The Subtle Tyranny of Interest Rates

Interest rates are the price of credit. They are the price of access to capital.

Now, it is obvious that pricing credit is not tyrannical in and of itself. Interest compensates a lender for default risk and the risk of inflation eroding the purchasing power of the money that they lend.

The tyranny I am getting at is subtle. It is the tyranny that Keynes pointed to when he proposed a euthanasia of the rentier. Keynes proposed that low interest rates would:

mean the euthanasia of the rentier, and, consequently, the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital.

Keynes pointed to an important feature of interest rates: the fact that capital has a cost is not just the result of default risk and the risk of inflation. It is also a result of the scarcity of capital.

Now, that is inevitable in a world where financial capital consists of metal that you dig up out of the ground.

But in our brave new state-backed fiat monetary system, why should capital be so scarce that those who have it can profit from its scarcity?

Obviously, central banks should not print money to the extent that it becomes worthless. But capital availability is absolutely critical to the advancement of society: the investment of capital is how societies become productive. It is how technology improves, and it is the key to wealth accumulation.

What Keynes didn’t specify was what exactly in the interest rate paid was the part that represented the “scarcity value” of capital.

Obviously, it doesn’t include the part that compensates for inflation, which is why we need to look at inflation-adjusted interest rates. And it isn’t the part that compensates for default risk. This is easily calculable too: it is the excess paid over lending to the monetary sovereign.

In the U.S. and Britain, that would be the American and British governments. In the eurozone — for complicated political reasons — there is no monetary sovereign exactly, but we might measure it by looking at it in terms of the spread against German government borrowing, because Germany seems to be the nation calling the lion’s share of the shots.

Here’s the real interest rate on U.S. 10-year government borrowing (I chose the 10-year because it is a benchmark, although I would have preferred to use a harmonized rate from across the yield curve.):

fredgraph-20

So what are we really seeing? The general trend is that real interest rates on U.S. government borrowing are overwhelmingly positive, with a few periodical exceptions where real rates on borrowing went a bit negative. This bias toward positive real interest rates on lending to the monetary sovereign, I would argue, is the rentier’s profit resulting from the scarcity of financial capital.

Year over year, that is going to compound heavily. It is these rentiers, I would argue, who should be euthanized. Not because they should be resented for doing well out of the system.  No. They should be euthanized because of the opportunity cost of devoting resources to enriching rentiers, resources that could be deployed productively elsewhere.

And how to euthanize the rentiers? Because we have identified what the rentier’s share is, the answer is very simple: making a real interest rate of zero on lending to the monetary sovereign an objective of monetary policy.

Update: After much debate, I have decided that euthanizing rentiers is not a matter for monetary policy, but a matter for fiscal policy. I have written another post discussing this.

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Why I Was Wrong About Inflation

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Back in 2007, I was much more interested in finance and trading than I was in macroeconomics. When the crisis — and the government’s macroeconomic response to the crisis — began in 2008 what was really needed to get a strong grasp of the situation was an understanding of macroeconomics, which I did not have as it was a topic I only really began studying in depth at that time. This led to some misconceptions, particularly about inflation. I mistakenly assumed — as did many at the time, and as do many today — that the huge expansion of the monetary base would lead to stronger inflation than the timid and low inflation we have seen in years since the programs began. While I strongly doubted the claims of individuals like Peter Schiff that hyperinflation might be nigh — as I understood that most historical hyperinflations occurred due to a collapse in production, not solely due to money printing — I thought a strong inflationary snapback was likely, Why? A mixture of real effects and expectations. If central banks are printing money at a higher rate, people will fear that money is becoming less scarce. If having more money in circulation does not begin to bid prices upward, producers will soon begin to raise prices to anticipate any such rise. Simply, I thought that central banks couldn’t print their way out of disaster without some iatrogenic side-effects. I assumed the oncoming pain was unavoidable, and that the onset of inflation was the price that would be paid. As Ludwig von Mises put it: “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

