The Cost of Code Red

By John Mauldin

(It is especially important to read the opening quotes this week. They set up the theme in the proper context.)

 “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

– Ludwig von Mises

“No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future.”

– Ludwig von Mises

“[Central banks are at] serious risk of exhausting the policy room for manoeuver over time.”

– Jaime Caruana, General Manager of the Bank for International Settlements

“The gap between the models in the world of monetary policymaking is now wider than at any time since the 1930s.”

– Benjamin Friedman, William Joseph Maier Professor of Political Economy, Harvard

To listen to most of the heads of the world’s central banks, things are going along swimmingly. The dogmatic majority exude a great deal of confidence in their ability to manage their economies through whatever crisis may present itself. (Raghuram Rajan, the sober minded head of the Reserve Bank of India, is a notable exception.)

However, there is reason to believe that there have been major policy mistakes made by central banks – and will be more of them – that will lead to dislocations in the markets – all types of markets. And it’s not just the usual anti-central bank curmudgeon types (among whose number I have been counted, quite justifiably) who are worried. Sources within the central bank community are worried, too, which should give thoughtful observers of the market cause for concern.

Too often we as investors (and economists) are like the generals who are always fighting the last war. We look at bank balance sheets (except those of Europe and China), corporate balance sheets, sovereign bond spreads and yields, and say it isn’t likely that we will repeat this mistakes which led to 2008. And I smile and say, “You are absolutely right; we are not going to repeat those mistakes. We learned our lessons. Now we are going to make entirely new mistakes.” And while the root cause of the problems, then and now, may be the same – central bank policy – the outcome will be somewhat different. But a crisis by any other name will still be uncomfortable.

If you look at some of the recent statements from the Bank for International Settlements, you should come away with a view much more cautious than the optimistic one that is bandied about in the media today. In fact, to listen to the former chief economist of the BIS, we should all be quite worried.

I am of course referring to Bill White, who is one of my personal intellectual heroes. I hope to get to meet him someday. We have discussed some of his other papers, written in conjunction with the Dallas Federal Reserve, in past letters. He was clearly warning about imbalances and potential bubbles in 2007 and has generally been one of the most prescient observers of the global economy. The prestigious Swiss business newspaper Finanz und Wirtschaft did a far reaching interview with him a few weeks ago, and I’ve taken the liberty to excerpt pieces that I think are very important. The excerpts run a few pages, but this is really essential reading. (The article is by Mehr zum Thema, and you can read the full piece here.)

Speculative Bubbles

The headline for the interview is “I see speculative bubbles like in 2007.” As the interviewer rolls out the key questions, White warns of grave adverse effects of ultra loose monetary policy:

William White is worried. The former chief economist of the Bank for International Settlements is highly skeptical of the ultra-loose monetary policy that most central banks are still pursuing. “It all feels like 2007, with equity markets overvalued and spreads in the bond markets extremely thin,” he warns.

Mr. White, all the major central banks have been running expansive monetary policies for more than five years now. Have you ever experienced anything like this?

The honest truth is no one has ever seen anything like this. Not even during the Great Depression in the Thirties has monetary policy been this loose. And if you look at the details of what these central banks are doing, it’s all very experimental. They are making it up as they go along. I am very worried about any kind of policies that have that nature.

But didn’t the extreme circumstances after the collapse of Lehman Brothers warrant these extreme measures?

Yes, absolutely. After Lehman, many markets just seized up. Central bankers rightly tried to maintain the basic functioning of the system. That was good crisis management. But in my career I have always distinguished between crisis prevention, crisis management, and crisis resolution. Today, the Fed still acts as if it was in crisis management. But we’re six years past that. They are essentially doing more than what they did right in the beginning. There is something fundamentally wrong with that. Plus, the Fed has moved to a completely different motivation. From the attempt to get the markets going again, they suddenly and explicitly started to inflate asset prices again. The aim is to make people feel richer, make them spend more, and have it all trickle down to get the economy going again. Frankly, I don’t think it works, and I think this is extremely dangerous.

So, the first quantitative easing in November 2008 was warranted?

Absolutely.

But they should have stopped these kinds of policies long ago?

Yes. But here’s the problem. When you talk about crisis resolution, it’s about attacking the fundamental problems that got you into the trouble in the first place. And the fundamental problem we are still facing is excessive debt. Not excessive public debt, mind you, but excessive debt in the private and public sectors. To resolve that, you need restructurings and write-offs. That’s government policy, not central bank policy. Central banks can’t rescue insolvent institutions. All around the western world, and I include Japan, governments have resolutely failed to see that they bear the responsibility to deal with the underlying problems. With the ultraloose monetary policy, governments have no incentive to act. But if we don’t deal with this now, we will be in worse shape than before.

But wouldn’t large-scale debt write-offs hurt the banking sector again?

Absolutely. But you see, we have a lot of zombie companies and banks out there. That’s a particular worry in Europe, where the banking sector is just a continuous story of denial, denial and denial. With interest rates so low, banks just keep ever-greening everything, pretending all the money is still there. But the more you do that, the more you keep the zombies alive, they pull down the healthy parts of the economy. When you have made bad investments, and the money is gone, it’s much better to write it off and get fifty percent than to pretend it’s still there and end up getting nothing. So yes, we need more debt reduction and more recapitalization of the banking system. This is called facing up to reality.

Where do you see the most acute negative effects of this monetary policy?

The first thing I would worry about are asset prices. Every asset price you could think of is in very odd territory. Equity prices are extremely high if you at valuation measures such as Tobin’s Q or a Shiller-type normalized P/E. Risk-free bond rates are at enormously low levels, spreads are very low, you have all these funny things like covenant-lite loans again. It all looks and feels like 2007.

And frankly, I think it’s worse than 2007, because then it was a problem of the developed economies. But in the past five years, all the emerging economies have imported our ultra low policy rates and have seen their debt levels rise. The emerging economies have morphed from being a part of the solution to being a part of the problem.

Do you see outright bubbles in financial markets?

Yes, I do. Investors try to attribute the rising stock markets to good fundamentals. But I don’t buy that. People are caught up in the momentum of all the liquidity that is provided by the central banks. This is a liquidity-driven thing, not based on fundamentals.

So are we mostly seeing what the Fed has been doing since 1987 – provide liquidity and pump markets up again?

Absolutely. We just saw the last chapter of that long history. This is the last of a whole series of bubbles that have been blown. In the past, monetary policy has always succeeded in pulling up the economy. But each time, the Fed had to act more vigorously to achieve its results. So, logically, at a certain point, it won’t work anymore. Then we’ll be in big trouble. And we will have wasted many years in which we could have been following better policies that would have maintained growth in much more sustainable ways. Now, to make you feel better, I said the same in 1998, and I was way too early.

What about the moral hazard of all this?

The fact of the matter is that if you have had 25 years of central bank and government bailout whenever there was a problem, and the bankers come to appreciate that fact, then we are back in a world where the banks get all the profits, while the government socializes all the losses. Then it just gets worse and worse. So, in terms of curbing the financial system, my own sense is that all of the stuff that has been done until now, while very useful, Basel III and all that, is not going to be sufficient to deal with the moral hazard problem. I would have liked to see a return to limited banking, a return to private ownership, a return to people going to prison when they do bad things. Moral hazard is a real issue.

Do you have any indication that the Yellen Fed will be different than the Greenspan and Bernanke Fed?

Not really. The one person in the FOMC that was kicking up a real fuss about asset bubbles was Governor Jeremy Stein. Unfortunately, he has gone back to Harvard.

The markets seem to assume that the tapering will run very smoothly, though. Volatility, as measured by the Vix index, is low.

Don’t forget that the Vix was at [a] record low in 2007. All that liquidity raises the asset prices and lowers the cost of insurance. I see at least three possible scenarios how this will all work out. One is: Maybe all this monetary stuff will work perfectly. I don’t think this is likely, but I could be wrong. I have been wrong so many times before. So if it works, the long bond rates can go up slowly and smoothly, and the financial system will adapt nicely. But even against the backdrop of strengthening growth, we could still see a disorderly reaction in financial markets, which would then feed back to destroy the economic recovery.

