Fire and Water

In a world where the first, last – and sometimes, the only – resort in times of trouble is to run the printing presses, you’d think people who don’t actually consider themselves to be witch-doctors would be convinced of the efficacy of the proposed remedies they prescribe.

Granted, the dosage gets increased every time and the delay while the ‘cure’ takes effect seems to become ever more protracted, but it still takes some neck to wade ever deeper into the mire while remaining fundamentally uncertain that there is actually a bottom to be found in that swamp.

Take the present Totentanz we are conducting around the ailing corpse of our lives, livelihoods, and liberties on account of this Covid thingummy.

Annualising the pace of money creation over the past seven months of panic, partial release, and purgatory, the Fed has managed a 60% rate of injection; the Russians, Canadians, Ozzies have attained the 40s; the Indonesians, are running at 35%; the Indians, Mexicans, Koreans, Japanese, Swedes, and Brits are well into the 20s; The ECB and PBOC are clocking rates in the teens. Bracketing this profusion, the Turks – as determined as ever to destroy their native currency – are way out in front at 117%, while the Swiss – conversely, as determined as ever to preserve theirs – are at what seems by comparison a shockingly modest 11%.

Translating all these numbers into US dollars and adding them together, we find that YOY money supply growth over this dominant subset of the industrial world economy is now clearly in excess of 20% – the fastest rate since the GFC, if we take it at face value. But if we factor in what those dollars will globally buy – using the broadest of the trade-weighted indices on offer – the spate is roaring along at its quickest since 2003 and has only been topped twice since the long era of subdued price inflation and secularly falling bond yields was ushered in, in the latter half of the 1980s.

To reinforce this sense of an extreme, the acceleration in that rate of growth has also only been topped once in the past half-century (and possibly, therefore, in the whole of human history) and that in the immediate, white-knuckle aftermath of Lehman’s failure, 12 years ago.

There are, of course, many reasons why the current flood has not swept us all away on an obvious inflationary tide. Most of these are spelled ‘lockdown’ or ‘curfew’.

As we have said before, such governmental enormities make us all a little like the character Ben Gunn in Robert Louis Stevenson’s classic tale, ‘Treasure Island’. Metaphorically, at least, we are marooned on a palm-fringed atoll, cursed like Midas to derive little benefit from the cash hoard piled up next to us.

We have been inundated with money, yet we are justifiably fearful of our future. We realise that the money will not yield any save the most precarious, speculative return. We are physically being prevented from using it as we would most prefer. Select as appropriate.

In this, however, we are also demonstrating that we are at once more flexible and less malleable than the Guardians suppose. We adapt. We flow. Yes – sometimes we are simply inert, but we can also be both imaginative and dogged in trying to achieve our initial objectives, even when the Powers That Be are trying to deny their attainment to us.

Outside of today’s extraordinary circumstances, the realisation that this is so is what gives rise to a good part of the wider angst among pundits and policy makers. From their lofty position on – or just behind – their thrones, it worries than that we, annoyingly obstreperous humans, tend not to respond as automatically as the textbooks and learned papers would have them believe we should.

Dude, where’s my price rise?

Over a longer horizon, we have to admit that generalized rises in the subset of things which make their way into the basket of consumer price indices have not been overly dramatic in recent years. At least, not if we ignore the usual basket cases to be found in emerging markets and Latin America or overlook the often heavily-administered costs of things like health, education, and ’green’ electricity – or if we leave housing out of our calculations.

Strangely enough, there are few consequences to monetary over-expansion to be seen if we choose to ignore the most obvious of them.

Three cheers, then, for the countervailing efforts of entrepreneurship, technological advance, the shale revolution, and the vast increase in productive capacity brought about by the incorporation of Communist Asia into the global market.

In a more rationally-ordered system, such advances would have led to a steady, largely benign fall in prices as a mark of material progress. The sad fact is that every central bank in the world has abandoned a study of the wider lessons of history concerning the beneficial nature of such periods and has instead become obsessed  with one sole, simplistic myth of what transpired when prices fell sharply during the singular and highly-complex events of the 1930s.

