Even the most innocent novel can give its reader a fresh perspective on the economy during the author’s time. Economic writings and economic conditions often inspired great writers who, in turn, allowed us to contemplate either a glimpse or a detailed picture of economic reality. Stendhal was influenced by Malthus, Flaubert by Bastiat, and Ayn Rand by Mises. Other novelists faithfully described the economic times of their lives. Émile Zola, for instance, brilliantly accounts for the French 1882 financial crisis in his novel L’Argent (1891) and unconsciously exhibits the evils of fractional reserve banking.
Just as Zola’s L’Argent, so too F. Scott Fitzgerald’s The Great Gatsby (1925) is a product of the business cycle. Some have interpreted Fitzgerald’s novel as an indictment against capitalism. It is not. It has been said that Gatsby is a product of alcohol prohibition, but Gatsby is also the unfortunate product of the Federal Reserve’s expansionist monetary policy. The “constant flicker” of the American life described by Fitzgerald in his celebrated novel is no less than the artificial boom driven by the Fed during the roaring twenties.
Inequality and the Fed during the Twenties
The Franco-Irish economist Richard Cantillon was among the first to notice the redistributive effects of monetary creation. Cantillon observed that the first to receive the newly created money saw their incomes rise whereas the last to receive the newly created money saw their purchasing power decline as consumer price inflation came about.
Under modern central banking, money is created and injected into the economy through credit on financial markets. Thus, the economics of Cantillon effects tells us that financial institutions benefit disproportionately from money creation, since they can purchase more goods, services, and assets for still relatively low prices.
One of the most visible consequences of this growth of financial markets triggered by monetary expansion is asset price inflation. Increases in asset prices will mainly benefit the wealthy for several reasons. First, the wealthy tend to own more financial assets than the poor in proportion to income. As the wealthy’s net worth increases, securities with continuously rising prices can be used as collateral for new loan requests. Second, it is easier for the richest individuals to contract debt in order to buy financial assets that can be sold later at a profit. Since credit-easing lowers the interest rate and therefore funding costs, the profits made by selling inflated assets bought on credit will be even greater. Finally, asset price inflation coming with the growth of financial markets will benefit the workers, managers, traders, etc., in the financial sector.
Not surprisingly, the development of ostentatious wealth and extreme inequality is one of the main themes in The Great Gatsby — which was published and written during the boom that would finally lead to the Great Depression. In his bestseller on the causes of the “Great Crash” of 1929 and the subsequent Great Depression in the United States, John K. Galbraith mentions “the bad distribution of income” as the first of “five weaknesses which seem to have had an especially intimate bearing on the ensuing disaster.” The cause of this rising inequality is to be found in asset price inflation.
The responsibility of the Fed in the asset price bubble of the 1920s cannot be doubted. Indeed, as late as 1927, Benjamin Strong, who was then governor of the Fed, told the French economist Charles Rist that he was going to give “a little coup de whiskey to the stock market.” Similarly, the former chairman of the Fed, Marriner S. Eccles, points to the rising inequality financed by credit expansion during the 1920s, when, “as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.”
Money in The Great Gatsby is either inherited or derives from the mysteries of high finance or comes from crime or is made on the sports field. Involuntarily, Fitzgerald unfolds the Cantillon effect before our eyes. Indeed, the artificially stimulated financial sector, Fitzgerald shows, creates a distinctive geography and urban space. Whereas Manhattan and Long Island benefit from the redistributive effects of money production by the Fed and the Wall Street banks, the rest of America suffers from them. Thus, in the first chapter of the book, Nick Carraway explains that “Instead of being the warm center of the world, the Middle West now seemed like the ragged edge of the universe — so I decided to go East and learn the bond business.” Under central banking, money is first of all where it is artificially produced rather than in the hands of the most talented entrepreneurs. Nick followed the money.
Easy Money and Consumerism
The Great Gatsby describes a society that had gone beyond industrialism to become driven by leisure and consumption. But this too was at least partially caused by the Fed’s policies. As Dr. Guido Hülsmann writes in The Ethics of Money Production (p.187): “The spiritual dimension of these inflation-induced habits seems obvious. Money and financial questions come to play an exaggerated role in the life of man. Inflation makes society materialistic.”
