See no evil, speak no evil…

Alasdair Macleod
Friday, September 1st

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

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

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

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

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

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

The Fed is clueless about the credit cycle

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Eurozone is running into deep monetary trouble

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

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

The German economy has been growing consistently for some time, and there are now signs that credit expansion is accelerating the growth of Germany’s imports at a faster rate than the growth of her exports. Domestic credit expansion leaking into imports tells central bankers that monetary policy is far too loose, particularly for an economy traditionally driven by savings. The Bundesbank, if it was still in charge, would have already raised interest rates far higher to curb credit demand.

Trying to impose a monetary policy which is suitable for a dynamic economy such as Germany’s, while the Mediterranean countries are still in the mire, is admittedly a huge problem for the ECB. There is no way the circle can be squared. Furthermore, the ECB is distorting bond yields so much, that the signal offered by monetary flows between bank ownership of government debt and lending to non-financials becomes impossible to detect, except well after the event when the statistics become available.

But overall, there are signs that the Eurozone’s non-financial sector is drawing on more credit. And unlike the US economy, the Eurozone is an increasing beneficiary of Chinese-driven trans-Asian expansion. Yet, the ECB is still issuing money to the banks at the rate of €60bn per month, with deposit rates at a ridiculous -0.4% for bank deposits and a base rate of 0%.

Mr Draghi claimed in his Jackson Hole speech the Eurozone is not as advanced in the business cycle as the US. He is horribly, and potentially catastrophically wrong in this assessment. The EU is not only well into the recovery phase of the ECB-driven credit cycle, but it has the pig-on-pork of a rapidly expanding Asian continent on its doorstep as well. Very soon, and it will be not long in coming, the ECB is going to have to slam on the monetary brakes very hard.

The ECB probably deludes itself the process can be managed. Not only is it badly wrong-footed, but the euro has already risen 14% against the dollar this year. Suddenly raising interest rates and driving the euro even higher will face considerable push-back from European exporters and their heavily lobbied governments. The effect on Eurozone bond prices risks destabilising Eurozone banks, which are not as well capitalised as their American counterparts.

The surprise the ECB faces will echo the astonishment of all central banks at the bombshell of the great financial crisis nine years ago. We might not even have much of a credit boom proper before the next credit crisis, so sudden will be the realisation that monetary policy is far adrift from reality. On our analysis, America may not have a credit boom at all, because it is excluded from the action in Asia, and has an alarming tendency towards protectionism. Instead, the dollar is likely to sink lower and lower, requiring interest rates to be eventually raised to curtail the price inflation effects.

The next credit crisis may be worse than you think

All this is a far cry from the Jackson Hole nonsense. The silence on monetary policy was resounding, given the looming credit crisis, which in this credit cycle looks like starting in Europe. Ms Yellen, who, far from finding that the Fed has successfully banished financial crises to the dustbin of history, will find her retirement marred by an even greater crisis than that of nine years ago.

The reason we know it will be bigger is the unfinished business of the last crisis left us with misallocated capital still tied up in failed and failing businesses, demonstrated by the steady accumulation to record levels of private sector debt. You need only look at the financial condition of the Mediterranean members of the Eurozone for prime examples of the evidence. The seeds of the next crisis lie not only in the misallocation of capital in this recovery phase of the credit cycle, but those of the previous one, and the one before that. In deferring credit crises, a super-cycle of credit boom and bust has built up, requiring greater and greater quantities of new fiat money to sustain it, a solution that will eventually fail.

No, Ms Yellen and Mr Draghi, your attempts to tame through regulation what you wrongly take to be a business cycle will fail spectacularly. You do not seem to realise your credit policies are the cause, never the solution. It is too late to stop seeing no evil in your actions, and speaking no evil about your own systemic failings.

i Ms Yellen’s speech, Financial Stability a Decade after the Onset of the Crisis is at

Mr Draghi’s speech, Sustaining openness in a dynamic global economy is at

ii For a description and resolution of Gibson’s paradox, see

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