanimously to continue their asset-purchasing program.

The British currency also slid versus the dollar after a government report showed claims for U.K. jobless benefits rose in May. The minutes of the central bank’s June 4 meeting showed policy makers decided it was too early to know if the measures designed to lower borrowing costs were working. The FTSE 100 Index fell to its lowest level since May 5, losing 1.2 percent.

“Stocks have been pummeled today as we shift toward a more risk-averse mentality and that’s conspiring to hit sterling,” said Jeremy Stretch, a senior currency strategist in London at Rabobank International. “The pound never does well in this sort of environment.”

The pound weakened 0.8 percent to 85.01 pence per euro by 5:05 p.m. in London, after earlier sliding as much as 1.2 percent, its steepest intraday decline since June 4. It depreciated 0.7 percent to $1.6296.

Claims for jobless benefits rose 39,300 to 1.54 million last month, the Office for National Statistics said today. A broader measure of U.K. unemployment climbed 232,000 to 2.26 million in the three months through April, the statistics office said. The Confederation of British Industry expects the jobless total to peak in the second quarter of 2010 at 3.03 million.

If you review the day to day news that pours from Bloomberg and Reuters, it is apparent that the wild swings seem to gyrate as positive indicators are followed closely by negative indicators. As each 'green shoots' story emerges, another closely follows pointing in the opposite direction. What then appears to follow is a wild swing in sentiment. However, the underlying trajectory of the OECD economies continues in a downwards direction.....making a mockery of each swing to illusory safety.

Fiscal Responsibility?

Perhaps the Bank of England has recognised that it can only prop up the bond market for so long. In a recent speech, the governor has made an explicit call for fiscal responsibility from the government.

The news follows on the heels of the G8 conference, in which exit strategies from stimuli were a subject of debate:

June 15 (Bloomberg) -- Group of Eight finance ministers began drawing up contingency plans for rolling back budget deficits and bank bailouts as the economy shows signs of recovery and investors start worrying about inflation.

Officials meeting in Lecce, Italy, over the weekend said it’s prudent to consider what exit strategies to deploy once global growth is secured and asked the International Monetary Fund to examine how to do so without reigniting the two-year crisis. At the same time, they said it’s premature to rein back more than $2 trillion in stimulus packages.

“Growth should remain the principal focus of policy,” U.S. Treasury Secretary Timothy Geithner said after the meeting ended on June 13. “It is too early to shift toward policy restraint.”

Policy makers trod a fine line in the knowledge that withdrawing stimulus measures too soon could choke the recovery before it starts, and allowing them to last too long might push up borrowing costs. They are also trying to reassure markets after the yield on the 10-year U.S. Treasury note rose last week to the highest since October.

“Markets aren’t looking for specific exit strategies now, but want governments to start thinking about them,” said Bill Witherell, chief global economist at Cumberland Advisors Inc. in Vineland, New Jersey, which oversees $1 billion in assets. “They worry that inflation is going to build up if nothing is done to withdraw the stimulus.”

The interesting point in all of this is that there is an admission implicit in this discussion. There is currently no solid plan of how or when it will be possible to reverse the massive measures taken to support the financial system and 'stimulate' the economy.

As an analogy to this we might think of a corporation going to a bank during troubled times to consider further lending. The bank might ask how long and how severe the downturn might be, and demand firm timescales for when and how the company will turn itself around. If sales are low, where will the new sales come from, if costs exceed revenues, how might the differences be resolved, if there are new competitors stealing market share, how might they regain their share? What new products are in the pipeline, when will they come to market, and what will their impact be on revenue?

Many, many posts ago last year I made a comparison between the US economy and the US automotive manufacturers. The comparison still stands, but now with the story of GM as an indicator of the inevitable ending when basic questions can not be answered. The US economy is in the same place as GM was when the first bailout of GM was issued. The answer at that time given by GM was that company would use the money to tide them over until they worked out a plan for the case of governments, they are not even beholden to any timetable on when they need to even put the plan together. They will get around to it at some point in the future.....

That people like the chief economist at Cumberland Advisors accepts this situation is more than a little baffling. However, I must accept that this is the world view of many who are driving markets. If these people were to have reviewed the situation of GM, they would not be looking at long distant economic performance, but the recent record of failure, and how that failure might be turned to success again. However, in the case of the US economy, they seem to see the equivalent of GM in 1950...and imagine that such long past performance would be an assurance of success for GM now.

Returning to the Bank of England, whilst disagreeing with them on so much, it is at least encouraging that they are pressing for answers from government, albeit whilst adding to problems by continuing to print money to support the financial system.

Anchoring goes Mainstream

In a current Telegraph article, it seems that Tom Stevenson may have picked up on my adaptation of Dan Ariely's anchoring theory.

There are many reasons why those decisions are invariably irrational. These heuristics, or psychological biases, are beginning to be unpicked by the new science of behavioural finance.