No surprise then that the romance between Gatsby and Daisy is fashioned by materialistic concerns. Daisy’s love for Gatsby is conditioned by his great wealth. Daisy’s emotions are “materialistic”:
Suddenly, with a strained sound, Daisy bent her head into the shirts and began to cry stormily.
“They’re such beautiful shirts,” she sobbed, her voice muffled in the thick folds. “It makes me sad because I’ve never seen such — such beautiful shirts before.”
Consumerism is a function of monetary inflation because easy money policies create the illusion of wealth and thus lead individuals to consume more than they would otherwise. Because consumption increases, the capital stock will decline and society will ultimately be poorer than it would have been. This naturally leads us to depict the cultural consequences of easy money which are so visible in The Great Gatsby.
The Cultural Consequences of Inflation
The cultural effects of inflation have perhaps never been clearer than during the 1920s. As H.L. Mencken writes in 1925 in his review of The Great Gatsby, “To find a parallel for the grossness and debauchery that now reign in New York one must go back to the Constantinople of Basil I.” Mencken then adds with typical wit and gusto:
The thing that chiefly interests the basic Fitzgerald is still the florid show of modern American life — and especially the devil’s dance that goes on at the top. He is unconcerned about the sweatings and sufferings of the nether herd; what engrosses him is the high carnival of those who have too much money to spend, and too much time for the spending of it. Their idiotic pursuit of sensation, their almost incredible stupidity and triviality, their glittering swinishness — these are the things that go into his notebook.
By meddling with money, the Fed created an illusion of wealth and contributed to the creation of an all-pervasive world of illusion. It is Paul Cantor, that patron saint of Austrian literary criticism, who has noticed the link between inflation and the distortion of reality. Under fiat money, reality is confused with illusion and inauthenticity becomes a prevalent trait among the people. As Paul Cantor writes:
In a paper money economy, one does not see gold anymore, but the currency gives the illusion of the presence of wealth. The increasingly mediated character of the modern economy, especially the development of sophisticated financial instruments, allows the government to deceive its people about the nature of its monetary policy. When a government tries to clip coins or debase a metal currency, the results are readily apparent to most people. By contrast, the financial inter-mediation involved in modern central banking systems helps to shroud monetary conditions in mystery.
This inauthenticity of the characters in The Great Gatsby is obvious. From the beginning, everyone is speculating about Gatsby’s true identity. “Somebody told me they thought he killed a man once” says one; “it’s more that he was a German spy during the war” answers another. Gatsby himself lies about the fact that he was educated at Oxford. Worse, Daisy’s love for Gatsby is revealed to be phony as she finally realizes that her allegiance is with her husband Tom.
For the reader who knows his monetary history, nothing is clearer in The Great Gatsby than the cultural decline for which the artificial inflation of the money supply is responsible. Central banking, today as in the 1920s, led formerly good Americans to lie, commit fraud, and desert hard work. As Nick Carraway narrates the first night he goes to Gatsby’s mansion:
I was immediately struck by the number of young Englishmen dotted about, all well dressed, all looking a little hungry, and all talking in low, earnest voices to solid and prosperous Americans. I was sure that they were selling something: bonds or insurance or automobiles. They were at least agonizingly aware of the easy money in the vicinity and convinced that it was theirs for a few words in the right key.
In an inflationary environment, one must dream of becoming an overnight success because the slow steady way of amassing a fortune by working hard simply will not work. Hard-working people are systematically screwed. George Wilson, the garage owner and the figure of the hard-working American is, with Gatsby himself, the great loser of the novel. Not only is his wife Tom Buchanan’s mistress but she ends up dead. In The Great Gatsby, the Cantillon effect holds true even for love and women. Fitzgerald, however, somehow anticipated the bust that inevitably follows the boom. Gatsby dies. Nick returns to the Middle West.
One disappointing aspect of The Great Gatsby is the lack of contrast between the nouveaux riches who got wealthy thanks to fraud and financial speculation and the entrepreneurially talented bourgeoisie. This contrast, for instance, was made much clearer in Émile Zola’s book L’Argent. In Fitzgerald’s world, on the other hand, all the rich people are immoral and disgusting creatures. To this extent, Zola was much more successful, more than 30 years before Fitzgerald, in accounting for the corruption of entrepreneurial values and the debauchery caused by modern finance under fractional reserve banking and central banking.
