Archive of September, 2012
Published on September 30th 2012
Click here to read this article in pdf format: September 30 2012 This week, we want to follow up on some thoughts from our last two letters, where we deduce the impact of the policies undertaken by both the Fed and the European Central Bank (ECB). As well, we provide a few comments on an ongoing debate: [...]
Click here to read this article in pdf format: September 30 2012
This week, we want to follow up on some thoughts from our last two letters, where we deduce the impact of the policies undertaken by both the Fed and the European Central Bank (ECB). As well, we provide a few comments on an ongoing debate: Will we ever experience hyperinflation?
Last week, we came up with three important conclusions:
-Conclusion No.1: The ECB backstop generates capital gains for the banks of the Euro zone and transforms risky sovereign debt into a carry product (i.e. an asset whose price is mostly driven by the interest it pays, rather than its risk of default, because this risk has been removed by the central bank)
This is what we wrote on Sept. 10th: “… Until now, selling distressed sovereign bonds to the ECB to avoid losses was a positive thing for the EU banks. However, going forward, as the backstop of the ECB is in place and the expectation of default is removed from the front end (i.e. 1 to 3 years), exchanging carry (i.e. interest income) for cash will be a losing proposition. The EU banks will demand that the euros be sterilized, to receive ECB debt in exchange at an acceptable interest rate…”
Where do we stand?
Everyone expects Spainto request a bailout and accept the conditions that would allow the ECB to buy their bonds. In the meantime, someone took the time to measure the impact of the ECB backstops over the past year and came up with a number: EUR9BN in capital gains. On Sep. 20th, the European Banks research team from Barclays published a note titled “Liability management-understanding the rationale”. Barclays estimates that in their liability management transactions on EUR200BN of unsecured debt, European Banks have gained EUR9BN, from lower interest expenses. This of course, came courtesy of the Fed first (remember the EURUSD swaps put in place at the end of 2011?) and the ECB later, with 3-year long-term refinancing operations. The chart below (source: Bloomberg) shows the iShares MSCI Europe Financial Sector Index Fund (ticker: EUFN). The rally that began at the end of July with the speculation on the future actions of the ECB has peaked, awaiting further news.
If we are correct with this conclusion, removing (i.e. buying) the assets backstopped by the ECB (i.e. sovereign debt) from the banks in the secondary market via the OMT (Outright Monetary Transactions), will be expensive to the banks. Why? Because these banks, which after so much misery, end up finding out that the assets they were holding are no longer in risk of default and provide a nice interest, will now have to hand these assets over to the ECB. It would be ok to do this every once in a while. However, the fiscal deficits of the EU countries do not happen every once in a while, but every minute and they keep on growing! Should the ECB seek to make the OMT sustainable as the fiscal deficits of the Euro zone periphery continue, the banks will have to be appropriately compensated. The risk remains then, that at a future, much later date, the ECB faces a net interest loss (between the interest it receives for their sovereign debt holdings and the one it pays to the banks). Under this scenario, the only alternative left will be to monetize that deficit all the way to hyperinflation. But in the meantime, let’s move to…
-Conclusion No.2: The ECB backstop will set a floor to yields
This is what we wrote: “…As the ECB backstops short-term sovereign debt, two results will emerge in the sovereign risk space: First, the market will discover the implicit yield cap and through rational expectations, that yield cap –having been validated by the ECB- will become the floor for sovereign risk within the Euro zone. The key assumption here is that primary fiscal deficits persist across the Euro zone…”
Where do we stand?
It is too early to say anything, as the ECB has not purchased anything yet and the potential secession ofCataloniaand recent protests have delayed (if we are correct) the establishment of a floor.
-Conclusion No.3: The ECB backstop will first push rates within the Euro zone to a convergence (periphery will have lower rates, core will see higher rates). And secondly, will force US rates to converge to the Euro zone rate, if the Euro zone survives the first convergence.
