Inflation

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Rich people prefer productive companies while the poor prefer shiny lumps of metal.

Gallup’s poll on Americans’ favorite investments always makes fascinating reading.

Every year, Gallup asks Americans to choose the best investment from the following choices: Real estate, stocks and mutual funds, gold, savings accounts and certificates of deposit, or bonds.In the years since the 2008 financial crisis and housing bust — after which Americans as a group briefly ranked gold as their favorite investment — real estate has once again swung back into favor:

[Gallup]

But as Barry Ritholtz notes over at Bloomberg View, the most interesting thing is that there are some serious differences between the investment styles of the poor and the rich.

Read More At TheWeek.com

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The taper is finally here: What the Fed’s move means for the economy


Ben Bernanke, in his final press conference as chairman of the Federal Reserve, announced today that the central bank would be tapering asset purchases to $75 billion a month, down from $85 billion, which has been widely seen as a modest first step toward reducing the Fed’s outsized role in financial markets and the economy.

The move caught many economists by surprise — a USA Today survey found that most economists polled said the Fed would maintain its current levels of quantitative easing, as the policy is known, before trimming down in January.

After the financial crisis in 2008, spooked investors started piling into low-risk assets like Treasuries, driving prices dramatically higher. The Fed’s aim in buying these assets was to take safe investments like Treasuries off the market, in order to encourage investors to take more risk and invest in higher-yielding and more productive ventures like stocks, equipment, and new employees.

The ultimate objective was more jobs, and more economic activity.

Read More At TheWeek.com

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Why the Volcker Rule won’t solve the problem of Too Big To Fail

The Volcker Rule was originally proposed to end the problem of banks needing taxpayer bailouts. Paul Volcker, the former chairman of the Federal Reserve, proposed that commercial banks using customer deposits to trade — a practice known as proprietary trading — played a key role in the financial crisis that began in 2007.

Five former Secretaries of the Treasury — W. Michael Blumenthal, Nicholas Brady, Paul O’Neill, George Shultz, and John Snow — endorsed the Volcker Rule in an open letter to the Wall Street Journal, writing that banks “should not engage in essentially speculative activity unrelated to essential bank services.”

The Volcker Rule was signed into law as part of the Dodd–Frank Wall Street Reform and Consumer Protection Act in July of 2010, but its implementation has been delayed until yesterday when it finally received approval from the five (!) regulatory agencies that will enforce it — the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Securities and Exchange Commission (SEC), and the Commodity Futures Trading Commission (CFTC).

Read More At TheWeek.com

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Is the rent really too damn high?

A new study from Harvard University shows that in the last thirty years, rents have risen and the income of renters has fallen:

[America’s Rental Housing]

Read More At TheWeek.com

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The London Real Estate Bubble

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In October, London real estate asking prices jumped 10%. In my view is kind of parabolic-looking jump has developed out of quite a silly situation, and one I think is a good exhibit of just how irrational and weird markets can sometimes be.  London real estate prices have been rising strongly for a long while, and a large quantity — over half for houses above £1 million — of the demand for London real estate is coming from overseas buyers most of whom are buying for investment purposes. It is comprehensible that London is a desirable place to live, and that demand for housing in London might be higher than elsewhere in the UK. It is a diverse and rich place culturally and socially, boasting a huge variety of shopping, parks, art galleries, creative communities, restaurants, monuments and landmarks, theatres and venues, financial service providers, lawyers, think tanks, technology startups, universities, scientific institutions, sports clubs and infrastructure. Britain’s legal framework and its straightforward tax structure for wealthy foreign residents has proven highly attractive to the global super rich. With London real estate proving perennially popular, and with the global low-interest rate environment that has made borrowing for speculation cheap and easy, it is highly unsurprising that prices and rents have pushed upward and upward as the global super rich — alongside pension funds and hedge funds — sitting on large piles of cash have sought to achieve higher yields than cash or bonds by speculating in real estate. In some senses, London real estate (and real estate in other globally-desirable cities) has become a new reserve currency. And while this has occurred, price rises have proven increasingly cyclical as both London residents and speculators have sought to buy. The higher prices go, the more London residents become desperate to get their feet on the property ladder in fear they won’t ever be able to do so, and the more speculators are drawn in, seeing London real estate as an asset that just keeps going up and up.

