Goldenfreude? how about Bankenfreude

Cheer if you will Goldbug bashers, but I suspect if Gold starts another swan dive, it won't be alone.  There may even come a time when you wish Gold would rise.

"Triumphalism," Paul Krugman opined in a 1997 New Republic article, "presents its own problems." Under the, dare I suggest, ironic headline, Superiority Complex, Mr. Krugman completed his thought: " though the "American model" has scored some important successes, it continues to fail in other respects, above all in generating an ever-increasing level of inequality. And we won't begin to address those failures if the national mood remains dominated by self-congratulation." He closed the article with sage advice for his readers: "The truth is that nothing in the experience of the last few years contradicts the idea that we could have a kinder, gentler economy that preserves the main virtue of the American system--high employment. All it would take is compassion. And a little less gloating."

Compassion, and a little less gloating might also help Mr. Krugman understand, rather than mock, Goldbugs- a label which, contra Krugman's caricature thereof, denotes a group exhibiting a very wide range of economic/investment views- while they are nursing their recently suffered monetary wounds. I imagine for every gold hoardin', gun totin', doomsday preppin' angry white male proclaiming the end of the world (they annoy me too),there's at least one confused, upset and perhaps unemployed person who's fed up with Wall Street's "head's I win, tails you lose" investment strategy, (or one, like myself, who believes structural reform-blocking rigidities in the developed world won't be overcome easily leaving only 2 eventual paths for excess liquidity, inflation or default). Those confused and unsettled Goldbugs, having witnessed a succession of bursting investment bubbles at home and more recently read about bank runs abroad might, not without justification, have decided to save in Gold, rather than a bank, or his mattress.

Mr. Krugman, alas, is not gloating alone over Goldbug's recent misfortunes. One clever soul coined the term Goldenfreude to describe his state of mind. Joe Weisenthal proclaims, EVERYONE Should Be Thrilled By The Gold Crash- a view echoed by Felix Salmon. Barry Ritholtz leavened his disdain for Goldbuggery with a sliver of compassion, I do not want to engage in Goldenfreude — the delight in gold bugs’ collective pain — but I am compelled to point out how basic flaws in their belief system has led them to this place where they are today. Gold, he avers, has no fundamentals and those who buy are engaging in the ultimate greater fool trade.

While living in SE Asia during their late 90s crisis I witnessed first hand one of Gold's great virtues- when a nation's banking system, and almost always coincidentally, currency, comes under pressure Gold holds its value. The haircut recently forced on Cypriot savers was far less than that inflicted on Gold by the market. In other words, despite recent declines I'd rather be holding Gold in Cyprus than waiting in an ATM line to withdraw my daily allotment of currency.

America, the gloaters might retort, is not Cyprus. No, it isn't, and I (casting off one aspect of Krugman's Goldbug caricature) sincerely hope we don't find ourselves in their financial straits. My bet is that such can only be avoided by further monetization AND, in the absence of rapid real sector productivity gains which don't exacerbate income inequality induced domestic tensions (unlikely given right wing intransigence on welfare state expansion or a domestic Modest Proposal a la Swift), wage and price inflation.

"A ha," Krugman, beating his gloating compatriots to the punch, would likely argue, "you Goldbugs are always talking about runaway inflation. Didn't you read my recent article mocking your inflation worries thusly: "But the runaway inflation that was supposed to follow reckless money-printing — inflation that the usual suspects have been declaring imminent for four years and more — keeps not happening."

I agree, and the absence of broad based inflation given the stimulus in an environment of limited structural reform outside the developing world is my concern. I suspect if Mr. Krugman would stop gloating, it might be his too (more on this below).  If the recent decline in Gold signals, as many gleefully hope, a decline in inflation expectations, might the US, and, I suspect, other mature industrial economies (Europe and Japan) be drawing ever nearer to a stall in growth followed by a liquidity crunch?

