Key Writings: Fabra on the Gold Standard
At this very moment, financial markets are again in disarray, threatened by a growing overhang of illiquid assets. While any illusion to generate fresh resources through economic growth seems to have given us the slip, Ben Bernanke has launched Operation Twist—a maneuver which, by itself, will further impair the liquidity of nothing less than the Fed’s portfolio.
The $400 billion program aims at driving down long-term interest rates. Such an aim, coupled with a central bank overnight rate set at zero, is the surest recipe for speeding up the fall of the United States economy—and, by osmosis, the euro zone as well—into the Japanese liquidity trap whereby the Bank of Japan has held its rate at or near zero since 1998.
There is rampant deflation in the “real” economy, owing to the build-up of an ever-increasing government debt bubble absorbing, as it were, the inflationary impulse generated by the banking system. With a vengeance, central and commercial banks continue monetizing any Treasury bonds not yet purchased by insurance companies and private investors.
In June of 2003, I foretold of such a worldwide crisis in Les Echos in an article titled, “La route de la déflation est toute trace.” In Europe (and still more so in France) during that year, politicians, elite managers, bankers, and trade-unionists were vociferously calling for the European Central Bank to push interest rates down abruptly, similar to what Alan Greenspan did two years earlier.
Let us not forget that historically, it was in 2001 that a very low-rate policy had been deliberately adopted in the United States as the most effective way to impede the failure of very big corporate bodies, especially banks. This was done, of course, without mentioning and probably without even being conscious that the proud Fed was following the Bank of Japan.
This chronology explains why such a policy is nowadays so entrenched in the North Atlantic zone. Undoubtedly, it is the main factor which, by itself, annihilates the most important benefit expected from a free market economy: its capacity for auto-regulation. No regulation whatsoever implemented from outside by “independent” commissions, authorities, or councils can fill the vacuum left by the deliberate emasculation of the principle of competition. This is the main reason that there is nothing either significant or curative to be expected from either the Dodd-Frank legislation in the United States or from Basel III in Europe.
To be sure, in 2001, interest rates should have been raised in a manner similar to that which the lucid and courageous Paul Volcker did between October 1979 and December 1981. (Volcker was the last great chairman of the Fed; he is not a partisan of the gold standard but then nobody is perfect).
Let us examine another example demonstrating how wise practices may be distorted altogether by intrusive lobbying and bad politics. For more than one hundred years, it has been admitted that in case of a liquidity panic, the best a central bank may do is to “lend and to lend freely.” Walter Bagehot (1826-1877) left his name in history for having said just that. This is quite a difference from what is done now in the western world; Japan included.
Bagehot recommended unlimited lending at a high rate of interest, not at zero or near-zero rates. The intention was to lend to companies, financial or non-financial caught momentarily by the general illiquidity of the market but essentially solvent. In other words, unlimited lending helped essentially sound corporate bodies, those sufficiently provided with equity capital, rather than preventing highly indebted companies from going bankrupt.
Later, I realized that the containment process mentioned above was bound to explode by the sheer gigantism of the government debt bubble. In mathematical terms, the value of longer-term bonds (quasi-automatically rolled over) bearing ever-lower interest rates tends to become infinite (see my September 2009 article entitled, “La dette publique, barrière artificielle contre l’hyperinflation”). We shall return to this subject again in the conclusion. Meanwhile, let us return to the latest Bernanke initiative.
Originally, the idea behind Operation Twist was not to frighten investors by ballooning again the Fed’s balance sheet already grossly inflated by QE1, QE2, and other interventions performed since 2007 by the central bank to increase the available quantity of money. The Fed chairman’s stratagem is bound to annihilate whatever banking soundness remains in the grossly swollen body of the Federal Reserve.
For all practical purposes, Operation Twist commits the Fed to raising cash by selling its highly liquid assets (short-term Treasury bonds and bills) and to using the proceeds to buy longer-term Treasury securities. By nature, these longer-term securities are highly speculative—the longer the maturity, the greater their volatility. Were they not bought by the central bank, they would currently be even more volatile because the United States and the euro zone have entered unknown territory. Worse still, this is deliberately unknown territory since the authorities (except, perhaps, to a certain extent Germany) plainly refuse to see the reality facing them.
The time is approaching, if it has not yet been reached in the western world, when central banks are as overblown and, consequently, as monstrously impotent as the likes of Goldman Sachs, Citibank, and French “universal” banks.