This myopia has led them to fight, tooth and nail, to prevent prices from reflecting the underlying economic reality and to persist in the obstinate pursuit of a shamanic ideal of encouraging a 2% per annum rise in their favoured price baskets (2% on average, as it is starting to become articulated). ‘Inflation’ has been largely hidden, therefore, if corrosive in confusing economic calculation and disrupting resource allocation, for all that.

Adding to such supply-side influences, moreover, one of the greater – largely unrecognised – issues is that ZIRP utterly erases the already blurred lines between money (which has a primarily transactional purpose) and savings (a means of deferring one’s own transactions, usually by enabling another’s).

By acting to making money into a vehicle of equal utility to a low-, or negative-yielding time deposit, QE has seen its crucial function as a medium of exchange subsumed anonymously into what has become a deepening repository for savings, too; hence what many loosely talk about as a drop-off in ‘velocity’.

Look at the Eurozone, for example, where ECB policy has seen M1 cannibalise the rest of the more closely watched M3 aggregate, to the extent that, despite ALL the intervening expansion of the central bank’s balance sheet, the ‘higher’, far less monetary components of the latter are only now drifting modestly higher from multi-year lows.

But none of this is to say that the opposite, defeatist strand of thought holds any more truth, either, when it tries to claim that money in our hands has lost its power to influence economic calculation, to affect the number and kind of transactions, or to alter prices and that it only ‘works’ if we hand it over to governments to scatter about on an ever expanding list of pet projects, as well as on the sadly necessary, remedial support payments being doled out to those they have prevented from earning a regular income.

Rainmakers or Rasputitsa?

Such is the state of confusion on this matter that we have even seen it said that not only does QE not equate to monetary increase; not only is it unable to raise prices (‘cause inflation’); but that it is actively ‘deflationary’.    

Now, to a limited extent there is a certain merit to the first of these contentions, but only to the extent that, in most present day regimes, the textbook “money multiplier” is largely a regulatory and practical anachronism, meaning that any automatic linkage between ‘base money’ – the currency and reserves printed and created by the central bank – and ‘inside money’ – the kind the commercial banks themselves generate on top of that through granting loans and buying securities – has been effectively disabled.

But, beyond this, we should always bear in mind that even if intervention has no further, self-stimulating effect beyond its first, more direst one; even if it only seems to be clogging up bank balance sheets with unheard of quantities of excess reserves, the central bank’s very act of buying a security by issuing a claim on itself gives the seller a new monetary title in all except the relatively rare cases where the surrendered paper was being held by means of a bank credit which the sale now allows to be paid back in full. Only in this specific instance does QE only effect what its critics dismiss as an ‘asset swap’ by turning a bank loan or reverse repo into a commensurate CB reserve balance.

One common way of thinking about how the ‘cumulative’ inflationary process occurs in general, is to argue that people tend only wish to hold a certain proportion of their real wealth in monetary form and so, should new money be forced upon them, they will each try to pass it on to their fellows by buying more of whatever real things they choose to acquire in exchange for it.

Since it is nigh on impossible for the system, as opposed to the individual, to be rid of its excess money, the ultimate effect is that the desired equilibrium is achieved through raising the price of many such real assets and thus restoring their proportion to a quantity of money which may be swollen in nominal terms (I have more pennies in my pocket), but which has become suitably depreciated in value (the coppers buy far fewer bonbons in the sweet shop).

If that process of change is long-lasting enough and sufficiently drastic in its evolution, it is not hard to imagine that the people affected by it will come to anticipate it and try to get ahead of it – serving only to make it worse through their combined actions as they do, of course.

