'Central bankers enthusiastic for more “quantitative easing” should beware..' - Martin Hutchinson
thoughts site

Advanced

'Central bankers enthusiastic for more “quantitative easing” should beware..' - Martin Hutchinson

Posted by ProjectC 
'..The British government made a very serious mistake in the 1920s. It was necessary for Great Britain to stabilize the currency. But they did not simply stabilize. In 1925, they returned to the pre-war gold value of the pound..'

'This was the same situation that led to the conditions in England in the latter part of the 1920s, which were important in bringing about the doctrines of Lord Keynes and the ideas of credit expansion that have been practiced in recent years. The British government made a very serious mistake in the 1920s. It was necessary for Great Britain to stabilize the currency. But they did not simply stabilize. In 1925, they returned to the pre-war gold value of the pound. That meant that the pound was a heavier pound afterwards and had a greater purchasing power than the pound, of let us say, 1920. A country like Great Britain that imports raw materials and foodstuffs and exports manufactures should not have made the pound more expensive. As Hitler expressed it, “They must either export or starve.” In such a country, in which the unions did not tolerate a drop in wage rates, it meant that the costs in pounds of manufacturing British products were increased in relation to production costs in countries which had not made a similar return to the gold standard.With higher costs, you must ask higher prices to stay in business. So you can sell fewer units and must cut production. Therefore, unemployment increased, and there was permanent mass unemployment.'

- Ludwig von Mises, '..to defeat all those ideological forces that are operating in favor of credit expansion.'


Central bankers enthusiastic for more “quantitative easing” should beware. They may find the move institutionally suicidal.'

'There is after all no need for a central bank in a free-market economy, but only for a means of storing and dispensing value. With modern electronic technology, a cash-free existence can be managed just as easily on the basis of gold as on the basis of dollars; the currency has no physical existence but is only a means of measuring value. If such a system spread, governments could find their money creation and management functions entirely dispensed with, as consumers and businesses increasingly relied on a private sector system operated by conservatively managed private sector banks...

Central bankers enthusiastic for more “quantitative easing” should beware. They may find the move institutionally suicidal.'


Disappearing Stores of Value

By Martin Hutchinson
October 12, 2010
Source

Brazilian minister of finance Guido Mantega last week accused the major economies of starting “currency wars.” To a large extent he was trying to divert attention from his own overspending misdeeds. However this week’s decision by the Bank of Japan to enter more “quantitative easing” and Chinese premier Wen Jiabao’s aggressive response to the EU/US campaign to force up the renminbi suggest that he’s right. Such a currency war will produce two problems. It will reproduce one of the more damaging features of the 1930s’ global depression. Even more important, it will leave the thrifty without an adequate source of value.

Competitive currency devaluation has traditionally been thought by economic historians to have been a major cause of the 1930s’ exceptional unpleasantness, yet another major policy error. Actually most of the policies involved were relatively forgivable compared with the rest of that decade’s appalling blunders. In 1925 the British had returned to gold at an overvalued parity, having in 1923 bottled out of introducing a modest Imperial Preference tariff, which would have removed Britain’s long-standing but in post-war circumstances economically suicidal unilateral free trade policy. After this, transatlantic payments balances were structurally out of kilter. Germany’s balance of payments was also destabilized by reparations payments, so its economy was only kept afloat by U.S. loans. Meanwhile France, seeing Britain’s mistake, returned to gold in 1928 at an undervalued parity.

Then after U.S. banks started going bust in late 1930, the Fed kept money too tight, sucking gold across the Atlantic and putting an intolerable strain on the British balance of payments and the German banking system. Britain solved its problem in 1931 by going off the Gold Standard, devaluing by about 25% and sorting its economy out by anti-Keynesian means. Germany failed to solve its problem, after which its electorate chose Nazism over the apparently failed free market. In the U.S. the incoming Roosevelt administration worsened the world’s imbalance problem by devaluing the dollar against gold, invalidating existing property rights by banning Gold Clauses, and refusing to participate usefully in the 1933 London Conference, called to sort out the mess. Finally in 1936 France, whose currency had now become overvalued, went off the Gold Standard and devalued.

