Currencies threatened by a credit crisisFeb 14, 2019·Alasdair Macleod
In this article I draw attention to the similarities between the current economic situation and that of 1929, and the threat to today’s unbacked currencies. There is the coincidence of trade protectionism with the top of the credit cycle, and there are the inflationary events that preceded it. The principal difference today is in modern macroeconomic delusions, which hold that regulating inflation of money and credit is the solution to all ills. I conclude that economic salvation can only come from ditching today’s macroeconomic theories and by returning to monetary stability through credible gold exchange standards.
There is an assumption in economic circles that when the general level of prices changes, it is always due to changes in supply and demand for goods and services. Prices change all the time, but without a change in the public’s preference for or against holding money and with all else being equal, the general level of prices simply cannot change. Changes in the general level of prices are due to changes in the purchasing power of the money, which stems from the public’s preferences for or against it and do not emanate from goods and services.
This may not at first sight appear to matter, but it calls into question the widespread assumption that price changes are only due to changes in supply and demand for goods and services. It is a basic error behind modern monetary theory (MMT), whose supporters are busy reviving Georg Knapp’s Chartalist theories of money, the theories that permitted Bismarck’s inflationary pre-war armament financing and the subsequent collapse of the German currency in 1923. Believers in a divine right for the state to issue currency will not let themselves be distracted by inconvenient facts. MMT followers are only one group of neo-Keynesian inflationists, who are generally blind to the blunders of their revisionist economics.
Instead, they assume that the purchasing power of a state-issued currency is objectively fixed, only varied by changes in its quantity. Preferences for or against money are not in their economic lexicon. They ignore the evidence of hyperinflations, where the loss of purchasing power is never a straight-line affair. A myopic approach allows them to believe their feared deflation can be offset simply by regulating the increase in the quantity of money to ensure price stability, when in fact they are advocating what amounts to a hospital pass.
This notwithstanding, it is the apparently innovative solutions of MMT and other whacky ideas to address the evolving global credit crisis that are likely to unite inflationists in their drive to buy off with yet more monetary inflation the consequences of their disruptive actions earlier in the credit cycle.
This article is the third in a series about a prospective credit crisis, and its likely characteristics. The first (Trade wars – a catalyst for economic crisis) discussed the consequences of American trade protectionism coinciding with the top of the credit cycle. The second (Why monetary easing will fail) gave three reasons why monetary easing would fail to secure intended economic objectives. This article is about the consequences of accelerating inflationary policies for the purchasing-power of state-issued currencies. The comparison upon which our analysis is based is the credit cycle that terminated in the Wall Street crash of 1929 and the slump that followed, for reasons that will become clear. But first, we must remind ourselves of those depressing events.
The 1930s experience
Until 1933, the American dollar was on a gold exchange standard, whereby members of the public could exchange their dollars for gold at the rate of $20.67 to the ounce. By then the great depression was well advanced, and prices of commodities and raw materials had fallen heavily. An index of raw material prices fell approximately 50% between September 1929 and Spring 1933. Semi-manufactured products lost 40% and finished goods 30%. Agricultural prices were especially hard hit, with farm products falling 60% and wholesale food prices declining over 45%.[i]
It was the fall in prices which led to the dollar’s devaluation to $35 per ounce of gold in January 1934, which by then was no longer available for public exchange. The dollar’s devaluation was an attempt to manage an economic outcome through price manipulation. But the reason for the collapse in prices in the first place was the dollar was tied to gold, and preferences for gold compared with goods had increased.
In effect, it was prices measured in gold through the medium of the dollar that was the issue. As noted above, when the general level of prices shifts, it is always because the purchasing power of the money they are measured in changes. Therefore, measured by an index of raw material prices, gold’s purchasing power doubled between September 1929 and Spring 1933. By the time of the dollar’s devaluation ten months later, the index of raw materials had recovered to a level which indicated a new dollar-gold relationship of $35 to the ounce was roughly right.