Mises – who personally lived through one of the wilder examples of such turmoil – explained it with the now well-known illustration of the housewife who at first had held off from buying a suddenly more expensive frying-pan, in the hope it would soon revert to the ‘normal’ price to which she had become ‘anchored’, but who eventually rushed out to buy not only the pan, but several other items, too, that she had painfully learnt would only ever cost more, not less, tomorrow.

Out of the Frying Pan…

If that all sounds too remote to be of much practical significance just now, consider what happens when the new money-today is used instead to those claims to money-tomorrow we call stocks and bonds.

Being carried out via the indiscriminate purchase of a limited set of IOUs, QE must drive up their price, depress their yield, and trigger a hunt for substitutes which exerts a baleful influence far across the pool of available securities. The compulsion may take the form of an inappropriate extension of maturity; in a hazardous lowering of credit standards; and in the incurrence of elevated leverage and foreign exchange risk on the part of even the most prudent, as they try to recover some of their lost income stream. 

QE therefore sets in train a range of unhelpful, positive feedbacks which are made worse in an over-financialized world of giant, benchmark-addicted, regulation-driven, Giffen-good acquisitive, Herd-mentality institutions whose principal anxiety is FOMOF – Fear of Missing Out on Fees. Lowered rate therefore lead to yet lower rates as even Keynes’ caricaturised ‘College Bursars’ give up their mean reversionary ways and become Momo punters of a stripe to rival the most hyperactive of day-traders (incidentally, further vitiating his already hollow arguments about the existence of ‘liquidity traps’).

That the most immediate impact is felt in financial markets does NOT mean, however, that there no real world effects. Artificially lowered rates allow people who would otherwise not pass then necessary financial viability test to be able both to acquire and to hold on to productive means – whether ones already in being or in the form of components to be assembled.

Lowered rates of time discount have an ancillary effect in shifting emphasis to productive combinations which are much slower to amortize  – to more ‘roundabout’ ones, in the parlance. When this is a natural consequence of either increased plenty or a more thriftily-inclined public freeing up resources from their more immediate uses, this is all to the good. But to mimic the beneficial effects of what is termed a lower ’time preference’ by monetary chicanery breaks this natural correspondence and begins throw ‘forced’ saver into conflict – and not co-operation – with falsely enabled borrower.

With money too easy, banks soon become reluctant to enforce much on the way of  discipline, being lulled into complicity by the fact that few of even their more dubious loans are currently going sour. What they often fail to realize – or simply face too many perverse incentives to recognise – is the fact that the count of such NPLs is down, not because no-one is making enough loans (as we recently saw argued), but because almost no borrower runs out of options to refinance on ever more favourable terms, no matter how weak his business prospects or how impaired his balance sheet.

In this way, we remove the sharp-edged, Darwinian scissor-blades of real capital scarcity and the ever-present risk of failure. Instead we find ourselves financing any fool’s pipe-dreams, any schemer’s projects, and any Dodo’s life-support package. The rapid build-up of economic dead wood which ensues is how artificial laxity only serves to undermine entrepreneurial efficiency.

We now progressively preclude much hope of earning traditional, steady returns in favour of those of the more eye-catching – though largely notional and systemically-unrealizable – kind which consist of inflated market quotations for shares in businesses which pay no dividends and make few profits (or even run chronically at a loss).

Those stretched investment horizons can therefore become essentially infinite as the appraisal of the worth of ‘roundabout’ methods is made entirely subject to swings in sentiment, to the exclusion of anything more solid.

Such inflated quotations, of course, rely solely on a continued monetization of the hopefulness of successive waves of the gullible and the greedy, as well as on the reluctant participation of those bereft of more meaningful alternatives.

One further, highly pernicious effect of QE is that it removes the already weak institutional restraints on government spending, both by lowering the interest burden on its prodigious amounts of outstanding IOUs and by ensuring its new ones find a ready buyer.

Competition for these is naturally skewed by the bottomless pockets of the central bank itself, but it also includes those running collective savings schemes whom we have noted face procedural and regulatory pressure to buy more – not less – of them, the lower their yield.

