Gold vs Silver – The 1896 US Presidential election

A photographic negative of recent election results

To the south are the debtors. With their incomes slumping and debt burdens rising they demand that the monetary authorities act, wanting a little inflation to ease the load. To the north are the creditors. Anxious that the rising wages from their manufacturing output will buy tomorrow what it will buy today they, by contrast, demand monetary discipline.

This is an apt description of contemporary Europe. It is, in fact, a description of the United States in the late 19th century. For the PIIGS we have the indebted farmers of the south and Great Plains demanding the inflationary coinage of silver. For the Germans, protecting the principle of (relatively) sound money, we have the bankers and industrial workers of the north-eastern states urging sound money and adherence to the gold standard.

The United States Constitution gave Congress the power “To coin Money, regulate the Value thereof, and of foreign Coin” and a Coinage Act was passed in 1792. This provided for the free coinage of silver and gold, a bimetallic system, with silver being coined at the rate of $1 for 371.25 grains of pure silver and gold at 24.75 grains of pure gold, a ratio of 15:1. This held while this mint ratio matched the market price ratio. But when, as was likely, they diverged then the metal undervalued at the mint flooded out and the other became the de facto monometallic money. After 1792 gold was undervalued and a de facto silver standard came about; after an alteration of the mint ratio in 1834 silver was undervalued and a de facto gold standard came about.

Messy and protracted attempts to restore convertibility after the Civil War inflation culminated in the fateful Coinage Act of 1873. Considering the controversy it would subsequently generate this Act passed rather unremarked but it was a clear break in American monetary affairs. While it allowed for free coinage of gold to resume in 1879 it said nothing about silver. This de jure demonetising of silver was little noticed as it had been de facto demonetised since 1834.

Two things returned the monetary question to prominence. One was a rise in the gold/silver ratio from around 16:1 in the early 1870s to 30:1 by 1896 owing to an increased international demand for gold and supply of silver. Another was agricultural hardship. Between 1872 and 1895 on a US Farm Average wheat prices fell by 59%. The price of cotton fell by 55.5% between 1881 and 1890. This crippled heavily indebted farmers in the south and Midwest.

There were two explanations for this. One credited dramatic agricultural productivity increases which saw cotton production increase by 111% and wheat production by 446% between 1859 and 1919. The activist Edward Atkinson wrote “[T]here is not a single commodity which has been subject to a considerable fall in price since 1873 or 1865, of which that change or decline in price cannot be traced to specific applications of science or invention…either to the production or distribution of that specific article without any reference whatever to the change in the ratio of gold to silver”

The other, favoured in agricultural areas, blamed a deflationary shrinkage in the money supply following the 1873 demonetisation of silver, which ‘Silverites’ called ‘The crime of 1873’. Figures emerged showing that money per capita in circulation had fallen from a peak of $31.18 in 1865 to $20.00 between 1875 and 1896. “Money in the business world and blood in the body perform the same functions and seem to be governed by similar laws” commented Illinois governor John Peter Altgeld, “When the quantity of either is reduced the patient becomes weak and what blood or money is left rushes to the heart, or center, while the extremities grow cold”

A succession of organisations arose seeking the remonetisation of silver at 16:1, a de facto silver standard. The most successful was the Populist Party under whose pressure the Democrats adopted a free silver policy in 1896. Both parties nominated Nebraska’s William Jennings Bryan for president that year. Bryan, gifted orator to his supporters, demagogue to his opponents, thundered famously at the Democratic convention in Chicago “You shall not press down upon the brow of labor this crown of thorns, you shall not crucify mankind upon a cross of gold”. To Bryan his opponents were “creditors; they hold our bonds, and our mortgages, and as the dollars increase in purchasing power, our debts increase and the holders of our bonds and mortgages gather in an unearned increment”.

The Republicans raised the gold standard with little enthusiasm, their traditional economic panacea was protectionism. Their nominee, Ohio’s William McKinley, had made his reputation on the tariff issue. Unlike Bryan, he won the nomination thanks to diligent preparation. While Bryan stumped 18,000 miles round the country McKinley, reasoning “I might just as well put up a trapeze on my front lawn and compete with some professional athlete as go out speaking against Bryan”, stayed in Canton, Ohio. There he pushed the themes of the protectionism and sound money; “We know what partial free trade has done for the labor of the United States. It has diminished its employment and earnings. We do not propose now to inaugurate a currency system that will cheat labor in its pay”.

McKinley won. Just as silver had a popular constituency so did gold. It was found among industrial workers, many of them German immigrants, who saw their real wages increase by 18% between 1879 and 1889. When, in previously Democrat and heavily German Milwaukee, the Democratic candidate said that “gold, silver, copper, paper, sauerkraut or sausages” could serve as money Milwaukee went Republican.