So why did that not occur? After all, plenty of internet goldbugs — and very serious people following the advice of people like John Taylor, Eugene Fama, and Niall Ferguson — were talking about the potential for a strong inflationary shock. The gold price was soaring — hitting a peak above $1900 an ounce in September 2011 — as people anticipating inflation sought to buy insurance against it. Well, for a start it seems like the public did not really buy into the notion of an oncoming inflationary shock. Expected inflation as measured by the University of Michigan has remained very close to the post-1980 norm since the crisis:

MICH_Max_630_378

But above and beyond this, the real monetary effects were not the ones I first assumed them to be. The total money supply — most of which is generated not by the Fed but in the private sector through lending — has been stagnant, even while the Federal Reserve is expanding the monetary base. So while the financial sector is flush with cash and has bid the stock market up above its pre-recession nominal peak, other goods in other sectors just have not had enough of a bid behind them to send inflation strongly upward because other areas of the economy (for instance housing, consumer electronics and real wages) have continued to deflate in the context of continued deleveraging, accelerating offshoring driving down wages and the receding effects of the 2008 oil shock.

Yet even more importantly the supply of goods in the West — flowing as it does from East to West, from the factories of the Orient to the consumers of the West — has remained strong and stable. There has been no destabilising, chaotic Chinese crash or revolution, even though many wished there would be in the wake of the Arab spring. And for all the talk by the Chinese and Russians of bond vigilantism, starting a new global reserve currency and dumping the dollar, that has not happened either. And why would it? Certainly, the Asian bond-buyers might have suffered a few years of negative real interest rates. This might have pissed them off. But undermining the Western recoveries further (which have been quite pathetic thus far) when such a high proportion of their assets — dollars and treasuries and increasingly real assets like land and industrials — are related to the economic performance of the West would be to cut off their nose to spite their face, while simultaneously risking conflict with the American military, whose capabilities remain unmatched. The Chinese and Russian talk of de-Americanisation and a post-American world is all bluff and bluster, all sound and fury signifying very little. In the long run, America will have to accept a world where it is no longer the sole global superpower, but there is no incentive for America’s competitors to hasten that way with the kind of aggressive economic warfare that might cause an economic shock.

On the other hand, it is certainly true that much of the new money entering the system is sitting as excess reserves. Is that a symptom of the inflation simply being delayed? Until the middle of last year I thought so. Now I very strongly doubt it. The existence of excess reserves in the system is not a symptom of stored-up future inflation, but a symptom of the weakness of the transmission mechanism for quantitative easing. Simply, the system is in a depression. The banking system is infected with a deep paranoia, and would prefer to sit on risk-free cash instead of lending money to businesses. If the money was lent out, there would be an increased level of economic and business activity. Therefore there is no guarantee of any additional inflation as the money is loaned out.

So I was wrong to worry that inflation could become an imminent problem. But I was wronger than this. The entire paradigm that I was basing these fears upon was flawed. Simply, I was ignoring real and present economic problems to worry about something that could theoretically become a problem in the future. Specifically, I was ignoring the real and present problem of involuntary unemployment to worry about non-existent inflation and non-existent Asian bond vigilantes. The involuntariness of unemployment is a very simple fact — there are not enough jobs for the number of jobseekers that exist, and there hasn’t been enough jobs since the crisis began. Currently there are just over three job seekers for every job. So unemployment and underemployment are not simply things that can be dismissed as a matter of workers becoming lazy, or preferring leisure to work. Mass unemployment has insidious and damaging social effects for individuals and communities — people who are out of work for a long time lose skills. For communities, crime rises, and health problems emerge. And there are 25 million Americans today who are either unemployed or underemployed as a practical matter it is not simply a case of sitting back and allowing the structure of production to adjust to the new economy. And worse, with unemployment high, spending and confidence remain depressed as the effects of high unemployment create a social malaise. This is a mass sickness — and in the past it has led to the rise of warmongering political figures like Hitler. So while it may be preferable for the private sector to be the leading job creator under ordinary conditions, while the private sector is engaging in heavy deleveraging this is impractical. Under such an eventuality the state is the only institution that can break the depressionary trend by creating paying jobs and fighting back against the depressionary tendency toward mass unemployment. Certainly, centralised bureaucracy can be a troublesome and distortionary thing. But there are many things — like mass unemployment and underemployment, and the social problems that that can bring — worse than centralised bureaucracy. And no — this kind of Keynesianism was not the problem in the 1970s.