One is "anchoring", the tendency of people to measure the value of an asset against some wholly irrelevant number. A study of this asked groups of people to estimate the number of doctors in London but only after they had first provided the last four digits of their phone number. People with the highest phone numbers consistently gave higher estimates of the number of doctors. Completely irrational, of course, but no different from fixating on RBS's share price two years ago when assessing whether it is good value now.

You can find my articles in which I discuss anchoring here and here. Of course, Dan Ariely is well known, and this could be coincidence. However, it would be nice to think that the posts on this blog might seep into the mainstream.

Inflation (again)

For regular readers, it will come as no surprise to find that CPI inflation is above expectations, according to a Telegraph article. As expected, the price of imports is now feeding into the prices of goods on the shelves. Apparently, there are something like £10billion worth of price increases on their way, according to a PWC report (no link for this). I have consistently argued that there will be no deflation for this reason.

In a very odd article, the Telegraph a few days ago came up with an alternative index of inflation, in which they proposed the UK was seeing deflation at -10%. On viewing the figures, it is apparent that the key variables are oil, the price of which again can be partly attributed to the £GB and partly to price rises out of the UK's control, and housing costs, which have been directly influenced by interest rates. The reason for publishing such an article, is completely unclear.....there is not even a source for the figures. Meanwhile a Mail article from April tells a story of soaring prices, according to their own index.

The reality is that, the CPI is the key index for the Bank of England, and the long promised deflation against the index has still not materialised. However, this was one of the great justifications for printing money......I guess that they might (at a push) claim the policy is working, but am not sure that they would want to bring attention to the policy in this context, in case it be subject to serious scrutiny.

Note 1: I am hoping to write an article on a fixed fiat currency system, and will try to put the thoughts that have appeared in different posts into a single post. I am not sure that the idea of a fixed currency could work, but my thoughts on the idea are becoming increasingly positive.

Note 2: I am publishing this in a bit of a rush, so I hope that there are no errors. Please feel free to identify any problems.....

Sunday, June 14, 2009

The Battle for Resource...

I have long argued that the big issue underlying the financial and economic crisis is the relationship between labour and the availability of commodities in relation to the increasing supply of labour. At the heart of my thesis is that, where there are constraints on the supply of a commodity, trade becomes a zero sum game (e.g. see post from September 2008, though there are earlier examples).

In a more recent article for Huliq, I outlined the argument in relation to oil:

If we take the example of oil, in 1997 output was around 75 million bpd, and output had only climbed to about 85 million bpd in 2007 (a chart here shows the output - not a good source but the chart is usefully clear and conforms to charts from better sources). What we can see from 1997-2007 is an approximate doubling of the labour force, and only a tiny increase in the output of another key component of economic activity.

This quite literally means that the availability of oil per worker has seen a significant decline. In such a situation, there must be a consequence. If a worker in country A increases their utilisation of oil, then a worker in country B will have less oil available.

It should be noted here that worker in this context is narrowly defined as labour with access to capital, technology and markets, such that the doubling of the labour supply refers to the full entry of, for example, China and India into the world economy. The result of competition for finite resources means that we have entered what I term a period of 'hyper-competition'.

The reason why I am returning to this theme is the following news article from the Times:

The desolate, sun-baked deserts of southwestern Bolivia are poised to become the energy battleground of the 21st century, with China and Japan staking early and aggressive claims in the great lithium land-grab.

Japan, observers say, may have won the first round, but, with its mainstream resource ambitions thwarted on the Rio Tinto deal, China could redouble its efforts to gain a foothold in the salt flats of South America and the all-important technology metals.

And also, from the same paper yesterday, we have another related story:

CHINA is stepping up its race to secure access to global oil reserves with an audacious £4.8 billion bid for Addax Petroleum, a London-listed group with fields in Iraqi Kurdistan and Nigeria.

Sinopec, the Chinese state oil group, is understood to have tabled the indicative offer last week, trumping an earlier bid by the Korean National Oil Corporation.

Addax, which has one of only two operational fields in Kurdistan, has seen interest from would-be buyers increase with the completion of an oil-export pipeline from the region.

Sinopec’s approach is further evidence of China’s determination to use its cash reserves to seize control of the raw materials it needs to sustain its rapid economic growth.

What we are now seeing might be described both figuratively and literally as a huge 'land grab'by China. It is figurative in the broad sense that China is using its massive accumulation of wealth to shop for commodities and commodity companies, and literal in the sense that China is now seeking massive deals on the lease of land for agriculture, and is by far the largest player in a new wave of land lease deals (from the Economist):

It is not just Gulf states that are buying up farms. China secured the right to grow palm oil for biofuel on 2.8m hectares of Congo, which would be the world’s largest palm-oil plantation. It is negotiating to grow biofuels on 2m hectares in Zambia, a country where Chinese farms are said to produce a quarter of the eggs sold in the capital, Lusaka. According to one estimate, 1m Chinese farm labourers will be working in Africa this year, a number one African leader called “catastrophic”.

