THE BEAR'S
LAIR Into
the monetary vortex By Martin
Hutchinson
Last week's revelation in the
US Federal Reserve minutes for its August 1
meeting that another quantitative easing - "QEIII"
- government bond purchase is almost inevitable
has intensified the recent upward trend in
markets. With fiscal and monetary policies more
extreme than any in history, now entering their
fifth year, and equally unprecedented advances in
communication and computing enabling ever-faster
trading, it's not surprising that market behavior
is anomalous.
Only the almost total
absence of inflation is strange. Soon, however,
that anomaly will be explained, as the immense
supply of negative-cost money causes the global
economy to spiral into
a vortex of
hyperinflationary collapse. The Mayan calendar, in
which the fourth world ends on December 21,
leading us to a Fifth World of greater
enlightenment, may be only too accurate,
economically speaking - but that enlightenment
will have been purchased at a fearful cost.
Probably the central puzzle of monetary
policy in the past two decades is that of
velocity. Money supply, however measured, has
increased consistently more rapidly than nominal
gross domestic product (GDP), so we are told that
monetary velocity has declined. The non-appearance
of the expected inflation in the past several
years of negative real interest rates is explained
by monetary velocity having declined even further.
This variable, which had increased consistently in
every decade since the Industrial Revolution or
even before, has now mysteriously turned tail and
is heading steadily downwards. Yet nobody can
explain why.
Ludwig von Mises was scathing
about the velocity concept; he called it "a
vicious mode of approaching the problem of prices
and purchasing power". When you examine the
concept more closely, you can see what he meant.
Since the invention of the Internet, our ability
to transfer money through means such as PayPal,
both within single economies and around the world,
has increased geometrically and our need for
physical cash has declined. Credit cards also
allow us to spend money in advance of receiving
it, thus further increasing its velocity.
Above all, there is the phenomenon of
"fast trading". More than two thirds of the volume
on the world's stock exchanges results from
computers flicking buy and sell orders at each
other, trying to make a tiny profit through
insider knowledge, for a millisecond or so, or
these days even less, of the other guy's trades.
Every week or so one of these systems
malfunctions, losing its owner several hundred
million dollars, causing the year's largest
initial public offering of shares to go up in
flames, maybe one day causing a planet-wide
catastrophe - who knows? - certainly not the
owners of these computer systems and their
laughably misnamed "risk managers". There's
monetary velocity for you!
Yet for two
decades reported monetary velocity has declined.
The concept is self-contradictory.
The
explanation lies in the rise in the last two
decades of immense stagnant balances, earning near
zero interest rates, which are never spent but
simply build up idly. The largest of these is
international central bank reserves, increasing at
17% annually since 1998 and now at a level of some
US$10 trillion. The chairman of the Bank of
Thailand said this week that Thailand's $176
billion of official reserves "should be spent on
boosting the economy rather than on doing nothing
useful" and was vilified by orthodox economists,
but really he has a point. (Unlike the Argentine
government, which has persistently found endless
unproductive ways to waste their currency
reserves, the current Thai government might spend
the money on useful infrastructure.)
A
second vast pool of useless liquidity is that of
the US banking system's free reserves at the Fed,
currently some $1.6 trillion. The Fed pays
interest on these, so since there are no other
uses for the money that don't involve risk, it's
not surprising that the banking system keeps them
high. It is however surprising that, four years
after the crisis, the system has not found a way
of deploying this pool of money more efficiently.
A third pool of useless money is the
"Target 2" balances of the European payments
system. This pool is somewhat different, even
chimerical. Even though the head of the Bundesbank
may go to sleep each night happy that he has $850
billion of short-term central bank obligations
sitting in his vaults, in reality these
obligations are derived from such as the Bank of
Greece, and not worth the paper that, being
virtualized, they are not written on.
Then
there is the $2 trillion of cash sitting on the
balance sheet of US non-financial corporations.
This can best be explained by thinking of all the
prudent corporate Treasurers, seeing interest
rates at record low levels, who have borrowed next
year's capital spending plan in the long-term
markets in order to avoid tapping them at next
year's higher rates.
