Tag Archives: john maynard keynes

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In The Long Run We’re All Dead

Niall Ferguson’s bizarre attack on John Maynard Keynes which he has now apologised for — claiming that Keynes’ lack of children led to him taking an irresponsible attitude to the long run — has prompted many apt responses regarding the fact that Keynes and his wife tried multiple times to have children, and that Keynes wrote many works that showed an acute thoughtfulness regarding the long run in essays such as Economic Possibilities For Our Grandchildren. 

But as soon as I heard Ferguson’s remarks, I re-read Keynes’ famous quote in full:

But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.

Keynes is actually saying the opposite of what Ferguson implied he was saying. Keynes is saying that economists who say that in the long run unemployment will fall and markets will move back toward equilibrium are making themselves useless. That unemployment will sooner-or-later fall is almost inevitable — eventually storms end, and rough seas become calm again.

But when unemployment has been high for years, and when the unemployed become so discouraged that they drop out of the labour force in vast numbers it is useless to merely quip that sooner or later markets will restore equilibrium. Having soaring unemployment, discouraged workers, rusting skills, dilapidated infrastructure, weak growth and idle capital now and potentially for years to come is a grossly and grotesquely irresponsible position. The effects of mass unemployment are damaging and lingering to families:

The stress of unemployment can lead to declines in individual and family well-being (Belle & Bullock, 2011). The burden of unemployment can also affect outcomes for children. The stress and depressive symptoms associated with job loss can negatively affect parenting practices such as increasing punitive and arbitrary punishment (McLoyd, 1998). As a result, children report more distress and depressive symptoms. Depression in children and adolescents is linked to multiple negative outcomes, including academic problems, substance abuse, high-risk sexual behavior, physical health problems, impaired social relationships and increased risk of suicide (Birmaher et al., 1996; Chen & Paterson, 2006; Le, Munoz, Ippen, & Stoddard, 2003; Verona & Javdani, 2011; Stolberg, Clark, & Bongar, 2002).

And damaging to wider communities:

Widespread unemployment in neighborhoods reduces resources, which may result in inadequate and low-quality housing, underfunded schools, restricted access to services and public transportation, and limited opportunities for employment, making it more difficult for people to return to work (Brisson, Roll, & East, 2009). Unemployed persons also report less neighborhood belonging than their employed counterparts, a finding with implications for neighborhood safety and community well-being (Steward et al., 2009).

Keynes’ point in the quote Ferguson was discussing was that economists should seek ways and means to minimise such damaging long-term effects. So whether or not we agree with Keynes’ philosophical and political conclusions, it is absolutely misleading to claim that “in the long run we’re all dead” was a call for hedonism or economic irresponsibility.

Any serious criticism of Keynes’ thought requires that critics have actually read and understood Keynes and not just absorbed second-hand caricatures of his ideas.

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The Unending British Deleveraging Cycle

Current estimates of what is known in the UK as the M4 money supply — cash outside banks, plus private-sector retail bank and building society deposits, plus private-sector wholesale bank and building society deposits and certificates of deposit — show a serious contrast between Britain and the United States:

UKvsUSM4

Could this divergence explain the strong divergence between UK and US real GDP?

RealGDP

I doubt it. It’s a chicken and egg question — does a prolonged deleveraging cycle explain real GDP weakness, or does real GDP weakness explain the prolonged deleveraging cycle? It may in fact be a self-reinforcing spiral effect where the first leads to the second and the second leads to more of the first, and so on. But there are a lot of other factors all of which may be contributing to the worsening situation — protracted weakness in business confidence, tax hikes, spending cuts, weak growth in the Eurozone, elevated youth unemployment, and uncertainty. All these factors are probably contributing to some degree to the weak GDP growth, and the prolonged deleveraging, and thus Britain’s depressionary economic condition.

But we can say that the difference cannot be that Britain’s monetary policy has not been aggressive enough. Britain’s monetary policy has been far more aggressive than that of the United States:

CB assets

How can we break the cycle? Well, as the above graph shows, more quantitative easing is unlikely to have a beneficial effect. The transmission mechanism is broken. What good is new money if it’s just sitting unused on bank balance sheets? What new productive or useful output can be summoned simply by stuffing the banks full of money if they won’t lend it?

The sad truth is that a huge part of the financial sector has failed. Its inefficiencies and fragilities were exposed in 2008, as a default cascade washed it into a liquidity crisis. And yet we have bailed it out, stuffed it full of money in the hope that this will bring us a new prosperity, in the delusional hope that by repeating the mistakes of the past, we can have a prosperous future.

The sad truth is that the broken, sclerotic parts of the financial sector must fail or be dismantled before the banks will start lending again, start putting monies into the hands of people who can create, innovate and produce our way to growth.

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Negative Nominal Interest Rates?

A number of economists and economics writers have considered the possibility of allowing the Federal Reserve to drop interest rates below zero in order to make holding onto money costlier and encouraging individuals and firms to spend, spend, spend.