How?

We are such a long way away from normal long term interest rates. Normal would be perhaps around four percent. Markets have a tendency to rush to the end point immediately. They overshoot. Keynes said in late Thirties that the long bond market could fluctuate at the wrong levels for decades. If fears of inflation suddenly re-appear, this can move interest rates quickly. Plus, there are other possible accidents. What about the fact that maybe most of the collateral you need for normal trading is all tied up now? What about the fact that the big investment dealers have got inventories that are 20 percent of what they were in 2007? When things start to move, the inventory for the market makers might not be there. That’s a particular worry in fields like corporate bonds, which can be quite illiquid to begin with. I’ve met so many people who are in the markets, thinking they are absolutely brilliantly smart, thinking they can get out in the right time. The problem is, they all think that. And when everyone races for the exit at the same time, we will have big problems. I’m not saying all of this will happen, but reasonable people should think about what could go wrong, even against a backdrop of faster growth.

And what is the third scenario?

The strengthening growth might be a mirage. And if it does not materialize, all those elevated prices will be way out of line of fundamentals.

Which of the major central banks runs the highest risk of something going seriously wrong?

At the moment what I am most worried about is Japan. I know there is an expression that the Japanese bond market is called the widowmaker. People have bet against it and lost money. The reason I worry now is that they are much further down the line even than the Americans. What is Abenomics really? As far as I see it, they print the money and tell people that there will be high inflation. But I don’t think it will work. The Japanese consumer will say prices are going up, but my wages won’t. Because they haven’t for years. So I am confronted with a real wage loss, and I have to hunker down. At the same time, financial markets might suddenly not want to hold Japanese Government Bonds anymore with a perspective of 2 percent inflation. This will end up being a double whammy, and Japan will just drop back into deflation. And now happens what Professor Peter Bernholz wrote in his latest book. Now we have a stagnating Japanese economy, tax revenues dropping like a stone, the deficit already at eight percent of GDP, debt at more than 200 percent and counting. I have no difficulty in seeing this thing tipping overnight into hyperinflation. If you go back into history, a lot of hyperinflations started with deflation.

Many people have warned of inflation in the past five years, but nothing has materialized. Isn’t the fear of inflation simply overblown?

One reason we don’t see inflation is because monetary policy is not working. The signals are not getting through. Consumers and corporates are not responding to the signals. We still have a disinflationary gap. There has been a huge increase in base money, but it has not translated into an increase in broader aggregates. And in Europe, the money supply is still shrinking. My worry is that at some point, people will look at this situation and lose confidence that stability will be maintained. If they do and they do start to fear inflation, that change in expectations can have very rapid effects.

More from the BIS

The Bank for International Settlements is known as the “central bankers’ central bank.” It hosts a meeting once a month for all the major central bankers to get together for an extravagant dinner and candid conversation. Surprisingly, there has been no tell-all book about these meetings by some retiring central banker. They take the code of “omertà” (embed) seriously.

Jaime Caruana, the General Manager of the BIS, recently stated that monetary institutions (central banks) are at “serious risk of exhausting the policy room for manoeuver over time.” He followed that statement with a very serious speech at the Harvard Kennedy School two weeks ago. Here is the abstract of the speech (emphasis mine):

This speech contrasts two explanatory views of what he characterizes as “the sluggish and uneven recovery from the global financial crisis of 2008-09.” One view points to a persistent shortfall of demand and the other to the specificities of a financial cycle-induced recession – the “shortfall of demand” vs. the “balance sheet” view. The speech summarizes each diagnosis [and]… then reviews evidence bearing on the two views and contrasts the policy prescriptions to be inferred from each view. The speech concludes that the balance sheet view provides a better overarching explanation of events. In terms of policy, the implication is that there has been too much emphasis since the crisis on stimulating demand and not enough on balance sheet repair and structural reforms to boost productivity. Looking forward, policy frameworks need to ensure that policies are more symmetrical over the financial cycle, so as to avoid the risks of entrenching instability and eventually running out of policy ammunition.

Coming from the head of the BIS, the statement I have highlighted is quite remarkable. He is basically saying (along with his predecessor, William White) that quantitative easing as it is currently practiced is highly problematical. We wasted the past five years by avoiding balance sheet repair and trying to stimulate demand. His analysis perfectly mirrors the one Jonathan Tepper and I laid out in our book Code Red.

How Does the Economy Adjust to Asset Purchases?

In 2011 the Bank of England gave us a paper outlining what they expected to be the consequences of quantitative easing. Note that in the chart below they predict exactly what we have seen. Real (inflation-adjusted) asset prices rise in the initial phase. Nominal demand rises slowly, and there is a lagging effect on real GDP. But note what happens when a central bank begins to flatten out its asset purchases or what is called “broad money” in the graph: real asset prices begin to fall rather precipitously, and consumer price levels rise. I must confess that I look at the graph and scratch my head and go, “I can understand why you might want the first phase, but what in the name of the wide, wide world of sports are you going to do for policy adjustment in the second phase?” Clearly the central bankers thought this QE thing was a good idea, but from my seat in the back of the plane it seems like they are expecting a rather bumpy ride at some point in the future.



Let’s go to the quote in the BoE paper that explains this graph (emphasis mine):

The overall effect of asset purchases on the macroeconomy can be broken down into two stages: an initial ‘impact’ phase and an ‘adjustment’ phase, during which the stimulus from asset purchases works through the economy, as illustrated in Chart 1. As discussed above, in the impact phase, asset purchases change the composition of the portfolios held by the private sector, increasing holdings of broad money and decreasing those of medium and long-term gilts. But because gilts [gilts is the English term for bonds] and money are imperfect substitutes, this creates an initial imbalance. As asset portfolios are rebalanced, asset prices are bid up until equilibrium in money and asset markets is restored. This is reinforced by the signalling channel and the other effects of asset purchases already discussed, which may also act to raise asset prices. Through lower borrowing costs and higher wealth, asset prices then raise demand, which acts to push up the consumer price level.

[Quick note: I think Lacy Hunt thoroughly devastated the notion that there is a wealth effect and that rising asset prices affect demand in last week’s Outside the Box. Lacy gives us the results of numerous studies which show the theory to be wrong. Nevertheless, many economists and central bankers cling to the wealth effect like shipwrecked sailors to a piece of wood on a stormy sea. Now back to the BoE.]

In the adjustment phase, rising consumer and asset prices raise the demand for money balances and the supply of long-term assets. So the initial imbalance in money and asset markets shrinks, and real asset prices begin to fall back. The boost to demand therefore diminishes and the price level continues to increase but by smaller amounts. The whole process continues until the price level has risen sufficiently to restore real money balances, real asset prices and real output to their equilibrium levels. Thus, from a position of deficient demand, asset purchases should accelerate the return of the economy to equilibrium.

This is the theory under which central banks of the world are operating. Look at this rather cool chart prepared by my team (and specifically Worth Wray). The Fed (with a few notable exceptions on the FOMC) has been openly concerned about deflationary trends. They are purposely trying to induce a higher target inflation. The problem is, the inflation is only showing up in stock prices – and not just in large cap equity markets but in all assets around the world that price off of the supposedly “risk-free” rate of return.



I hope you get the main idea, because understanding this dynamic is absolutely critical for navigating what the Chairman of the South African Reserve Bank, Gill Marcus, is calling the next phase of the global financial crisis. Every asset price (yes, even and especially in emerging markets) that has been driven higher by unnaturally low interest rates, quantitative easing, and forward guidance must eventually fall back to earth as real interest rates eventually normalize.

Trickle-Down Monetary Policy

For all intents and purposes we have adopted a trickle-down monetary policy, one which manifestly does not work and has served only to enrich financial institutions and the already wealthy. Now I admit that I benefit from that, but it’s a false type of enrichment, since it has come at the expense of the general economy, which is where true wealth is created. I would rather have my business and investments based on something more stably productive, thank you very much.