This is what we wrote: “…within that maturity range selected by the ECB for its secondary market purchases (up to three years), the market will arbitrage between the rates of core Europe and its periphery, converging into a single Euro zone yield target….” and “…If the () trend proves true, there would be no reason to believe that the short-term US sovereign yield should keep as low as it is vs. the equivalent EU sovereign yield. For all practical purposes, in the segment of up-to-3 years, the European Central Bank would set the value of the world’s risk-free rate! The big assumption here is of course, that the first trend, above, holds true. Only then, the arbitrage between the US sovereign yield and the EU sovereign yield could be triggered…”
Where do we stand?
Again, with the political struggle between the periphery and coreEuropeand (within the periphery) between the people and their appointed leaders, this convergence has been temporarily interrupted
The charts below (source: Bloomberg) show the convergence that started at the end of July, in 2-yr rates (but can also be observed in 10-yrs, not shown here). In the second chart, we show theUS30-yr yield, which suggests that a bearish trend is building (i.e. higher yields), consistent with our conclusion. Time will decide….
All this would indicate that the key to what’s coming next is simply political, which brings us back to one of the first letters of the year, titled “An analytic framework for 2012”, where we precisely showed the tragic (and spiraling) circularity of enhanced deficits, adjustments programs and coercion by the EU council, backstopped by the actions of the ECB. We reproduce a chart from that letter, below.
As the problem spirals, the actions of the ECB must strengthen: If at the beginning of the year, 3-yr lines of secured lending bought time, by September, “conditional” but unlimited bond purchases were now required. A few months from now, that conditionality will surely be merely a simple protocol. In every turn of this circularity, as unemployment, prices and fiscal deficits grow, so does social unrest. Social unrest therefore is the determinant in this overdetermined system.
To those familiar with Algebra, we suggest that the Ponzi scheme we live in is actually an overdetermined system, because there is no solution that will simultaneously cover all the financial and non-financial imbalances of practically any currency zone on the planet. Precisely this limitation is the driver of the many growing confrontations we see: In the Middle East, in the South China Sea, in Europe and soon too, in North America. That these tensions further develop into full-fledged war is not a tail risk. The tail risk is indeed the reverse: The tail risk is that these confrontations do not further develop into wars, given the overdetermination of the system!
Some final comments on hyperinflation
We have noticed of late that there’s a debate on whether or not the US dollar zone will end in hyperinflation and whether or not the world can again embrace the gold standard. We will not discuss the latter today. With the regards to the former, we think it is still early to talk about hyperinflation. We don’t know when it will take place. All we can guarantee is that there are certain conditions necessary to see inflation spike up and morph into hyperinflation, and such conditions have not crystallized yet. However, there is a high risk at this stage in the game that they do, and we briefly examined that risk for the Euro zone, on September 10th.
Money has two purposes: to store value and to transact. There is however another use of money, which is a derivative of the storage-of-value use. The use of money to repay debt.
Those who demand money to repay debts do not do so to store value or to transact. But as long as there are debts outstanding, there will be a demand for currency to repay that credit. This means that, in order to see such demand diminish, we need to see defaults first, which will along eliminate credit extended in fiat, debased currency. As this process unfolds, the banking system goes bankrupt, is nationalized, and credit is directed towards and centrally managed by the government. This may easily takes years, but it is taking place in the Euro zone right now. The repo market and futures markets die along and central banks end up becoming counterparties in cross currency and interest rate swaps. Once this stage is reached, the private sector is out of the system and fiat money is only demanded to transact. Here’s when the velocity of circulation of money starts to rise exponentially.
As these successive steps are passed, slowly, central banks suffer structural changes in their balance sheets. For instance, let’s take the example of Argentina. At one point, after many devaluations of the peso, the central bank by 1982 had become the main USD swap counterparty for corporate credit. However, to avoid a wave of bankruptcies after the June 1982 devaluation (after the Falklands War), it refinanced USD denominated debt at a 23% lower exchange rate, and in the process sold FX insurance at a cost (for the corporations entering the transaction) of 5%/month, when the inflation rate was 7.9%/month. This was going to be a huge burden that accelerated the deficit of the central bank, which of course was monetized (refer here), unleashing the first high inflation of 1985.
