theory of money


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As of last week, our assessment of the overall market return/risk profile remains dominated by three factors, the first being wickedly extreme valuations (which we associate with near-zero expected S&P 500 nominal total returns over the coming 12-year period, with the likelihood of interim losses on the order of 50-60%), the second being the most extreme syndromes of overvalued, overbought, overbullish conditions we define, and the third – and the most important in terms of near-term market risk – being divergent and deteriorating market internals on the measures we use to assess investor risk-preferences.

It’s important to emphasize that this full set of conditions has been present during only a fraction of the advancing half-cycle since 2009, and that on balance, the S&P 500 has lost value during these periods. Moreover, this is the same set of conditions that allowed us to anticipate the 2000-2002 and 2007-2009 collapses.

Investors would do well to understand the distinction between an overvalued market that retains uniformly favorable market internals, and an overvalued market that has lost that feature. I’ve openly detailed our challenges in this half cycle and how we adapted, primarily in 2014 (see Being Wrong In An Interesting Way for a detailed narrative). The central lesson of this half-cycle is not that quantitative easing or zero interest rates can be relied on to permanently support stocks, but rather, that the novel and deranged monetary policy of the Federal Reserve was able to encourage continued yield-seeking speculation long after the emergence of “overvalued, overbought, overbullish” extremes that had reliably heralded steep downside risk in prior market cycles across history. In the face of zero interest rates, one had to wait for market internals to deteriorate explicitly (indicating a shift in investor preferences from speculation to risk-aversion), before adopting a hard-negative market outlook.

Even here, an improvement in market internals would defer our immediate concerns about severe downside risk. Presently, however, investors who believe our current defensiveness is simply “more of the same” haven’t absorbed the central lessons of our challenges in the advancing portion of this market cycle, nor the distinctions that could potentially save them from extraordinary market losses over the completion of this cycle.

How to wind down a $4 trillion balance sheet

Last week, the Federal Reserve issued a set of Policy Normalization Principles and Plans, by which the size of its portfolio of government securities would “decline in a gradual and predictable manner until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.” Essentially, as existing securities held by the Fed mature, the Fed would reinvest the proceeds into new government securities only to the extent that those proceeds exceed “caps” which begin at $10 billion monthly, expand by an additional $10 billion every 3 months, and top out at $50 billion monthly.

Recall how the Federal Reserve’s open market transactions operate. When the Fed buys Treasury securities or U.S. government agency securities from the public (it can’t buy them directly from the Treasury, because, see, that would make us look like a banana republic), it pays for those securities by creating bank reserves, which are deposited in the seller’s bank account. The bonds become assets on the Fed’s balance sheet, and the reserves are liabilities of the Fed (as is the currency in your pocket, which you can verify by looking at the top line just above the picture of a President). The sum of currency and bank reserves comprises the “monetary base,” which is the only version of the money supply that the Fed can directly control. In short, when the Fed buys bonds, the Fed creates base money. When the Fed sells bonds (or Fed holdings mature without the Fed reinvesting the proceeds in new bonds), the Fed retires base money.

How does this relate to short-term interest rates? Well, historically, neither currency nor bank reserves have earned interest (I’ll discuss a new wrinkle shortly). As the Fed creates more zero-interest base money, some investors decide that they would prefer to hold a closely competing asset that does earn interest; the most similar option being Treasury bills. Those transactions don’t change the amount of outstanding base money or Treasury bills; it just changes who owns them, and at what price. Increasing the size of the zero-interest monetary base encourages some investors to bid up Treasury bills (which drives down the interest rate on Treasury bills), and the process stops at the point where the yield on Treasury bills is just low enough to make investors indifferent between holding zero-interest base money and those now-lower yielding Treasury bills. Put another way, the new level of short-term interest rates ensures that investors, in aggregate, are willing to hold the outstanding quantity of both base money and Treasury bills. Conversely, contracting the size of the monetary base tends to raise short-term interest rates.

Economists know this relationship between base money and interest rates as the “liquidity preference curve.” As a practical matter, though, one has to normalize the monetary base by the size of the economy itself, so we find that the actual relationship is between Treasury bill yields and the ratio of monetary base/nominal GDP. The chart below shows this link; our version of the liquidity preference curve, in U.S. data since 1929. It’s one of the most robust relationships you’ll find in economics. The Fed does not have to make guesses about exactly what is required to normalize its balance sheet, except to the extent that it ignores a century of evidence.

Notice the little scatter of points in recent quarters that are slightly above the level one would expect given the current size of the monetary base. These points can exist because the Fed has added a new wrinkle in recent quarters. Because quantitative easing was pushed to deranged (literally de-ranged) extremes, the only way to raise interest rates above zero without immediately cutting the monetary base in half was to explicitly pay banks for holding idle reserves. This new practice of paying interest on reserves is how the Fed has raised rates in recent quarters, without the need to massively contract its balance sheet.

One of the risks the Fed is courting here is that if it buys, say, a 7-year Treasury bond, and its average policy rate over the next 7 years exceeds the yield-to-maturity when the Fed bought the bond, it will effectively be engaging in fiscal policy because it will have to pay more interest to banks than the interest it actually receives on the bond, and it would not recover that difference at maturity. This would effectively be unconstitutional, since only Congress can authorize such expenditures through an explicit budget process. It will be interesting to see how this plays out.

Currently, there are about 20 cents of monetary base outstanding for every $1 of U.S. nominal GDP. On the subject of “holding no more securities than necessary,” the Fed’s balance sheet remains more than $1 trillion larger than is actually necessary to produce zero interest rates, and is nearly $2 trillion larger than the level that could achieve the current 1% Federal Funds target, without any need to pay banks interest on their idle reserves.

Given the extraordinarily well-behaved relationship between short-term interest rates and the ratio of the monetary base to nominal GDP, we can easily estimate the level of interest rates consistent with any particular size of the Fed’s balance sheet. A “static” or steady-state estimate does reasonably well, and requires only the current level of MB/GDP (though the best function is non-linear). One obtains a better fit across history by including the 6-month lagged value of MB/GDP as well, since there is a clear tendency for rates to decline faster than the static estimate when the monetary base is expanding, and to rise faster than the static estimate when the monetary base is contracting.

The latest statement from the Federal Reserve suggests a projected course for short-term interest rates reaching 3% by 2019, which would effectively require a 0.25% rate hike roughly every 5 months. Regardless of whether one agrees with that projection or not, it is relatively straightforward to project the size of the monetary base that would be consistent with that final target, without requiring the Fed to pay interest on excess bank reserves (IOER). Below, I’ve included both our dynamic and our static estimates of interest rates that would be consistent, in the absence of IOER, with the normalization plan announced by the Fed (much larger balance sheet contractions would be required to actually reach the Fed’s interest rate projections at each point in time in the absence of IOER). The chart below assumes that the Fed begins its normalization plan in December of this year, and pursues it until the Fed balance sheet is sufficient to achieve a 3% target. I estimate that a 3% target would be reached (using dynamic estimates) in 2020, after which the monetary base would have to continue to decline for a while longer, though at a reduced pace, in order to maintain that target over time.

The chart below shows the associated trajectory of the monetary base under a bona-fide normalization plan. Depending on whether one uses static or dynamic estimates, the monetary base would have to decline from its current level of $3.8 trillion to a range between $2.2 and $2.6 trillion in order to establish a 1% target rate (without IOER); between $1.9 and $2.3 trillion to establish a 2% target rate; and between $1.7 and $2.1 trillion to establish a 3% target rate. If the Federal Reserve maintains a larger balance sheet, achieving those targets would require continued explicit payments of interest to banks on idle reserves, and the Fed would continue to exceed the historical parameters required to implement sound monetary policy. The chart below assumes a 5% growth rate for nominal GDP. Slower growth would require somewhat greater balance sheet contraction to achieve various interest rate targets (without IOER) over the coming years.

Frankly, we’re not hopeful that the coming years will unfold gently, not because the Fed will or will not normalize its balance sheet, but because a great deal of damage is already baked-in-the-cake as the result of years of yield-seeking speculation and low-grade credit issuance. If there was clear evidence that activist monetary policy has reliable economic benefits (above and beyond those that can be expected from simple mean-reverting behavior of non-monetary variables like output and employment, which is the entire story of the recovery since 2009), there might be some justification for what the Fed has done. But as I detailed in Failed Transmission: Evidence on the Futility of Activist Fed Policy, despite vapid theoretical diagrams and baseless verbal prose to the contrary, the hard economic data fail to support that view.

