Ludwig von Mises - Human Action. A Treatise on Economics
Make no mistake; central bankers are laying the groundwork for their own demise.
Their hubris knows no bounds.
Federal Reserve Chief Ben Bernanke is preparing the market for quantitative easing part two (QEII). It is widely believed that the Fed's balance sheet will expand by a further $1 trillion.
This is leading to heavy selling of the US dollar. As a result, currencies all around the world are rising in terms of the dollar, and their governments and central banks don't like it.
The dollar index (see chart) has previously traded lower than it is now:
But demand from the world's consumer of last resort, the US, is probably more tepid than it has been at any time when the dollar index was at lower levels. Hence dollar weakness is leading to a loss of competitiveness for many nations who have built their economic model on exporting to the US.
As a result, we are now seeing nations from Asia to South America deliberately try to weaken their currencies against the US dollar in a vain attempt to maintain the post 1971 (end of Bretton Woods currency system) global economic order.
This is the beginning of currency wars not seen since the 1930s.
In addition to Ben Bernanke readying the markets for QEII, officials from the former head honcho of the central banking world, the Bank of England (BOE), have been spouting their own hubris.
Deputy Governor Charles Bean recently told savers that it was part of the BOE's strategy to keep interest rates low and that they could not expect to live off the interest from their savings.
In non-central banking parlance he means to say; the BOE is determined to maintain negative real interest rates to cause mild but persistent inflation. Inflation is an insidious tax on society, affecting in particular the prudent and the savers (who, as you will see below, are the ones who actually provide a nation with its productive capital).
But inflation benefits the banking class because it erodes the value of the bad debts made during the boom. Instead of taking responsibility for the bad lending decisions, by writing off debts and wiping out the management and investors who made the lending possible, inflation allows the system and status quo to be maintained.
Mr Bean's comments reflect the complete arrogance of the central banking community.
Following hot on his heels was Adam Posen, external member of the BOE's Monetary Policy Committee. He recently delivered a speech with the title, 'The case for doing more'. In it, he argued the same tired old mantra of central bankers everywhere:
"The risks that I believe we face now are...ones of sustained low growth turning into a self-fulfilling prophecy, and/or inducing a political reaction that could undermine our long-run stability and prosperity. Inaction by central banks could ratify decisions both by businesses to lastingly shrink the economy's productive capacity, and by investors to avoid risk and prefer cash."
So according to Posen, inaction by the central bank could threaten England's prosperity. We would argue that previous action by the central bank is exactly what has threatened the country's prosperity. More action can only make things worse in the long run.
How?
Let's go back to the Mises quote at the beginning of the article. He says that booms and busts are the unavoidable outcome of repeated attempts to lower the market rate of interest by means of credit expansion. It may have been written in 1949 but it still holds true today.
It effectively means that central bank attempts to push the market rate of interest below the 'natural rate' cause widespread distortions in production and consumption. This leads to a misallocation of resources and consequently, booms followed by busts.
We'll show you how this happens.
First, a description of the natural rate of interest. The interest rate is the price of money at any particular time. The natural rate, or equilibrium rate of interest, is the rate that seeks to balance out the needs and desires of savers and consumers.
In a world without central bankers, a falling rate of interest would be the result of an increase in savings. Basic economics tells us that savings = investment. So as these savings make their way into the banking system banks have more money available to lend to investors. The increased quantity of funds available pushes down the price of money. In other words an increase in savings causes the natural rate of interest to decline.
Think carefully about the signals that are being sent here. An increase in savings suggests individuals are deferring consumption into the future. We would therefore expect to see consumption declining as savings rise. The lower rate of interest improves the economics of longer-term projects designed to take advantage of an expected increase in future consumption.
But if individuals decide to consume more of their incomes now and save less, there will be less 'money' available for investment and in a free market in money, the natural rate of interest will rise under this scenario. In short, the price of money, set by the market, has a natural tendency to curb excesses because they help coordinate economic production over time. If there are not enough savings, interest rates should rise and vice versa.
Now, let's introduce the central bank into the equation. When a central bank lowers the rate of interest it does so by injecting money into the banking system. These additional 'reserves' are created from nothing. Commercial banks then utilise these reserves as the basis for a new round of fractional reserve based credit creation.
