Central bankers have collectively lost the plot. They must raise interest rates or face their doom, W. Hague (via TELEGRAPH)

It was May 6 1997, and the forlorn Tory survivors of Labour’s landslide election victory five days earlier had to make our first collective decision. On that day, the new Chancellor, Gordon Brown, announced that henceforth the Bank of England would have operational independence from governments.

We decided not to demur. In private, we had considered doing the same thing ourselves. The idea that central banks should be free of political pressures and the electoral cycle as they set interest rates had become a prevailing one across the world – with good reason after the many wild swings in inflation and interest rates over previous decades. 

Ever since, the Bank, like its counterparts such as the US Federal Reserve and the European Central Bank, has been setting interest rates as it wishes to achieve a sustained, low rate of inflation. But such central banks are now in deep trouble, perhaps deeper than they realise. Eight years after the global financial crisis they are still pursuing emergency policies that are becoming steadily more unpopular and counter-productive. Unless they change course soon, they will find their independence increasingly under attack.   

Theresa May warned in her conference speech about low interest rates fuelling inequality. Donald Trump rages against the chair of the Fed, Janet Yellen. Germans are restive about the lax monetary policy of the ECB. What has gone wrong? 

In 2008 the central banks reacted to a massive crisis they had completely failed to foresee by cutting rates to record lows and embarking on “quantitative easing” – pumping trillions of dollars into their economies by buying up the assets of commercial banks. The trouble is that eight years later they are, to varying degrees, still doing it. Like doctors keeping their patients on a drip many years after an operation, they are losing credibility and producing very dangerous side effects.  

There are at least 10 serious drawbacks to this – all of which can be accepted for a short period but become either politically explosive or economically unwise if continued indefinitely. 

1. Savers find it impossible to earn a worthwhile return, which drives them into riskier assets thus causing the price of houses and shares to be inflated ever higher. 

2. Higher asset prices make people who own them much richer, while leaving out many others, seriously exacerbating social and political divides and fuelling the anger behind “populist” campaigns. 

3. Pension funds have poor returns and therefore suffer huge deficits, causing businesses to have to put more money into them rather than use it for expansion. 

4. Banks find it harder to run a viable business, contributing to the banking crisis now visibly widespread in Italy and Germany in particular. 

5. Those people who are able to save more do so, because they need a bigger pot of savings to get an equivalent return, so low interest rates cause those people to spend less, not more. 

6. Companies have an incentive to use borrowed money to buy back shares – which they are doing on a big scale – rather than spend the money on new and productive investments. 

7. Central banks are starting to buy up corporate bonds, not just government bonds, to keep the system inflated – so they are acquiring risky assets themselves and giving preference to some companies over others. 

8. “Zombie companies”, which can only stay in business because they can borrow so cheaply, are kept going even though they would not normally be successful – dragging down long-term productivity. 

9. Pumping up the prices of stock markets and houses without an underlying improvement in economic performance becomes ever more difficult to unwind and ultimately threatens an almighty crash whenever it does come to an end – wiping out business and home buyers who got used to ultra-low rates for too long. 

10. People are not stupid; when they see emergency measures going on for nearly a decade it undermines their confidence in authorities, who they think have lost the plot. 

I am not an economist but I have come to the conclusion that central banks collectively have now indeed lost the plot. The whole point of their independence was that they could be brave enough to make people confront reality. Yet in reality they are blowing up a bubble of make-believe money to avoid immediate pain, except for penalising the poor and the prudent. 

Highcharts/Bank of England

Earlier this year I put this view to the top staff at the central bank of a major Far East economy, thinking they might set my mind at rest and explain why everything made sense. But, far more alarmingly, they said they agreed with me: their problem was that no single authority can opt out of these policies because they might cause a recession for their own country unless there was a global, co-ordinated move gently to raise interest rates. 

The policies of any one central bank may well be perfectly rational, including the recent decisions of the Bank of England after the referendum. But so is a decision by any one sheep to run with the flock when in danger. The trouble is that the whole flock might be heading for a cliff. 

Some central bankers would mount a strong defence of their approach. They would explain that there is a global glut of savings, so interest rates are in any case kept low by market forces. This is true, but it does not mean those rates have to be driven to zero, or even below zero now in some places, by the authorities. 

They would also say that their mandate is to keep inflation low and positive and that’s it. All these other effects that I have mentioned are not their business, because they are not political leaders. They are just doing a technical job. 

I have bad news for them. The accumulating effects of loose monetary policy globally are intensely political. When pension funds renege on promises, or inequality widens further, or savers become desperate, huge public and political anger is gong to burst over the heads of the world’s central banks. 

The only way out is for the US Fed to summon the courage to lead the way to higher interest rates, and others to follow slowly but surely. If they fail to do so, the era of their much-vaunted independence will come, possibly quite dramatically, to its end. 

“Helicopter money” – reality bites BIS, by Mr Claudio Borio

Since the Great Financial Crisis, central banks in the major economies have adopted a whole range of new measures to influence monetary and financial conditions. The measures have gone far beyond the typical pre-crisis mode of operation – controlling a short-term policy rate and moving it within a positive range – and have therefore come to be known as “unconventional monetary policies.” To be sure, some of these measures had already been pioneered by the Bank of Japan roughly a decade earlier in the wake of that country’s banking crisis and uncomfortably low inflation. But no one had anticipated that they would spread to the rest of the world so quickly and become so daring, testing the boundaries of the unthinkable.

As growth has remained disappointing and inflation stubbornly below targets, the range and size of these measures have increased. Hence the growing use of long-term liquidity support, large-scale asset purchases, sizable increases in bank reserves (so-called QE) and, of late, even the introduction of negative policy rates. In the wake of these measures, the central banks’ monetary base (cash and bank reserves) has ballooned in step with the overall size of their balance sheets (see graph). 