The parallel with the situation in the Euro zone is self-evident: If the ECB starts buying sovereign bonds as fiscal deficits continue, the recent transitory appreciation of the Euro (to $1.3150 was mainly driven by short covering and the capital gains in financials, mentioned above) is not sustainable. In the long run, the intervention of the ECB would only devalue the Euro, creating a currency mismatch for those companies in the Euro zone that issued USD denominated debt. Thanks to the FX swaps by the Fed and the crowding out of the ECB in favour printing Euros for government debt, these companies are more numerous than they would have been. Therefore, the ingredient for an hyperinflationary process is already present, but we’re not quite there yet…
In the end, by the time the use of fiat money is reduced to its transactional role, central banks run huge deficits, called quasi-fiscal. They have backstopped government debt, money markets, repo markets, future markets and derivatives markets. The interest they pay on their liabilities to sterilize their actions always ends being higher than the one they receive for their assets. And it makes perfect sense: Otherwise, nobody would have asked these central banks to be their backstop! An additional source of fuel for this fire is the so called Olivera effect (after Julio H. Olivera). This is another ingredient to turn a mild inflationary process into hyperinflation. This effect refers to the fact that when inflation reaches a relevant number, it becomes profitable for taxpayers to delay their tax filings, which reduces the tax burden. Governments are thus forced print more money to cover the loss in real revenue they suffer.
The fact that we are still in the early chapters of the story just narrated does not allow us to state that hyperinflation is only a tail risk. The tail risk is (again) the reverse: That all the steps central banks took since 2008 won’t lead to spiraling quasi-fiscal deficits.
central banks,ECB,Fed,hyperinflation,Italy,overdetermined systems,Ponzi,quasi-fiscal deficits,rates convergence,social unrest,Spain,uses of money
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Published on September 16th 2012
…Perhaps, we will no longer be able to talk about “the” risk-free rate of interest, when we refer to the US sovereign yield…
Click here to read this article in pdf format: September 16 2012
Last week, after the German Bundesverfassungsgericht decided not deactivate the debt monetization program announced by Mr. Draghi a week earlier, the Italian government sold EUR4BN in 4.75% 2014 notes at an average yield of 2.75%. This compares with 4.65% obtained at a sale of the securities on July 13th.
With the European Central Bank backstopping short-term EU sovereign debt (as long as the issuer submits to a fiscal adjustment program), we should see two trends taking place:
The first one, mentioned in our last letter, is that the market should arbitrage between the rates of core Europe and its periphery, converging into a single Euro zone target yield. The Italian auction mentioned above, together with continuous weakness in Germany’s sovereign debt, the movement of capital out of the US dollar to the Euro zone (lifting the Euro to $1.31) and the rally in EU banks, would seem to indicate that this convergence is slowly materializing. The critical piece here, the one that will really nail this coffin, is the return of deposits transferred to the core of the Euro zone, back to the periphery that originated them. This is what’s behind the ongoing negotiations towards a banking union. Ironically, if the banking union was successful, making deposits return to banks of the periphery, it would make it easier for the Germans to leave the Euro zone, because the current imbalances of the Target 2 system would disappear, radically lowering the cost of the exit!
The second trend, the one we missed last week, consists in that –perhaps- we will no longer be able to talk about “the” risk-free rate of interest, when we refer to the US sovereign yield. If the first trend proves true, there would be no reason to believe that the short-term US sovereign yield should keep as low as it is vs. the equivalent EU sovereign yield. For all practical purposes, in the segment of up-to-3 years, the European Central Bank would set the value of the world’s risk-free rate! The big assumption here is of course, that the first trend, above, holds true. Only then, the arbitrage between the US sovereign yield and the EU sovereign yield could be triggered.
What would the levels be, for the up-to-3 year yields? As we know, the European Central Bank will not pre-commit to a yield target. Of course, they don’t want to be challenged, because there is only so much they can sterilize before they start suffering a net interest loss, as we explained last week. But from a dynamic perspective, what counts is not the level, but the driver: In the long run, as the sterilization fails (also explained in our last letter and first proposed back on May 13th, 2010), the short-term “risk-free” rate of interest would be driven by the consolidated fiscal deficit of the Euro zone.
