The lesson from the events of 2007-2008 should have been clear: Boosting GDP with loose money – as the Greenspan Fed did repeatedly between 1987 and 2005 and most damagingly between 2001 and 2005 when in order to shorten a minor recession it inflated a massive housing bubble – can only lead to short term booms followed by severe busts. A policy of artificially cheapened credit cannot but cause mispricing of risk, misallocation of capital and a deeply dislocated financial infrastructure, all of which will ultimately conspire to bring the fake boom to a screeching halt. The ‘good times’ of the cheap money expansion, largely characterized by windfall profits for the financial industry and the faux prosperity of propped-up financial assets and real estate (largely to be enjoyed by the ‘1 percent’), necessarily end in an almighty hangover.
The crisis that commenced in 2007 was therefore a massive opportunity: An opportunity to allow the market to liquidate the accumulated dislocations and to bring the economy back into balance; an opportunity to reflect on the inherent instability that central bank activism and manipulation of interest rates must generate; an opportunity to cut off a bloated financial industry from the subsidy of cheap money; and an opportunity to return to sound money and, well, to capitalism. Because for all the thoughtless talk of this being a ‘crisis of capitalism’, a nonsense concocted on the facile assumption that anything that is noisily supported by bankers must be representative of free market ideology, the modern system of ‘bubble finance’, cheap fiat money and excessive debt has precious little to do with true free-market capitalism.
That opportunity was not taken and is now lost – maybe until the next crisis comes along, which won’t be long. It has become clear in recent years – and even more so in recent months and weeks – that we are moving with increasing speed in the opposite direction: ever more money, cheaper credit, and manipulated markets (there is one notable exception to which I come later). Policy makers have learned nothing. The same mistakes are being repeated and the consequences are going to make 2007/8 look like a picnic.
From ‘saving the world’ to blowing new bubbles
Of course, I was never very optimistic that the route back to the free market and sound money would be taken. At the time I left my job in finance in 2009 and began to write Paper Money Collapse, the authorities had already decided that to deal with the consequences of easy-money-induced bubbles we needed more easy money. ‘Quantitative easing’, massive bank bailouts, deficit spending and ultra-low policy rates had become the policy of choice globally. But at least the pretense was upheld for a while that these were temporary measures – ugly and unprincipled but required under the dreadful conditions of 2008 to safe ‘the system’. The first round of debt monetization after the Lehman collapse – the exchange of $1 trillion of mortgage-backed securities on bloated bank balance sheets for freshly minted bank reserves from Bernanke’s printing press under ‘quantitative easing 1.0’ (QE1) – was presented as an emergency measure to avoid bank collapses and a systemic crisis.
I never thought that this was a convincing rationale as it was clear to me that whatever the accumulated dislocations were, there was ultimately no alternative to allowing the market to identify and liquidate them. Aborting, delaying and sabotaging this essential process of economic cleansing and rebalancing would only cause new problems. Even on the assumption that these were measures to deal with extreme ‘tail events’, I could not then and cannot now support them. But it is becoming abundantly clear that these measures are neither temporary nor restricted to avoiding bank runs or systemic chaos but that now, after the public has become sufficiently accustomed to them and a cheap-money-addicted financial industry has begun to incorporate them into their business models, they constitute the ‘new normal’, that they are now the accepted ‘modern’ tool kit of central bankers. Zero interest rates, trillion-dollar open-market operations to manipulate asset prices and to ‘manage’ the yield curve are now just another day in the modern fiat money economy. Nobody talks of restraining central bank activism. Rather, the temptation is growing to use these tools to kick-start another artificial boom.
In his excellent new book The Great Deformation – The Corruption of Capitalism in America, David Stockman provides a fascinating account of how the principles of sound money, balanced budgets and small government have progressively been weakened, betrayed, undermined and ultimately completely abandoned in American politics (often by Republican politicians and even some of the alleged ‘free market heroes’ of Republican folklore), and how today’s cocktail of bubble finance and trillion-dollar deficits represents the delayed but inevitable blossoming of destructive seeds that were sown with Roosevelt’s New Deal and Nixon’s default on the Bretton Woods gold exchange standard. In a chapter on the recent crisis, Stockman argues convincingly that the shameful bailout of Wall Street in 2008, in particular of Goldman Sachs, Morgan Stanley, and a few other highly leveraged entities via the bailout of ‘insurance’ giant AIG, were sold to Congress and the wider public with exaggerated claims that the nation’s real economy was at imminent risk of collapse. From my position as an economist and a market participant at the time of these events, Stockman’s analysis and interpretation strike me as entirely consistent and correct. But even if we were willing to give more credit to the claims of the ‘bailsters’ and interventionists that the fallout for Main Street would have been substantial, that would only further underline how far the Fed’s preceding easy money policies had destabilized the economy, and the question would still remain whether it could ever be a reasonable objective of policy to sustain these large-scale dislocations against market forces.