Returning to my recent article in Huliq, it is possible to see that the great game is now afoot, and that game is one in which the most competitive economies will win:

What we are seeing is a competition for the available supply of resources, and it is quite literally a zero sum game [erroneously written as gain in the original]. In such circumstances, the resources will flow to the labour that utilises the resource in the most cost effective way, and where there is the commensurately high return on capital. In other words, where resources are finite, where there is an increase in labour per unit of commodity, then there is a situation of hyper-competition.

The shape of what we are witnessing is slightly different to the way that I envisaged the competion would play out (at least when I first contemplated the way it would play out). My original vision was that it would be the competitive state of economies that would determine where resources would be allocated. Instead of this, the situation is one in which the countries with the greater financial resources are seeking to lock in natural resources through financial fire power.

This approach, in particular the growing activity of China, chimes with two other themes that have emerged in the blog. The first is the ambition of China to replace the $US with the RMB, and the second in the diversification of China's reserves away from $US assets into commodities. In a speculative article on how China might ditch the $US, I wrote the following:

As they move out of $US they would likely buy as many precious metals as possible without driving the price too high, as well as buying into emerging market, European and Japanese bonds. In doing so, they will be taking risks but with the benefit that they will be positioning the RMB as the next reserve currency. Furthermore, it is no secret that China has been trying to buy into various commodity companies (or natural resource companies), such as the ongoing saga of the Chinalco purchase of Rio Tinto or their wider expansion of investments in this sector.

I have been tracking the emergence of the RMB as a world currency over many posts. A strategy of locking more and more resources into Chinese hands would support such a strategy, with potential to influence a move to pricing of commodities in RMB. It is apparent that China is stepping up their determination and will to secure ever more sources of resource.

I have described this as a 'great game', but perhaps game is not the right word. When countries start to compete for resources in this way, one of the outcomes might be climbing tensions between the players. As yet, those tensions are not too heated, but there is worrying potential for this to be the future direction. There are indications that China sees this potential in their development of a 'blue water' navy (e.g. see here), which will allow them to project their power more broadly.

At the heart of the problem is that the massive increase in supply of labour has indeed created a zero sum game. As long as there is potential for shortages of key commodities, the world will remain in a situation of hyper-competition. The worrying part of all of the current activity is that the nature of the competition is perhaps fiercer than I imagined.

Note 1:

I have commented at the end of my recent article on the bond smuggling in Italy. Having rooted around on the subject, I came accross an article on ABC news which reports a massive forgery operation in US bonds, dated February of this year. The forgery includes the large denominations found in the hands of the smugglers. I found the article in a comment (sorry, I forget where), and it appears from the article that the bonds are likely forged. Lemming asks how this squares with the smugglers being Japanese, as the forgery operation is in the Philippines. At this stage, I am not sure.

However, as I emphasised in the article, this was all a little too 'James Bond'. As such, if a rational explanation emerges, I go with that. In this case, there is the underlying idiocy that anyone might have thought that they could pass off such large denominations as genuine. I forget who now, but I think one commentator on the blog pointed to the idea that we should never underestimate stupidity. It seems that idiocy is frighteningly common.....

The alternative is that the bonds are real, and that the forgery in the Philippines is just a coincidence. This coincidence is best measured against the coincidences of the recent Japanese unbridled support for the $US, and the location of the G8 in Italy. From my point of view, the forgery looks more particular now that it is no longer the North Koreans in the frame (as they would not have been likely to have undertaken such a poorly laid plan).

One puzzling aspect does remain, however. Why have the media not picked up on this story? It really is a great story, whatever the status of the bonds.....

Note 2: Lord Keynes - thanks for the link to Mises on the fixed money supply. Interesting reading....

Note 3: Lemming - you are right about China, but their industry is currently 'facing' towards supply to the West. As such, any change to domestic consumption will require possibly painful restructuring...

Friday, June 12, 2009

Japan Secretly Selling Smuggled $US bonds?

I need to be very clear before writing this post that it is highly speculative, if not fanciful. As such, I would caution readers to view the post as some wild speculation.

The cause of the speculation is an article on Bloomberg, as follows:
June 12 (Bloomberg) -- Japan is investigating reports two of its citizens were detained in Italy after allegedly attempting to take $134 billion worth of U.S. bonds over the border into Switzerland.

“Italian authorities are in the midst of the investigation, and haven’t yet confirmed the details, including whether they are Japanese citizens or not,” Takeshi Akamatsu, a spokesman for the Ministry of Foreign Affairs, said by telephone today in Tokyo. “Our consulate in Milan is continuing efforts to confirm the reports.”

An official at the Consulate General of Japan in Milan, who only gave his name as Ikeda, said it still hasn’t been confirmed that the individuals are Japanese. “We are in contact with the Italian Financial Police and the Italian Public Prosecutor’s Office,” Ikeda said by phone today.