At some point, perhaps during the next financial collapse, the public may become willing to demand that policymakers support their behavior with systematic evidence of reliable correlations and substantial effect sizes linking policy actions to real economic activity. Instead, we know only one thing for certain, which is that, across history, extended periods of easy money, and the resulting frenzies of low-quality credit issuance and yield-seeking speculation that follow, have regularly unraveled into crisis and collapse. If one repeatedly learns that feeding a beast can briefly appease it, but predictably makes it more enormous, savage, and unstable, it is best to remember the lesson. Instead, central bankers have doomed the world to learn that lesson again.

Presently, the most reliable market valuation measures we identify (those best correlated with actual subsequent S&P 500 10-12 year annual total returns) range between 140% and 165% above their historical norms. No market cycle in history, even those featuring quite low interest rates, has failed to draw them within 25% of those norms, or below, implying the likelihood of a 50-60% market decline over the completion of the current cycle.

Suspending the misplaced faith in easy money

Meanwhile, remember that Fed policy matters little once investors become averse to risk. The combination of market valuations and market internals is the most important feature to consider. It’s clear that, in the recent market cycle, zero interest rate policy was able to sustain yield-seeking speculation and uniformly favorable market internals long after extreme “overvalued, overbought, overbullish” syndromes emerged. That’s a lesson we will not forget. But that lesson is far different from assuming that easy money or low interest rates will support extreme valuations even in the face of divergent and deteriorating market internals.

Investors should recognize that in data since 1940 and prior to 2008, U.S. interest rates were at or below present levels about 15% of the time. During those periods, the average level of the Shiller cyclically-adjusted P/E was about -50% below present levels, and the average ratios of MarketCap/GVA, MarketCap/GDP and Tobin’s Q (market capitalization to replacement cost of corporate assets) were all about -60% below present levels. That’s roughly the same distance that current market valuations are from post-war pre-bubble norms, even regardless of the level of interest rates. Put simply, investors have vastly overstated the argument that low interest rates “justify” extreme market valuations. Indeed, the correlation between the two is weak, nonexistent, or goes entirely the wrong way in most periods of U.S. history outside of the inflation-disinflation cycle from 1970 to 1998.

The chart below is instructive. The blue line (left scale, log, inverted) shows the ratio of nonfinancial market capitalization to nonfinancial corporate gross value-added, including estimated foreign revenues. The red line (right scale) shows the actual subsequent S&P 500 nominal average annual total return over the following 12-year period. The purple line shows 3-month Treasury bill yields. The green line shows long-term Treasury bond yields. The fact that this graph is a chaotic tangle of lines is a reminder that the link between interest rates and market valuations is far more tenuous than investors seem to assume.

As I detailed in The Most Broadly Overvalued Moment in Market History, to the extent that investors view interest rates as important, the proper way to factor them in is to first use existing prices and valuations to estimate prospective market returns (an exercise of arithmetic that does not require the use of interest rates), and then to compare those prospective returns with interest rates to judge whether prospective equity market returns are adequate. At present, we estimate that despite their rather depressed yields, Treasury bonds, as well as a sequence of investments in Treasury bills, are likely to outperform the total return of the S&P 500 well beyond a 12-year horizon. That’s a far cry from how stocks were priced between late-2008 and 2012 (see the chart above).

If our measures of market internals improve, we would defer our immediate concerns about downside risk, regardless of current valuation extremes. That’s particularly true if market internals were to improve along with a shift back to zero interest rates (which is essentially the lesson of the pre-2014 period). Indeed, an improvement in market action following a material retreat in valuations would likely shift us to a constructive or aggressive position, even if the retreat in valuations comes far short of a reversion to historically normal valuations. Note that all of these possibilities prioritize the behavior of market internals (and the investor risk-preferences they capture) above Fed policy in and of itself. The same prioritization holds versus economic factors, earnings growth, and a host of other variables.

I’ll say this once again. Our Achilles Heel in the advancing portion of this cycle was straightforward: in prior market cycles across history, the emergence of extreme overvalued, overbought, overbullish syndromes had an urgency that preceded even the behavior of market internals. Quantitative easing disrupted that regularity. But even since 2009, the S&P 500 has lost value, on average, in periods that joined rich valuation, “overvalued, overbought, overbullish” syndromes, and deterioration in the uniformity of market internals. That’s the combination we currently observe, and our market outlook will shift as the evidence does.

Recall that the Fed eased persistently and aggressively throughout the 2000-2002 and 2007-2009 downturns. Once uniformly favorable market internals are lost and investor preferences shift toward risk aversion, monetary policy is not supportive of equities, because safe, liquid money market assets are seen as desirable assets rather than inferior ones. When market internals deteriorate following an extended period of wickedly overvalued, overbought, overbullish conditions, market collapses have typically followed, regardless of the response of the Federal Reserve. Investors should understand that lesson now. My impression is that they are going to need it.

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Many mainstream economists, perhaps a majority of those who have an opinion, are opposed to tying a central bank’s hands with any explicit monetary rule. A clear majority oppose the gold standard, at least according to an often-cited survey. Why is that?

First some preliminaries. By a “gold standard” I mean a monetary system in which gold is the basic money. So many grains of gold define the unit of account (e.g. the dollar) and gold coins or bullion serve as the medium of redemption for paper currency and deposits. By an “automatic” or “classical” gold standard I mean one in which there is no significant central-bank interference with the functioning of the market production and arbitrage mechanisms that equilibrate the stock of monetary gold with the demand to hold monetary gold. The United States was part of an international classical gold standard between 1879 (the year that the dollar’s redeemability in gold finally resumed following its suspension during the Civil War) and 1914 (the First World War).

Why isn’t the gold standard more popular with current-day economists? Milton Friedman once hypothesized that monetary economists are loath to criticize central banks because central banks are by far their largest employer. Providing some evidence for the hypothesis, I have elsewhere suggested that career incentives give monetary economists a status-quo bias. Most understandably focus their expertise on serving the current regime and disregard alternative regimes that would dispense with their services. They face negative payoffs to considering whether the current regime is the best monetary regime.

Here I want to propose an alternative hypothesis, which complements rather than replaces the employment-incentive hypothesis. I propose that many mainstream economists today instinctively oppose the idea of the self-regulating gold standard because they have been trained as social engineers. They consider the aim of scientific economics, as of engineering, to be prediction and control of phenomena (not just explanation). They are experts, and an automatically self-governing gold standard does not make use of their expertise. They prefer a regime that values them. They avert their eyes from the possibility that they are trying to optimize a Ptolemaic system, and so prefer not to study its alternatives.

The actual track record of the classical gold standard is superior in major respects to that of the modern fiat-money alternative. Compared to fiat standards, classical gold standards kept inflation lower (indeed near zero), made the price level more predictable (deepening financial markets), involved lower gold-extraction costs (when we count the gold extracted to provide coins and bullion to private hedgers under fiat standards), and provided stronger fiscal discipline. The classical gold standard regime in the US (1879-1914), despite a weak banking system, did no worseon cyclical stability, unemployment, or real growth.

The classical gold standard’s near-zero secular inflation rate was not an accident. It was the systemic result of the slow growth of the monetary gold stock. Hugh Rockoff (1984, p. 621) foundthat between 1839 and 1929 the annual gold mining output (averaged by decade) ran between 1.07 and 3.79 percent of the existing stock, with the one exception of the 1849-59 decade (6.39 percent growth under the impact of Californian and Australian discoveries). Furthermore, an occasion of high demand for gold (for example a large country joining the international gold standard), by raising the purchasing power of gold, would stimulate gold production and thereby bring the purchasing power back to its flat trend over the longer term.

A recent example of a poorly grounded historical critique is provided by textbook authors Stephen Cecchetti and Kermit Schoenholtz. They imagine that the gold standard determined money growth and inflation in the US until 1933, and so they count against the gold standard the US inflation rate in excess of 20% during the First World War (specifically 1917), followed by deflation in excess of 10% a few years later (1921). These rates were actually produced by the policies of the Federal Reserve System, which began operations in 1914. The classical gold standard had ended during the Great War, abandoned by all the European combatants, and did not constrain the Fed in these years. Cecchetti and Schoenholtz are thus mistaken in condemning “the gold standard” for producing a highly volatile inflation rate. (They do find, but do not emphasize, that average inflation was much lower and real growth slightly higher under gold.) They also mistakenly blame “the gold standard” — not the Federal Reserve policies that prevailed, nor the regulatory restrictions responsible for the weak state of the US banking system — for the US banking panics of 1930, 1931, and 1933. Studies of the Fed’s balance sheet and activities during the 1930s have found that it had plenty of gold (Bordo, Choudhri and Schwartz, 1999; Hsieh and Romer, 2006, Timberlake 2008). The “tight” monetary policies it pursued were not forced on it by lack of more abundant gold reserves.

