A popular view these days is that the euro is a failed experiment because economically and/or politically disparate countries cannot share a currency without eventually bringing on a major crisis. Another way of expressing this conventional wisdom is: a monetary union (a common currency) cannot work without a fiscal union (a common government). This is unadulterated hogwash. Many different countries in completely different parts of the world were able to successfully share the same money for centuries. The money was called gold.

The fact that a bunch of totally disparate countries in Europe have a common currency is not the problem. The problem is the central planning agency known as the European Central Bank (ECB), which tries to impose a common interest rate across these diverse countries/economies. This leads to even more distortions than arise when such agencies operate within a single country (the Fed in the US, for example), which is really saying something considering the distortions caused by the Fed and other single-country central banks.

I’m reticent to pick on John Hussman, because his analysis is usually on the mark. However, his recent comments on the Greek crisis and its supposed relationship to a common currency make for an excellent example of the popular view that I’m taking issue with in this post. Here is the relevant excerpt from the Hussman commentary, with my retorts interspersed in brackets and bold text:

“The prerequisite for a common currency is that countries share a wide range of common economic features. [No, it isn't! Money isn't supposed to be a tool that is used to manipulate the economy, it is supposed to be a medium of exchange.] A single currency doesn’t just remove exchange rate flexibility. It also removes the ability to finance deficits through money creation, independent of other countries. [Removing the ability to finance deficits through money creation is a benefit, not a drawback.] Moreover, because capital flows often respond more to short-term interest rate differences (“carry trade” spreads) than to long-term credit conditions, the common currency of the euro has removed a great deal of interest rate variation between countries. [No, the ECB has done that. In the absence of the ECB, interest rates in the euro-zone would have correctly reflected economic reality all along.] It may seem like a good thing that countries like Greece, Spain, Italy, Portugal, and others have been able to borrow at interest rates close to those of Germany for nearly two decades. But that has also enabled them to run far larger and more persistent fiscal deficits than would have been possible if they had individually floating currencies. [This is completely true, but it is the consequence of a common central bank, not a common currency.]

The euro is essentially a monetary arrangement that encourages and enables wide differences in economic fundamentals between countries to be glossed over and kicked down the road through increasing indebtedness of the weaker countries in the union to the stronger members. [The ECB, not the common currency, encourages this.] This produces recurring crises when the debt burdens become so intolerable that even short-run refinancing can’t be achieved without bailouts.

Greece isn’t uniquely to blame. It’s unfortunately just the first country to arrive at that particular finish line. Greece is simply demonstrating that a common currency between economically disparate countries can’t be sustained without continuing subsidies from the more prosperous countries in the system to less prosperous ones. [If this is true, how did economically disparate countries around the world use gold as a common currency for so long without the more prosperous ones having to subsidise the less prosperous ones?]“

Money is supposed to be neutral — a medium of exchange and a yardstick. It is inherently no more problematic for totally disparate countries to use a common currency than it is for totally disparate countries to use common measures of length or weight. On the contrary, there are advantages to the use of a common currency in that trading and investing are made more efficient.

In conclusion, the problem is the central planning of money and interest rates, not the fact that different countries use the same money. It’s a problem that exists everywhere; it’s just that it is presently more obvious in the euro-zone.

A lot of nonsensical commentary gets written about the Commitments of Traders (COT) data for gold (and silver). The information in the COT reports can be used as an indicator of gold-market sentiment. Nothing more, nothing less. It cannot validly be used to support the theory that “commercial” traders (primarily bullion banks) have been conducting a long-term price-suppression scheme.

One of the most important points to understand with regard to the positioning of traders in the gold futures market is that the group known as speculators drives the short-term price trends. This is made apparent by the following chart, which was created by Saxo Bank and linked at the article posted HERE. The chart clearly shows that, with only a few minor discrepancies, over the past three years the net position of speculators in the COMEX futures market (the black line) has moved with the gold price (the red line). More specifically, it shows that speculators start adding to their collective net-long position at price lows and continue to add until the price makes a short-term top, at which point they become net sellers and their collective net-long position begins to decline. The process is self-reinforcing, in that a rising price prompts buying and a falling price prompts selling by the trend-followers within the speculating community. Note that a chart stretching back well beyond 2012 would show the same relationship.