Monetary policies implemented by central banks around the world are beginning to diverge in a major way. And don’t look now, but that sort of divergence almost always spells disaster for all or part of the global economy. Which is why Indian Central Bank Governor Rajan is pounding the table for more coordinated policies. He can see what is going to happen to cross-border capital flows and doesn’t appreciate being caught in the middle of the field of fire with hardly more than a small pistol to defend himself. And the central banks even smaller than his are bringing only a knife to the gunfight.



The Fed & BoE Are Heading for the Exits…

In the United States, Federal Reserve Chairwoman Janet Yellen is clearly signaling her interest – if not outright intent – to turn the Fed’s steady $10 billion “tapering” of its $55 billion/month quantitative easing program into a more formal exit strategy. The Fed is still actively expanding its balance sheet, but by a smaller amount after every FOMC meeting (so far)… and global markets are already nervously anticipating any move to sell QE-era assets or explicitly raise rates. Just like China’s slowdown (which we have written about extensively), the Fed’s eventual exit will be a global event with major implications for the rest of the world. And US rate normalization could drastically disrupt cross-border real interest rate differentials and trigger the strongest wave of emerging-market balance of payments crises since the 1930s.

In the United Kingdom, Bank of England Governor Mark Carney is carefully broadcasting his intent to hike rates before selling QE-era assets. According to his view, financial markets tend to respond rather mechanically to rate hikes, but unwinding the BoE’s bloated balance sheet could trigger a series of unintended and potentially destructive consequences. Delaying those asset sales indefinitely and leaning on rate targeting once more allows him to guide the BoE toward tightening without giving up the ability to rapidly reverse course if financial markets freeze. Then again, Carney may be making a massive, credibility-cracking mistake.



While the BoJ & ECB Are Just Getting Started

In Japan, Bank of Japan Governor Haruhiko Kuroda is resisting the equity market’s call for additional asset purchases as the Abe administration implements its national sales tax increase – precisely the same mistake that triggered Japan’s 1997 recession. As I have written repeatedly, Japan is the most leveraged government in the world, with a government debt-to-GDP ratio of more than 240%. Against the backdrop of a roughly $6 trillion economy, Japan needs to inflate away something like 150% to 200% of its current debt-to-GDP… that’s roughly $9 trillion to $12 trillion in today’s dollars.

Think about that for a moment. At some point I need to do a whole letter on this, but I seriously believe the Bank of Japan will print something on the order of $8 trillion (give or take) over the next six to ten years. In relative terms, this is the equivalent of the US Federal Reserve printing $32 trillion. To think this will have no impact on the world is simply to ignore how capital flows work. Japan is a seriously large economy with a seriously powerful central bank. This is not Greece or Argentina. This is going to do some damage.

I have no idea whether Japan’s BANG! moment is just around the corner or still several years off, but rest assured that Governor Kuroda and his colleagues at the Bank of Japan will respond to economic weakness with more… and more… and more easing over the coming years.

In the euro area, European Central Bank Chairman Mario Draghi – with unexpected support from his two voting colleagues from the German Bundesbank – is finally signaling that more quantitative easing may be on the way to lower painfully high exchange rates that constrain competitiveness and to raise worryingly low inflation rates that can precipitate a debt crisis by steepening debt-growth trajectories. This QE will be disguised under the rubric of fighting inflation, and all sorts of other euphemisms will be applied to it, but at the end of the day, Europe will have joined in an outright global currency war.

I don’t expect the Japanese and Europeans to engage in modest quantitative easing. Both central banks are getting ready to hit the panic button in response to too low inflation, steepening debt trajectories, and inconveniently strong exchange rates.

While the Federal Reserve, European Central Bank, Swiss National Bank, Bank of England, and Bank of Japan have collectively grown their balance sheets to roughly $9 trillion today, the next wave of asset purchases could more than double that balance in relatively quick order.

This is what I mean by Code Red: frantic pounding on the central bank panic button that invites tit-for-tat retaliation around the world and especially by emerging-market central banks, leading to a DOUBLING of the assets shown in the chart below and a race to the bottom, as the “guardians” of the world’s primary currencies become their executioners.



The opportunity for a significant policy mistake from a major central bank is higher today than ever. I share Bill White’s concern about Japan. I worry about China and seriously hope they can keep their deleveraging and rebalancing under control, although I doubt that many parts of the world are ready for a China that only grows at 3 to 4% for the next five years. That will cause a serious adjustment in many business and government models.

It is time to hit the send button, but let me close with the point that was made graphically in the Bank of England’s chart back in the middle of the letter. Once central bank asset purchases cease, the BoE expects real asset prices to fall… a lot. You will notice that there is no scale on the vertical axis and no timeline along the bottom of the chart. No one really knows the timing. My friend Doug Kass has an interview (subscribers only) in Barron’s this week, talking about how to handle what he sees as a bubble.

“Sell in May and go away” might be a very good adage to remember.

Amsterdam, Brussels, Geneva, San Diego, Rome, and Tuscany

I leave Tuesday night for Amsterdam to speak on Thursday afternoon for VBA Beleggingsprofessionals. There will be a debate-style format around the theme of “Are there any safe havens left in this volatile world?” I plan to write my letter from Amsterdam on Friday and then play tourist on Saturday in that delightful city full of wonderful museums. Then, if all goes well, I will rent a car and take a leisurely drive to Brussels through the countryside, something I have always wanted to do. I may try to get lost, at least for a few hours. Who knows what you might stumble on?

I will be speaking Monday night in Brussels for my good friend Geert Wellens of Econopolis Wealth Management before we fly to Geneva for another speech with his firm, and of course there will be the usual meetings with clients and friends. I find Geneva the most irrationally expensive city I travel to, and the current exchange rates don’t suggest I will find anything different this time.

I come back for a few days before heading to San Diego and my Strategic Investment Conference, cosponsored with Altegris. I have spent time with each of the speakers over the last few weeks, going over their topics, and I have to tell you, I am like a kid in a candy store, about as excited as I can get. This is going to be one incredible conference. You really want to make an effort to get there, but if you can’t, be sure to listen to the audio CDs.  You can get a discounted rate by purchasing prior to the conference.

The Dallas weather may be an analogy for the current economic environment. To look out my window is to see nothing but blue sky with puffy little clouds, and the temperature is perfect. My good friend and business partner Darrell Cain will be arriving in a little bit for a late lunch. We’ll go somewhere and sit outside and then move on to an early Dallas Mavericks game against the San Antonio Spurs. Contrary to expectations, the Mavs actually trounced the Spurs down in San Antonio last week. Of course the local fans would like to see that trend continue, but I would not encourage my readers to place any bets on the Mavericks’ winning the current playoff series.

I live only a few blocks from American Airlines Center, and so normally on such a beautiful day we would leisurely walk to the game. But the local weather aficionados are warning us that while we are at the game tornadoes and hail may appear, along with the attendant severe thunderstorms. That kind of thing can happen in Texas. Then again, it could all blow south of here. That sort of thing also happens.

So when I warn people of an impending potential central bank policy mistake, which would be the economic equivalent of tornadoes and hail storms, I also have to acknowledge that the whole thing could blow away and miss us entirely. I think someone once said that the role of economists is to make weathermen look good. Recently, 67 out of 67 economists said they expect interest rates to rise this year. We’ll review that prediction at the end of the year.

I’ve been interrupted while trying to finish this letter by daughter Tiffani, who is frantically trying to figure out how to buy tickets to get us to Italy (Tuscany) for the first part of June for a little vacation (along with a few friends who will be visiting). I am going to take advantage of being in Rome at the end of that trip, in order to spend a few days with my friend Christian Menegatti, the managing director of research for Roubini Global Economics. We will spend June 16-17  visiting with local businessmen, economists, central bankers, and politicians. Or that’s the plan. If you’d like to be part of that visit, drop me a note.

Finally I should note that my Canadian partners, Nicola Wealth Management, are opening a new office in Toronto. They will be having a special event there on May 8. If you’re in the area, you may want to check it out.