With central banks delving further down into their box of unconventional tools, calls for them to take a deep breath and pull out “helicopter money” have intensified. What was just a thought experiment designed to shed light on how money affects the economy is now threatening to become a reality. Proponents of this tool – more soberly described as “overt money financing” of government deficits – see it as a sure-fire way to boost nominal spending by harnessing central banks’ most primitive power: their unique ability to create money at will. But can helicopter money work in the way its proponents claim? And is the balance of benefits and costs worth it? Our answer to both of these questions is no.

Proponents argue that helicopter money is special because it amounts to a permanent increase in non-interest bearing central bank liabilities (“money”) as the counterpart of the deficit. This form of financing is most effective because money is free and debt is not. Permanent monetary financing means less government debt and thus lower interest payments forever. All else equal, this saving should boost nominal demand, as there would be no need to raise additional taxes. Moreover, the argument continues, the central bank is then free to increase interest rates again whenever it wishes while the lower amount of debt outstanding will still yield savings. This is the best of all possible worlds: Demand is boosted without the collateral damage of prolonged exceptionally low interest rates.

Devil in the details

Or so it seems. But the devil is in the details.

As we have argued elsewhere, the reasoning may be correct in the stripped-down models people have in mind, but not in reality. In fact, the central bank faces a stark choice: Either helicopter money results in interest rates permanently at zero, so that control over monetary policy is lost forever, or else it is equivalent to either debt or to tax-financed government deficits, in which case it would not yield the additional boost. Since losing monetary policy control forever is not a feasible option, helicopter money is just fiscal policy dressed up.

The reason is hidden in an obscure but critical corner of the financial market. Contrary to what the stylized models suggest, it is not the amount of cash that determines interest rates but what the central bank does with bank reserves (commercial banks’ deposits at the central bank), over which it has a monopoly. Monetary deficit financing will, in effect, amount to an equivalent increase in bank reserves. If the central bank issued more cash than people demanded, the amount in excess of desired balances would inevitably be converted into bank deposits and then switched by banks into reserves (see in the graph how steadily and slowly cash grows, reflecting the demand for it). If the government issued checks, the same would happen. If the reserves are non-interest bearing – as they must be for helicopter money – the increase will inevitably also drive the short-term (overnight) rate to zero. This is because when the system as a whole has an excess of reserves, no one wants to be left holding it but someone must.

The problem arises once the central bank decides to raise interest rates again, as this, alas, would not be consistent with helicopter money. To do so, the central bank has only two options. Either it pays interest on those reserves at the policy rate, in which case this is equivalent to debt financing from the perspective of the consolidated public sector balance sheet – there are no interest savings. Or else it imposes a non-interest bearing compulsory reserve requirement to absorb the reserves, but this is equivalent to tax financing – someone in the private sector must bear the cost. While the tax would in the first instance fall directly on banks, they could decide to pass it on to their customers — for example, in the form of higher intermediation spreads.

Thus, either helicopter money comes at a prohibitive price – giving up control over monetary policy forever – or else, choreography and size aside, in its watered-down version it is not very different from what some central banks have already been doing: engineering temporary increases in reserves which may happen to coincide with increases in government deficits (a form of QE). Views about QE’s effectiveness differ, but we would be talking about “more of the same.” Such a policy already exploits the synergies between ultra-low interest rates and fiscal policy so as to enhance any expansionary impact that fiscal policy may have.

That said, choreography and size do matter. And they don’t speak in favor of the tool. Imagine policymakers went down this route, announcing that they were embarking on a “new” policy and explicitly linking the increase in reserves with higher public sector deficits. They could hide the inconvenient truth and renege on their promise not to raise rates. But this would hardly be an example of good policy, and in any case its effectiveness would at best be doubtful – the private sector would surely anticipate this possibility to some extent, thereby tempering the impact of the signal. Alternatively, policymakers could hope that the fanfare surrounding the tool would induce people to spend more. This is a possible but by no means obvious outcome. And in any case, unless the exercise is repeated over and over again on a large scale, its impact is likely to be only temporary.

And therein lies the danger. It is hard to imagine helicopter money not ending up in fiscal dominance, the outcome that would obviously be inevitable in its purest form, where interest rates are kept at zero forever. Sooner or later this could indeed erode the value of money, but at the cost of losing the public’s confidence in our monetary institutions – a trust so painfully gained over the years – and with unpredictable consequences. It would be a Pyrrhic victory.

“We Need the Pain that Comes with More Saving”

 C. Jay Engel, Mises Daily

The endgame of monetary side manipulations is upon us. Since 2008, central banks have done what they thought was needed to bring the markets back from the pain they experienced during the crash. The problem, of course, is that these Keynesians and Monetarists placed the high level of stock markets as the goal of “policy” and confused booming asset levels with economic growth.

The enemy of prosperity, in the eyes of global economic policymakers, is the desire of the consumer to save and  businesses to refrain — even in the short term — from investment. As such, their “solution” was the very poison that has infected the Western world over the decades: more credit, lower costs of money, more push for “consumer demand.”

The Current Orthodoxy Is Failing

But “easy” monetary policy has merely led to debt-ridden economies and a bubble that is increasingly being exposed as a complete farce. January saw a market pullback tease that reminded investors that what was pushed up artificially can’t be sustained forever. Monetary policy, even if it goes to negative interest rate territory with a vengeance, isn’t going to be the miracle drug needed to provide a better economic foundation. Austrians have long known this. The mainstream is just starting to publicly admit it.