Most of the “beggar thy neighbor” currency devaluations of the 1930s were thus reasonable reactions to difficult circumstances; only FDR and the German electorate took actions motivated by primitive nationalism. Thus the chances of a repeat performance of this unpleasant farce, which proved hugely damaging to the nascent 1930s economic recovery, seem pretty high – one need not suspect more than normal malice on the part of any of the actors concerned.

The nexus of the current problem is China. Between 2005 and 2008 China played a constructive role in world economic arrangements, revaluing its currency by about 20% against the dollar and thereby shrinking its balance of payments surplus. Then at the end of 2008, the Chinese government (one of very few which could properly afford it) undertook a massive “fiscal stimulus” program. This was corruptly managed as always but on the whole sensibly directed towards infrastructure, including the Wuhan-Guangzhou rail line, begun only in 2005 and completed in December 2009, on which trains cover 601 miles in only 3 hours. China’s rapid growth in 2009 brought down its balance of payments surplus, indeed the balance swung briefly into deficit in April 2010. However as U.S. consumer and government spending, artificially stimulated by an excessive budget deficit and over-expansionary monetary policy, sucked in Chinese imports once more, the U.S. payments deficit with China widened again.

The case for a massive revaluation of the renminbi is thus a weak one. Premier Wen is further justified in resisting it because China’s rapid growth has brought an explosion of wage rises of 20% or in some cases even 60%. Thus, while the Chinese consumer market is an engine of growth, domestic costs are rising rapidly and its exporters are being horribly squeezed. Wen is happy to reorient Chinese growth towards the domestic market, but naturally doesn’t want his major export industries to go belly-up. He thus wants only a gentle upward path for the renminbi, avoiding extra strain on exporters.

China is therefore justified in resisting U.S. and EU demands on the currency front, however obnoxious its foreign policy may be in other respects. The United States and Japan have through exceptionally foolish fiscal and monetary policies tilted their economies into major imbalance, and it’s not clear why this should be regarded as China’s problem. Nevertheless, the rational U.S./Japanese responses, to raise interest rates and slash budget deficits, are unlikely to be forthcoming in the short term. Instead both countries seem determined to pursue the dangerous and counterproductive policies of further quantitative easing and competitive devaluation.

The interesting unknown is the reaction of the European Central Bank. Under heavy German influence, the ECB is less subject than other central banks to the sillier fashions in monetary policy. (It must remembered in this context that Bank of England Governor Mervyn King was one of the 364 economists who signed an angry letter to the Times in 1981 claiming that Margaret Thatcher’s successful deflationary policies were doomed – those people should never subsequently have been allowed near the levers of power.) Left to its own devices, the ECB would be moving gently in the direction of raising its short-term interest rate from the current 1% while attempting to enforce draconian fiscal discipline on the less self-controlled countries of southern Europe or those like Ireland with banking systems similarly lacking in self-control.

If the U.S., the Japan and Britain all go in for quantitative easing, the ECB will have a problem. Once the inevitable inflation (which the Fed now regards as a solution rather than a problem) has intensified in its trading partners, Europe’s comparative cost position will improve. However in the short term if its major trading partners all trash their currencies the ECB will find a mass of hot money flooding to the euro, forcing it up and pushing even the well-run but export-dependent Germany back into recession. Thus, however reluctantly, the ECB may be forced into some quantitative easing of its own.

The immediate economic effect of all this money sloshing around will be obvious: more inflation and higher gold and commodity prices, as beleaguered savers seek refuge from the mass currency debasement. It probably won’t surprise most people to see the flood of money create new and damaging bubbles, for example in junk bonds, as warned this week by ECB President Jean-Claude Trichet. However the long-term effect is more significant, and more pernicious.

