FedWatch

Mario Draghi’s Fatal Conceit

On 23 August 2017, the president of the European Central Bank (ECB) gave a speech titled “Connecting research and policy making” at the annual assembly of the winners of the Nobel Price for Economics in Lindau, Germany.1 What Mr Draghi talked about on this occasion — and especially what he didn’t talk about — was quite revealing.

Any analysis of the causes of the latest financial and economic crisis is conspicuously absent from Mr Draghi’s remarks. One gets the impression that the crisis came basically unexpected, out of the blue. There is no mention of the role of central banks, the monopoly producers of unbacked paper (or: fiat) money, played for the crisis.

No word that central banks had for many years manipulated downwards interest rates — accompanied by an excessive increase in credit and money supply — causing an unsustainable “boom.” When the bust set in — triggered by the spreading of the US subprime crisis across the globe — the ugly consequences of this central bank monetary policy came to the surface.

In the bust, many governments, banks and consumers in the euro area found themselves financially overstretched. The economies of Southern Europe especially do not only suffer from malinvestment on a grand scale, they also found themselves in a situation in which they have lost their competitiveness.

Mr Draghi, however, doesn’t deal with such unpleasant details. Instead, he lets his audience know how well the ECB pursued a policy of "crisis solution." His narrative is straightforward: Without the ECB’s bold actions, the euro area would have fallen into recession-depression, perhaps the euro area would have broken apart.

The analogy to such a line of argumentation would be praising a drug dealer, who provides the drug addict (who became a drug addict because of him) with just another shot. Repeated consumption of drugs does not heal but damages drug addict. Who would applaud what the drug dealer does? Likewise: would it be appropriate to praise the ECB’s action?

Mr Draghi presents himself as a fairly modest, intellectually ‘undogmatic’ central bank president stressing the importance of the insights produced by economic research for real life monetary policy making (thereby dutifully applauding the output of the economics profession). But the policy maker’s approach is far from being scientifically impartial.

Draghi's Flawed Methods 

Today’s economics research — as it is pursued, and taught, by leading mainstream economists — rests on a scientific method that is borrowed from natural science and builds on positivism-empiricism-falsificationism.2 This approach, used in economics, does not only suffer from logical inconsistencies, its embedded skepticism and relativism has, in fact, has let economics astray. 

Under the influence of positivism-empiricism-falsificationism economic theory – in particular monetary theory and financial market theory – has become the intellectual stirrup-holder of central banking, legitimizing the issuance of fiat money, the policy of manipulating the interest rate, the idea of making the financial system ‘safer’ through regulation.

In this vein, Mr Draghi praises especially the independence of central banks — for it would shield central bankers from destabilizing political outside influence. One really wonders how this argument — one-sided as it is — could find acceptance, especially in view of the fact that independent central banks have caused the great crisis in the first place.

The Central Bank's Many Friends

Why is there hardly any public opposition to Mr Draghi’s narrative? Well, a great deal of experts on monetary policy — coming mostly from government sponsored universities and research institutes — tends to be die-hard supporters of central banking. The majority of them would not find any fundamental, that is economic or ethic, flaw with it.

These so-called “monetary policy experts,” devoting so much time and energy for becoming and remaining an expert on monetary policy, unhesitatingly favor and accept without reservation the very principles on which central banking rests: the state’s coercive money production monopoly and all the measures to assert and defend it.

The upshot of such a mindset is this: “Once the apparatus is established, its future development will be shaped by what those who have chosen to serve it regard as its needs,”3 as F.A. Hayek explained the irrepressible expansionary nature of a monopolistic government agency – like a central bank.

Experts, keenly catering to the needs of the state and the banks, will make monetary policy increasingly complex and incomprehensible to the general public. Just think about the confusing abbreviations the ECB uses such as, say, APP, QE, CBPP, OMT, LTRO, TLTRO, ELA etc.4 In this way central bankers effectively sneak themselves out from public and parliamentary control.

Has the ECB Violated its Mandate? 

It comes therefore as no surprise Mr Draghi hails “non-standard policy measures” such as quantitative easing through which the central bank subsidizes financially ailing governments and banks in particular. Mr Draghi, however, does not leave it at that. He also suggests that monetary policy should shake off remaining restrictions that hamper policy maker’s discretion:

[W]hen the world changes as it did ten years ago, policies, especially monetary policy, need to be adjusted. Such an adjustment, never easy, requires unprejudiced, honest assessment of the new realities with clear eyes, unencumbered by the defence of previously held paradigms that have lost any explanatory power.

These remarks come presumably because the German Constitutional Court has found indications that the ECB’s government bond purchases may violate EU law and has asked the European Court of Justice to make a ruling. The German judges say that ECB bond buys may go beyond the central bank's mandate and inhibit euro zone members' activities.

The issue is no doubt delicate: If the ECB is prohibited from buying government bonds (let alone reverse its purchases), all hell may break loose in the euro area: Many government and banks would find it increasingly difficult to roll-over their maturing debt and take on new loans at affordable interest rates. The euro project would immediately find itself in hot water.

Without a monetary policy of ultra-low interest rates and bailing out struggling borrowers by printing up new money (or promising to do so, if needed) the euro project would already have gone belly up. So far the ECB has indeed successfully concealed that the pipe dream of successfully creating and running a single fiat currency has failed.

The crucial question in this context is, however: What has changed in economics in the last ten years? Unfortunately, economists that follows the doctrine of positivism-empiricism-falsificationism feel encouraged to question, even reject, the idea that there are immutable economic laws, preferring the notion that ‘things change’ that ‘everything is possible’.