The Savings-Glut Myth

However, the right lessons are not being learned by either the economic policymakers or the financial pundits. In fact, the most dangerous economic fallacies still underlie their entire financial worldview. For instance, there is the ever-constant theme that there is a “glut of savings” and that low consumer demand is the chief villain that stands opposed to economic stabilization. Martin Wolf, writes in The Financial Times:

that the global economy is slowing durably. The OECD now forecasts growth of global output in 2016 “to be no higher than in 2015, itself the slowest pace in the past five years”. Behind this is a simple reality: the global savings glut — the tendency for desired savings to rise more than desired investment — is growing and so the “chronic demand deficiency syndrome” is worsening.

The proper economic way of thinking does not blame the economic pain on savings, nor does it desire an artificial, government-driven, attempt to coax people into consuming and “investing.” In fact, the economic reality of the situation is that savers are to be praised, not admonished; and that the refraining from consumption is the very means by which malinvestment can be most swiftly liquidated.

For the Austrian-school thinkers, the collapsing of the bubble that results from people “hoarding” their money and refusing to purchase over-priced “assets” is the precondition for future economic growth. This is because it is the bubble, not the bust, that is the problem. The bubble is the time of malinvestment and mismatch between consumer time preferences and resource allocation that results from the artificial expansion of the supply of money. It is the falsification of interest rates that encourages investment into areas that the economy is not prepared to handle. And while in the near term the bubble appears as prosperity and good times, it is actually the very seeds of destruction being sown. It is this piece of the boom-bust cycle that is destructive and impoverishing. The bust is merely the needed adjustment that gives society the wonderful opportunity to “start over” and do it right this time. Unfortunately, we never actually get to do things right, because the economic bureaucrats in our unfree-market system fear the bust more than the boom. They have it all backward!

How Saving Heals the Problems Caused by Bubbles

So then, the so-called “global savings glut,” has the economic role of encouraging the readjustment of capital asset prices back toward their proper levels. The refusal to participate in the bubble, it is true, is harmful for the overvalued stock market levels worldwide. But what the mainstream does not understand is that overvalued stock market levels is a result of the underlying rot in the system itself. The pain to be experienced in a collapse will surely shock an entire generation of unprepared retirees, especially those relying on pension levels which are tied closely to stock market performance in the near to medium term.

But if the economy is ever going to slough off generations of central bank-induced malinvestment, if the economy is ever going to shift to a proper and sustainable foundation of capital accumulation, if future generations are going to live in a truly prosperous world, the pain is unavoidable. Propping up the markets and encouraging misguided consumption and malinvestments will be the death blow to western civilization. Only near-term pain can allow long-term growth. Economic savings are the cure, and to be welcomed with open arms.

Janet Yellen And The Federal Reserve Are Losing Credibility

Peter Schiff, By Jason Shubnell

U.S. central bankers decided to maintain the FFR range at 0.25 to 0.50 basis points, keeping the discount rate at 1.00 percent.

While the Federal Reserve did see indicators of a strengthening labor market (along with projections of 4.5 percent unemployment by 2018), not all may be well. The central bank cut its 2016 GDP forecast to 2.2 percent from 2.4 percent previously, and also said global economic and financial developments pose risk for markets.

Fed Chair Janet Yellen spoke for about an hour to discuss the Fed’s outlook. However, is the Fed is losing credibility? Peter Schiff thinks so.

“The public knows that the economy is weak (that’s why Trump and Sanders are doing well),” Schiff told Benzinga in an email. “But the Fed can’t admit it and they are looking stupid as a result.”

Peter Schiff expects increasingly dovish movement as the year goes on, pushing down the dollar.

“Most economists are saying that the current pickup in Inflation must mean that the economy is improving,” Schiff said. “To reach this conclusion one must not only ignore the basics of economics but also the very many signs that the economy is currently weakening drastically… The optimistic conclusion is that wages will rise to match price increases. But that is not happening (the last payroll report showed a huge drop in weekly earnings). So what we have is rising prices and flat wages…a terrible mix for consumers.” 

Schiff said if the Fed were to raise rates in this environment, it would risk igniting a serious recession that would have huge political implications. Instead of risking this, he said, the Fed will continue to say that they want to raise, while hoping the economy will reverse course and strengthen.

“But the more likely scenario is that the Fed does nothing while promising to do something,” Schiff‘s email said. “But if the economy weakens further, they will have to officially call of future hikes, and perhaps go back to zero. They will of course have to ignore any additional signs of inflation to do so. When the market realizes that, the dollar will plunge, and non-dollar markets and gold will outperform.”

Schiff then highlighted the current decline in U.S. manufacturing would be the first time since 1952 that Industrial Production has declined for four straight months without the U.S. economy not being in recession. A worse-then-expected 0.5 percent month-over-month plunge (near the worst since 2009) led to a 1.0 percent year-over-year drop, the fourth monthly decline.

The market responded positively following the 2 p.m. ET release. The Dow closed at its highest level of 2016 at 17,325.76. The SPDR S&P 500 ETF Trust SPY spiked sharply following the announcement, closing up about 0.6 percent at $203.39.

Schiff concluded by saying Yellen’s biggest loss of credibility today was when she said “April remains a live meeting.”

“There is literally no one in the world that expects a hike in April,” Schiff said.

 

BONUS TRACK: World’s Second Largest Reinsurer Buys Gold, Hoards Cash To Counter Negative Interest Rates

Zerohedge 

The world’s second-largest reinsurer, German Munich Re which is roughly twice the size of Berkshire Hathaway Re, is boosting its gold reserves and buying gold in the face of the punishing negative interest rates from the European Central Bank, it announced today.

As caught by Mark O’Byrne at GoldCore and reported by Thomson Reuters this afternoon, the world’s largest reinsurer is far from alone in seeking alternative investment strategies to counter the near-zero or negative interest rates that reduce the income insurers require to pay out on policies.

Munich Re has held gold in its coffers for some time and recently added a cash sum in the two-digit million euros, Chief Executive Nikolaus von Bomhard told a news conference.

 “We are just trying it out, but you can see how serious the situation is,” von Bomhard said.