As is the case in any market, the speculators in gold tend to be most bullish/optimistic just prior to significant price tops and most bearish (or least optimistic) just prior to significant price bottoms. That’s why the COT information can be used as a sentiment indicator. And as with most sentiment indicators, the COT’s weakness is that there are no absolute benchmarks. For example, while we can be confident that a short-term price bottom for gold will coincide with a relatively low level for the speculative net-long position in COMEX gold futures, there’s no way of knowing that level in advance.

If we lump large speculators and small (non-reporting) traders together under the “speculators” label, then the “commercial” position is simply the inverse of the speculative position. In order for speculators to become net-long by X contracts, commercials must become net-short by X contracts. This is a function of mathematics, since the futures market is a zero-sum game. Furthermore and as discussed above, we know that it’s the group known as “speculators” that’s driving the process since the price has a strong positive correlation with this group’s net-long position.

Therefore, getting angry with commercials for shorting gold futures — as some gold bulls do — is equivalent to getting angry with speculators for buying gold futures, since speculators, as a group, cannot possibly increase their long exposure in gold futures unless commercials, as a group, increase their short exposure.

With the return to a currency that can be devalued at will by its own government being spoken of in some quarters as part of the solution to Greece’s economic malaise, this is an opportune time to reprint a piece about currency devaluation that was originally included in a TSI commentary in July of last year. The gist of the piece is that currency devaluation cannot possibly help, but it can certainly hurt. Here it is, beginning with a quotation from a surprising source.

“Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the existing distribution of wealth*. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become ‘profiteers’, who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and it does it in a manner which not one man in a million is able to diagnose.”

The above quotation is perfect. It does such a good job of succinctly describing why currency devaluation is a destructive policy, both economically and socially, that it could have been written by Mises. Strangely, therefore, it was written by Keynes**.

It seems that Keynes understood the problems wrought by policies designed to debauch (devalue) the currency, but such understanding is nowhere to be seen among his modern-day followers. Instead, the modicum of sense contained in the writings of Keynes has been discarded by the Keynesians of today in favour of a total focus on “aggregate demand”. If you wrongly believe the economy to be an amorphous blob driven by changes in “aggregate demand”, then you are looking at the economy through a lens that creates such a distorted view of the world that what you perceive is the opposite of reality. When looking through such a lens, currency-devaluation policy can appear to be justifiable.

One of the most common ‘justifications’ for currency devaluation is that it makes local exporters more competitive. The problem, as explained in previous TSI commentaries, is that it can only benefit exporters at the EXPENSE of consumers and importers. There can be no net benefit to the economy. Moreover, the beneficiaries only benefit temporarily. The reason is that a sustained reduction in a currency’s value on the foreign exchange market requires relatively high monetary inflation, which leads to rises in domestic prices that not only counteract any benefit to exporters from the exchange-rate decline, but also distort relative prices in a way that makes the overall economy less efficient.

Related to the “we need to devalue our currency to make our exports more competitive” idiocy is the handwringing that happens in reaction to trade deficits. According to neo-Keynesian orthodoxy, every dollar that flows out of the US due to a trade deficit is a dollar less of spending within the domestic economy, which, in turn, leads to a weaker domestic economy and higher unemployment. In reality, however, every dollar that flows out due to a trade deficit eventually returns as some form of investment. That’s why the $500B+ annual US trade deficit has not reduced the US money supply. As Joseph Salerno (a good economist) explains in a 17th July article, trade-deficit dollars get invested by foreigners in US stocks, bonds, real estate such as buildings and golf courses, and financial intermediaries like banks and mutual funds, with many of the dollars ultimately being lent to or invested in US businesses. These businesses then spend the dollars on paying wages and buying real capital goods like raw materials, plants and equipment, and software. The point is that the flow of spending in the US economy is not diminished by a negative trade balance, but merely re-routed. There will be a redirection of labor and capital out of export industries into industries producing consumer and capital goods for domestic use, with no net loss of jobs. A net loss of jobs will, however, come about due to policies put in place to ‘fix’ a perceived trade-deficit problem.