The Asahi newspaper reported today Italian police found bond certificates concealed in the bottom of luggage the two individuals were carrying on a train that stopped in Chiasso, near the Swiss border, on June 3.

The undeclared bonds included 249 certificates worth $500 million each, the Asahi said, citing Italian authorities. The case was reported earlier in Italian newspapers Il Giornale and La Repubblica and by the Ansa news agency.

If the securities are found to be genuine, the individuals could be fined 40 percent of the total value for attempting to take them out of the country without declaring them, the Asahi said.

The Italian embassy in Tokyo was unable to confirm the Asahi report.

I placed a comment against my last post on first reading the story, in which I speculated on what might be going on, and suggested the following:
If the bonds are genuine (unconfirmed), the big question is who might have such a large sum? The only logical answer is a nation state, and with the individuals being Japanese, that would suggest Japan.

The second question is why they are smuggling them?

I have been speculating on this subject and have come up with some wild scenarios. I would like to emphasise that these are 'wild'.

However, the best answer that I could find is that the Japanese government wants to dump US bonds on the quiet. As such, they sought to transfer them to Switzerland, where they could then sell them, and disguise the point of origin of the selling.

In doing so they would avoid spooking the markets by making a Japanese sell-off of US bonds visible. As a large holder of US debt, any significant sell-off would potentially commence a $US rout.

This might make sense, but why would the smugglers go via Italy?

This is all wild, wild speculation, and it is still unconfirmed that the bonds are genuine.

However, if the bonds are genuine, I can see no other logical explanation. In the (unlikely) event that such speculation were correct, it really would be the start of the end of the $US.
I had picked up the article about the smuggling in my regular trawl through the financial news. A short while after writing the comment, I found an article reporting on the G8 meeting.....which is located in Italy.

This means that senior Japanese financial officials are in Italy, and these are the very people who might wish to undertake the quiet dumping of bonds. I was unable to find out who was attending from Japan, but it is a certainty that it would include all the necessary key players necessary for this kind of undertaking.

Regarding the matter of whether the bonds are genuine, this from the Asia News:

Italian authorities have not yet determined whether they are real or fake, but if they are real the attempt to take them into Switzerland would be the largest financial smuggling operation in history; if they are fake, the matter would be even more mind-boggling because the quality of the counterfeit work is such that the fake bonds are undistinguishable from the real ones.

What caught the policemen’s attention were the billion dollar securities. Such a large denomination is not available in regular financial and banking markets. Only states handle such amounts of money.

Please note that these size of securities are only used in state to state transactions. The problem then arises as to why any counterfeiter might forge such instruments? It is not like forging a $US 100 bill, where it might pass off in a shop. In this case, if you try to use this kind of forgery, then whoever accepts it is going to want to know 100% for certain that it is genuine. They will certainly want to know a lot about it, and no forgery is therefore likely to be of any value whatsoever. As such, why forge such an instrument?

In the meantime, the Japanese have suddenly started talking up the prospects for the $US:

June 12 (Bloomberg) -- Japanese Finance Minister Kaoru Yosano said his government is confident about the outlook for U.S. Treasuries, signaling the second-biggest foreign holder of the securities will keep buying them amid record sales.

“We have complete trust in the fact that the U.S. views its strong-dollar policy as fundamental,” Yosano, 70, said in an interview in Tokyo on June 10 before attending a Group of Eight meeting of finance ministers starting today in Italy. “So our trust in U.S. Treasuries is absolutely unshakable.”

It could be argued that this public statement contradicts any secret selling of US bonds. However, if you are about to dump a large amount of US bonds into the market, the best way to cushion the impact might be to boost the value by suggesting that there is a strong buyer in the market. The fact that the alleged buyer is in fact a seller will not be known until much later. In the meantime, Japan gets brownie points from the US administration.

In all of this, it should be remembered that Japan is the world's second largest holder of US treasuries. Any public selling by Japan would therefore result in a $US crash, and would wipe out the value of much of the value of Japanese reserves. Back in January, I was discussing the $US dilemma for the major creditors of the US as follows:
The trouble is that, with so many countries holding these $US reserves, most of whom have their own economic problems, it is likely that everyone is having the same thoughts, and confronting similar problems. What you have is a situation in which there is something like a Mexican stand-off. As soon as one starts selling, then everybody must start selling. They are all, at the same time, terrified of selling, because in doing so, they destroy the value of what they are selling. It is a time bomb just waiting to go off.
Selling the bonds without appearing to sell them would be an excellent solution to the standoff. On the one hand you can sound positive, continue to make purchases, reassure the market, and meanwhile offload ever more of the dangerous (toxic) assets through the back door.

Normally, such massive amounts of assets would be impossible to move without regulators noticing, and without alarm bells going off. However, if it is the government and central bank acting, there is no reason why the alarm bells might not be switched off.