And almost as soon as the election was over prices began to rise as new gold discoveries increased the money supply. Whether this was due to luck or equilibrating tendencies in the gold standard is still disputed.  And here, if not before, the historical analogy breaks down. There is no such light at the end of the Euro-tunnel.

This is an early draft of an article which appeared in The Salisbury Review

Bubble. Burst. Liquidity. Repeat

Increasing both

In March 2000 the dot com bubble burst. From a peak of 5,048.62 on March 10th, 24 percent up on late 1999, the NASDAQ Composite index had fallen to half that by late 2000. GDP growth slumped and unemployment steadily climbed from under 4 percent in late 2000 to a peak of 6.25 percent in mid-2003.

On January 3rd, 2001, Alan Greenspan acted and cut the Fed funds rate to 6 percent. By June 2003 it was down to 1 percent where it stayed until June 2004. The effects are well known. This wave of liquidity was directed by government action like the Community Reinvestment Act, government bodies like Fannie Mae and Freddie Mac, and a minefield of moral hazard in a financial sector which knew it would be bailed out of any trouble, into a housing bubble.

That bubble burst too. With inflation on its way up from 2 percent in mid-2003 to 4.7 percent in October 2005, Greenspan gradually raised the Fed funds rate, reaching 5.25 percent in June 2006. But this crippled many people who had borrowed at lower rates to buy property. The number of new foreclosure starts in the US increased by more than 50 percent to 1.1 million between 2006 and 2007.

Assets backed with these non-performing loans crashed in value. Banks holding them saw their balance sheets ravaged. Seeing counterparty risk everywhere, banks stopped lending to each other and the LIBOR, usually about 0.15 percent above where the market thinks the bank rate will be in three months’ time, shot up to over 6.5 percent in August 2007. The credit crunch had arrived.

And Greenspan, his academic successor Ben Bernanke, and central bankers around the world reacted as they had to the bursting of the dot com bubble. The Fed funds rate went back down from 5.25 percent in September 2007 to 0.25 percent in December 2008. Likewise, between July 2007 and March 2009 the Bank of England slashed its Base Rate from 5.75 percent to 0.5 percent. Even the supposedly cautious European Central Bank reduced its key rate from 4.25 percent in summer 2008 to 1 percent by the spring of 2009.

When this failed to have the desired stimulative effect central bankers began trying to pull down the long end of the yield curve. Under Quantitative Easing the Bank of England spent £375 billion of newly printed money on British government debt. The Federal Reserve is spending $85 billion dollars a month on bonds.

There is a pattern here. A bubble in assets (dot com stocks) bursts and central banks react by hosing liquidity into the system. But this liquidity inflates another bubble (property) and when that bursts central banks react by hosing liquidity into the system…

In the high Keynesian noon of the post-war period it was widely thought that monetary policy was ineffective for macroeconomic management (it is debatable how much this is actually owed to Keynes). All that could be hoped for from monetary authorities was support for the fiscal policies which really had the clout to equilibrate the economy.

But this Keynesian paradigm fell apart with the stagflation of the 1970s. Money mattered was the lesson and it became the primary tool of macroeconomic management, replacing fiscal action, at least until the ‘Return of the Master’ following the credit crunch.

But what has this meant in practice? As interest rates are lowered in response to an adverse shock investment, calculations change, especially when, like Alan Greenspan, those behind the policy publicly promise its continuance. To the extent that this fosters a wealth effect, consumption, as well as investment, may be stimulated. And this, in fact, is exactly the way the policy is supposed to work.

But the rates cannot stay that low indefinitely, nor, despite the jawboning by monetary policymakers, are they intended to. At some point they will rise. Again, this actually is the way the policy is supposed to work.

And when those rates do rise what happens to those marginal investors who made their decision when rates were at their lowest? What happened to the NINJAs who bought condos in Michigan when interest rates were 1 percent when the rates went up in 2006? They were scuppered. And what will happen to all the enterprises which are currently dependent on interest rates remaining at their historic lows when those rates start to rise? It is because more people are now asking that question that markets have turned skittish recently, since Ben Bernanke even began to discuss a possible future ‘tapering’ of Quantitative Easing.

Those rates will have to rise at some point. But, when they do, whichever bubble we have now will burst. Our monetary authorities have printed themselves into a corner.

This is what passes for macroeconomic management. As one of the high priests of this bubble-onomics, Paul Krugman, advised in 2002 in the wake of the dot com bust “To fight this recession the Fed needs…soaring household spending to offset moribund business investment…Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble”. And no, that’s not taken out of context.