By worrying over the potential for future inflation or future bond vigilantism due to monetary and fiscal stimulus, I was contributing to the problem of mass unemployment, first of all by not acknowledging the problem, and second by encouraging governments and individuals to worry about potential future problems instead of real-world problems today. As it happened, a tidal wave of evidence has washed these worries away. It is clear from the economic data that inflation is not a concern in a depressionary economy, just as Keynesian-Hicksians heuristics like IS/LM suggested.

Of course, if the depression ends of its own accord then inflation could become a problem again.  If the United States were to experience a strong unexpected spurt of growth sustained over a year or so, pushing unemployment significantly down and growth significantly up, inflation could rise appreciably. The Federal Reserve would have to quickly taper both its unconventional policies and probably begin to raise rates. Of course, that is rather unlikely in the present depressionary environment. But certainly, it is a small possibility. That would be the time for the Federal Reserve to start to worry about inflation. A strong negative energy shock — like the one experienced by the UK in 2010 and 2011 — could push inflation higher too, yet that would be a transitory factor in the context of the wider depressionary environment, and would most likely fall back of its own accord.

If the Fed was engaging in actual helicopter drops — the most direct transmission mechanism possible — there would likely be a stronger inflationary response than that which we have seen thus far. Yet ultimately, this might prove desirable. After all, if the private sectors of the entire Western world have a very large nominal debt load which they are struggling to deleverage, some stronger inflation would certainly begin to minimise that. Yes, that is redistribution from lender to borrower. No, creditors will not be happy about this. But in the end, creditors may find it easier to take an inflationary haircut than face twenty years of depressionary deleveraging as Japan has done. Although the West certainly does not have the same demographic troubles as Japan, such an outcome is possible unless people — governments, entrepreneurs, individuals, society — decide that unemployment and a lack of demand in the economy must be tackled, and do something about it. Then can we confidently expect to climb out of the lip of the deleveraging trap.

Japan’s Deflation Persistence

It's deflating...

Is it all about the age of the population?

One in four people in Japan will be older than 65 in 2014, compared with 9.6 percent in China and 14.2 percent in the U.S., according to data compiled by the U.S. Census Bureau.

Now, because they have had longer to accrue weal the older people tend to have more savings, or have retired and live in a fixed income, and therefore benefit from deflation But correlation is not causation. Certainly, Japan’s older population loves deflation. But the issue is the love of deflation, not the age of the population, per se. More than 80 percent of respondents in a Bank of Japan (8301) survey released this month who noticed rising prices last year said it was bad. Deflation-loving Japanese voters are the main stumbling block to Abe and Kuroda’s desire to reflate the Japanese economy back to inflation (to incentivise borrowing) and growth.

One of the peculiarities of state-backed fiat money is that it is a medium of exchange that the people of a state are expected to share. Clearly, individuals existing in a state will by definition have different motivations, different time preferences, and different conceptions of what constitutes good money. Different individuals have different preferences for inflation and deflation — while deflation helps savers, younger generations without savings are hit by stagnant wages and diminished incentives for borrowing. Inflation incentivises borrowing, and deflation incentivises saving, but these things are both to a great degree two sides of the same coin — deposited savings are lent out by banks. So when a population comes to love deflation and savings soar — and about 56 percent of household assets were in cash or bank deposits in 2012, according to a Bank of Japan report — the glut of savings depresses interests rates. With the value of savings rising, savers have little incentive to spend. This, ceteris paribus, constrains spending.