For the moment, let's assume that this wild speculation about the story is true. If it is the case that the men who have been arrested are acting in order to commence a sell of US bonds, it is quite likely that they will either be government finance officials, or members of the Naicho (Japanese intelligence service - reports to the prime minister). If it is the former, then a link can be made to the government but, if the latter, then it will be difficult to ever establish a connection.

In the meantime, how will the US and Japan handle the situation, if the bonds are real?

The important point is that it is not in the interest of either country to admit to the operation. For the US, if they point the finger at Japan, they will need to admit that one of the largest holders of bonds is dumping them, and this will cause a run on the $US. For the Japanese, their interest in not revealing what they have been up to is self-evident. If the bonds are genuine, it will need one or both of the governments to confirm that they are genuine. It is in the interests of both governments to deny that this is the case. The most likely story will be that it is a North Korean counterfeiting operation, as they are well known for this kind of activity.

Meanwhile, the Italians will be unable to prove the case one way or another. Without confirmation of the authenticity of the bonds from the US or Japan, how might they establish the truth one way or another? In addition, it is unlikely that the Italians would want to upset the US by pushing the matter.

In short, whether the bonds are genuine or not, I would be very surprised to see that this story goes much further.

The underlying story, if this wild speculation were to be true, is that the Japanese are dumping the $US. If this were the case, then the $US is finished, and we can expect to see it collapse in the very, very near future.

As I have said, this is all wild speculation. However, it does have a kind of painful logic. If the Japanese are, like the Chinese, increasingly dubious about holding $US reserves, then this would be a way of unloading the position whilst gaining the maximum value from the holdings. I have long argued on this post that $US bonds are largely worthless, the Chinese suspect that this may be the case, so why not the Japanese? As another example, Peter Schiff is discussing the absurdity of Japan having faith in the $US.

Once again, I can only emphasise that what I am writing is highly speculative. I have no evidence either way, but can see no other explanation of this rather extraordinary story. If anyone has a less fanciful explanation, then I will welcome comments. This is all very odd, and I do feel that my 'take' on it is quite questionable. It really is moving into the realms of James Bond movies....questions to answer, in particular are...; Is there any reason why anyone might want to forge the bonds? Who, and how might they pass them off? What mechanism might they use to sell the forgeries?

Over to you, the readers, for alternative considerations....

Thursday, June 11, 2009

Inflation, Deflation and Money

The post that follows is a slight change of direction. I started one post (see below) and found the question of money was nagging at me. In particular, there were some interesting comments on the subject of money after my last post.

The first point I would like to consider is output and money. The measure of output is a bit of a tricky problem when looking at an economy. In particular, if the measure is made in currency x then, if there is inflation of currency x, it appears that output is actually increasing by this measure.

If we imagine that factory x produces 100 units a day, and there is £100 available to purchase these units, we have 1 unit = £1. If we increase the supply of money without increasing output, then we will have more money chasing the output but still no more output. This is inflation. If we then record output in £, we will measure an increase in output. However, this is not the whole story....

MattinShanghai, a regular commentator, has raised the issue of inflation and money supply as follows:
You've talked a lot about the dangers of hyperinflation resulting from the uncontrolled printing of money by central governments. I have to admit that I'm quite confused about the whole subject, and reading numerous opinions published both by "experts" and amateurs, does not help. On the one hand, there are voices saying that we are on the road to Wiemar-style hyper inflation. Others say that the destruction of paper wealth in real estate and the stock markets, collapse of the markets for securities which underwrote many of issued loans, bankruptcy of financial institutions etc. have "shrunk" the money supply so much, that no amount of central bank money printing can fill the "black hole" and avert deflation.

I suppose that my natural reaction in the face of this is simply to suspend judgment and adopt a "wait and see" position. But I also do seem to have some fundamental problems with supposedly "uncontroversial" aspects (at least in mainstream economics) of money theory. I wonder if you or any of your readers can enlighten me on the subject and point out where I'm wrong.
Matt goes on to offer a critique of mainstream economic formulae, and highlights the absurdity of the fudge factors in the formulae. I find myself in agreement with his critiques.

I have previously discussed at some length the nature of money. In particular, I have argued that money is what 'we' collectively believe it to be. Although Matt has suggested that he disagrees with me on what money might be, I find that he hits the nail on the head in the following point:
But it gets worse. Take the money supply 'M'. What is it? Is it just the sum of notes and coins in circulation? What about money stored in jars buried in gardens? Does this count? How about credit card limits? Savings accounts? Private debts? Cheques "in the post"? Questions and more questions...
What I have argued is that money is 'money' when we believe it to be money. When a shop accepts a credit card, and a person generates a debt on the card, the shop is accepting the payment as real money. They believe that the credit card will provide them with x number of electronic currency units that they will be able to exchange for goods and services in the future.

If I am a worker, and I am short of cash, I might exchange my labour to mow your lawn at some future point in time in exchange for your buying me a beer. I might write an IOU note, promising that I will, within a week, spend an hour mowing your lawn. In turn, you might transfer that IOU to another person in exchange for some cakes that they have baked, and I will have to mow that person's lawn for one hour instead.

