The Magicians At The Bank Of England (with close support from No 10 & 11 Downing Street)

Who made this very sound statement two years ago in relation to QE I?

The last resort of desperate governments when all other policies have failed

Answer: George Osborne, our Chancellor.

Sometime soon it will have to stop because in the end printing money leads to inflation.

Answer: our Prime Minister. Both of these statements were made in 2009 when the first round of QE unfolded. If people are spending less, it follows that the money unit is being used less. Indeed corporate balance sheets are paying down debt and chalking up healthy cash balances. Coupled with this, in a fractional reserve system, when money gets repaid and not relent, as we know, it came from nothing, and it goes back to nothing. Personal savings are at their highest for many years as households do the same, pay off debt and replenish cash balances. Bank reserves are the highest they have been for a long time in relation to overall bank balance sheet size. God help us if people do start to spend again in the fashion of old as there will be the mother of all inflations. By the way, many empirical studies, most notably by Friedman, show us that the demand for money is very stable. As we have discussed here before, regime policy uncertainty will cause people to hold precautionary balances, but only for a short period of time. With the first round of QE of £200bn and now the second of £75bn we have nearly added 15% to the money supply. They way out for the Bank of England is to massively raise interest rates as part of a very tight money policy. Either way, this is bad news for us. Hoping a mild inflation will reduce our real debts over time is a very dangerous game. As soon as the inflation genie is out of the bottle, and we all realise that our money is depreciating, we will spend it, retailers will reprice to take into account the new demand, and prices will soar. They are hoping not only for a mild inflation, but also for those in receipt of the new money, the people who have had their gilts bought with the new money, to then go and spend it and get those “animal spirits” working again. So the bankers once again win. More expensive houses, more fast cars and boats, with their bonuses for organizing the buying of the gilts. The banks get the new money deposited with them and can then shore up their balance sheets even further, as I suspect they are still concerned about all the wonky property loans and dodgy sovereign debt they need to wipe off their books. Thus, giving effectively £75bn of money out of the ether to the banks will not have the desired effect of increasing lending or spending (besides the bankers’ toys already mentioned). We all just have our purchasing power diminished while that of the banking system is raised. They get the new wealth effect, not you! As most of these institutions are replete with failed corporate executives, still in the same jobs, who will more than likely repeat the same mistakes, who are regulated by the same people in differently named organizations, we have once more a recipe for disaster. As we always say on this site, the creditors get fleeced . A pensioner buying an annuity today with a £300k pension would have got £22,500 pa and now will get £18,500, should the yields go down to where they want it. The ongoing war on the poor is relentless.  Pensioners just have to swallow a 30% pay cut. Forget looters in Tottenham, we will have geriatrics in the streets of green and leafy middle class suburbia smashing the place up if they are not careful. They will suffer for the mistakes of past governments who in partnership with the banks created the mother of all credit booms, which has led to the largest misallocation of resources since the 30s. As blame for the artificial boom does not lie with the Conservative Party, but with the Blair and Brown money regimes, I can’t fathom why the current government keeps trying to repeat the policy mistakes of the previous one, especially when they condemned this approach to money policy back in 2009. One further thing, if they do pull yields down on gilts, this may well make borrowing costs marginally cheaper, but lets face it: if 50 basis points means you live or die in business, you are kidding yourself that you have a viable business anyway. Likewise, if you are a home owner who is so close to the wire that a fraction of a interest rate move wipes you out, then you are a renter of a home, not an owner. The quicker you default, then better for you and your family. Release your burden, rent, and feed your family. No one will be saying at your funeral “he was a great man, he honoured his mortgage. Even though he never should have taken it out because he could not afford it, he was advised by the bank to do so.  What’s more, they were so kind that they gave him a mortgage worth more than the house, so he could buy his furniture.  Failing to feed his kids and getting divorced did not trouble this honorable man; for the rest of his life he toiled for the bank.” Embrace default and let’s get this correction over and done with, so we can carry on and rebuild our lives in peace.

