How Could It Happen?

By Grant Williams

November 25, 2014

“How could this have happened when everything was normal?”
“I was walking along the road with two friends – the sun was setting – suddenly the sky turned blood red – I paused, feeling exhausted, and leaned on the fence – there was blood and tongues of fire above the blue-black fjord and the city – my friends walked on, and I stood there trembling with anxiety – and I sensed an infinite scream passing through nature.”
“ ‘What’s happened to me,’ he thought. It was no dream.”
“Well, this is basically the end, so the answers should be in these next few pages. I doubt they will surprise you, but you never know. I don’t know how smart or thick you are. You could be Albert Einstein for all I know, or some literary prizewinner, or maybe you’re just middle of the road like me.”























Official Sales by Central Banks
Estimated Leasing (Veneroso)
Mine Production
Net Western divestment (bullion, jewelry & scrap (est.)































































































How the ‘Reserve’ Dollar Harms America

Ending the greenback’s reserve-currency role will raise savings and make U.S. companies more competitive.

By Lewis E. Lehrman And John D. Mueller

Nov. 20, 2014 6:54 p.m. ET

For more than three decades we have called attention on this page to what we called the “reserve-currency curse.” Since some politicians and economists have recently insisted that the dollar’s official role as the world’s reserve currency is instead a great blessing, it is time to revisit the issue.

The 1922 Genoa conference, which was intended to supervise Europe’s post-World War I financial reconstruction, recommended “some means of economizing the use of gold by maintaining reserves in the form of foreign balances”—initially pound-sterling and dollar IOUs. This established the interwar “gold exchange standard.”

A decade later Jacques Rueff, an influential French economist, explained the result of this profound change from the classical gold standard. When a foreign monetary authority accepts claims denominated in dollars to settle its balance-of-payments deficits instead of gold, purchasing power “has simply been duplicated.” If the Banque de France counts among its reserves dollar claims (and not just gold and French francs)—for example a Banque de France deposit in a New York bank—this increases the money supply in France but without reducing the money supply of the U.S. So both countries can use these dollar assets to grant credit. “As a result,” Rueff said, “the gold-exchange standard was one of the major causes of the wave of speculation that culminated in the September 1929 crisis.” A vast expansion of dollar reserves had inflated the prices of stocks and commodities; their contraction deflated both.

The gold-exchange standard’s demand-duplicating feature, based on the dollar’s reserve-currency role, was again enshrined in the 1944 Bretton Woods agreement. What ensued was an unprecedented expansion of official dollar reserves, and the consumer price level in the U.S. and elsewhere roughly doubled. Foreign governments holding dollars increasingly demanded gold before the U.S. finally suspended gold payments in 1971.

The economic crisis of 2008-09 was similar to the crisis that triggered the Great Depression.

This time, foreign monetary authorities had purchased trillions of dollars in U.S. public debt, including nearly $1 trillion in mortgage-backed securities issued by two government-sponsored enterprises, Fannie Mae and Freddie Mac. The foreign holdings of dollars were promptly returned to the dollar market, an example of demand duplication. This helped fuel a boom-and-bust in foreign markets and U.S. housing prices. The global excess credit creation also spilled over to commodity markets, in particular causing the world price of crude oil (which is denominated in dollars) to spike to $150 a barrel.

Perhaps surprisingly, given Keynes ’s central role in authoring the reserve-currency system, some American Keynesians such as Kenneth Austin, a monetary economist at the U.S. Treasury; Jared Bernstein, an economic adviser to Vice President Joe Biden ; and Michael Pettis, a Beijing-based economist at the Carnegie Endowment, have expressed concern about the growing burden of the dollar’s status as the world’s reserve currency. For example, Mr. Bernstein argued in a New York Times op-ed article that “what was once a privilege is now a burden, undermining job growth, pumping up budget and trade deficits and inflating financial bubbles.” He urged that, “To get the American economy on track, the government needs to drop its commitment to maintaining the dollar’s reserve-currency status.”