However, sound economics tells us that there are iron laws of human action. For instance, a rise in the quantity of money does not make an economy richer, it merely reduces the marginal utility of the money unit, thus reducing its purchasing power; or: suppressing the interest rate through the central bank must result in malinvestments and boom and bust.

In other words: Sound economics tells us that central bankers do not pursue the greater good. They debase the currency; slyly redistribute income and wealth; benefit some groups at the expense of others; help the state to expand, to become a deep state at the expense of individual freedom; make people run into ever greater indebtedness.

What central bankers really do is cause a "planned chaos." Unfortunately, the damages they create — such as, say, inflation, speculation, recession, mass unemployment etc. — are regularly and falsely attributed to the workings of the free market, thereby discouraging and eroding peoples’ confidence in private initiative and free enterprise.

The failure of such interventionism — of which central bank monetary policy is an example par excellence — does not deter its supporters. On the contrary: They feel emboldened to pursue their interventionist course ever more boldly and aggressively to achieve their desired objectives. Mr Draghi made a case in point when he said in July 2012:

“[W]e think the euro is irreversible” and “the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”5 Hayek’s warning in his book Fatal Conceit (1988) goes unheard: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design."6

Mr Draghi’s speech should not convince us that monetary policy rests on sound economics, or that the ECB works for the greater good. If anything, it shows that economics has been twisted and deformed to service the needs of the state and its central bank – which increasingly erodes what little is left of the free market to keep the fiat money system going.

Holding up the fiat euro will result in a coercive redistribution of income and wealth among people, within and across national borders, to an extent historically unprecedented in times of piece. As a tool of an effectively anti-democratic policy, the single European currency will remain a source of interminable conflict, injustice, and it will be a drag on peoples’ prosperity. 

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Not Even Junk Will Fetch High Interest Rates Anymore

08/28/2017Doug French

The Federal Reserve tries and tries and just can’t muster up some price-tag ripping price inflation. Blowing up its balance sheet from $900 billion to $4.5 trillion would have seemed to send us to Zimbabwe, but no, prices just won’t cooperate with the monetary masterminds toiling away in the Eccles Building.

MarketWatch’s Caroline Baum says Fed Chairs used to call these things conundrums. However, “Conundrums are a thing of the past. Nowadays, Fed Chairwoman Janet Yellen has an explanation — an excuse, really — for almost anything, from the atypical behavior of asset prices to inconsistencies in economic relationships,” writes Baum.

We’re told by President Trump that we’re at full employment, yet prices (the way the Fed measures them anyway) can’t get to the 2 percent increase level Yellen et. al. considers nirvana.

Baum writes that the Fed called price changes “transitory” then they were “definitional challenges” followed by “idiosyncratic factors,” such as “a precipitous drop in the price of wireless telecommunications services this year.”

It’s in all the economic textbooks: Nothing stops inflation like a drop in cell phone fees.

This summer, private economists are pointing to drops in hotel rates as depressing CPI and whatnot. However, Ms. Baum knows, “Inflation is a monetary phenomenon. When the Fed expands its balance sheet through asset purchases, it has no control over where that newly created money will go: toward the purchase of goods and services; or into financial assets, such as stocks, junk bonds or housing.”

She continues, “The Fed’s asset purchases lower risk-free Treasury rates, encouraging investors to reach for yield and buy riskier assets.

“Because asset prices aren’t part of official inflation measures, and because identifying an asset bubble is beyond their scope, central bankers eschew using monetary policy to respond to them.”

The Fed is not alone in its bubble enabling. A Bloomberg Businessweek headline screams, “Even the Junkiest Sovereign Debt Now Pays Less Than 6%.” with the subtitle naming the culprit, “Central bank buying has distorted the market and reduced yields on the lowest-rated debt.”

It’s not just those cranky Austrians calling central bankers on the carpet for their monetary mischief these days. Everyone knows, is holding their breath, and hoping for the best.

Natasha Doff explains,

The junkiest emerging-market bonds yield less now than U.S. Treasury bills did as recently as 1999. Yields on state debt of Mongolia, Ukraine and Belarus -- at seven levels below investment grade, among the world's lowest ranked -- have dropped under 6 percent in the past two months.

It is as Ms. Baum writes, “Asset prices are a symptom; excessive credit growth is the cause.”

William White wrote in a 2009 paper that bubble episodes have the following in common: leverage, speculation and declining credit standards.

For instance money losing Tesla looked to sell $1.5 billion of junk bond debt and ended up selling $1.8 billion because the demand was so high for it's B- rated paper.

"I won't call it a bubble," said Andrew Feltus, co-head of high yield and bank loans at Amundi Pioneer Asset Management in Boston told Reuters. "The (market) fundamentals are pretty good."

Some would disagree. According to ValueWalk, “Tesla, Inc. is an over-hyped, lousy company, from a financial perspective, that is destined to go bankrupt.”

Famed Short-seller Jim Chanos said last year the announced $2.6 billion merger with SolarCity Corp. will make Tesla Motors Inc. a "walking insolvency."

A “walking insolvency” can borrow more than it wants at 5.3%; now that’s a conundrum.

Douglas French is former president of the Mises Institute, author of Early Speculative Bubbles & Increases in the Money Supply, and author of Walk Away: The Rise and Fall of the Home-Ownership Myth.

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Are Central Banks Nationalising the Economy?

08/24/2017Daniel Lacalle

The FT recently ran an article that states that “leading central banks now own a fifth of their governments’ total debt.”

The figures are staggering.

