Tag Archives: Austrian School

Muddy Waters – Central Banks, interest rates and the need for fiscal policy

9 September 2015

JR Max Wheel

 

Central Banks appear to be in a total quandry about interest rates with the result that we have had a ludicrous situation of near zero interest rates for seven years in the US and UK. Whilst ZIRP rates and QE were supposed to trigger a return to economic normality, they have not done so. The growth and employment statistics have improved in both countries, but something has broken in the present model. It is not just zero hours contracts and a drift to self-employment, growth in production is weak and uncertain in most advanced countries and much of this antedates the now evident problems in China and emerging markets. The fear factor is that the underlying economies are too weak to sustain a change in policy. That way we remain in thrall like an addict and that normalization is somehow not possible!

 

If you are an Austrian school economist you might take comfort from the fact that this all results from a massive misallocation of resources and hence no real surprise at all. Interest rates are and meant to be fundamental signals; that they are not thanks is in no small measure thanks to Central Bank policy manoeuvres and QE which goes a long way to explain the disconnect. Whilst few would argue that in the immediate aftermath of 2008 massive intervention and stimulus was needed, it has now become embedded; this is unhealthy. Any attempt to unwind QE or to raise rates has resulted in behaviour like the 2013 US “taper tantrum”, throwing markets into reverse gear. Persistent low-interest rates discourages savings and blows asset bubbles – the most obvious ones being the property and until very recently stock markets: meantime asset managers are seeking yield even via the re-generation of securitized assets based on inflated property prices. Have we learned nothing? It seems not.

 

The banks have also retreated substantially from traditional intermediation, itself a result of weakening incentives to lend and potentially damaging to balance sheets, this often leaves SME companies in difficulties, whilst institutional investors like pension funds face increasing mismatches between liabilities and weak returns on assets. None of this looks in the least bit helpful to a sustained return to a normalized economy.

 

The commentariat continues to assert that QE has not/will not bring forth inflation, but this is because central banks do not count asset price inflation, (typically equities and property) gains in their calculations: this is an error that needs addressing. It is not the dog that didn’t bark, rather the one that was ignored. The big news though has been oil prices and the price decline of any major factor input would logically contain inflation, but for how long? Monetary policies pursued by central banks are often accompanied by long lags, so maybe we should be looking out say 2 years before sensing signs. Clearly the oil price will have asymmetric effects on economies depending  on whether they are importers or exporters of energy.

 

The BIS latest annual report makes for required reading, for anyone mystified by the current malaise. It can be found here: www.bis.org/publ/arpdf/ar2015_ec.pdf It calculates that between Dec 2015 and May 2015 some US$ 2 trillion of LT sovereign debt is trading at negative yields. This is clearly unsustainable, yet at the same time sovereign debt levels continue to rise. A further problem is the erratic movements in currencies, the dollar and euro have moved quite violently in opposite directions, and the Chinese have engineered a decline in the value of the RMB. The global nature of the US $ in trade is a rapid transmission mechanism to other and especially emerging markets, not helped by the collapse of the commodities “super-cycle” .

What the BIS gets absolutely right is that monetary policy alone cannot succeed in bringing about a normalized economy, that much is blindingly obvious, there needs to be a proper role for fiscal policies and to avoid building up additional and unwelcome problems, we had better address the imbalances – a good starting point would be a move to begin the process of raising interest rates and reining in QE. The latter has only worked fitfully at best and production and investment will only recover when it is able to judge from an appropriate benchmark. Managing this will have to be communicated to markets a whole lot better than the shall we, shan’t we approach of the Fed or specious “forward guidance”  approach of the Bank of England.

 

Printing money – is QE a cure or another disease?

JR Max Wheel

11 September 2014

 

 

So Britain and the US are both growing again, whilst the Eurozone is struggling to escape the clutches of incipient deflation and stagnation, is this triumph for Anglo-Saxon pragmatic policy or is there something fishy about this “recovery”. Why are interest rates stuck at the zero-bound still in the UK and the EU? Why are asset prices, like UK houses so high? Why are US and UK stock markets at or near record levels implying the crisis is over actually telling us? If so, why after so much “austerity” over the past 4+ years is the stock of Government debt in the UK and US still rising? The economic press is still calling for the Eurozone to go even further and pace the Bundesbank, start its own programme of quantitative easing to kick-start growth. The neo-Keynesian approach is invariably about tackling deficient demand, pump-priming and spending as the correct policy response to recession and incipient deflation.