There are of course serious economic historians who have done valuable research on the performance of the classical gold standard and yet remain critics. Their main lines of criticism are two. First, they too lump the classical gold standard together with the very different interwar period and mistakenly attribute the chaos of the interwar period to the gold standard mechanisms that remained, rather than to central bank interference with those mechanisms. In rebuttal Richard Timberlake has pertinently asked how, if it was the mechanisms of the gold standard (and not central banks’ attempts to manage them) that destabilized the world economy during the interwar period, those same mechanisms managed to maintain stability before the First World War (when central banks intervened less or, as in the United States, did not exist)? Here, I suggest, a strong pre-commitment to expert guidance acts like a pair of blinders. Wearing those blinders, even if it is seen that the prewar system differed from and outperformed the interwar system, it cannot be seen that this was because the former was comparatively self-regulating and the latter was comparatively expert-guided.

Second, it is always possible to argue in defense of expert guidance that even the classical gold standard was second-best to an ideally managed fiat money where experts call the shots. Even if central bankers operated on the wrong theory during the 1920s, during the Great Depression, and under Bretton Woods, not to mention during the Great Inflation and the Great Recession, today they operate (or can be gotten to operate) on the right theory.

In the worldview of economics as social engineering, monetary policy-making by experts must almost by definition be better than a naturally evolved or self-regulating monetary system without top-down guidance. After all, the experts could always choose to mimic the self-regulating system in the unlikely event that it were the best of all options. (In the most recent issue of Gold Investor, Alan Greenspan claims that mimicking the gold standard actually was his policy as Fed chairman.) As experts they sincerely believe that “we can do better” by taking advantage of expert guidance. How can expert guidance do anything but help?

Expert-guided monetary policy can fail in at least three well-known ways to improve on a market-guided monetary system. First, experts can persist in using erroneous models (consider the decades in which the Phillips Curve reigned) or lack the timely information they would need to improve outcomes. These were the reasons Milton Friedman cited to explain why the Fed’s use of discretion has amplified rather than dampened business cycles in practice. Second, policy-makers can set experts to devising policies to meet goals that are not the public’s goals. This is James Buchanan’s case for placing constraints on monetary policy at the constitutional level. Third, where the public understands that the central bank has no pre-commitments, chronically suboptimal outcomes can result even when the central bank has full information and the most benign intentions. This problem was famously emphasized by Finn E. Kydland and Edward C. Prescott (1977).

These lessons have not been fully absorbed. A central bank that announces its own inflation target (as the Fed has), and especially one that retains a “dual mandate” to respond to real variables like the unemployment rate or the estimated output gap, retains discretion. It is free to change or abandon its inflation-rate target, with or without a new announcement. Retaining discretion — the option to change policy in this way – carries a cost. The money-using public, uncertain about what the central bank experts will decide to do, will hedge more and invest less in capital formation than they would with a credibly committed regime. A commodity standard — especially without a central bank to undermine the redemption commitments of currency and deposit issuers — more completely removes policy uncertainty and with it overall uncertainty.

Speculation about the pre-analytic outlook of monetary policy experts could be dismissed as mere armchair psychology if we had no textual evidence about their outlook. Consider, then, a recent speech by Federal Reserve Vice Chairman Stanley Fischer. At a May 5, 2017 conference at the Hoover Institution, Fischer addressed the contrast between “Committee Decisions and Monetary Policy Rules.” Fischer posed the question: Why should we have “monetary policy decisions … made by a committee rather than by a rule?” His reply: “The answer is that opinions — even on monetary policy — differ among experts.” Consequently we “prefer committees in which decisions are made by discussion among the experts” who try to persuade one another. It is taken for granted that a consensus among experts is the best guide to monetary policy-making we can have.

Fischer continued:

Emphasis on a single rule as the basis for monetary policy implies that the truth has been found, despite the record over time of major shifts in monetary policy — from the gold standard, to the Bretton Woods fixed but changeable exchange rate rule, to Keynesian approaches, to monetary targeting, to the modern frameworks of inflation targeting and the dual mandate of the Fed, and more. We should not make our monetary policy decisions based on that assumption. Rather, we need our policymakers to be continually on the lookout for structural changes in the economy and for disturbances to the economy that come from hitherto unexpected sources.

In this passage Fischer suggested that historical shifts in monetary policy fashion warn us against adopting a non-discretionary regime because they indicate that no “true” regime has been found. But how so? That governments during the First World War chose to abandon the gold standard (in order to print money to finance their war efforts), and that they subsequently failed to do what was necessary to return to a sustainable gold parity (devalue or deflate), does not imply that the mechanisms of the gold standard — rather than government policies that overrode them — must have failed. Observed changes in regimes and policies do not imply that each new policy was an improvement over its predecessor — unless we take it for granted that all changes were all wise adaptations to exogenously changing circumstances. Unless, that is, we assume that the experts guiding monetary policies have never yet failed us.

Fischer further suggested that a monetary regime is not to be evaluated just by the economy’s performance, but by how policy is made: a regime is per se better the more it incorporates the latest scientific findings of experts about the current structure of the economy and the latest models of how policy can best respond to disturbances. If we accept this as true, then we need not pay much if any attention to the gold standard’s actual performance record. But if instead we are going to judge regimes largely by their performance, then replacing the automatic gold standard by the Federal Reserve’s ever-increasing discretion cannot simply be presumed a good thing. We need to consult the evidence. And the evidence since 1914 suggests otherwise.

Contrary to Fischer, there is no good reason to presume that expert-guided monetary regimes get progressively better over time, because there is no filter for replacing mistaken experts with better experts. We have no test of the successful exercise of expertise in monetary policy (meaning, superiority at correctly diagnosing and treating exogenous monetary disturbances, while avoiding the introduction of money-supply disturbances) apart from ex post evaluation of performance. The Fed’s performance does not show continuous improvement. As previously noted, it doesn’t even show improvement over the pre-Fed regime in the US.

A fair explanation for the Fed’s poor track record is Milton Friedman’s: the information necessary for successful expert guidance of monetary policy is simply not available in a timely fashion. Those who recognize this point will be open to considering the merits of moving, to quote the title a highly pertinent article by Leland B. Yeager, “toward forecast-free monetary institutions.” Experts who firmly believe in expert guidance of monetary policy, of course, will not recognize the point. They will accordingly overlook the successful track record of the automatic gold standard (without central bank management) as a forecast-free monetary institution.

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We live in an age of advanced monetary surrealism. In Q1 2017 alone, the largest central banks created the equivalent of almost USD 1,000 bn. worth of central bank money ex nihilo. Naturally the fresh currency was not used to fund philanthropic projects but to purchase financial securities1. Although this ongoing liquidity supernova has temporarily created an uneasy calm in financial markets, we are strongly convinced that the real costs of this monetary madness will reveal themselves down the line.

We believe that the monetary tsunami created in the past years, consisting of a flood of central bank money and new debt, has created a dangerous illusion: the illusion of a carefree present at the expense of a fragile future. The frivolity displayed by many investors is for example reflected by record-low volatility in equities, which have acquired the nimbus of being without alternative, and is also highlighted by the minimal spreads on corporate and government bonds.

Almost a decade of zero and negative interest rates has atomised any form of risk aversion. While the quantitative easing programmes are still going at full throttle in many places without the media paying much attention, the situation in the USA looks decidedly different: seven years after the Fed funds rate had been set to zero, the first interest rate hike by the Federal Reserve in December 2015 marked the end of the longest period of immobility in terms of interest rate policy in history. To many market participants, this overdue step towards normalising the monetary policy is the confirmation of the much-desired comeback of the US economy.

However, the interest rate reversal that had been announced for years got off to a sluggish start. Market participants became increasingly nervous in 2016 when it started turning out that central banks would not be remotely able to stick to the speed of four interest rate hikes as announced. After the FOMC meeting in March 2016, the first question that CNBC journalist Steve Liesman asked Janet Yellen was:

“Does the Fed have a credibility problem […]?”2

We believe that the absence of the often-quoted sustainable economic recovery is one factor to blame for the passivity of the Fed. The depreciation of the Chinese currency and the still falling yields at the long end of the yield curve in 2016 are two others, as a result of which the Fed had to procrastinate until December 2016.

The gold price celebrated a remarkable comeback during this hesitant phase of the Fed. Last year we confidently opened the “In Gold We Trust” report with the line “Gold is back!”. We had anticipated the passivity of the Fed as well as the return of the bull market. The gold price seemed to have experienced a sustainable trend reversal in USD, and we felt our bullish stance had just been confirmed.