Abe and Kuroda are fighting to break Japan out of the liquidity trap. They have specific growth and inflation targets — 1% inflation, and 3% income growth and have a clear plan to hit those targets. But fighting against the widely-desired status quo — that is, deflation — in a democratic state is difficult. If Japanese people love deflation, they will vote for it at the polls. If Abe and Kuroda are to succeed in reigniting inflation, they need to convince Japanese savers to change their minds about inflation, and challenge the idea that saving in Yen is a desirable thing. After all, saving is not confined solely to the state-backed fiat currency. In a more inflationary environment, savers often choose to save through ownership of assets whose prices are increasing — land, real estate, commodities and currencies other than the state-backed fiat currency. In principle, there is no reason why Japan’s ageing population may not prove capable of moving its desire for savings into different media, and letting the Yen inflate. In practice, deflation and saving in Yen is cemented as a norm. That may prove extremely difficult to overcome.

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!

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.

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:

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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.

Why the Gold Crash? The Failure of Inflation to Take Off

One of the key features of the post-2008 gold boom was the notion that inflation was soon about to take off due to Bernanke’s money printing.

But so far — by the most-complete inflation measure, MIT’s Billion Prices Project — it hasn’t:

AnnualInflation

To me, this signifies that the deflationary forces in the economy have so far far outweighed the inflationary ones (specifically, tripling the monetary base), to such an extent that the Fed is struggling to even meet its 2% inflation target, much less trigger the kind of Weimar or Zimbabwe-style hyperinflation that some gold enthusiasts have projected.

The failure of inflation to take off (and thus lower real interest rates) is probably the greatest reason why gold’s price stagnated from 2011 and why gold has gone into liquidation the last week. With inflation low, investors became more cautious about holding gold. With the price stagnant, the huge gains that characterised gold’s rise from 1999 dried up, leaving more and more long-term investors and particularly institutional investors leaving the gold game to hunt elsewhere for yield.

I myself am an inflation agnostic, with deflationista tendencies. While I tend to lean toward the notion of deeply-depressed Japan-style price levels during a deleveraging trap, price levels are also a nonlinear phenomenon and could both accelerate or decelerate based on irrational psychological factors as much as the level of the money supply, or the total debt level, or the level of deleveraging. And high inflation could certainly take off as a result of an exogenous shock like a war, or series of natural disasters. But certainly, betting the farm on a trade tied to very high inflation expectations when the underlying trend is largely deflationary was a very bad idea, and those who did like John Paulson are being punished pretty brutally.

The extent to which this may continue is uncertain. Gold today fell beneath its 200-week moving average for the first time since 2001. How investors, and particularly institutional investors react to this is uncertain, but I tend to expect the pendulum to swing very far toward liquidation. After all, in 2011 most Americans named gold the safest investment, and now that psychological bubble is bursting. That means that for every goldbug buying the dip, many more may panic and sell their gold. This could easily turn to a rout, and gold may fall as low as the cost of production ($900), or even lower (especially considering gold’s high stock-to-flow ratio). Gold is a speculation in that it produces no return other than price rises. The last time gold got stuck in a rut, it was stuck there for almost 20 years.

However, my case for physical gold as a small part of a diverse portfolio to act as a hedge against systemic and counterparty risks (default cascades, Corzine-style vaporisation, etc) still stands, and lower prices are only good news in that regard. The financial system retains very many of its pre-2008 fragilities as the deregulated megabanks acting on margin continue to speculate in ways that systematise risk through balance sheet interconnectivity. Another financial crisis may initially lower the price of gold on margin calls, but in the long run may result in renewed inflows into gold and a price trend reversal. Gold is very much a barometer of distrust in the financial, governmental and corporate establishment, and as middle class incomes continue to stagnate and income inequality continues to soar there remain grave questions over these establishments’ abilities to foster systemic prosperity.