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Chinese Treasury Contradictions…

One mistake I may have made in the two years I have been writing publicly is taking the rhetoric of the Chinese and Russian governments a little too seriously, particularly over their relationship with the United States and the dollar.

Back in 2011, both China and Russia made a lot of noise about dumping US debt, or at least investing a lot less in it. Vladimir Putin said:

They are living beyond their means and shifting a part of the weight of their problems to the world economy. They are living like parasites off the global economy and their monopoly of the dollar. If [in America] there is a systemic malfunction, this will affect everyone. Countries like Russia and China hold a significant part of their reserves in American securities. There should be other reserve currencies.

And China were vocally critical too:

China, the largest foreign investor in US government securities, joined Russia in criticising American policymakers for failing to ensure borrowing is reined in after a stopgap deal to raise the nation’s debt limit.

People’s Bank of China governor Zhou Xiaochuan said China‘s central bank would monitor US efforts to tackle its debt, and state-run Xinhua News Agency blasted what it called the “madcap” brinkmanship of American lawmakers.

But just this month — almost two years after China blasted America for failing to cut debt levels — China’s Treasury holdings hit a record level of  $1.223 trillion.  And Russian treasury holdings are $20 billion higher than they were in 2012. So all of those protestations, it seems, were a lot of hot air. While it is true that various growing industrial powers are setting up alternative reserve currency systems, China and Russia aren’t ready to dump the dollar system anytime soon.

Now, the Federal Reserve has to some degree further enticed China into buying treasuries by giving them direct access to the Treasury auctions, allowing them to cut out the Wall Street middlemen. Maybe if that hadn’t happened, Chinese Treasury ownership would be lower.

But ultimately, the present system is very favourable for the BRICs, who have been able to build up massive manufacturing and infrastructural bases as a means to satisfy American and Western demand. In that sense, the post-Bretton Woods globalisation has been as much a free lunch for the developing world as it has been for anyone else. And why would China and Russia want to rock the boat by engaging in things like mass Treasury dumpings, trade war or proxy wars? They are slowly and gradually gaining on the West, without having to engage in war or trade war. As I noted in 2011:

I believe that the current world order suits China very much — their manufacturing exporters (and resource importers) get the stability of the mega-importing Americans spending mega-dollars on a military budget that maintains global stability. Global instability would mean everyone would pay more for imports, due to heightened insurance costs and other overheads.

Of course, a panic in the Chinese mainland — maybe a financial crash, or the bursting of the Chinese property bubble — might result in China’s government doing something rash.

But until then it is unlikely we will see the Eurasian holders of Treasuries engaging in much liquidation anytime soon — however much their leaders complain about American fiscal and monetary policy. Actions speak louder than words.

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A Visual Representation of the Zero Bound

I’ve been trying to understand the relationship between savings and interest rates in the economy. There are many theoretical models and constructs that purport to represent the relationship between savings and interest rates, but it is interesting to look at it from an empirical standpoint. This graph shows savings at depository institutions as a percentage of GDP against the Federal Funds Rate:

Mises

The actual cause of the desire to save rather than consume or invest is uncertain. Perhaps this is a demographic trend — with more people closing in on the retirement age, they seek to save more of their income for retirement. Perhaps it is a psychological trend — fear of investment in stock markets and bond markets, due to fear of corruption, or market crashes or a general distrust of corporations. Perhaps it is a shortage of “safe” assets — by engaging in quantitative easing, central banks are removing assets from markets and replacing them with base money, and deleveraging corporations are paying down rather than issuing new debt. Perhaps it is anticipation of deflation — people expecting that saved money will increase its purchasing power in future. Perhaps it is a combination of all these things and more. But whatever it is, we know that there is an extraordinary savings glut.

There have been a lot of assertions that interest rates at present are unnaturally or artificially low. Well, what can we expect in the context of such a glut of savings? Higher interest rates? Based on what?

There was a clear negative association between savings and interest rates up until interest rates fell to zero, while the savings rate continued to soar. Theoretically, lower interest rates ceteris paribus should inhibit the desire to save, by lowering the reward for doing so. But interest rates cannot fall below zero at least not within our current monetary system — there exist some theoretical proposals to break the zero bound using negative nominal interest rates, but these remain untested and controversial. Even tripling the monetary base — an act that Bernanke at least believes simulates an interest rate cut at the zero bound — has not discouraged the saving of greater and greater levels of the national income.