Have a great week, and make sure you take a little time to enjoy life. Avoid tornadoes.

Your hoping for a major upset analyst,

John Mauldin, Editor
Mauldin Economics

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The article Thoughts from the Frontline: The Cost of Code Red was originally published at Mauldin Economics

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Peter Schiff Shares His Offshore Strategies

By Nick Giambruno

I’d bet that most International Man readers are familiar with Peter Schiff. He is a financial commentator and author, CEO of Euro Pacific Capital, and is known for accurately predicting the 2008 financial crisis.

He also has a very keen understanding of internationalization. Peter shares with me his strategies in this must read discussion below that I am happy to bring exclusively to International Man readers. (If you are not already a member, you can join for free here.)

Nick Giambruno: Peter, do you see the potential for another financial crisis in the U.S. playing out in the not so distant future?

Peter Schiff: Unfortunately, yes. I mean, how soon is very difficult to tell. In fact, right now you’ve got a high level of complacency. The stock markets are rallying to new highs, nominal highs. People seem to be convinced that the worst is behind us, that the central banks of the world have solved their problems by papering them over. But, you know, I don’t think they’ve solved anything. I think they’ve compounded the underlying problems that caused the last crisis, and so now the next crisis will be that much worse because of what the central banks did, in particular the Federal Reserve.

The Fed is right now trying to prop the economy up, the housing market up with cheap money, and it is operating under the delusion that one day it can take that cheap money away and the economy and the housing market will just sustain on their own, but that’s not possible. The Fed is building an economy that is completely dependent on that cheap money. And so if you take it away, the economy implodes, but if you don’t take it away, then it’s worse.

Nick Giambruno: So what measures do you see coming into place—things such as capital controls?

Peter Schiff: Well, certainly as currencies depreciate, governments look to try to find ways to stop the bleeding. What’s really is going on with inflation is that you have a huge transfer of wealth from savers and lenders to debtors, and of course the US government is the world’s biggest debtor, but a lot of American voters are in debt too.

If you’re a saver and you don’t want to watch your assets confiscated through the printing press, then you’re going to try to protect yourself. You might do that by moving your dollars abroad, converting them to foreign currencies, trying to get out of harm’s way, and that’s when you have the government potentially coming in with capital controls.

Putting taxes on foreign currency transactions or maybe outright prohibiting them altogether, that will make it more difficult for you or more expensive to take protective measures. I think we’ve already got the beginnings of capital controls in the United States. The government is making it very difficult for Americans to do business abroad. Many foreign financial institutions, banks, and even bullion depositories are refusing to do business with American citizens for fear of retaliation by the IRS or other government agencies.

Nick Giambruno: So what can Americans and others living under a desperate government do to minimize this risk?

Peter Schiff: Well, the first thing that you could do is minimize your purchasing power risk. So you don’t have to get your money into a foreign bank or foreign brokerage account to get out of the dollar. I help Americans diversify globally within a US account, but their portfolio consists of foreign assets, whether it’s foreign bonds, government bonds, corporate bonds, foreign stocks, dividend-paying stocks, commodities, or precious metals. These are all things that will protect purchasing power in an inflationary time period, and things that the federal government—the Federal Reserve—can’t levy the inflation tax on.

If you’re more worried about political risk—about the US government seizing your assets—then you want to take the next step. This is not just getting out of the dollar, but getting your money out of the country. But again, the US government is making that more difficult right now.

I know personally. I set up a foreign brokerage firm as a subsidiary of my foreign bank, which I also set up, called Euro Pacific Bank. I did this predominantly for foreigners who were having trouble investing with my US brokerage firm. The securities rules and regulations are now so onerous that it almost caused me to view any foreigner as a terrorist. So if somebody in Australia wanted to open up an account with me, there was so much paperwork involved that oftentimes they would just give up halfway through the process. So what I did is I set up this foreign bank so that I wouldn’t have to operate under those confines, so I can be more competitive to a foreign investor, but I can’t offer these services to Americans.

My foreign bank is no different than many other foreign banks. In order to really protect the privacy of my foreign customers, I can’t accept American customers. And if I accepted American customers, my compliance cost would be so high that I would have to charge my foreign customers more for transactions to try to stay in business. So to mitigate all that regulation and the potential of having to share all the information on my foreign clients with the US government, I’m just not taking American customers with my foreign bank.

Nick Giambruno: So Euro Pacific Bank, where is it headquartered and why did you choose that jurisdiction?

Peter Schiff: It’s in St Vincent and the Grenadines (the Caribbean). I did it for a number of reasons: it’s close to me, but also because of the banking laws. You have secrecy, privacy, and you have no tax. They’re not going to impose any income tax on my company as an offshore bank, they’re also not going to impose any taxes, any withholding taxes on my bank’s customers’ interest income or their capital gains. And no one is going to pierce the wall of secrecy. You’re going to have to go in to a St. Vincent’s court and get a local court order to get any information from my bank.

The bank is regulated, but it’s not nearly as onerous as the type of regulations that I would face trying to do this business from the United States. In fact, some of the things we’re doing offshore might be completely impossible because they would no longer be economically viable if I tried to do them in America, but I can do them offshore because the government doesn’t impose these artificial barriers.(Editor’s Note: You can find out more about Euro Pacific Bank here.)

Nick Giambruno: Generally speaking, which countries are you particularly bullish on?

Peter Schiff: It’s kind of like a monetary or economic triage; I’m always looking around the world to see which countries are in the least bad shape, which countries are the least reckless and the least irresponsible. You really can’t find any one country that’s doing it perfectly. You just have to find the ones that are making the fewest mistakes.

And I think high on that list are Singapore and Hong Kong. Those markets are relatively free of regulation, free of taxation. I mean, it’s not nonexistent, but on a relative basis you have a lot more freedom there, and so you have a lot more prosperity there. You have much better economic fundamentals. And not just in those two places, but in Southeast Asia in general, in a lot of the emerging economies, you’ll find a lot less government and a lot more freedom. People are working harder, they’re saving, they’re producing, and they’re exporting. You don’t have these trade deficits, budget deficits, and you don’t have armies of people looking to retire on government entitlements. In Europe, we still like Switzerland even though they are making mistakes tying their currency to the euro. I think eventually they will change that policy. Scandinavia, we have been investors in Norway, we’ve been investors in Sweden. Also Australia and New Zealand have been longtime favorites. We’ve been investing down there or even closer to home in Canada. We do have some investments in South America. We’re diversifying around the world trying to get into the right countries, the right currencies, the right asset classes.

Nick Giambruno: On a different note, we’ve seen the number of US citizens renouncing their citizenship sharply increase. We have also seen high-profile people like Tina Turner and Eduardo Saverin give up their US citizenship. Would Tina be eligible to use Euro Pacific Bank?

Peter Schiff: Yes, once you renounce your US citizenship. The only people who can’t bank with me are American citizens, or green card holders. So once you are no longer an American citizen, as long as you don’t reside in the United States, then you are welcome at the bank.

I think a lot of people are doing this obviously for tax reasons, although they can’t necessarily claim it’s for tax reasons. You have to fill out a form if you want to renounce your citizenship—which, by the way, you can only get from a foreign embassy or consulate. Those forms used to be free. Now they’re $500 apiece. So think about that. If they can charge you $500 for that form, they could charge $5,000, they could charge $5,000,000. They could basically make it impossible for you to leave. And they’re trying to make it more difficult ever since Eduardo Saverin from Facebook went to Singapore.

Now the government is trying to come up with all sorts of ways to punish Americans who try to give up their citizenship, and this really is the sign of a nation in decay. Fifty years ago, nobody would want to give up American citizenship. They would cherish it. The fact that so many people are paying tremendous amounts of money to get this albatross off their neck shows you how much times have changed, that an American passport is not an asset to be cherished but a liability that people are willing to pay to get rid of.

Nick Giambruno: And what about yourself? Do you believe you are adequately diversified internationally?

