The euro saw its biggest single-day move against the dollar since 2009 yesterday, writes John Stepek. It went up like a rocket.
What happened? Have we suddenly learned that Europe’s economy is much stronger than anyone realised? Did Greeks start paying taxes en masse? Has the fundamental outlook for Europe been transformed overnight?
Of course not
It’s because European Central Bank boss Mario Draghi didn’t make interest rates quite as negative as everyone had expected, and he didn’t print as much extra money as everyone had expected.
Yes, it now costs banks a bit more to deposit their money with the ECB – that rate fell from –0.2% to -0.3%. And yes, the ECB will print money for longer. It’s extended its $60bn-a-month printing spree until March 2017, from September 2016.
But Draghi had led markets to expect more. So people who’d sold the euro in expectation of even bigger rate cuts and even more money printing were deeply disappointed. As a result, the single currency surged higher – a lot higher.
Meanwhile markets around the world were caught off balance – the Dow had its worst day in a long while.
I’ll be looking at this in more detail next week (and the potential impact on the Federal Reserve’s decision later in the month – frankly, Janet Yellen will be pleased to see the dollar isn’t quite the one-way bet that everyone believes).
But it just hammers home a key point I’ve made here over and over again. It’s stunning – given our purported belief in free markets as an efficient capital allocation mechanism – that the words and (relatively minor) actions of just one man can have such a huge impact on all of the world’s most important markets.
And it’s hard to know how we escape from this central-bank dependent world.
Which brings us to the third and final part of Tim Price’s discussion with Dan Denning and Nick O’Connor.
Tim – a long-time MoneyWeek contributor and professional wealth manager – has long been troubled by the state of the monetary system and aims to protect his clients and readers from what he sees as an inevitably disastrous endgame.
In this morning’s excerpt, Nick asks Tim how much longer the current system can endure. Check it out below. (You can see the first part of Tim’s interview here, and the second part here.)
(And if you haven’t yet got your copy of Tim’s new book, The War on Cash, buy it now – you might not agree with it, but it’s certainly worth understanding the scenario that he outlines.)
The corruption of Cassandra
Dan Denning: Now I want to play the devil’s advocate on the creation of credit here, because I think it’s an important distinction. What’s the difference between a central bank creating money from nothing to buy assets, and a retail bank who, when they make a loan to you, does it on a fractional reserve basis? So you borrow the money and you open your business or you get a mortgage. That money didn’t exist before either.
Tim Price: I hope I’m broadly correct in terms of the accuracy of the figures here. But I think something like 97% of the money that exists was lent into being by commercial banks. So that’s the importance of commercial banks and the whole money creation business. Central banks aren’t even the issue. It’s really the commercial banks. But to trace this back to source, the reason why we’re still living with this painful legacy and zero and negative interest rate policy and quantitative easing, is because the commercial banks lost the plot.
So earlier this week we had the whole six-years-delayed investigation and report into HBOS. I mean talk about a rapid reaction force. So mysteriously the statute of limitations means that people who did dumb things can no longer be held accountable for those dumb things. But that’s the source of the problem – that the commercial banking sector got way out of its depth and required the help of the central bank. So maybe I’ve been a little bit guilty of overlabouring the finger-pointing at the central banks because this has always been essentially a commercial banking problem.
Nick O’Connor: I think there’s an important distinction in that the central banks had a choice at that point whether to allow the system to cleanse itself via the laws of capitalism or free-market economics, however you want to say it. Basically when someone does something wrong they are punished for it. They pay the price. There’s a consequence if they’re good actions or if they’re bad actions and they chose to ignore that and to reinforce the bad decision making.
Tim: Well, you just had a Niagara of moral hazard. There’s a relevant bit in Andrew Ross Sorkin’s book, Too Big to Fail. Sorkin had tremendous access to the people who really mattered in the States in 2008, and fairly early on in the book there’s an account of the transcript from Jamie Dimon at JP Morgan with his board. It was done on the Saturday morning of the weekend that Lehman Brothers failed. So Lehman failed effectively just prior to the Tokyo market opening on the Sunday evening.
On the Saturday morning of that weekend, Dimon basically addressed his senior executive troops and said: “We should be prepared for Lehman Brothers filing for Chapter 11 bankruptcy. We should be prepared for Merrill Lynch filing. We should be prepared for Morgan Stanley filing. Pause. We should be prepared for Goldman Sachs filing.” Now that is a transcript of a conversation that actually occurred, and the immediate response to that was there was a sharp intake of breath on the other end of the line. Dimon was quite correctly pointing out that this could have gone down a different way than actually transpired.