Jack Farchy In The FT On $5000 Gold

FT – Bullion bulls talk of $5000 gold Historically, gold and silver were the money of choice, freely chosen by the people as the most marketable commodities. The value of your labour was measured in these precious metals. Wicked Kings through the ages debased the people’s money for their own profit. The last English king to do this was Henry VIII. Our money was free from debasement for many years thereafter; the value of our work undebauched. Today, governments around the world assume the powers of kings of old as they embark on the “monetisation” of their debt, minting new money from nowhere. They call it QE. Since 1971, when Nixon severed the last link to gold (struggling to pay for the latest war), paper currencies have been the most extreme derivatives, resting on a mere memory of underlying value. CDO squared has nothing on paper fiat. So the people are voting with their feet, and returning to ancient currency — to gold and silver. How much does an ounce of gold buy you today? $1800 worth of goods and services. And a year ago? $1200 worth of goods and services. How much purchasing power been taken away from you? How long will governments around the world, with no political will to tackle their dangerous debts and zombie banks, be able to maintain confidence in their paper systems? I do not know, but I feel that we’re fast approaching a day when the whole western monetary system will fundamentally change. I hope the new paper will be redeemable in gold or silver. Governments can’t mint this stuff up like magic. They will be forced to raise money through taxation alone, according to what the public will bear. No longer will they be able to kick the can down the road, while stealthily confiscating the fruits of our labour. I am delighted that even the FT, that stalwart of conventional economics, is now asking ‘how high could gold go?‘. Let us hope they consider the fundamentals, and recall our long, sorry history of debasement.

Hayek vs Keynes @ Buttonwood

Readers, if you saw the first video of Hayek v Keynes and the explanation of their key contributions in the rap format, then watch this Part Two, you will love it. If you haven’t seen the original, I urge you to watch Part One. Enjoy! [youtube height=”600″ width=”620″][/youtube]  

Video of Huerta de Soto's Hayek Lecture

We have previously posted the text of Huerta de Soto’s speech, and an audio recording via Cobden Centre Radio. It was a fantastic event, and I’m pleased that we can now provide a video recording as well: [vimeo height=”400″ width=”620″][/vimeo] LSE Hayek Lecture 2010: Professor Jesús Huerta de Soto from Cobden Centre on Vimeo.  

Could The World Go Back To The Gold Standard?

Martin Wolf asks “Could the world go back to the gold standard?

During any period of monetary disorder — the 1970s, for example, or today — a host of people calls for a return to the gold standard. This is not the only free-market response to the current system of fiat (or government-made) money. Other proposals are for privatising the creation of money altogether. (See, on this, Leland Yeager, professor emeritus at the University of Virginia and Auburn University, in the latest issue of the Cato Journal.) But the gold standard is the classic alternative to fiat money. It is not hard to understand the attractions of a gold standard. Money is a social convention. The advantage of a link to gold (or some other commodity) is that the value of money would apparently be free from manipulation by the government. The aim, then, would be to “de-politicise” money. The argument in favour of doing so is that in the long-run governments will always abuse the right to create money at will. Historical experience suggests that this is indeed the case.

Wolf’s answer is predictable, but the whole article is worth reading.

Banking: From Bagehot to Basel, and Back Again

As reported yesterday on, there were some very encouraging statements in Mervyn King’s Monday speech to the Buttonwood Gathering in New York. King noted that “Of all the many ways of organising banking, the worst is the one we have today”. After considering various possible reforms, he moved on to some that were “more radical” (my emphasis):