Today, there is no such relationship between the dollar and gold. While the US Treasury holds gold reserves, they are not available for monetary exchange. Furthermore, it is the stated objective of monetary policy to maintain a rate of price inflation targeted at two per cent. Therefore, if we face a replay of the slump following the Wall Street Crash then it is the purchasing power of gold that will rise, while that of the dollar will fall. This assumes the general price level can be controlled, which is never the case. And to the extent that other currencies use the dollar as their international yardstick, they will lose purchasing power as well.
The next crisis could be on the scale of 1929-34
We have no way of knowing the future in advance, but there are enough common factors that suggest the next credit, financial and systemic crisis might be of a similar or even greater level of disruption compared with the stockmarket collapse in 1929 and the great depression that followed it. This is why it was worth revisiting those events. Factors common to both periods are summed up in the following four bullet points:
- On 30 October 1929 Congress passed the Smoot-Hawley Tariff Act. Getting wind of it in advance, investors sold stocks, driving prices down 34% in just fifteen days. Smoot-Hawley coincided with the top of the credit cycle, which made the combination brutal for both markets and the economy. Not only did 1929 mark the end of the greatest bull market in stocks since the South Sea bubble, but the destruction of personal wealth was wholly unexpected throughout society. Today, we face a similar combination of American trade protectionism being introduced at the top of the credit cycle. Stockmarket psychology seems equally unprepared today for the consequences.
- There has been a prolonged period of monetary inflation since the Lehman crisis, lasting ten years to date. This compares with the inflationary period between 1921-29 of eight years. Furthermore, today’s inflationary phase of the credit cycle is in addition to a series of previous inflationary cycles, leaving a heritage of past distortions still to be unwound. Before the 1921-29 period, a short sharp depression in 1920-21 meant there was an insignificant legacy of economic and financial distortions carried over. Therefore, a credit and systemic crisis today has the potential to be more damaging than the crisis that preceded the great depression.
- In 1921-29, the price-inflation consequences of monetary expansion were concealed by benefits from improved farming and manufacturing methods. Today, price inflation is also concealed through statistical manipulation. The lack of apparent price inflation in the earlier period coupled with low long-bond yields (less than 4%) fuelled a stock market boom that ended in 1929. The same dynamics today have fuelled a similar stock market boom, which may have ended last year.
- In 1921-29, the growth of bank lending at approximately 50%[ii] over the period was similar to commercial and industrial bank lending between 2009-18, which increased by 57%.[iii] The reason for this comparison is bank lending in the 1920s was substantially to commercial and industrial customers. Additionally, in the 1920s finance through discounted bills became highly inflationary.[iv] The current period commenced with a massive monetary injection by the Fed, and in addition both consumers and the government are also heavy borrowers.
There are also some additional factors to consider for the current credit cycle.
- The overall consequences of a credit and economic crisis are greatly magnified by the lower proportion of genuine production relative to the whole economy today. Compared with the 1920s, state finances today are more highly geared to economic outcomes.
- What has been ignored by inflationists is the economic destruction from monetary inflation, which transfers wealth from bank depositors and wage-earners to the banks, their favoured customers, the government and the central bank. Therefore, inflationary monetary policies conceal the true extent of an economic slump, make it worse and certainly do not cure it.
- In 1929-34, Banks defaulted in large numbers. Central banks today do their utmost to stop commercial banks from failing. The demands for yet more monetary inflation will be impossible to resist because of the need to support both the banking system and rapidly deteriorating government finances.
- Central banks are breaking ranks, with Russia and China leading Asian states away from the dollar. Russia already has gold as its principal reserve currency, and China has successfully become the world’s largest gold miner and refiner, while her people take up nearly two-thirds of global mine supply[v]. The consequences for currencies whose issuing banks do not follow this Asian path could be significantly worsened if they continue to insist gold plays no part in their monetary policy.