Yet the bigger the bubble, the bigger the bust. And I think what we are seeing in London is a large psychological bubble, a mass delusion built on other delusions. Chief among these delusions is that real estate should be seen as a productive investment, as an implicit pension fund, or as a guaranteed source of real yield. While investors can look at real estate however they like, there is no getting away from the fact that real estate is a deteriorating asset. Sitting on a deteriorating asset and hoping for a real price gain — or even to preserve your purchasing power — is a speculation, not a productive investment. For commercial enterprises buying as a premises for business, or for residents buying as a place to live this is not in itself problematic. But as an investment this can be hugely problematic. It is just gambling on a deteriorating asset under the guise of buying a “safe” asset.

Of course, in the UK where housing has been treated by many successive governments as an investment, and as a haven for savings and pensions, real estate owners have done particularly well. Governments have been willing to prop up the market with liquidity via schemes like Help To Buy and via restrictive planning laws to rig the market to restrict supply. This may make investors feel particularly secure, but governments can be forced — not least by demographics — to swing in another direction. An important side-effect of continually rising prices and a restricted supply of housing is that many people will not be able to afford to buy a home. With the house prices-to-wages ratio sitting far above the long-term average, the next UK government will come under severe pressure within the next few years to allow — and probably subsidise — much more housebuilding to bring down housing costs for the population. The past-trend of government-protected gains may have inspired a false sense of security in investors.

But such a reversal of policy would not in itself crash the London real estate market. After all, London is a unique place in Britain, and the majority of the new housebuilding may take place away from London. More likely, the bubble will simply collapse under the weight of its own growth. Sooner or later, even with liquidity cheap and plentiful, the number of speculators seeking to cash out will exceed the number of speculators seeking to cash in, and confidence will dip. Sometimes, this simply equates to a small correction in the context of a large upward trend, but sometimes — especially when it can be negatively rationalised — it manifests into a deeper malaise.

When this occurs, one probable rationalisation is as follows.  Domestically, many of the relatively low-income artists, designers, technologists, musicians, students, artisans, academics, service workers and professionals (etc) who make London London are priced out, then they will go and contribute to communities elsewhere where rents and housing costs are lower — Birmingham, Manchester, Glasgow, Paris, Berlin, out into the sprawl of the home counties, and deeper into the English countryside, to places where a four bedroom house costs the same as a studio apartment in central London. Where once this would have been culturally, professionally and socially prohibitive, fast, ubiquitous internet allows for people to live a culturally and socially connected life without necessarily living in a big city like London. Internationally, other cheaper cities and jurisdictions will simply catch up with London in terms of amenities and desirability to the global super class. Competition for global capital  is huge, and while London as an Old World metropolis has done well since 2008, it may suffer in the wake of renewed competition from newer, cheaper, faster-growing Eastern metropolises.

When the bubble begins to burst — something that I think could occur endogenously within the next five years, especially if the fast increases continue — speculators, and especially speculators who are heavily leveraged may face severe problems, resulting in a worsened liquidation and contraction, and possibly threatening the liquidity of heavily-invested lenders. As many people at the table are sitting on big gains, they may prove desperate to cash out. Just as many presently feel pressured to get in to avoid being priced out of London forever, a downward turn could be severely worsened as many who are heavily invested in the bubble and scared of losing gains on which they hoped to fund retirements (etc) feel pressured to get out. Such an accelerated liquidation could easily lead to another recession. While I doubt that London prices will fall below the UK average, prices may see a very sharp correction. The psychological bubble is composed of multiple fallacies — that housing is a safe place to put savings and not a speculation, that deteriorating real estate should yield higher returns than productive business investments, that the UK government will continue to protect real estate speculators, that large flows of capital from overseas speculators will continue into London. A bursting of any of these fallacies could begin to bring the whole thing into question, even in the context of continued provision of liquidity from the Bank of England.

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The Trouble With Shadowstats

Often, when I talk about inflation being low, people who disagree tend to cite John Williams’ Shadowstats as evidence that price inflation is not low at all.

Now, I don’t disagree with the idea that some people have experienced a higher level of price inflation than the CPI. Everyone experiences a different rate of inflation based on their purchasing habits, so by definition everyone’s individual rate will diverge from the official rate to some degree; some will be higher, and some will be lower. And I don’t disagree that rising food and fuel prices have been a problem for welfare recipients and seniors on a fixed income, etc, who spend a higher proportion of their income on food and fuel than, say, young professionals with a lot of disposable income.

What I do disagree with is bad statistical methodology. Shadowstats is built on the belief that the Bureau of Labor Statistics changed their methodology in the 1980s and 1990s, and that if we were using their original methodology the level of inflation would be much higher. Shadowstats presents what they claim to be the original methodology. But Shadowstats is not calculating inflation any differently.They are not using the 1980s or 1990s methodology that they believe would be higher.  All Shadowstats is doing is taking the CPI data and adding on an arbitrary constant to make it look like inflation is higher!