Be that as it may, the dislocations were largely sustained and plenty of new ones added. Talk of ‘exit strategies’ – that is, of a ‘normalization’ of interest rates and shrinking of central bank balance sheets – has now pretty much died down. Super-low interest rates are now a permanent tonic for the financial industry. In fact, the nature of the debate has shifted markedly over the past 15 months as the idea is progressively gaining adherents that the new hyper-interventionist tool-kit of the central bankers that was slipped in under the cloak of avoiding financial Armageddon in 2008 should now be used pro-actively to start a new easy-money-induced credit boom, that aggressive money printing and debt monetization should be employed to generate a new growth cycle. Many economists are de facto demanding a new bubble.
In America, QE2 was already targeted at boosting the prices of government debt and thereby lowering interest rates and encouraging more lending – which naturally means more borrowing and more debt, the opposite of deleveraging and rebalancing. And QE3 – which is an open-ended $85-billion-a-month price-fixing exercise for selected mortgage- and government- securities – is even targeted officially at lowering the unemployment rate, meaning Fed officials seriously claim that they can create (profitable and lasting?) jobs by cleverly manipulating asset prices.
The resurgence of the money cranks
Rising real wealth is always and everywhere the result of the accumulation of productive capital, which means real resources saved through the non-consumption of real income, and its employment by entrepreneurs in competitive markets under the guidance of uninhibited price formation. This process requires apolitical, hard and international money. Monetary debasement always hinders real wealth creation; it does not aid it. Easy money leads to boom and bust, never to lasting prosperity. Easy money is not a positive-sum game and not even a zero-sum game. It is always and everywhere a negative-sum game.
To claim, instead, that an economy’s performance and society’s wealth is lastingly enhanced by pumping more fiat money through its financial system requires a considerable degree of economic illiteracy and, in the wake of the recent crisis, selective amnesia. Not too long ago, such assertions as to the benefit of inflation and money printing would have clearly marked its proponent as a money crank. But the cranks are now manning the monetary policy ships everywhere, and the international commentariat is either willingly complicit in spreading economic nonsense or intellectually challenged when it comes to exposing the naivete and recklessness of these policies.
Nothing confirms the renewed dominance of money crankism more than the present sad spectacle of Japan, a country that became a post-WWII economic powerhouse in no small measure thanks to the old capitalist virtues of hard work, high savings rates, strong capital accumulation, and innovative and international-minded entrepreneurship, now taking a leaf out of the policy book of Argentina and embarking on a mission of aggressive money printing, currency debasement, asset price manipulation and inflationism. Japanese savers are already losing international purchasing power by the bucket load as the Yen keeps plummeting in international markets.
The idea that currency debasement will result in lasting, self-sustained growth and rising prosperity is positively laughable. I do not doubt that Japan’s new initiative of aggressive monetization has the potential to improve the headline numbers on a number of corporate earning reports and to even give a near-term boost to GDP. Like most drugs, easy money tempts its users with the promise of an immediate but short-lived high. What is, however, absolutely certain is that whatever ‘stimulus’ is generated in the short term is bought at the price of more imbalances (most certainly higher indebtedness) that will weigh down severely on the Japanese population in the future. What is even more worrying is that Japan’s gigantic pool of government debt – held to a large extent by an aging population as a ‘pension nest egg’ and by domestic banks on highly levered balance sheets– is a veritable powder keg, and the Bank of Japan’s new inflation strategy is tantamount to playing with fire.
The deflation myth
It has become commonplace to justify Japan’s monetary ‘experimentation’ with reference to the country’s long suffering under supposedly ‘crippling’ deflation. Even otherwise respectable financial newspapers and journals lazily repeat this standard refrain. It is complete and utter nonsense. Whatever Japan’s problems are, and I am sure they are numerous and sizable, deflation is not one of them.