But our gold(en) optimism was stopped in its tracks again in autumn 2016. The gold price declined significantly, in particular in the last quarter of 2016, even though the maximum drawdown has never exceeded 20%. We can therefore still call the status quo a correction within the confines of a new bull market, but we want to openly admit that we had not foreseen the dent in the gold price performance. Our target price of USD 2,300 for June 2018 may therefore prove overly optimistic. But what was the trigger of the sudden reverse thrust of the gold price?

Ironically, it was Donald J. Trump. The election of the presidential candidate originally unloved by Wall Street fuelled hopes of a renaissance of America on the basis of a nationalistic growth policy. President Trump brought about a change in sentiment, especially among a class of society that had lost its trust in the economic system and political institutions. Stocks received another boost, and the increase in the gold price was (temporarily) halted.

The Fed seems to be keen to use the new euphoria on the markets in order to push the normalisation of monetary policy. Even if the journalistic mainstream is abundantly convinced of the sustainability of the US interest rate reversal, a contradiction is embedded in the narrative of the economic upswing triggered by Trump: if the economic development, as claimed by the Fed in the past years, was actually rosy even prior to Trump’s victory, the candidate promising in his central message to make America great AGAIN would presumably not have won. The narrative of a recovering US economy is the basis of the bull market in equities.

The valuation level of the US equity market is nowadays ambitious, to put it mildly – both in absolute numbers and in terms of the economic output. This prompts the conclusion that the U.S. is caught up for the third time within two decades in an illusionary bubble economy created by money supply inflation and equipped with an expiry date. In comparison with the earlier two bubbles, however, the excess is not limited to certain sectors (technology in 2000, credit in 2008), but it is omnipresent and includes various asset classes, especially also bonds and (again) property. In view of the current situation, the renowned analyst Jesse Felder rightly talks about an “Everything Bubble”.4 From our point of view, the concept of the classic investment portfolio, which calls for shares to satisfy the risk appetite and bonds as safety net, must be critically questioned.

While markets are already celebrating the future successes of Trumponomics, the structural weakness of the US real economy is revealed yet again in the latest growth figures. According to the most recent estimate, the US economy expanded in Q1 2017 by a meagre 1.2 % y/y. In combination with an inflation rate of more than 2%, this means that the U.S. is at the edge of stagflation – a scenario we have warned about on several prior occasions. But markets are obviously taking a different view than we are. At least for now.

Moreover, the ratio of real assets to financial assets is currently the lowest since 1925.5 In a study worth reading, Michael Hartnett, chief strategist at Bank of America Merrill Lynch, recommends to “get real”, i.e. to reallocate investments from financial assets into real assets.

“Today the humiliation is very clearly commodities, while the hubris resides in fixed-income markets”

as Hartnett explains. Gold, diamonds, and farmland show the highest positive correlation with rising inflation, whereas equities and bonds are negatively correlated with increasing prices, a finding that we have pointed out repeatedly. The political trend towards more protectionism and stepped-up fiscal stimuli will also structurally drive price inflation.6

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Scarcely more than a year since it was signed, the Smithsonian Agreement, the “greatest monetary agreement in the history of the world” (in the words of President Nixon) lay in shambles. And so the world vibrates, with increasing intensity, between fixed and fluctuating exchange rates, with each system providing only a different set of ills. We apparently live in a world of perpetual international monetary crises.

In this distressing situation, the last few years have seen the burgeoning of a school of economists who counsel a simple solution for the world’s monetary illness. Since fixed exchange rates between currencies seem to bring only currency shortages and surpluses, black markets and exchange controls, and a chronic series of monetary crises, why not simply set all these currencies free to fluctuate with one another? This group of economists, headed by Professor Milton Friedman and the “Chicago School,” claims to be speaking blunt truths in the name of the “free market.” The simple and powerful case of the Friedmanites goes somewhat as follows:

Economic theory tells us the myriad evils that stem from any attempt at price controls of goods and services. Maximum price controls lead to artificially created shortages of the product; minimum controls lead to artificial unsold surpluses. There is a ready cure for these economic ills; they are caused not by processes deep within the free market economy, but by arbitrary government intervention into the market. Remove the controls, let market processes have full sway, and shortages and surpluses will disappear.

Similarly, the monetary crises of recent years are the product of government attempts to fix exchange rates between currencies. If the government of Ruritania fixes the “rur” at a rate higher than its free market price, then there will be a surplus of rurs looking for undervalued currencies, and a shortage of these harder currencies. The “dollar shortage” of the early postwar years was the result of the dollar being undervalued in terms of other currencies; the current surplus of dollars, as compared to West German marks or Japanese yen, is a reflection of the overvaluation of the dollar compared to these other currencies. Allow all of these currencies to fluctuate freely on the market, and the currencies will find their true levels, and the various currency shortages and surpluses will disappear. Furthermore, there will be no need to worry any longer about deficits in any country’s “balance of payments.” Under the pre-1971 system, when dollars were at least theoretically redeemable in gold, an excess of imports over exports led to a piling up of dollar claims and an increasingly threatening outflow of gold. Eliminate gold redeemability and allow the currencies to fluctuate freely, and the deficit will automatically correct itself as the dollar suppliers bid up the prices of marks and yen, thereby making American goods less expensive and German and Japanese goods more expensive in the world market.

Such is the Friedmanite case for the freely fluctuating exchange rate solution to the world monetary crisis. Any objection is met by a variant of the usual case for a free market. Thus, if critics assert that changing exchange rates introduce unwelcome uncertainty into world markets and thereby hinder international trade, particularly investment, the Friedmanites can reply that uncertainty is always a function of a free price system, and most economists support such a system. If the critics point to the evils of currency speculation, then Friedmanites can reply by demonstrating the important economic functions of speculation on the free commodity markets of the world. All this permits the Friedmanites to scoff at the timidity and conservatism of the world’s bankers, journalists, and a dwindling handful of economists. Why not try freedom? These arguments, coupled with the obvious and increasingly evident evils of such fixed exchange rate systems as Bretton Woods (1945–1971) and the Smithsonian (1971–1973), are bringing an increasing number of economists into the Friedmanite camp.

The Friedmanite program cannot be fully countered in its details; it must be considered at the level of its deepest assumptions. Namely, are currencies really fit subjects for “markets”? Can there be a truly “free market” between pounds, dollars, francs, and so on?

Let us begin by considering this problem: suppose that someone comes along and says, “The existing relationship between pounds and ounces is completely arbitrary. The government has decreed that 16 ounces are equal to 1 pound. But this is arbitrary government intervention; let us have a free market between ounces and pounds, and let us see what relationship the market will establish between ounces and pounds. Perhaps we will find that the market will decide that 1 pound equals 14 or 17 ounces.” Of course, everyone would find such a suggestion absurd. But why is it absurd? Not from arbitrary government edict, but because the pound is universally defined as consisting of 16 ounces. Standards of weight and measurement are established by common definition, and it is precisely their fixity that makes them indispensable to human life. Shifting relationships of pounds to ounces or feet to inches would make a mockery of any and all attempts to measure. But it is precisely the contention of the gold standard advocates that what we know as the names for different national currencies are not independent entities at all. They are not, in essence, different commodities like copper or wheat. They are, or they should be, simply names for different weights of gold or silver, and hence should have the same status as the fixed definition for any set, of weights and measures.

Let us bring our example a bit closer to the topic of money. Suppose that someone should come along and say, “The existing relationship between nickels and dimes is purely arbitrary. It is only the government that has decreed that two nickels equal one dime. Let us have a free market between nickels and dimes. Who knows? Maybe the market will decree that a dime is worth 7 cents or 11 cents. Let us try the market and see.” Again, we would feel that such a suggestion would be scarcely less absurd. But again, why? What precisely is wrong with the idea? Again the point is that cents, nickels, and dimes are defined units of currency. The dollar is defined as equal to 10 dimes and 100 cents, and it would be chaotic and absurd to start calling for day-to-day changes in such definitions. Again, fixity of definition, fixity of units of weight and measure, is vital to any sort of accounting or calculation.

To put it another way: the idea of a market only makes sense between different entities, between different goods and services, between, say, copper and wheat, or movie admissions. But the idea of a market makes no sense whatever between different units of the same entity: between, say, ounces of copper and pounds of copper. Units of measure must, to serve any purpose, remain as a fixed yardstick of account and reckoning.

The basic gold standard criticism of the Friedmanite position is that the Chicagoites are advocating a free market between entities that are in essence, and should be once more, different units of the same entity, that is, different weights of the commodity gold. For the implicit and vital assumption of the Friedmanites is that every national currency—pounds, dollars, marks, and the like—is and should be an independent entity, a commodity in its own right, and therefore should fluctuate freely with one another.