Meanwhile, a number of conservatives, such as Bryan Riley and William Wilson at the Heritage Foundation, James Pethokoukis at the American Enterprise Institute and Ramesh Ponnuru at National Review are fiercely defending the dollar’s reserve-currency role. Messrs. Riley and Wilson claim that “The largest benefit has been ‘seignorage,’ which means that foreigners must sell real goods and services or ownership of the real capital stock to add to their dollar reserve holdings.”

This was exactly what Keynes and other British monetary experts promoted in the 1922 Genoa agreement: a means by which to finance systemic balance-of-payments deficits, forestall their settlement or repayment and put off demands for repayment in gold of Britain’s enormous debts resulting from financing World War I on central bank and foreign credit. Similarly, the dollar’s “exorbitant privilege” enabled the U.S. to finance government deficit spending more cheaply.

But we have since learned a great deal that Keynes did not take into consideration. As Robert Mundell noted in “Monetary Theory” (1971), “The Keynesian model is a short run model of a closed economy, dominated by pessimistic expectations and rigid wages,” a model not relevant to modern economies. In working out a “more general theory of interest, inflation, and growth of the world economy,” Mr. Mundell and others learned a great deal from Rueff, who was the master and professor of the monetary approach to the balance of payments.

Those lessons are reflected in the recent writings of Keynesians such as Mr. Austin, who has outlined what he calls the “iron identities” of international payments, which flow from the fact that global “current accounts, global capital accounts, and global net reserve sales, must (and do) sum to zero.”

This means that a trillion-dollar purchase, say, of U.S. public debt by the People’s Bank of China entails an equal, simultaneous increase in U.S. combined deficits in the current and capital accounts. The iron identities necessarily link official dollar-reserve expansion to the declining U.S. investment position.

The total U.S. international investment position declined from net foreign assets worth about 10% of gross domestic product in 1976 to minus-30% of GDP in 2013—while the books of U.S. private residents went from 10% of U.S. GDP in 1976 down to balance with the rest of the world in 2013. The entire decline in the U.S. net international investment position was due to federal borrowing from foreign monetary authorities—i.e., government deficit-financing through the dollar’s official reserve-currency role.

Ending the dollar’s reserve-currency role will limit deficit financing, increase net national savings and release resources to U.S. companies and their employees in order to remain competitive with the rest of the world.

Messrs. Riley and Wilson argue that “no other global currency is ready to replace the U.S. dollar.” That is true of other paper and credit currencies, but the world’s monetary authorities still hold nearly 900 million ounces of gold, which is enough to restore, at the appropriate parity, the classical gold standard: the least imperfect monetary system of history.

Messrs. Lehrman and Mueller are principals of LBMC LLC, an economic and financial market consulting firm. Mr. Lehrman is the author of “The True Gold Standard: A Monetary Reform Plan Without Official Reserve Currencies” (TLI Books, 2012). Mr. Mueller is the author of “Redeeming Economics: Rediscovering the Missing Element” (ISI Books, 2014).

Op-Ed Columnist

Rock Bottom Economics

The Inflation and Rising Interest Rates That Never Showed Up

NOV. 23, 2014

Paul Krugman

Six years ago the Federal Reserve hit rock bottom. It had been cutting the federal funds rate, the interest rate it uses to steer the economy, more or less frantically in an unsuccessful attempt to get ahead of the recession and financial crisis. But it eventually reached the point where it could cut no more, because interest rates can’t go below zero. On Dec. 16, 2008, the Fed set its interest target between 0 and 0.25 percent, where it remains to this day.
The fact that we’ve spent six years at the so-called zero lower bound is amazing and depressing.