What happened was that the Fed, for whatever reason, allowed Lehman Brothers to fail and it was probably about, you know, settling some old scores between Wall Street rivals. But as soon as they appreciated the damage that Lehman’s failure had caused, everybody else then miraculously got bailed out. So Goldman Sachs, for example, widely regarded as the premier investment bank, was mysteriously allowed to convert to a bank holding company and get direct funding from the Fed, a privilege that Lehman Brothers was never accorded. AIG was bailed out so that Goldman Sachs could also be bailed out.
It could have gone down a different way. There’s no counter factual so we’ll never know. But what you could have had was the virtual extinguishing of Wall Street as we then knew it, and you could have had something similar happen here in the UK. So it took former Bank of England governor Mervyn King, I think, 12 months to acknowledge – after the fact – that at the height of the crisis, the Bank of England came within hours of closing down the UK operations of Lloyds and RBS. And can we imagine for a second what the impact would have been if two of the biggest high street banks in the UK suddenly had no money left coming out of the ATM machines? I would posit that that is the equivalent, not of financial martial law, but of actual martial law.
Dan: Well, that’s powerful. In that sense, you can understand the rationale for it – the people who would have suffered the most from the failure, from the collapse of the institutions, were not the people who took the risks with money and made bad decisions, but ordinary people who had money in the bank.
Tim: But this still could have gone down a different way. As it was, I think we ended up with the worst of all possible worlds. We ended up with a fudge whereby both Lloyds and RBS were kept as quasi-private companies (albeit with significant state ownership), but in a slightly more free-market sense – a more Schumpeterian creative destruction sense – maybe governments should have completely nationalised those banks. They would have been bad banks, but they could have been nationalised. You would have kept the depositors whole, but bondholders and equity holders would have been completely wiped out, which is what they deserved, because those banks were insolvent.
Dan: And there’s a process for that. There’s already a free-market process for dealing with a failed institution – who gets paid, who doesn’t get paid, how they come out of bankruptcy.
Tim: You just queue up to wait for the administrators.
Nick: I’m not saying they necessarily had to let them go, but there were ways of securing the majority of people’s deposits while punishing people, probably professional investors, who’d made poor financial decisions. There’re ways of doing that.
Tim: It comes down to straightforward choice. The government and the government’s agents, in the form of the central banks, back in 2008 could have taken the short, sharp, shock route. They elected not to. By not taking that route, in my opinion, they ensured a years-long deflationary depression as a result. There was no good outcome from this at all. There was no easy fix. The only question was: do you want your resolution to be brutal, nasty, painful, but quick, or do you want it to be like the 1930s? And the decision that they effectively took was, well, we’ll have it like the 1930s please. That’s my take on how this has gone down.
Nick: Well, let’s talk about that. So it’s seven years on I think today. And today is the day we’re publishing your book, The War on Cash. But one of the things I wanted to ask you was this: often one of the slight criticisms people have of us and the things that we publish is: “Oh, you’ve been saying that for years and it hasn’t happened yet”. And actually I get a fair amount of emails like that, and one of the things I always write back and say is: “We know, we know that. We think about these sorts of things and we challenge ourselves and we don’t just ignore that kind of criticism or that kind of objection.” But I wanted to ask you about that Tim because a couple of years ago you wrote something in your newsletter, The Price Report, about the idea of being a Cassandra. Let me just quote it back to you:
“Cassandra in Greek mythology was the beautiful daughter of the King of Troy. The god Apollo granted her the power of prophecy, but when she spurned his advances, her subsequent reward was a curse – nobody would ever believe her. Cassandra foresaw both the Trojan War and the final destruction of Troy. She even warned of the Greek soldiers hiding in the Trojan horse. Every prediction was ignored. As befits Greek tragedy and the epic tradition, she lost her mind, was raped seeking shelter in the Temple of Athena, and was brutally murdered.
“The word Cassandra has taken on a slightly different context in the financial market. Linguists call this a functional shift when a word or phrase morphs from having one specific meaning to suddenly taking on another meaning. In the context of our modern markets a Cassandra is someone who cries wolf just a little too often.”
You go on to say that you’ve been accused of being a Cassandra more times than I can remember. I’ve no objection to the charge in the first context, but I suspect it’s meant more often in the second as somebody crying wolf just a little too often. So I wanted to ask you about that – how much do you think about that? Does that accusation bother you? Is it something that nags away at you?
Tim: Not really. I mean haters are going to hate, so that’s just the nature of things. But I stand by that original suggestion that the word Cassandra has morphed from being someone who issues a prophesy that nobody believes to someone who is perpetually crying wolf. And I entirely understand and accept that it’s maybe frustrating for people, when faced with a somewhat stark prediction or statement about a crisis or predicament that is going to have a fairly painful resolution saying, “Well, you said that five, six years ago and it hasn’t come to pass”. But just because something hasn’t come to pass doesn’t mean it won’t come to pass.