Consider this potential catalyst for the Gold crash. "Macroeconomic stimulus," said a US Treasury FX Report chiding Japan for the recent, now reversed, Yen slide, "...cannot be a substitute for structural reform that raises productivity and trend growth." We'll return to structural reform momentarily after a look at market reaction. The Yen's rapid recovery following this report's release was coincident with the Gold crash- perhaps both price adjustments represent market belief that inflation games (currency debasement either externally or internally) won't be tolerated.  With austerity the rage in European policy circles (we aren't far behind in that regard, thanks to the Republicans), competitive devaluation verboten and Gold signalling, to the cheers of many, declining inflation expectations, I'd be surprised if yet another liquidity crunch isn't around the corner.

Factors Behind the Forecast:  Structural Rigidities and Over-Leveraged Finance

Despite recent record profits, the US financial system, still dependent on a few highly leveraged (how else to achieve such profits in a low interest rate environment) TBTF banks, is far from stable. Many mortgaged home-owners are still looking up at the zero-equity line. Those cheering the absence of inflation simply, it seems to me, because such makes Goldbugs look stupid, might want to consider that in a highly leveraged economy, the cascading defaults of deflation- the "it" Bernanke assured us wouldn't happen here- always loom in the background.

Cheer if you will Goldbug bashers, but I suspect if Gold takes another swan dive, it won't be alone. As we've seen over the past few days, Gold price declines are mirrored to various degrees by oil, other commodities, and equities. Declining prices, if such becomes the trend, will lead to higher unemployment and, amplified by the former, declining house prices and rising foreclosures. In the teeth of such an event, some might be yearning for the days when Gold was rising and inflation was assumed. I'll admit, such a scenario favors the dollars-saved-in-a-mattress strategy rather than Gold ownership but both tactics are anti-investments ridiculed by Goldbug bashers.

The elephant in the room for the Goldenfreuders is the lack of structural reform in the developed world- an omission perhaps due to a focus on high frequency and exclusion of low frequency economic factors. Structural reform, for those unfamiliar, refers to changes in the capital structure (factories, transport systems, education programs, agricultural methods, etc.) that hope to produce more for less. China's rapid economic growth over recent decades is, in large part, an effect of these reforms such as the shift, in 1978, from communal to industrial farming.

Significant structural reforms are often resisted.  Consider the resistance some individuals display when asked to eat less, drink and smoke less, and exercise more.  Note, "when asked."  Change is much easier (but not guaranteed) when it's wanted.  Consider, for example, the rapid adoption of computers and cell phones.  I doubt even severe coercion could have done half as much in twice the time.  Fortunately the benefits of these new technologies were readily apparent and despite some resistance by, e.g., book store owners to Amazon, those individual losses were smaller than the aggregate productivity gain.  Those productivity gains created an environment where jobs were plentiful, further easing stress caused by the destruction economic creation usually entails- agriculturalists rarely coexist harmoniously with hunter gatherers but they produce more food per acre meaning, if the latter adapt to the new system, both groups can survive.

In cases when reform calls for the destruction of wealthy industries with government ties, substantial legal changes, or labor downtime and re-education for a significant portion of the work-force (especially in the absence of a decently funded welfare state), resistance can effectively block what would likely be widespread productivity gains.  Pre WWII rail transport in continental Europe seems a case on point.  International disagreements over railway standards and routes (an example of structural reform-blocking rigidities) kept the continent from reaping the productivity gains a fully connected rail system promised- and delivered, after a devastating war cleared away both dissent and, sadly, large chunks of the old rail system.  Expanding on von Clausewitz for the modern world (which finds the more apt term, political-economy, too archaic) war is not just politics by other means but economics by other means- the worst means, in my view.

Structural reform-blocking rigidities are, in a sense, other words for productivity sapping rent seeking- e.g. from a bottom up perspective, Luddites breaking machinery or US autoworkers striking to avoid being replaced thereby, and from a top down perspective, trade barriers (tariffs) or de jure monopolies (Britain's BBC prior to 1955).  Profits and Investments in rent seeking industries, particularly when higher productivity methods are known and feasible, tend to be misdirected from entrepreneurial activity (why make a better or cheaper widget when it's cheaper to bribe a competition stifling official?).  Bribery doesn't seem to me a very economically productive activity although it obviously benefits some while irking others.