The ECB last week cut its main interest rate to zero and dropped the rate on its deposit facility to -0.4 percent from -0.3 percent, increasing the amount banks are charged to deposit funds with the central bank.

Munich Re is one of the largest reinsurance companies in the world – It oversees €231 billion in investments. A small 3% allocation to gold would equate to buying gold worth €8.19 billion. At the current spot price of €1,130 per ounce that would equate to 7.2 million ounces or 225.4 tonnes of gold bullion

The news is interesting and we believe that other institutions will follow in their footsteps and diversify into gold in order to protect themselves from negative yields. We have not heard of any other non central bank institutions diversifying into gold but it stands to reason that a small percentage will follow in Munich Res footsteps.

* * *

It isn”t just gold: the German company confirms that when rates turn negative enough, physical cash will be increasingly more valuable.

As Bloomberg reports, the German company will store at least 10 million euros ($11 million) in two currencies so it won’t have to pay for the right to access the money at short notice, von Bomhard said at a press conference in Munich on Wednesday. “We will also observe what others are doing to avoid paying negative interest rates,” he said.

Institutional investors including insurers, savings banks and pension funds are debating whether it may be worth bearing the insurance and logistics costs of holding physical cash as overnight deposit rates fall deeper below zero and negative yields dent investment returns. The ECB last week cut the rate on its deposit facility, which banks use to park excess funds, to minus 0.4 percent.

“This may well become a mass phenomenon once interest rates are low enough — the only question will be where that exact point is,” said Christoph Kaserer, a professor of finance at the Technische Universitaet in Munich. “For large institutions, that may be the case sooner rather than later. The ECB will react with countermeasures, such as limiting cash.”

As Bloomberg adds, Munich Re’s strategy, if followed by others, could undermine the ECB’s policy of imposing a sub-zero deposit rate to push down market credit costs and spur lending. Cash hoarding threatens to disrupt the transmission of that policy to the real economy.

Munich Re, which oversees a total of 231 billion euros in investments, wants to test how practical it would be to store banknotes, having already kept some of its gold in vaults, von Bomhard said. This comes at a time when consumers are increasingly using credit cards and electronic banking to pay for transactions. Deutsche Bank AG Chief Executive Officer John Cryan has predicted the disappearance of physical cash within a decade.

“This shows the difficulties that the ECB is facing in its efforts to stimulate the real economy,” said Andreas Oehler, a professor of finance at Bamberg University in Bavaria. “Charging negative rates on overnight liquidity doesn’t stimulate longer-term lending. All it does is make companies’ and institutions’ payment transactions more expensive.”

Incidentally, once the Fed’s infatuation with playing central planning doctor fizzles as the economy relapses into an accelerating downward spiral, negative rates are coming to the US next, as such the real-time experiments of how to evade a repressive monetary regime such as those conducted by the Munich Re CEO will be particularly useful to those who want to protect their assets once NIRP crosses the Atlantic.

 

“Helicopter Money to the Rescue” by Frank Hollenbeck (Mises)

Following the unconventional monetary policy of negative interest rates, central banks are now considering an even more desperate measure: “helicopter money.” Milton Friedman is credited with this idea:

Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community. Let us suppose further that everyone is convinced that this is a unique event which will never be repeated.

The goal of such a policy is to put money directly into people’s pockets to boost aggregate demand. The post-2008 QE policy had similar objectives. The lowering of interest rates was intended to boost bank lending and indirectly consumer spending. Instead, the result was a boom in asset prices and a surge in excess reserves. The idea of helicopter money — in contrast — is to bypass the middleman, the banks, and provide funds directly to consumers.

How would such a policy be implemented? One idea is for a tax rebate financed by more government bonds purchased by the central bank. The tax cuts would be financed by printing money. The only real difference between helicopter money and the QE implemented since 2008, is that the private sector would be spending the money instead of the government. A large part of the debt issued since 2008 to finance government spending has been purchased by the central bank. It now holds $2.5 trillion of the $19 trillion dollars of US debt, effectively monetizing much of the additional borrowing since 2008. The effect on aggregate demand would simply be for the private sector to spend the money instead of the government sector. It would be a continuation of the current policy of financing expenditures by creating intrinsically worthless pieces of paper.

There’s Never a Shortage of Demand

Of course, this is a very Keynesian perspective that the economic problem is a lack of aggregate demand. The reality is that we never have a shortage of demand. The reason we work, we produce, is to consume; there is never a lack of demand. The primary function of prices is to ration output against an insatiable desire to consume or demand. As Ricardo said in 1820, “men err in their production; there is no deficiency of demand.”

The problem is never one of insufficient demand, but of supply being misaligned with demand. This faulty widespread educational indoctrination about aggregate demand is the poison eating at the heart of macroeconomics and similar to past universal beliefs in truisms that were never true — like the sun revolving around the earth.

The economic literature has focused on the permanency of such a helicopter drop. Such a policy is seen by contemporary economists as more effective if it was permanent. If so, people would expect inflation and advance their purchases to take advantage of current lower prices. In a Keynesian framework, this is viewed as beneficial since it would move demand forward. A similar but opposite argument has been promulgated to demonize deflation (see here and here). Of course, people are not lab rats, and they formulate their expectations on a multiple of different factors. They may even pay higher prices if current purchases better align with the timeline of needs. This is why few buy Christmas presents during January sales.

Another excuse for helicopter money is to allow the central bank to reach its 2 percent inflation target. As though 2 percent was some magical number that would allow the economy to reach its economic sweet spot.