However, post crash fiscal policy has been stymied by the grotesque levels of debt and monetary policy has reached a limit: zero or negative real interest rates have exposed the limitations of Central Bank policy and buying up assets or long-term lending through money printing is “kicking the can down the road” towards a bigger and even less tractable crisis. Already both the US and UK Central Banks are having difficulty in executing an exit strategy from emergency stimulus. The Austrian School seems to have a reasonable set of answers to the above issues and to the true followers it even predicts the likely outcome of such policies. Austrian school economists are often derided as cranks, but their key distinction is a careful focus on the behaviour of the individual not on aggregates, on markets which can behave, if not rigged and in so doing they have revived a lot of carefully reasoned, if somewhat dense classical economic theory. They may not have all the answers but then a quick look at Keynes deliberate? misreading of Say’s Law ought to make mainstream thinkers stop and reconsider. Steven Kates 1998 study is a worthwhile starting point for aficionados.

 

If you have monetary stimulus by a Central Bank you are deliberately encouraging the banks to create more money as fractional reserve banks tend to do anyway, except of course when as over the last few years they choose not to do so! You seek to manipulate a price mechanism, the interest rate to reduce the impact of the downturn and unsurprisingly it ceases to reflect a real price. At zero rates why would you save at all?

Increasing the supply of money will reduce the interest rate, at which point borrowers could be expected to cash in, after all almost any project will appear to have a positive real rate of return, yet investment languishes. Standard Keynesian theory would explain that was due to an absence of demand and hence an unwillingness to invest in plant and machinery. Looked at from the Austrian dimension this is actually nonsense because it fails to take into account of money as a commodity. Saving is purely deferred consumption and it does not equal investment, my decision to save (out of income) is a genuine choice and initially reduces consumption. But in any properly functioning economy it also lowers the cost of debt and hence producers desire to invest in varying degrees of near term or far term projects. Investment for the Austrians is not a single concept; it embraces everything from R & D to purchase of or construction of new capacity. Unfortunately for Central Banks, increasing the money supply is not saving at all and its effect is to lower investment and to increase consumption, especially of essentials. What we have in a fiat money system is a constant see-saw between over-consumption and underinvestment. This arises precisely because of a continual misallocation of resources, do we recognize misallocation, you bet, look at housing, I could buy one or two more at cheap rates available, add to that a dash of capital flight from Greece and other indebted countries and we have exactly that phenomenon. Meanwhile productive enterprise like SMEs, cannot borrow because the banks will not lend or because the SMEs faced with such uncertainty choose not to indebt themselves. The effect of this is a temporary boom followed by a contraction, all due to wrong pricing signals.

 

Such signal errors are so frequent because Central Banks and/or Governments constantly manipulate the price of money in the mistaken belief that they can control it effectively. They amplify the oscillations between boom and bust. Remember the “Greenspan put” and the ultra low-interest rates post the dot.com crash and 9/11, property prices were a one way bet, at least until the crash and credit crunch of 2008, now the same cycle is repeating again. Classical economics focused a great deal on market clearing prices and consistency of supply and demand interactions, what is happening is that market clearing is not occurring; hence we have not only zombie banks but zombie companies, where in an attempt to “manage” the economy, banks are not clearing their balance sheets of dubiously valued assets, nor are chronically indebted companies going bust and as a result the patient cannot recover because the toxic stuff remains in the system. Why?

 

The theory again is that things are so bad that it risked a global implosion and that the air had to be let out of the system slowly. This sounds fair enough as an expedient, but how long does one give a bank or company to recognize the level of impairment? We know to our cost that the alternative was collapse and in such case the State felt it had no choice but to intervene, in doing so we had better not lose sight of the distortions and malinvestments that have happened already and start the process of correction by trying to bring fiscal and monetary policy into some balance. UK and US debt to GDP levels are still rising, mainly because the spending cuts and tax rises necessary to bring them into balance have been out of kilter not merely during the bust years, but for many cycles before that. The situation of the deeply indebted Eurozone is simply put, desperate; the Euro is reminiscent of the gold standard with its rigid insistence on levels of debt and deficit that cannot be managed thanks to the currency straightjacket. Central Banks are drifting into the same mindset as the Fed and BOE, barring Bundesbank or the German Constitutional Court overruling it. Unfortunately the effects will be the same, either a breakup of the currency area or adjustment as is occurring as a result of lost wages, output and unemployment. Given the latent nationalist sentiments still present in Europe, the chances of a sensible adjustment or an internal agreement amongst its members for commonality of debt and management look slim. The Austrian School points out some timely reminders which even in a world of floating exchange rates matter as much as ever.