This should be obvious from their data, which has the exact same curve as the CPI data at a higher level:

alt-cpi-home2 (1)

In fact, according to James Hamilton of Econbrowser, John Williams admitted in 2008 that his numbers are just inflated CPI data:

Last month I called attention to an analysis by BLS researchers John Greenlees and Robert McClelland of some of the claims by John Williams of Shadowstats about the consequences for reported inflation of assorted technical decisions made by the BLS. Williams asked me to update with a link to his response to the BLS study. I am happy to do so, along with offering some further observations of my own.

You can follow the link to Shadowstats’ response to Greenlees and McClelland and judge for yourself, but my impression is that the response is more philosophical than quantitative. In a separate phone conversation, Williams further clarified the Shadowstats methodology. Here’s what John said to me: “I’m not going back and recalculating the CPI. All I’m doing is going back to the government’s estimates of what the effect would be and using that as an ad factor to the reported statistics.”

Price changes and inflation are important topics, and constructing alternate measures of inflation is a worthwhile activity. Researchers at MIT have tried to do this with their Billion Prices Project, which measures price trends across a much, much larger range of products and locations than CPI:

BPP

What the Billion Prices Project implies for Shadowstats is that the CPI is roughly correct, and there is no vast divergence between real-world price trends and the CPI number. Of course, maybe the 1980s and 1990s methodology would be different from the current numbers. It would be very interesting to compare the current CPI methodology with the older CPI methodologies and with the BPP data! But assessing this empirically would require someone to mine through the raw CPI data since the 1980s and recalculate the outputs with the real earlier methodology — a far longer, more difficult and sophisticated process than taking the CPI outputs and adding an arbitrary constant!

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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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What Are Interest Rates And Can They Be Artificially Low Or High?

Many economic commentators believe that interest rates in America and around the world are “artificially low”. Indeed, I too have used the term in the past to refer to the condition in Europe that saw interest rates across the member states converge to a uniformly low level at the introduction of the Euro, only to diverge and soar in the periphery during the ongoing crisis.

So what is an interest rate? An interest rate is the cost of money now. As Eugen von Böhm-Bawerk noted, interest rates result from people valuing money in the present more highly than money in the future. If a business is starting out, and has insufficient capital to carry out its plans it will seek investment, either through selling equity in the ownership of the business, or through credit from lenders. For a lender, an interest rate is their profit for giving up the spending power of their capital to another who desires it now, attached to the risk that the borrower will default.

In monetary economies, money tends to be distributed relatively scarcely. In a commodity-based monetary system, the level of scarcity is determined by the physical limits of how much of a commodity can be pulled out of the ground. In a fiat-based monetary system, there is no such natural scarcity, but money’s relative scarcity is controlled by the banking system and central bank that lends it into the economy. If money was distributed infinitely widely and freely, there would be no such thing as an interest rate as there would be no cost to obtaining money now, just as there is no cost to obtaining a widely-distributed and freely-available commodity like air (at least on the face of the Earth!). Without scarcity money would lose its usability as a currency, as there is no incentive to trade for a substance which is uniformly and effectively infinitely available to everyone. So an interest rate is not only the cost of money, but also a symptom of its scarcity (and, as Keynes pointed out, a key mechanism through which rentiers profit).

So, where does the idea that interest rates can be made artificially low or artificially high arise from?

The notion of an artificially low or high interest rate implies the existence of a natural interest rate, from which the market rate diverges. It is a widely-held notion, and indeed, Ron Paul made reference to the notion of a natural rate of interest in his debate with Paul Krugman last year. A widely-used definition of the “natural rate of interest” appears in Wicksell (1898):

There is a certain rate of interest on loans which is neutral in respect to commodity prices, and tends neither to raise nor to lower them.

This is easy to define and hard to calculate. It is whatever interest rate yields a zero-percent inflationary level. Because interest rates have a nonlinear relationship with inflation, it is difficult to say precisely what the natural interest rate is at any given time, but Wicksell’s definition specifies that a positive inflation rate means the market rate is above the natural rate, and a negative inflation rate means the market is below the natural rate. (Interestingly, it should be noted that the historical Federal Funds Rate comes pretty close to loosely approximating the historical difference between 0 and the CPI rate, despite questions of whether the CPI really reflects the true price level due to not including housing and equity markets which often record much greater gains or greater losses than consumer prices).