One simple solution, advocated by my colleague David Miles, would be to move to very much higher levels of capital requirements – several orders of magnitude higher. A related proposal is to ensure there are large amounts of contingent capital in a bank’s liability structure. Much more loss- absorbing capital – actual or contingent – can substantially reduce the size of costs that might be borne outside of a financial firm. But unless complete, capital requirements will never be able to guarantee that costs will not spill over elsewhere. This leads to the limiting case of proposals such as Professor Kotlikoff’s idea to introduce what he calls “limited purpose banking” (Kotlikoff, 2010). That would ensure that each pool of investments made by a bank is turned into a mutual fund with no maturity mismatch. There is no possibility of alchemy. It is an idea worthy of further study. Another avenue of reform is some form of functional separation. The Volcker Rule is one example. Another, more fundamental, example would be to divorce the payment system from risky lending activity – that is to prevent fractional reserve banking (for example, as proposed by Fisher, 1936, Friedman, 1960, Tobin, 1987 and more recently by Kay, 2009). In essence these proposals recognise that if banks undertake risky activities then it is highly dangerous to allow such “gambling” to take place on the same balance sheet as is used to support the payments system, and other crucial parts of the financial infrastructure. And eliminating fractional reserve banking explicitly recognises that the pretence that risk-free deposits can be supported by risky assets is alchemy. If there is a need for genuinely safe deposits the only way they can be provided, while ensuring costs and benefits are fully aligned, is to insist such deposits do not coexist with risky assets.

On regulation, King notes

We certainly cannot rely on being able to expand the scope of regulation without limit to prevent the migration of maturity mismatch. Regulators will never be able to keep up with the pace and scale of financial innovation. Nor should we want to restrict innovation. But it should be undertaken by investors using their own money not by intermediaries who also provide crucial services to the economy, allowing them to reap an implicit public subsidy.

He concludes

There is no simple answer to the too important to fail nature of banks. Maturity transformation brings economic benefits but it creates real economic costs. The problem is that the costs do not fall on those who enjoy the benefits. The damaging externalities created by excessive maturity transformation and risk-taking must be internalised. A market economy has proved to be the most reliable means for a society to expand its standard of living. But ever since the Industrial Revolution we have not cracked the problem of how to ensure a more stable banking system. We know that there will always be sharp and unpredictable movements in expectations, sentiment and hence valuations of financial assets. They represent our best guess as to what the future holds, and views about the future can change radically and unpredictably. It is a phenomenon that we must learn to live with. But changes in expectations can create havoc with the banking system because it relies so heavily on transforming short-term debt into long-term risky assets. For a society to base its financial system on alchemy is a poor advertisement for its rationality. Change is, I believe, inevitable. The question is only whether we can think our way through to a better outcome before the next generation is damaged by a future and bigger crisis. This crisis has already left a legacy of debt to the next generation. We must not leave them the legacy of a fragile banking system too.

Related articles:

Halligan: QE Now Seen As An Aggressive Depreciation Tool

Another superb article from Liam Halligan:

While the US has doubled its monetary base over the last 18 months, the UK’s base money supply has tripled. That’s right – UK base money is now three times bigger as a percentage of GDP than it was at the start of 2009. Given all that money-printing – sorry, QE – the danger is that inflation expectations take hold, and price pressures spin out of control. For now, a lot of the UK’s QE money remains “inert”, and therefore not yet inflationary, seeing as the banking sector has so far refused to lend it on to firms and households – one reason the UK economy remains so weak. That will continue to be the case, in my view, until the banks have black-mailed the British government into following America’s “lead”, and expanded QE to include the purchase of toxic corporate “assets”  as well as government bonds. Eventually, though – and it may not take long – the huge expansion of the UK’s base money supply will cause broader monetary aggregates to balloon as well, even if credit creation multiples remain relatively subdued. The QE money is out there and is almost impossible to withdraw. Once that money gets into circulation, and is leant against many times over, the UK could face “stagflation” – when high and rising inflation combines with an economic slump.

I recommend the whole article.

Why Do We Have to Argue the Case for Free Trade?

I gave the following presentation at a fringe event during the Conservative conference in Birmingham.