  • Without any recession or crisis, major central banks are purchasing more than $200 billion a month in government and private debt, led by the ECB and the Bank of Japan.
  • The Federal Reserve owns more than 14% of the US total public debt.
  • The ECB and BOJ balance sheets exceed 35% and 70% of their GDP.
  • The Bank of Japan is now a top 10 shareholder in 90% of the Nikkei.
  • The ECB owns 9.2% of the European corporate bond market and more than 10% of the main European countries’ total sovereign debt.
  • The Bank of England owns between 25% and 30% of the UK’s sovereign debt.

A recent report by Nick Smith, an analyst at CLSA, warns of what he calls ”the nationalization of the secondary market.”

The Bank of Japan, with its ultra-expansionary policy, which only expands its balance sheet, is on course to become the largest shareholder of the Nikkei 225’s largest companies. In fact, the Japanese central bank already accounts for 60% of the ETFs market (Exchange traded funds) in Japan.

What can go wrong? Overall, the central bank not only generates greater imbalances and a poor result in a “zombified” economy as the extremely loose policies perpetuate imbalances, weaken money velocity, and incentivize debt and malinvestment.

Believing that this policy is harmless because “there is no inflation” and unemployment is low is dangerous. The government issues massive amounts of debt and cheap money promotes overcapacity and poor capital allocation. As such, productivity growth collapses, real wages fall and purchasing power of currencies fall, driving the real cost of living up and debt to grow more than real GDP. That is why, as we have shown in previous articles, total debt has soared to 325% of GDP while zombie companies reach crisis-high levels, according to the Bank of International Settlements.

Government-issued liabilities monetized by the central bank are not high-quality assets, they are an IOU that is transferred to the next generations, and it will be repaid in three ways: with massive inflation, with a series of financial crises, or with large unemployment. Currency purchasing power destruction is not a growth policy, it is stealing from future generations. The “placebo” effect of spending today the Net Present Value of those IOUs means that, as GDP, productivity and real disposable income do not improve, at least as much as the debt issued, we are creating a time bomb of economic imbalances that only grows and will explode sometime in the future. The fact that the evident ball of risk is delayed another year does not mean that it does not exist.

The government is not issuing “productive money” just a promise of higher revenues from higher taxes, higher prices or confiscation of wealth in the future. Money supply growth is a loan that government borrows but we, citizens, pay. The payment comes with the destruction of purchasing power and confiscation of wealth via devaluation and inflation. The “wealth effect” of stocks and bonds rising is inexistent for the vast majority of citizens, as more than 90% of average household wealth is in deposits.

In fact, massive monetization of debt is just a way of perpetuating and strengthening the crowding-out effect of the public sector over the private sector. It is a de facto nationalization. Because the central bank does not go “bankrupt,” it just transfers its financial imbalances to private banks, businesses, and families.

The central bank can “print” all the money it wants and the government benefits from it, but the ones that suffer financial repression are the rest. By generating subsequent financial crises through loose monetary policies and always being the main beneficiary of the boom, and the bust, the public sector comes out from these crises more powerful and more indebted, while the private sector suffers the crowding-out effect in crisis times, and the taxation and wealth confiscation effect in expansion times.

No wonder that government spending to GDP is now almost 40% in the OECD and rising, the tax burden is at all-time highs and public debt soars.

Monetization is a perfect system to nationalize the economy passing all the risks of excess spending and imbalances to taxpayers. And it always ends badly. Because two plus two does not equal twenty-two. As we tax the productive to perpetuate and subsidize the unproductive, the impact on purchasing power and wealth destruction is exponential.

To believe that this time will be different and governments will spend all that massive “very expensive free money” wisely is simply delusional. The government has all the incentives to overspend as its goal is to maximize budget and increase bureaucracy as means of power. It also has all the incentives to blame its mistakes on an external enemy. Governments always blame someone else for their mistakes. Who lowers rates from 10% to 1%? Governments and central banks. Who is blamed for taking “excessive risk” when it explodes? You and me. Who increases money supply, demands “credit flow,” and imposes financial repression because “savings are too high”? Governments and central banks. Who is blamed when it explodes? Banks for “reckless lending” and “de-regulation”.

Of course, governments can print all the money they want, what they cannot do is convince you and me that it has a value, that the price and amount of money they impose is real just because the government says so. Hence lower real investment, and lower productivity. Citizens and companies are not crazy for not falling into the trap of low rates and high asset inflation. They are not amnesiac.

It is called financial repression for a reason, and citizens will always try to escape from theft.

What is the “hook” to let us buy into it? Stock markets rise, bonds fall, and we are led to believe that asset inflation is a reflection of economic strength.

Then, when the central bank policy stops working — either from lack of confidence or because it is simply part of the liquidity — and markets fall to their deserved valuations, many will say that it is the fault of “speculators,” not the central speculator.

When it erupts, you can bet your bottom dollar that the consensus will blame markets, hedge funds, lack of regulation and not enough intervention. Perennial intervention mistakes are “solved” with more intervention. Government won on the way up, and wins on the way down. Like a casino, the house always wins.

Meanwhile, the famous structural reforms that had been promised disappear like bad memories.

It is a clever Machiavellian system to end free markets and disproportionately benefit governments through the most unfair of competitions: having unlimited access to money and credit and none of the risks. And passing the bill to everyone else.

If you think it does not work because the government does not do a lot more, you are simply dreaming.