The notion of a natural rate of interest is interesting and helpful — certainly, high levels of inflation can be challenged through decreasing interest rates (or more generally increasing credit-availability), and deflation can be challenged by decreasing interest rates (or more generally increasing credit availability). If the goal of monetary policy is price stability, then the notion of a “natural interest rate” as a guide for monetary policy is useful.

But policies of macrostabilisation have been strongly questioned by the work of Hyman Minsky, which posited the idea that stability is itself destabilising, because it leads to overconfidence which itself results in malinvestment and credit and price bubbles.

Austrian Business Cycle Theory (ABCT) developed by Ludwig von Mises and Friedrich Hayek, most influentially in Mises’ 1912 work The Theory of Money and Credit, theorises that the business cycle is caused by credit expansion (often fuelled by excessively low interest rates) which pours into unsustainable projects. The end of this credit expansion (as a result of a collapse resulting from excessive leverage, or from the failure of unsustainable projects, or from general overproduction, or for some other reason) results in a panic and bust. According to ABCT, the underlying issue is that the banking system made money cheaply available, and the market rate of interest falls beneath the natural rate of interest, manifesting as price inflation.

I do not dispute the idea that bubbles tend to coincide with credit expansion and easy lending. But it is tough to say whether credit expansion is a consequence or a cause of the bubble. What is the necessary precursor of an unsustainable credit expansion? Overconfidence, and the idea that prices will just keep going up when sooner or later the credit expansion will run out steam. This could be the overconfidence of central bankers, who believe that macrostabilisation policies have produced a “Great Moderation”, or the overconfidence of traders who hope to get rich quick, or the overconfidence of homeowners who see rising home prices as an easy opportunity to remortgage and consume more, or the overconfidence of private banks who hope to make bumper gains on loans or loan-related securities (Carl Menger noted that fractional reserve banking and credit-fuelled bubbles originated in economies with no central bank, in contradiction of those ABCT-advocates who go so far as to say that without central banking there would be no business cycle at all).

And is price stability really “natural”? Wicksell (and other advocates of a “natural rate of interest” like RBCT and certain Austrians) seem to imply so. But why should it be the norm that prices are stable? In competitive markets — like modern day high-tech markets — the tendency may be toward deflation rather than stability, as improving technology lowers manufacturing costs, and firms lower prices to stay competitive with each other. Or in markets for scarce goods — like commodities of which there exists a limited quantity — the tendency may be toward inflation, as producers may have to spend more to extract difficult-to-extract resources form the ground. Ultimately, human action in market activity is unpredictable and determined by the subjective preferences of all market participants, and this applies as much to the market for money as it does for any market. There is no reason to believe that prices tend toward stability, and the empirical record shows a significant level of variation in price levels under both the gold standard and the modern fiat system.

Ultimately, if interest rates are the cost of money, and in a fiat monetary system the quantity and availability of money is determined by lending institutions and the central bank, how can any interest rate not be artificial (i.e. an expression of the subjective opinions, forecasts and plans of those involved in determining the availability of credit and money including governments and central bankers)? Even under a commodity-money system, the availability of money is still determined by the lending system, as well as the miners who pull the monetary commodity or commodities out of the ground (and any legal tender laws that define money, for example monetising gold and demonetising silver).

And if all interest rates in contemporary markets are to some degree artificial this raises some difficult questions, because it means that the availability of capital, and thus the profitability (or unprofitability) of rentiers are effectively policy choices of the state (or the central bank).

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Whose Insured Deposits Will Be Plundered Next?

283756588_ad5af0208e_o

According to Zero Hedge, it could be Spain:

 Spain, it would appear, has changed constitutional rules to enable a so-called ‘moderate’ levy on deposits.

New legislation in New Zealand suggests that depositor funds could be used to bail out banks there, too.

Far more worrying for American and British depositors though is this paragraph Golem XIV brings up from a joint Bank of England and FDIC paper from 2012 which points to the possibility of using deposit insurance funds to bail out illiquid banks:

The U.K. has also given consideration to the recapitalization process in a scenario in which a G-SIFI’s liabilities do not include much debt issuance at the holding company or parent bank level but instead comprise insured retail deposits held in the operating subsidiaries. Under such a scenario, deposit guarantee schemes may be required to contribute to the recapitalization of the firm, as they may do under the Banking Act in the use of other resolution tools. The proposed RRD also permits such an approach because it allows deposit guarantee scheme funds to be used to support the use of resolution tools, including bail-in, provided that the amount contributed does not exceed what the deposit guarantee scheme would have as a claimant in liquidation if it had made a payout to the insured depositors.