Let us consider: what are pounds, francs, dollars? Where do they come from? The Friedmanites take them at face value as things or entities issued at will by different central governments. The British government defines something as a “pound” and issues or controls the issue of whatever number of pounds it decides upon (or controls the supply of bank credit redeemable in these “pounds”). The United States government does the same for “dollars,” the French government the same for “francs,” and so on.

The first thing we can say, then, is that this is a very curious kind of “free market” that is being advocated here. For it is a free market in things, or entities, which are issued entirely by and are at the complete mercy of each respective government. Here is already a vital difference from other commodities and free markets championed by the Chicago school. Copper, steel, wheat, movies are all, in the Friedman scheme, issued by private firms and organizations, and subject to the supply and demand of private consumers and the free market. Only money, only these mysterious “dollars,” “marks,” and so on, are to be totally under the control and dictation of every government. What sort of “free” market is this? To be truly analogous with free markets in other commodities, the supply of money would have to be produced only by private firms and persons in the market, and be subject only to the demand and supply forces of private consumers and producers. It should be clear that the governmental fiat currencies of the Friedmanite scheme cannot possibly be subject only to private and therefore to free market forces.

Is there any way by which the respective national moneys can be subject solely to private market forces? Is such a thing at all possible? Not only is the answer yes, but it is still true that the origin of all these currencies that the Friedmanites take at face value as independent entities, was, each and every one, as units of weight of gold in a truly private and free market for money.

To understand this truth, we must go back beyond the existing fiat names for money and see how they originated. In fact, we need go back only as far as the Western world before World War I. Even today, the “dollar” is not legally defined an independent fictive name; it is still legally defined by U.S. statute as a unit of weight of gold, now approximately one-forty-second of a gold ounce. Before 1914, the dollar was defined as approximately one-twentieth of a gold ounce. That’s what a “dollar” was. Similarly the pound sterling was not an independent name; it was defined as a gold weight of slightly less than one-fourth of a gold ounce. Every other currency was also defined in terms of a weight of gold (or, in some cases, of silver). To see how the system worked, we assume the following definition for three of the numerous currencies:

1 dollar defined as one-twentieth of a gold ounce;
1 pound sterling defined as one-fourth of a gold ounce;
1 franc defined as one-hundredth of a gold ounce.

In this case, the different national currencies are different in name only. In actual fact, they are simply different units of weight of the same commodity, gold. In terms of each other, then, the various currencies are immediately set in accordance with their respective gold weights, namely,

1 dollar is defined as equal to one-fifth of a pound sterling, and to 5 francs;
1 franc is defined as equal to one-fifth of a dollar, and to one twenty-fifth of a pound;
1 pound is defined as equal to 5 dollars, and to 25 francs.

We might say that the “exchange rates” between the various countries were thereby fixed. But these were not so much exchange rates as they were various units of weight of gold, fixed ineluctably as soon as the respective definitions of weight were established. To say that the governments “arbitrarily fixed” the exchange rates of the various currencies is to say also that governments “arbitrarily” define 1 pound weight as equal to 16 ounces or 1 foot as equal to 12 inches, or “arbitrarily” define the dollar as composed of 10 dimes and 100 cents. Like all weights and measures, such definitions do not have to be imposed by government. They could, at least in theory, have been set by groups of scientists or by custom and commonly accepted by the general public.

This “classical gold standard” had numerous and considerable economic and social advantages. In the first place, the supply of money in the various countries was basically determined, not by government dictates, but—like copper, wheat, and so on—by the supply and demand forces of the free and private market. Gold was and is a metal that has to be discovered, and then mined, by private firms. Its supply was determined by market forces, by the demand for gold in relation to the demand and supply of other commodities and factors; by, for example, the relative cost and productivity of factors of production in mining gold and in producing other goods and services. At its base, the money supply of the world, then, was determined by free market forces rather than by the dictates of government. While it is true that governments were able to interfere with the process by weakening the links between the currency name and the weight of gold, the base of the system was still private, and hence it was always possible to return to a purely private and free monetary system. To the extent that the various currency names were kept as strictly equivalent to weights of gold, to that extent the classical gold standard worked well and harmoniously and without severe inflation or booms and busts.

The international gold standard had other great advantages. It meant that the entire world was on a single money, that money, with all its enormous advantages, had fully replaced the chaotic world of barter, where it is impossible to engage in economic calculation or to figure out prices, profits, or losses. Only when the world was on a single money did it enjoy the full advantage of money over barter, with its attendant economic calculation and the corollary advantages of freedom of trade, investment, and movement between the various countries and regions of the civilized world. One of the main reasons for the great growth and prosperity of the United States, it is generally acknowledged, was that it consisted of a large free-trading area within the nation: we have always been free of tariffs and trading quotas between New York and Indiana, or California and Oregon. But not only that. We have also enjoyed the advantage of having one currency: one dollar area between all the regions of the country, East, West, North, and South. There have also been no currency devaluations or exchange controls between New York and Indiana.

But let us now contemplate instead what could happen were the Friedmanite scheme to be applied within the United States. After all, while a nation or country may be an important political unit, it is not really an economic unit. No nation could or should wish to be self-sufficient, cut off from the enormous advantages of international specialization and the division of labor. The Friedmanites would properly react in horror to the idea of high tariffs or quota walls between New York and New Jersey. But what of different currencies issued by every state? If, according to the Friedmanites, the ultimate in monetary desirability is for each nation to issue its own currency—for the Swiss to issue Swiss francs, the French their francs, and so on—then why not allow New York to issue its own “yorks,” New Jersey its own “jersies,” and then enjoy the benefits of a freely fluctuating “market” between these various currencies? But since we have one money, the dollar, within the United States, enjoying what the Friedmanites would call “fixed exchange rates” between each of the various states, we don’t have any monetary crisis within the country, and we don’t have to worry about the “balance of payments” between New York, New Jersey, and the other states.

Furthermore, it should be clear that what the Friedmanites take away with one hand, so to speak, they give back with the other. For while they are staunchly opposed to tariff barriers between geographical areas, their freely fluctuating fiat currencies could and undoubtedly would operate as crypto-tariff barriers between these areas. During the fiat money Greenback period in the United States after the Civil War, the Pennsylvania iron manufacturers, who had always been the leading advocates of a protective tariff to exclude more efficient and lower cost British iron, now realized that depreciating greenbacks functioned as a protective device: for a falling dollar makes imports more expensive and exports cheaper.1 In the same way, during the international fiat money periods of the 1930s (and now from March 1973 on), the export interests of each country scrambled for currency devaluations, backed up by inefficient domestic firms trying to keep out foreign competitors. And similarly, a Friedmanite world within the United States would have the disastrous effect of functioning as competing and accelerating tariff barriers between the states.

And if independent currencies between each of the fifty states is a good thing, why not go still one better? Why not independent currencies to be issued by each county, city, town, block, building, person? Friedmanite monetary theorist Leland B. Yeager, who is willing to push the reductio ad absurdum almost all the way by advocating separate moneys for each region or even locality, draws back finally at the idea of each individual or firm printing his own money. Why not? Because, Yeager concedes, “Beyond some admittedly indefinable point, the proliferation of separate currencies for ever smaller and more narrowly defined territories would begin to negate the very concept of money.”2 That it would surely do, but the point is that the breakdown of the concept of money begins to occur not at some “indefinable point” but as soon as any national fiat paper enters the scene to break up the world’s money. For if Rothbard, Yeager, and Jones each printed his own “Rothbards,” “Yeagers,” and “Joneses” and these each amng billions freely fluctuating on the market were the only currencies, it is clear that the world would be back in an enormously complex and chaotic form of barter and that all trade and investment would be reduced to a virtual standstill. There would in fact be no more money, for money means a general medium for all exchanges. As a result, there would be no money of account to perform the indispensable function of economic calculation in a money and price system. But the point is that while we can see this clearly in a world of “every man his own currency,” the same disastrous principle, the same breakdown of the money function, is at work in a world of fluctuating fiat currencies such as the Friedmanites are wishing upon us. The way to return to the advantages of a world money is the opposite of the Friedmanite path: it is to return to a commodity which the entire world can and does use as a money, which means in practice the commodity gold.

One critic of fluctuating exchange rates, while himself a proponent
of “regional currency areas,” recognizes the classical argument for one world money. Thus, Professor Mundell writes:

It will be recalled that the older economists of the nineteenth century were internationalists and generally favored a world currency. Thus John Stuart Mill wrote in Principles of Political Economy, vol. 2, p. 176:

… So much of barbarism, however, still remains in the transactions of most civilized nations, that almost all independent countries choose to assert their nationality by having, to their own inconvenience and that of their neighbors, a peculiar currency of their own.