In the long run, the desire to save increasingly massive percentages of the national income will cool down. Sooner or later some externality will jolt the idle resources in the economy into action. But that is the long run. In the short run saving keeps soaring. Investors are not finding better investment opportunities for their savings and the structure of production does not appear to be adjusting very fast to open up new opportunities for all of that idle cash.

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On the Relationship Between the Size of the Monetary Base and the Price of Gold

The strong correlation between the gold price, and the size of the US monetary base that has existed during the era of quantitative easing appears to be in breakdown:

fredgraph

To emphasise that, look at the correlation over the last year:

inversecorrelation

Of course, in the past the two haven’t always been correlated. Here’s the relationship up to 2000:

2000

So there’s no hard and fast rule that the two should line up.

My belief is that the gold price has been driven by a lot of moderately interconnected factors related to distrust of government, central banks and the financial system — fear of inflation, fear of counterparty risk, fear of financial crashes and panics, fear of banker greed and regulatory incompetence, fear of fiat currency and central banking, belief that only gold (and silver) can be real money and that fiat currencies are destined to fail. The growth in the monetary base is intimately interconnected to some of these — the idea that the Fed is debasing the currency, and that high or hyperinflation or the failure of the global financial system are just around the corner. These are historically-founded fears — after all, financial systems and fiat currencies have failed in the past. Hyperinflation has been a real phenomenon in the past on multiple occasions.

But in this case, five years after 2008 these fears haven’t materialised. The high inflation that was expected hasn’t materialised (at least by the most accurate measure). And in my view this has sharpened the teeth of the anti-gold speculators, who have made increasingly large short sales, as well as the fears of some gold buyers who bought a hedge against something that hasn’t materialised. The global financial system still possesses a great deal of systemic corruption, banker greed and regulatory incompetence, and the potential for future financial crashes and blowups, so many gold bulls will remain undeterred. But with inflation low, and the trend arguably toward deflation (especially considering the shrinkage in M4 — all of that money the Fed printed is just a substitute for shrinkage in the money supply from the deflation of shadow finance!) gold is facing some strong headwinds.

And so a breakdown in the relationship between the monetary base has already occurred. Can it last? Well, that depends very much on individual and market psychology. If inflation stays low and inflation expectations stay low, then it is hard to see the market becoming significantly more bullish in the short or medium term, even in the context of high demand from China and India and BRIC central banks. The last time gold had a downturn like this, the market was depressed for twenty years. Of course, those years were marked by large-scale growth and great technological innovation. If new technologies — particularly in energy, for example if solar energy becomes cheaper than coal — enable a new period of spectacular growth like that which occurred during the last gold bear market, then gold is poised to fall dramatically relative to output.

But even if technology and innovation does not produce new organic growth, gold may not be poised for a return to gains. A new financial crisis would in the short term prove bearish for gold as funds and banks liquidate saleable assets like gold. Only high inflation and very negative real interest rates may prove capable of generating a significant upturn in gold. Some may say that individual, institutional and governmental debt loads are now so high that they can only be inflated away, but the possibility of restructuring also exists even in the absence of organic growth. A combination of strong organic growth and restructuring would likely prove deadly to gold.

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The New Swedish Model?

Swedish-flag-credit-Matti-Matilla

The advocates of “austerity now!” are talking about Sweden.

Last year Fraser Nelson wrote in The Spectator:

When Europe’s finance ministers meet for a group photo, it’s easy to spot the rebel — Anders Borg has a ponytail and earring. What actually marks him out, though, is how he responded to the crash. While most countries in Europe borrowed massively, Borg did not. Since becoming Sweden’s finance minister, his mission has been to pare back government. His ‘stimulus’ was a permanent tax cut. To critics, this was fiscal lunacy — the so-called ‘punk tax cutting’ agenda. Borg, on the other hand, thought lunacy meant repeating the economics of the 1970s and expecting a different result.

Three years on, it’s pretty clear who was right. ‘Look at Spain, Portugal or the UK, whose governments were arguing for large temporary stimulus,’ he says. ‘Well, we can see that very little of the stimulus went to the economy. But they are stuck with the debt.’ Tax-cutting Sweden, by contrast, had the fastest growth in Europe last year, when it also celebrated the abolition of its deficit. The recovery started just in time for the 2010 Swedish election, in which the Conservatives were re-elected for the first time in history.