A further appetite is whetted among the speculative crowd, piggy-backing on the rise in bond prices which the first two tribes have brought about. This latter class of chancers will be all the more resolute in chasing gains, the more they have been given an unwonted reassurance about the nature of their gamble by the idiotic central-banking vogue of issuing ‘forward guidance’ – i.e., promising them that no effort will be spared to load the dice in their favour.

Thomas Farriner’s Bakery

Studiously ignoring this, the true message of the financial markets, the PhD set which holds such sway over our lives focuses instead on what its members decry as a lower ‘neutral rate’ of interest (‘r-star’, in the jargon). This Cheshire Cat of modern economics is the intrinsically unobservable rate whose observance would theoretically exert no long-term influence on real economic development and thus is the invisible target for which the central bank should always try to aim.

Since the pointy-heads are largely prey to the persistent fallacy that interest rates are ultimately determined by ‘productivity’ (an argument whose fatal circularity was exposed by the Austrians a good hundred years ago), they often appeal to the what they calculate is the contemporary drop-off in aggregate output per man-hour worked for confirmation of r-star’s decline. Needless to say, they never stop to wonder if the forcibly-lowered interest rates which their advocacy supports are the cause of the decline in economic efficiency – for the reasons we have outlined above – rather than the converse.

Regardless of that caveat, once they set to hunt this particular hare, they quickly run into several unresolvable complications. This might lead one to wonder if the concept might be quietly dropped from the Counsels of the Wise, but inability to settle the issue is no drawback to those wedded to it since it encourage countless leaned papers to be produced, each crammed full of impenetrable vector algebra, in the attempt to count how many angels really do dance on the head of this particular pin.

When the riddle is addressed, one common approach starts by making all manner of unprovable – if not indeed untenable – assumptions about how far the real economy lies from its estimated full potential. But the other, increasingly popular angle is to start by torturing the data relating to prices in the bond markets on the highly suspect basis that these reflect a rational, stable, and far more accurate consensus about the state of said economic conditions.

For all the impressive mathematical legerdemain employed in the effort, this firstly  begs the question of whether financial markets really are such reliable mirrors of reality or whether they more often function as self-referential systems whose own excesses can profoundly alter reality itself. The fact that the sorry, three-hundred year, empirical record of recurring manias and panics, booms and busts would tend to suggest that the latter is true is enough to ensure that the possibility is routinely overlooked.

Furthermore, the itch to start crunching numbers and displaying one’s facility with MATLAB is far too intense to allow for any recognition of the fact that market prices are partly where they are because of both past policy and the expectation of how that policy will develop in future. This adaptive relation is made all the more incestuous when the bond markets’ guesses become the policy-maker’s benchmarks, thus making them into both input and output in the decision matrix with often comical results.

In the final analysis, the country-fair game of ‘Guess the Weight of the Ox’ can hardly be expected to display much of Galton’s Wisdom of the Crowd if the judges are not only sitting on the scales but are seen to be engaged in filling their pockets with stones throughout the course of the competition.

With a certain grim inevitability, then, the misplaced exercise of so much expensively-educated grey matter nearly always finds that, in an economy sapped of much organic strength by previous episodes of over-accommodation, policy is too restrictive. The post-docs and professors end up braying predictably for yet MORE, inherently-enervating central bank intervention to be undertaken in order to offset the weaknesses which the previous rounds of such academically-endorsed ‘stimulus’ have themselves set in train.

So, yes. QE is a blight which leads to a loss in wealth which of late has been mainly a counterfactual of could’ve-would’ve-should’ves rather than something more readily identifiable. But it would be a brave  – or a foolish – forecaster who would go all-in on the premise that it will not mutate, post-Lockdown, into a much more tangible cycle of widespread impoverishment given the vast amount of dry tinder being stacked up and while paying heed to our Overlords’ evident desire both to set a match to that kindling and to keep the flames diligently banked and stoked long thereafter.