The critical part of these two very different transactions is that they must be based upon a belief that the currency in question will be repaid in goods or services in the future. If I am actually lazy and unreliable, and therefore unlikely to meet my promise of lawn mowing, then it is unlikely that my IOU would get very far as a currency for exchange. Quite simply, people will not believe that they will be paid.

I have previously given another example; the famine currency. If we are in a situation of famine, and there is a limited supply of food still available, then the idea of what money is will shift. If I offer my services to you in return for payment, and I am on the point of starvation, I will want to be paid in food. You might offer me piles of gold bullion but, if that gold bullion can not be exchanged for food, then I will reject that as a currency, and only accept the food. Gold can not buy what I need, and therefore ceases to have meaning as a currency. The same might be said of any medium of exchange that might be offered to me, if it ceases to allow me to buy food.

Money is therefore a matter of perception. In a previous example, I have pointed to the lines outside of Northern Rock. The people in those lines wanted bits of paper with the head of the queen printed on them, not IOUs provided by Northern Rock. Northern Rock held large numbers of IOUs, but individuals refused to believe in them. They no longer believed that the IOUs would do the equivalent of purchasing one hour of lawn mowing.

It is when we see money in these simple terms that the arguments about deflation make sense, but it is also possible to see how they do not finally add up.

Banks have been passing on the savings of people (value of their labour) to provide credit in return for IOUs. Those people who have provided the IOUs have promised to apportion part of their future labour in return for the money. The trouble is that there was so much money pouring into countries like the UK from overseas, that prices of assets such as houses rose. As such, there was a boom in the issuance of IOUs which started to exceed the ability to repay the IOUs, or at least impossible without a significant fall in consumption of those issuing the IOUs.

In real terms, a Japanese worker has provided a car to a UK consumer. The UK consumer has promised to repay the labour of the Japanese labour with an equivalent value of labour. For the moment we will leave aside the difficult question of how labour might be valued. In our lawn mowing example it was a beer for an hour of lawn mowing, but it might equally have been an hour of building a shed. The important part is that there is an expectation that the returned labour will have a value that is worthwhile to the recipient.

The problem that has arisen is that the Japanese labour has been exchanging their labour for IOUs, but the labour in receipt of the IOUs is unwilling to return an equivalent value of goods or services. The credit crisis is simply a recognition of this fact.

In other words, huge amount of the IOUs are no longer recognised as money, or at best are seen as debased money.

At first blush, this appears to support the deflationary argument. It appears that the money supply in the countries that were recipients of the labour of countries like Japan, now have less money. After all, individual IOUs have ceased to be an accepted unit of money. There is a lack of belief that the individuals can repay in an appropriate value of goods or services.

However, instead of issuing credit to individuals, the new method is to extend ever more credit to governments. As such, instead of lots of individual IOUs being generated, there is a single huge IOU being developed as a replacement. Just as with the individual IOUs, there is an implicit promise to return the value of the labour at some future date. In other words, even as one form of money is being destroyed, more money is being created as a replacement. Of even greater concern is that the previous money that was supposed to have been destroyed, has not in fact been destroyed. It is being converted into the new form of money - government IOUs (of course, government debt was expanding even before the credit crisis, but I hope that you understand the point).

Now, if we return to the beer and lawn mowing example, one of the key features of the transaction is that I have consumed the beer. Now if we imagine that I am not just issuing the IOU to you, but making similar deals all around the town, I am getting extremely drunk, and having a very good time this week. However, all the time I am drinking, I am in a situation where I am promising greater and greater amounts of labour to people all over the town. In fact, I am promising that next week I will undertake 100 hours of lawn mowing. In other words, for the consumption of this moment in time, I am going to have to have a very tough week next week. In addition, even if I do all 100 hours of mowing, I will have to use all of that labour for repayment, and will not be able to exchange my labour for beer during that week.

I wake up on Monday morning with an almighty hangover, and can not face the job of the mowing. As you would expect, the creditors of my beer drinking binge are none too happy when I fail to show up for work. The problem they face is that the beer has now been consumed, and there is no way to get it back.

Unlike in the analogy that I have provided, there is another important consideration. In the real world, governments are now borrowing more, and promising to repay the debts that were accumulated during the binge. As a result of this, the creditors are willing to continue to extend credit. The important point about government is that they can, through the taxation system, enforce less consumption upon people, and indirectly force them to work more. In other words, they are in a position where they can allow me to drink more beer now, but make me work the necessary 100 hours next week. It is on this basis that creditors continue to lend.

As such, as the situation exists, there is more money flooding into the economy, and ever more IOUs being issued in return. In other words, the money supply continues to increase, and the form of money is IOUs.