Originally published at DLacalle.com
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How Rand Paul Can Free Americans from the Fed

08/22/2017Tho Bishop

Ever since entering the Senate, Rand Paul has continued his father’s work in advocating for an audit of the Federal Reserve. This week, writing for the Daily Caller, Senator Paul renewed his efforts, illustrating how the recent era of unconventional monetary policy has made an audit all the more important:

In 2009, then-Fed Chairman Ben Bernanke was able to refuse to tell Congress who received over two trillion in Fed loans, and it took congressional action and a Bloomberg lawsuit to force the Fed to reveal the details of what it did in more than 21,000 transactions involving trillions of dollars during the 2008 financial crisis.  A one-time audit of the Fed’s emergency lending mandated by Congress revealed even more about the extent to which the Fed put taxpayers on the hook.

When pushed to defend the lack of transparency for the Federal Reserve, officials like Janet Yellen and Treasury Secretary Steve Mnuchin point to the myth of the Fed independence — a position that requires outright ignorance of the history of America’s central bank and the executive branch. Of course it’s quite usual for the Senate to base the merits of legislation entirely off of fallacious arguments, so they have continued to be the legislative body holding up a Fed audit with little indication they are prepared to move.

Given that reality, it is time for Senator Rand Paul to change his approach and introduce another piece of legislation from his father’s archives: the Free Competition in Currency Act.

While not as catchy as “End the Fed”, this piece of legislation – inspired by the work of F.A. Hayek – was perhaps Ron Paul’s most radical pieces of legislation. The idea was quite simple: eliminate legal tender laws mandating the use of US Dollars and remove the taxes Federal and State governments place on alternative currencies — such as gold and silver. While the original legislation did apply to “tokens,” an updated version should explicitly include the growing market of cryptocurrencies as a good with monetary value that should not be taxed.

What this would do is create a more even playing field between the dollar and alternative currencies, allowing an easy way for Americans to safeguard their wealth if they ever have reason to doubt the wisdom of the Federal Reserve’s policies. Just as Senator Paul advocated for the ability of Americans to be able to opt-out of the failing Obamacare system, this bill would grant Americans a lifeboat should the weaknesses inherent with the Fed’s fiat money regime expose themselves.

Unlike most examples of monetary policy reforms, which tend to be the products of ivory tower echo chambers, competition in currency would reflect active political trends. In recent years, states like Texas, Utah, and – in 2017 – Arizona have passed laws allowing the use of silver and gold for use in transactions. Meanwhile, other countries have looked to embrace the potential of cryptocurrencies for their monetary regimes. This makes this not only an idea that is good on paper, but one whose time has come.

As alluded to before, simply because a policy makes sense does not mean the Senate will act on it. That doesn’t mean the conversation and debate isn’t worth having. While it may still be on the horizon, there has been a steady drumbeat in Washington for the Federal Reserve to face some sort of reform. For two Congressional sessions in a row, the House has passed legislation explicitly calling for the Fed to embrace a “rules-based monetary system.” While this approach may sound better than today’s PhD standard, it doesn’t solve the problems inherent with central banking and fiat money.

Monetary rules such as “NGD Targeting” – which has the support of a rare coalition including the Cato Institute, Mercatus Center, Christina Romer, and Paul Krugman — should never be seen as a “reasonable compromise” for those skeptical about the Fed. Instead it’s simply another way of disguising central planning in a way to make it more palpable to the public, and therefore more difficult to stop. By putting this bill out there, Rand Paul can help frame the debate and bring a real solution to the table. Something that wouldn't force the Fed to change a single thing, only making them compete on the market like the producer of other good or service. 

After all, as is the case with healthcare, or shoes, the best sort of “monetary policy” is competition on the market. Not one dictated by government. 

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How Central Banking Increased Inequality

08/15/2017Louis Rouanet

Although today high levels of inequality in the United States remain a pressing concern for a large swath of the population, monetary policy and credit expansion are rarely mentioned as a likely source of rising wealth and income inequality. Focusing almost exclusively on consumer price inflation, many economists have overlooked the redistributive effects of money creation through other channels. One of these channels is asset price inflation and the growth of the financial sector.

The rise in income inequality over the past 30 years has to a significant extent been the product of monetary policies fueling a series of asset price bubbles. Whenever the market booms, the share of income going to those at the very top increases. When the boom goes bust, that share drops somewhat, but then it comes roaring back even higher with the next asset bubble.

The Cantillon Effect

The redistributive effects of money creation were called Cantillon effects by Mark Blaug after the Franco-Irish economist Richard Cantillon who experienced the effect of inflation under the paper money system of John Law at the beginning of the 18th century.1 Cantillon explained that the first ones to receive the newly created money see their incomes rise whereas the last ones to receive the newly created money see their purchasing power decline as consumer price inflation comes about.

Following Cantillon and contrary to Fisher and other monetary theorists of his time, Ludwig von Mises was the first to emphasized these Cantillon effects in terms of marginal utility analysis. With an increase in the stock of money, the cash balances of the early receivers of the newly created money increase. Correspondingly, the marginal utility they give to money decreases and the individuals in question buy either investment or consumption goods, thus bidding up the prices of those goods and increasing the cash balances of their sellers. With this step by step process, the price of goods will increase only progressively and affect both the distribution of income and wealth as well as the different price ratios.

Financialization, Asset Price Inflation and Inequality

In accordance with the Cantillon effect, inflation can increase inequality depending on the channel it takes, but increasing inequality is not a necessary consequence of inflation. If it happened that the poorest in society were the first receivers of the newly created money, then inflation could very well be the cause of decreasing inequality.