Problems with Money Creation

Of course, 2 percent growth over 35 years cuts the purchasing power of money in half. It is a wealth transfer from the late recipients of the money, wage earners and the poor, to the early recipients of the money, the government and the banking sector: the central bank acting as a reverse robin hood. Also such monetary shenanigans simply interfere with the function of prices to allocate resources where society deems most urgent (see here). The reality is that there is no empirical or theoretical justification to support a 2 percent target. The period of the greatest growth in the US during the nineteenth century, from 1820 to 1850 and from 1865 to 1900, was associated with significant deflation. In those two cases, prices were cut in half.

Common sense states that you cannot repeal the law of scarcity by printing intrinsically worthless pieces of paper to finance private or government expenditures. If that were true, counterfeiting would be legal and Zimbabwe would be like heaven. The initial effect of such printing is a temporary illusion of prosperity which begets more printing leading to ever increasing amounts of distortion to prices.

Friedman’s comments about helicopter money included an important caveat: it is unlikely that the helicopters would fly only once.

DEUS EX MACHINA

by Egon von Greyerz – Dec 2011 (GoldSwitzerland)
With most of the world’s major economies as well as the financial system bankrupt, there is only one solution that can save the world economy. Like in the Greek tragedies, Deus ex Machina is now the only way that the world can avoid a total economic collapse. This would involve God being lowered down onto the world stage and miraculously saving the plot.

DEUS EX MACHINA by Leo Lein – www.leolein.se

For those few who believe in this, may God bless them. But since this is a very unlikely solution most people will instead rely on governments and central banks to save us. But how can anyone possibly believe that totally incompetent and clueless politicians and central bankers could solve anything. They created the problem in the first place and are therefore totally unsuitable to play the role of Deus. The main objective of governments is to stay in power and thus to buy votes. Therefore they are incapable of taking the right decisions. And the opposition, aspiring to power is even less suitable since they will lie through their teeth and promise the earth in order to be elected. (We know that there are exceptions like Ron Paul, but the voters will most probably find his medicine too strong to swallow.)

What about central bankers, can’t they save us? Unfortunately any sensible person who becomes a central banker loses all his senses and becomes a prisoner of the political system.

Solution?

So if there is no Deus ex Machina and if governments or bankers can’t rescue the world, who can and what is the solution. Let us return to the wise von Mises to look at the options available now:

“THERE IS NO MEANS OF AVOIDING THE FINAL COLLAPSE OF A BOOM BROUGHT ABOUT BY CREDIT EXPANSION. THE ALTERNATIVE IS ONLY WHETHER THE CRISIS SHOULD COME SOONER AS A RESULT OF A VOLUNTARY ABANDONMENT OF FURTHER CREDIT EXPANSION, OR LATER AS A FINAL OR TOTAL CATASTROPHE OF THE CURRENCY SYSTEM INVOLVED”

Ludwig von Mises

Mises is absolutely correct: “There is no means of avoiding a final collapse of a boom brought about by credit expansion”. Whatever politicians, bankers, economists or others experts say, there is no solution to this crisis. We have reached the end of the road and are now staring into the abyss.

The credit manufacturing system that started in 1913 when the Fed was founded, began its terminal phase in 1971 when Nixon abolished gold backing of the dollar. It has been clear to us for at least 20 years that the outcome was inevitable. It was never a question of “if” but only “when” it would happen. It is now clear to us that the false prosperity that the world has experienced by printing unlimited amounts of money will very soon come to an end. Thus the “if” and “when” conditions are now satisfied so the remaining question is HOW?

To try to answer this let’s return to Mises: “The alternative is only whether the crisis should come sooner as a result of voluntary abandonment of further credit expansion ….” 

To stop the money printing and credit creation would be the only sensible way of ending the failed quasi-capitalist, socialist experiment which is in the process of destroying the structure of the Western world. For almost 100 years we have lived on a system based on debt. This has created a false prosperity as well as false values. The transfer of capital from private enterprise to government by massive taxation is approaching 50% in many countries (see table). The average for 18 industrialised countries is almost 40%. This means that on average 40% of the productive economy is transferred to a non-producing entity (government) which wastes most of the money in the process of redistribution. But not only that, since the state has taken over up to 50% of the economy in these countries, the desire to work, to strive, to take risk and to invent has been taken away from a major part of the population.

For a great many people it is now totally natural to rely on the state for their needs rather than on themselves. And the state needs to borrow/print ever increasing amounts to perpetuate this economy based on an illusion. This situation is totally untenable. Since any additional money printing will only exacerbate the crisis and make the final collapse so much greater, the swiftest solution would be let the financial system implode now. We need to reset the world to a level which is sustainable. The consequences of this implosion would be a collapse of the financial system and a reset of debt to zero. Although this is unthinkable to any government or politician, it would be by far the quickest way to get the world back on its feet with no major debts, minimal government interference, and no central bank that can print money. It would be like a forest fire getting rid of all the dead wood. Out of that would rise masses of green shoots in the form of strong unchequered growth. The transition will of course be traumatic and the current generation will experience enormous hardship. But not voluntarily abandoning the money printing now will just delay the inevitable and the consequences will be dramatically greater and affect many future generations.

Anyone who has followed my articles will know my view that governments worldwide are totally incapable of stopping the money printing. This is their only means of staying in power and buying votes. But not only that, this is the only method they know. This has been their patent solution to all economic problems in the last decades. Not that this is new in history. Most empires have resorted to diluting the value of money by reducing the gold/silver content of coins or printing paper money. But as far as I know it has never before been done by so many countries simultaneously to such an extent.

Since there won’t be any voluntary abandonment of credit creation what will the likely outcome be? Again let’s use Mises words: “…… a final or total catastrophe of the currency system involved”.  The problem this time is that we are not talking about one currency or one country. No, we are talking about most of the world’s major currencies. We have been used to measuring currencies and economies on a relative basis i.e. against each other. But this is a total fallacy since all major currencies have been in a race to the bottom for the last 100 years. Most currencies have lost between 97% and 99% against real money –GOLD – since 1913. And since 1999, most currencies have lost 80% or more against gold. So paper money has been a very poor measure of wealth in the last 100 years. Governments are creating credit and paper money and consequently through their fraudulent actions “stealing” from the people whilst at the same time increasing the people’s dependence on the state. And the people does not understand that the value of paper money is declining continuously. But gold reveals the deceitful destruction of paper money. This is why governments do not like gold and try to suppress the gold price.