Now if we were just to imagine that Japan was the only creditor, then we can see that we have a growing debt of labour to Japan. That debt translates into a future commitment to provide goods and services of 'x' value to Japan. If we then think of this in practical terms, each gilt (for example) that is issued is a call on the output of the UK economy. If we then see no increase in the output of the economy, we can see a greater amount of labour owed per unit of labour. If each unit of labour is producing one unit, but we keep issuing ever more IOUs against that one unit, then it becomes less and less possible for that labour to service the debt. What you have is more and more IOUs making demands on the one unit of output. That is inflation.

In addition to this, we have the confounding factor of what I would call 'traditional' money. This is the units of £GB, and I call this traditional on the basis that this is what the people who lined up at Northern Rock believed to be money.

As regular readers will be aware, the Bank of England is creating more of this traditional money, but is doing so without any commensurate increase in output from the economy. This means that, in addition to more IOU money being issued, there is more traditional money being issued. This is, in effect, a double whammy. Both the issuance of traditional money and the issuance of IOUs represent a commitment of future labour in return for the credit now. They are both being expanded at a time when the output from labour is not expanding.

The one factor I have not included in the example of the real world is time. In the case of the lawn mowing, I specified 'next week'. As many are aware, government debt is issued over a range of time periods, such that in different periods, different quantities of debt are due for repayment. I have not included time, as there is currently no proposed time frame for government to start repaying the overall burden of debt. Rolling over existing debt, whilst accumulating more debt, means that the time frames are moot points.

The only solution to these problems are as follows:
  1. There is a massive reduction in consumption, and an expansion in working hours. This would allow an increase in output available for repayment of debt. This is deemed as politically unacceptable.
  2. The government takes the credit offered, and later repays it with less value than was implicit in the original bargain. This is the process of inflation, in which the government allows ever more issue of money whilst not demanding that labour reduces consumption and increases hours to the necessary level for repayment. Under these circumstances, more money will be chasing the existing output, such that the value of all UK money is debased. Inflation.
  3. The government, by magic, engineers a productivity miracle such that output exceeds the increase in the amount of money.
The current policy is item number two, but with number 3 as the excuse for greater borrowing.

If we think of money in the terms that I have discussed, it becomes apparent that the reality of money is contingent on the belief that it will have a future value in goods or services. In issuing IOUs, governments are increasing the money supply, as they are increasing the promise of future goods and services. The problem that arises is that they are being dishonest, as there is no way that they intend to repay the IOUs in full.

They are like me drinking too much beer, refusing to work the 100 hours I have promised, and only accepting that I will do 39 hours of lawn mowing. Not only do I refuse to do the 100 hours, I also insist that many of the 39 hours I undertake is used to purchase more beer. In other words, I am cheating my creditors. My currency of IOUs is debased, and is inflated.

When I have discussed money on previous occasions it has always been highly contentious. I fully expect that there will be further debate on this post, and will try to find time to address any of the points. In the meantime, I would like to just highlight the key points of the arguments.
  1. Money is a belief in anything that is seen as a medium of exchange for the future value of labour (i.e. goods and services). Money is only money so long as people believe that it might be exchanged for goods and services that they need/want.
  2. The value of money is determined by the total supply of money, measured as a division of labour output divided by the units of money in supply, over time in which the money might be utilised. e.g. the timescale of IOUs is a factor in the value of money, as in the case of the lawn mowing. Time and value is contingent on the amount of money calling upon labour output in a given period.
The last point is complex, and I hope it makes sense (I had to re-read it myself and I'm still not certain). However, the principles I am outlining are my best explanation of money, and why there must be inflation.

This leaves the timing of inflation in relation to the two points above. The money supply, according to my understanding of money, is increasing. The question that remains is how that increase might eventually translate into demand for the value of labour, at what time. This is a question that is, quite frankly, beyond me. However, I hope that, from this explanation, it is apparent why inflation might be delayed for some time. My suspicion is that inflation will be prompted through a collapse in belief in UK issued money, rather than a progressive increase in inflation as debt falls due.

Of one thing I am certain. More money is being issued than can be supported by output. Short of a miracle in productivity, I see no prospects for anything other than hyper-inflation.

Below is the original article that I was going to write. Somehow, thinking about the points below led me into the discussion of money. The post below may make more sense in light of the discussion of money.

More Green Shoots.....

There has been yet more talk recently of economic recovery in the UK, and the £GB has strengthened as a result. This is a perfect illustration of the point that I made in my recent TFR article - that any good or bad news will see wild swings in markets.

In this case, the good news has been provided by an economic think tank, the National Institute of Economic and Social Research (NIESR). The Telegraph reports their findings:

The NIESR figures were the latest sign that parts of the economy have been staging a modest recovery, and coincided with data from the Office for National Statistics, which showed that UK manufacturing output increased by 0.2pc in March.

It was slightly better than economists expected and represented the second monthly rise in a row after the ONS revised up March's figure from a fall of 0.1pc to an increase of 0.2pc.