Of course, since this
has gone on for several years, there are many
corporate Treasurers who are now working on the
capital spending plan for 2043. Still at least
this avoids actually returning some of that cash
to shareholders - perish the thought! After all,
at some time in the next couple of decades there
may come an opportunity for a truly
value-destroying acquisition on which the cash can
be spent.
The result currently is a
situation in which a small part of the world's
money supply is rushing around like a blue-arsed
fly, carrying out transactions at a rate of
several terabits a second, while most of it sits
idly polishing its fingernails and earning its
owners a measly 0.0005%. Needless to say, this is
not a stable situation.
It's difficult to
specify precisely what will be the outcome of all
this, since neither theory nor past experience
offer much guidance - indeed we are in the area of
wild, unsubstantiated guesses. Mine, for what it's
worth, is that the small portion of the money
supply that is doing all the work is now
redoubling its efforts, given additional verve by
"quantitative" easing by the Fed next month and a
further massive bond purchase program by the
European Central Bank.
Asset prices are
once again headed to the skies and the glorious,
celestial gold bull market for which gold bugs
have yearned for the last decade is at last in
progress. From July 1978 to January 1980, the gold
price soared from $175 per ounce to $850; we may
well see such a rise again, from a base almost 10
times as high.
This will not last, of
course; indeed its most obvious terminus is
already in sight, in the form of November's
election. Whichever candidate wins, time horizons
in the market will shift in early November from
the next six months to January 2017. On that time
horizon, the market picture is clouded. Another $5
trillion on US Federal debt, which will be
incurred in the next four years, puts it at an
Italian or Greek level (though still short of the
lofty heights reached in Japan).
What's
more, 2017 is the year that the Social Security
system, which since 2009 has been running an
unexpected deficit instead of the anticipated
surplus, tips over finally and starts running
sizeable deficits, with the cash outflow
increasing until the Baby Boomers start dying off
in large numbers in the 2030s.
This could
lead to two possible outcomes (again, remember,
we're guessing here, but anyone who says they are
not is a liar!). One would be a bond panic, in
which US real interest rates rise because risk
premiums soar, much as has happened in Spain and
Italy, where 10-year rates are in the 6% range.
European monetary policy, as here,
attempts to be ultra-sloppy, but in Spain and
Italy it can't be because anyone wanting to borrow
in those economies must pay a premium over the
local governments, ie, a substantial real interest
rate. Such a rise in real interest rates, which
might happen quite suddenly, would cause a crash
in stock markets and gold prices, and a
substantial recession. Since the recession would
worsen the budget deficit, the Fed would be
powerless to alleviate it, and "stimulus" would be
out of the question. This would be very
unpleasant, and is rather the outcome our
political class deserves. On the other hand - look
on the bright side - we would probably avoid major
inflation.
The other possible outcome
would be a further surge in optimism about the
economy, without a bond panic. In that case, stock
markets would continue to rise, gold would soar to
the moon, and all the idle cash balances in the US
banking system, corporations, central banks, and
so forth would be put to work. Since at this point
we would have active money supply far larger than
before, and today's elevated level of tech-induced
velocity, the result would be burst of inflation,
not 4-5% as in the 1970s, but Weimar-style,
reaching 20-25% very quickly and soaring
thereafter.
The good news - we would not
necessarily experience another major recession, at
least not immediately, and the federal debt
problem would become much less onerous. This is
the outcome that Fed chairman Ben Bernanke
deserves, and would provide a useful lesson to
future Fed chairmen not to get drawn down his
path.
Both outcomes are possible with
either party winning in November, but if you asked
me to guess, I'd say the first outcome is more
likely with a Barack Obama victory and the second
outcome more likely with a Mitt Romney victory.
Either way, the denouement will not be pleasant,
and we will emerge from the Mayan apocalypse wiser
about economic cause and effect.
Meanwhile, until November, we are caught
up in the vortex. Enjoy the ride!
Martin Hutchinson is the author
of Great Conservatives (Academica Press,
2005) - details can be found on the website
www.greatconservatives.com - and co-author with
Professor Kevin Dowd of Alchemists of Loss
(Wiley, 2010). Both are now available on
Amazon.com, Great Conservatives only in a
Kindle edition, Alchemists of Loss in both
Kindle and print editions.
(Republished
with permission from PrudentBear.com.
Copyright 2005-12 David W Tice &
Associates.)
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