For an example of a structural rigidity overcome consider recent changes in US law which reduced regulations on where and how (think fracking) petroleum products can be extracted.  Fracking has changed N. Dakota from a deficit to a surplus state and driven unemployment to near zero.  Before you send me a nasty-gram, I'm not arguing such is an unalloyed good- insufficient profits are likely flowing to those who have been and certainly will be negatively affected (this is no environmentally neutral practice).  I'm merely pointing out the positive economic benefits thereof.

To digress for a moment, first with an apology to the economically literate for the rudimentary and likely (to some) unsatisfactory treatment of these issues and second with further explanation thereof: the ideological (and physical) battle between communism and capitalism over the past two centuries is the battle between productivity and people.  In my view, productivity is most effectively and durably enhanced at an imaginary "sweet spot" between radical laissez faire (think Ayn Rand) and communal ownership (Marx).  Transfer payments, whether private (charity) or public (government welfare) are, in my view, necessary to ensure social cooperation within the capitalist framework.  Domestic dissent is a sign that transfer payments are, whether as a result of insufficient funds or inefficient distribution, not performing their function.  Labor dissent in many developed economies (Occupy and austerity protests in America and Europe respectively) suggest to me a hopefully solvable but currently intractable transfer payment crisis.  The pendulum has swung too far right which isn't meant to obviate calls therefrom for greater transfer payment efficiency.

Cheers for the Gold crash sound to my ears like cheers for austerity in Europe and further dismantling of the welfare state in the US. If Japan needs inflation now, don't we as well? Perhaps we too should join the Euro? and give up our right to buy time with inflation?

I'll close with a look at another structural reform-blocking rigidity whose removal might justify a moment of schadenfreude. The phrase "Too Big To Fail" speaks to a de jure monopoly of sorts for those protected banks.  Potential competitors were blocked from taking over business which would have looked elsewhere for financial services absent government support.  Competition was stifled and the public debt increased.  I believe, but for delusional faith in the virtues of these institutions (more below), a less costly, competition enhancing solution could have emerged from the crisis of 2008 and resolving that rigidity would have eased tensions between labor and capital. 

Consider: Would current budget negotiations in the US be so contentious in the absence of the recent bail-out and additional debt incurred?

Returning to the delusion, TBTF banks remind me of Alchemists wasting labor and resources trying to turn lead into gold, or, more accurately, trying to squeeze more profit out of trade than trade generates.  Finance, at best, facilitates trade. In practice it records, analyses, calculates and communicates. What Amazon did to the local book merchant a similar company (or 5 or 20) can do even more effectively to finance.  Surely networked computing should decrease the cost of finance for the rest of the economy. 

On the bright side, the presence of rigidities suggests greater future productivity upon their resolution, although it would be tragic if such resolution comes via violence rather than diplomacy.  I believe a new cooperation enhancing agreement between labor and capital is possible.  Given the European example, I believe American energy efficiency can be increased.   As noted above, I believe American financial efficiency can be greatly enhanced through the dissolution of TBTF. 

When that happens I'll suggest a new word- Bankenfreude- and might even indulge in some myself.  I'll swap my Gold for currency and put it back in the game.  Until then, I'll remain a Goldbug.

Full disclosure (if it wasn't obvious) I own gold.

THE Riddle Has Been Solved

Many readers will think that the last person whose opinion should be consulted on the issue of rating agency reform is a former rating agency employee. Maybe they’re right, but I did learn one thing from rating hundreds of complex securities. Contrary to what some may think, there are no easy solutions here. Unintended consequences are guaranteed. Gary Witt, former MD of Moody's Investor Services

What riddle?

Why is the industrialized world in the mess it's in?

Mr. Witt, writing at The Baseline Scenario answers this question, in my view, correctly.