There has long been talk of a restocking of inventory, and it is likely that this is the process in action (assuming the figures are accurate). However, there is something faintly absurd in such figures, and this is illustrated in the following quote:
Meanwhile, governments across the world have seen their budget deficits explode as they seek to cushion their economies from the crisis. In the US and the UK, the fiscal deterioration is especially severe - with deficits this year around 12pc of GDP each and no credible medium term plans for balancing their budgets.
What we have here are two figures that simply do not add up to anything. On the one hand we have an explosion of fiscal deficits to around 12pc of GDP, and on the other hand we have a minuscule uptick in a couple of indices. In other words, the situation is so dire that the monstrous pouring of money by the government is still leaving the economy in a situation where it is barely into positive territory on a couple of indicators. The real question here is to ask what this indicators would be showing if the debt spigot were to shut down.

It is at that point that we would start to see the underlying output of wealth creation, in contrast to debt fuelled activity.

It is a long time since I discussed the essential reality of government borrowing, and borrowing in general. For every £1 of borrowing now for consumption there will be £1 less to be spent on consumption in the future. If I have a credit card and I spend £25 on a meal today, next month I will have £25 less (+ interest) to spend on a meal next month. The only way that this may not be the case is if my earnings in the future outstrip the debt, in which case I might still have £25 to spend on a meal, instead of £25 + my increased earnings. Even in this case, my consumption now is restricting my future consumption.

In the case of government, if they borrow to spend money on a nurse this year, there will in the future be the same amount unavailable for spending in the future. In other words, one nurse now, costs one nurse (+interest) in the future. Again, the same provisos apply as with the credit card debt.

The question that then arises is to ask how earnings might increase such that they outstrip borrowing. The only way that this can happen is if there is significant investment in the productive parts of the economy, such that productivity rises. This applies to directly to the example of personal debt, and indirectly to government debt. As a worker, I need to achieve greater increases in my income if I am to be able to continue to spend at the same level as I am now, and these increases can only be sustained through greater output in my area of work. If not, at some point in the future, my spending must decline. In the case of government, it is possible to continue with the same spending only if I tax more from the economy, but this is replacement of private spending with government spending. This is neutral for the economy overall in terms of total consumption.

This discussion does not consider an ongoing increase in borrowing, which appears to be the current solution. In this case, all that is happening is that there is the build-up of a larger future contraction in consumption.

Within this scenario is a deep problem. If the government and individuals continue to borrow for consumption now, then there is less money available for investment into productive output. If the government borrows £40,000 today to pay for a nurse (figure guessed at for illustration), then there is exactly £40,000 less for investment into future increases in output of new wealth (i.e. there is less money available for investment into business). The situation is, of course, complicated by the problem that finance is global, such that an individual economy might have finance for both consumption and investment, but the problem in aggregate remains accross the world economy. Bearing in mind the explosion in government borrowing accross the OECD this presents a problem.

What we are looking at is a situation in which there must be a significant future increase in output per person, a massive growth in productivity, if there is not to be a future contraction. However, there is no prospect or indication of such a productivity miracle on the horizon. Whilst it is impossible to deny that such a miracle is possible, it currently looks improbable. In the meantime, governments are competing for finite capital that might make such a growth in productivity possible, thereby making it less probable.

Returning to the slight uptick in output reported in the Telegraph, what we are seeing is the fruits of debt fuelled consumption, not increases in output that might be sustained in the medium term. This is a best case scenario, but it is just as likely that there will be a tail off in the output once inventories are rebuilt.

At this point I was going to discuss inflation, and at this point I moved to the other article. The point I was trying to explain is that it is quite possible that inflation will offer the illusion of increased output. I suspect that, it is quite possible we will start to see inflationary effects appearing in the economy, and that these might be mistaken for recovery.

As such, I am increasingly concerned that there will be a relaxation of governments as a result of thinking that they have solved the crisis. The problem is that, instead of solving the crisis, they are simply deepening the crisis.

Note 1: The discussion of the Austrian school proved to be very interesting. I am happy to see that I could find some common ground with Lord Keynes on the point that commodity currencies are as subject to debasement by government as fiat currencies.

One of the interesting points in the discussion was the role of ideology in forming views on economics. Regular readers may have noted that I pick 'n mix from various sources, wherever I see a point of interest. As such, I value the Austrian school's critique of Keynesian solutions, but disagree with their approach on many points. I am endlessly impressed with Adam Smith, but still believe that trade can be a zero sum game and so forth. In other words, I do not subscribe to a particular ideology, and am not bound by any particular school of thought.

Whilst having a libertarian streak, in that I mistrust government, I still see a role for government in many areas, such as healthcare, or ensuring legal frameworks operate fairly. I simply believe that power should, as far as possible, not be concentrated. As such, wherever possible government should be minimised and powers dispersed.

However, I would hope that the balance of my personal approach is best expressed in the articles on reform. I am not sure that the ideas would fit neatly into any ideology.

Note 2: A long post, but I hope that it proves to be interesting.