In effect, the artificial boost in reserves provides a signal that savings have increased which leads to an increase in investment...but the signal is false. Investments increase even though the real level of savings is quite low. And as we point out above, if savings are low that means consumption is high. Because the signal is false, in time the investments turn out to be 'bad' and the boom turns to bust.
This is exactly what was behind the credit crisis of 2008/09. An excess of false savings in the banking system led to overinvestment. As soon as credit dried up, the mal-investments were exposed and projects all around the world were put on hold (because future consumption levels were in doubt). In a short period in 2008/09 commodity prices fell more than they did in the Great Depression. Even the largest producers in the world suffered share price falls of more than 50%.
You may recall that when the full force of the US housing bust hit financial markets around September 2008, interest rate 'spreads' over government bond yields, and therefore market rates of interest, began to rise sharply.
Why? To signal the need for an increase in real savings and to lower consumption. The effects of such an adjustment would not have been pretty. Indeed, allowing rates to increase would have caused a deep recession.
Building on the wisdom gained from decades of central banking experience, what happened next? Errr...co-ordinated global interest rate cuts...another huge injection of artificial savings and the promotion of consumption. Exactly the opposite of what would occur if a free market in money existed.
Now the monetary stimulus from 2008/09 is beginning to dissipate. But even more distortions have resulted, the effects of which are morphing into nascent currency wars.
This brings us to the second part of Mises' quote:
"The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion or later as the final and total catastrophe of the currency system involved."
Today's currency system, with the US dollar as the global reserve currency and all others in some way tied to it, is beginning to break down. With reckless and clueless central bankers still held in high esteem by governments and wider society, at this point there does not appear to be any reason to think that 'the final and total catastrophe of the currency system' will be avoided.
That is not meant to be a sensationalist comment. For those of you who have been reading for a while know we are not into hyperbole. But this is the reality facing investors who choose to look beneath the headlines and shallow analysis. If you're genuinely interested in protecting your wealth, this stuff matters.
How a disintegrating monetary and currency system impacts investment markets is a very tough call to make. At the two extremes there is hyperinflation or deflation. Neither scenario is good for investors but at this point we still lean toward a deflationary outcome.
One thing is for sure though - central bankers are out of control. Future generations will look back on this period of economic history and wonder how we could have been so stupid to allow unelected officials to brazenly, inexpertly and contemptuously control the price of money.
As a result, we are now seeing nations from Asia to South America deliberately try to weaken their currencies against the US dollar in a vain attempt to maintain the post 1971 (end of Bretton Woods currency system) global economic order.
This is the beginning of currency wars not seen since the 1930s.
In addition to Ben Bernanke readying the markets for QEII, officials from the former head honcho of the central banking world, the Bank of England (BOE), have been spouting their own hubris.
Deputy Governor Charles Bean recently told savers that it was part of the BOE's strategy to keep interest rates low and that they could not expect to live off the interest from their savings.
In non-central banking parlance he means to say; the BOE is determined to maintain negative real interest rates to cause mild but persistent inflation. Inflation is an insidious tax on society, affecting in particular the prudent and the savers (who, as you will see below, are the ones who actually provide a nation with its productive capital).
But inflation benefits the banking class because it erodes the value of the bad debts made during the boom. Instead of taking responsibility for the bad lending decisions, by writing off debts and wiping out the management and investors who made the lending possible, inflation allows the system and status quo to be maintained.
Mr Bean's comments reflect the complete arrogance of the central banking community.
Following hot on his heels was Adam Posen, external member of the BOE's Monetary Policy Committee. He recently delivered a speech with the title, 'The case for doing more'. In it, he argued the same tired old mantra of central bankers everywhere:
"The risks that I believe we face now are...ones of sustained low growth turning into a self-fulfilling prophecy, and/or inducing a political reaction that could undermine our long-run stability and prosperity. Inaction by central banks could ratify decisions both by businesses to lastingly shrink the economy's productive capacity, and by investors to avoid risk and prefer cash."