Another common ‘justification’ for currency devaluation is that it lowers real wages and thus gets around the problem that the nominal price of labour tends to be ‘sticky’. The idea is that nominal wage rates are excessively slow to fall in response to reduced demand for workers, and that currency devaluation helps by surreptitiously reducing the real price of labour. The first point to note here is that the ‘stickiness’ of wages was never a problem in the US prior to the 1930s, when the Hoover and Roosevelt Administrations took steps to prevent wages from falling in response to a severe economic downturn. A second and related point is that government payments to the unemployed can reduce the incentive for able-bodied people to accept lower wages to re-enter the workforce. In other words, if nominal wages are problematically ‘sticky’ it is because of government intervention, not the free market. Third, the knowledge that modern money relentlessly loses purchasing power over time would tend to make nominal wages ‘stickier’ than they would otherwise be. In other words, the policy designed to address the perceived problem of ‘sticky’ wages actually contributes to the problem. In any case, these points are not critically relevant. Regardless of whether wages really are ‘sticky’ and regardless of the cause of the supposed problem, ‘sticky’ wages could never logically justify a policy that must ultimately weaken the economy.

The primary problem with currency devaluation is that it leads to non-uniform changes in prices throughout the economy. In effect, the implementers of devaluation policy send false price signals into the economy, which leads to more investing mistakes than would otherwise happen. As a result of the greater number of investing mistakes, there ends up being less wealth. Furthermore, the smaller pool of wealth will be redistributed by the devaluation policy, often in a way that is so obviously unfair that it provokes calls for new interventions and punitive taxes. It therefore puts the economy on the proverbial “slippery slope”.

In summary, Keynes wasn’t right about much, but early in his career he was absolutely right about currency devaluation. It is a process that engages all the hidden forces of economic law on the side of destruction, and it does so in a manner that not one man in a million will be able to diagnose.

    *The undeserved wealth distribution caused by currency devaluation policy is the root cause of today’s fixation on “inequality”. Unfortunately, none of the most popular writers on this topic understand the cause of the perceived problem.

    **The quotation is from Chapter 6 of Keynes’ 1919 book titled “The Economic Consequences of the Peace”.

It’s not an overstatement to say that over the 6-year period beginning in September-2008, the US Federal Reserve went berserk with its Quantitative Easing (QE). The following chart shows that the US Monetary Base, an indicator of the net quantity of dollars directly created by the Fed*, had a gentle upward slope until around August of 2008, at which point it took off like a rocket. More specifically, the Monetary Base gained about 30% during the 6-year period leading up to September of 2008 and then quintupled (gained 400%) over the next 6 years. Is it therefore fair to say that the Fed has now ‘shot its load’ and will be unable to do much in reaction to the next financial crisis and/or recession?

Unfortunately, the answer is no. The sad truth is that the Fed is not only capable of doing a lot more, it will almost certainly pump a lot more money into the economy the next time its senior management decides that the financial or economic wheels are falling off.

The Fed is capable of doing a lot more because it is not yet remotely close to running out of things to monetise. For example, the US Federal debt is presently about $18.1T and will probably top $20T within the next two years. This means that there is plenty of scope for the Fed to add to its current $2.5T stash of Treasury securities. Also, the Fed is not strictly limited in what it can monetise. Up until now it has been monetising Mortgage-Backed and Agency securities in addition to Treasury securities, but it could branch out into other asset-backed securities (those backed by auto loans or student debt, for instance), municipal bonds, investment-grade corporate bonds, and equity ETFs. If the situation were perceived to be sufficiently dire it could even change the rules to allow itself to monetise commercial and residential real-estate.

And the Fed almost certainly will do a lot more on the money-pumping front in the face of future economic and/or stock market weakness, because it has not only failed to learn the right lessons from the events of the past 15 years, it has learned exactly the wrong lessons. Rather than learning that injecting more money into the economy in an effort to mitigate the fallout from a busted bubble leads to a bigger bubble, a bigger bust, greater hardship and structural economic weakness, its senior management is convinced that the QE and interest-rate-suppression programs provided a substantial net benefit to the overall economy. Given this conviction in the righteousness of its previous actions, why wouldn’t the Fed do more of the same if the perceived need were to arise in the future? The answer, of course, is that it would. And it will.

In conclusion, those who think that the Fed is incapable of further monetary expansion do not have a good understanding of the situation, and those who believe that the Fed could do more, but will choose not to as the result of newfound financial prudence or concern for the well-being of savers, are naive.

*The Monetary Base is made up of currency (physical notes and coins) in circulation outside the banking system plus bank reserves. Bank reserves aren’t counted in the True Money Supply, but for every dollar of reserves created by the Fed as part of its QE the Fed also adds a dollar of money to the economy via a deposit into the demand account of a Primary Dealer. That is, QE results in the one-for-one creation of money and reserves. For a more detailed explanation, refer to my 16th February 2015 post.