One reason why Fitzgerald was incapable of elucidating different categories of rich was his insensitive ignorance of the financial sector itself. Contrary to Garet Garett’s novel The Driver (1922) which precisely describes the inner workings of the financial sector, Fitzgerald is sloppy and particularly unknowledgeable when it comes to describing the stock market. Thus, there probably is a germ of truth when Mencken writes that The Great Gatsby is “no more than a glorified anecdote, and not too probable at that.” Nonetheless, the moral decay on display in Fitzgerald’s novel serves, not merely as titillation for the reader, but as an object lesson in the evils of both central banking and prohibition.
Adjunto reseña/reflexión sobre el clásico ya libro del biólogo Jared Diamond, Armas, gérmenes y acero (Debate). Libro en la lista de imprescindibles de Bill Gates o Charlie Munger y que da perspectiva de largo alcance sobre los últimos 13.000 años de nuestra historia que es lo mismo que explicar la lenta, compleja y heterogénea revolución agrícola (domesticación de plantas silvestres y alimentos), donde se sitúa el origen de la escritura, la formación de ciudades y Estados, o la religión. Lectura imprescindible.
Adjunto un breve reflexión sobre el magnífico libro Gulag: la historia de los campos de concentración soviéticos, de Anne Applebaum, premio Pulitzer en 2004, y editado por el sello de Random House Debate que dirige Miguel Aguilar. Applebaum, al igual que uno de sus maestros Richard Pipes (también editado por Debate), destaca la relativamente poco conocida historia de la Revolución Rusa y de los regímenes comunistas en general, a veces incluso idealizada por algunos, y que sin duda no tiene el estigma de otras ideologías como el nazismo o el fascismo pese a que el comunismo ha causado el mismo tipo de sufrimiento, terror y muerte, sino más.
En próximas entregas: La Revolución Rusa, Richard Pipes (Debate, 2016).
Mervyn King is the British Ben Bernanke. An eminent academic economist, who now teaches both at New York University and the London School of Economics, King was from 2003 to 2013 Governor of the Bank of England. In short, he is a very big deal. Remarkably, in The End of Alchemy he frequently sounds like Murray Rothbard.
King identifies a basic problem in the banking system that has again and again led to financial crisis.
“The idea that paper money could replace intrinsically valuable gold and precious metals, and that banks could take secure short-term deposits and transform them into long-term risky investments came into its own with the Industrial Revolution in the eighteenth century. It was both revolutionary and immensely seductive. It was in fact financial alchemy — the creation of extraordinary financial powers that defy reality and common sense. Pursuit of this monetary elixir has brought a series of economic disasters — from hyperinflation to banking collapses.”
How exactly is this alchemy supposed to work?
“People believed in alchemy because, so it was argued, depositors would never all choose to withdraw their money at the same time. If depositors’ requirements to make payments or obtain liquidity were, when averaged over a large number of depositors, a predictable flow, then deposits could provide a reliable source of long-term funding. But if a sizable group of depositors were to withdraw funds at the same time, the bank would be forced either to demand immediate repayment of the loans it had made, … or to default on the claims of depositors.”
Readers of Rothbard’s What Has Government Done to Our Money? will recognize a familiar theme.
Many have sought to salvage the alchemy of banking by resorting to a central bank. By acting as a lender of last resort, a central bank can bail out banks in need of funds to satisfy anxious depositors and thus avert the danger of a bank run. The alchemy of transforming deposits into investments can now proceed.
Though he was one of the world’s leading central bankers, King finds fault with this “solution.” A local bank can be rescued by getting money from the central bank, but the process generates new problems. Thomas Hankey, a nineteenth-century Governor of the Bank of England, pointed out some of these in response to Walter Bagehot, the classic defender of the central bank as the lender of last resort:
[i]f banks came to rely on the Bank of England to bail them out when in difficulty, then they would take excessive risks and abandon “sound principles of banking.” They would run down their liquid assets, relying instead on cheap central bank insurance — and that is exactly what happened before the recent  crisis. The provision of insurance without a proper charge is an incentive to take excessive risks — in modern jargon, it creates “moral hazard.”
Given the dangers of financial alchemy, what should we do about it? Again, King strikes a Rothbardian note. He writes with great sympathy for one hundred percent reserve banking.