One of the great myths in economics is that of some sort of stable equilibrium. It is apparent that active monetary policy is little better at producing that than fiscal policy proved. Instead the economy is characterised by crises of increasing frequency and amplitude and the only solutions policymakers appear to have to deal with them will buy ever shorter-lived respite at the cost of increasing both the frequency and amplitude of crises.

We are in an equilibrium of sorts, but it is an equilibrium of crises.

This article originally appeared at The Commentator

I hate to say it but…

This last week has seen articles from Roger Bootle and Allister Heath warning of the consequences of a bursting in the “bond bubble”. Now we have the Bank of England’s Andrew Haldane saying

If I were to single out what for me would be the biggest risk to global financial stability right now, it would be a disorderly reversion in government bond yields globally.

We’ve seen shades of that over the last two to three weeks.

We have intentionally blown the biggest government bond bubble in history. We’ve been vigilant to the consequences of that bubble deflating more quickly than we might otherwise have wanted. That’s a risk we as FPC need to be very vigilant to.”

As I asked on The Commentator last August, Is the bond bubble the biggest yet?

Cyprus and banking

Fractional reserve joyride

This is democracy in the European Union. Last week the Cypriot parliament voted down a proposal to secure the €10 billion funding needed to bail out its crippled banks that would have imposed a one off “solidarity levy” of 6.75% on bank deposits under €100,000 and 9.9% on those over. This week the Cypriots were offered the money in return for a deal which shuts the second biggest bank and scoops up €4.2 billion from uninsured deposits and moves the insured deposits (under €100,000) to the Bank of Cyprus where deposits over the €100,000 will be taxed at 40%. The Cypriot MPs, from Churchill to Quisling in seven days, accepted.

The counterproductive stupidity of the proposal has been widely noted. It’s difficult to see how the aim of shoring up Cypriot banks which have had their capital bases ravaged by haircuts on Greek government debt will be helped by a policy which is almost certain to cause a run on those very same banks.

But the strongest reaction was moral outrage that the Cypriot government, at the behest of the troika, was considering simply helping itself to its citizen’s cash. Personally I’m unclear how this is morally different to what governments do all the time. Indeed, in the age of the welfare state, big government, and redistributive tax and spending, it has become the governments raison d’être to do exactly this day in day out.

But we shouldn’t dismiss the idea so quickly. It stems from the notion that banks act as warehouses for deposits; that we go to the bank, make a deposit, and that that deposit sits there until we go back to the bank and take it out. Of course, under a fractional reserve banking system it doesn’t work like that at all. Just like the garage attendants who took Ferris Bueller’s Ferrari for a joyride round Chicago when he left it in their care, bankers lend multiples of our deposits straight out the back door as soon as we’ve taken them in the front door. In this sense, as Detlev Schlichter points out, deposits in banks are not like sticking your money in a safe; rather they are “loans to highly leveraged businesses”

You might say that no one actually thinks on that level when they deposit their money in a bank. Well, firstly, why wouldn’t they? The very fact that a bank pays interest on deposits (however small that might currently be) should be a warning sign that they are not merely humble warehouses. Ask yourself, how many warehouses pay you for the privilege of storing your stuff? They don’t because a warehouse has operating costs; it needs a building, it needs staff. It has to charge the people who leave stuff there, its depositors, a fee to cover these expenses.

A bank also has operating expenses; it too needs the buildings and the staff and much else besides. Yet, as the bank takes in your deposits and incurs these expenses, unlike the warehouse it pays you. It must, therefore, have another source of income, and it does; the yield on its assets, assets bought with your deposits. The bank is able to pay you interest because it is accumulating assets with your cash; the bankers are taking the Ferrari for a ride. That banks pay interest on deposits proves that they are not simply warehouses.

Secondly, are we sure that people don’t act like that? As a personal example, my old flatmate’s mum had money in Northern Rock and when it hit trouble she demanded a bailout. “Why did your mum put her money into Northern Rock?” I asked “Because they offered good interest rates” she replied.

Of course they did. That’s because their funding model, lending long term at typically higher interest rates with money borrowed short term at relatively lower interest rates was, ultimately, as risky as it sounds. Many Cypriot banks were offering rates of a relatively healthy 6% or more, but then they were investing 160% of Cyprus’ GDP in Greek government bonds.

One of the first things they teach you in GCSE Business Studies is that profit is the reward for risk. The high interest rates offered by Northern Rock and the Cypriot banks were indicators that they were engaged in something relatively risky. If you choose to take that risk on then I wish you all the best, but you should not expect a taxpayer bailout when things go sour to turn your investment into a one way bet; heads I win, tails I don’t lose.