Fiat currency was tried on a number of occasions before the twentieth century, most of which ended in hyperinflationary collapse – think of the Continental Congress’s “continentals” or the French Revolutionary “assignats.” Only in the exceptionally stable and well-run society of Song Dynasty China did it provide an adequate store of value for more than two centuries, although even there collapse followed once the Mongols, nearly as aggressive in monetary creation as they were militarily, got control of the printing presses. Through the eighteenth and nineteenth centuries, fiat money was regarded as an unfortunate but temporary expedient for poorly-run countries, to be replaced by a return to the Gold Standard as soon as financially possible.

The reversal came after the destruction of World War I, when in a world of rapidly increasing population the Gold Standard was found to be unacceptably deflationary (because gold supplies could not be increased fast enough to keep up.) Maynard Keynes provided spurious rationales for a fiat money system, which is always preferred by governments because they profit from the seignorage of creating money of no intrinsic value. In a world where governments were relied upon for unemployment insurance, old age pensions and increasingly healthcare, it seemed natural to trust them to maintain careful control over the money supply. While huge monetary mistakes were made – notably by the Fed in the Great Depression – the central confidence problem of a fiat money system was overcome. Only in regions such as Latin America where confidence in government remained weak did investor fear of fiat money produce its normal bouts of hyperinflation and dollarization. Even here it appeared by the 1990s that wise advice from the IMF would limit the problem except in countries whose economies were anyway unstable.

A global turn towards money creation would reverse this. It would quickly become obvious that none of the world’s major currencies now represented a stable store of value. Moreover, except for marginal exceptions like Switzerland and Canada, it would become clear that governments could no longer be trusted with a fiat currency system. This happened to a certain extent with the Anglo/U.S. inflation of the 1970s, but at that time the Deutschemark, managed by the admirable Bundesbank, remained substantial and available to investors.

This collapse of confidence would not restore the Gold Standard. While global population increase is declining, official opposition to a Gold Standard would undoubtedly remain too strong for it to be restored. Should hyperinflation arrive, the official response would probably be some equivalent of German chancellor Gustav Stresemann’s 1923 rentenmark scheme, following the Weimar hyperinflation, in which the currency was declared to be backed by the value of Germany’s land. With the smoke and mirrors stripped away, that was simply another fiat currency; the German government did not own the country’s land, and no conceivable mechanism existed for land to be delivered in exchange for monetary claims.

However the private sector does not necessarily need government in order to act. This week the first “Gold to go” gold-dispensing ATMs in the United States were announced, by which investors will be able to use cash or credit cards to buy gold bars of up to 8 ounces or krugerrands, with the prices updated electronically every 10 minutes. Initially, the market will be one-way; there will be no provision for gold to be sold back to the ATMs. However over the longer term, if inflation becomes a problem, it seems likely that the bugs will be ironed out and that investors will be able to hold their cash reserves directly in gold.

The next step would be for them to be able to hold gold denominated bank accounts, accessible primarily by debit card, operated presumably by banks run more conservatively than current U.S. banking regulations prescribe. Since the debit cards would be entirely conventional, a gold account holder would be able to operate in daily life just as does a current Internet-savvy consumer who has liberated himself from physical cash.

There is after all no need for a central bank in a free-market economy, but only for a means of storing and dispensing value. With modern electronic technology, a cash-free existence can be managed just as easily on the basis of gold as on the basis of dollars; the currency has no physical existence but is only a means of measuring value. If such a system spread, governments could find their money creation and management functions entirely dispensed with, as consumers and businesses increasingly relied on a private sector system operated by conservatively managed private sector banks. Unless governments physically prohibited the creation of such a system (which FDR did in 1933 but might not be possible in a democracy today) they would find themselves bereft of power or even influence in the monetary sphere.

Central bankers enthusiastic for more “quantitative easing” should beware. They may find the move institutionally suicidal.