To show how far the debasement of the balance sheet of the Fed has already been pushed, let us examine a highly significant, although rarely mentioned, signal. Jacques Rueff, one of the most acute tête financières of the twentieth century, would have viewed it as an appalling warning. Since December 2009, commercial paper among the Fed’s assets has altogether disappeared. Commercial paper, an emblematic instrument of economic activity, has been displaced on the Fed’s balance sheet by a huge increase in the amount of virtual claims on future taxpayer liabilities issued by the Treasury. Professor Rueff would have likened this phenomenon, closely linked with cumulative fiscal deficits, to the famous Gresham’s Law. According to Gresham’s Law, bad money is taking the place of good money.
Rueff’s explanation might be summarized as follows. When the “false claims” issued by the Treasury to fund a permanently ongoing deficit enter the portfolio of the central bank (or of any other bank), they are first substituted for commercial paper arriving at maturity (and consequently repaid). The money thus created by the deficit is, therefore, automatically reabsorbed. It is no longer so absorbed as soon as the amount of government’s debt issued by the Treasury exceeds the amount of discounted commercial paper arrived at maturity.
In short, any responsible central bank should, more categorically than ever, abstain from acquiring—that is, monetizing—longer-term bonds. Their presence on the Fed’s balance sheet is by itself a symbol of its increasing rigidity. That is to suggest the Fed’s future impotence when the moment arrives, as it necessarily will, for the central bank to mop up by the hundreds of billions in excess liquidities from the market by selling its semi-frozen assets. The lone event—to put up for sale once-accumulated, long-term Treasuries (courtesy of Operation Twist)—would inflame the government debt market, increase the interest rate from near zero to double-digit rates, leaving Treasury bonds, formerly having been considered a near riskless investment, almost valueless.
Let us hope that in the not too distant future (perhaps months), the Fed will have to change course in order to move away from such a nightmare scenario and its built in near-zero-interest rate policy. The problem is that the near-zero-interest rate policy proceeds directly from an economic and financial paradigm used and worshipped as an intolerant religion by those in business and the academy with vested interests.
But something new might bring about the overdue renewal of thoughts and practices in modern financial science—especially as more and more evidence of the mainstream mindset being completely out of touch with reality is revealed. Such is the case for the way the Fed is obsessively viewing and cultivating its own power. In thinking and in practice, the chairman (and the Board he leads) exclusively equates that power with the privilege to issue money at the stroke of a pen. In other words, what is relentlessly stressed and promoted by the Fed, as it has evolved, say, since January 2001, is its quasi-unlimited power to buy. From this point of view, hyperinflation may be characterized as a paradoxical power to print money, a reductio ad absurdum, illustrating how and why the power to buy and print is doomed to become more and more ineffective if due attention is not simultaneously dedicated, whatever the circumstances, to the capability to sell those acquired assets.
One of the first and most destructive consequences of the collapse of the Bretton Woods gold-dollar system has been the fall into oblivion of a clear-cut notion of liquidity. A liquid asset was once considered that which the holder (either a bank or a household, either a huge corporate body or a shopkeeper) could dispose of at will at any moment without any significant loss. From this strict definition (and the kind of behavior and management it supposes), we have shifted to a much looser definition whereby a liquid asset is one which you can easily sell or trade. Actually, the very notion of liquidity has thus been dissipated by the indefinite world of trading. But trading may be suddenly interrupted in the whole North Atlantic area when financial markets happen to be seized up by what economists commonly designate as a “shock.” (Shocks—such as the collapse of the stock market and bankruptcy of Lehman Brothers—have become notorious since October 1987 and, still more so, since September/October 2008.) The very term, “shock,” conveys the illusion that these events are not of our own making.
At the apex of Argentine’s recent history, a relatively large part of its people had to take care of the liquidity of their own incomes. Civil servants were receiving their wages in the form of one-month Treasury bills whereas the butcher needed to be paid with butter, sugar, cigars, if not with cash. By postponing the issuing of fresh cash, the Buenos Aires government as a whole (that is, the state and the central bank) desperately endeavored to (slightly) mute inflation. In the corporate sector, practices using any-payment-except-cash were tried. Such extreme episodes led to a sober—and, somewhat refreshing—conclusion. Sustained liquidity has much to do with a twin restoration: a balanced budget for the government, and the promotion of unleveraged equity capital as the main source of finance for the economy, including banks.
In such an environment, three- or six-month Treasury bills would be fully recognized again—they never completely lose that quality—as purely liquid assets in the sense that they are issued in anticipation of near-future tax revenue. Secondly, commercial paper would constitute again, alongside short-term Treasury bills, the natural counterpart of the money issued by the banking system. In the meantime, nothing is more absurd for central banks than massively injecting liquidities into the economy in order to restore the “liquidity” of financial markets. On the contrary, liquidity has everything to do with the quality of claims, not with their quantity.