Firstly, there is no economic rationale for assuming that the type of moderate and ongoing deflation (secular deflation) that analysts suspect in Japan and that is the result of stable money and marginal improvements in productivity could constitute a problem for the economy’s performance. Why such deflation is harmless (and even preferable to moderate inflation) I explain in detail in chapter 5 of Paper Money Collapse. I make no claim to originality here, as this insight was widely accepted among most serious mainstream economists up to and including the first third of the twentieth century when it became sadly ‘forgotten’ rather than refuted. But if you don’t want to take my word for it or go through the argument in my book, or if you want to have ‘empirical evidence’, then you might want to listen to Milton Friedman, hardly an advocate of the gold standard, who (together with Anna Schwartz) analyzed the late 19th century economy of the United States which had both stronger growth and much more deflation (in particular after the fiat money episode of the Civil War had ended) than Japan had over the past 20-odd years, and who concluded that U.S. data “casts serious doubts on the validity of the now (1963) widely held view that secular price deflation and rapid economic growth are incompatible.”
Secondly, there is not even any deflation in Japan that deserves the name. The data (which is here) does not support it. I am sure the economists at the Bank of Japan employ massive magnifying glasses to detect deflation in their data series. What Japan has is, by any rational standard, price stability.
In February 2013, the consumer price index (CPI) stood at 99.3. Ten years earlier, in February 2003, it stood at 100.3, and ten years before that, in February 1993, at 99.6. Apart from the fact that, as with any price-index data, the methodology, accuracy and relevance of these statistics is always highly debatable, it is clear that if we do take the data at face value we see an economy that has roughly enjoyed stable prices for two decades. In fact, prices rose marginally in the late 1990s, remained stable for a few years, and have recently declined marginally.
In February of this year, the inflation rate was -0.6 percent year over year. Would any of the commentators who lament Japan’s ‘crippling deflation’ claim that an inflation rate of +0.6 percent year over year would constitute worrying inflation, or even deserve the label ‘inflation’ at all? Would it not simply be called a rounding error? – By comparison, official UK inflation stood at +2.8 percent year over year in February 2013 and has fluctuated between +1.1 percent and +5 percent over the past 4 years alone. What monetary system is more conducive to rational economic calculation and planning – Japan’s or Britain’s? (It should be worth noting that over those 4 years the British economy has NOT outperformed Japan, despite its ‘wonderful’ inflation.)
Those commentators who tell us that this ‘crippling deflation’ is hurting the economy because people postpone spending decisions in anticipation of lower prices, want us to believe that Mr. and Mrs. Watanabe don’t buy a new popup toaster for ¥3,930 this year because – at a 0.6 percent p.a. deflation rate – they can reasonably assume that it will only cost ¥3,906 to buy the same toaster next year. And they won’t even buy it next year at ¥3,906 because the year after that it will only cost ¥3,883. The Watanabes would thus be able to save ¥47 over two years by not eating any toast (and it goes without saying that they may save considerably more by never eating toast!). This is a saving of – wait for it! – $0.47 or £0.31 (at present exchange rates) for postponing the purchase of a standard consumption item for two years – 730 mornings without toast! The notion that this ‘crippling’ deflation is holding back Japanese growth is simply beyond ridiculous, yet you can hardly open a newspaper these days without seeing such nonsense presented as economic analysis. (I would recommend that these experts on consumer psychology call the people at Apple, Samsung and other providers of tablets, smartphones and various consumer technology items and tell them that they are missing a trick: it is evidently rising prices that get people buying, not falling prices!)
Funding the state
The deflation argument is so flimsy that one can only assume it is a convenient scapegoat for a different agenda: securing printing-press funding for the state. Under Japan’s new monetary debasement plan, the Bank of Japan will practically buy the entire annual issuance of new government debt and thus fund excessive public sector spending directly via the printing press. Japan is famously the world’s most highly indebted state at 230% of GDP and runs an annual budget deficit of around 10% of GDP. Even the most troubled members of EMU enjoy better funding stats.
The often-heard argument that such profligacy has evidently not been punished by markets for years and decades, so why should the day of reckoning be any nearer now, is unconvincing. For years, the Japanese public has in fact saved and has faithfully handed its private savings over to the state, which immediately wasted them on Keynesian ‘stimulus’ projects that will never bring a meaningful return (bridges and roads to nowhere, public pools, agricultural subsidies). For a long time it was to a considerable degree private frugality that funded public excess. But now the savings rate has collapsed to 2 percent and given the shrinking workforce and aging population is unlikely to ever recover. Private savings are thus no longer sufficient to fund the state’s recklessness, so now it is up to the Bank of Japan to keep the state in business and maintain a mirage of solvency. The inflationary implications of funding massive government waste through money-printing rather than voluntary savings are, of course, considerable.