So, how is the Swedish economy doing?

Well, the good thing about assessing the Swedish economy is that Sweden remains monetarily sovereign, meaning that its economy is not dependent upon the monetary policy of a foreign agency like the ECB. This means that it can be fairly assessed side-by-side with other Western monetary sovereigns like Britain, America and Japan.

The thing that austerians are so excited about is that Sweden currently has low debt and is running balanced budgets:

sweden-government-debt-to-gdp

But that hasn’t meant that unemployment has been low. In fact, right now it’s worse than American, British and Japanese unemployment:

sweden-unemployment-rate

And while Sweden’s low debt and balanced budgets may have resulted in low rates, its rates are not significantly lower than Britain and America, and are higher than Japan who carry the highest debt load of all:

sweden-government-bond-yield

But to be fair real GDP growth in Sweden since the crisis has been relatively decent — although notably still below its pre-2008 trend — beating the other three countries who all performed poorly:

fredgraph

I think that Sweden is benefiting less from its actions during the slump and more from its actions during the boom.

In my view, Sweden’s focus on bringing down deficits in the years from 2004 until the crisis in 2008 was very responsible and prudent. Sweden had no wasteful expansionary spending in the mid 2000s on things like occupying Iraq. It was not enacting expensive legislation like No Child Left Behind, Medicare D and unfunded tax cuts that bloated government budgets.

Coming into the crisis with a low debt-to-GDP ratio is very healthy because it gives the government additional fiscal space to cut taxes, and spend money on infrastructure, public goods and tax rebates to bring down the unemployment rate, which is the one aspect of the Swedish macroeconomy with significant room for improvement. An unemployment rate approaching 9% is undeniably unhealthy, and it is disappointing that the Swedish treasury with so much wiggle room is not doing more to assist the private sector in bringing down unemployment. And even though Sweden has had more growth than other Western countries, it has still not caught up with its pre-2008 growth trend.

Sweden’s unemployment woe illustrates that Sweden is not a paradigm of the supposed virtues of austerity in all seasons. Austerity in the slump just frees up resources while the economy is already suffering from a high degree of slack in resources — capital (high savings, low interest rates) and labour (high unemployment). Sweden illustrates this just as much as other Western nations.

The lesson we should take from Sweden is that a countercylical spending policy — less spending in the boom, more spending in the slump — is preferable.

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Even After All The QE, The Money Supply Is Still Shrunken

Here are the broadest measures of the US money supply, M3 and M4 as estimated by the Center for Fiscal Stability:

Charts6_amfm1

With the total money supply still at an absolute level lower than its 2008 peak, it is obvious that the Federal Reserve in tripling the monetary base — an expansion by what is in comparison to other components of M4 a relatively small amount — has been battling staggering deflationary forces. And with the money supply still lower than the 2008 peak and far-below its pre-2008 trend, the Fed is arguably struggling in this battle (even though by the most widely-recognised measure, the CPI-U the Fed has kept the US economy out of deflation). 

Those who have pointed to massively inflationary forces in the American economy based on a tripling of the monetary base, or even expansion of M2 clearly do not understand that the Fed does not control the money supply. It controls the monetary base, which influences the money supply but the big money in the US economy is created endogenously through credit-creation by traditional banks and shadow banks. The Fed can lead the horse to water by expanding the monetary base, but in such depressionary economic conditions it cannot make the horse drink.

What does this imply? Well, either the monetary transmission mechanism is broken, or monetary policy at the zero bound is ineffectual.

What it also implies is that hyperinflation (and even high inflation) remains the remotest of remote possibilities in the short and medium terms. The overwhelming trend remains deflationary following the bursting of the shadow intermediation bubble in 2008, and to offset this powerful deflationary trend the Fed is highly likely to have to continue to prime the monetary pump Abenomics-style into the foreseeable future.

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No Investment is an Island

kennedy-island-big

A Chinese woman from Kunming is attempting to sue the Federal Reserve for debasing the dollar:

A woman in Kunming, Yunnan province, is trying to sue the United States central bank after discovering that the real value of the US$250 she put in an account in 2006 had shrunk by 30 per cent.

She claims it was a result of the Federal Reserve issuing too much money.

Her attorney, her son Li Zhen , called the lawsuit “litigation for the public good” which aimed to stop the Fed from continuing its quantitive easing policy and promote people’s awareness of their rights.