Endless Money Printing – QE

And how will the currency system collapse? The answer to this question is very simple – through endless money printing. There will be no lasting austerity programmes in any country that can print money. Governments are incapable of sticking to austerity measures since in the end that is a guaranteed way of losing power. As power is the main purpose of all governments, they will use any method to retain it. Within the Eurozone, individual countries can of course not print money but the ECB and the IMF will take care of that. So whilst world leaders are procrastinating and bickering in G8, G20 and all other “summit” meetings, it is absolutely guaranteed that the final outcome will be one QE package after the next. Governments and central banks know that without limitless money printing there would be a deflationary collapse of the banking system and world economy.

The table below shows the financing requirements of the PIGS countries in the next few years. Just Italy and Spain will require €1 trillion in the next 4 years and of that 1/2 trillion Euros in 2012. Only printed money will take care of that.

For many years it has been absolutely crystal clear to some of us (sadly a very small minority) that many major sovereign nations are bankrupt as well as the world financial system. Banks are only surviving because they, with the blessing of governments, are allowed to value trillions of dollars of toxic and worthless assets at full value. And on top of that there are more than $1 quadrillion outstanding in derivatives. These are outside the banks’ balance sheets and there are virtually no reserves against them. The banks are netting the value down to virtually nothing and then applying a miniscule reserve against this net amount. First of all, the netting is only valid when the counterparty pays. When there is a counterparty failure, which is very likely in the coming financial collapse, gross remains gross and the $1 quadrillion remains $1 quadrillion. Secondly, a major part of the derivatives are worthless or not protecting the investors as we have seen with for example Freddie Mac, Fannie Mae, Lehmans and lately MF Global. MF Global had bought CDs to hedge their investment in Greek debt. But they hadn’t understood what they had bought and it turned out it offered no protection at all.

Hyperinflation

The “final or total catastrophe of the currency system” will occur as a result of the QE or unlimited money printing that will very soon start in the EU, USA, UK, Japan and many more countries. And this currency destruction will lead to hyperinflation as I have stated for many years. Throughout history, substantial government deficits leading to money creation or printing have always been the cause of hyperinflation. Because hyperinflation is always the result of a collapsing currency and not of excess demand.

To any thinking individual, it is totally incomprehensible that governments and central banks believe that an insolvent world can be saved by debt issued by bankrupt nations and then bought by the issuers themselves as there is no other buyer. This is the perfect recipe for self-destruction and “total catastrophe of the system.”

IMF, EU and other failed monstrosities

Time and time again, the world creates massive costly, bureaucratic and unaccountable structures that have idealistic and totally unrealistic objectives.

Take the IMF for example. This is what their mission statement states: “The International Monetary Fund (IMF) is an organization of 187 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world.”

If financial stability, high employment, sustainable economic growth and reducing poverty are the objectives of the IMF, then they have failed on every single point. So here we have an organisation that receives/borrows money from mainly bankrupt states and then lends the money to countries that cannot or will not ever repay the funds. And in order to carry out this totally futile task, the IMF takes a major cut in between to finance its costly and failed operation. The world does not need monstrous and costly structures that totally fail in their mission. Thus, the IMF should be closed.

Turning to the EU, they state on their website: “The main objectives of the Union are now to promote peace, the Union’s values and the well-being of its peoples”. There are other stated objectives such as: “sustainable development, based on balanced economic growth and price stability, a highly competitive social market economy, aiming at full employment and social progress, and a high level of protection and improvement of the quality of the environment.” 

The EU or the EEC as it was first called was created in the late 1950s. This was a prosperous period in the world economy based on real growth (not debt). As often is the case, politicians with illusions of grandeur create superstructures which only function in good times. The EU’s main objective of creating peace and well-being of the people is now being severely tested. If we for example asked Spanish youth (50% unemployed) about their well-being or Greek people or the Portuguese etc, we would get a tirade of abuse and complaints about the EU. Instead of “creating peace”, we are seeing major tension within the EU that could lead to serious conflicts. And as to “balanced economic growth and full employment”, this has all come to an end. The false prosperity, mainly based on debt, has also come to an end and the EU can only survive intact with the aid of endless money printing. But even that would only be a temporary reprieve. The EU is a failed experiment which is extremely costly and inefficient. The economic ruin of Ireland, Greece, Spain, Portugal, Italy, France etc would not have happened to the same extent without the EU. Like all artificial fiat currencies, the Euro was doomed to fail. Without the Euro, countries like for example Ireland, Spain or Greece would have recovered much faster.

Final or total catastrophe

So we are heading to the final stage or as Mises says a “final or total catastrophe of the currency system involved”. I don’t think that even Mises envisaged at the time that this could involve a major part of the world rather than just one country. This is why this catastrophe will be unprecedented in world history and have consequences that will affect the world economically, socially and geopolitically for a very long time.

Wealth Preservation – Gold

Since 2002 we have advised investors to put up to 50% of their assets into physical gold, stored outside the banking system. Gold has appreciated between 15% and 20% per annum since 2002 depending on the base currency. And most stock markets have declined 70-85% against gold in the last ten years. In spite of this most major investor groups (institutional, funds, asset managers or individuals) own no gold. Gold is money and reflects the total destruction of paper money. But most investors do not understand gold. Common arguments I hear is that “you can’t eat gold” or that “gold pays no return.”  It seems that these investors prefer to eat paper money. And as to the argument that there is no yield on gold, who needs yield on an asset that has massively outperformed all major asset classes in the last 11 years. And if we look at 2011, gold has greatly outperformed stock markets in most major countries. Whilst stock markets are down between 1% and 24% in 2011, gold is up more than 20% against all major currencies. So in real terms (gold) all stock markets are doing very badly but still investors persist in riding these falling trends.