Peter Schiff: I think my investments are; I own a lot of foreign stocks. I have a lot of precious metals, I have a lot of mining shares. But I still live in the United States, so I’m obviously still vulnerable here. My family is here, so I haven’t done anything about a physical exit strategy. Although I do think I have financial resources that would afford me the ability to relocate, but I haven’t actually taken any steps other than setting up a foreign business. I have the foreign bank in the Caribbean. I have a brokerage firm Euro Pacific Canada, and so I’ve got offices up there.

I’m also thinking about opening up an office in Singapore and trying to move more of my business—particularly my asset management business—to move it from the US. Not only because of favorable tax treatment outside the US, but because of the regulatory environment. If you want to be globally competitive, you need to be in an area where you can minimize these costs because if I have those costs and my competitors don’t, then I am at a disadvantage. And also because I think that over time people are going to be more and more hesitant about sending their money to the United States. So if I’m going to manage money, I might have to manage it offshore, because I think people will be worried about sending it here. They might be worried that the US government might take it.

If it ever gets really, really bad that you feel that you have to leave, by then it might be illegal to take any gold or silver out of the country. Right now you can take more than $10,000 worth of cash or cash equivalents—which would include gold bullion—out of the country as long as you tell the government that you’re taking it. And if you don’t tell them and they catch you, there’s a big fine and jail penalty. But one day it might not be the case. It might be that you are prohibited from taking any significant amount of money out of the country, and who knows what the penalty might be if they catch you. But if it’s already out of the country, then you don’t have to worry, because you’re leaving with nothing and the money is on the other side of the border waiting for you.
 
Nick Giambruno: So the idea is to preempt capital controls?

Peter Schiff: Yeah, well, you get out the window before they slam it shut. That’s the whole idea, and right now those windows are shutting all around as more and more offshore institutions are saying “no thank you” to an American customer. But the other reason that you want to act sooner too is if they impose exchange controls or fees on purchasing precious metals. They don’t ban them, but they have a big tax on the transaction or a big tax on the foreign exchange. If you want to buy Swiss francs, they can have a transaction tax. You want to get your money out of the dollar before those taxes are imposed, because if you wait until they’re imposed, then you can’t get as much money out, because a lot of it is being lost to taxes.

In getting out of the dollar, you’re trying to avoid the inflation tax, but they’re hitting you with some other kind of tax in the process because that’s really what they are trying to do. A lot of people are worrying about the income tax or the estate tax and they go through elaborate means to try to minimize those taxes, but then they leave themselves vulnerable to what might be the biggest tax of all: and that’s the inflation tax. So you have to act to protect yourself before so many people are trying to protect themselves that the government makes it almost impossible to do so.

Editor’s Note: Internationalization is your ultimate insurance policy. Whether it’s with a second passport, offshore physical gold storage, or other measures, it is critically important that you dilute the amount of control the bureaucrats in your home country wield over you by diversifying your political risk.

You can find Casey Research’s A-Z guide on internationalization by clicking here.

The article Peter Schiff Shares His Offshore Strategies was originally published at International Man

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Thoughts from the Frontline: Interview with Steve Forbes

By John Mauldin

I'm not certain how many interviews I've done over the last decade. Hundreds? I know it is a lot. There are some interviewers who can somehow tease out what you really have in you. Tom Keene at Bloomberg, for instance, forces you to bring your A game, at whatever level you play. He brings it out of you. You know that he is smarter than you will ever be and that you should really be asking him the questions. Except that you're not smart enough to ask the questions. I have to confess that every time I walk into the room with Tom I'm a little intimidated. I try never to show it, somewhat like the new kid on the block trying to put on a brave face, but inside I keep looking for the exit doors just in case I throw up all over myself. At the end of the day I'm still a small town country boy from Bridgeport, Texas, trying to figure out how the big city works.

And then there's Steve Forbes. If I've done hundreds of interviews, then Steve has done many thousands, on the presidential campaign trail with the best of the best, and gods did he learn the craft. I've done multiple interviews with Steve, and every time I sit down with him I feel that I'm with my best friend. Maybe it's because we have a ton of shared values and I have read and admired him for years. I truly think he would've made a great president in the mold of Ronald Reagan, but for whatever reason New Hampshire did not agree. As I think even Steve will admit, while he may have a philosophical mind meld with Reagan, the Gipper had some small genetic extra, call it what you will.

But for whatever reason, Steve seems to bring out the passion in me. When I think about what central bank policies are doing to savers and investors, how we are screwing around with the pension system, circumventing rational market expectations because of an untested economic theory held by a relatively small number of academics, I get a little exercised. And Steve gives me the freedom to do it.

And so a few weeks ago, philosophically like minded old friends sat down at his offices in New York to talk about the world in general. Monetary policy, Janet Yellen, gold, stocks, commodities, the time value of money, grandchildren, and a lot of other stuff, all folded together into what I think may be the best interview I've ever done in my career. Steve gives me the room to be me and allows that passion that has always been inside me to come to the fore. And with his smile and gentle demeanor, he eggs it on.

So this week, for the first time in 14 years of Thoughts from the Frontline, I offer you  a wide ranging interview with John Mauldin, as conducted by the inimitable Steve Forbes. You can watch the video on our home page (lower right, under "Latest Video") or read the transcript below.



John Mauldin: How Central Bankers Will Ruin The Global Economy

John Mauldin, investor and co-author of the new book Code Red, recently sat down with me to discuss monetary policy, a still-lagging economy, and how he might operate the Federal Reserve if he were in Ben Bernanke's or Janet Yellen's shoes.

Steve Forbes: John, good to have you back again.

John Mauldin: Steve, it is always fun to be with you.

Forbes: You've got a new book out, called Code Red.

Mauldin: Yes.

Forbes: Hot off the press.

Mauldin: Yeah, show it up twice now. There we go.

Forbes: Code Red, Jack Nicholson, A Few Good Men. Explain first the title.

Mauldin: Well, in that movie Jack Nicholson famously felt that he had to protect America. He was in charge. And so he issued his famous "code red," and his line was, "You need me on that wall." So at the beginning of the book I paraphrased his speech as if it were Ben Bernanke talking or now Janet Yellen:

"You need me on that committee. You want me on that central bank. Yes, you work for savers and creditors, but I'm responsible for whole economies. I have greater things to worry about."

So in 2008 the central banks of the world had to issue a code red.

It's like, a patient is brought by ambulance to the hospital, and instead of operating you put him on morphine. Or it's like asking the arsonist to put out the fire. Part of the reason we had this very crisis was because of central bank policies and government regulations and the interweaving of large investment banks and politicians and central bankers. I don't want to get into conspiracy theories; I think it's just people's self interest.

Forbes: How about a stupidity theory?

Mauldin: Some of it was stupid, but some of it was just greed. Nonetheless, we had a crisis. The banking system froze up. We went to the edge of the abyss. We looked over and it was a long way down. And I believe central banks appropriately provided liquidity. That was their function, and I would argue that almost the sole true function of a central bank is to be there when the stuff hits the fan.
Forbes: To be what Bagehot called the lender of last resort.

Mauldin: Yes, the lender of last resort. That being said, they never took the patient off morphine. At your and my age, we've had the unpleasant experience of caring for friends who are in the hospital. And in today's world, my mother has a hip operation, and they have her up and walking the next day.

They just opened up her hip, put a new hip in. One of my good friends, the same thing – the next day he's up and walking. Forget this morphine stuff. Forget lying around in a hospital bed like we used to have to do. Well, the central banks are still operating with 1900s medicine, so they just kept the patient on morphine.
And now the patient is addicted. The problem is, when you want to end that addiction, whether it's alcohol or drugs or quantitative easing, withdrawal is not going to be pretty. But the Fed's hope is that somehow or other, "We can get the economy going. We can create animal spirits," and that people won't notice when they start withdrawing a trillion dollars a year of monetary easing out of the global system.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

© 2013 Mauldin Economics. All Rights Reserved.



