Central Planners and Untenable Theories
The European Central Bank again cut the interest rates it controls. Notably, the deposit rate was moved deeper into negative territory. It is now -0.2% (minus 20 basis points, that is not a typo). The ECB says it’s trying to nudge prices higher, but it’s actually feeding the cancer of falling interest.
The linked article above, like most, is focused on the quantity of euros and the presumed direct relationship to price. The following bit of editorializing from that article is uncontroversial in Frankfurt, London, New York, Mumbai, or Shanghai.
“Inflation weakened to a five-year low in August, just 0.3% in annual terms. That is far below the ECB’s target of a little under 2% over the medium term, raising fears that the region could face a debilitating stretch of weak or falling prices that hampers debt-financing and investment. Those fears intensified as market-based measures of inflation expectations weakened, too.”
The chart shows the 5yr./5yr. swap rate, a.k.a. the 5 year forward inflation breakeven rate. This is the “inflation rate”, or rather the annual rate of change in harmonized euro area CPI, which market participants expect to reign 5 years hence over the following 5 years. This inherently imprecise datum is employed by the ECB as a measure of whether long term inflation expectations are “well anchored” (chart caption by PT).
The Credit Gradient
The United States, and every country, is subject to a monetary authority and legal tender laws. Here in the U.S. we have the Federal Reserve, a central bank that plans money and credit. The Fed thought they had perfected their planning (but of course it cannot be perfected). They thought they had ended the boom and bust cycle, and brought us into a brave new era, their so-called great moderation that ended in 2008. All they really did was manage the banking system to the brink of insolvency.
Let’s try a thought experiment. Suppose the monetary central planner attempts to fix the problem of insolvency by massive injections of liquidity. The central bank buys bonds. It dictates rates near zero on the short end of the yield curve, and promises not to raise rates for years to come. What perverse outcome would we expect?
Arbitrageurs see a green light, telling them that they can safely borrow short to buy long bonds. As the price of a bond goes up, the rate of interest goes down—it’s a rigid mathematical inverse. This is how suppression of short-term rates causes suppression of long-term rates.
The Death of Goodwill
This is the first piece in what I intend to be a series, on the theme I think of as the Death of Goodwill. There was (and still is) a huge difference between the attitudes of people in America and the attitudes of those in third-world countries. I use the word goodwill for this difference. For centuries, Americans have been helping one another raise barns, live through hard times, and get up when they fall in the street. Unfortunately, goodwill is being strangled. There are numerous mechanisms for this, though all have bad governance at the core.
With the death of goodwill will come the collapse of civil society, and its twin sister law and order.
Immigration For Republicans
This essay is not intended to address a crisis that may be occurring on the border at this time. I make no comment on that. Nor does it discuss the issues around war, such as how to deal with citizens of enemy nations. This essay is not a policy proposal, it does not set out, for example, when an immigrant can become a citizen and attain the vote or what to do to immigrants who commit crimes. It has but one purpose: to enumerate and respond to the common arguments used in favor of an impenetrable and guarded border fence to shut down immigration.
The Machines Are Coming!
Recently, I have seen a lot of discussion about the future of employment. Many people, from futurists to Leftists, are saying that machines will replace people and most people will be unemployed. This is hogwash, though it has been popular for at least 200 years, when the Luddites were smashing machinery.
Perhaps they didn’t know better, in the early days of Industrial Revolution. Maybe they really didn’t think of machines as providing an escape from drudgery.
They might not have thought that people were freed from long days of backbreaking labor. They may not have considered that increasing productivity benefits the worker, the investor, and the customer—pretty much everyone.
Today, we don’t have their excuse. Economics teaches these points clearly, and this is not my point in writing this essay.
Motoman caught in flagrante delicto, stealing the job of a short order cook. Somebody's got to do something!
(Photo credit: AP)
Legal Tender Renders Planning Impossible
There is much confusion over what the legal tender law does. I have read articles, written by people who are otherwise knowledgeable about economics, claiming that legal tender forces merchants to accept dollars under threat of imprisonment. Recently, I wrote a short article for Forbes clarifying how legal tender law works in the US.
Legal tender law has nothing to do with merchants. If you want to sell steak dinners in your restaurant for silver, you may legally have at it. Unfortunately, the tax code discourages your would-be customers as I wrote in another article.