… Mill, like Bagehot and others, was concerned with the costs of valuation and money changing, not stabilization policy, and it is readily seen that these costs tend to increase with the number of currencies. Any given money qua numeraire, or unit of account,fulfills this function less adequately if the prices of foreign goods are expressed in terms of foreign currency and must then be translated into domestic currency prices. Similarly, money in its role of medium of exchange is less useful if there are many currencies; although the costs of currency conversion are always present, they loom exceptionally larger under inconvertibility or flexible exchange rates. Money is a convenience and this restricts the optimum number of currencies. In terms of this argument alone, the optimum currency area is the world, regardless of the number of regions of which it is composed.3

There is another reason for avoiding fiat paper currency issued by all governments and for returning instead to a commodity money produced on the private market (for example, gold). For once a money is established, whatever supply of money exists does the full amount of the “monetary work” needed in the economy. Other things being equal, an increase in the supply of steel, or copper, or TV sets is a net benefit to society: it increases the production of goods and services to the consumers. But an increase in the supply of money does no such thing. Since the usefulness of money comes from exchanging it rather than consuming it or using it up in production, an increased supply will simply lower its purchasing power; it will dilute the effectiveness of any one unit of money. An increase in the supply of dollars will merely reduce the purchasing power of each dollar, that is, will cause what is now called “inflation.” If money is a scarce market commodity, such as gold, increasing its supply is a costly process and therefore the world will not be subjected to sudden inflationary additions to its supply. But fiat paper money is virtually costless: it costs nothing for the government to turn on the printing press and to add rapidly to the money supply and hence to ruinous inflation. Give government, as the Friedmanites would do, the total and absolute power over the supply of fiat paper and of bank deposits—the supply of money—and we put into the hands of government a standing and mighty temptation to use this power and inflate money and prices.

Given the inherent tendency of government to inflate the money supply when it has the chance, the absence of a gold standard and “fixed exchange rates” also means the loss of balance-of-payments discipline, one of the few checks that governments have faced in their eternal propensity to inflate the money supply. In such a system, the outflow of gold abroad puts the monetary authorities on increased warning that they must stop inflating so as not to keep losing gold. Abandon a world money and adopt fluctuating fiat moneys, and the balance-of-payments limitation will be gone; governments will have only the depreciating of their currencies as a limit on their inflationary actions. But since export firms and inefficient domestic firms tend actually to favor depreciating currencies, this check is apt to be a flimsy one indeed.

Thus, in his critique of the concept of fluctuating exchange rates, Professor Heilperin writes:

The real trouble with the advocates of indefinitely flexible exchange rates is that they fail to take into sufficient consideration the causes of balance-of-payments disequilibrium. Now these, unlike Pallas Athene from Zeus’ head, never spring “fully armed” from a particular economic situation. They have their causes, the most basic of which [are] internal inflations or major changes in world markets.

“Fundamental disequilibria” as they are called … can and do happen. Often however, they can be avoided: if and when an incipient inflation is brought under control; if and when adjustments to external change are effectively and early made. Now nothing encourages the early adoption of internal correctives more than an outflow of reserves under conditions of fixed parities, always provided, of course, that the country’s monetary authorities are “internationally minded” and do their best to keep external equilibrium by all internal means at their disposal.4

Heilperin adds that the desire to pursue national monetary and fiscal policies without regard to the balance of payments is “one of the widespread and yet very fallacious aspirations of certain governments … and of altogether too many learned economists, aspirations to ‘do as one pleases’ without suffering any adverse consequences.” He concludes that the result of a fluctuating exchange rate system can only be “chaos,” a chaos that “would lead inevitably … to a widespread readoption of exchange controls, the worst conceivable form of monetary organization.”5

If governments are likely to use any power to inflate fiat currency that is placed in their hands, they are indeed almost as likely to use the power to impose exchange controls. It is politically naive in the extreme to place the supply of fiat money in the hands of government and then to hope and expect it to refrain from controlling exchange rates or going on to impose more detailed exchange controls. In particular, in the totally fiat economy that the world has been plunged into since March 1973, it is highly naive to expect European countries to sit forever on their accumulation of 80-odd billions of dollars—the fruits of decades of American balance-of-payments deficits—and expect them to allow an indefinite accumulation of such continually depreciating dollars. It is also naive to anticipate their accepting a continually falling dollar and yet do nothing to stem the flood of imports of American products or to spur their own exports. Even in the few short months since March 1973 central banks have intervened with “dirty” instead of “clean” floats to the exchange rates. When the dollar plunged rapidly downward in early July, its fall was only checked by rumors of increased “swap” arrangements by which the Federal Reserve would borrow “hard” foreign currencies with which to buy dollars.

But it should be clear that such expedients can only stem the tide for a short while. Ever since the early 1950s, the monetary policies of the United States and the West have been short-run expedients, designed to buy time, to delay the inevitable monetary crisis that is rooted in the inflationary regime of paper money and the abandonment of the classical gold standard. The difference now is that there is far less time to buy, and the distance between monetary crises grows ever shorter. All during the 1950s and 1960s the Establishment economists continued to assure us that the international regime established at Bretton Woods was permanent and impregnable, and that if the harder money countries of Europe didn’t like American inflation and deficits there was nothing they could do about it. We were also assured by the same economists that the official gold price of $35 an ounce—a price which for long has absurdly undervalued gold in terms of the depreciating dollar—was graven in stone, destined to endure until the end of time. But on August 15, 1971, President Nixon, under pressure by European central banks to redeem dollars in gold, ended the Bretton Woods arrangement and the final, if tenuous, link of the dollar to redemption in gold.

We are also told, with even greater assurance (and this time by Friedmanite as well as by Keynesian economists) that when, in March 1968, the free market gold price was cut loose from official governmental purchases and sales, that gold would at last sink to its estimated nonmonetary price of approximately $10 an ounce. Both the Keynesians and the Friedmanites, equal deprecators of gold as money, had been maintaining that, despite appearances, it had been the dollar which had propped up gold in the free—gold markets of London and Zurich before 1968. And so when the “two-tier gold market” was established in March, with governments and their central banks pledging to keep gold at $35 an ounce, but having nothing further to do with outside purchases or sales of gold, these economists confidently predicted that gold would soon disappear as a monetary force to reckon with. And yet the reverse has happened. Not only did gold never sink below $35 an ounce on the free market, but the market’s perceptive valuation of gold as compared to the shrinking and depreciating dollar has now hoisted the free market gold price to something like $125 an ounce. And even the hallowed $35 an ounce figure has been devalued twice in the official American accounts, so that now the dollar—still grossly overvalued—is pegged officially at $42.22 an ounce. Thus, the market has continued to give a thumping vote of confidence to gold, and has brought gold back into the monetary picture more strongly than ever.

Not only have the detractors of gold been caught napping by the market, but so have even its staunchest champions. Thus, even the French economist Jacques Rueff, for decades the most ardent advocate of the eminently sensible policy of going back to the gold standard at a higher gold price, even he, as late as October 1971 faltered and conceded that perhaps a doubling of the gold price to $70 might be too drastic to be viable. And yet now the market itself places gold at very nearly double that seemingly high price.6

Without gold, without an international money, the world is destined to stumble into one accelerated monetary crisis after another, and to veer back and forth between the ills and evils of fluctuating in exchange rates and of fixed exchange rates without gold. Without gold as the basic money and means of payment, fixed exchange rates make even less sense than fluctuating rates. Yet a solution to the most glaring of the world’s aggravated monetary ills lies near at hand, and nearer than ever now that the free-gold market points the way. That solution would be for the nations of the world to return to a classical gold standard, with the price fixed at something like the old current free market level. With the dollar, say, at $125 an ounce, there would be far more gold to back up the dollar and all other national currencies. Exchange rates would again be fixed by the gold content of each currency. While this would scarcely solve all the monetary problems of the world—there would still be need for drastic reforms of banking and central bank inflation, for example—a giant step would have been taken toward monetary sanity. At least the world would have a money again, and the spectre of a calamitous return to barter would have ended. And that would be no small accomplishment.

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It is ironic in a way that the Federal Reserve and its “rate hikes” have played a crucial role in setting back “reflation.”  There was some renewed hope up until that last FOMC vote in mid-March.  But since then, contrary to how markets “should” approach a higher federal funds band, bonds and funding have moved opposite. Swap spreads that for the first two and a half months of this year were decompressing, suggesting an easing in “dollar” pressure, began to compress (meaning for the 10s and 30s more negative) all over again after March 15.