Stock markets will benefit temporarily from QE but it is still our view that they will fall another 90% against gold in the next few years.

The correction in the precious metals is now likely to be over and we should see the metals going to new highs in 2012. I had the pleasure of becoming acquainted with Alf Field at the recent Gold Symposium in Sydney where we were both speakers together with Eric Sprott, John Embry and Ben Davies amongst others. Alf is one of the few in the world, if not the only one, who knows how to apply the Elliott Wave principle successfully to gold. Alf’s next intermediate target is at least $4,500 and the ascent to this target could be rapid. That would probably mean a silver price of $150. These technical forecasts certainly confirm the fundamentals as outlined in this article.

The world is in a total mess and there is absolutely no solution to this unprecedented crisis. The hyperinflationary depression that we will experience in the next few years will totally destroy the majority of the credit based wealth that has been created in the last few decades. 

In order to preserve wealth and keep capital intact, it is critical to keep a major part of investment assets in precious metals held outside the banking system. But for investors who continue to follow conventional wisdom, they will sadly find that their investment strategy was merely conventional and contained no wisdom.

Culture Clash Janus, by Bill Gross

A respected reporter recently asked me what were a few important things I had learned from all this and all of that during the past decade and I surprised myself and perhaps him by answering that I now realized that younger generations – the Xers and Millenials – were far different generations from my own. “How so?” he asked. They are ephemerally connected as opposed to hardwired, I replied. They hold history less dear and appreciate freshly baked inclusiveness more; they are inclined to move on instead of settle and build, perhaps because employer loyalty has weakened as well; they are more temporary residents than architects. But they are the future.

The challenge for me as a Boomer, I said, was to understand this, yet not sacrifice my generation’s heritage that had made these evolving differences possible. This generation gap, I continued, was just that – a far distance from one side of a chasm to the other. And yet, I thought, (having concluded the interview) culturally we were much the same: making positive, sometimes obsessive contributions at work; loving our families, our pets. No chasm there to bridge. A common culture. But common cultures themselves morph and sometimes quickly so, producing substantial gaps from one figurative day to the next. Most humans who walked this Earth were alive inside a culture that was constant for centuries, yet now it seemed that technology was mutating standards like a cytoplast or perhaps at worst – a cancer cell. Who could say whether this new life form was positive or negative? Who could say that an older generation was any less an ideal than the succeeding one? My experience of the divide between Boomers and Xers is like that; I recognize that youth will be served, but not always for the better.

Yet, if I (you) understood that to be somewhat true, what should I (you) do differently? How to live a life – this Shakespearian brief candle? Should I listen to the beat of a bass drum instead of an ancient tom-tom? Would I dare dance to strange new music with a different step? “Forward” is my futile response. Forward – with difficult questions. John Denver expressed it succinctly, “If there’s an answer, it’s just that it’s just that way”.

Change propels economies as well as cultures, and sometimes before we are even aware of it. We listen to Trump and Bernie, then Cruz and Hillary as if one of them might be the mythical Wizard of Oz, guiding us down that yellow brick road to reinvigorate growth. They all try to emulate the Wizard of course. “Change you can believe in” was Obama’s mantra and then there was Clinton’s “I come from a city called Hope” and so on. Eisenhower was probably the last honest politician. “I like Ike” was his promise for the future, and I think many voters actually did – like Ike. But back then and certainly now, it was the economy that was changing, not politicians’ promises for a better future, and government policies usually took years to respond. If Thatcher and Reagan sparked a “revolution” of tax policy, it was a long lagged response to decades of growth constricting government policies. If the Great Recession exposed holes in those free market ideologies, then to my way of thinking, seven years of Obama have not yet addressed the cracks in our global financial system. Our economy has changed, but voters and their elected representatives don’t seem to know what’s really wrong. They shout: (1) build a wall, (2) balance the budget, (3) foot the bill for college, or (4) make free trade less free. “That will fix it” they discordantly proclaim, and after November’s election some unlucky soul may do one or more of the above in an effort to make things better. Similar battles are being fought everywhere. Brazil and Venezuela approaching depression’s edge; leftist and right-wing government elections in Euroland; Spain without a government; Brexit; China’s ever-changing five year plan; Japan’s obsessional quest for 2% inflation. “Fix it, fix it, restore our hope for a better future”, beats the world’s tom-tom. Or is it a bass drum? It’s loud, whichever generational beat you dance to.

But here’s the thing. No one in 2016 is really addressing the future as we are likely to experience it, and while that future has significant structural headwinds influenced by too much debt and an aging demographic, another heavy gust merits little attention on the political stump. I speak in this Outlook to information technology and the robotization of our future global economy. Virtually every industry in existence is likely to become less labor-intensive in future years as new technology is assimilated into existing business models. Transportation is a visible example as computer driven vehicles soon will displace many truckers and bus/taxi drivers. Millions of jobs will be lost over the next 10-15 years. But medicine, manufacturing and even service intensive jobs are at risk. Investment managers too! Not only blue collar but now white collar professionals are being threatened by technological change.