What’s even more amazing and depressing, if you ask me, is how slow our economic discourse has been to catch up with the new reality. Everything changes when the economy is at rock bottom — or, to use the term of art, in a liquidity trap (don’t ask). But for the longest time, nobody with the power to shape policy would believe it.
What do I mean by saying that everything changes? As I wrote way back when, in a rock-bottom economy “the usual rules of economic policy no longer apply: virtue becomes vice, caution is risky and prudence is folly.” Government spending doesn’t compete with private investment — it actually promotes business spending. Central bankers, who normally cultivate an image as stern inflation-fighters, need to do the exact opposite, convincing markets and investors that they will push inflation up. “Structural reform,” which usually means making it easier to cut wages, is more likely to destroy jobs than create them.
This may all sound wild and radical, but it isn’t. In fact, it’s what mainstream economic analysis says will happen once interest rates hit zero. And it’s also what history tells us. If you paid attention to the lessons of post-bubble Japan, or for that matter the U.S. economy in the 1930s, you were more or less ready for the looking-glass world of economic policy we’ve lived in since 2008.
But as I said, nobody would believe it. By and large, policy makers and Very Serious People in general went with gut feelings rather than careful economic analysis. Yes, they sometimes found credentialed economists to back their positions, but they used these economists the way a drunkard uses a lamppost: for support, not for illumination. And what the guts of these serious people have told them, year after year, is to fear — and do — exactly the wrong things.

Thus we were told again and again that budget deficits were our most pressing economic problem, that interest rates would soar any day now unless we imposed harsh fiscal austerity. I could have told you that this was foolish, and in fact I did, and sure enough, the predicted interest rate spike never happened — but demands that we cut government spending now, now, now have cost millions of jobs and deeply damaged our infrastructure.
We were also told repeatedly that printing money — not what the Fed was actually doing, but never mind — would lead to “currency debasement and inflation.” The Fed, to its credit, stood up to this pressure, but other central banks didn’t. The European Central Bank, in particular, raised rates in 2011 to head off a nonexistent inflationary threat. It eventually reversed course but has never gotten things back on track. At this point European inflation is far below the official target of 2 percent, and the Continent is flirting with outright deflation.
But are these bad calls just water under the bridge? Isn’t the era of rock-bottom economics just about over? Don’t count on it.
It’s true that with the U.S. unemployment rate dropping, most analysts expect the Fed to raise interest rates sometime next year. But inflation is low, wages are weak, and the Fed seems to realize that raising rates too soon would be disastrous. Meanwhile, Europe looks further than ever from economic liftoff, while Japan is still struggling to escape from deflation. Oh, and China, which is starting to remind some of us of Japan in the late 1980s, could join the rock-bottom club sooner than you think.
So the counterintuitive realities of economic policy at the zero lower bound are likely to remain relevant for a long time to come, which makes it crucial that influential people understand those realities. Unfortunately, too many still don’t; one of the most striking aspects of economic debate in recent years has been the extent to which those whose economic doctrines have failed the reality test refuse to admit error, let alone learn from it. The intellectual leaders of the new majority in Congress still insist that we’re living in an Ayn Rand novel; German officials still insist that the problem is that debtors haven’t suffered enough.
This bodes ill for the future. What people in power don’t know, or worse what they think they know but isn’t so, can very definitely hurt us.

Global policy mix turns more growth friendly

Gavyn Davies

Nov 24 07:00

Dissatisfaction abounds in policy circles and among respected economic commentators (like Martin Wolf and Paul Krugman) about the weak and patchy recovery in global GDP which has been underway since 2009. Rightly so. At minimum, Japan and the euro area seem to be mired in secular stagnation.

Yet the financial markets do not seem to share this global pessimism. Although there was a brief growth scare in the equity markets in October, this vanished almost immediately, and markets are again in optimistic mode.

Are the markets living in a parallel universe, or are they smelling a near term improvement in global GDP growth?

In recent days, the 2014 oil shock has induced central banks to ease monetary conditions further. Admittedly, many analysts think that monetary policy is now firing blanks. But lower oil prices, if maintained, will themselves boost global GDP by 0.5-1.5 percent next year. Furthermore, the global fiscal drag that has dampened the recovery in the past four years has now virtually disappeared.

It may not be enough to spell the end to secular stagnation, but the new policy mix should point to a somewhat better year for growth in the developed economies in 2015 – perhaps even in the euro area, where pessimism has recently become quite extreme.

It is now accepted by most economists that the repeated disappointments in global growth projections since 2010 have occurred because aggregate demand has fallen short even of the sluggish growth in potential GDP, in each successive year. Global economic policy has not been able to sustain demand growth at the rate required to stabilise inflation at the 2 per cent target in most economies.