Miles Kimball details one such plan:

The US Federal Reserve’s new determination to keep buying mortgage-backed securities until the economy gets better, better known as quantitative easing, is controversial. Although a few commentators don’t think the economy needs any more stimulus, many others are unnerved because the Fed is using untested tools. (For example, see Michael Snyder’s collection of “10 Shocking Quotes About What QE3 Is Going To Do To America.”) Normally the Fed simply lowers short-term interest rates (and in particular the federal funds rate at which banks lend to each other overnight) by purchasing three-month Treasury bills. But it has basically hit the floor on the federal funds rate. If the Fed could lower the federal funds rate as far as chairman Ben Bernanke and his colleagues wanted, it would be much less controversial. The monetary policy cognoscenti would be comfortable with a tool they know well, and those who don’t understand monetary policy as well would be more likely to trust that the Fed knew what it was doing. By contrast, buying large quantities of long-term government bonds or mortgage-backed securities is seen as exotic and threatening by monetary policy outsiders; and it gives monetary policy insiders the uneasy feeling that they don’t know their footing and could fall into some unexpected crevasse at any time.

So why can’t the Fed just lower the federal funds rate further? The problem may surprise you: it is those green pieces of paper in your wallet. Because they earn an interest rate of zero, no one is willing to lend at an interest rate more than a hair below zero. In Denmark, the central bank actually set the interest rate to negative -.2 % per year toward the end of August this year, which people might be willing to accept for the convenience of a certificate of deposit instead of a pile of currency, but it would be hard to go much lower before people did prefer a pile of currency. Let me make this concrete. In an economic situation like the one we are now in, we would like to encourage a company thinking about building a factory in a couple of years to build that factory now instead. If someone would lend to them at an interest rate of -3.33% per year, the company could borrow $1 million to build the factory now, and pay back something like $900,000 on the loan three years later. (Despite the negative interest rate, compounding makes the amount to be paid back a bit bigger, but not by much.) That would be a good enough deal that the company might move up its schedule for building the factory.  But everything runs aground on the fact that any potential lender, just by putting $1 million worth of green pieces of paper in a vault could get back $1 million three years later, which is a lot better than getting back a little over $900,000 three years later.  The fact that people could store paper money and get an interest rate of zero, minus storage costs, has deterred the Fed from bothering to lower the interest rate a bit more and forcing them to store paper money to get the best rate (as Denmark’s central bank may cause people to do).

The bottom line is that all we have to do to give the Fed (and other central banks) unlimited power to lower short-term interest rates is to demote paper currency from its role as a yardstick for prices and other economic values—what economists call the “unit of account” function of money. Paper currency could still continue to exist, but prices would be set in terms of electronic dollars (or abroad, electronic euros or yen), with paper dollars potentially being exchanged at a discount compared to electronic dollars. More and more, people use some form of electronic payment already, with debit cards and credit cards, so this wouldn’t be such a big change. It would be a little less convenient for those who insisted on continuing to use currency, but even there, it would just be a matter of figuring out with a pocket calculator how many extra paper dollars it would take to make up for the fact that each one was worth less than an electronic dollar. That’s it, and we wouldn’t have to worry about the Fed or any other central bank ever again seeming relatively powerless in the face of a long slump.

First of all, I question the feasibility of even producing a negative rate of interest, even via electronic currency. Electronic currency has practically zero storage costs. What is to stop offshore or black market banking entities offering a non-negative interest rate? After all, it is not hard to offer a higher-than-negative rate of interest for the privilege of holding (and leveraging) currency. A true negative interest rate environment may prove as unattainable as division by zero.

But assuming that such a thing is achievable, I think that a negative rate of interest will completely undermine the entire economic system in clear and visible ways that I shall discuss below (“white swans”), and probably also — because such a system has never been tried, and it is a radical departure from the present norms — in unpredictable and emergent ways (“black swans”).

Money has historically had multiple functions; a medium of exchange, a unit of account, a store of purchasing power. To institute a zero interest rate policy is to disable money’s role as a store of purchasing power. But to institute a negative interest rate policy is to reverse money’s role as a store of purchasing power, and turn money into a drain on purchasing power.

Money evolved organically to possess all three of these characteristics, because all three characteristics have been economically important and useful. To try to strip currency of one of its essential functions is to risk the rejection of that currency.

How would I react in the case of negative nominal interest rates? I’d convert into a liquid medium that was not subject to a negative rate of interest. That could be a nonmonetary asset, a foreign currency, a digital currency or a precious metal. I would actively seek ways to opt out of using the negative-yielding currency at all — if I could get by using alternative currencies, digital currencies, barter, then I would.  I would only ever possess a negative-yielding currency for transactions (e.g. taxes) in which the other party insisted upon the negative-yielding currency, and would then only hold it for a minimal period of time. It seems only reasonable that other individuals — seeking to avoid a draining asset — would maximise their utility by rejecting the draining currency whenever and wherever possible.

In Kimball’s theory, this unwillingness to hold currency is supposed to stimulate the economy by encouraging productive economic activity and investment. But is that necessarily true? I don’t think so. So long as there are alternative stores of purchasing power, there is no guarantee that this policy would result in a higher rate of  economic activity.

And it will drive economic activity underground. While governments may relish the prospect of higher tax revenues (due to more economic activity becoming electronic, and therefore trackable and traceable), in the present depressionary environment recorded and taxable economic activity could even fall as more economic activity goes underground to avoid negative rates. Increasingly authoritarian measures might be taken — probably at great cost — to encourage citizens into using the negative-yielding legal tender.