Under modern central banking however, money is created and injected into the economy through the credit channel and first affects financial markets. Under this system, commercial banks and other financial institutions are not only the first receivers of the newly created money but are also the main producers of credit money. This is so because banks can grant loans unbacked by base money. In a free-banking system, this credit creation power of banks is strictly limited by competition and the clearing process. Under central banking however, the need for reserves is relaxed as banks can either sell financial assets to the central bank in open market operations, or the central bank can grant loans to banks at relatively low interest rates. In both cases, central banks remove the limits of credit expansion by determining the total reserves in the banking system. In other words, commercial banks and other financial institutions are credited with so-called base money that has not existed before. Thus, the economics of Cantillon effects tells us that financial institutions benefit disproportionately from money creation, since they can purchase more goods, services, and assets for still relatively low prices. This conclusion is backed by numerous empirical illustrations. For instance, the financial sector contributed massively to the growth of billionaire’s wealth (see table below).

rouanet1_1.png

We can list four main reasons why the growth of financial markets is triggered by an expansion of the money supply:2 (1) because financial titles are often used as collateral in debt contracts; (2) because the anticipation of price-inflation, which is a common trait among all fiat money regimes, discourages the hoarding of money thus encouraging both the demand for and the supply of financial titles; (3) because the production of money through central banks is a matter of sheer human will and is therefore prone to developing moral-hazard in the financial world. This leads to an artificially high demand for financial titles and increases the supply of such titles by the same token. And (4) because the manipulation of credit by central banks and banks, by lowering the interest rate in the short run, particularly affects the demand for capital and the capital structure during the course of the business cycle.

One of the most visible consequence of this growth of financial markets triggered by monetary expansion is asset price inflation. In a completely sound money system where credit only depends on the amount of saving rather than on fiduciary credit, there is very little room for generalized and persistent asset-price inflation as the amount of funds which can be used to purchase assets is strictly limited. In other words, the phenomenon of asset-price inflation is a child of credit inflation.

Asset price inflation in turn benefit mostly the richest in society for several reasons. First, the wealthy tend to own more financial assets than the poor in proportion to his income. Second, it is easier for the richest individuals to contract debt in order to buy shares that can be sold later at a profit. Since credit easing lowers the interest rate and therefore funding costs, the profits made by selling inflated assets bought at credit will be even greater. Finally, asset price inflation coming with the growth of financial markets will benefit the workers, managers, traders, etc. working in the financial sector. It will also benefit the CEO's of the publicly traded companies who will be paid more as the capitalization value of their company increases. Hence, the correlation between asset prices and income inequality has been, as expected, very strong.

rouanet2_0.png

However, most monetary economists ignored — and continue to ignore — asset-price inflation and do not see it as a consequence of an inflated money supply. A reader of A Monetary History of the US (1963) by Friedman and Schwartz or of Allan Meltzer's A History of the Federal Reserve (2004) will not find one mention of asset price inflation. This oversight leads to the effects of inflation on inequality to be underestimated or ignored. Periods of growing inequality and monetary inflation such as the 1920's or the 2000's were associated with a high rate of asset-price inflation but relatively stable consumer prices. Therefore, to focus on consumer price inflation as the only variable accounting for monetary policy leaves out most of the effects of money creation on inequality.

Since the 2008 financial crisis, the so-called unconventional monetary policies have often been justified on the ground that something must be done in the short run since, as would have said J.M. Keynes, "In the long run, we are all dead." But as our monetary system tends to increase inequality, and if the goal is to improve the standards of living of the least well-off in society, then central banking and artificial monetary creation may be more costly than usually assumed by policy-makers.

  • 1. Blaug, M. (1985) Economic Theory in Retrospect, 4th edition, Cambridge: Cambridge University Press.
  • 2. I owe the three first reasons to Mises Fellow Karl Friedrich Israel. See: Israel, K. F. (2016a). In the long run we are all unemployed? The Quarterly Review of Economics and Finance. (64). 67-81.
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Central Banks Are Hiding the True Price of Risk

If you invest your money, you will have to deal with numerous risks. For instance, if you buy a bond, you run the risk of the borrower defaulting or being repaid with debased money. As a stock investor, you face the risk that the company's business model will not live up to expectations, or that it, at the extreme, will go bankrupt. In an unhampered financial market, prices are formed for these and other risk factors.

For instance, a bond with a high default risk will typically carry a high yield. The same goes for debt denominated in an unsound currency. Stocks of companies that are deemed risky tend to trade at a lower valuation level than those considered low risk. All these risk premiums, if determined in the unhampered market, constitute a portion of an asset’s price, be it a bond or a share. They play a vital role in the way capital is allocated in an economy.

Risk premiums are meant to compensate investors for the risk of losses resulting from adverse developments. If you buy a stock at a depressed price relative to the firm’s earnings power, it tends to reduce your downside (while offering the chance of great gains). At the same time, risk premiums increase investors’ cost of capital. This, in turn, discourages them from engaging in overly risky investments.

Decline in risk premiums:

polleit1_5.png

In other words, risk premiums determined in an unhampered market align the interests of savers and investors. Of course, one cannot be sure that ex ante risk premiums are always correct. Sometimes it turns out that risks were overestimated, sometimes they were underestimated. However, the unhampered market is still the best and most efficient means to determine the price of risk.

Central Banks Suppress Risk Premiums

Central banks, however, interfere and corrupt the best practice of the formation of the price of risk. In the last financial and economic crisis, central banks had lowered interest rates to unprecedented low levels and ramped up the quantity of (base) money to keep financially ailing governments and banks afloat and the economy going. In fact, they effectively put out a ‘safety net’, providing insurance to financial markets against potential systemic losses.

