Equicapita UpdateSeptember 2013

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CENTRAL BANKERS BEGIN TO SEE THE PAINT AND THE OUTLINE OF THE CORNER

On the topic of ZIRP, needless to say we continue to live in historic financial times and in particular in the first synchronized, global, fiat money inflation effort. We have ZIRP and negative real interest rates in virtually every major market and the monetary base of the world’s reserve currency is growing rapidly. This is an unsustainable trend if history and the Austrian School of Economics is a guide. It has been written many times before in one form or another but it bears repeating - there is no way to create capital and the prosperity that flows from it other than through private savings and private production - simply printing money does not create capital. Sadly this is a message to which our governments, under the sway of Keynesian ideology, are unwilling to listen. It is axiomatic that state spending requires that capital is first taken out of the hands of the profit making private sector activities via taxes, borrowing or inflation and then deployed in typically, loss-making public sector activities. Having said this, the current bout of excess money printing is simply a stealthy confiscation/redistribution scheme that allows capital to be harvested from savers/pension funds and extracted by governments and the financial sector. Obviously while I believe that eliminating ZIRP/QE is the right thing to do for the long-term health of the economy, the recent equity and bond market declines are but modest harbingers of the unintended short-term consequences that the Fed’s prolonged ZIRP/QE program and its termination will wreak - rollover and convexity risk. These risks will loom large if and when the US Federal Reserve and its global proxies, in the form of the Bank of Japan, European Central Bank and the Bank of England, stop their massive bond-buying sprees and rates normalize. I believe it is these issues that are making central bankers nervous as they start to see the outline of the corner into which they are painting themselves.

Equicapita Update

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Equicapita Update (continued)

Sovereign borrowers have had virtually unfettered access to the credit markets over the last two decades. Those privileges are gradually being revoked as the ability to repay is being called into doubt. Without the ability to roll over obligations at current historically depressed interest rates, the truly precarious nature of sovereign finances will be revealed. Consider that while interest rates for many developed nations are at generational lows, sovereign debt loads as a percentage of GDP are at all time highs. What happens to western governments when their borrowing costs rise from 2% to something approaching the long-term historical average of 5%? In countries like Japan and the US, the answer is that the majority of the budget would be dedicated simply to paying interest. Perhaps this sounds alarmist and unlikely. But consider that, as of 2012, US federal government debt exceeds US$ 15 trillion. In 2011, the US government paid US$ 454 billion in interest (an implied rate of 2.9%). The Congressional Budget Office notes that federal government debt will rise to US$ 20 trillion by 2015. If we assume that it carried a rate of 5% instead of 3%, interest payments would total US$ 1 trillion or 45% of current tax revenues. Clearly, state debt service as a percent of tax revenues is already at high levels for most developed nations, yet interest rates are at historic lows. As state finances enter distress, they are forced to finance themselves at shorter durations creating roll-over risk. The combination of interest servicing issues and duration compression leaves them heavily exposed to even modest increases in interest rates. When rates rise, state revenues will be rapidly consumed by just the interest on servicing their debt, let alone funding day-to-day commitments.

And therein lies the issue. Our commitments are entering a high growth phase in the face of deteriorating demographics and growing dependency ratios. The magnitude of our impending entitlement costs are largely being ignored despite some lip service coverage in the mainstream media. Layer on an absence of political support for a reduction in government spending and can some form of printing press inflationary default be far behind? It’s certainly difficult to see how any combination of tax increases, economic growth or marginal adjustments to entitlements is going to close western funding gaps. To quote Jens Parssons from the “Dying of Money: Lessons of the Great German & American Inflations”

Everyone loves an early inflation. The effects at the beginning of inflation are all good. There is steepened money expansion, rising government spending, increased government budget deficits, booming stock markets, and spectacular general prosperity, all in the midst of temporarily stable prices. Everyone benefits, and no-one pays. That is the early part of the cycle. In the later inflation, on the other hand, the effects are all bad. The government may steadily increase the money inflation in order to stave off the latter effects, but the latter effects patiently wait. In the terminal inflation, there is faltering prosperity, tightness of money, falling stock markets, rising taxes, still larger government deficits, and still roaring money expansion, now accompanied by soaring prices and an ineffectiveness of all traditional remedies. Everyone pays and no-one benefits. That is the full cycle of every inflation.” Emphasis mine

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Equicapita Update (continued)

The Austrian School of Economics has many useful insights on the economic consequences of state intervention in the economy and unbridled monetary expansion. Friedrich Hayek, a prominent Austrian economist, wrote “The Road to Serfdom” and “The Fatal Conceit” as a warning against the prevention of the free operation of the markets - privatizing gains and socializing losses is not capitalism and not good for the economy despite what politically connected too-big-to-fail banks would like us to believe. It has been central bank control over the cost of money (i.e. interest rates) and the moral hazard created with “too big to fail” that led directly to the problems we now face. More of the same will not solve our problems - let interest rates normalize and insolvent financial institutions suffer the consequences. The unvarnished truth is that we are living beyond our means and dishonestly passing the cost onto future generations - Herbert Hoover once prophetically said, “Blessed are the young for they shall inherit the national debt”.