The idea that governments must bail out busted banks is rarely questioned nowadays except by those who wish to be labelled some sort of economic ‘extremist’. In his book ‘How Capitalism Will Save Us’, free marketeer Steve Forbes has four index references to Joseph Schumpeter and 14 for creative destruction including one saying that “Washington should have let GM and Chrysler reorganise under existing bankruptcy laws”. Yet he answers the question of why the bailout of Detroit was wrong and that of Wall Street right by saying “The bailout was a necessary evil to avoid a collapse of the global economy”. Capitalism will not save banking, it seems.

But government bailouts of busted banks turn the investment that depositing is under fractional reserve banking into a no lose situation. This encourages risky investing and is how shaky banks become ‘too big to fail’. Goldman Sachs and JP Morgan were bailed out five times in the 20 years before 2008 so why wouldn’t they pile into subprime mortgage debt?

What is happening in Cyprus is undoubtedly a terrible situation for all involved. But if anyone is going to stump up for the bailout of Cypriot banks, isn’t it both fair and sensible that those who do are their investors?

This article originally appeared at The Cobden Centre

Why is David Blanchflower so scared of the truth?

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The Michael Howard of economics

A couple of weeks back I took David Blanchflower of the New Statesman to task over the failure of his recent attempt to justify his infamous 2009 prediction that “unemployment could easily reach four million”. Blanchflower responded on Twitter: “If spending cuts are made too early and the monetary and fiscal stimuli are withdrawn “if crucial- buffooonery” (sic).

In fairness to Blanchflower he did preface his 2009 doomsday scenario with exactly those words. But let’s look a little more closely at Blanchflower’s warnings of the twin evils of tight money and spending cuts.

First, monetary policy. Who, in 2009, was advocating the tightening monetary policy? Possibly a few Austrians (though not all of them). Not many others. Certainly, as far I recall, no one in the Conservative Party as Blanchflower claimed. If I am wrong (and I have scoured the internet) and there were leading Conservatives advocating monetary tightness in 2009 then please, let me know.

But if, as I’m pretty sure is the case, nobody in the Conservative Party was advocating the early withdrawal of monetary stimuli then why on earth did Blanchflower waste anyone’s time warning them about it?

And what about the fiscal side of Blanchflower’s prediction? He loudly and regularly makes the point that ‘Slasher’ Osborne (I know, not much as nicknames go) has cut government spending and plunged Britain into renewed recession. I asked Blanchflower once or twice (or thrice) by how much ‘Slasher’ Osborne has cut government spending to send us into recession.

The answers I got ranged from “go and look it up yourself” to “go back into your hole” and “If you want to hire me to do consulting work for you I will bill at my normal high rates min 3hrs half up front”. How sad that when given a chance to engage and educate, a man who holds a teaching position chose instead to act in such a petulant and childish manner. How terrifying that someone so shifty, evasive, and brittle under pressure, was once a member of the Monetary Policy Committee.

Well, I went and looked up the numbers and the reasons for Blanchflower’s reticence quickly became apparent. In the fiscal year ending April 2010, Labour’s last in office, the British government spent £660.8 billion and in the year ending April 2012 it was £688 billion: an increase of 4.1 percent. Over the same period, however, we have had above target inflation which has given us a real terms cut in government spending of of 2.7 percent.

That’s it. After a decade which saw Labour double government spending in real terms it has been pruned by 2.7 percent. Hardly ‘slashing’ and all delivered by Mervyn King and his failure to keep inflation at 2 percent. If he had we’d have had a very slight real terms increase in spending; but that, presumably, really would have meant the monetary tightness Blanchflower was wailing about back in 2009.

I don’t suppose the monikers ‘Slasher King’ or ‘Trimmer’ Osborne would be much LOLZ for the Prof on Twitter. You can see why he was desperate to avoid giving a straight answer; his whole shtick would collapse if he did.

Blanchflower might argue that some areas of government spending have been cut quite drastically but there are two points to be made there. First, The Master himself, John Maynard Keynes, famously said that it didn’t matter too much what you spent your fiscal stimulus on, whether it’s Pyramids, wars, or burying old bottles full of cash and digging them up again. The key thing was to get the money spent.

Second, you have to wonder what else Blanchflower expects. Even with record low interest rates, British government debt, for which we are all liable, has risen so vertiginously that by 2015 it is estimated that we will be spending £70 billion a year on debt interest, up from £31 billion in 2008. To some extent we are seeing spending on welfare being cut so we can give the money to bond investors instead. Don’t like it? Don’t run up a load of debt.