Having said this, the remaining question is what determines the value of the long-term risk-free rate of interest. The Fed, in our view, although not announced last Thursday, will eventually continue to purchase long-term US sovereign debt. Effectively in the beginning, the Fed would set the value of the risk-free yield curve, past the three-year point. When things get out of control and inflation expectations for the US dollar take the lead (in a few years), the fiscal deficit of the US should determine the dynamics of the long-end of the curve….Does that make sense? No! (At least not, if you are not Keynesian) Because if “things get out of control”, we must say good bye to long-term interest rates altogether. That market will evaporate, and the US will only be able to sell short-term debt. At that point, if the Euro zone still exists as we know it, the battle for the ownership of the risk free rate will have been won by the European Central Bank, by definition. Why? Because by definition, if the Euro zone still exists, it is because they succeeded in stabilizing their fiscal problems. Otherwise, the shortening of the term horizon for the US sovereign yield should continue contracting, until hyperinflation completely wipes it out.
With these thoughts in mind, one cannot but wonder at the idiocy blindness of those who sustain that both the European and the US central banks removed “tail risks” in the last days, with their new measures. To start, the whole idea that a tail risk exists is simply a fallacy of Keynesian economics. It assumes there is a universe of possible outcomes and, as if humans acted driven by animal spirits, randomly, each one of them has a likelihood of occurring. In all honesty….what else can occur if a central bank prints money to generate a bubble? Why would the bursting of the bubble be called a tail risk, rather than the logical outcome? Why, if that was tried in 2001 in the US, resulting in the crisis of 2008…why would it be any different now, when there is an explicit announcement to print billions per month? Why?
The splitting of the risk-free interest rates, in short and long terms, and the “moving” of the short-term to the Euro zone somehow sadly reminds us of the division of the Roman Empire, between West and East, when the capital moved to Constantinople. Is this ominous?
Finally, as inflation expectations, post the ECB/Fed announcements pick up, the rally in credit (i.e. IG18 credit default swaps index reaching 83bps) is telling us that banks outside the Euro zone or the USD zone -banks which did not benefit so much from a “portfolio” effect-, will have a hard time remaining profitable, unless they take additional risks, or they get themselves the same subsidy that the ECB and the Fed give to their zombie banks. This suggests to us that the Canadian dollar should not rise significantly above the US dollar.
banking union,banks,Canadian dollar,Draghi,Euro-zone,European Central Bank,Federal Reserve,IG18,portfolio effect,Risk-free rate,tail risk,Target 2
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Published on September 10th 2012
Click here to read this article in pdf format: September 10 2012 We finally heard the intentions of Mr. Draghi, President of the European Central Bank (“ECB”). We only need to know the conditions Germany’s Verfassungsgericht will impose on September 12th. We believe they will be relevant. On Thursday, Draghi told us he intends (1) [...]
Click here to read this article in pdf format: September 10 2012
We finally heard the intentions of Mr. Draghi, President of the European Central Bank (“ECB”). We only need to know the conditions Germany’s Verfassungsgericht will impose on September 12th. We believe they will be relevant.
On Thursday, Draghi told us he intends (1) to purchase sovereign debt in the secondary market, (2) that before he does so, the issuing country must submit to certain conditions within a fiscal adjustment program, (3) that when he finally buys the debt, he will buy any debt (new or outstanding) with a maturity lower than three years, (4) that after buying it, he will sterilize the transaction, (5) that the collateral pledged so far for liquidity lines will not be subject to minimum credit ratings any longer, (6) that the ECB will accept to rank pari-passu with other creditors going forward, and (7) that the Securities Market Programme will be terminated, with the purchased debt held until maturity. According to Mr. Draghi (but not toGermany), buying debt with a tenor lower than three years does not constitute government financing. The number three, it seems, is a magical number.