- Bond yields in the 1929-34 period fell to levels that are still higher than those of today, with the lowest yield on long bonds at 3.26% in April 1931.[vi] The originary rate at that time reflected the dollar’s convertibility into gold. The originary rate of interest is set by the time-preference accorded to money in free markets, so is primarily the public’s view of the quality of that money. Today, dollar and other currency bond yields remain heavily suppressed, with five out of six major central banks still expanding their balance sheets and three of them with negative interest rates.[vii] The risk is that when markets adjust to a time-preference value that takes account of this aggressive monetary debasement, a massive interest rate shock will be triggered.
- The widespread use of exchange-traded and indexed funds divorces investors from investment risk. If and when an increase in market risk becomes apparent, the public are likely to become indiscriminate sellers of ETFs and other index trackers, accelerating a stock market decline and bringing forward a collateral-led shock.
In summary, greater monetary forces appear to be at play today than existed in 1929-34. If they undermine the ability of policymakers to manage outcomes, the monetary consequences are bound to be very serious. But they will different in one important respect compared with ninety years ago: the purchasing power of gold can be expected to rise substantially while the purchasing powers of currencies fall. The success of policymakers in managing a crisis similar in scale to that of the great depression depends on their understanding of economics, which is our next topic.
The great depression informed today’s academics
The monetary policies followed by central banks will be crucial for the survival of state-issued currencies in the coming years, if as seems increasingly likely, we are on the verge of a new credit crisis.
Experience gained from the great depression is behind today’s economic theories. By that time, leading proponents of the Austrian school of economics had demonstrated that the causes of the great depression had their roots in the monetary expansion of the previous decade. Leading theorists, particularly Von Mises and Hayek perfected market-based sound-money theories, their validity honed and confirmed by Europe’s post-war monetary collapses in the early 1920s.
Meanwhile, in 1913 the US had established a federal banking system, which flourished in the 1920s on the back of credit expansion. The warnings of Austrian economists about credit expansion were ignored. When the crash they predicted occurred, the federal banking system excused itself from culpability. Instead, theories that deflected blame to free markets and absolved the federal system were actively promoted. A new theory of statism that enhanced the supposed virtues of state-issued money gradually evolved. And it is this which has become the basis of today’s macroeconomic theory.
Austrian and other laissez-faire free-market economic theories were passed over. Today, nearly everyone subscribes to macroeconomics. Its high priests claim it fundamentally differs from classical economics, which they assert is relevant only to microeconomic analysis. It became a handy way for neo-classical economists to absolve themselves from addressing fundamental questions, such as Say’s law, the socialist calculation problem, and other established truths impossible to explain away.
At the heart of macroeconomics is mathematics. Macroeconomists imply that in aggregate, the uncertainties of future human action cancel out, validating a mathematical approach. With this comes statistics aggregating transactions and prices. To neo-Keynesians, monetarists and MMT followers alike, government statistics are the basis for economic and monetary policies. But because they exclude human action, they are fundamentally flawed and badly misleading for policy determination.
These economic policies are sure to be applied even more vigorously to resolve the next crisis. They are the sources of the errors that if continued are bound to lead to a devastating conclusion. The logical outcome is the end of fiat currencies and all state theories of money. The Austrians had a description for it, having experienced it in 1922 and observed Germany the following year: the crack-up boom, or flight out of state currency into real values.
The likely progression of a new credit crisis
If, as seems likely, central banks see an increasing probability of recession, then interest rate policies will initially be eased. The rally in stock markets since mid-December has been discounting this possibility, which is now emerging as fact. However, cautious cuts in interest rates at the start of a cyclical downturn usually fail to stimulate the economy, only leading to a market rally, which in 1929-30 lasted five months. This one has lasted two so far and still counting.
The future course for advanced economies depends on the confidence of lending bankers in the medium-sized and small businesses that make up roughly 80% of total business activity. We have already seen funding dislocations in the corporate bond markets, which will have confirmed to bankers the increasing risk attached to offering working-capital facilities for businesses. Businesses which based their calculations on cheap credit being available are putting investment plans on hold and considering cutting existing commitments, at least in part because of their bankers’ cautious attitude. This is already evident in capital investment statistics around the world.