Nobel Prize winning economist Michael Spence wrote in 2014 that “should the digital revolution continue…The structure of the modern economy and the role of work itself may need to be rethought.” The role of work? Sounds like code for fewer jobs to me. And if so, as author Andy Stern writes in Raising the Floor, a policymaker – a future President or Prime Minister – must recognize that existing government policies have “built a whole social infrastructure based on the concept of a job, and that concept does not work anymore.” In other words, if income goes to technological robots whatever the form, instead of human beings, our culture will change and if so policies must adapt to those changes. As visual proof of this structural change, look at Chart I showing U.S. employment/population ratios over the past several decades. See a trend there? 78% of the eligible workforce between 25 and 54 years old is now working as opposed to 82% at the peak in 2000. That seems small but it’s really huge. We’re talking 6 million fewer jobs. Do you think it’s because Millenials just like to live with their parents and play video games all day? I think not. Technology and robotization are changing the world for the better but those trends are not creating many quality jobs. Our new age economy – especially that of developed nations with aging demographics – is gradually putting more and more people out of work.

 

Chart I: Advance of the Robots, Retreat of Labor

 

Source: U.S. Bureau of Labor Statistics

 

What should the policy response be? Retraining and education sound practical and are at the head of every politician’s promised ticket for the yellow brick road, but to be honest folks, I doubt that much of it will be worth the expense. Four years of college for everyone might better prepare them to be a contestant on Jeopardy, but I doubt it’ll create more growth; for the Universities perhaps, but not many good jobs for the students. Instead we should spend money where it’s needed most – our collapsing infrastructure for instance, health care for an aging generation and perhaps on a revolutionary new idea called UBI – Universal Basic Income. If more and more workers are going to be displaced by robots, then they will need money to live on, will they not? And if that strikes you as a form of socialism, I would suggest we get used to it. Even Donald Trump claims he won’t leave anyone out on the street – a liberal Republican thought if there ever was one. And they are on the street you know. Check out any major downtown in the U.S. if you want to see our future culture. Not the stadiums with the box seats; the streets with the tents and grocery carts. But the concept of UBI is not really new or foreign to capitalistic cultures like that of the U.S. We already have sort of a UBI floor. It’s called food stamps and the earned-income tax credit, but those alone will not keep the growing jobless and homeless off city and suburban streets. The question is how high this UBI should be and how to pay for it, not whether it’s coming in the next decade. It is. Strangely, the concept is endorsed more by conservatives than liberals and in Silicon Valley as well. Even with a theoretical $10,000 UBI per eligible citizen, the cost of $1-2 trillion dollars is seen as an income pool to consume many of the high tech products they produce. 

Higher taxes are one way to pay for it, but let me suggest another – something that a Rand Paul or father Ron would have been good at. Drop the money from helicopters. Now, even though this idea sounds more fictional than Trump’s 15 foot wall, it really isn’t. Milton Friedman, then Ben Bernanke and now a host of respected economists including the conservative Economist magazine itself are introducing the idea. These advocates do not really intend to throw money out of choppers. In broader terms, they are advocating fiscal stimulus but stimulus that isn’t paid for with private borrowing or taxes. That last sentence is critical – “not with private borrowing or taxes”. Democrats and Republicans alike can endorse that.

Instead, the money can be printed by central banks as it has been recently. It’s a hard concept to understand and that’s why politicians never discuss it – nor do most central bankers, who want to preserve the sanctity of their “balance sheets” and independence of their institutions. But the independence between central banks and government is rapidly eroding – a new culture is forming if only by necessity. Printing money via QE is in effect a comingling of monetary and fiscal policy, of central bank and treasury. The Fed, the ECB, BOJ and BOE have in effect bought bonds from their treasuries for 6 years now in order to allow them to spend money in support of their sagging economies. They buy the bonds by printing money or figuratively dropping it from helicopters – expanding their balance sheets in the process. They then remit any net interest from their trillions of dollars or Yen bond purchases right back to their treasuries. The money in essence is free of expense and free of repayment as long as the process continues uninterrupted. Technically, the central bank will argue, they have not allowed their treasuries to finance for free because they will sell the bonds back to the free market one day. Not a chance. The only way out for Japan for instance with 350% of debt to GDP and much of it owned by the BOJ is to extend and extend maturities at 0% interest until private markets catch on. Which frankly is what they want. Global markets wising up to the scheme will precipitate the sale of the remaining JGB’s, weaken the Yen and create their magical 2% inflation!

Oh this sounds too good to be true. Just print the money! Well to be honest, a politician – and a central banker – should admit that increasing joblessness must be paid for somehow.

1. Raising taxes (not lowering them, Donald) is one way.

2. Issuing more and more debt via the private market is another (not a good idea either in this highly levered economy).

3. A third way is to sell debt to central banks and have them finance it perpetually at low interest rates that are then remitted back to their treasuries. 

Money for free! Well not exactly. The Piper that has to be paid will likely be paid for in the form of higher inflation, but that of course is what the central banks claim they want. What they don’t want is to be messed with and to become a government agency by proxy, but that may just be the price they will pay for a civilized society that is quickly becoming less civilized due to robotization. There is a rude end to flying helicopters, but the alternative is an immediate visit to austerity rehab and an extended recession. I suspect politicians and central bankers will choose to fly, instead of die.

 Private banks can fail but a central bank that can print money acceptable to global commerce cannot. I have long argued that this is a Ponzi scheme and it is, yet we are approaching a point of no return with negative interest rates and QE purchases of corporate bonds and stock. Still, I believe that for now central banks will print more helicopter money via QE (perhaps even the U.S. in a year or so) and reluctantly accept their increasingly dependent role in fiscal policy. That would allow governments to focus on infrastructure, health care, and introduce Universal Basic Income for displaced workers amongst other increasing needs. It will also lead to a less independent central bank, and a more permanent mingling of fiscal and monetary policy that stealthily has been in effect for over 6 years now. Chair Yellen and others will be disheartened by this change in culture. Too bad. If there is an answer, the answer is that it’s just that way.

Investment implications: Prepare for renewed QE from the Fed. Interest rates will stay low for longer, asset prices will continue to be artificially high. At some point, monetary policy will create inflation and markets will be at risk. Not yet, but be careful in the interim. Be content with low single digit returns.