We will mince no words: Mr. Draghi has opened the door to hyperinflation. There will probably not be hyperinflation because Germanywould leave the Euro zone first, but the door is open and we will explain why. To avoid this outcome, assuming that in this context the Eurozone will continue to show fiscal deficits, we will also show that it is critical that the Fed does not raise interest rates. This can only be extremely bullish of precious metals and commodities in the long run. In the short-run, we will have to face the usual manipulations in the precious metals markets and everyone will seek to front run the European Central Bank, playing the sovereign yield curve and being long banks’ stocks. If in the short-run, the ECB is the lender of last resort, in the long run, it may become the borrower of first resort!
The policy of the ECB resembles that which the central bank of Argentinaadopted in April of 1977, which included sterilization via issuance of debt. This policy would result in the first episode of high inflation eight years later, in 1985 and generalized hyperinflation in 1989. Indeed, Argentina’s hyperinflation was not caused by the primary fiscal deficit of the government, but by the quasi-fiscal deficit suffered by its central bank. We will not elaborate on a comparison today, but will simply show how the Euro zone can end up in the same situation. To those interested in Argentina as a case study, we recommend this link (refer section II.2 “Cuasifiscal Expenditures”, page 13 of the document)
Mechanics of the sterilization
In the chart below, we describe what we think Draghi has in mind, when he refers to sterilization. In stage 1, the governments whose debt will be bought by the ECB (EU governments) issue their bonds (sov bonds, a liability), which is purchased by the Euro zone banks (EU banks). These bonds will be an asset to the banks, which will in exchange create deposits for the governments (sov deposits, a liability to the banks and an asset to the EU governments).
In stage 2, the EU banks sell the sov bonds to the European Central Bank. The ECB buys them issuing Euros, which become an asset of the EU banks. The EU banks have thus seen a change in the composition of their assets: They exchanged interest producing sov bonds for cash. Until now, selling distressed sov bonds to the ECB to avoid losses was a positive thing for the EU banks. However, going forward, as the backstop of the ECB is in place and the expectation of default is removed from the front end (i.e. 1 to 3 years), exchanging carry (i.e. interest income) for cash will be a losing proposition. The EU banks will demand that the euros be sterilized, to receive ECB debt in exchange at an acceptable interest rate.
The sterilization is seen in stage 3: The ECB issues debt, which the EU banks purchase with the Euros they had received in exchange of their sov bonds. Currently, the ECB is issuing debt with a 7-day maturity. Should the situation worsen (as described further below), this will be a disadvantage that could make high inflation easier to set in.
We can see the result of the whole exercise in stage 4: The ECB is left with sovereign bonds, with a maturity of up to three years, as an asset financed by its 7-day debt. The EU banks own the ECB 7-day debt, and need a positive net interest income to profit from the deposits (sov deposits and also private deposits) that support that ECB debt (their asset).
What could go wrong
As can be observed in the chart above, at the end of the sterilization, the ECB is left with two assets which will generate a net interest income: Interest receivable from sov bonds – Interest payable on ECB debt.
If the interest payable on the ECB debt was higher than that received from the sov bonds, the European Central Bank would have a net interest loss, which could only cover by printing more Euros. This would be a spiraling circularity where the net interest loss forces the ECB to print euros that need to be sterilized, issuing more debt and exponentially increasing the net interest loss. This perverse dynamic of a net interest loss born out of sterilization affected the central bank of Argentina, although for different reasons, beginning in 1977. It generated a substantial quasi-fiscal deficit which would later morph into hyperinflation in 1989. Without entering into further details about the Argentine experience, we must however ask ourselves under what conditions could the Euro zone befall to such dynamic. That is the purpose of this article.
As the ECB backstops short-term sovereign debt, two results will emerge in the sovereign risk space: First, the market will discover the implicit yield cap and through rational expectations, that yield cap –having been validated by the ECB- will become the floor for sovereign risk within the Euro zone. The key assumption here is that primary fiscal deficits persist across the Euro zone. Secondly, within that maturity range selected by the ECB for its secondary market purchases (up to three years), the market will arbitrage between the rates of core Europe and its periphery, converging into a single Euro zone yield target.