Even though the degree of alchemy of the banking system was much less fifty or more years ago than it is today, it is interesting that many of the most distinguished economists of the first half of the twentieth century believed in forcing banks to hold sufficient liquid assets to back 100 percent of their deposits. They recommended ending the system of “fractional reserve banking,” under which banks create deposits to finance risky lending and so have insufficient safe cash reserves to back their deposits.
Like Rothbard, King calls attention to the insights of the nineteenth-century Jacksonian William Leggett. King cites an article of 1834 in which Leggett said:
Let the [current] law be repealed; let a law be substituted, requiring simply that any person entering into banking business shall be required to lodge with some officer designated in the law, real estate, or other approved security, to the full amount of the notes which he might desire to issue.
King may to an extent resemble Rothbard; but unfortunately he is not Rothbard; and alert readers will have caught an important difference between King’s idea of one hundred percent reserve banking and Rothbard’s. King’s notion, unlike Rothbard’s, still allows banks to expand the money supply. The “liquid assets” need not be identical with the deposits: they need only be easily convertible into money should the need arise to do so.
King’s own plan to “end the alchemy” allows for substantial monetary expansion. He calls his idea the “pawnbroker for all seasons (PFAS)” approach. This is a form of “liquidity” insurance. Banks would have to put up in advance as collateral with the central bank some of their assets. This would act as a “form of mandatory insurance so that in the event of a crisis a central bank would be free to lend on terms already agreed.” So long as the insurance had been paid, though, the central bank would still bail the bank out in a crisis by giving it more money. Contrast this with the plan suggested in the quotation from Leggett, in which if a bank could not redeem its notes, depositors could proceed directly against the bank’s assets. This allows no monetary expansion; and Rothbard’s plan is of course more restrictive still.
Having come so close to Rothbard, why does King shrink from the final step? Why does he still allow room for monetary expansion? He fears deflation.
Sharp changes in the balance between the demand for and supply of liquidity can cause havoc in the economy. The key advantage of man-made money is that its supply can be increased or decreased rapidly in response to a sudden change in demand. Such an ability is a virtue, not a vice, of paper or electronic money. … The ability to expand the supply of money in times of crisis is essential to avoid a depression.
But if the demand for liquidity suddenly increases, when the monetary stock is constant, cannot falling prices for goods satisfy the demand? King, here following Keynes, is skeptical. “Wage and price flexibility does help to coordinate plans when all the markets relevant to future decisions exist. But in practice they do not, and in those circumstances cuts in wages and prices may lower incomes without stimulating current demand.” Prices may keep falling indefinitely.
Other possibilities of coordination failure also trouble King, and underlying them is an important argument. Following Frank Knight, he distinguishes between risk and uncertainty.
Risk concerns events, like your house catching fire, where it is possible to define precisely the nature of that future outcome and to assign a probability to the occurrence of the event based on past experience. … Uncertainty, by contrast, concerns events where it is not possible to define, or even imagine, all possible future outcomes, and to which probabilities cannot therefore be assigned.
We live in a world of radical uncertainty, and thus we cannot be sure that relying on market prices to adjust to changes in the demand to hold money suffices to avert catastrophe. It is for this reason that resort to monetary expansion sometimes is needed.
This argument moves altogether too fast. It does not follow from the fact that Knightian uncertainty prevails widely that one must take seriously the possibility that prices and wages would fall indefinitely. In a situation of uncertainty, we cannot, by hypothesis, calculate probabilities; but this does not require that we take outlandish possibilities as likely occurrences that must be averted by the government. Some reason needs to be given for supposing that prices will continue to fall indefinitely. Why would entrepreneurs not be able to correct the situation, without resorting to monetary expansion? We are not faced with a dichotomy between exact mathematical calculation, in the style of an Arrow-Debreu equilibrium, and blind groping in the dark.
King himself acknowledges that in the American depression of 1920 to 1921, no resort to the government was needed.
The striking fact is that throughout the episode there was no active stabilization policy by the government or central bank, and prices moved in a violent fashion. It was, in the words of James Grant, the Wall Street financial journalist and writer, “the depression that cured itself.”
It is encouraging that King cites the Austrian economist James Grant, but he draws from his work an insufficient message. “The key lesson from the experience of 1920–21 is that it is a mistake to think of all recessions as having similar causes and requiring similar remedies.” In view of the manifold invidious consequences, fully acknowledged by King, of government intervention, should we not rather emphasize the need to rely on the unhampered market? King nevertheless merits praise for coming close, in his own way, to many Austrian insights.