Of course, Blanchflower would argue that we don’t actually need to worry. We just keep printing and borrowing the money we need. The £450 billion the coalition will have added to the national debt by April 2013 is too stingy; the doubling of the national debt over its lifetime too miserly. With views like that you can understand why Blanchflower runs scared from any rational discussion.

So, back in 2009, Blanchflower was warning us about something that wasn’t going to happen. After trying and failing to exonerate his 2009 prediction his argument now is that he wasn’t wrong, just irrelevant. But then you might find yourself asking why we should pay much attention to a slippery peddler of irrelevancies. Why indeed.

With his affected rudeness and terror of reasonable discussion with anyone who might disagree with him, Blanchflower is a sort of pound store Paul Krugman. But, without a bestselling book, a Nobel Prize, and with a column in the Independent rather than the New York Times, that’s a bit like comparing Donovan to Bob Dylan.

Cyprus: The ghost of the West yet to come

Get used to it

When the European Union (with German money) mounted its most recent bailout of Greece, one of the conditions was a 75 percent write down of Greek government debt. For the Cypriot banks, which had made loans to the Greek government totalling 160 percent of Cyprus’s GDP, this was disastrous.

With their capital bases smashed the Cypriot government felt obliged to bail them out. Lacking the funds to do so (in 2011 the IMF reported that the assets of Cypriot banks totalled 835 percent of GDP) it turned to the European Union (in reality Germany again) for a bailout.

The Germans are reluctant to lend money without conditions. If the terms of the bailout are accepted by the Cypriot parliament, in return for the €10 billion corporation tax will rise from 10 percent to 12.5 percent and interest on bank deposits will be subject to a withholding tax.

But the most controversial aspect is the proposal that bank deposits will be subject to a one off “solidarity levy”, amounts under €100,000 at a rate of 6.75 percent and those over €100,000 at 9.9 percent.

This is the eurozone crisis at its most extreme but it only differs from events in Ireland, Greece, Spain, Italy, and Portugal, by degree. And in as far as  government eventually has to tailor its outgoings to suit its income it is really just an extreme version of the situation which will also eventually face Japan, Britain, and the US, probably in that order.

So what lessons does Cyprus hold for those who still have all this to come?

The first concerns the relationship between banks and our politicians. Over the last few years politicians elected to represent the people have rarely missed an opportunity to dump debts on those people in the interests of saving banks and other financial institutions which have hit trouble. We have been told that banks occupy a unique position in our economy such that the laws of economics don’t apply to them as they apply to Woolworths or Blockbuster. They are too vital, we are told, too big to fail.

Functioning banks certainly are a key part of a modern financial system but why should the same be said of the toxic zombies who are blundering round the current financial landscape?

And how did these rotten banks get so big in the first place? It’s because governments and central banks prop them up. Bad banks rarely go out of business, they just lumber on, soaking up and destroying more wealth. Goldman Sachs and JP Morgan were bailed out five times in the 20 years before 2008.

The second lesson is that there really is no such thing as private property. In extremis the government considers itself entitled to any amount of your property it desires even if, as in the Cypriot case, it means revoking its own commitments to protect bank deposits.

But then this is the logical outcome of taxation. If you think that a shortage of government revenue can be solved by the government simply helping itself to someone else’s revenue you really can’t have a philosophical problem with this. If you believe in the 50p tax rate this is where you end up.

The third lesson is the limits of democracy. The Cypriot Prime Minister, Nicos Anastasiades, ran at the last election on a promise to protect depositors. Now he stands behind a lectern explaining why he cannot protect depositors. The greater a country’s debts the fewer are its options and in the euro, with no possibility of devaluation, this problem is exacerbated.

The Cypriots will probably feel much as the Irish or Portuguese did to have their economic policy decided by the Troika of the EU, the International Monetary Fund, and the European Central Bank. They may feel a touch like the Spanish or French did when they elected an anti-austerity candidate only to find that they get some measure of austerity anyway. They may end up feeling like the Greeks or Italians who skipped these intermediary steps and went straight to having their governments foisted upon them by the European Union.

This isn’t just a lesson for eurozone members. Labour currently lead in British opinion polls, appealing to soft-headed types who think that we can back to the big spending and even bigger borrowing days of Gordon Brown if only we tick the right box on a ballot slip. In the United States Barack Obama won re-election last year on the promise that the Chinese will continue to lend the US the money to live it up.

British and American voters might not have been slapped in the face with reality in the same way as the bottom half of the eurozone has thanks to their ability to trash their currencies, but it will come. Sooner or later they will be faced with the fact that a country cannot indefinitely live beyond its means and that voting for snake oil salesmen who tell you there is, is a sure fire recipe for disappointment.