It appears that the psychology underlying productive activity has changed. Every time a central banker makes a reassuring statement, instead of applauding it, commercial bankers question the motive, saying there’s no smoke without fire. It’s the same for investors. Next time the stockmarket slides, look out for senior government figures attempting to reassure investors, and investors taking the hint that things must be worse than they appear if they need reassuring.
If suspicions are correct that trade tariffs being introduced at the top of a credit cycle is lethal timing, then equities could be embarking on a substantial bear market. It follows that there will be a switch from owning stocks as a sure-fire way of making money to owning stocks rapidly becoming a liability. The speed of the switch in sentiment will depend on a number of influences. But given that a comparison with the 1929-32 crash has some validity, it could be unexpectedly severe. There is also uncertainty over an additional factor, the presence of index-tracking funds.
Index trackers are not investments, though they are authorised and marketed as such. They are bets on a market’s direction. It stands to reason that when the direction changes, there will be widespread liquidation of bullish trackers and increased interest in trackers which profit from falling markets. Therefore, the speed of the fall could be accelerated significantly by liquidation of these funds.
The effect of a deepening economic crisis on government finances in welfare-driven states is potentially catastrophic. Not only will welfare commitments rise, but tax revenues will fall. And as noted above, the genuinely productive element of a modern welfare state upon which the whole economy depends has already shrunk as a proportion of the whole. Furthermore, governments will be reluctant to return to the days of austerity. So-called, but not austerity at all, because only expected increases in spending were scaled back. Simultaneously, governments everywhere will be increasing their borrowing, thereby draining wealth and capital resources from the already depleted productive sectors of their economies at an accelerating pace.
Central banks will find themselves attempting to finance escalating government deficits and underwriting their commercial banking systems with all their derivatives at the same time. Monetary inflation can only be cranked up, on top of the monetary inflation that persisted for all the cycle just ended, with five of the major central banks still expanding their balance sheets and three of them still imposing negative interest rates.
This is why, unless there is a major change of policy direction, the purchasing power of unbacked fiat currencies will be undermined. The destruction of wealth through monetary inflation, far from rescuing the economy, simply adds to the national woes by devaluing the efforts and wealth of ordinary people. Accordingly, unless there is a rapid acceptance that self-serving macroeconomic policies are at the root of this evil, interest rates will quickly rise beyond the authorities’ control as the fiat money delusion is revealed for what it is.
There is a way to stabilise interest rates, which government economists won’t like: return to a credible gold exchange standard, then interest on long-term government borrowing will be capped at under 5% and falling, assuming credibility in government finances is restored. It will require far higher gold prices to stick, which will catch out any government which has been lying about its bullion reserves. But at least that will give government finances a chance to stabilise while other actions to reduce the burden of government on the productive sector of the economy are put in place.
[i] See Wholesale Commodity Prices 1929-34: https://fraser.stlouisfed.org/files/docs/publications/SCB/pages/1935-1939/2755_1935-1939.pdf
[ii] All-bank Statistics, United States 1896-1955, Table A-1. https://fraser.stlouisfed.org/title/39
[iii] See St Louis FRED Series BUSLOANSNSA
[iv] See America’s Great Depression, Murray Rothbard, Part ll, The Inflationary Boom 1921-29, particularly pages 117-132.
[v] Measured by deliveries out of Shanghai Gold Exchange vaults, gross of returned scrap.
[vi] See https://alfred.stlouisfed.org/series?seid=LTGOVTBD.
[vii] The Fed until recently has been contracting its balance sheet. The Bank of England, Bank of Japan, Swiss National Bank and Bank of China have continued with balance sheet expansion. The ECB officially stopped its asset purchase programme in December 2018 but continues to reinvest maturing bonds and bond coupons.
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