I remember very vividly having this conversation with Dylan Grice, an analyst who was previously with Soc Gen, at an investment seminar in Zurich. It was about five years ago, and we were discussing this whole thing – the kind of circles in which I move I think could be fairly described as Austrian school sympathisers, and these are people who are worried about the system. They’re worried about a systemic failure and have a real belief in the primacy of sound money and small government, neither of which of course we have.
We were discussing all these issues and Dylan made a very valid point. Let’s go back to the birth of the Soviet Union, he pointed out. The Soviet Union was born in the chaos of the revolution in 1917 and thereafter, on a fairly regular basis, you would have credible outside agencies saying: “well, that system can’t last. This whole state-directed socialist model is going to fail”. That was true, but the Berlin wall didn’t fall until 1989. So a completely dysfunctional system lasted a lifetime. It outlived everybody who would have made that prediction.
So the best I can say is that I hope that this ongoing dysfunctional mess doesn’t last a lifetime because I’ve got pretty fed up with it. I’m sure many other people have too, but if the question is: “when does this get resolved in whatever form that resolution takes?” then nobody has the answer. So I entirely accept I’ve now been completely surprised at the duration of this omnishambles. But, you know, nobody can say with a clear conscience or absolute conviction when this is going to end.
I think most objective observers would say there is clearly something rotten in the state of Denmark, but nobody can predict precisely when the rottenness gets purged from the system. That’s the pivotal, critical frustrating problem that we’re all faced with. We can recognise there’s a problem, and there may or may not be various answers or resolutions. But the one thing we can’t say, none of us can say is, when this mess gets resolved.
Nick: There was one quote that you used that I thought was particularly valid in this case from the godfather of value investing, Ben Graham. It said: “You are neither right nor wrong because the crowd disagrees with you. You are right because your data and your reasoning are right.” That was almost like a sermon, wasn’t it?
Tim: Here endeth the lesson.
Nick: But I think that’s true and I would say that the data and the reasoning are what we’re laying out in The War on Cash. That’s the argument in full. It’s fleshed out, it’s thought through and if you are sceptical about the things that we’re saying –
Tim: Then you have to prove that the data and the reasoning are incorrect.
Nick: Yes, exactly. It’s healthy to be sceptical, but it’s also healthy to shout and to challenge people’s arguments – I would encourage all of our readers and listeners to do that because we’re not here to preach to you.
Tim: It’s all about having a debate.
Nick: Exactly, so if you are interested in the sort of stuff we talk about – even if you’re sceptical, we acknowledge that not everybody will accept the sort of things we say – I think The War on Cash is a good opportunity to read the arguments in full, consider them and then make up your own mind whether or not you think the reasoning is correct.
Dan: You’re also probably being a little hard on yourself or unfair because it’s possible to sustain a political system for many years through coercion. So you throw people in jail. You steal their resources.
Tim: Send them to the gulag.
Dan: And so through coercion you can do a lot of things. One thing that the people on Wall Street and in the media and what I would call a mainstream approach – the non-Austrian approach to this whole problem – they have consistently underestimated the frequency and the magnitude of crises that can hit the system. Alan Greenspan encouraged people to use variable-rate loans – interest-only loans. He saw that as a financial innovation that would produce greater home ownership in America. He didn’t see it as creating a giant risk in the financial system. Even as that happened with the subprime crisis starting to boil over in 2007, 2008, Ben Bernanke went up in front of Congress and said – it’s contained, it’s not a problem.
Tim: And also that we’ve never had a national housing price decline in American history ie with the strong implication, therefore, that because something’s never happened before, it therefore can never happen in the future.
Dan: Right and I think that’s a point that I would make: that financial markets these days are so integrated, so complex and so sensitive to both interest rates and liquidity, that we don’t really know how quickly the next crisis could come, or how destructive it could be. But we know that everybody who’s telling us not to worry about it has been pretty much wrong for the last 20 years.
So if you’re taking it on their advice that there’s nothing to worry about – well, they have a pretty crappy track record, and all it takes is one time. If that happens to people who are close to their retirement age now or at retirement, then they should ask themselves if they can afford another year where their equity portfolio falls by 50%, because that’s what at stake for a lot of people. It’s not just money in the bank. If most people take it on faith that everybody else has got things under control and it happens again, it’s going to be devastating. And that’s why I think we go out of our way to make sure people understand that.
Maybe you don’t agree with it, maybe you think the probability is low, maybe it sounds remote or it just seems like an extreme position, but that would be an extreme outcome. So I think for me that’s why we consistently want to make sure people are aware of what’s at stake even if they don’t agree. Anyway, thank you for coming in, Tim.
Tim: Pleasure.
Category: Central Banks