Paul Schmelzing is a visiting scholar at the Bank from Harvard University, where he concentrates on 20th century financial history. In this guest post, he looks at the current bond market through the lens of nearly 800 years of economic history.
The economist Eugen von Böhm-Bawerk once opined that “the cultural level of a nation is mirrored by its interest rate: the higher a people’s intelligence and moral strength, the lower the rate of interest”. But as rates reached their lowest level ever in 2016, investors rather worried about the “biggest bond market bubble in history” coming to a violent end. The sharp sell-off in global bonds following the US election seems to confirm their fears. Looking back over eight centuries of data, I find that the 2016 bull market was indeed one of the largest ever recorded. History suggests this reversal will be driven by inflation fundamentals, and leave investors worse off than the 1994 “bond massacre”.
Bond “bull markets” since 1285
Chart 1: The Global risk free rate since 1285
As a contemporary of fin-de-siècle Vienna, Böhm-Bawerk witnessed a period of unprecedented internationalization, deepening trade relations, and technological innovation – associated with the parallel financial phenomena of the expansion of London-based merchant banks, and the growth in global capital mobility(triggering the heyday of the “cash nexus”). At this point, yields on the global “risk free bond” – then British consols – had fallen to an all-time low of 2.48% in 1898 (Chart 1). But not least his own enthusiasm should prove short-lived: soon after his writing, rates entered what Richard Sylla and Sidney Homer later defined as the “first bear bond market”.
Indeed, judging purely by historical precedent, at 36 years, the current bond bull market had been stretched. As chart 2 shows, over 800 years only two previous episodes – the rally at the height of Venetian commercial dominance in the 15th century, and the century following the Peace of Cateau-Cambrésis in 1559 – recorded longer continued risk-free rate compressions. The same is true if we measure the period by average decline in yields per annum, from peak to trough. With 33 bps, only the rallies following the War of the Spanish Succession, and the election of Charles V as Holy Roman Emperor surpass the bond performance since Paul Volcker’s “war on inflation”.
Chart 2: Length and size of bull markets since 1285
Modern bear shock markets, 1925-2016
It thus appears timely to ask about the characteristics of bear bond markets. Since Homer and Sylla’s first bear market, on our count the United States (the current issuer of the global risk-free asset) experienced 12 modern “bond shock” years, during which selloff dynamics cost long-term sovereign bond creditors more than 15% in real price terms.
Aggregating these bear markets (chart 3), we find that, at 6.1% CPI year-on-year on average, “bond shock years” record inflation levels almost double the long-term trend, at 3.1%. Global growth equally is below average, though not in recession territory. Interestingly, during bond bear markets, US federal deficits, with 2.3% of GDP, actually fall slightly below the post-1945 average track record of 2.9%. An increase in the supply of bonds, therefore, seems not decisive to the weakening in price levels.
Chart 3: Macroeconomic outcomes in bear markets
Bond turbulence, however, has traditionally struck investors in different shapes – especially since the time of Homer/Sylla’s first bear market. Below we present three types of modern bear bond case studies to illustrate that – while historically inflation acceleration has been a solid predictor of sharp bond selloffs – some prominent episodes appear less correlated with fundamentals, and can inflict similar levels of losses.
Type 1: The inflation reversal, 1967-1971
The “inflation reversal” leaves bondholders particularly bruised, and is most clearly associated with fundamentals: namely a sharp turnaround in realized consumer price inflation (CPI). This scenario correctly weighs on the minds of today’s reflationists. US bonds lost 36% in real price terms during 1965-1970, slightly outstripping losses during the 20th century’s first bear market (Chart 4). Annual CPI more than tripled in the same timeframe, from 1.6%, to 5.9%. Looser fiscal policies seem to have played only a secondary role in the 1965-70 bond sell-off, though the Vietnam War put some unexpected pressure on the federal budget. The deficit widened from just 0.2% in 1965, to 2.8% three years later – but USTs continued to decline when public finances swung back into positive territory.
Chart 4: The bear market of 1967-71
Type 2: The Sharp Reversal, 1994
The 1994 “bond massacre” has attracted particular attention of late, and represents a second type of reversal, characterized by steep, but short-lived turbulence that is associated more with financial sector leverage and exogenous positioning – rather than macro fundamentals.