Decline in risk premiums:

polleit2_3.png

By doing so, central banks have put investor risk aversion to sleep: Under their guidance, financial markets are now betting on, and have high confidence in, monetary policy makers successfully fending off any new problems in the economic and financial system. This seems to be the message the price action in financial markets is conveying to us. For instance, stock price fluctuations have returned to very low levels, accompanied by strong stock market gains and high valuations.

The yield spread of risky corporate bonds over US Treasuries has returned to levels last seen in early 2008. Or look at the prices for credit default insurance for bank bonds. They also have returned to pre-crisis levels, suggesting investor credit concerns have markedly declined. In other words, investors are back again, eagerly taking on additional credit risk and willingly financing corporates’ investments at suppressed costs of capital.

Central banks have thus not only artificially reduced interest rates by lowering credit costs, they have also artificially reduced risk premiums by (explicitly or implicitly) signaling to the financial markets that they are prepared to basically ‘do whatever it takes’ to prevent another meltdown as witnessed in 2008/2009. The consequence is that financial markets and economies depend on central bank action more than ever before.

There is no easy way out of this situation. If interest rates go up — be it through rate hikes or the elimination of the ‘safety net’ — the current recovery will most likely come to a halt, if it does not turn into a bust straight away: With higher interest rates, the economic structure, built on artificially low interest rates, would run into serious trouble. The idea of central banks ‘normalizing’ interest rates without output losses or even a recession appears illusionary at best.

Against this backdrop, it is interesting to see that, for instance, the US Federal Reserve and the European Central Bank (ECB) may want to bring short-term interest rates back up (further). At the same time, however, there is no evidence that monetary policymakers have any plans to remove the ‘safety net’ that has so successfully brought down risk premiums in asset markets and thus the cost of capital.

That said, even an increase of central banks’ short-term funding will not bring about a normalization of the cost of capital — as risk premiums will most likely remain artificially suppressed. Capital misallocation will continue and the artificial boom is kept alive and well. Investors, therefore, face quite a challenge: Malinvestments continue, and downside risks increase, while it might be too early to jump ship.

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The Rise of Zombie Companies — And Why It Matters

08/08/2017Daniel Lacalle

The Bank of International Settlements (BIS) has warned again of the collateral damages of extremely loose monetary policy. One of the biggest threats is the rise of “zombie companies.” Since the “recovery” started, zombie firms have increased from 7.5% to 10.5%. In Europe, Bof A estimates that about 9% of the largest companies could be categorized as “walking dead.”

What is a zombie company? It is — in the BIS definition — a listed firm, with ten years or more of existence, where the ratio of EBIT (earnings before interest and taxes) relative to interest expense is lower than one. In essence, a company that merely survives due to the constant refinancing of its debt and, despite re-structuring and low rates, is still unable to cover its interest expense with operating profits, let alone repay the principal.

This share of zombie firms can be perceived by some as “small.” At the end of the day, 10.5% means that 89.5% are not zombies. But that analysis would be too complacent. According to Moody’s and Standard and Poor’s, debt repayment capacity has broadly weakened globally despite ultra-low rates and ample liquidity. Furthermore, the BIS only analyses listed zombie companies, but in the OECD 90% of the companies are SMEs (Small and Medium Enterprises), and a large proportion of these smaller non-listed companies, are still loss-making. In the Eurozone, the ECB estimates that around 30% of SMEs are still in the red and the figures are smaller, but not massively dissimilar in the US, estimated at 20%, and the UK, close to 25%.

The rise of zombie companies is not a good thing. Some might say that at least these companies are still functioning, and jobs are kept alive, but the reality is that a growingly “zombified” economy is showing to reward the unproductive and tax the productive, creating a perverse incentive and protecting nothing in the long run. Companies that underperform get their debt refinanced over and over again, while growing and high productivity firms struggle to get access to credit. When cheap money ends, the first ones collapse and the second ones have not been allowed to thrive to offset the impact.

Low interest rates and high liquidity have not helped deleverage. Global debt has soared to 325% of GDP. Loose monetary policies have not helped clean overcapacity, and as such zombie companies perpetuate the glut in many sectors, driving down the growth in productivity and, despite historic low unemployment rates, we continue to see real wages stagnate.

The citizen does not benefit from the zombification of the economy. The citizen pays for it. How? With the destruction of savings through financial repression and the collapse of real wage growth. Savers pay for zombification, under the mirage that it “keeps” jobs.

Zombification does not boost job creation or buy time, it is a perverse incentive that delays the recovery. It is a transfer of wealth from savers and healthy companies to inefficient and obsolete businesses.

The longer it takes to clean the overcapacity — which stands above 20% in the OECD — and zombification of the economy, the worse the outcome will be. Because, when the placebo effect of monetary policy disappears, the domino of bankruptcies in companies that have been artificially kept alive will not be offset by the improvement in high added-value sectors. Policymakers have decided to penalize the high productivity sectors through taxation and subsidize the low productivity ones through monetary and fiscal policies. This is likely to create a vacuum effect when the bubble bursts.

The jobs and companies that they try to protect will disappear, and the impact on banks’ solvency and the real economy will be much worse.

Avoiding making hard decisions from a crisis created by excess and overcapacity ends up generating a much more negative effect afterward.

Reprinted with permission of the author. Daniel Lacalle has a PhD in Economics and is author of Escape from the Central Bank TrapLife In The Financial Markets, and The Energy World Is Flat (Wiley).