Banking would be turned upside down. Lending at a negative rate of interest — and suffering from the likely reality that negative rates discourages deposits — banks would be forced to look to riskier or offshore or black market activities to achieve profits. Even if banks continued to lend at low positive rates, the negative rates of interest offered to depositors would surely lead to a mass depositor exodus (perhaps to offshore or black market banks offering higher rates), probably leading to liquidity crises and banking panics.

As Izabella Kaminska wrote in July:

The simple fact of the matter is that in a negative carry world – or a flat yield environment for that matter – there is no role or purpose for banks because banks are forced into economically destructive practices in order to stay profitable.

Additionally, a negative-yielding environment will result in reduced income for those on a fixed income. One interesting effect of the present zero-interest rate environment is that more elderly people — presumably starved of sufficient retirement income — are returning to the labour force, which is in turn crowding out younger inexperienced workers, who are suffering from very high rates of unemployment and underemployment. A negative-yielding environment would probably exacerbate this effect.

So on the surface, the possibility of negative nominal rates seems deeply problematic.

Japan has spent almost twenty years at the zero bound, in spite of multiple rounds of quantitative easing and stimulus. Yet Japan remains mired in depression. The fact remains that both conventional and unconventional monetary policy has proven ineffective in resuscitating Japanese growth. My hypothesis remains that the real issue is the weight of excessive total debt (Japan’s total debt load remains as precipitously high as ever) and that no amount of rate cuts, quantitative easing or unconventional monetary intervention will prove effective. I hypothesise that a return to growth for a depressionary post-bubble economy requires a substantial chunk of the debt load (and thus future debt service costs) being either liquidated, forgiven or (often very difficult and slow) paid down.

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The Mathematicization of Economics

If one thing has changed in the last one hundred years in economics it has been the huge outgrowth in the usage of mathematics:

This is largely a bad development, for a number of reasons.

First of all layers of mathematics acts as a barrier to public understanding. While mathematics is a useful language for communicating complex ideas, those without training in mathematics will struggle to grasp what an author is trying to communicate if a paper consists mostly of equations untranslated into English. This is bad practice; it is easier to baffle with bullshit in an unfamiliar language than it is in plain English.

Second, mathematical models are always simplifications. Human action and economic behaviour is complex and unpredictable. While mathematical models can sometimes approximate a pattern quite well and so have some limited uses as toys, the complexity of human behaviour means that there are always unmodelled variables that can throw off a model’s output. Over-reliance upon or excessive faith in mathematical models can lead to bad forecasting and bad policy decisions. The grand theoretical-mathematical approach to economics is fundamentally flawed.

Third, attempting to smudge the human reality of economics into cold mathematical shackles is degenerative. Economics is a human subject. Human behaviour is not mechanical, it is not mechanistic. Physicists can very accurately model the trajectories of rocks in space. But economists cannot accurately model the trajectories of prices, employment and interest rates down on the rocky ground.

Economics would benefit from self-restraint in regard to the usage of mathematics. Alfred Marshall made some useful suggestions:

  1.  Use mathematics as shorthand language, rather than as an engine of inquiry.
  2.  Keep to them till you have done.
  3. Translate into English.
  4. Then illustrate by examples that are important in real life
  5. Burn the mathematics.
  6. If you can’t succeed in 4, burn 3. This I do often.

I hope the blowout growth in mathematics in economics is a bubble that soon bursts.

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The Contrarian Indicator of the Decade?

Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.

Sir John Templeton

Buy the fear, sell the greed. Since bottoming-out in 2009 markets have seen an uptrend in equity prices:

Now it seems like the euphoria is setting in. And in perfectly, deliciously ironic time, as shares of AIG — the behemoth at the heart of the 2008 crash — are returning to the market. Because reintroducing bailed-out companies to the market worked well last time didn’t it?

Joe Weisenthal:

Markets are down a hair today, but the theme of the morning is clear: Uber-bullishness. Everywhere.

This is the most unanimously bullish moment we can recall since the crisis began.

Note that this comes as US indices are all within a hair of multi-year highs, and the NASDAQ returns to levels not seen since late 2000.

Big macro hedge funds, who have been famously flat-footed this year, are now positioned for a continued rally.

Bank of America’s Mary Ann Bartels:

Macros bought the NASDAQ 100 to a net long for the first time since June, continued to buy the S&P 500 and commodities, increased EM & EAFE exposures, sold USD and 10-year Treasuries. In addition, macros reduced large cap preference.

J.P. Morgan’s Jan Loeys:

We think the positive environment for risk assets can and will last over the next 3-6 months. And this is not because of a strong economy, as we foresee below potential global growth over the next year and are below consensus expectations. Overall, we continue to see data that signal that world growth is in a bottoming process.

SocGen’s Sebastian Galy:

The market decided rose tinted glasses were not enough, put on its dark shades and hit the nightlife.

And the uber-bullishness is based on what? Hopium. Hope that the Fed will unleash QE3, or nominal GDP level targeting and buy, buy, buy — because what the market really needs right now is more bond flippers, right? Hope that Europeans have finally gotten their act together in respect to buying up periphery debt to create a ceiling on borrowing costs. Hope that this time is different in China, and that throwing a huge splash of stimulus cash at infrastructure will soften the landing.