It’s not difficult to assess why that was the case, where eurodollar futures, for example, could rise in price and therefore signal a (much) lower interest rate paradigm in the not-too-distant future despite the outwardly “hawkish” policy stance.  I wrote earlier this week:

“The markets ‘wanted’ the Fed exit to be the one that was described three years earlier, where ‘overheating’ was a more common term slipped consciously into policymaker speeches and media presentations. But the Fed only disappointed, with Janet Yellen at her press conference forced by less fawning questioning to admit, complete with the deer-in-headlights stare only she can give, that none of the models foresaw any uptick in growth whatsoever. Worse, the FOMC statement confirmed that though the CPI was nearly 3% at that moment, it was indeed going to be just a temporary artifact of oil price base effects, and that officially inflation was not expected to return to ‘normal’ until after 2019. Major, major buzzkill.”

In other words, as we have been saying all along, the Fed is exiting not because recovery is coming but because it never will.  There is, in their official judgment, nothing left for monetary policy to accomplish.  This pathetic economic condition, which they describe in their own way, through calculations like low or possibly negative R*, is now our baseline. What was unthinkable just three years ago (in the mainstream) is reality; ten years ago, it was plain impossible.

In January 2009, I wrote, “The economy is not likely to repeat the Japanese scenario.”  Unlike Japan, I reasoned, the American economy was far more dynamic and flexible, qualities that counterintuitively were on display at that very moment.  US businesses were laying off millions of workers every month, a horrible result for them but systemically what was necessary to restore profitability and cash flow.  Japan’s economy in the 1980’s and 1990’s was a contradiction of rigidity and a tangle of sclerosis, I thought, therefore its undoing and where the US would defeat the comparison.

Now so many years later, here the whole world sits in exactly the Japanese scenario.  Boy, was I wrong thinking that the Fed’s inability to affect the monetary system would be so easily set aside; or, if not so easily than overcome after enough time through good ol’ Americana.  I quite reasonably if naively assumed that faced with such incompetence on the policy level the far more dynamic American economy (which it was) would find its way out of that mess through other means. I had failed to appreciate the scale of the disaster on a longer timescale, how the eurodollar system had over the decades before entangled itself in everything here and everywhere else; and what that truly meant.

The most unambiguous and convincing evidence is how interest rates are low and have only remained that way no matter what, echoing what Milton Friedman wrote in 1963 about the 1930’s.  The issue cannot be business but money.

“The Federal Reserve repeatedly referred to its policy as one of ‘monetary ease’ and was inclined to take credit – and, even more, was given it – for the concurrent decline in interest rates, both long and short.”

He wrote again in the 1990’s warning the Japanese of the same condition, calling it the “interest rate fallacy” because though it is a clear sign of monetary tightness it is made unclear by economists who never seem able to understand money.  It’s a weird result for any central bank to be staffed with people who, at the top at least, can’t comprehend the nature of their own primary task.  It is far more so when it is a major central bank in a premier economy facing an historic liquidity situation.

It is downright criminal given the economic consequences of it, first Japan now the world.  The repeated situation strains all credibility, for the Japanese case was up to 2007 one of the most studied in all history.  How in the world could US (and European) officials end up making all the very same mistakes?

For one, US policymakers believed, in a way as I did, that they were superior to their Japanese counterparts.  In June 2003, the FOMC discussed these very scenarios and how the Bank of Japan was already at a place they increasingly believed they might have to follow.  QE had begun in March 2001 on that side of the Pacific, and was expanded after only a few months. In the US, the Federal Reserve had lowered the federal funds rate, what they believed was “stimulus”, even well more than a year after the official end of the dot-com recession.

By the start of summer in 2003, the short-term money rate was down to 1%, a level only a few years before that was thought beyond the pale of good monetary stewardship; so much so, that the gathered committee members at that meeting waxed philosophically about what they were doing, and even as Alan Greenspan contemplated what they really could do. The tone of that part of the discussion, centered on Japan and its experience at the zero lower bound that for the Fed had suddenly come into view, was “what if it’s us?”

“MR. KOHN.  Another problem in Japan was that the authorities were overly optimistic about the economy. They kept saying things were getting better, but they didn’t. To me that underlines the importance of our public discussion of where we think the economy is going and what our policy intentions are.”

That’s only true if you can be honest about it.  Japanese policy was only ever the same as American policy in that respect, for in all cases central banks believe they hold enormous power that given the will to use can only result in the preferred outcome.  Stimulus of the monetary type has been reduced to a tautology, or at best unchallenged circular logic; it works because it works. Or, as Ben Bernanke stated in his infamous “deflation” speech of November 2002:

“But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”

He made that statement which was received without controversy as a technical matter; philosophically, he was criticized in the Weimar Germany kind of way without thinking it all the way through. A year before, the Federal Reserve, as well as the Bank of Japan I have to assume, had already found startling contrary evidence, at least as far as quantitative easing was concerned.  QE as an operative scheme is simple and straightforward; purchase assets from private banks so as to increase the level of bank reserves, therefore satisfying Milton Friedman’s supply critique. That was the same argument that Bernanke was echoing in 2002, to raise the money supply through whatever means so as to achieve what he claimed and therefore expected.

Mark Spiegel, an economist at the Federal Reserve Bank of San Francisco, had published in November 2001 an account of some already serious deficiencies observed in the effects of QE then ongoing in Japan.  As everyone expected as a matter of basic central bank math, Japan’s M1 that had sharply decelerated in its growth rate reversed course with the introduction of BoJ’s bond buying scheme expanding so-called base money.  But, as Spiegel detected, in the real world it wasn’t so simple and easy:

“While M1 has indeed enjoyed robust positive growth since the inception of the quantitative easing strategy, there has been a matching decline in the aggregate known as ‘quasi-money,’ which includes time deposits and a number of other less liquid assets. While the central bank can increase the stock of narrow money in the economy, the banks appear to be treating the exercise much like a swap of near-zero and zero interest rate assets, and they are responding with little change in their lending activities.”

The US and global banking system after 2007 has acted in the same way, as both Japanese banks in 2001 (and after) as well as American and European banks post-crisis did more than just what Spiegel had described. This liquidity “swap” was indeed far-reaching, eventually over time eroding balance sheet factors in any number of ways.  I have tracked gross notional derivative books as a proxy for this very behavior, which suggests that in truth the conditions of bank balance sheets and therefore money in Japan as everywhere else is worse than even Spiegel spelled out fifteen and a half years ago.

We are left with one, and only one, conclusion; Ben Bernanke was right that the Federal Reserve as the duly appointed US government agency is in possession of the printing press.  However, quantitative easing no matter how much academic gloss it is given is not it. Actual monetary conditions are determined by a myriad of other outside factors (relating exclusively to bank balance sheets) that appear impervious to QE-type strategies, a verdict rendered by sixteen years of experience in Japan and another eight in the US and elsewhere.

You could have made a quantitative case against QE in the Japanese or the first American instances, where the “Q” part was simply too small.  In the last five years in particular that factor has, too, been empirically eliminated, most especially by the Bank of Japan’s QQE reaching now half a quadrillion in yen reserves with the same results (none positive).

Why the Federal Reserve merely followed in BoJ’s footsteps for all these years is almost inexplicable; almost.  Again, going back to that meeting in June 2003, policymakers here knew it wasn’t working and Alan Greenspan began to wonder about his own capabilities.

“CHAIRMAN GREENSPAN.  What is useful, as has been discussed, is to build up our general knowledge so that when we are confronted with the need to respond with a twenty-minute lead time—which may be all the time we will have—we have enough background understanding to enable us to make informed decisions. We need to know how the system tends to work to be able to make the necessary judgments without asking one of our skilled technical practitioners to go off and run three correlations between X, Y, and Z. So I think the notion of building up our knowledge generally as a basis for functioning effectively is exceptionally important.”

Or, as I put it a year ago, make sure you can actually do what you say you can do before you have to do it.  The emphasis was in 2003 clearly on the “before you have to do it part” and largely because of how the Bank of Japan was executing a theoretically sound strategy that wasn’t producing the desired or expected results. But they never did that. The FOMC as well as most of the academic literature instead focused on BoJ’s execution of QE rather than the technical factors that were clearly suggesting (really proving) from the very beginning at the very least far more complexity in money than was assumed.

And so it brings the world back to repeating the Japanese mistakes, as Governor Kohn described them so many years ago, “They kept saying things were getting better, but they didn’t.”  The Fed was never honest in its assessment of what it really could do so that by the time D-day arrived for them they were arrogantly dismissive even of direct market contradictions (especially eurodollar futures that were in early 2007 correct and have remained so despite all the QE’s).  It wouldn’t have mattered if the FOMC had their skilled practitioners run off and do X, Y, and Z correlations, because X, Y, and Z were all based on the same mistaken premises, those of Ben Bernanke’s 2002 speech. Throughout the crisis period officials kept claiming “things were getting better” (subprime is contained) only to see the whole thing nearly collapse.  Afterward it was always the same, “things were getting better” (green shoots) even though QE1 was followed by a QE2, another global liquidity crisis, a QE3, a QE4, and then another global liquidity crisis.