We're in the mess we're in because there are no easy solutions. There haven't been easy solutions for quite a few decades as all of the "low hanging fruit" of industrialization currently being harvested in countries like China has long ago been harvested in the west.

Industrialization for economies is like adolescence for humans. It's a period of time when natural growth overpowers constraints that would hobble children or mature adults. There are easy solutions for adolescents and young adults but as we age our choices are more often an exercise in finding the lesser evil.

So it is, I believe, for US (and European and Japanese) economic policy makers. Shifting away from a financially centered economy will be painful. Wealth will be lost, interest rates will rise, and investment capital will become more scarce. We'll have to compete again, which tends to difficult for those who have grown accustomed to dominating.

"What evil," you might be wondering, "makes the above the better option?"

The alternative, in my view, is all of the above, but worse, and with less ownership. We won't be competing, we'll be sharecropping, as Warren Buffet once quipped.

In other words, I believe our economic woes are already built into the system. The expected growth in the New American Century, upon which dream, in part, credit was extended, didn't materialize.  Our choices now are between growing out of our dilemma- paying down debt with income(and lots of inflation)- or selling assets in lieu thereof.

Western Economies are, in a sense, middle-aged. There are no quick fixes available, just choices between accepting reality and having it forced on us.

The Big School and Convertibility Lost

As described in The Partnership: The Making of Goldman Sachs: Coyne [CEO of J. Aron] learned that the central banks of many nations kept their currency reserves in gold bars stored in the vaults of the Bank of England in London or the New York Federal Reserve Bank. Taken together, all this great wealth of nations had what Coyne saw as one fascinating characteristic: It earned zero return. It just sat in the vaults. But Coyne knew that the time value of money always figured into any futures contract...so he called on the central bankers in one country after another and made what appeared to be a generous and innovative offer: "Lend me your sterile bars of gold bullion and I'll pay you a fee of one half of one percent every year!"

Why then was this forbid? Why but to awe,
Why but to keep ye low and ignorant,
His worshippers; he knows that in the day
Ye Eate thereof, your Eyes that seem so cleere,
Yet are but dim, shall perfetly be then
Op'nd and cleerd, and ye shall be as Gods
Milton: Paradise Lost

There are, it may seem to a new student of economics, more schools of thought in the field than stars in the sky. I sometimes wonder if David Bohm, author of, inter alia, The Qualitative Infinity of Nature, might have felt more comfortable as an Economist than a Physicist. While the physical sciences, according to Thomas Kuhn, exhibit totalitarian tendencies with violent revolutions, Economics is far more democratic, tolerating, albeit not without disputes, multiple coincident schools of thought.

Of late, however, one school of economic thought has become increasingly dominant in policy making circles. The Big School holds that the larger a financial institution becomes the more protected it should be, and vice versa, the smaller a financial entity is, the less protection it should receive.

As an example of this (somewhat) facetious claim, consider the views of JPM's David Lowman: Like all loans, mortgage contracts are based on a promise to repay money borrowed. Importantly, there is no provision in the mortgage contract, express or implied, that the lender will restore equity or reduce the repayment amount if the value of the collateral – be it a home, a car or a stock market investment – depreciates. If we re-write the mortgage contract retroactively to restore equity to any mortgage borrower because the value of his or her home declined, what responsible lender will take the equity risk of financing mortgages in the future? What responsible regulator would want lenders to take such risk?

In other words, the same bank (there were, of course, others) whose inability to meet its contractual obligations a few years ago was such that it needed loans from, and preferential swapping of toxic for performing securities with, the Fed, equity support from the Treasury, and a release from the onerous task of marking securities to market, NOW thinks contracts, regulations and agreements are sacrosanct.

I wonder if the issue up for debate was deriviatives regulation or marking toxic assets to market, would any person from a bank end a paragraph with "what responsible regulator would want lenders to take such risks?"

Big School Rules.