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This Time, It's a Bubble in Rentals

08/04/2017Doug French

Sin City’s projected 5,000 new apartment units for this year makes no noise nationally in the latest real estate craze. “In 2017, the ongoing apartment building-boom in the US will set a new record: 346,000 new rental apartments in buildings with 50+ units are expected to hit the market,” writes Wolf Richter on Wolf Street. That is three times the number of units that came on line in 2011.

Richter continues, “Deliveries in 2017 will be 21% above the prior record set in 2016, based on data going back to 1997, by Yardi Matrix, via Rent Café. And even 2015 had set a record. Between 1997 and 2006, so pre-Financial-Crisis, annual completions averaged 212,740 units; 2017 will be 63% higher!”

I’ve written before about the high-rise crane craze in Seattle, but that’s nothing compared to New York and Dallas, that are adding 27,000 and 25,000 units, respectively. Chicago is adding 7,800 units despite a shrinking population and rents decreasing 19 percent.

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Not surprisingly, Fannie Mae and Freddie Mac are financing this rental housing boom. I wrote recently, the GSEs made 53% of all apartment loans in 2016, down from their combined 68% market share in 2012. “So, their conservator, The Federal Housing Finance Agency (FHFA), recently eased the GSE’s lending caps so they can crank out even more loans.”

Mary Salmonsen writes for multifamilyexecutive.com, “Currently, Fannie and Freddie are particularly dominant in garden apartments [and] in student housing, with 62% and 61% shares, respectively. The two remain the largest mid-/high-rise lenders but hold only 35% of the market.”

Mr. Richter warns us, “Government Sponsored Enterprises such as Fannie Mae guarantee commercial mortgages on apartment buildings and package them in Commercial Mortgage-Backed Securities. So taxpayers are on the hook. Banks are on the hook too.”

But, for the moment, it’s build them and they will come; first renters, then complex buyers. Wall Street giant “The Blackstone Group acquired three Las Vegas Valley apartment complexes for $170 million, property records show,” writes Eli Segall for the Las Vegas Review Journal. “Overall, it bought 972 units for an average of $174,900 each.”

Sales like this has developers going as fast as they can. I heard an apartment developer say Vegas has at least four more good years left in this cycle and is scrambling for new sites. In the land of Starbucks, Microsoft and Amazon, it’s thought the boom will never end. Richter writes, “the new supply of apartment units hitting the market in 2018 and 2019 will even be larger. In Seattle, for example, there are 67,507 new apartment units in the pipeline.”

However, while no one was paying attention, “the prices of apartment buildings nationally, after seven dizzying boom years, peaked last summer and have declined 3% since,” Richter writes. “Transaction volume of apartment buildings has plunged. And asking rents, the crux because they pay for the whole construct, have now flattened.”

As usual, cheap money entices developers to over do it, and the fall will be just as painful.

Douglas French is former president of the Mises Institute, author of Early Speculative Bubbles & Increases in the Money Supply, and author of Walk Away: The Rise and Fall of the Home-Ownership Myth.

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The Fed Gave Wall Street a Bomb, and the Taxpayers are Paying Ransom

08/02/2017Tho Bishop

When Janet Yellen testified before the House Financial Services Committee last month, she faced grilling on a topic that hasn’t received enough mainstream attention: the interest being paid on excess reserves at the Fed. While the topic has come up occasionally since the program began in 2008, it is worth noting that Yellen was pushed by both Jeb Hensarling, the committee chairman, and Andy Barr, the chairman of the Monetary Policy Subcommittee. While ending this taxpayer subsidy to Wall Street is important, it’s also important to understand the dangers posed by allowing these excess reserves to be lent out of major financial institutions.

RELATED: "Who Benefits from the Fed?" by David Howden

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To understand what is at stake, recall back to 2008 when many Fed observers were concerned about the inflation dangers posed by the policies of the Bernanke Fed. In a six year period, the base money supply increased over four-fold. Understandably, this sparked grave fears about the devaluation of the dollar — fears that, to date, have yet to really present themselves in the CPI. While stock prices, real estate prices, and other types of asset-price inflation are likely being fueled by this monetary policy, the Fed isn’t facing political pressure from inflation concerns — but rather being grilled by misinformed legislators for not reaching their (unfortunate) 2% inflation target.

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This is, in part, due to the fact that a lot of this new money has been kept sterile by being parked within the Fed itself as excess reserves. Today, more than $2 trillion worth of these reserves are parked at the Fed, which means that only two thirds of the newly created money has actually been pumped into the “real economy.”

RELATED: "Central Banks Should Stop Paying Interest on Reserves" by Brendan Brown

Now this policy should rightfully puncture the narrative that the Fed was at all concerned with providing liquidity to businesses on Main Street (i.e., not big banks). After all, if the aim of the various rounds of QE was to get banks to loan, then paying them not to is irrational. Instead, the Fed was using taxpayer dollars to subsidize the very same banks that they just bailed out. We are continuing, to this day, to pay banks to not make loans. 

While Bernanke repeatedly dismissed the problem of incentives posed by paying 25 basis points on these reserves, the reality is that this was a risk-free investment at a time of great market volatility. Considering that several important banks had issues passing the Fed’s stress tests — tests are designed to exaggerate the stability of the financial sector — it doesn’t require a great logical leap to suggest that the Fed misrepresented this program to public in the name of “stabilizing” the financial sector. In 2016, this policy paid $16 billion to big banks, a number that will likely rise as the interest rate payments go up with every increase in the federal funds rate (we are now paying 1.25% interesthigher than the public can receive from their own banks.)