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Outside the Box: A Limited Central Bank

By John Mauldin

This week’s Outside the Box is unusual, even for a letter that is noted for its unusual offerings. It is a speech from last week by Charles I. Plosser, President of the Federal Reserve Bank of Philadelphia at (surprisingly to me) the Cato Institute’s 31st Annual Monetary Conference, Washington, DC.

I suppose that if Dallas Fed President Richard Fisher had delivered this speech I would not be terribly surprised. I suspect there are some other Federal Reserve officials here and there whoare in sympathy with this view Plosser presents here, but for quite some time no serious Fed official has outlined the need for a limited Federal Reserve in the way Plosser does today. He essentially proposes four limits on the US Federal Reserve:

• First, limit the Fed’s monetary policy goals to a narrow mandate in which price stability is the sole, or at least the primary, objective;
• Second, limit the types of assets that the Fed can hold on its balance sheet to Treasury securities;
• Third, limit the Fed’s discretion in monetary policymaking by requiring a systematic, rule-like approach;
• And fourth, limit the boundaries of its lender-of-last-resort credit extension.

“These steps would yield a more limited central bank. In doing so, they would help preserve the central bank’s independence, thereby improving the effectiveness of monetary policy, and they would make it easier for the public to hold the Fed accountable for its policy decisions.”

Some of you will want to read this deeply, but everyone should read the beginning and ending. I find this one of the most hopeful documents I have read in a long time. Think about the position of the person who delivered the speech. You are not alone in your desire to rein in the Fed.

Two points before we turn to the speech. Both Fisher and Plosser will be voting members of the FOMC this coming year. Look at the lineup and the philosophical monetary view of each of the members of the FOMC. Next year we could actually see three dissenting votes if things are not moving in a positive direction, although another serious proponent of monetary easing is being added to the Committee, so it may be that nothing will really change.



I am not seriously suggesting that the reigning economic theory that directs the action of the Fed is going to change anytime soon, but you will see assorted academics espousing a different viewpoint here and there. I think there may come a time in the not-too-distant future when the current Keynesian viewpoint is going to be somewhat discredited and people will be open to a new way to run things. This will not happen due to some great shift in philosophical views but because the current system has the potential to create some rather serious problems in the future. This is part of the message in my latest book, Code Red.

A lot of education and change in the system is needed. I want to applaud Alan Howard and his team at Brevan Howard for making one of the largest donations in business education history to Imperial College to establish the new Brevan Howard Centre for Financial Analysis to study exactly these topics and counter what is a particularly bad direction in academia. The two leaders at the new center, Professors Franklin Allen and Douglas Gale, are renowned for their pioneering research into financial crises and market contagion – that is, when relatively small shocks in financial institutions spread and grow, severely damaging the wider economy. This new center will help offer a better perspective. What we teach our kids matters. I hope other major fund managers will join this effort!

And speaking of Code Red, let me pass on a few quick reviews from Amazon:

“Excellent review of our current economic circumstances and what we can do about it to protect our assets. Even better, it is written with the non-economist in mind.”

“I read this book from cover to cover in 24 hours and was glued to every page. Do I know how to protect my saving exactly? No. But I have the critical information necessary to make informed decisions about my investments. My husband recommended this book to me after reading a brief article, and I'm so glad I impulsively bought it. It will definitely change my investment decisions moving forward and perhaps even provide me with more restful nights of sleep.”

You can order your own copy at the Mauldin Economics website or at Amazon, and it is likely at your local book store.

It is getting down to crunch time here in Dallas as far as the move to the new apartment is concerned. Work is coming along and most of it is done, although some things will need to be finished after I move in. Furniture is being delivered and moved in as I write, and today an the new kitchen is being entirely stocked, courtesy of Williams-Sonoma – they'll be showing up in a few minutes. I am fulfilling a long-held dream (maybe even a fantasy or fetish) of throwing everything out of the kitchen and starting over from scratch. Between my kids and a returning missionary couple, all the old stuff will find a new home, and I will renew my role as chief chef with new relish next week.

I have always maintained that I think I am a pretty good writer but I a brilliant cook. With a new kitchen from top to bottom, I intend to spend more time developing my true talent. Between the new media room and my cooking, I hope I can persuade the kids (and their kids!) to come around more often. Yes, there are a few bumps and issues here and there, but in general life is going well. I just need to get into the gym more. Which we should all probably do!

Your feeling like a kid in a candy store analyst,

John Mauldin, Editor Outside the Box

---

 

A Limited Central Bank

 

Presented by Charles I. Plosser, President and Chief Executive Officer, Federal Reserve Bank of Philadelphia

Cato Institute’s 31st Annual Monetary Conference, Washington, D.C.

Highlights

• President Charles Plosser discusses what he believes is the Federal Reserve’s essential role and proposes how this institution might be improved to better fulfill that role.

• President Plosser proposes four limits on the central bank that would limit discretion and improve outcomes and accountability.

• First, limit the Fed’s monetary policy goals to a narrow mandate in which price stability is the sole, or at least the primary, objective;

• Second, limit the types of assets that the Fed can hold on its balance sheet to Treasury securities;

• Third, limit the Fed’s discretion in monetary policymaking by requiring a systematic, rule-like approach;

• And fourth, limit the boundaries of its lender-of-last-resort credit extension.

• These steps would yield a more limited central bank. In doing so, they would help preserve the central bank’s independence, thereby improving the effectiveness of monetary policy, and they would make it easier for the public to hold the Fed accountable for its policy decisions.

 

Introduction: The Importance of Institutions

 

I want to thank Jim Dorn and the Cato Institute for inviting me to speak once again at this prestigious Annual Monetary Conference. When Jim told me that this year’s conference was titled “Was the Fed a Good Idea?” I must confess that I was little worried. I couldn’t help but notice that I was the only sitting central banker on the program. But as the Fed approaches its 100th anniversary, it is entirely appropriate to reflect on its history and its future. Today, I plan to discuss what I believe is the Federal Reserve’s essential role and consider how it might be improved as an institution to better fulfill that role.

Before I begin, I should note that my views are not necessarily those of the Federal Reserve System or my colleagues on the Federal Open Market Committee (FOMC).

Douglass C. North was cowinner of the 1993 Nobel Prize in Economics for his work on the role that institutions play in economic growth.¹ North argued that institutions were deliberately devised to constrain interactions among parties both public and private. In the spirit of North’s work, one theme of my talk today will be that the institutional structure of the central bank matters. The central bank’s goals and objectives, its framework for implementing policy, and its governance structure all affect its performance.

Central banks have been around for a long time, but they have clearly evolved as economies and governments have changed. Most countries today operate under a fiat money regime, in which a nation’s currency has value because the government says it does. Central banks usually are given the responsibility to protect and preserve the value or purchasing power of the currency.² In the U.S., the Fed does so by buying or selling assets in order to manage the growth of money and credit. The ability to buy and sell assets gives the Fed considerable power to intervene in financial markets not only through the quantity of its transactions but also through the types of assets it can buy and sell. Thus, it is entirely appropriate that governments establish their central banks with limits that constrain the actions of the central bank to one degree or another.

Yet, in recent years, we have seen many of the explicit and implicit limits stretched. The Fed and many other central banks have taken extraordinary steps to address a global financial crisis and the ensuing recession. These steps have challenged the accepted boundaries of central banking and have been both applauded and denounced. For example, the Fed has adopted unconventional large-scale asset purchases to increase accommodation after it reduced its conventional policy tool, the federal funds rate, to near zero.

These asset purchases have led to the creation of trillions of dollars of reserves in the banking system and have greatly expanded the Fed’s balance sheet. But the Fed has done more than just purchase lots of assets; it has altered the composition of its balance sheet through the types of assets it has purchased. I have spoken on a number of occasions about my concerns that these actions to purchase specific (non-Treasury) assets amounted to a form of credit allocation, which targets specific industries, sectors, or firms.