Now, for simplicity, let’s say that the discovered yield cap, which going forward will be a floor, is 4%. This 4% will be a risk-free rate, which in a world of ultra-low interest rates, will look very tempting. The problem is that the risk-free condition holds as long as the bond is bought by the European Central Bank. In the zombie banking system of the Euro zone, where the profitability of banks has been destroyed, banks will not be able to survive if they pass this risk-free yield on to the central bank, unless….unless the central bank compensates them for that lost yield with a “reasonable” rate on the debt it issues during the sterilization. And no, we are not thinking of 75bps!
What is then a reasonable rate? Well, a rate that leaves a profit after paying for deposits. Yes, we know that that is not a problem today, in the context of zero interest rates. But if the floor sovereign rate for the whole Euro zone converged to a relatively significant positive number, banks would only be able to attract the billions in deposits they lost –which are needed in the first place to buy the sovereign bonds in the primary market- at rates higher than the sovereign floor rate received by the ECB. Why higher? Firstly, because unlike the holders of sovereign bonds, depositors do not have the explicit backstop of the European Central Bank on their deposits, which are leveraged multiple times. The liquidity lines provided by the European Central Bank may disappear at a moment’s notice, which is why money left the periphery to the core of the EU zone. An alternative to the European Central Bank, if the deposits from the private sector did not stop falling, would be to keep lending to the EU banks. But this is not feasible in the long run, given the shortage of available collateral. Secondly, as the yield cap becomes the convergence floor, the market’s inflation expectations crystallize into a meaningful expected inflation rate.
Therefore, should fiscal deficits persist in the Euro zone, it is conceivable that as these so-called Outright Monetary Transactions (OMT) develop, we may eventually see net interest losses run by the European Central Bank. It is clear that a net interest loss would be expansionary of the monetary base, because in order to pay for that interest loss, the central bank would have to print more euros, which would need to be sterilized, increasing its debt and interest losses exponentially. It should be noted that once the market’s expectations adapt to this rate of growth in the supply of money, a net interest gain by the central bank, for whatever reason, would be seen contracting the supply of money and therefore, deflationary!
Having said this, we think that the time frame for such a result would be considerable. It would take years for this to unfold and it is very unlikely that it ends in hyperinflation because Germany and the rest of core Europe would leave the Euro zone before it gets there. We present another chart below, to visualize our thoughts:
If we were to see a process like the one just described, it would be very hard for the Fed to engage in an exit strategy that would lift interest rates. If it did, the interest rates both the European Central Bank and the EU banks would have to pay on its debt and to attract deposits, respectively, would increase meaningfully. The contagion risk to the USD zone would be very significant and the Fed would have to “couple” its balance sheet to that of the Euro zone via currency swaps. The segmentation seen today in the Eurodollar market, with Libor being a completely useless benchmark, would only accentuate.
This thesis, if proved correct, is bullish of EU banks in the short-to-medium run (before the private sector collapses in a wave of defaults due to higher interest rates, beginning with the sovereign risk-free floor validated by the ECB last Thursday) and very bullish of precious metals and commodities in the long run.
1977,Argentina,Draghi,EFSF,European Central Bank,exit strategy,Fed,hyperinflation,inflation,OMT,Outright Monetary Transactions,Securities Market Program,sterilization,Verfassungsgericht,zero-interest rate policy,ZIRP
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Published on September 2nd 2012
Today, we want to examine the origins of the idea that ultra-low rates of interest can exist, how this idea came about, why it was flawed and how it leads to an informal economic system.
Click here to read this article in pdf format: September 2 2012
Over the past months (and particularly in the last weeks), we have increasingly read negative comments on the ongoing zero-interest rate policy (ZIRP) and in some instances, negative-interest rate policy (NIRP). We find these comments were anecdotal. Not superfluous but anecdotal. They touch on the influence of ZIRP on savings, on the profitability of banks, on fiscal policies, on debt, etc. Perhaps, the anecdotal format is explained by an inclination towards induction rather than deduction and perhaps our discomfort with this is driven by our familiarity with the Austrian method.