While both the public and Fed critics on Capitol Hill should be outraged at this clear example of cronyism, simply ending it is not enough. After all, the danger of refusing to pay ransom money is that the ransomer will follow through on their threat. If the Fed was to simply stop payment on these funds, and banks decided to lend it out — then $2 trillion would be injected into credit markets. Given the amplifying effects of a fractional reserve banking system, it’s easy to see how quickly this could unleash severe inflationary pressures.

So this is the true policy issue going forward, how do you stop the taxpayer subsidy to Wall Street while avoiding lighting the fuse to Bernanke’s inflation bomb? One way would be to increase reserve requirements. Currently banks with over $115.1 million in liabilities have to keep 10% at the Fed, by raising that number up you will not only serve to keep this expansion of the monetary base “sterile,” but will make the banking sector as a whole more stable.

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The Fed Remains on Course – to Trouble

The Federal Reserve (Fed) is widely expected to continue to tighten its monetary policy this year. According to a latest Reuters Poll, the Fed is likely to start shrinking its US$4 trillion balance sheet in September and, moreover, raise further its key interest rate, which is currently standing in a range of 1.0 to 1.25 percent, in the fourth quarter this year.

According to mainstream economic wisdom, the time has come for the US economy to return to a more normal level of interest rates. Industrial output is expanding at a decent clip, official unemployment has declined markedly, and prices in the stock and housing market show a sustained upward drift. Considering these circumstances, the US economy can now shoulder a tighter monetary policy, it is said.

It should be understood, however, that there will be side-effects, even unintended consequences, if and when the Fed hikes interest rates further. Most importantly, the Fed doesn’t know where the “neutral interest rate” is. If it does too much, the economy will collapse. If it does not do enough, it will only prolong the artificial boom, causing ongoing malinvestment and, ultimately, another crisis.

Admittedly, this is nothing new: The Fed has always been a cause of boom and bust. It sets into motion an artificial boom by issuing new fiat money through bank credit expansion. Such a boom, however, must sooner rather than later collapse and turn into a bust. It is, therefore, strongly advised to expect nothing good coming out of Fed interventions.

Going Through the Numbers

This of course holds true for the Fed’s plan to start selling securities it has bought during the financial and economic crisis to prop up the economic and financial system. Back in 2008 and 2009, the Fed provided the US banking system with an enormous cash infusion by granting loans to and purchasing securities from banks.

The Fed ramped up banks' cash holdings from US$ 24,9bn to US$ 2,398.1bn from September 2008 to July 2017. It did so by buying Treasuries and mortgage-backed securities (MBS) amounting to US$ 1,908.9bn and US$1,770.3bn, respectively. In the meantime, however, banks have repaid most of the loans provided by the Fed.

This, in turn, has reduced banks' cash holdings to US$ 2,398.2bn. As a result, it has become impossible for the Fed to sell all the bonds it has purchased. Simply put: The US banking system does currently not have enough base money to pay for the Fed’s crisis-related bond purchases of US$3.755.8bn.

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If the Fed were to shed just 64 percent of its current bond holdings, the base money supply in the US banking system would be completely wiped out, making the banking sector effectively illiquid. In this process, US interbank interest rates would presumably spike, sending shock waves through the economic and financial system, not only in the US but worldwide.

Three Options

It is safe to assume that the Fed and the banks would want to avoid such a scenario. This leaves the Fed with three options. Option 1: The Fed sells only a (small) part of its current Treasury and MBS to avoid a liquidity shortage in the interbank money market. In other words: The Fed would have to keep sitting on a significant part of its bond holdings and buy new bonds once they mature.

Option 2: The Fed sells off its bond holdings and, at the same time, runs liquidity providing operations to keep banks sufficiently equipped with cash. It purchases, for instance, consumer and/or corporate loans from banks issuing new base money. As a result, the Fed’s assets in its balance sheet would see Treasuries and MBS go down, and consumer and corporate loans go up.

Option 3: The Fed swaps its Treasury and MBS holdings into short-term maturities and sells these papers over time, thereby reducing the base money supply in the banking system as far as possible. This way, the Fed would reduce its active involvement in the credit markets somewhat, confining it mainly to the short-term end of the market.

Interest Rates will Remain Distorted

That said, it will be enlightening to see which option the Fed will ultimately choose. Option 1 and 2 would be indicative of the Fed wanting to retain its powerful grip on the price action and consequently the yields in fixed income markets. Option 3, in turn, would suggest that the Fed allows interest rates in the long-term end of the market to normalize at least to some extent.

Whatever option it chooses, however, the Fed will, one way or another, keep distorting interest rates. By issuing new quantities of fiat money through credit expansion, the Fed inevitably wreaks havoc on the economy's price system. It manipulates the perception of risk and flatters the value of future cash flows.

This, in turn, causes many economic and social problems. Most importantly, the Fed’s actions debase the purchasing power of the US dollar, thereby destroying much of peoples' life savings. What is more, the Fed’s policy coercively redistributes income and wealth, and it also brings about costly boom and busts.

Just to be on the safe side: The Fed is not the solution to all these problems. It is the actual cause. Whatever the US central bank will do: Be assured it will remain on course to trouble. And trouble there will be – and unfortunately so, whatever the Fed will be doing in terms of setting interest rates and dealing with the bonds it has purchased against issuing new fiat dollars.

While this is certainly a gloomy message, it might help investors to make wise decisions. Because if the Fed causes another round of trouble, it will most likely resort to even lower interest rates and issuing even more fiat money. So whatever happens short-term, there is good reason to expect that the fiat dollar — and this holds true for all fiat currencies — will lose value.

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