In the real world—as contrasted with the misrepresentation of it by the Friedmanite monetarists—the whole amount of fresh liquidities issued at zero percent are used by the banks buying Treasuries. How could they be used by households “to boost global demand” as Ben Bernanke appears to hope? The Fed is not in a position to raise the “claims” (wages) of households.
What explains the ideology according to which an incremental quantity of money will result in boosted economic activity through the revival of “global demand”?
First of all, Ben Bernanke’s obsession is not to repeat the “fatal mistakes” that the Fed supposedly made as a response to the collapse of the stock exchange in October 1929. Namely, to raise interest rates and drastically contract what is commonly designated as the “money supply.” Evidence seems to have been established that the sudden collapse of prices was not triggered, as Milton Friedman has it, by the Fed contracting the so-called “money supply” at the wrong moment. The contraction came later as a mechanical adjustment to a much lower (~30%) price level (Peter Temin, 1976).
Secondly, and contrary to what most mainstream economists assert, the “money supply” is not symmetrical with demand for money. According to classical economics (and more logically!), the quantity of money in circulation is entirely determined by the demand of cash by the users of money. For example, if I sell my house, I shall receive from the buyer (supposing him solvent) a certain amount of money equal to the price of the house. The universally admitted (at least in the English-speaking world) expression “money supply” suggests a misleading metaphor. (However sophisticated they may be, a lot of economic theories and assertions are based on metaphors.) The quantity of money in circulation is compared with the quantity of water which you allow, manipulating (or, at best, fine-tuning) the tap, to fill the “tub” of your bathroom. At best, the central bank can render dearer the access to borrowing. The “power” of a central bank has nothing to do with the arbitrary fine-tuning of the so-called money supply. But the central bank has the power to help immensely with the smooth functioning of the markets in ensuring perfect liquidity at any time in whatever circumstances.
Rarely have I been so stupefied, as a press commentator, than in reading the incredible remarks made by the Fed Chairman Ben Bernanke, on November 21, 2002, before the National Economists Club. His speech was titled, “Deflation: Making Sure ‘It’ Doesn’t Happen Here.” The article I wrote was entitled “L’incroyable message d’un membre de la Fed,” and was published on December 13, 2002. That day, I understood that the world will not escape from a financial and monetary crisis as severe as the crisis in the thirties. Most of the “in case of” measures then advocated by Bernanke have been implemented over the last four years or so—quantitative easing, Operation Twist, etc., except for one policy which would be the equivalent of Milton Friedman’s “helicopter of money.” I guess Bernanke couldn’t “sell” such an absurd policy to the Fed Board unless the West turns mad and lonely and becomes guided by the appeal for vain provocation.
Modern economics completely fails to acknowledge that inflation (including bubbles) and deflation are twin effects at different stages of the same pathology: universal addiction to debt, a highly inferior substitute both for capital (economic activity) and for taxation (state). Hence, it is nonsense to cure deflation (voluntarily or forced resorption of debts) by inflating the economy. Macroeconomics wrongly attributes deflation to a collapse of aggregate demand, whereas the latter (if such an independent concept exists) is a consequence of debt deflation.
Zero-interest-rate policy is a factor in its own right of zero growth, recession, and further deflation. A zero-interest-rate policy will not induce the banks to assume the risk of lending more to the entrepreneurial sector. Why would banks do so as they are offered an immediately lucrative bargain, a priori riskless as long as the overnight central bank rate remains very low, buying of Treasury bonds? The yield of such investments may have become very low (between 1% and 1.5% in Japan for ten-year bonds). Nevertheless, it is much higher than the cost (near zero percent) of the funding at near zero. When Bernanke hints at holding the Fed’s rate at zero until mid-2013, he is promoting the Japanese way. No recovery is sustainable without fresh investments in the productive sectors. Such investments are crowded out because of a large portion of savings being sucked in by the great borrower: the government. Any benefit supposedly arising from public spending is largely offset. According to the currently admitted surrealist doctrine, the central bank is “constrained” by the “zero bound.” It cannot lend at a lower rate.
But Bernanke is happy: the central bank can find other ways of “injecting liquidity” into the system through policies such as “quantitative easing.” Another method would be to announce an “inflation target,” quite unconventional indeed!
Paul Krugman and Ben Bernanke have been urging Japanese authorities to announce an inflation target, perhaps creating a financial Armageddon? A huge overhang of government debt is a creature unto itself, awkward to manipulate. At first notice of, say, an annual inflation target of four percent, millions of household holders of Japanese government bonds (JGBs) might suddenly fear a collapse in the value of their holdings. They might decide to sell. But who would be the buyers if not the Bank of Japan?
The fragile barrier against hyperinflation would melt into a flow of fake liquidities.
BY PAUL FABRA: