See no evil, speak no evil…


by Alasdair Macleod, Goldmoney:

The Jackson Hole speeches of Janet Yellen and Mario Draghi last week were notable for the omission of any comment about the burning issues of the day:

…where do the Fed and the ECB respectively think America and the Eurozone are in the central bank induced credit cycle, and therefore, what are the Fed and the ECB going to do with interest rates? And why is it still appropriate for the ECB to be injecting raw money into the Eurozone banks to the tune of $60bn per month, if the great financial crisis is over?i

Instead, they stuck firmly to their topics, the Jackson Hole theme for 2017 being Fostering a dynamic global economy. Both central bankers told us how good they have been at controlling events since the last financial crisis. Ms Yellen majored on regulation, bolstering her earlier-expressed belief that financial crises are now unlikely to happen again, because American banks are properly regulated and capitalised.

Incidentally, more regulation hampers economic dynamism, contra to the subject under discussion, and confirms Ms Yellen has little understanding of free markets. Mario Draghi, however, told us of the benefits of financial regulation and globalisation, and how that fostered a dynamic global economy. But a cynic reading between the lines would argue that Mr Draghi’s speech confirms the ECB is in thrall to Brussels and big business, and is merely representing their interests. And he couldn’t resist the temptation to have a poke at President Trump by expressing the benefits of free trade.

Hold on a moment, free trade? Does Mr Draghi really understand the benefits of free trade?

That’s what he said, but his speech was all about the importance of regulating everything Eurozone citizens can or cannot do. It is permitted free trade in a state-regulated environment. It is a version of free trade according to the EU rule book, agreed with big European business, which advises Brussels, which then sets the regulations. It is a latter-day Comintern that allows you to trade freely only on terms set by the state for prescribed goods with other states of a similar disposition. Draghi’s speech was essentially justifying the status quo laced with Keynesian-based central bank dogma.

The Fed is clueless about the credit cycle

Let us return to the real issue at hand, the questions that went begging about monetary policy. More confident central bankers in control of their brief might have said something about it, if only in passing. But with Ms Yellen we have a problem. If, as she claims, the Fed has cured America of financial crises, why hasn’t the Fed normalised interest rates already? Even on the US Government’s heavily-sedated consumer price index, inflation is at the Fed’s target, as are its highly-questionable unemployment numbers. Interest rates should already be normalised, which means they ought to be considerably higher than they are today.

As a rough rule of thumb, bond market investors in the past expected a free market to reflect the originary rate, the real rate shorn of all lending risk, of two or three per cent adjusted for price inflation for medium to long-term government bonds. That indicates a yield level of four per cent or more on 10-year Treasuries, even on government inflation estimates. Meanwhile, the 10-year US Treasury yields only 2.15{5f621241b214ad2ec6cd4f506191303eb2f57539ef282de243c880c2b328a528}, and the Fed funds rate is currently targeted between one and one and a quarter per cent. Something is very wrong.

Correction: everything about this is wrong. The statistics are self-serving and bogus, so you cannot judge interest rates by referring to them. But worst of all is something that goes unquestioned today, and that is interest rates are a function of the markets, not central banks. They cannot possibly know what normalised rates should be.

That’s why we have a credit cycle, born out of the central banking system’s guesses. Central banks always err on the low side for interest rates, partly because of the long-standing moral antipathy against high interest rates and partly because of the Keynesian theology which accords with it. Over time, this suppression of interest rates has led us all into a global debt trap, because of the sheer size of it, which has accumulated to well over $200 trillion. That’s about three times global GDP.

Normalising interest rates would spring the debt trap firmly shut. The whole Western financial system would be threatened by a combination of defaults and collapsing asset values, starting from the weakest point in the global financial system. With debt of today’s magnitude, it will take nominal interest rate rises of only one or two per cent to set off the crisis Ms Yellen believes will never happen again. It is a repeating credit cycle endemic to the fractional reserve monetary system and central banking’s monetary intervention. And when the crisis hits, yet again for the umpteenth time, central banks will flood the system with ever larger quantities of cash.

Easy money and credit does its hidden damage by subverting economic calculation. The accumulation of miscalculations always leads into a crisis. When it happens, the crisis is sudden and unexpected by the banking community. The crisis phase of the credit cycle is nowadays curtailed by central banks, who come charging to the rescue with unlimited fiat money to offset contracting bank credit. They think by stopping the reallocation of capital from miscalculated investments, they are saving the world. They are not: all they are doing is making the economy less efficient by burdening it with a legacy of unrepayable debt for the next credit cycle. Hence, the sluggishness of Western economies which have progressively lost their productive mojo. These are the monetary policies that have become a growing impediment to Jackson Holes’ “fostering a dynamic global economy”.