After bottoming in the autumn of 1993, US bond market yields started ascending quickly, even amid discount rates on a 30-year low. A rollercoaster performance followed, which saw bond volatility surge to levels not seen since the Volcker inflation fight. However, US bonds were firmly back in bull territory by 1995, adding 18.1% in prices after inflation.
Neither inflation expectations – which peaked at an unexciting 3.4%– nor fiscal policies, which remained on the steady Clinton consolidation path, offer satisfactory explanations for the rout. Though journalistic accounts link the sell-off with the Fed’s February 1994 decision to raise short-term rates, closer investigations suggest a loose correlation at best. As the data proves, volatility in US 10 year bonds started rising in Q3-1993, while official discount rates were only raised in May 1994 – at a time when volatility had almost peaked already (Chart 5).
Chart 5: The “Bond Massacre” of 1994
Evidence from the financial sector rather suggests that the dramatic increase in leveraged bond positions by both US hedge funds and mundane money managers set in motion self-reinforcing liquidations once uncertainty over emerging markets including Turkey, Venezuela, Mexico, and Malaysia – all of which experienced sharp capital flow volatility – put pressure on speculative positions. Against current predispositions, it seems unlikely a sell-off today would trigger only a brief spark in volatility, and soon revert to the secular post-1981 trajectory.
Type 3: The VaR shock, Japan 2003
But as our third type illustrates, bond turbulence can be highly discriminatory across maturities. Given the latest decision by the Bank of Japan to target long-term bond yields, after a period of unprecedented yield curve flattening, parallels emerge to the 2003 Japanese curve steepening episode, sometimes dubbed the ”Value at Risk Shock” (Chart 6). Back then, markets underwent a notable rollercoaster of the term structure against the backdrop of “tapering fears” over the BoJ’s bond buying program, the Iraq War, and domestic tax hikes.
Chart 6: The Japanese bear market of 2003
“VAR shocks” have especially deep impacts on the banking sector, whose profitability in the maturity transformation business tracks prevailing curve steepness. The dramatic flattening of the JGB term structure prior to March 2003 therefore went hand-in-hand with a sustained sell-off in the TOPIX bank index, which fell to multi year lows. Prominent financial institutions, such as Resona Group, had to be rescued through billion Dollar public bailouts.
Though the TOPIX recovered, and realized Japanese inflation only accelerated modestly, the sudden steepening of the JGB curve from the middle of 2003 posed a new set of challenges: calibrated risk management structures, known as “Value-at-Risk” models, required banks to shed JGB assets once their price started plummeting. Since most banks followed similar quantitative signals, and exerted a traditionally strong home bias in their fixed income portfolios, a concerted dumping of government bonds ensued.
What does the historical track record imply for current markets? A pessimistic reader could certainly identify gloomy ingredients for the “perfect storm”: the potential for a painful steepening of bond curves, after a sustained flattening as in 2003, coupled with monetary tightening; and a multi-year period of sustained losses due to a structural return of inflation as in 1967.
On the one hand, the anecdotal fear that a repeat of a 1994-type of bond crash is likely seems somewhat exaggerated, given progress on bank leverage regulations – while the current global capital flow cycle has already almost fully reversed from the cycle peak.
Type-1 and Type-3 bear markets warrant more attention. Global inflation dynamics are picking up, at a time when Central bankers voice more tolerance for “inflation overshoots”. Though currently bank equity investors are cheering the steepening of yield curves, meanwhile, the 2003 Japan episode should fix regulators’ attention on the growing home-bias in government bonds. Problematically, the IMF has warned that VAR risks have risen “significantly” in Japanese financial institutions after the financial crisis, given a continued build-up of JGB concentration in balance sheets. In Europe, the trend is equally one-directional: Italian monetary financial institutions, for instance, hold 18% of their assets in domestic government loans and securities, up from 12% in 2008. In most geographies, these bonds, despite efforts to the contrary, remain mainly held in “available-for-sale” portfolio buckets, where they have to be marked-to-market.
On balance, then, more than to a 1994-style meltdown, fixed income assets seem about to be confronted with dynamics similar to the second half of the 1960s, coupled with complications of a 2003-style curve steepening. By historical standards, this implies sustained double-digit losses on bond holdings, subpar growth in developed markets, and balance sheet risks for banking systems with a large home bias.