But in the midst of all that hopium, let’s consider at least that quantitative easing hasn’t really reduced unemployment — and that Japan is still mired in a liquidity trap even after twenty years of printing. Let’s not forget that there is still a huge crushing weight of old debt weighing down on the world. Let’s not forget that the prospect of war in the middle east still hangs over the world (and oil). Let’s not forget that the iron ore bubble is bursting. Let’s not forget that a severe drought (as well as stupid ethanol subsidies) have raised food prices, and that food price spikes often produce downturns. Let’s not forget the increasing tension in the pacific between the United States and China (because the last time the world was in a global depression, it ended in a global conflict).

It would be unwise for me to predict an imminent severe downturn — after all markets are irrational and can stay irrational far longer than people can often stay solvent. But this could very well be the final blow-out top before the hopium wears off, and reality kicks in. Buying the fear and selling the greed usually works.

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Gold, Price Stability & Credit Bubbles

John Cochrane thinks that central banks can attain the price-stability of the gold standard without actually having a gold standard:

While many people believe the United States should adopt a gold standard to guard against inflation or deflation, and stabilize the economy, there are several reasons why this reform would not work. However, there is a modern adaptation of the gold standard that could achieve a stable price level and avoid the many disruptions brought upon the economy by monetary instability.

The solution is pretty simple. A gold standard is ultimately a commitment to exchange each dollar for something real. An inflation-indexed bond also has a constant, real value. If the Consumer Price Index (CPI) rises to 120 from 100, the bond pays 20% more, so your real purchasing power is protected. CPI futures work in much the same way. In place of gold, the Fed or the Treasury could freely buy and sell such inflation-linked securities at fixed prices. This policy would protect against deflation as well as inflation, automatically providing more money when there is a true demand for it, as in the financial crisis.

The obvious point is that the CPI is a relatively poor indicator of inflation and bubbles. During Greenspan’s tenure in charge of the Federal Reserve, huge quantities of new liquidity were created, much of which poured into housing and stock bubbles. CPI doesn’t include stock prices, and it doesn’t include housing prices; a monetary policy that is fixed to CPI wouldn’t be able to respond to growing bubbles in either sector. Cochrane is not really advocating for anything like the gold standard, just another form of Greenspanesque (mis)management.

Historically, what the gold standard meant was longer-term price stability, punctuated by frequent and wild short-term swings in purchasing power:

In its simplest form (the gold coin standard), gold constrains the monetary base to the amount of gold above ground. The aim is to prevent bubble-formation (in other words, monetary growth beyond the economy’s inherent productivity) because monetary growth would be limited to the amount of gold dug out of the ground, and the amount of gold dug out of the ground is limited to the amount of productivity society can afford to spend on mining gold.

Unfortunately, although gold levels are fixed, levels of credit creation are potentially infinite (and even where levels of credit creation are fixed by reserve requirements, shadow credit creation can still allow for explosive credit growth as happened after the repeal of Glass-Steagall). For example, the 1920s — a period with a gold standard — experienced huge asset bubble formation via huge levels of credit creation.

In any case, I don’t think that the current monetary regimes (or governments — who love to have the power to monetise debt) will ever change their minds. The overwhelming consensus of academic economists is that the gold standard is bad and dangerous.

In a recent survey of academic economists, 93% disagreed or strongly disagreed with this statement:

If the US replaced its discretionary monetary policy regime with a gold standard, defining a “dollar” as a specific number of ounces of gold, the price-stability and employment outcomes would be better for the average American.

That question is skewed. A gold standard can also be a discretionary regime; gold can be devalued, it can be supplemented with silver, and it can be multiplied by credit. And the concept of “price-stability” is hugely subjective; the Fed today defines “price stability” as a consistent 2% inflation (which on an infinite timeline correlates to an infinite level of inflation — the only stable thing being the rate at which the purchasing power of a dollar decreases).

If anything, the events of 2008 — which I interpret as a predictable and preventable housing, securitisation, and debt bubble stemming very much from central bank mismanagement of the money supply under Greenspan — secured the reputation of central banking among academic economists, because the bailouts, low rates and quantitative easing have prevented the feared debt-deflation that Milton Friedman and Ben Bernanke postulated as the thing that prolonged and worsened the Great Depression.

The Japanese example shows that crashed modern economies with excessive debt loads can remain stagnant for long periods of time. My view is that such nations are in a deleveraging trap; Japan (and more recently the Western nations) hit an excessive level of debt relative to GDP and industry at the peak of the bubble. As debt rises, debt servicing costs rise, leaving less income for investment, consumption, etc.

Throughout Japan’s lost decade, and indeed the years that followed, total debt levels (measured in GDP) have remained consistently high. Simply, the central bank did not devalue by anywhere near enough to decrease the real debt load, but nor have they devalued too little to result in a large-scale liquidation episode. They have just kept the economy in stasis, with enough liquidity to keep the debt serviceable, and not enough to really allow for severe reduction. The main change has been a transfer of debt from the private sector, to the public sector (a phenomenon which is also occurring in the United States and United Kingdom).