So according to Posen, inaction by the central bank could threaten England's prosperity. We would argue that previous action by the central bank is exactly what has threatened the country's prosperity. More action can only make things worse in the long run.
How?
Let's go back to the Mises quote at the beginning of the article. He says that booms and busts are the unavoidable outcome of repeated attempts to lower the market rate of interest by means of credit expansion. It may have been written in 1949 but it still holds true today.
It effectively means that central bank attempts to push the market rate of interest below the 'natural rate' cause widespread distortions in production and consumption. This leads to a misallocation of resources and consequently, booms followed by busts.
We'll show you how this happens.
First, a description of the natural rate of interest. The interest rate is the price of money at any particular time. The natural rate, or equilibrium rate of interest, is the rate that seeks to balance out the needs and desires of savers and consumers.
In a world without central bankers, a falling rate of interest would be the result of an increase in savings. Basic economics tells us that savings = investment. So as these savings make their way into the banking system banks have more money available to lend to investors. The increased quantity of funds available pushes down the price of money. In other words an increase in savings causes the natural rate of interest to decline.
Think carefully about the signals that are being sent here. An increase in savings suggests individuals are deferring consumption into the future. We would therefore expect to see consumption declining as savings rise. The lower rate of interest improves the economics of longer-term projects designed to take advantage of an expected increase in future consumption.
But if individuals decide to consume more of their incomes now and save less, there will be less 'money' available for investment and in a free market in money, the natural rate of interest will rise under this scenario. In short, the price of money, set by the market, has a natural tendency to curb excesses because they help coordinate economic production over time. If there are not enough savings, interest rates should rise and vice versa.
Now, let's introduce the central bank into the equation. When a central bank lowers the rate of interest it does so by injecting money into the banking system. These additional 'reserves' are created from nothing. Commercial banks then utilise these reserves as the basis for a new round of fractional reserve based credit creation.
In effect, the artificial boost in reserves provides a signal that savings have increased which leads to an increase in investment...but the signal is false. Investments increase even though the real level of savings is quite low. And as we point out above, if savings are low that means consumption is high. Because the signal is false, in time the investments turn out to be 'bad' and the boom turns to bust.
This is exactly what was behind the credit crisis of 2008/09. An excess of false savings in the banking system led to overinvestment. As soon as credit dried up, the mal-investments were exposed and projects all around the world were put on hold (because future consumption levels were in doubt). In a short period in 2008/09 commodity prices fell more than they did in the Great Depression. Even the largest producers in the world suffered share price falls of more than 50%.
You may recall that when the full force of the US housing bust hit financial markets around September 2008, interest rate 'spreads' over government bond yields, and therefore market rates of interest, began to rise sharply.
Why? To signal the need for an increase in real savings and to lower consumption. The effects of such an adjustment would not have been pretty. Indeed, allowing rates to increase would have caused a deep recession.
Building on the wisdom gained from decades of central banking experience, what happened next? Errr...co-ordinated global interest rate cuts...another huge injection of artificial savings and the promotion of consumption. Exactly the opposite of what would occur if a free market in money existed.
Now the monetary stimulus from 2008/09 is beginning to dissipate. But even more distortions have resulted, the effects of which are morphing into nascent currency wars.
This brings us to the second part of Mises' quote:
"The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion or later as the final and total catastrophe of the currency system involved."
Today's currency system, with the US dollar as the global reserve currency and all others in some way tied to it, is beginning to break down. With reckless and clueless central bankers still held in high esteem by governments and wider society, at this point there does not appear to be any reason to think that 'the final and total catastrophe of the currency system' will be avoided.
That is not meant to be a sensationalist comment. For those of you who have been reading for a while know we are not into hyperbole. But this is the reality facing investors who choose to look beneath the headlines and shallow analysis. If you're genuinely interested in protecting your wealth, this stuff matters.
How a disintegrating monetary and currency system impacts investment markets is a very tough call to make. At the two extremes there is hyperinflation or deflation. Neither scenario is good for investors but at this point we still lean toward a deflationary outcome.
One thing is for sure though - central bankers are out of control. Future generations will look back on this period of economic history and wonder how we could have been so stupid to allow unelected officials to brazenly, inexpertly and contemptuously control the price of money.
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