In a Jonathon Demme film appropriately (for our purposes) titled "Stop Making Sense", the Talking Heads' David Byrne asked, "Well, how did I get here?"

The Big School took its cue from Kuhn and engaged not in democratic debate, but totalitarian revolt. They appropriated Walter Bagehot's views on the Central Bank's Lender of Last Resort facility in times of crisis but perverted them in the process. Instead of the outline presented in Lombard Street of "very large loans at very high rates" which, in modern times, became, "lend freely at a high rate", the Big School preaches the doctrine of "lending freely (to the banks) at a very low rate" thereby relieving the Central Bank of its responsibility to enforce prudence.

I may, however, be wrong in assuming the Big School appropriated their "lend freely (to the banks) at a very low rate" doctrine from Bagehot (they may simply have thought "lots of free money would sure be nice"), because this implies a reading thereof. If they had read Lombard Street they would have found these lines of concern about big banks, and management practices obscured from review:

The second misgiving, which many calm observers more and more feel as to our largest joint stock banks, fastens itself on their government. Is that government sufficient to lend well and keep safe so many millions?

All that the best board of directors can really accomplish [in the largest joint-stock banks] is to form a good decision on the points which the manager presents to them, and perhaps on a few others which one or two zealous members of their body may select for discussion

There is no more unsafe government for a bank than that of an eager and active manager, subject only to the supervision of a numerous board of directors, even though that board be excellent, for the manager may easily glide into dangerous and insecure transactions, nor can the board effectually check him.

Our great joint stock banks are imprudent in so carefully concealing the details of their government, and in secluding those details from the risk of discussion. The answer, no doubt, will be, “Let well alone; as you have admitted, there hardly ever before was so great a success as these banks of ours; what more do you or can you want?” I can only say that I want further to confirm this great success and to make it secure for the future. At present there is at least the possibility of a great reaction. Supposing that, owing to defects in its government, one even of the greater London joint stock banks failed, there would be an instant suspicion of the whole system. One terra incognita being seen to be faulty, every other terra incognita would be suspected. If the real government of these banks had for years been known, and if the subsisting banks had been known not to be ruled by the bad mode of government which had ruined the bank that had fallen, then the ruin of that bank would not be hurtful. The other banks would be seen to be exempt from the cause which had destroyed it. But at present the ruin of one of these great banks would greatly impair the credit of all. Scarcely any one knows the precise government of any one; in no case has that government been described on authority; and the fall of one by grave misgovernment would be taken to show that the others might as easily be misgoverned also. And a tardy disclosure even of an admirable constitution would not much help the surviving banks: as it was extracted by necessity, it would be received with suspicion. A sceptical world would say, “Of course they say they are all perfect now; it would not do for them to say anything else”.

A read of Lombard Street would not have led to the Big School's conclusion that the Lender of Last Resort should, in times of crisis, lend only to the banks, and even insolvent ones.

Bagehot advised differently: A panic, in a word, is a species of neuralgia, and according to the rules of science you must not starve it. The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to “this man and that man,” whenever the security is good. In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them.

In other words, Bagehot argued the Central Bank's responsibility was to "the market", not the banks.

Further, he argued: the majority to be protected, are the “sound” people, the people who have good security to offer. He also speaks to the issue of unsound people, perhaps using a bit of wishful thinking: No advances indeed need be made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business. That in a panic the bank, or banks, holding the ultimate reserve should refuse bad bills or bad securities will not make the panic really worse; the “unsound” people are a feeble minority, and they are afraid even to look frightened for fear their unsoundness may be detected;

While the fraction of business which is unsound today is likely larger than in Bagehot's England, I suspect most is sound. Unfortunately, the unsound elements, while small in practical classification (derivatives, mortgage backed securities, etc.) are huge in terms of currency relative to the whole economy.

Big School means Big Problems

Why, I wonder, did the other schools of thought so meekly submit to the Big School's totalitarian revolution? Perhaps the question might better be phrased, what problem(s) deemed intractable by most other schools of thought did the Big School solve.