This is sobering, in view of the unprecedentedly expansionary monetary policy that has been in place since the crash. But aggressive action by the central banks has been unable to offset fully the tightening in fiscal policy that all the major economies have embarked upon since 2010. The easy monetary/tight fiscal stance has emerged everywhere, though with somewhat different timing from one major economy to another. Its success has been limited:

The graph above shows some broad brush measures of the overall stance of fiscal and monetary policy in the major developed economies since the crash1, and also the rate of growth in GDP relative to potential.

There have been three phases of policy:

• From 2008-09, both fiscal and monetary policy were eased simultaneously, in order to soften the crash. This worked to some extent, leading to above trend growth in 2010.

• From 2010-14, initially encouraged by the IMF and the G20, policy embarked on a period of fiscal consolidation, and the central banks moved into a second phase of quantitative easing.

This did not result in a robust recovery in GDP. In fact, growth was generally stuck at or below potential in this phase and, time after time, initially optimistic economic forecasts had to be revised sharply downwards.

• The third phase started to take shape in 2014. Fiscal authorities, probably accepting that budget multipliers have proven higher than they expected during the second phase, have shifted a long way from austerity towards neutrality. This was led by the US and the UK but is now being followed by Japan and even the euro area. Central banks, however, have not responded to this shift by withdrawing monetary support. True, the Federal Reserve and the Bank of England have halted QE, but the Bank of Japan and the ECB have stepped into the breach. The overall rate of global central bank balance sheet expansion is actually accelerating.

How confident can we be that the third phase – monetary expansion and fiscal neutrality – will prove significant and durable?

On the fiscal side, there is little doubt that the US and Japan have now stopped tightening budgetary policy for at least a couple of years. In the euro area, the originally planned tightening in 2014 and 2015 has also now been replaced by a neutral stance, due to delayed consolidation in France and Italy.

More surprisingly, there is market chatter that some Anglo-Saxon policy makers returned from the G20 meetings in Australia last weekend speculating that the fiscal policy stance in the euro area might even be eased in the next year or two. Reportedly, they were optimistic that the Juncker plan for €300 billion of extra investment will have some substance, and that the gap before this plan takes effect could even be filled with an emergency fiscal easing of (say) 1 per cent of GDP in 2015 and 2016.

This sounds improbable, based on what is being said in public, but the Germans might conceivably have decided that a controlled fiscal easing in the euro area would be preferable to open-ended purchases of sovereign debt by the ECB, which they would not fully control. We may discover more at the next European summit on 18-19 December.

Turning to global monetary policy, the oil shock is clearly having a major impact on central bank thinking. Initially, many economists said that central banks would “look through” the decline in headline inflation, because core inflation would not be changing. In fact, however, they have shown themselves to be very worried that the drop in headline inflation will, this time, unhinge inflation expectations, increasing the risk of getting stuck in a deflation trap.

The Bank of Japan moved first, attributing its latest monetary easing directly to the effects of lower oil prices. On Friday, ECB President Draghi, in his most explicitly dovish speech ever, said that inflation expectations are “excessively low” and that reported inflation must be raised “without delay … as fast as possible”. Lower oil prices seems to have increased his sense of urgency considerably. Even the Federal Reserve, which is normally very resistant to placing too much emphasis on headline inflation rates, seems concerned about persistent “lowflation”.

Finally, the interest rate cuts by the People’s Bank of China on Friday may not be a big deal in themselves, but they do suggest that the drop in headline inflation will lead to generally lower rates in the emerging world as well. Apart from lower inflation, the exchange rate effects triggered by monetary easing in Japan and the euro area are causing many other countries to act.

So the oil shock is directly boosting global growth, and is also triggering a further major monetary easing, just as fiscal tightening is becoming neutral. Without engaging in irrational exuberance, it seems quite possible that, for the first time in half a decade, global growth forecasts for 2015 will need to be revised upwards, not downwards.

[1] The forecasts for 2015-16 are estimates by the author based on latest policy announcements in the major economies.