Today, we want to examine the origins of the idea that ultra-low rates of interest can exist, how this idea came about, why it was flawed and how it leads to an informal economic system. It was a fallacy based on misunderstanding of the rate of interest and human action.
Origins of the idea that ultra-low rates of interest can exist
From our very limited knowledge in the history of economic thought, we are inclined to believe that the topic of zero interest rates was first introduced by John M. Keynes, when he contemplated the possibility of the existence of a liquidity trap (chapter 13), in his so-called “General Theory of Employment, Interest and Money”. Keynes did not see this as the result of explicit policy but as an aberration of market participants, driven by their animal spirits, which define their liquidity preferences.
Keynes’ concepts were popularized in visual format by Sir John Hicks , when he came up with the famous IS-LM model. In the graph below, following this model, we can see that the equilibrium rate of interest is negative. The “S” line is an indifference curve for the aggregate supply of loanable funds. In the axes, we see a benchmark rate of interest (r, vertical ax) and income (horizontal). The “I” line is the indifference curve for investment demand. As the rate of interest falls or income rises, the demand for investment goods increases. If the rate of interest falls too, the aggregate supply of loanable funds decreases.
The chart also shows that there is an income level that would get us to a desired level of employment (Yp). Logically, it would seem that either a higher level of investment or a lower level of savings is required, to “bridge the income gap”.
In our view, the whole approach of thinking in terms of indifference curves is ridiculous. Nobody is ever indifferent. Everybody is always making a decision. Having said that, let’s remember that Keynes challenged the notion that both investments and savings were sensitive to the rate of interest. For Keynes, investment demand was mainly a function of income and secondarily
of the rate of interest. In the same fashion, savings were also driven by income. To Keynesians, savings are by-product of consumption, that part of the income we did not consume at the end of a period:
Investment = f (Y)
Savings = Income – Consumption, but as consumption is a function of income: Savings = Y – C (Y)
Why the idea was flawed
It should now be clear that there is an inconsistency in simultaneously believing that investment demand and savings are mainly driven by income but that it is necessary to lower the interest rate to boost investment, as the Fed does…and the Fed is Keynesian! Keynes also thought that fiscal policy was necessary to boost investment demand, so that the intersection between the I curve and the S curve takes place at a positive rate of interest. By the same token, Keynes must have not considered increasing savings to bridge the gap (i.e. an increase in the supply of loanable funds), because that would have meant a reduction in income! In his own words (from Chapter 13): “and whilst an increase in the volume of investment may be expected, ceteris paribus, to increase employment, this may not happen if the propensity to consume is falling off…(= savings increase)”
According to Professor Jesús Huerta de Soto, Keynes lacked a theory of capital, which cornered him into an horrible circularity:
On one hand, Keynes thought that the rate of interest was determined by the liquidity preference of the public (as in the chart above, because the liquidity preference determines the supply of loanable funds). In his own words: “…whilst an increase in the quantity of money may be expected, ceteris paribus, to reduce the rate of interest, this will not happen if the liquidity-preferences of the public are increasing more than the quantity of money…”
On the other hand, Prof. Huerta de Soto rightly notes, if you asked Keynes what determines the liquidity preference of the public…he will answer: The rate of interest does! We think (we are not PhDs in Economics or historians of economic thought) the evidence of what Prof. Huerta de Soto points is found on Chapter 15:
“…In normal circumstances the amount of money required to satisfy the transactions-motive and the precautionary-motive is mainly a resultant of the general activity of the economic system and of the level of money-income(…); whereas experience indicates that the aggregate demand for money to satisfy the speculative-motive usually shows a continuous response to gradual changes in the rate of interest, i.e. there is a continuous curve relating changes in the demand for money to satisfy the speculative motive and changes in the rate of interest (…).. Indeed, if this were not so, “open market operations” would be impracticable…”
In summary, Keynes thought that the liquidity preference of the public determined the rate of interest, and that the rate of interest was determined by the liquidity preference of the public (i.e. the aggregate demand for money to satisfy the speculative-motive). Keynes oversaw that the rate of interest is nothing else but an inter-temporal rate of exchange, between present and future consumption.