How can even the most robust and dynamic economy move even slightly forward under those conditions?  That is another result we have over the last ten years fully tested and established; it can’t. Whatever the unobserved direct effects of monetary tightness, such outward and visible instability is another depressive factor all its own, and a very important one.

Because of one simple variable we have followed a path that a decade ago was believed literally impossible. Indeed, everything that has happened this last period had it been described to someone in 2005 would have sounded totally insane.  And there is only one factor capable of creating that situation, the one, tragically, most experts were the least concerned about. Life does have a habit of unfolding in that way, where the one thing you don’t expect is what kills you in the end. Call it the maestro’s curse, no conundrum required.

We aren’t yet dead, though we are now living in John Maynard Keynes’ long run.  Apologies to Dr. Keynes, it does matter, quite a bit actually.  Chaos, whether social or political, is the inevitable product of extended economic dysfunction.  People will put up with a lot, a large recession and even a sluggish recovery, but no people (the Japanese have committed to demographic suicide) will be able to withstand the social consequences of unceasing bleakness and no legitimate answers for it.  Such a condition offends all modern sense of human progress.

It is a testament to how far down we have gone, that in 2017 pleading with the Fed to just say it one more time, “things are getting better”, because that is all that is left standing between the comforting fiction and the cold reality of Japanification.  It could only have been a bitter blow, for the Fed in truth was up until now good for only that one thing, meaning optimism; carefully worded, of course, but in the end constant positivity about recovery even if always off just over the horizon. For many, that fiction was more meaningful than being led unwilling to the truth about a world without growth.

Thus, all hope is not extinguished, merely transposed to right where it belonged all this time.  Central bankers have said “listen to us because that is the only way for recovery”; only now to say instead, “listen to us because there is no recovery” as if nobody is allowed to notice the change.  We need only stop listening to economists altogether because they were wrong then and utterly so now.  The problem isn’t economics but economists, the former having been removed from the latter generations ago.

That is the great unappreciated truth about Japanification. It was never about zombie banks and asset bubbles, at least so far as separate issues from economists who know nothing, prove they know nothing, and then refuse to learn when all results show it. Nobody ever bothers to challenge a central banker about money because who would ever do such a thing?  It is such a thin façade, though, as once you move past it to do so is incredibly easy.  One need read only a single FOMC transcript from 2008 (and now 2011) to establish this.

As “reflation” hopes fade just as they did three years ago, how the world proceeds is a choice.  It is a collective one, but one that must be made nonetheless. We can allow nothing to ever change as the Japanese have.  The political situation in Japan has been upended several times over the past quarter-century, but what is the one thing that has remained constant no matter which side sits in power?  The Bank of Japan.  Republican or Democrat, what is the one thing that hasn’t changed in America?  Monetary policy that was and remains strangely devoid of any money.

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The theoretical foundation for the book comes from Ludwig von Mises, the great Austrian economist, who pointed out that credit is a claim on resources. Tamny reasons that if credit is a claim on resources, then new credit cannot be created unless new resources are created. This renders the idea of ‘excess credit’ an oxymoron. And if there cannot be more credit than output than there cannot be an excess of credit over output.

Tamny makes the argument that new credit can only be created if there are new resources that are also created. This argument is incorrect.

Credit is a claim on resources and when credit increases and there is no increase in resources, the price paid for those resources also rises. Therefore there is no necessity for an expansion in resources, for there to be an expansion in credit. This is why a credit expansion leads to inflation.

Credit, when newly created, is not distributed evenly. Certain institutions and people receive that credit first and the new credit gradually disperses throughout the economy over time.

 

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The theoretical foundation for the book comes from Ludwig von Mises, the great Austrian economist, who pointed out that credit is a claim on resources. Tamny reasons that if credit is a claim on resources, then new credit cannot be created unless new resources are created. This renders the idea of ‘excess credit’ an oxymoron. And if there cannot be more credit than output than there cannot be an excess of credit over output.

This line of reasoning causes Tamny to call in to doubt the Austrian Theory of the Business Cycle, at least the popularly understood versions of it. After all, if there can’t be excess credit at all, then there certainly can’t be excess-credit-driven over-production. Yes, some parts of the economy can grow too much, due to credit mis-allocation, but the economy in general cannot be made to grow above capacity due to allege ‘excess credit’. Thus, the Fed doesn’t cause economy-wide bubbles, only sectional distortions. Central bank interventions such as interest rate setting, on balance, actually decrease the expansion of the economy – perhaps even during the ‘bubble’ period.

On the way to this conclusion, Tamny takes aim at the idea that under a fractional reserve banking system, new money is created in the banking system according to a ‘money multiplier’. In doing this, he stays faithful to supply-side thinking, but veers greatly from almost every other camp, including the mainstream.

I welcome Tamny, a former editor of mine at Forbes and a good friend, into this debate. If the ideas he’s attacking can withstand the attack, then they’ll be stronger for having been challenged. If not, then good riddance to them. The theoretical foundations of the money multiplier are in need of a shaking up. So is monetarism. The Fed quadrupled monetary base in response to the Great Recession, and many commentators called for imminent spikes of high, perhaps even hyper, inflation.

Since early 2010 I, myself, have been a short-term inflation dove (but long-term inflation hawk) because I had  concluded that financial over-regulation and the European debt crisis would cause money to be hoarded both domestically and abroad, and that inflation would tarry until those issues had resolved themselves.  This put me at odds with many of the most highly visible Austrians and monetarists, many of who have been veritable Chickens Little clucking about imminent hyper-inflation. This has given ammunition to left-of-center critics such as Paul Krugman.

Tamny’s answer as to why exploding led balance sheets have not led to exploding price inflation is that the Fed cannot create money and therefore quadrupling its balance sheet does not cause inflation.

I think the Austrian answer would be that the Fed cannot create money by itself, but that it needs banks and their money multiplier to do so. For Rothbard and his acolytes, this process is akin to counterfeiting and should be illegal because it is a form of fraud. To tolerate fractional reserve banking is to invite exploding inflation. The milder form of this view comes from monetarists who favor higher capital requirements for banks to reign in the money multiplier.

But what about the natural brakes on the multiplier? Banks don’t just lend ad infinitum: There are many nations in the world which do not place any reserve requirements on their banks. What prevents them from infinite money multiplication? Answer: Incentives. If bankers over-lend, they will end up lending to those who are unlikely to repay. Banks end up eating the loss…or at least suffering the humiliation of bail-out and Federal takeover.

One of the key issues goes back to a debate about what this stuff called M2, quasi-money which results from the money multiplier actually is. For supply-siders, these deposits are called credit. For Austrians, they are called money. But although this argument has a semantic aspect, there are more than semantics at issue: there’s a methodological difference.

Austrians tends to focus on theory: definitions of words, deductive processes of reasoning. Tamny comes at this as a financial journalist first and a theoretician second. He sees a world in which the Fed has exploded its balance sheet without seeming to have made much difference. He sees a world in which most business lending is done outside of the world of banks and their fractional reserve powers of multiplication. He sees a world in which credit seems quite difficult to get, even though the Fed has embarked on ‘easy money’ policies. And if reality doesn’t square with the traditional theories, even of allies, then so much the worse for the theories.

When I asked Tamny in a recent interview where debasement does come from (if not from the Fed) he acknowledged that he really doesn’t have a firm answer, and called for the thinkers of the various schools to get together and hash that question out. I think that would be a good idea. What I’ve always loved about supply-side thinking is its willingness to look at the world as it is and learn economics from the economy instead of from economists. On the other hand, what I’ve always loved about Austrian economics is that it sees economics as the science of human action, which potentially makes it highly adaptable. If economics is big enough to include all the ways people try to get what they want, then its theoretical limits are as unconstrained as the variety of human wants and means. This makes Austrian theory expandable enough to include anything which we economists can observe.

Tamny has revived moribund monetary theory debates between supply siders and Austrians of yore by once again taking up the supply side arguments against money multipliers. By doing so he has done all the camps a service by shaking things up enough to create an opportunity for all of us to improve our thinking.

I sat down across a Skype line with Tamny recently to talk about Who Needs the Fed?, what supply-siders can learn from the working class revolt which swept Trump into office, and a few other topics. You can listen to the interview here.

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