The risk here is not that the policy of monetary debasement will again amount to ‘pushing on a string’ and fail to raise inflation and inflation expectations. The much riskier and likelier outcome is that this policy will ultimately ‘succeed’. The aging Japanese population sits on a massive pile of government debt that is not backed by productive capital but that the population still considers its ‘pension assets’. Debasing the purchasing power of fixed income streams that Japanese pensioners draw from this pool will ultimately dampen domestic consumption – the very component of GDP that the inflationists claim to boost with their monetary debasement. If inflation only rises from -0.6 percent to +1 percent, the entire Japanese yield curve is ‘under water’. Only very long maturity bonds will still provide a positive real yield. This will also hurt the banks which are massive (leveraged) owners of government debt. And of course, a meaningful sell-off in the bond market would quickly wipe out bank capital.
Such a sell-off may still not occur anytime soon. At the present UK inflation-rate of +2.8 percent, most of the UK’s government bonds are also trading at negative real yields. In fact, in recent months many bond investors around the world have exhibited a remarkable willingness to hold bonds at negative real returns. It appears as if many of these securities have become, in the eyes of their holders, ‘cash equivalents’, i.e. instruments that are held for reasons of safety and liquidity, not for reasons of income generation. How far the central banks can exploit this phenomenon is uncertain. Central banks cannot turn water into wine but almost any asset into (fiat) money by ‘monetizing’ them. The only limit to this operation is the willingness of the public to hold these new ‘monetized’ assets, and frankly I doubt that there is money demand in Japan to the tune of 230 percent of GDP. – We shall find out.
Money crankism will spread
‘Abenomics’ will not solve Japan’s problems; it will make the Japanese worse off and it has the potential to trigger a mighty financial crisis. Yet, what is surely inevitable might not be imminent. During the early honeymoon between ‘Abenomics’ and financial reality, the idea of printing yourself to prosperity is likely to have imitators, with the UK being a prime candidate. In terms of total indebtedness, the UK is the one industrialized country that can compete with Japan, meaning it is in the same supersized debt-pickle. Even the timid attempts by Chancellor Osborne to lower the speed at which Her Majesty’s government goes further into debt are being attacked as savage ‘austerity’ by the opposition and large parts of the media. In his latest budget he put the remaining taxpayer-chips on another housing bubble and gave the Bank of England more room to ignore inflation. Over at Thredneedle Street, the Deputy Governor of the Bank of England, Paul Tucker, openly fantasized about negative interest rates recently, outgoing Governor Mervyn King voted for more QE (overruled), and Governor-elect Mark Carney promises to be, well, – flexible. Bottom line: desperation is spreading. Watch this place! Chances are the Old Lady is the next to throw any remaining caution and remaining vestiges of monetary sanity to the wind and – go ‘all in’.
This will end badly.
P.S.: As to ‘the exception’, the only place where money crankism is not the order of the day yet is – the Euro Zone!– Yes, I am serious. – I know, I know. This is an amalgamation of semi-socialist, semi-bankrupt welfare states that share the same politicized paper currency issued by a central bank that has already bailed out too many banks, has manipulated various government bond markets and whose balance sheet as a percent of GDP is larger than the Fed’s. However: In a global sea of monetary madness there are at least a few remaining signs of sanity and orthodox monetary discipline on display in the much derided EMU. Greece was allowed or encouraged to default on part of its debt, which meant that bond-holders had to eat losses. Cyprus’ biggest bank is being wound down, which means depositors are going to eat losses, too. There is a persistent push towards ‘austerity’. On the fiscal front, the Euro Zone easily outperforms the US, the UK and, of course, Japan. While the Fed has increased its balance sheet girth by almost $300 billion in the first three months of 2013 alone, the ECB has reduced its own by almost €400 billion over the same time. My rule is this: The more Professor Krugman is foaming at the mouth and the more apoplectic the commentary from the strategists, analysts and economists in the bailout-addicted financial industry get, the more it seems that Mrs Merkel & Co are getting a few things right.