Goldman: Pound to hit 15-year highs against the euro

We are in a "multi-year phase of a US dollar recovery" and markets are underestimating the power of the trend

By Ambrose Evans-Pritchard, International Business Editor

4:52PM GMT 20 Nov 2014

Pound heading to €1.54 by 2017
Pound heading to €1.54 by 2017, according to the US investment bank Photo: Joe Partridge/Rex Features

Sterling is to climb relentlessly against the euro over the next three years and will reach levels last seen at the turn of the century, according to new forecasts by Goldman Sachs.
The US investment bank said the dollar will rise even faster as the American economy powers ahead and interest rates rise steeply, touching parity against the euro and climbing to 140 Japanese yen. The Brazilian real will tumble to 3.10 as the commodity boom continues to deflate.
“We are in a multi-year phase of a US dollar recovery. The market may be underestimating the scope and persistence of that trend,” it said.
The euro will drop to 0.65 against the pound by 2017, driven by capital inflows rather than trade effects. This approaches levels seen in the period from 1999-2002 when Germany’s economy fell into a deep slump and the Neuer Markt for hi-tech stocks collapsed. This is a dramatic revision since the bank’s previous forecast was 0.85. “Euro downside remains our top conviction view,” it said.
Goldman Sachs said the European Central Bank is still reluctant to buy sovereign bonds and launch full-blown quantitative easing but is likely to act more aggressively than markets expect when it finally does.

On an inverted basis, UK exchange rate would be €1.54 to the pound by 2017. This turn would Europe into a cheap region for holidays once again, and offer bargain basement prices for farmhouses in Tuscany or Aquitaine.
Yet such a dramatic rise in sterling cannot easily be justified by the underlying weakness of the British economy, which already has the worst current account deficit in the developed world. It was running at 5.2pc of GDP in the second quarter.
While part of this deficit is due to the economic relapse in the eurozone, it also suggests that the exchange rate is badly overvalued even at current levels. The International Monetary Fund estimates that the pound is 5pc to 10pc too strong.

The exchange rate follows the divergence in Interest rates

Cumulative inflation in the UK has been much higher than in the eurozone, without any improvement in relative productivity. A return to the euro-sterling exchange rate of fifteen years ago would imply a massive overvaluation, and could push the UK deficit towards 7pc of GDP.
“The current account deficit is probably the worst in history,” said David Bloom from HSBC.

“We have only three problems with sterling: cyclical, structural, and political; and we don’t really believe in this recovery.”

“We think that whatever infects the eurozone also infects Britian. They feed into each other and that is why we think sterling will go down with the euro. The dollar is the only rose between these two thorns,” he said.

Euro/Sterling rate for the last 20 years

The Goldman Sachs forecasts were contained in its predictions for 2015, a list that includes a “New Oil Order” as extra crude supply from Libya, Iraq, and Iran pushes prices even lower.
The bank said the US Federal Reserve will not raise rates until September of next year, later than the markets expect. But it will then move faster and on a steeper trajectory than widely assumed as it tries return to a “neutral” rate of 4pc. The report insists that this will be “manageable” for the world, invoking the curious argument that bond tapering has so far been benign and that Fed tightening will therefore continue to be so in the future.

The analysis of Fed policy almost certainly reflects the broad outlook of William Dudley, a Goldman Sachs economist before he became head of the New York Fed. He is one of the most influential figures on the voting committee. Mr Dudley’s views have tended to prevail over recent meetings and are tracked closely by analysts.
The latest Fed minutes played down concerns about the strength of the dollar, suggesting that the closed nature of the US economy makes it resilient against an exchange rate shock.

Goldman Sachs said the US economic expansion has “several years to run” and will drive another long phase of global growth.
The S&P 500 index of Wall Street stocks will rise to 2,300 by 2017, the Stoxx Europe 600 index will rise to 440, and the Japanese Topix wil hit 1,900, so bask in sunlit uplands and enjoy. Gold will go nowhere.

Undercover Economist

November 21, 2014 3:49 pm

Why a house-price bubble means trouble

Tim Harford

A housing boom is the economic equivalent of a tapeworm infection

Buying a house is not just a big deal, it’s the biggest. Marriage and children may bring more happiness – or misery, if you’re unlucky – but few of us will ever sign a bigger cheque than the one that buys that big pile of bricks, mortar and dry rot.