Eventually — because the costs of the deleveraging trap makes organically growth very difficult — the debt will either be forgiven, inflated or defaulted away. Endless rounds of tepid QE (which is debt additive, and so adds to the debt problem) just postpone that difficult decision. The deleveraging trap preserves the value of past debts at the cost of future growth.

Under the harsh discipline of a gold standard, such prevarication is not possible. Without the ability to inflate, overleveraged banks, individuals and governments would default on their debt. Income would rapidly fall, and economies would likely deflate and become severely depressed.

Yet liquidation is not all bad.  The example of 1907 — prior to the era of central banking — illustrates this.

As the WSJ noted:

The largest economic crisis of the 20th century was the Great Depression, but the second most significant economic upheaval was the panic of 1907. It was from beginning to end a banking and financial crisis. With the failure of the Knickerbocker Trust Company, the stock market collapsed, loan supply vanished and a scramble for liquidity ensued. Banks defaulted on their obligations to redeem deposits in currency or gold.

Milton Friedman and Anna Schwartz, in their classic “A Monetary History of the United States,” found “much similarity in its early phases” between the Panic of 1907 and the Great Depression. So traumatic was the crisis that it gave rise to the National Monetary Commission and the recommendations that led to the creation of the Federal Reserve. The May panic triggered a massive recession that saw real gross national product shrink in the second half of 1907 and plummet by an extraordinary 8.2% in 1908. Yet the economy came roaring back and, in two short years, was 7% bigger than when the panic started.

Although liquidation episodes are painful, the clear benefit is that a big crash and depression clears out old debt. Under the present regimes, the weight of old debt remains a burden to the economy.

But Cochrane talking about imposing a CPI-standard (or Greenspan talking about returning to the gold standard) is irrelevant; the bubble has happened, it burst, and now central banks must try to deal with the fallout. Even after trillions of dollars of reflation, economies remain depressed, unemployment remains elevated and total debt (relative to GDP) remains huge. The Fed — almost 100 years old — is in a fight for its life. Trying to balance the competing interests of creditors — particularly those productive foreign nations like China that produce much of America’s consumption and finance her deficits — against future growth is a hugely challenging task. The dangers to Western economies from creditor nations engaging in punitive trade measures as  a retaliatory measure to central bank debasement remain large (and the rhetoric is growing fiercer). Bernanke is walking a tightrope over alligators.

In any case even if a gold standard were to be reimposed in the future, history shows that it is unlikely to be an effective stop against credit bubbles. Credit bubbles happen because value is subjective and humans are excitable, and no regime has proven itself capable of fully guarding against that. Once a credit bubble forms, the possibilities are the same — liquidation, inflation or debt forgiveness. Today, central banks must eventually make a choice, or the forces of history will decide instead.

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Is Marxism Coming Back?

It is true that as the financial and economic crises roll on, as more and more disasters accumulate, as more people are thrown into unemployment and suffering that more and more of us will question the fundamentals of our economic system. It is inevitable that many will be drawn to some of the criticisms of capitalism, including Marxism.

The Guardian today published a salutary overview of this revival:

In his introduction to a new edition of The Communist Manifesto, Professor Eric Hobsbawm suggests that Marx was right to argue that the “contradictions of a market system based on no other nexus between man and man than naked self-interest, than callous ‘cash payment’, a system of exploitation and of ‘endless accumulation’ can never be overcome: that at some point in a series of transformations and restructurings the development of this essentially destabilising system will lead to a state of affairs that can no longer be described as capitalism”.

That is post-capitalist society as dreamed of by Marxists. But what would it be like? “It is extremely unlikely that such a ‘post-capitalist society’ would respond to the traditional models of socialism and still less to the ‘really existing’ socialisms of the Soviet era,” argues Hobsbawm, adding that it will, however, necessarily involve a shift from private appropriation to social management on a global scale. “What forms it might take and how far it would embody the humanist values of Marx’s and Engels’s communism, would depend on the political action through which this change came about.”

Marxism is a strange thing; it provides a clean and straightforward narrative of history, one that irons out detail and complication. It provides a simplistic “us versus them” narrative of the present. And it provides a relatively utopian narrative of the future; that the working classes united will overthrow capitalism and establish a state run by and for the working classes.

Trouble is, history is vastly more complicated than the teleological narrative provided by dialectical materialism. The economic and social reality of the present is vastly more complicated than Marx’s linear and binary classifications. And the future that Marx predicted never came to fruit; his 19th Century ideas turned into a 20th Century reality of mass starvation, failed central planning experiments, and millions of deaths.

Certainly, the system we have today is unsustainable. The state-supported financial institutions, and the corporations that have grown up around them do not live because of their own genius, their own productivity or innovation. They exist on state largesse — money printing, subsidies, limited liability, favourable regulation, barriers to entry. Every blowup and scandal — from the LIBOR-rigging, to the London Whale, to the bungled trades that destroyed MF Global — illustrates the incompetence and failure that that dependency has allowed to flourish.

The chief problem that Marxists face is their misidentification of the present economic system as free market capitalism. How can we meaningfully call a system where the price of money is controlled by the state a free market? How can we meaningfully call a system where financial institutions are routinely bailed out a free market? How can we meaningfully call a system where upwards of 40% of GDP is spent by the state a free market? How can we call a system where the market trades the possibility of state intervention rather than underlying fundamentals a free market?