The legal tender law targets the lender. It grants to debtors a right to repay a debt in dollars. In practice, this means that if you lend gold, the debtor gets a free put option at your expense. If the gold price rises, he can repay in dollars. If it falls, of course he will be happy to repay in gold. It’s a rotten deal for the lender.
The relationship between lender and borrower is mutually beneficial, or else it would not exist. The parties are exchanging wealth and income, creating new wealth and new income in the process. The government is displeased by this happy marriage, and busts it up by sticking a gun in the lender’s face. His right to expect his partner to honor a signed agreement is violated.
Because no lender will lend gold under such circumstances, gold is relegated to hoarding and speculation only. This strikes a blow to savers, because the best way to save is to lend and earn interest. Savers are forced to choose betweenhoarding gold, getting no yield, or holding dollars and getting whatever yield crumbs are dropped by the Fed.
If there’s no lending in gold, what takes its place? The Fed force-feeds credit in ever-larger amounts, and at ever-falling interest rates.
The Fed is supposed to make its credit decisions in order to optimize two variables. First, employment shouldn’t be too high or too low. Second, consumer prices shouldn’t rise too quickly or too slowly. The Fed has little ability to predict employment and prices, and even less control over them.
The Price of Shipping Is Collapsing
A recurring theme of mine is that one cannot understand the world in terms of the linear Quantity Theory of Money. Let’s look at the cost of shipping.
The money supply has certainly been expanding since 2008. And yet the price of shipping has almost completely collapsed. From a high over 11,000 it’s now down to 755. This is a drop of almost 94%.
The Baltic Dry Index is a dollar price of moving the major materials by sea. The chart shows from just before the acute phase of the crisis to today, July 16, 2014.
I like to look at the Baltic Dry because, unlike commodities, there is no way to speculate on it and hence drive up the price. (If readers are aware of some sort of futures market or other way for speculators to use credit to bid up prices, then I encourage them to please contact me.) – via Monetary Metals, click to enlarge.
Europe Stricken With Negative Deposit Rate
On Thursday, the European Central bank cuts to three of its benchmark interest rates. This is nothing unusual since the global financial crisis began. We are now accustomed to desperate central bank responses. Interest rates have been falling for decades, and the trend continues. What is unusual—unprecedented for a major central bank—is to lower the deposit rate below zero.
A negative deposit rate means that when a bank keeps extra cash on account at the central bank, it pays the central bank a percentage. It’s like telling the banks that having cash is a privilege, for which they must pay. If it sounds pretty crazy, that’s because it is. First, let’s look at what the ECB says it will do. Then we can dive in and see the likely outcome.
Mario Draghi, President of the ECB, said, “the measures will contribute to a return of inflation rates to levels closer to 2%.” The central bank has been talking a lot about the problem of deflation, by which it means falling prices. The ECB hopes to avoid this fate worse than death, by pushing more euros into circulation. It actually wants prices to relentlessly rise, for salaries to relentlessly lose purchasing power, and for savings to relentlessly erode.
With fiat money, prices rise. This is especially hurtful to people who are struggling to afford food and shelter. Pushing up the cost of living does no good to anyone, but harms the poor most of all. Only a central banker could truly love inflation.
The Lazy 1970’s vs. the Frenetic 2000’s
Many people today see the Fed’s Quantitative Easing as money printing. They remember what happened in the 1970’s, and they instantly jump to conclusions. However, we live in a different world. To illustrate this, consider the following story about Joe, a promising and eager young manager in a struggling manufacturing company.
Joe excitedly walks into the boardroom and pitches his idea. “Let’s borrow a billion dollars. We can use it to build a massive warehouse and to buy massive quantities of our raw materials!”
The senior management team stares at him. The CEO demands, “Why?”
“We need to have a stockpile at every level. We should start with 3 months of raw materials, and a three-month buffer of work-in-progress in between every one of the 27 steps of our manufacturing line. And even better, we need to warehouse finished product. We shouldn’t ship anything that hasn’t been sitting for at least 4 months. Ideally six, but we can start with four.” Joe has the bit in his teeth now.
He rushes on. “Bernanke has printed so much money, and Yellen is going to continue. We already have massive inflation and it’s going to get worse! By borrowing to buy stuff that is only going up in price, we can make extra profits and protect ourselves from supply shocks as the cost of commodities rises out of sight!”
The CFO leans over to whisper in the ear of a young assistant, Bill. Bill does a quick Google search and finds the price of copper, which is one of the most important raw materials the company buys. Bill puts the copper chart up on the screen. It has fallen a third over the past few years.
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