My best guess; one of the problems the Big School solved is Triffin's Dilemma. Alternatively, a previous (temporary) "solution" of Triffin's Dilemma, the London Gold Pool, was brought back to life, a la Frankenstein's monster which begat Big School thinking.

Triffin's Dilemma states that when a national money is used as an international medium of exchange and international reserve there will be trade-offs between the national and global effects of the reserve currency issuer's monetary policy. Moreover, the reserve currency issuer nation would soon find that it had to run increasing current account deficits to provide liquidity to the rest of the world. This, in turn, would erode confidence in reserve currency convertibility, eventually leading to international currency instability and potentially a break down in world trade.

Robert Triffin forecast the breakdown of the Bretton Woods system based on this dilemma. Of late, his work has been cited by the PBOC.

Issuing countries of reserve currencies are constantly confronted with the dilemma between achieving their domestic monetary policy goals and meeting other countries´ demand for reserve currencies. On the one hand,the monetary authorities cannot simply focus on domestic goals without carrying out their international responsibilities on the other hand,they cannot pursue different domestic and international objectives at the same time. They may either fail to adequately meet the demand of a growing global economy for liquidity as they try to ease inflation pressures at home, or create excess liquidity in the global markets by overly stimulating domestic demand. The Triffin Dilemma, i.e., the issuing countries of reserve currencies cannot maintain the value of the reserve currencies while providing liquidity to the world, still exists. Zhou Xiaochuan: hairman, Monetary Policy Committee of the People's Bank of China

Triffin, in the late 50s, called for the creation of a new global currency to act as international reserve, along the lines of Keynes' Bancor, or the IMF's SDR (deliberations for the creation of which were informed of his concerns), which, in my view, invites a whole new set of problems, but may still, barring a significantly large, in economic terms, country usurping the US$'s role, e.g. China (which invites similar problems, and leads to the US' loss of the exorbitant privilege), prove the best solution. A "free banking" system of competing moneys is another option.

As the US, not entirely without globally altruistic justification, did not want the Bancor in 1960 any more than it wanted it in 1945, the dilemma of convertibility fears was managed by illusion by way of intervention. The London Gold Pool was established in 1961 to keep the "market price" of Gold at $35 and thus reduce the incentive to demand promised convertibility from the Fed.

This worked until French demands for Gold were not satisfied. The cartel failed to maintain prices within the target and within a few years Nixon's closing of the Gold window ended US$-Gold convertibility.

I'll spare you the details of the 70s inflation and early 80s newfound stability. Suffice it to write that US$ reserves were accepted as semi-convertible- if not to Gold at a fixed price, at least to Gold and a basket of commodities with limited (until recently) fluctuations at new, higher prices.

In one (presumably easily accepted) respect, Big School banks that created and kept markets going in multiple new ($ based) investment vehicles helped sustain the sense of convertibility so long as those markets were trading.  Markets to spend one's $s, even if one never shops there, engender a sense of stability.

Also coincident with this new found stability was the beginning of a business deal between J. Aron (purchased by Goldman Sachs in 1981) and Central Banks around the world. As described in The Partnership: The Making of Goldman Sachs: Coyne [CEO of J. Aron] learned that the central banks of many nations kept their currency reserves in gold bars stored in the vaults of the Bank of England in London or the New York Federal Reserve Bank. Taken together, all this great wealth of nations had what Coyne saw as one fascinating characteristic: It earned zero return. It just sat in the vaults. But Coyne knew that the time value of money always figured into any futures contract...so he called on the central bankers in one country after another and made what appeared to be a generous and innovative offer: "Lend me your sterile bars of gold bullion and I'll pay you a fee of one half of one percent every year!" (pg. 258)

The book goes on to detail that J. Aron was actually making 8% on the deal with no money down, "it produced a nearly infinite rate of return." The book suggests they pulled a fast one on the central banks.