Misunderstanding of the rate of interest and human action
This inter-temporal exchange rate is very relevant and we dare to say, instinctive. The fact that we understand it at its most basic level, which is the awareness of our mortality, is precisely what made us evolve into human beings. When time has a price, when the inter-temporal rate of exchange is relevant, when the rate of interest is positive and important, men tend to be more desperate than otherwise and they create, they take risks, they look for more efficient ways to produce what they need, they become more productive…they grow!
This basic instinct is so strong that even if a central bank determines that the rate of interest should be zero, humans, aware of their life cycle, will refrain from consuming today in exchange for consuming more tomorrow. Before you disagree with us on this, think about the following: The curve “S” above is for loanable funds, not for savings! If the interest earned from these funds is not “enough”, that will not prevent people from saving. People will just not invest their savings in loanable funds, in securitizable assets (which is in line with Hernando De Soto’s works on informal economies) . They will save in non-financial assets and if the public markets, manipulated by central banks don’t acknowledge that inter-temporal exchange rate, the public assets will be privatized.
Thus, we should not be surprised if, under zero-interest-rate policies in the developed world, we witness a growing trend in corporate leverage, with vertical integration, share buybacks and private equity funds taking public companies private. It would be only natural. We warned of this back on May 7th.
Another way of examining this is the following: The zero interest rate indicates that time is free. And as anything that is free is wasted, time will also be wasted. Therefore, the equity of a firm, which is the equivalent of a call option on the assets of a firm, will become very cheap in terms of the debt of the company, as the debt does not grow with time because no interest is due on it (this only holds true, if the company is profitable, as a friend pointed to us). Arbitraging for this distortion in relative value, lifts the price of stocks, and to make this process sustainable in time, central banks need to keep throwing liquidity to the system, until they no longer can….
Now, if savings leave the matrix “system”, we will see in the long run an important de-leveraging, as the credit multiplier becomes less and less powerful. With more assets outside the system, the pricing mechanism becomes less efficient, since there are fewer signals to market participants. Capital markets disappear, specialization decreases, economies of scale are threatened. With more assets outside the system, productivity plunges and with it, unemployment skyrockets in rigid (unionized) labour markets (characteristic of developed economies). As developed economies, with high stock of capital, rely on economies of scale, this fundamental transformation has enormous damaging potential.
The flight from the system brings more financial repression as a logic reaction. In those nations with established
coercive savings plans pension plans , politicians set their eyes on these virgin pools of capital, to force a bid to their liabilities (i.e. sovereign debt). This process eventually spirals, since the financial repression aimed to prevent market participants from protecting their inter-temporal exchange decisions, grows exponentially and brings about precisely the opposite outcome: A complete defence of savings, now fully thrown into an informal economy.
At this point, something has to be said about wealth transfer, because not every market participant is able to re-allocate his/her investments and re-direct his/her savings from the system to the informal world. Those who cannot save enough, those employed in firms and trapped in pension plans, will see their assets evaporate. If the harm is too significant, it may even be a cause for them to leave their condition as employees and become self-employed. This is the landmark of underdeveloped economies: A huge mass of self-employed, undercapitalized citizens in an informal system. The informality prevents them from accessing credit, which enhances their undercapitalization.
Finally, we ask that you note one last thing: As productivity, employment and production decrease, even a steady and low rate of inflation has the potential to morph into hyperinflation. It’s only a matter of time, and it occurs once the capital markets (including the futures markets) vanish, when the only reason to demand currency is for transactional purposes, when the demand of currency to settle debts is only marginal.
capital markets,consumption,debt,equity,Fed,financial repression,Hernando De Soto,Huerta de Soto,Human Action,informal economies,inter-temporal rate of exchange,investments,John Maynard Keynes,liquidity preference,loanable funds,negative interest rates,NIRP,savings,Sir John Hicks,zero interest rates,ZIRP
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