However, there is a way to assess where we are in the credit cycle. Gibson’s paradox, which was impossible for the Keynesians to resolve, demonstrated that in a free economy it is demand for savings from businessmen that sets the marginal rate at which savers are prepared to defer their current spending. It is not, as Keynes averred, the greedy rentier forcing an unnecessary cost on the entrepreneur. Instead of being set by the saver, the level of interest rates correlate with the one thing a businessman knows best, the price at which he can expect to sell his production.ii

Importantly, that is where the correlation lies, not with the rate of inflation, which is what central banks assume in setting interest rate policy. Therefore, the amount of interest a businessman is prepared to pay is determined by the difference between the other factor costs of production and the anticipated wholesale value of the product. If the differential widens, an investing businessman can afford to bid up interest rates. If the differential contracts, borrowing at higher rates becomes uneconomic. The correlation between wholesale prices and wholesale borrowing rates is a reasonable fit for this reason.

Therefore, we should pay attention to the yield on a suitable government bond, as an indicator for the wholesale originary borrowing rate in a fiat currency. If we take the 10-year US Treasury bond as a marker this loan rate, tracking the yield should indicate changes in the level of borrowing demand from the wider economy, the small and medium size enterprises that make up 80{5f621241b214ad2ec6cd4f506191303eb2f57539ef282de243c880c2b328a528} of the non-financial sector, in accordance with Gibson’s paradox. It should give us an early warning of widening demand for bank credit.

Of course, this rate is distorted by interest rate suppression, and by loan demand from the financial sector itself, so we cannot take it as an interest rate proxy per se. It turns out that the yield first bottomed at 1.5{5f621241b214ad2ec6cd4f506191303eb2f57539ef282de243c880c2b328a528} in 2012, which probably sets a date for the end of the crisis phase and the beginning of the recovery phase of the current credit cycle, now in its sixth year. This was followed by a rise in yield to touch 3{5f621241b214ad2ec6cd4f506191303eb2f57539ef282de243c880c2b328a528}, when corporate borrowing for share buy-backs and for geared financial speculation on Wall Street soared.

It then tested that low level again in July 2016, as these factors abated. More recently, it rose strongly from that time to hit a high of 2.5{5f621241b214ad2ec6cd4f506191303eb2f57539ef282de243c880c2b328a528} last December, from which it has declined steadily to the current level at 2.15{5f621241b214ad2ec6cd4f506191303eb2f57539ef282de243c880c2b328a528}.

This is admittedly imprecise, but if it is telling us anything it is that US businesses are most recently stalling in their loan demand. This could reflect margins being squeezed by rising commodity prices, though in a service-oriented economy this effect should not be given undue weighting. But on a flow of funds basis, we can take it that the US economy is still in the minor ups and downs of a recovery phase in terms of commercial demand for credit. The softness of credit demand since December is probably what convinces the Fed that the current level of interest rates can be maintained, with a modest upwards bias in time.

However, we know that while interest rates remain heavily suppressed, it allows business propositions to be financed which are not otherwise commercially justified. Long-term projects appear to become viable, that will be uneconomic when rates normalise. The longer this goes on, the greater will be the drip-feed accumulation of distortions during the credit recovery phase that will have to be washed out in the next credit crisis.

To summarise, credit demand from non-financial businesses is not yet expanding at an accelerating rate, the distortions from suppressed interest rates are nevertheless accumulating, and yet the Fed seems blissfully unaware of the dangers accruing for the next financial crisis.

The Eurozone is running into deep monetary trouble

The US is an economy geographically isolated from the rest of the world, except from its close neighbours. And even NAFTA, the trade agreement that conjoins them, is under threat from President Trump’s administration. Europe is very different, with a dynamic Asian economy, stimulated by massive Chinese investment and spending, offering new business opportunities. The development of China’s overland silk road is already having a major impact, with rail freight quantities rapidly expanding in both directions. Admittedly, some of this is replacing freight that would have gone by sea or air, but there is still a substantial increase in the transhipment of goods overall.

European manufacturers are waking up to this potential. A brand-new Mercedes can be shipped from Stuttgart and be in a saleroom in Beijing in a little over two weeks. Similarly, Zanussi can railroad white goods from its Chinese factories to its European distributors, saving both time and money compared with using sea routes. The benefits of this trade, even with EU protective tariffs, are not to be underestimated. Furthermore, it is expanding rapidly on the back of interest-free monetary policy.

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