These credit policies cross the boundary from monetary policy and venture into the realm of fiscal policy.³ I include in this category the purchases of mortgage-backed securities (MBS) as well as emergency lending under Section 13(3) of the Federal Reserve Act, in support of the bailouts, most notably of Bear Stearns and AIG. Regardless of the rationale for these actions, one needs to consider the long-term repercussions that such actions may have on the central bank as an institution.

As we contemplate what the Fed of the future should look like, I will discuss whether constraints on its goals might help limit the range of objectives it could use to justify its actions. I will also consider restrictions on the types of assets it can purchase to limit its interference with market allocations of scarce capital and generally to avoid engaging in actions that are best left to the fiscal authorities or the markets. I will also touch on governance and accountability of our institution and ways to implement policies that limit discretion and improve outcomes and accountability.

Goals and Objectives

 

Let me begin by addressing the goals and objectives for the Federal Reserve. These have evolved over time. When the Fed was first established in 1913, the U.S. and the world were operating under a classical gold standard. Therefore, price stability was not among the stated goals in the original Federal Reserve Act. Indeed, the primary objective in the preamble was to provide an “elastic currency.”

The gold standard had some desirable features. Domestic and international legal commitments regarding convertibility were important disciplining devices that were essential to the regime’s ability to deliver general price stability. The gold standard was a de facto rule that most people understood, and it allowed markets to function more efficiently because the price level was mostly stable.

But, the international gold standard began to unravel and was abandoned during World War I.⁴ After the war, efforts to reestablish parity proved disruptive and costly in both economic and political terms. Attempts to reestablish a gold standard ultimately fell apart in the 1930s. As a result, most of the world now operates under a fiat money regime, which has made price stability an important priority for those central banks charged with ensuring the purchasing power of the currency.

Congress established the current set of monetary policy goals in 1978. The amended Federal Reserve Act specifies the Fed “shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Since moderate long-term interest rates generally result when prices are stable and the economy is operating at full employment, many have interpreted these goals as a dual mandate with price stability and maximum employment as the focus.

Let me point out that the instructions from Congress call for the FOMC to stress the “long run growth” of money and credit commensurate with the economy’s “long run potential.” There are many other things that Congress could have specified, but it chose not to do so. The act doesn’t talk about managing short-term credit allocation across sectors; it doesn’t mention inflating housing prices or other asset prices. It also doesn’t mention reducing short-term fluctuations in employment.

Many discussions about the Fed’s mandate seem to forget the emphasis on the long run. The public, and perhaps even some within the Fed, have come to accept as an axiom that monetary policy can and should attempt to manage fluctuations in employment. Rather than simply set a monetary environment “commensurate” with the “long run potential to increase production,” these individuals seek policies that attempt to manage fluctuations in employment over the short run.

The active pursuit of employment objectives has been and continues to be problematic for the Fed. Most economists are dubious of the ability of monetary policy to predictably and precisely control employment in the short run, and there is a strong consensus that, in the long run, monetary policy cannot determine employment. As the FOMC noted in its statement on longer-run goals adopted in 2012, “the maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market.” In my view, focusing on short-run control of employment weakens the credibility and effectiveness of the Fed in achieving its price stability objective. We learned this lesson most dramatically during the 1970s when, despite the extensive efforts to reduce unemployment, the Fed essentially failed, and the nation experienced a prolonged period of high unemployment and high inflation. The economy paid the price in the form of a deep recession, as the Fed sought to restore the credibility of its commitment to price stability.

When establishing the longer-term goals and objectives for any organization, and particularly one that serves the public, it is important that the goals be achievable. Assigning unachievable goals to organizations is a recipe for failure. For the Fed, it could mean a loss of public confidence. I fear that the public has come to expect too much from its central bank and too much from monetary policy, in particular. We need to heed the words of another Nobel Prize winner, Milton Friedman. In his 1967 presidential address to the American Economic Association, he said, “…we are in danger of assigning to monetary policy a larger role than it can perform, in danger of asking it to accomplish tasks that it cannot achieve, and as a result, in danger of preventing it from making the contribution that it is capable of making.”⁵ In the 1970s we saw the truth in Friedman’s earlier admonitions. I think that over the past 40 years, with the exception of the Paul Volcker era, we failed to heed this warning. We have assigned an ever-expanding role for monetary policy, and we expect our central bank to solve all manner of economic woes for which it is ill-suited to address. We need to better align the expectations of monetary policy with what it is actually capable of achieving.

The so-called dual mandate has contributed to this expansionary view of the powers of monetary policy. Even though the 2012 statement of objectives acknowledged that it is inappropriate to set a fixed goal for employment and that maximum employment is influenced by many factors, the FOMC’s recent policy statements have increasingly given the impression that it wants to achieve an employment goal as quickly as possible.⁶

I believe that the aggressive pursuit of broad and expansive objectives is quite risky and could have very undesirable repercussions down the road, including undermining the public’s confidence in the institution, its legitimacy, and its independence. To put this in different terms, assigning multiple objectives for the central bank opens the door to highly discretionary policies, which can be justified by shifting the focus or rationale for action from goal to goal.

I have concluded that it would be appropriate to redefine the Fed’s monetary policy goals to focus solely, or at least primarily, on price stability. I base this on two facts: Monetary policy has very limited ability to influence real variables, such as employment. And, in a regime with fiat currency, only the central bank can ensure price stability. Indeed, it is the one goal that the central bank can achieve over the longer run.

Governance and Central Bank Independence

 

Even with a narrow mandate to focus on price stability, the institution must be well designed if it is to be successful. To meet even this narrow mandate, the central bank must have a fair amount of independence from the political process so that it can set policy for the long run without the pressure to print money as a substitute for tough fiscal choices. Good governance requires a healthy degree of separation between those responsible for taxes and expenditures and those responsible for printing money.

The original design of the Fed’s governance recognized the importance of this independence. Consider its decentralized, public-private structure, with Governors appointed by the U.S. President and confirmed by the Senate, and Fed presidents chosen by their boards of directors. This design helps ensure a diversity of views and a more decentralized governance structure that reduces the potential for abuses and capture by special interests or political agendas. It also reinforces the independence of monetary policymaking, which leads to better economic outcomes.

Implementing Policy and Limiting Discretion

 

Such independence in a democracy also necessitates that the central bank remain accountable. Its activities also need to be constrained in a manner that limits its discretionary authority. As I have already argued, a narrow mandate is an important limiting factor on an expansionist view of the role and scope for monetary policy.

What other sorts of constraints are appropriate on the activities of central banks? I believe that monetary policy and fiscal policy should have clear boundaries.⁷ Independence is what Congress can and should grant the Fed, but, in exchange for such independence, the central bank should be constrained from conducting fiscal policy. As I have already mentioned, the Fed has ventured into the realm of fiscal policy by its purchase programs of assets that target specific industries and individual firms. One way to circumscribe the range of activities a central bank can undertake is to limit the assets it can buy and hold.

In its System Open Market Account, the Fed is allowed to hold only U.S. government securities and securities that are direct obligations of or fully guaranteed by agencies of the United States. But these restrictions still allowed the Fed to purchase large amounts of agency mortgage-backed securities in its effort to boost the housing sector. My preference would be to limit Fed purchases to Treasury securities and return the Fed’s balance sheet to an all-Treasury portfolio. This would limit the ability of the Fed to engage in credit policies that target specific industries. As I’ve already noted, such programs to allocate credit rightfully belong in the realm of the fiscal authorities — not the central bank.

A third way to constrain central bank actions is to direct the monetary authority to conduct policy in a systematic, rule-like manner.⁸ It is often difficult for policymakers to choose a systematic rule-like approach that would tie their hands and thus limit their discretionary authority. Yet, research has discussed the benefits of rule-like behavior for some time. Rules are transparent and therefore allow for simpler and more effective communication of policy decisions. Moreover, a large body of research emphasizes the important role expectations play in determining economic outcomes. When policy is set systematically, the public and financial market participants can form better expectations about policy. Policy is no longer a source of instability or uncertainty. While choosing an appropriate rule is important, research shows that in a wide variety of models simple, robust monetary policy rules can produce outcomes close to those delivered by each model’s optimal policy rule.