What Coyne may not have known was that at least some governments may well have done the deal for nothing. J. Aron offered to do what the London Gold Pool had done, and was willing to take the risk itself- a risk passed on in the merger to GS.  An added benefit, assuming the deal worked as described, no gold had to actually be sold on the market, paper gold would suffice.

GS was not alone in this game. By the mid to late 80s when I was at Chase (now JPM), our Gold desk (fortunately positioned right behind the options desk where I worked) was playing the same game. Paper gold flooded the market.

One of the reasons I began working with GATA a decade ago was my observation (shared by them) of Gold's stubborn reluctance to rise in price despite the rapidly increasing external US$ reserves. If Gold was, as Triffin asserted, undervalued in the early 60s, surely, I thought, it was a steal in 2000 at $275.

Global US$ reserves have done nothing but rise since, at an increasing pace.

In 1978, Triffin and Mundell were warning of a sudden collapse of the US$ due to the growth of those reserves. Back then they wrote in astonishment of US$ reserves in the few hundreds of billions. Now, such reserves are measured in the trillions.

Without concrete data I can only speculate as to the extent of Central Bank gold leasing, or its effect on the price. In the past few years, the price of Gold has risen above $1000. Interestingly the price broke above the early 1980s high of $800 when problems began appearing in large US banks. The mid 2008 dollar squeeze in international markets capped its advance at that time, only to bring the US banking system to the brink of disaster.

How causal the coincidence proves to be remains a mystery. What seems certain is that, if Central Bank gold leasing is a policy aimed at extending the life of the US$ as global reserve currency, the banks so engaged cannot be allowed to fail, or the game is over.

Thus, I wonder how much effect, if any, the Gold leasing practices of the big NY banks had on the decision to make them too big to fail.

Have we dodged Triffin's dilemma by trying to maintain the illusion of convertibility only to invite a banking collapse worse than Bagehot's worse nightmare?

How will the US respond if an economy as large as China's needs a boost in international liquidity?  How large might an IMF rescue package need to be to keep China from suffering a disastrous contraction?  Would the US, as is its wont, allow the current account to widen further to ensure China repaid the IMF?

What if Japan needs IMF support?

How far off might such events be?

Big Questions for the Big School

The Kins(l)ey Report (on Inflation)

One could, in a debate of US inflation prospects, discuss the virtues of issuing the currency in which your debt is denominated, and the ability of US political leadership to enact tough change counter-balanced, I think, by the magnitude of the debt in question relative to world GDP, and the actual history of US political leadership to enact tough change. But my aim is not (in this essay) a reasoned debate but a notice of the lack thereof.


If, like me, you're an official member of the pajama wearing blogger corps, you might be familiar with the recent debate over US inflation prospects between Michael Kinsley and Paul Krugman, et. al. If not, here's Kinsley's initial article, Krugman's rebuttal, Kinsley's retort, and Krugman's rebuttal of the retort.

Krugman's second rebuttal dripped with condescension, or so it seemed to me, recalling memories of school yard bullies. Those memories tempted me to begin this article with a quip about Krugman needing to pick on someone his own size......, but I'll use a different metaphor.

"Ouch!," you might be thinking, "that's a bit cruel."

True.

So's this line from Krugman to Kinsley: "I’m tempted to get into an argument about whether it’s “bullying” to suggest that if you’re going to write about an economic issue, you might want to study it first. But what I really want to do is..."

Don't you love the artful use of the non-statement statement?

Aside from my belief that future events are more likely to follow some variation of Kinsley's nightmare scenario than Krugman's Japan model (about which, more here), the element of the exchange that inspired this post was Krugman's nasty dismissal of an apparently serious inquiry from one who apparently admires his views.

Kinsley's initial article contains statements like: "am I crazy?", "Every economist I admire, from Paul Krugman and Larry Summers on down, is convinced that inflation will remain low for as long as we can predict", "I can’t help feeling that the gold bugs are right", and "My fear is not the result of economic analysis. It’s more from the realm of psychology."

These are the words of a humble student searching for wisdom to quell his fears.