STRANGER THAN FICTION?

Even with all the historical evidence, do the people running central banks today understand where inflation comes from? Federal Reserve Governor Janet Yellen is purported to be a prime contender to replace Ben Bernanke as the Chairman of the US Federal Reserve. Just so that Yellen’s view on printing money and the Fed’s supposed ability and role to create full employment she has been quoted: “If it were possible to take [nominal] interest rates into negative territory, I would be voting for that.” (Emphasis mine) Helicopter Ben to be replaced with Negative Janet – it seems that there is not relief in sight for savers.

In my book “Cantillon’s Curse” I used the SS Gairsoppa as a graphic example of a central banks’ inability to stabilize prices. The Gairsoppa was sunk in 1941 by a German submarine. Among its cargo was 7 million ounces of silver worth approximately US$ 2.5 million at the time. The 2012 value of the silver is approximately US$ 210 million. Would anyone even bother trying to recover the contents if the ship had been carrying US$ 2.5 million in non-redeemable paper currency instead? Obviously not and subsequent to my writing the cargo has been recovered proving the timeless value of hard assets in a non-redeemable paper currency world.

The idea that the vast majority of economic forecasters suffer from a tendency to project current conditions into the future indefinitely I think is not a controversial statement for the average observer. It’s a failing that is virtually hard-wired into us all and tends to make us to a lessor or greater extent poor at predicting significant turning points. Currently there is a certain triumphant tone amongst the Keynesian set that, to their way of thinking, aggressive global ZIRP has not triggered any apparent inflation or other detrimental unintended consequences. There is a strong element of the absence of evidence being treated as evidence of absence in this thought process – a failing that mainstream economic thinkers have demonstrated time and time again in the last three decades – each crisis is a surprise, and by being a surprise (at least to Keynesians) relieves the professional punditry class of the obligation to re-examine basic assumptions. Of course there is a large volume of historical information to assist us in predicting what a large-scale money inflation does to the economy. The inimitable Dylan Grice wrote an interesting review of the Weimar Republic inflation. Apparently, economic thinkers at the time were adamant that increasing the money supply would not and was not increasing the rate of inflation.

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Equicapita Update (continued)

Prussian central banker Rudolf von Havenstein was liberally monetizing Germany’s large fiscal deficits as foreign investors fled the German bond markets (sound familiar?) Grice wrote:

Surely we understand what happens when deficits are financed with printed money, and that it is only backward and corrupt states that don’t know any better, like Bolivia and Zimbabwe? ... And anyway, how could Von Havenstein not have known that the continued and escalating printing of money to fund government deficits would cause inflation? The United States experience of unrestrained money printing during the Civil War had been well documented, as had the hyperinflation of revolutionary France in the late 18th century. …

The fact is we do understand the economics of inflation. Despite what economists everywhere say about being in “uncharted territory” with QE, we know that if you keep monetizing deficits eventually you get inflation, and we know that once you’re on that path it can be extremely difficult to get off it. But we knew that then. The real problem is that inflation is an inherently political variable and that concern over debt sustainability and unfunded welfare obligations leaves us more dependent on politicians than we have been in many decades. (Emphasis mine)

QUOTABLE QUOTES

“Just because you do not take an interest in politics doesn’t mean politics won’t take an interest in you.” –Pericles

“There are two ways to be fooled. One is to believe what isn’t true; the other is to refuse to believe what is true.” –Søren Kierkegaard

“People can foresee the future only when it coincides with their own wishes, and the most grossly obvious facts can be ignored when they are unwelcome.” –George Orwell

“An economist’s guess is liable to be as good as anybody else’s.” –Will Rogers

“When the people find that they can vote themselves money that will herald the end of the republic.” –Benjamin Franklin

“Economic progress is the work of the savers, who accumulate capital, and of the entrepreneurs, who turn capital to new uses. The other members of society, of course, enjoy the advantages of progress, but they not only do not contribute anything to it; they even place obstacles in its way.” –Ludwig von Mises

“The first requisite of a sound monetary system is that it put the least possible power over the quantity or quality of money in the hands of the politicians.” –Henry Hazlitt

“Alexander Hamilton started the U.S. Treasury with nothing, and that was the closest our country has ever been to being even.” –Will Rogers

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