The final lesson though, and perhaps the scariest, is that those in charge are no smarter than the average bloke in the street. It is difficult to find the words for the stupidity of trying to shore up Cypriot banks with a policy which will cause a run on those very same banks.

Cyprus offers a grim glimpse of a possible future for the wider western world: politicians who will sacrifice the people for banks, the expropriation of private property to pay for it, the diminishing options offered by the political process, and idiots in charge. Let’s hope they aren’t coming to a crisis near you.

This article originally appeared at The Commentator

UK’s downgrade: Only spending cuts left to try

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Draw an X on Britain’s economy and win a Mini Metro*

The central, simple fact of British economic and political life is its government’s deficit of £119 billion, about 8 percent of GDP. As I wrote recently, “That works out at about £326 million pounds added to Britain’s national debt every single day, £13.6 million every single hour, £226,000 every single minute, or £3,766 every single second of fiscal year 2012/2013.”

Yet, so far, we have been able to finance this growing mountain of debt incredibly cheaply. As this debt has multiplied, yields on British gilts, the interest rate the government pays to borrow, have been hitting record lows.

There are broadly two schools of thought on this paradox. One, roughly Keynesian, says that these low yields reflect a strong appetite for British government debt in preference to investment in business or spending on consumption. The outlook of investors is, on this view, so pessimistic that they want to stash their wealth in the safe haven of gilts and it is the British government’s job to spend these savings via deficits so as to avoid a collapse of aggregate demand.

Another school of thought is more sceptical. It sees the source of the strong demand for gilts as the Bank of England, which bought up £375 billion worth of them (about a third of the national debt) under its Quantitative Easing program. On this view such fiscal wriggle room comes at the expense of monetary manipulation which would, if continued, lead to even higher inflation.

As esoteric as this might sound it is a debate that matters for all of us. The British government is accumulating so much debt that even with record low interest rates the amount it spent on debt interest increased by 8.7 percent in 2011/2012 to £48.2 billion, more than it spends on defence. Just imagine what would happen to that figure if gilt yields were to rise.

This is not a problem say some, many, though not all, from the Keynesian tradition. The British government never has to worry about whether it can pay back debt denominated in sterling, they say, because it can just get the Bank of England to produce as much new sterling as it needs to cover it.

The idea of George Osborne and Mark Carney running the printing presses to pay their bills might fill you with worries about inflation. Nonsense, the ‘Keynesians’ reply, if anyone thought inflation would be a problem this would be reflected in rising gilt yields and, as we’ve seen, yields are low.

When the coalition came to power in 2010 it rejected the Keynesian thinking and applied four tools to reduce the deficit; First there would be some tax rises; second, some spending cuts (while talking a lot about ‘austerity’ and ‘tough choices’); third, monetary policy, it was tacitly agreed with the Bank of England, would remain exceptionally easy.

But, fourth, most of the heavy lifting would be done by economic growth. In March 2012 the Office of Budget Responsibility predicted that growth would be chugging along at 0.7 percent for 2012 and 2 percent in 2013. George Osborne claimed that low yields on British gilts reflect the bond markets faith in this strategy.

And yet Britain’s economy has stubbornly refused to grow. In December the OBR downgraded its growth forecasts to -0.1 percent for 2012 and 1.2 percent for 2013. This has blown a hole in the coalition’s economic strategy.

The deficit, originally slated for extinction by 2015, will, on revised predictions, be with us until at least 2017. It looks likely that borrowing for 2012/2013 could turn out to be even higher than it was in 2011/2012.

And since the New Year this news, coupled with the Bank of England’s persistent failure to deal with above target inflation, seems to be causing some investors to reconsider Britain’s credit worthiness. Sterling has slumped to its lowest level since summer 2010. In the last six months yields on 10-year index-linked gilts have risen from 2.4 percent to 3.2 percent. The only surprise about Moody’s downgrade on Friday was that they waited this long.

In their bid to stave off the nightmare scenario of soaring yields, policymakers increasingly find their hands tied. Taxes cannot be raised, the failure of the 50p tax rate shows that our heads are bumping up against the Laffer Curve already. Spending to boost growth, which some are, incredibly, still advocating, simply risks immediate disaster. And with inflation stubbornly stuck above target Osborne cannot expect much help from Mervyn King or Mark Carney.