Paul Schmelzing is an academic visitor to the Bank from Harvard University’s History Department.
When Marco Polo went to China he discovered something better than alchemy. Rather than turning base metals into gold, he marvelled that the Chinese were creating money out of paper. But what the 13thcentury Venetian traveller could not know was how perilous a paper currency would prove for the country that invented it.
At intervals in their history, Chinese rulers have succumbed to the temptation to pay off spiralling debts simply by rolling the money printing presses. Inflationary scourges ravaged dynasty after dynasty, with both the
Mongols and Mao Zedong’s Communists seizing power in a country eviscerated by depreciated paper.
Such episodes sound uncomfortable echoes for Beijing as it wrestles to control its latest bout of monetary exuberance. The current tussle to ward off a financial crisis pits the world’s most powerful authoritarian system against the propensity of money to resist control as it seeps and flows like water through unattended apertures.
China’s problem this time is not inflation, at least not yet. It is rather that Beijing has again sent its printing presses into overdrive, creating what is almost certainly the biggest pool of domestic liquidity in history to help stimulate its economy and finance a crushing debt burden. The danger is that if the renminbi loses value internally or gushes out of China, a wave of unpaid debts could precipitate a crisis.
The dimensions of China’s liquidity splurge are startling. Ousmène Jacques Mandeng, formerly with the International Monetary Fund, has calculated that between 2007 and 2015 China created 63 per cent, or $16.1tn, of the growth in the world’s supply of money.
China now has more money coursing through the arteries of its economy than the eurozone and Japan combined — and almost as much as the US and the eurozone combined. Since the financial crisis, commentators have focused on the efforts of US, European and Japanese central banks to print money through “quantitative easing”, but China’s output has eclipsed them all.
Marco Polo would have been impressed. He noted with awe China’s capacity to print off as much money as it needed: “It may certainly be affirmed that the grand khan has a more extensive command of treasure than any other sovereign in the universe”.
But for China’s modern rulers, the effusion of liquidity presents as many problems as it promises to resolve. The main issue is that debts are piling up almost as fast as China generates money to service them, creating what Jonathan Anderson of the Emerging Advisors Group calls a “debt funding bubble”.
In his analysis, China’s crunch point will come when there is a disruption in the supply of money needed to pay total debts that amount to about 250 per cent of China’s gross domestic product, the highest level among any large emerging market.
Mr Anderson sees peril mainly in the form of a “madcap proliferation” of flaky financial institutions that lend out money they have raised by issuing debt. The potential for something to go wrong is considerable among a “chaotic hodgepodge of banks and non banks” that are fuelling China’s credit boom.
Officials also see another source of vulnerability. They fear that Chinese corporations and citizens will decide en masse that they would be better off taking their money abroad to buy companies or invest in gold, stocks or real estate. Such capital flight could sap the liquidity that is required to keep China’s bubble from popping.
These concerns explain Beijing’s plans to restrict outbound foreign investment. People familiar with the plans told the Financial Times that China intends to scrutinise acquisitions of overseas companies costing more than $1bn if they are outside the investors’ core business scope. Meanwhile, stateowned enterprises will not be allowed to invest more than $1bn on a single real estate transaction abroad. Gold purchases are also being curbed.
With outbound investments from Chinese corporations running at $150bn in the first 10 months of this year, up from $121bn last year, such outflows are increasingly being seen as part of a complex of problems that have also driven down China’s stockpile of foreign exchange reserves from almost $4tn in early 2014 to $3.12tn in October.
Outflows of even as much as $1tn may not seem too debilitating when set against China’s proven capacity to generate plentiful supplies of money. But the fact that Beijing is taking action reveals the knifeedge upon which Chinese policymakers are balancing.
So engorged with easy money have they become that Chinese banks are on average four times larger today than they were just eight years ago. But riskier still is the fact that several of its midsized banks rely for funding on socalled wholesale operations — a euphemism for issuing debt to relend.
The folly inherent in such a form of alchemy has been understood for at least 800 years. Ye Shi, a Song dynasty adviser, warned that issuing “kongqian” — or “empty money” that is not backed by assets — would stoke inflation and reduce people’s incomes. His emperor did not listen, triggering economic chaos that enfeebled China before the Mongol invasion.
Marco Polo noted with awe Chinese rulers’ capacity to print off as much cash as they needed