Today we do not have a market economy; we have a corporate economy.

As Saifedean Ammous and Edmund Phelps note:

The term “capitalism” used to mean an economic system in which capital was privately owned and traded; owners of capital got to judge how best to use it, and could draw on the foresight and creative ideas of entrepreneurs and innovative thinkers. This system of individual freedom and individual responsibility gave little scope for government to influence economic decision-making: success meant profits; failure meant losses. Corporations could exist only as long as free individuals willingly purchased their goods – and would go out of business quickly otherwise.

Capitalism became a world-beater in the 1800’s, when it developed capabilities for endemic innovation. Societies that adopted the capitalist system gained unrivaled prosperity, enjoyed widespread job satisfaction, obtained productivity growth that was the marvel of the world and ended mass privation.

Now the capitalist system has been corrupted. The managerial state has assumed responsibility for looking after everything from the incomes of the middle class to the profitability of large corporations to industrial advancement. This system, however, is not capitalism, but rather an economic order that harks back to Bismarck in the late nineteenth century and Mussolini in the twentieth: corporatism.

The system of corporatism we have today has far more akin with Marxism and “social management” than Marxists might like to admit. Both corporatism and Marxism are forms of central economic control; the only difference is that under Marxism, the allocation of capital is controlled by the state bureaucracy-technocracy, while under corporatism the allocation of capital is undertaken by the state apparatus in concert with large financial and corporate interests. The corporations accumulate power from the legal protections afforded to them by the state (limited liability, corporate subsidies, bailouts), and politicians can win re-election showered by corporate money.

The fundamental choice that we face today is between economic freedom and central economic planning. The first offers individuals, nations and the world a complex, multi-dimensional allocation of resources, labour and capital undertaken as the sum of human preferences expressed voluntarily through the market mechanism. The second offers allocation of resources, labour and capital by the elite — bureaucrats, technocrats and special interests. The first is not without corruption and fallout, but its various imperfect incarnations have created boundless prosperity, productivity and growth. Incarnations of the second have led to the deaths by starvation of millions first in Soviet Russia, then in Maoist China.

Marxists like to pretend that the bureaucratic-technocratic allocation of capital, labour and resources is somehow more democratic, and somehow more attuned to the interests of society than the market. But what can be more democratic and expressive than a market system that allows each and every individual to allocate his or her capital, labour, resources and productivity based on his or her own internal preferences? And what can be less democratic than the organisation of society and the allocation of capital undertaken through the mechanisms of distant bureaucracy and forced planning? What is less democratic than telling the broad population that rather than living their lives according to their own will, their own traditions and their own economic interests that they should instead follow the inclinations and orders of a distant bureaucratic-technocratic elite?

I’m not sure that Marxists have ever understood capitalism; Das Kapital is a mammoth work concentrating on many facets of 19th Century industrial and economic development, but it tends to focus in on obscure minutiae without ever really considering the coherent whole. If Marxists had ever come close to grasping the broader mechanisms of capitalism — and if they truly cared about democracy — they would have been far less likely to promulgate a system based on dictatorial central planning.

Nonetheless, as the financial system and the financial oligarchy continue to blunder from crisis to crisis, more and more people will surely become entangled in the seductive narratives of Marxism. More and more people may come to blame markets and freedom for the problems of corporatism and statism. This is deeply ironic — the Marxist tendency toward central planning and control exerts a far greater influence on the policymakers of today than the Hayekian or Smithian tendency toward decentralisation and economic freedom.

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Fiat Money Kills Productivity?

I have long suspected that a money supply based on nothing other than faith in government could be a productivity killer.

Last November I wrote:

During 1947-73 (for all but two of those years America had a gold standard where the unit of exchange was tied to gold at a fixed rate) average family income increased at a greater rate than that of the top 1%. From 1979-2007 (years without a gold standard) the top 1% did much, much better than the average family.

As we have seen with the quantitative easing program, the newly-printed money is directed to the rich. The Keynesian response to that might be that income growth inequality can be solved (or at least remedied) by making sure that helicopter drops of new money are done over the entire economy rather than directed solely to Wall Street megabanks.

But I think there is a deeper problem here. My hypothesis is that leaving the gold exchange standard was a free lunch: GDP growth could be achieved without any real gains in productivity, or efficiency, or in infrastructure, but instead by just pumping money into the system.

And now I have empirical evidence that my hypothesis may possibly have been true — total factor productivity.

In 2009 the Economist explained TFP as follows:

Productivity growth is perhaps the single most important gauge of an economy’s health. Nothing matters more for long-term living standards than improvements in the efficiency with which an economy combines capital and labour. Unfortunately, productivity growth is itself often inefficiently measured. Most analysts focus on labour productivity, which is usually calculated by dividing total output by the number of workers, or the number of hours worked.

A better gauge of an economy’s use of resources is “total factor productivity” (TFP), which tries to assess the efficiency with which both capital and labour are used.

Total factor productivity is calculated as the percentage increase in output that is not accounted for by changes in the volume of inputs of capital and labour. So if the capital stock and the workforce both rise by 2% and output rises by 3%, TFP goes up by 1%.