This just leaves spending cuts which have barely been tried so far. Osborne and King have run out of short term fiscal and monetary sticking plasters. Radical surgery cannot be postponed. Just under a year ago I wrote that “The British economy is walking a tightrope. On the one hand it has deficits the size of Greece; on the other it has interest rates as low as Germany.” We might be about to find out which it is that goes.

This article originally appeared at The Commentator

* Not legally binding

Ground control to Major Krugman

Krugman

Paul Krugman was ill/The Day the Earth Stood Still…

One of the standard charges against believers in smaller government is that we are all fans of Ayn Rand and imagine ourselves as John Galt. I get this thrown at me despite the fact that I have never read a single thing Rand wrote.

Indeed, Paul Ryan got a roasting for his admiration of Rand from New York Times columnist Paul Krugman who called Rand “a very unserious, unreasonable novelist”. And maybe Krugman is right? Perhaps basing your political and economic philosophy on an old science fiction novel is the height of weirdness.

But hang on, what’s this? In an article for the Guardian titled ‘Asimov’s Foundation novels grounded my economics‘, Krugman writes, “I grew up wanting to be Hari Seldon, using my understanding of the mathematics of human behaviour to save civilisation.”

It’s worth reading that again and remembering that it’s from the same man who quotes the well-worn joke about Atlas Shrugged and Lord of the Rings; “the unrealistic fantasy world portrayed in one of those books can warp a young man’s character forever; the other book is about orcs.” If nothing else, at least Krugman’s suggestion that a fake alien invasion could rescue the economy makes a little more sense now.

For those who haven’t waded through Isaac Asimov’s several Foundation novels, Krugman explains:

In Foundation, we learn that a small group of mathematicians [including Krugman’s hero Hari Seldon] have developed ‘psychohistory’ (a) rigorous science of society. Applying that science to the all-powerful Galactic Empire in which they live, they discover that it is in fact in terminal decline, and that a 30,000-year era of barbarism will follow its fall. But they also discover that a carefully designed nudge can change that path…The novels follow the unfolding of that plan

There’s only one brief description of a space battle – and the true purpose of the battle, we learn, is not the defeat of an ultimately trivial enemy but the creation of a state of mind that serves the Plan

There are a series of moments in which the fate of the galaxy seems to hang in the balance… Each of these crises is met by the men of the hour, whose bravery and cunning seem to offer the only hope. Each time, the Foundation triumphs. But here’s the trick: after the fact, it becomes clear that bravery and cunning had nothing to do with it, because the Foundation was fated to win thanks to the laws of psychohistory. Each time, just to drive the point home, the image of Hari Seldon, recorded centuries before, appears in the Time Vault to explain to everyone what just happened.

You can see how Krugman pictures himself. He is one of a small band of Psychokeynesians who possess an insight, the IS/LM model, which enables them to predict the future of economies and gives them the tools – vast deficits and credit expansion – to steer them.

Anything that supports the Psychokeynesian analysis is evidence; anything that doesn’t is simply a ruse. And when the next bit of corroborating evidence floats along, Hari Krugman emerges from a Time Vault to say “told you so”.

But there’s a problem. It’s true that Krugman spotted the housing bubble in 2005 but then he had been calling for it in 2002. This might lead you to question Krugman’s omnipotence. Or you might want to wait for Hari Krugman to appear and explain how this crafty Knight’s Move is actually part of The Plan.

Hari Krugman celebrates his clairvoyance:

The IS-LM model (don’t ask) told us that under depression-type conditions like those we’re experiencing, some of the usual rules would cease to apply: trillion-dollar budget deficits wouldn’t drive up interest rates, huge increases in the money supply wouldn’t cause runaway inflation. Economists who took that model seriously back in, say, early 2009 were ridiculed and lambasted for making such counterintuitive assertions. But their predictions came true.

But considering that they also predicted that this mountain of debt and avalanche of new money would lead to economic recovery then no, their predictions didn’t come true.

Remember former Chair of the Council of Economic Advisors Christina Romer’s prediction that President Obama’s Keynesian stimulus would see American unemployment peak at 8 percent in late 2009 and fall to a little over 5 percent today? Remember that American unemployment actually peaked at over 10 percent in late 2009 and stands at 7.9 percent today?

This doesn’t worry Hari Krugman a bit. In the course of a spat with economist Robert P. Murphy, Krugman wrote:

[I]t’s really important to distinguish between fundamental predictions of a model and predictions that an economist happens to make that don’t really come from the model… [T]he unfortunate Romer-Bernstein prediction of a fairly rapid bounceback from recession reflected judgements about future private spending that had nothing much to do with Keynesian fundamentals, and therefore sheds no light on whether those fundamentals are correct. In short, some predictions matter more than others.