Human Co-operation and the Universal Division of Labour

Adam Smith showed us, and it is not disputed internally within the nation, that specialisation in tasks has led to the explosion of the population and material prosperity.  One person the farmer, one the hunter, one the gatherer, one the home maker, etc., with the specialisation always geared to who is best at doing the task. This is accepted by all rational people. Ricardo showed us that what applies to the individuals in the nation should also apply to the free trade between the nations of the world.  It is always advantageous for each nation to concentrate all its efforts to produce things it is best at, even if it could produce some other lesser goods better than the next best producer. So why does this idea meet such resistance? Why do we allow crony capitalists and other vested interests to get a privileged, protected position — such as the European Union farmers when they argue for the Common Agriculture Policy (CAP) — that allows them to push up the prices of their goods and services at the expense of you and me, the consumer?

The Irrefutable Case for Free Trade

David Beckham is a super star football player, who also learned the skills of his father the gas fitter. His father, Beckham senior is a gas fitter who wanted to be a superstar football player Let’s say that David can hire a gas fitter for £20 per hour. With a little practice, he could be twice as efficient as his father. We will imagine that he could market his own gas fitting services for £40 per hour. By playing football, we will suppose that Beckham  can earn £10,000 per hour. Meanwhile, his father the gas fitter couldn’t make more than £1 an hour playing football. Beckham Jnr has a 2-to-1 advantage as a gas fitter, but a 10,000-to-1 advantage football star. If he divides his time equally between gas fitting his own house and playing football, his total output for the week can be valued at: 10 hours gas fitting  x £40 per hour = £400 10 hours football x £10,000 per hour = £100,000 Total output: £100,400 If David’s father divides his time the same way we could value his production as follows: 10 hours gas fitting  x £20 per hour = £200 10 hours football x £1 per hour = £10 Total output: £210 Between them, David and father have produced £100,610 worth of output.

The Law of Association (Mises) or the Law of Comparative Advantage (Ricardo)

Now let’s examine the situation if, as we expect, David hires his father. David’s production can now be valued at: 20 hours football x £10,000 per hour = £200,000 Total output: £200,000 And his father’s at: 20 hours gas fitting x £20 per hour = £400 Total output: £400 Their total output has risen to £200,400.

The Greatest Protectionist Block in European History: The European Union

With this case proven, our politicians should use the irrefutable law of association to call for the dismantling of fortress Europe as it price gouges its hapless taxpayers. The Taxpayers Alliance report “Food for Thought” by Dr Lee Rotherham shows us that the EU protectionist food policies costs the UK £10.3 bn per year or £400 of net disposable income per household. CAP is one aspect of the protectionism sponsored by the EU depriving us of a higher living standard; the real cost of all their interventions is many thousands of pounds per year for the EU taxpayer.

Cobden and Peel

For those interested in free trade, one of Cobden’s finest orations was delivered in the House of Commons on March 13, 1845, and described by John Morley as “probably the most powerful speech he ever made:

Men on the Tory benches whispered to one another, “Peel must answer this.” But Peel crushed in his hand the notes he had made and remarked, “Those may answer him who can.”

The Corn Laws were abolished by persuasive, clear, rational and logical argument. I hope some of the politicians here today will be able to do the same with the protectionist EU, and have that abolished.

Limited Purpose Banking?

In April, I reviewed Jimmy Stewart is Dead by Laurence Kotlikoff. Yesterday, Jerry O’Driscoll posted a review of his own:

Chapter 1 of the book is titled “It’s a Horrible Mess,” and in it Laurence Kotlikoff, a professor of economics at Boston University, reminds the reader of the breadth, depth, and horror of the global financial crisis. It is a cure for the dispassionate observer of events, an indictment that would send all but those with ice water in their veins to sign up for the Tea Party Express. The book is a particularly well-written account of the crisis that begins in housing finance, spreads throughout the financial system, and then throughout the real economy. The crisis hit in tsunami-like waves beginning in 2007 and continued into 2009. In Kotlikoff’s words, “We thought we had well-functioning banking and insurance companies with competent directors, world-class managers, responsible regulators, and incorruptible rating companies. But overnight, we it learned it was a sham.”