The wise Professor Krugman begins his rebuttal with: "Mike Kinsley has an odd piece in the Atlantic in which he confesses himself terrified about future inflation, even though there’s no hint of that problem in the real world."

You can almost see the sneering Professor holding up the student's paper in front of the class as you read the words (at least I could).

Using the tried and true nasty Professor trick of tossing about a bit of relevant jargon and a counter-example, Krugman expects Kinsley to slink back into his seat.

To his credit, Kinsley doesn't flinch.... much. He almost falls for the Professorial misdirection (debating whether a sudden 100% inflation shock is better than a Weimar hyper-inflation is like debating whether losing both legs is better than getting killed- I see your point, but I'll take none of the above) but then gets back on point, telling the Prof (in effect), "you didn't answer my question."

Why not inflation?

As Kinsley argued, the 70s demonstrated the US is not immune to inflation and Gold has risen from $275 to over $1000 during the past decade. Perhaps Kinsley's main confusion lies in his focus on the future tense, instead of seeing it as an ongoing issue.

Kinsley's search for the truth on inflation reminds me of Alfred Kinsey's search for truth on human sexual habits, which led to the publication of two books on human sexuality known collectively as the Kinsey Reports. Like Kinsley (or so it seems to me) Kinsey's search for truth battled with popular conceptions of what should (in some views) be, but wasn't.

In a sense Kinsey reported on what everyone (collectively) knew, but was afraid to say. The fear (perhaps, with the benefit of hindsight, somewhat justified) among then current opinion shapers was, in part, that open discussion would release the genie from the bottle. Hugh Hefner, of Playboy fame, credits Kinsey with opening his eyes to human sexual experience.

Krugman, in my view, is too smart an economist to dismiss outright the possibility of another significant inflation episode in the US, which may or may not be followed by hyper-inflation.

To use his phrasing, for those dismissing prediction of substantial US inflation, what is it about the US now that looks different to you from Thailand, Korea and Indonesia in say, 1997 (or Russia in 1998, or Iceland just recently)? Substantial public and private sector debt? Check. Huge expansion in the monetary base? Check. Large external debts and ongoing external deficits? Check. Increasing difficulties rolling over ever shorter term debt? Check. And yet each of those countries suffered, not multi-year hyperinflation, admittedly, but a sudden substantial (50-100% or more) inflation shock.

There are, admittedly, differences. As I wrote, I was using his phrasing and argument form. One could debate the virtues of issuing the currency in which your debt is denominated, and the ability of US political leadership to enact tough change counter-balanced, I think, by the magnitude of the debt in question relative to world GDP, and the actual history of US political leadership to enact tough change. But my aim is not a reasoned debate but a notice of the lack thereof.

Mr. Krugman might snidely respond to my snidely put question that the issue was hyper-inflation. I lived in Asia during their crisis and such shocks are worth worrying about even if hyper-inflation is avoided (besides, his use of Japan- a nation which self-finances, which seems to me a critical distinction- as counter-point suggests even moderate inflation is unlikely). Moreover, as Kinsley notes, who knows what policy makers will opt to do when the next crisis erupts. The history of the Bernanke Fed is not one of monetary restraint in a time of crisis.

I suspect that Krugman, not the economist, but the opinion shaper is, like those Kinsey battled, trying to keep the genie in the bottle- thus the Professorial dismissal instead of reasoned discussion of the issue. Inflation has both psychological and real world causes- when the two unite, the fireworks begin.

Perhaps, in a limited fashion, the Kinsley Report on Inflation will have a similar effect as Kinsey's, (then again maybe both should be seen as catalyst instead of cause) by bringing the debate into the open.

I wonder who the Hugh Hefner of Inflation will prove to be- perhaps Bill Murphy of GATA?

My advice to Kinsley is to have the courage of his convictions and buy some Gold, the price of which may have been as suppressed as reasoned open debate on US inflation prospects appears to be- both actions aim at the same effect.  I did (at $275 for Krugman's information) and I'm still holding.