Here’s US total factor productivity:

As soon as the USA left the gold exchange standard,  total factor productivity began to dramatically stagnate. 

Random coincidence? I don’t think so — a fundamental change in the nature of the money supply coincided almost exactly with a fundamental change to the shape of the nation’s economy. Is the simultaneous outgrowth in income inequality a coincidence too?

Doubters may respond that correlation does not necessarily imply causation, and though we do not know the exact causation, there are a couple of strong possibilities that may have strangled productivity:

  1. Leaving the gold exchange standard was a free lunch for policymakers: GDP growth could be achieved without any real gains in productivity, or efficiency, or in infrastructure, but instead by just pumping money into the system.
  2. Leaving the gold exchange standard was a free lunch for businesses: revenue growth could be achieved without any real gains in productivity, or efficiency.
And it’s not just total factor productivity that has been lower than in the years when America was on the gold exchange standard — as a Bank of England report recently found, GDP growth has averaged lower in the pure fiat money era (2.8% vs 1.8%), and financial crises have been more frequent in the non-gold-standard years.

The authors of the report noted:

Overall the gold standard appeared to perform reasonably well against its financial stability and allocative efficiency objectives.

Still think it’s a barbarous relic?

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Debt is Not Wealth

Here’s the status quo:


These figures are staggering; the advanced nations typically have between three and ten times as much total debt as they have economic activity. In the United Kingdom — the worst example — if one year’s economic activity was devoted entirely to paying down debt (impossible — people need to eat and drink and pay rent, and of course the United Kingdom continues to add debt) it would take ten years for the debt to be wiped clean.

But the real question is why? Why are both debtors and creditors willing to build a status quo of massive unprecedented debt?


From the side of the creditors, I think the answer is the misconception that debt is wealth. Debt can be used as collateral, or can be securitised and traded on exchanges (which itself can become a form of shadow intermediation, allowing for a form banking outside the accepted regulatory norms). To keep the value of debt high, and thus keep the debt illusion rolling along (treasury yields keep falling) central banks have been willing to swap out bad debt for good money. But debt is not wealth; it is just a promise, and in today’s world carries huge counter-party risk. Until you convert your debt-based promissory assets into real-world tangible assets they are not wealth.

From the side of the debtors, I think the answer is that debt is easy. Why work for your consumption when instead you can take out a home equity loan or get a credit card? Why buy the one car that you can afford when instead you can buy two with debt?

But there is another side in this world: the side of the central planners. Since the time of Keynes and Fisher there has been an economic revolution:

Deflation has effectively been abolished by central banking.  And so we get to where we are today: the huge and historically unprecedented outgrowth of debt. Deleveraging necessitates economic contraction, which produces the old Keynesian-Fisherian bugbear of debt-deflation, which the central planners abhor. So they print. Where once deflation often made debts unrepayable, and resulted in mass defaults, liquidation and structural transformation, today — thanks to money printing — debtors get their easy lunch of cheap debt, and creditors get their pound of flesh, albeit devalued by the inflation of the monetary base. It has been a superficially good compromise for both creditors and debtors. Everyone has got some of what they want. But is it sustainable?

The endless post-Keynesian outgrowth of debt suggests not. In fact, what is ultimately suggested is that the abolition of small-scale deflationary liquidations has just primed the system for a much, much larger liquidation later on. Bad companies, business models and practices that might otherwise not have survived under previous economic systems today live thanks to bailouts and money-printing. This moral hazard has grown legs and evolved into a kind of systemic hazard. Unhealthy levels of leverage and interconnection that once might have necessitated failure (e.g. Martingale trading strategies) flourish today under this new regime and its role as counter-party-of-last-resort. With every rogue-trader, every derivatives or shadow banking blowup, every Corzine, every Adoboli, every Iksil, comes more confirmation that the entire financial system is being zombified as foolish and dangerous practices are saved and sanctified by bailouts.

With every zombie blowup comes the necessity of more money-printing, and with more money-printing to save broken industries seems to come more moral hazard and zombification. Is that sustainable?

Already, central bankers are having to be clever with their money printing, colluding with financiers and sovereign governments to hide newly-printed money in excess reserves and FX reserves, and colluding with government statisticians to hide inflation beneath a forest of statistical manipulation. It is no surprise that by the BLS’ previous inflation-measuring methodology inflation is running at a much higher rate than the new:

Worse, in the modern financial world, we see an unprecedented level of interconnection. The impending Euro-implosion will have ramifications to everyone with exposure to it, and everyone with exposure to those with exposure to it. Not only will the inflation-averse Europeans have to print up a huge quantity of new money to bail out their financial system (the European financial system is roughly three times the size of the American one bailed out in 2008), but should they fail to do so central banks around the globe will have to print huge quantities of money to bail out systemically-important financial institutions with exposure to falling masonry. This is shaping up to be a true test of their prowess in hiding monetary inflation, and a true test of the “wisdom” behind endless-monetary-growth fiat economics.