This is a quite bizarre claim. If I buy and hold a currency or instruments denominated in that currency, I try to understand the mechanisms through which the market price (or my subjective valuation) of that asset could increase or decrease. In buying dollars, market participants tacitly accept the actions of the United States government and the Federal Reserve system. They tacitly accept that dollars (and implicitly, dollar-denominated instruments) are freely reproducible in either cotton-linen blend, or as digital currency in accordance with the Federal Reserve’s mandate, which includes a definition of price stability of 2% inflation (reduction in purchasing power as measured by the CPI-U) per year.

This is true with other liquid media, as well as less liquid assets like land, companies and capital goods. With gold and silver, future market prices are dependent on the actions and subjective expectations of gold miners and market participants. How much gold will they bring to the market? How much will they dig up out of the ground? To what extent will future market participants desire to hold and own gold? These are the questions one must implicitly answer in buying or selling gold.

The same is true for seashells, Bitcoin, Yen, Sterling, Euro. The differences are in physical characteristics, and the web of social interactions around them. All currencies and liquid assets are built on social interaction. The future viability of any currency or asset is dependent upon a complex web of social interactions.

Users and holders of Bitcoin today have an extraordinarily precise timetable for future monetary production — with Bitcoin, the great uncertainty lies in whether people will choose to use Bitcoin or not, and whether or not governments will try to outlaw it. For modern state-backed fiat currencies, there are legislatively-defined price stability targets designed to regulate monetary production, although the actions of central bankers and macroeconomists may surprise many holders of the currency. The power of the state also matters; a collapse of a state usually spells doom for any fiat currency it has issued.

When we buy something as a store of purchasing power, we enter into an implicit contract with ourselves to accept the currency risks and counterparty risks associated with it. That is our due diligence. Purchasing dollars and then complaining that the Federal Reserve is debasing them is incoherent. No investment is an island, insulated from risk. It is the same as purchasing gold before Columbus sailed to the Americas and complaining when conquistadors brought back huge new supplies of gold that diluted the money supply. The discovery of huge new gold supplies is part of the risk in holding gold, just as quantitative easing is part of the risk in holding dollars.

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The Magazine Cover Top?

John Hussman makes an entirely unscientific but still very interesting point about market euphoria — as epitomised by a recent Barron’s professional survey leading a magazine cover triumphantly proclaiming “Dow 16000″ — as a contrarian indicator:

wmc130422a

I have no idea whether or not the Dow Jones Industrial Average will hit 16,000 anytime soon. A P/E ratio of 15.84 seems relatively modest even in the context of some weakish macro data (weak employment numbers, weak business confidence, high energy input costs) and that priced in real GDP they look considerably more expensive, but it’s healthy to keep in mind the fact that euphoria and uber-bullishness very often gives way to profit-taking, stagnating prices, margin calls, shorting, panic and steep price falls. That same scenario has taken place in both gold and Bitcoin in the past couple of weeks. Leverage has been soaring the past couple of months, implying a certain fragility, a weakness to profit-taking and margin calls.

Psychologically, there seems to be a bubble in the notion that the Fed can levitate the DJIA to any level it likes. I grew up watching people flip houses in the mid-00s housing bubble, and there was a consensus among bubble-deniers like Ben Stein that if the housing market slumped, central banks would be able to levitate the market. Anyone who has seen the deep bottom in US housing best-exemplified by a proliferation of $500 foreclosed houses knows that even with massive new Fed liquidity, the housing market hasn’t been prevented from bottoming out. True, Bernanke has been explicit about using stock markets as a transmission mechanism for the wealth effect. But huge-scale Federal support could not stop the housing bubble bursting. In fact, a Minskian or Austrian analysis suggests that by making the reinflation of stock indexes a policy tool and implying that it will not let indexes fall, the Fed itself has intrinsically created a bubble in confidence. Euphoria is always unsustainable, and the rebirth of the Dow 36,000 meme is a pretty deranged kind of market euphoria.

Nonetheless, without some kind of wide and deep shock to inject some volatility — like war in the middle east or the Korean peninsula, or a heavy energy shock, a natural disaster, a large-scale Chinese crash, a subprime-scale financial blowup, or a Eurozone bank run  — there is a real possibility that markets will continue to levitate. 16,000, 18,000 and 20,000 are not out of the question. The gamble may pay off for those smart or lucky enough to sell at the very top. But the dimensions of uncertainty make it is a very, very risky gamble.