It would be nice to report that buyers and sellers are paragons of rationality, and the housing market itself a well-oiled machine that makes a sterling contribution to the working of the broader economy. None of that is true. House buyers are delusional, the housing market is broken and a housing boom is the economic equivalent of a tapeworm infection.

As a sample of the madness, consider the popular concept of “affordability”. This idea is pushed by the UK’s Financial Conduct Authority and seems simple common sense: affordability asks whether potential buyers have enough income to meet their mortgage repayments. That question is reasonable, of course – but it is only a first step, because it ignores inflation.

Illustration of warped houses by Harry Haysom - for Undercover Economist©Harry Haysom

To see the problem, contrast today’s low-inflation economies with the high inflation of the 1970s and 1980s. Back then, paying off your mortgage was a sprint: a few years during which prices and wages were increasing in double digits, while you struggled with mortgage rates of 10 per cent and more. After five years of that, inflation had eroded the value of the debt and mortgage repayments shrank dramatically in real terms.

Today, a mortgage is a marathon. Interest rates are low, so repayments seem affordable. Yet with inflation low and wages stagnant, they’ll never become more affordable. Low inflation means that a 30-year mortgage really is a 30-year mortgage rather than five years of hell followed by an extended payment holiday. The previous generation’s rules of thumb no longer apply.

Because you are a sophisticated reader of the Financial Times you have, no doubt, figured all this out for yourself. Most house buyers have not. Nor are they being warned. I checked a couple of the most prominent online “affordability” calculators. Inflation simply wasn’t mentioned, even though in the long run it will affect affordability more than anything else.

This isn’t the only behavioural oddity when it comes to housing markets. Another problem is what psychologists call “loss aversion” – a disproportionate anxiety about losing money relative to an arbitrary baseline. I’ve written before about a study of the Boston housing crash two decades ago, conducted by David Genesove and Christopher Mayer. They found that people who bought early and saw prices rise and then fall were realistic in the price they demanded when selling up. People who had bought late and risked losing money tended to make aggressive price demands and failed to find buyers. Rather than feeling they had lost the game, they preferred not to play at all.

The housing market also interacts with the wider economy in strange ways. A study by Indraneel Chakraborty, Itay Goldstein and Andrew MacKinlay concludes that booming housing markets attract bankers like jam attracts flies, sucking money away from commercial and industrial loans. Why back a company when you can lend somebody half a million to buy a house that is rapidly appreciating in value? Housing booms therefore mean less investment by companies.

 . . . 

House prices have even driven the most famous economic finding of recent years: Thomas Piketty’s conclusion (in joint work with Gabriel Zucman) that “capital is back” in developed economies. Piketty and Zucman have found that relative to income, the total value of capital such as farmland, factories, office buildings and housing is returning to the dizzy levels of the late 19th century.
But as Piketty and Zucman point out, this trend is almost entirely thanks to a boom in the price of houses. Much depends, then, on whether the boom in house prices is a sentiment-driven bubble or reflects some real shift in value. One way to shed light on this question is to ask whether rents in developed countries have boomed in the same way as prices. They haven’t: research by Etienne Wasmer and three of his colleagues at Sciences Po shows that if we measure the value of houses using rents, there’s no boom in the capital stock.

The housing market then, is prone to bubbles and bouts of greed and denial, is shaped by financial rules of thumb that no longer apply, and sucks the life out of the economy. It even muddies the waters of the great economic debate of our time, about the economic significance of capital.

One final question, then: is it all a bubble? That is too deep a question for me but there is an intriguing new study by three German economists, Katharina Knoll, Moritz Schularick and Thomas Steger. They have constructed house-price indices over 14 developed economies since 1870. The pattern is striking: about 50 years ago, real prices started to climb inexorably and at an increasing rate. If this is a bubble, it’s been inflating for two generations.

At least dinner-party guests across London will continue to have something to bore each other about. Not that anybody will be able to afford a dining room.

Tim Harford’s latest book is ‘The Undercover Economist Strikes Back’. Twitter: @TimHarford
Illustration by Harry Haysom