Quite so Paul. Apparently the predictions that come true matter; those that don’t, don’t.

In his Guardian piece Krugman excitedly writes of “the possibility of a rigorous, mathematical social science that understands society, can predict how it changes, and can be used to shape those changes.” Well, looking at the record it’s clear that Hari Krugman hasn’t found it.

Or maybe he has, and we mere mortals simply need to wait for his shimmering likeness to appear from the Time Vault and say “told you so.”

This article originally appeared at The Commentator

Is the Conservatives’ economic trump card warranted?

Let’s roll

It is part of Conservative Party mythology that it is repeatedly elected to clean up Labour’s economic messes. Indeed, 1931, 1951, 1979, and 2010 saw Labour bequeath the Conservatives a steaming pile to deal with. The only possible exception was 1970 when, following the calamitous sterling devaluation of 1967, Roy Jenkins wielded the austerity axe and got the British government’s finances into something approaching order.

Yet, truthfully, Britain has been plagued with economic mismanagement from both sides of the Commons and Labour could make much the same complaint of the Conservatives.

In 1929 Ramsay MacDonald’s Labour took over an economy wrecked by the attempt of Stanley Baldwin’s Conservative government to peg sterling to gold at pre-World War One parity. In both 1964 and 1974 Harold Wilson inherited the messy aftermath of pre-election booms engineered by Conservative chancellors Reg Maudling and Anthony Barber respectively. In 1987 the Conservatives inherited the messy aftermath of a pre-election boom they themselves engineered.

The Conservatives’ playing of their economic competence trump card always required a fair bit of bluff.

Recent developments suggest that George Osborne might think of delving into the same old bag of Conservative chancellors’ tricks as Maudling, Barber and Lawson. This government has nailed itself to the mast of the economy. Put simply, if the economy is growing healthily come 2015 the Conservatives will win. If not they are toast.

So far it’s not looking good. News that GDP contracted by 0.3 percent in the fourth quarter of 2013 meant that the UK economy continues to flat line. This is nothing to do with so called ‘austerity’ but the entirely predictable and unavoidable consequence of a massively indebted economy trying to reduce its indebtedness.

Either way, whether the dreaded ‘triple dip’ is avoided or not, it is looking increasingly unlikely that GDP growth in 2015 will be of the magnitude necessary to bring re-election.

So with 2015 approaching, Cameron and Osborne might come to look favourably on incoming Bank of England governor Mark Carney consummating his flirtation with Nominal GDP Targeting (NGDPT).

NGDPT starts from the observation that money supply targets proved a poor rudder for monetary policy due to problems of defining the money supply and changes in velocity, and inflation targeting proved unable to prevent asset price inflation. With NGDPT the idea is that the central bank sets a path for nominal GDP growth and manipulates the money supply sufficiently to achieve it.

So, if it’s decided that nominal GDP should grow by 5 percent a year, and nominal GDP looks to be increasing above that rate, the monetary authority engages in the sale of securities so as to suck money out of the economy to get nominal GDP growth back on target.

Likewise, if nominal GDP was growing at a rate below 5 percent, the situation we are currently in, the monetary authority engages in the purchase of securities so as to pump money into the economy and get nominal GDP growth back on target.

NGDPT and the market monetarists who propose it have faith in the power of monetary policy. Austrian liquidation or Keynesian liquidity traps can be blasted out of existence with a sufficient charge of base money. Or, as Ben Bernanke put it in one of market monetarism’s foundational statements:

“the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”

You can see the attraction of all this to Cameron and Osborne but will they be allowed to get away with it? The mass production of sterling dictated by NGDPT in our current predicament would, in theory, have the effect of reducing sterling’s value on the exchange markets which will make imports into Britain more expensive and Britain’s exports to everywhere else cheaper.

In practice this is exactly what has been happening. The massive expansion of its balance sheet by the Bank of England has seen sterling crash by 15 percent since 2008 which has propped up British exports (it is this avenue which wasn’t open to Ireland).

But if you devalue to boost your exports of goods and services, any increase in those exports is matched by a reduction in someone else’s. This is why the competitive devaluations of the 1930s, as countries scrambled for a share of diminishing world trade, became known as ‘beggar they neighbour’.

And it looks unlikely that our neighbours are going to let themselves be beggared by Britain’s NGDPT. The Federal Reserve continues to buy $85 billion of bonds each month. In Japan Shinzo Abe is pushing an inflation target of 2 percent in a bid to boost its flagging exports. This will come at the expense of German exports which might cause policymakers in Berlin look more kindly on François Hollande’s calls for a devaluation of the euro. The race is on to see who beggars who first.

This article originally appeared at The Commentator