Systematic policy can also help preserve a central bank’s independence. When the public has a better understanding of policymakers’ intentions, it is able to hold the central bank more accountable for its actions. And the rule-like behavior helps to keep policy focused on the central bank’s objectives, limiting discretionary actions that may wander toward other agendas and goals.

Congress is not the appropriate body to determine the form of such a rule. However, Congress could direct the monetary authority to communicate the broad guidelines the authority will use to conduct policy. One way this might work is to require the Fed to publicly describe how it will systematically conduct policy in normal times — this might be incorporated into the semiannual Monetary Policy Report submitted to Congress. This would hold the Fed accountable. If the FOMC chooses to deviate from the guidelines, it must then explain why and how it intends to return to its prescribed guidelines.

My sense is that the recent difficulty the Fed has faced in trying to offer clear and transparent guidance on its current and future policy path stems from the fact that policymakers still desire to maintain discretion in setting monetary policy. Effective forward guidance, however, requires commitment to behave in a particular way in the future. But discretion is the antithesis of commitment and undermines the effectiveness of forward guidance. Given this tension, few should be surprised that the Fed has struggled with its communications.
What is the answer? I see three: Simplify the goals. Constrain the tools. Make decisions more systematically. All three steps can lead to clearer communications and a better understanding on the part of the public. Creating a stronger policymaking framework will ultimately produce better economic outcomes.

Financial Stability and Monetary Policy

 

Before concluding, I would like to say a few words about the role that the central bank plays in promoting financial stability. Since the financial crisis, there has been an expansion of the Fed’s responsibilities for controlling macroprudential and systemic risk. Some have even called for an expansion of the monetary policy mandate to include an explicit goal for financial stability. I think this would be a mistake.

The Fed plays an important role as the lender of last resort, offering liquidity to solvent firms in times of extreme financial stress to forestall contagion and mitigate systemic risk. This liquidity is intended to help ensure that solvent institutions facing temporary liquidity problems remain solvent and that there is sufficient liquidity in the banking system to meet the demand for currency. In this sense, liquidity lending is simply providing an “elastic currency.”

Thus, the role of lender of last resort is not to prop up insolvent institutions. However, in some cases during the crisis, the Fed played a role in the resolution of particular insolvent firms that were deemed systemically important financial firms. Subsequently, the Dodd-Frank Act has limited some of the lending actions the Fed can take with individual firms under Section 13(3). Nonetheless, by taking these actions, the Fed has created expectations — perhaps unrealistic ones — about what the Fed can and should do to combat financial instability.

Just as it is true for monetary policy, it is important to be clear about the Fed’s responsibilities for promoting financial stability. It is unrealistic to expect the central bank to alleviate all systemic risk in financial markets. Expanding the Fed's regulatory responsibilities too broadly increases the chances that there will be short-run conflicts between its monetary policy goals and its supervisory and regulatory goals. This should be avoided, as it could undermine the credibility of the Fed’s commitment to price stability.

Similarly, the central bank should set boundaries and guidelines for its lending policy that it can credibly commit to follow. If the set of institutions having regular access to the Fed’s credit facilities is expanded too far, it will create moral hazard and distort the market mechanism for allocating credit. This can end up undermining the very financial stability that it is supposed to promote.

Emergencies can and do arise. If the Fed is asked by the fiscal authorities to intervene by allocating credit to particular firms or sectors of the economy, then the Treasury should take these assets off of the Fed’s balance sheet in exchange for Treasury securities. In 2009, I advocated that we establish a new accord between the Treasury and the Federal Reserve that protects the Fed in just such a way.⁹ Such an arrangement would be similar to the Treasury-Fed Accord of 1951 that freed the Fed from keeping the interest rate on long-term Treasury debt below 2.5 percent. It would help ensure that when credit policies put taxpayer funds at risk, they are the responsibility of the fiscal authority — not the Fed. A new accord would also return control of the Fed’s balance sheet to the Fed so that it can conduct independent monetary policy.

Many observers think financial instability is endemic to the financial industry, and therefore, it must be controlled through regulation and oversight. However, financial instability can also be a consequence of governments and their policies, even those intended to reduce instability. I can think of three ways in which central bank policies can increase the risks of financial instability. First, by rescuing firms or creating the expectation that creditors will be rescued, policymakers either implicitly or explicitly create moral hazard and excessive risking-taking by financial firms. For this moral hazard to exist, it doesn’t matter if the taxpayer or the private sector provides the funds. What matters is that creditors are protected, in part, if not entirely.
Second, by running credit policies, such as buying huge volumes of mortgage-backed securities that distort market signals or the allocation of capital, policymakers can sow the seeds of financial instability because of the distortions that they create, which in time must be corrected.

And third, by taking a highly discretionary approach to monetary policy, policymakers increase the risks of financial instability by making monetary policy uncertain. Such uncertainty can lead markets to make unwise investment decisions — witness the complaints of those who took positions expecting the Fed to follow through with the taper decision in September of this year.

The Fed and other policymakers need to think more about the way their policies might contribute to financial instability. I believe that it is important that the Fed take steps to conduct its own policies and to help other regulators reduce the contributions of such policies to financial instability. The more limited role for the central bank I have described here can contribute to such efforts.

Conclusion

 

The financial crisis and its aftermath have been challenging times for global economies and their institutions. The extraordinary actions taken by the Fed to combat the crisis and the ensuing recession and to support recovery have expanded the roles assigned to monetary policy. The public has come to expect too much from its central bank. To remedy this situation, I believe it would be appropriate to set four limits on the central bank:

• First, limit the Fed’s monetary policy goals to a narrow mandate in which price stability is the sole, or at least the primary, objective;

• Second, limit the types of assets that the Fed can hold on its balance sheet to Treasury securities;

• Third, limit the Fed’s discretion in monetary policymaking by requiring a systematic, rule-like approach;

• And fourth, limit the boundaries of its lender-of-last-resort credit extension and ensure that it is conducted in a systematic fashion

• These steps would yield a more limited central bank. In doing so, they would help preserve the central bank’s independence, thereby improving the effectiveness of monetary policy, and, at the same time, they would make it easier for the public to hold the Fed accountable for its policy decisions. These changes to the institution would strengthen the Fed for its next 100 years.

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Bloomberg: Crude Oil Falls From Two Year High on Speculation China May Raise Interest Rates

Crude oil declined from a two year high in New York on speculation China will raise interest rates, damping growth in the world’s biggest energy consumer. Crude fell for the first time in three days and was set for a weekly drop. Equities slid on signs China is preparing to increase the cost of borrowing to curb inflation and the dollar traded near a six week high against the euro as Group of 20 leaders hold an emergency meeting amid concern that Europe’s debt crisis is worsening.

“For the time being $90 is going to be a very strong resistance level; above that, it’s too expensive,” said Andy Sommer, a senior analyst at EGL AG in Dietikon, Switzerland. “There’s a lot of uncertainty about Chinese monetary policy. If they tighten further, that has implications for the oil market.”

Crude for December delivery fell as much as $2.30, or 2.6 percent, to $85.51 a barrel in electronic trading on the New York Mercantile Exchange. It was at $86.08 at 1:15 p.m. London time. Yesterday, the contract rose to $88.63, the highest price since Oct. 9, 2008. Brent crude for December settlement fell as much as $2.16, or 2.4 percent, to $86.65 a barrel on the ICE Futures Europe exchange in London. The contract expires Nov. 15. The more actively traded January futures fell $1.59 to $87.51.

The MSCI Asia Pacific Index retreated 1.4 percent. The Stoxx Europe 600 Index fell as much as 1.8 percent and Standard & Poor’s 500 Index futures slid 1.5 percent. China’s inflation rate rose to the fastest in two years last month, fueling speculation an interest-rate increase is imminent. “People are betting on the Chinese rates and the discussions in the G-20 meeting are responsible for the current heavy selloff,” said Tetsu Emori, a commodity fund manager at Astmax Co. in Tokyo.......Read the entire article.


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