Central bankers have shirked the historical growth cycle consisting both of periods of growth and expansion, as well as periods of contraction and liquidation. They have certainly had a good run. Those warning of impending hyperinflation following 2008 were proven wrong; deflationary forces offset the inflationary impact of bailouts and monetary expansion, even as food prices hit records, and revolutions spread throughout emerging markets. And Japan — the prototypical unliquidated zombie economy — has been stuck in a depressive rut for most of the last twenty years. These interventions, it seems, have pernicious negative side-effects.

Those twin delusions central bankers have sought to cater to — for creditors, that debt is wealth and should never be liquidated, and for debtors that debt is an easy or free lunch — have been smashed by the juggernaut of history many times before. While we cannot know exactly when, or exactly how — and in spite of the best efforts of central bankers — I think they will soon be smashed again.

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Enter the Swan

Charles Hugh Smith (along with many, many, many others) thinks there may be a great decoupling as the world sinks deeper into the mire, and that the dollar could be set to benefit:

This “safe haven” status can be discerned in the strengthening U.S. dollar. Despite a central bank (The Federal Reserve) with an avowed goal of weakening the nation’s currency (the U.S. dollar), the USD has been in an long-term uptrend for a year–a trend I have noted many times here, starting in April 2011.

That means a bet in the U.S. bond or stock market is a double bet, as these markets are denominated in U.S. dollars. Even if they go nowhere, the capital invested in them will gain purchasing power as the dollar strengthens.

All this suggests a “decoupling” of the U.S. bond and stock markets from the rest of the globe’s markets. Put yourself in the shoes of someone responsible for safekeeping $100 billion and keeping much of it liquid in treacherous times, and ask yourself: where can you park this money where it won’t blow up the market just from its size? What are the safest, most liquid markets out there?

The answer will very likely point the future direction of global markets.

Smith is going along with one of the most conventional pieces of conventional wisdom: that in risky and troubled times investors will seek out the dollar as a haven. That’s what happened in 2008. That’s what is happening now as rates on treasuries sink to all-time-lows. And that’s what has happened throughout the era of petrodollar hegemony.

But the problem with conventions is that they are there to be broken, the problem with conventional wisdom is that it is there to be killed, roasted and served on a silver platter.

The era of petrodollar hegemony is slowly dying, and the assumptions and conventions of that era are dying with it. For now, the shadow of that old world is still flailing on like Wile E. Coyote, hovering in midair.

As I wrote last week:

How did the dollar die? First it died slowly — then all at once.

The shift away from the dollar has quickly manifested itself in bilateral and multilateral agreements between nations to ditch the dollar for bilateral and multilateral trade, beginning with the chief antagonists China and Russia, and continuing through Iran, India, Japan, Brazil, and Saudi Arabia.

So the ground seems to have fallen out from beneath the petrodollar world order.

Enter the Swan:

We know the U.S. is a big and liquid (though not really very transparent) market. We know that the rest of the world — led by Europe’s myriad issues, and China’s bursting housing bubble — is teetering on the edge of a precipice, and without a miracle will fall (perhaps sooner, rather than later).

But we also know that America is inextricably interconnected to this mess. If Europe (or China or both) disintegrates, triggering (another) global default cascade, America will be stung by its European banking exposures, its exposures to global energy markets and global trade flows. Simply, there cannot be financial decoupling, not in this hyper-connected, hyper-leveraged world.

And would funds surge into US Treasuries even in such an instance? Maybe initially — fund managers have been conditioned by years of convention to do so. But how long  can fund managers accept negative real rates of return? Or — much more importantly — how long will the Fed accept such a surge? The answer is not very long at all. Bernanke’s economic strategy has been focussed  on turning treasuries into a losing investment, on the face of it to “encourage risk-taking” (or — much more significantly — keep the Treasury’s borrowing costs cheap).

All of this suggests a global crash or proto-crash will be followed by a huge global money printing operation, probably spearheaded by the Fed. Don’t let the Europeans fool anyone, either — Germany will not let the Euro crumble for fear of money printing. When push comes to shove they will print and fiscally consolidate to save their pet project (though perhaps demanding gold as collateral, and perhaps kicking out some delinquents). China will spew trillions of stimulus money into more and deeper malinvestment (why have ten ghost cities when you can have fifty? Good news for aggregate demand!).

So Paul Krugman will likely get something much closer to what he claims to want. Problem solved?

Nope. You can’t solve deep-rooted structural problems — malinvestment, social change, deindustrialisation, global trade imbalances, systemic fragility, financialisation, imperial decline, cultural stupefaction (etc, etc, etc) — by throwing money at problems. All throwing more money can do is buy a little more time (and undermine the currency). The problem with that is that a superficial recovery fools policy-makers, investors and citizens into believing that problems are fixed when they are not. Eventually — perhaps slowly, or perhaps quickly — unless the non-monetary problems are truly dealt with (very unlikely), they will boil over again.

As the devaluation heats up things will likely become a huge global game of beggar thy neighbour. A global devaluation will likely increase the growing tensions between the creditor and debtor nations to breaking point. Our current system of huge trade imbalances guarantees that someone (the West) is getting a free lunch , and that someone else (the Rest) is getting screwed. Such a system is fundamentally fragile, and fundamentally unstable. Currency wars will likely give way to economic wars, which may well give way to subterfuge and proxy wars as creditors seek their pound of flesh, and debtors seek to cast off their chains. Good news, then, for weapons contractors and the security state.