O’Driscoll thinks the Achilles heel of Kotlikoff’s proposals is their reliance on a financial regulator:

Kotlikoff excels at detailing the failings of the existing regulatory structure, but does not explain why his proposed system would work any better. If the regulators at the FFA face the same incentives as do those at the SEC (and the rest of Washington’s alphabet soup panoply of regulators), then we should expect the same outcome. Government regulation, no matter the industry, typically fails for two reasons. First, there is the Hayekian knowledge problem. The information needed for effective regulation is dispersed across firms, the industry, and even the economy. There is no effective means for marshaling and centralizing the information within the agency. Second, regulators are routinely captured by the industry they regulate. Through frequent interaction with members of the industry, regulators come to identify with the industry’s interests over the public’s. The revolving door between industry and government exacerbates that problem.

Even so, he concludes:

There is a great deal to recommend this book. First, there is Kotlikoff’s recounting of the crisis itself. Second, there is sense of the manifest injustice of a system in which bad actors get to gamble with other people’s money. Third, there is the challenge to do something radical to reform a system that is radically dysfunctional.

Read the whole review.

Is there room for Austrian Ideas at the top table?

In December 2008, Dr Anthony Evans and I wrote an article for the IEA asking, in these testing times for central banks, whether there is room for Austrian Ideas at the top table.

Historically there have been roughly three main ideas that explain macroeconomic fluctuations, and they can be demonstrated with a brief (and highly stylised) overview. The first to emerge stems from Vienna, with the works of Ludwig von Mises and Friedrich Hayek. This focuses on the communicative role played by interest rates, which signal to entrepreneurs the willingness of consumers to forgo current goods for the sake of greater future consumption. When central banks create monetary expansion this disrupts the signal and alters relative prices. Entrepreneurs invest due to low interest rates, but since this is not backed by greater savings the ‘boom’ is unsustainable. When inflationary pressures caused by the printing of money mean that interest rates rise, a recession is the inevitable consequence. The second is associated with John Maynard Keynes and his followers in Cambridge, England (such as Joan Robinson) and Cambridge, Massachusetts (such as N. Gregory Mankiw and Paul Krugman). This approach shifts attention from demand or supply shocks to emphasise the frictions within a market economy that amplify relatively minor shocks into real (i.e. output and employment) effects. Issues such as price rigidity and capital market imperfections are market frictions that require aggregate demand management to overcome. The third main idea is associated with the New Classical and real business cycle (RBC) theorists who view cyclical activity as being the outcome of random productivity shocks. Under certain assumptions supply-side shocks (such as energy prices, changes in productivity, regulations, civil unrest) alter the natural rate of output, and the economy efficiently responds. For simplicity we label these three main frameworks as ‘Vienna’, ‘Cambridge’ and ‘Chicago’, and use doughnut charts to illustrate their similarities and differences: Figure 1: Chicago vs Cambridge vs Vienna

We argue that

the neoclassical synthesis of classical (Chicago) and Keynesian (Cambridge) macroeconomics that underpins central bank philosophy is a necessary but not sufficient use of the ideas available. And as we shall see, current economic conditions are prompting a return to distinctly Austrian (Vienna) ideas across the mainstream media.

We conclude,

There seems to be an increasing acceptance amongst economic commentators that loose monetary policy has fuelled credit bubbles; a too-narrow focus on CPI has prevented central bankers from fully noticing; and the risk of a minor recession should outweigh the threat of future inflation. By providing the context for these ideas we hope this interest is extended to central bankers. In these testing times there should be an open mind for the most appropriate frameworks to influence monetary policy. There is a vacant seat at the top table, and it is time that it was filled.

We encourage you to read the whole article. [prettyfilelist type=”pdf,xls,doc,zip,ppt,img,mp3″ filestoshow=”294,” hidefilter=”true” hidesort=”true” hidesearch=”true” openinnew=”true” filesPerPage=”3″]