Of course, if deposit insurance money is used as a resolution tool to bail out a bank which then goes on to fail anyway (as we have already seen multiple times since 2008 — a bank receives a large liquidity injection, and goes onto fail anyway) depositors could end up moneyless.

As Golem XIV notes:

The new system makes the Deposit Guarantee fund available for use as bail out money.

The rationale is that if using your deposit guarantee fund for propping up the bank ‘saves’ the bank from collapse then you wouldn’t need that deposit guarantee would you? This overlooks the one lesson we have all learned from the bank bail outs of the last 5 years, that the bail outs are never, ever, ever, a one off. The first one fails to save the bank as does the second and third and and and.

So if I have read the above correctly – the new system raids the Deposit Protection scheme, gives it to the bank instead of you  and when that fails to save the bank…then what? The bank fails again and there is no money left in the Deposit Guarantee scheme.

Now, in the case of this kind of scenario actually happening, it seems probable that governments and central banks would try to replenish the deposit insurance fund. Whether the fund would be replenished to its full extent, or whether insured depositors would suffer an effective haircut remains to be seen.

These kinds of policy suggestions coming from governments and central banks are extremely worrying for depositors, because it implies that what is happening to Cypriot depositors and Cypriot banks could be forced onto British and American depositors. In a worst-case-scenario, criminally minded bankers (of which there seem to be many) could even use this provision to intentionally run off with deposits.

We know that the TBTF banking sector (or G-SIFI’s — global systemically important financial institutions — as they are now known) remains fragile, over-connected and dependent on insider advantages. That means that over the next few years, it remains possible that there could be another severe banking crisis in Britain or America or both.

Just what in the world do financial regulators think they are doing even implying that depositor guarantee funds could be used to bail out banks under such an eventuality? Such a recommendation — and the attendant possibility of insured depositor haircuts — could severely impact confidence in the banking sector, just as it has done in Cyprus. The possibility that insurance money may go down the toilet to bail out illiquid banks will make some uneasy to invest their money in the banks. If a severe banking crisis looms, it could lead to bank runs, just as is happening in Cyprus. The trend, if events in Cyprus and Europe continue to escalate, and if other jurisdictions do not take steps to protect depositors from banker greed, is toward depositors losing faith in the banking system, and seeking other stores of purchasing power — mattress stuffing, bitcoin, tangibles.

Essentially, if there is to be any confidence in the banking system, the possibility of depleting liquidity insurance funds to bail out banks needs to be taken off the table completely. The possibility of insured depositor haircuts needs to be taken off the table completely. If banks need bailing out, the money must not come from insured depositors, or funds designed to compensate insured depositors. If banks fail, the losers should be the uninsured creditors.

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Is Inflation Always And Everywhere a Monetary Phenomenon?

Yesterday, I asked:

It is true that the equation I am referring to — MV=PQ, where M is the money supply, V is velocity, P is the price level and Q is output — is not exactly Friedman’s equation. It was initially theorised by John Stuart Mill, and formulated algebraically by Irving Fisher, but adopted by Friedman and his monetarist followers to the extent that Milton Friedman had it as his car number plate:

268621-127539779936939-Erwan-Mahe_origin

MV=PQ itself is a tautology that ties together three disparate variables — the money supply (M), the price level (P) and the output (Q) — by creating a quantity — velocity (V) — that is not observed directly, but is instead computed retrospectively from the three other variables. But, nonetheless, so long as we can overlook the fact that V is not directly observed (which ultimately we should not, but that is another story) it is true that MV=PQ accurately describes monetary reality.

Friedman’s famous quote seems to contradict his beloved equation:

Inflation is always and everywhere a monetary phenomenon, in the sense that it cannot occur without a more rapid increase in the quantity of money than in output.

Within the parameters of the equation, an increase in P can come from any of the other three variables in the equation — all else being equal a decrease in Q, or an increase in M, or an increase in V.

The only way that Friedman’s statement could be true is if V and Q were stable. Friedman did actually claim that V was largely stable, but empirical data rules this out. Here’s velocity:

velocity

And here’s output:

dGDP

Neither of these are constant, or even particularly stable, meaning that it is impossible within the parameters of Friedman’s own equation for inflation (changes in P) to solely be a monetary phenomenon. Inflation by Friedman’s own mathematical definition is a result of a combination of factors. And in the real world, it is far, far, far more complicated — a price index generalises a staggering array of human actions, each one the outcome of an equally vast array of psychological, social and economic influences.