Daniel Lacalle

The Myths of Paper Money

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This article was published in El Confidencial on Sept 19th, 2012

“Paper money eventually returns to its intrinsic value – zero.” Voltaire 

Have you seen the stock markets? What about commodities? Everything is shooting higher. Do we blame evil speculators for the move? No. I forgot that the media only calls us speculators when markets fall, and investors when everything goes up. The fact is that investors are moving into risky assets due to the massive destruction of money by the concerted activity of central banks, which is impacting soft and energy commodities, while it also generates bubbles by artificially lowering the cost of capital.So far, central banks have injected $9 trillion in four years in the global economies to generate zero marginal increase in gross domestic product or employment compared to initial expectations. That is the great “success” of the eternal plan of monetary expansion of central banks. Creating money out of nothing, not justified by real economic activity.

“We are creating money out of thin air, we’ve lost control” Ron Paul.

However, we read over and over again that “it could have been worse” if massive monetary expansion hadn’t been implemented. And then we repeat the same mistakes. Why not? Trust us, “this time it’s different.” Money is free.

But this time we have several additional problems for this new attempt at solving real economy issues with paper money to work:

  • The additional liquidity has little effect when business and consumer confidence wanes.
  • The monetary expansion takes place while China and emerging markets are in contraction as shown by their industrial indices.
  • In contrast to 2009, this new boost of paper money is not accompanied by a strong boost in industrial investments. 100 percent of the industrial companies we have seen this week are reducing their global investments.
  • This third money shower by the Federal Reserve is not accompanied by enormous possibilities of cost cuts as in 2008. This reduced ability to generate profits by reducing costs has been reflected in the deteriorating performance of the S&P 500 ex financial (-1.5 percent yoy).

In my view we are trying to recreate the same bubbles that led us to this crisis: housing, stocks and commodities.

If anything, what surprises me every day is that the general public applauds and celebrates the wild monetary expansion as a good thing, when it only benefits stocks and creates inflation, especially in commodities and gold. I imagine that the press will find a scapegoat afterwards in evil speculators or OPEC or any other, but the market is only looking to protect savings from the destruction created by massive money printing, rates at record lows and inflation risk. We are living a process of trying to rebuild bubbles, whether in financial markets or real estate through bad banks and mortgage backed securities.

As disposable income disappears and we learn that indiscriminate monetary policy does not work, we seem to accept the deception on the grounds that “it would have been worse” without monetary expansion. And while we wonder why we cannot make ends meet we are told that “official inflation” is supposedly “very low.”

Well, as The Kinks sang “Give the people what they want.” You wanted it, you got it. After the conference of the European Central Bank, the Fed, almost as a duel between sheriffs, brings out the money printing machine and the media not only celebrates it but demands the same in Europe. We forget that the United States, since the dollar is used in 75 percent of global transactions, exports inflation, while the euro is only used between the countries of the monetary union, meaning they import inflation.

The risks of quantitative easing

We commented on Thursday how what surprised us most of Federal Reserve Chairman Ben Bernanke’s conference is that he seemed to copy the ECB’s policy of secrecy. He looks to purchase mortgage backed securities until the employment rate stabilizes … and that is, how much? Until when?

It’s easy to forget it, but we are in the most aggressive period of easing -creation of paper money -ever. In four years, the amount of monetary stimulus artificially created by the world’s central banks amounts to about $9 trillion, more debt, with an imperceptible impact on growth and employment. But “it would have been worse”, we read.

It is worth reviewing the implications of monetary expansion using, among others, Credit Suisse’s and Boenning & Scattergood’s wonderful analysis of the risks that are accumulating.

QE generates commodity inflation, especially agricultural and energy, and although stocks go up, the operating results of companies and their ordinary profits remain weak because growth deteriorates. Easing does not generate growth and jobs, only asset inflation and stock market bubbles. According to three different studies (D’Amico & King, Yellen and Gagnon) the two previous monetary injections, called QE1 and QE2, generated between 0.90 and 1.10 percent annual inflation added to the system. Of course, we must analyse real inflation, not the official one, as this article explains: Why the Fed’s Method Core Inflation Is Not an Accurate Indicator.

QE does not create jobs. One of the myths of monetary expansion is that “successive QEs have created two million jobs in the US”. Not true, as the vast majority of US jobs were created outside the monetary expansion programs in the oil sector (due to the revolution of shale gas-oil) and the healthcare sector. But, even if we accepted that the figure is true, the policy failure is spectacular if QE created just two million jobs, unemployment has remained stagnant and all at a cost of $2 trillion, or c1 million dollars in debt for each job “created.”

QE does not generate a “wealth effect.” One of the myths of QE is the belief that rising stock markets and house prices create a “perceived wealth” effect leading people to consume. However, that’s not true. Once people have lost confidence in the political and institutional system, see labour insecurity and inflationary pressures in their monthly bills, they do not rush to consume. And they still have to see the bill for this colossal new debt.

QE does not support economic growth. It has been proven over and over that these policies do not generate improved industrial or manufacturing activity. One only has to see the graph below:

As with any suffering patient, injections of adrenaline are increasingly becoming less effective. The marginal return of expansionary policies, which should be “exceptional” and have become common, are increasingly less effective and we read then that more stimulus is needed. US economist Paul Krugman himself was mentioning that QE3 might not be enough, and some analysts are already hinting at QE4 aimed at bonds.

This is the first time the Fed avoids talking of sterilization of assets -that is, that instead of selling as much as the Fed is buying it will increase debt- until “the unemployment environment improves.”

– The impact on commodities is obvious. I see an impact on gold and oil as a protection against inflation and loss of value of currencies in the race to see who prints more and worse, and on ‘soft commodities’ (food ) due to the multiplier effect of inflation and, with the loss of value of the dollar, the impoverishment of the producing countries.

– On debt, QE supports the bubble in “high yield” bonds because government bonds of low-risk countries are sold with almost negative real return, making risky bonds the only option to capture some yield.

– The impact on equities is twofold:

– On the one hand, a more aggressive “flight to junk,” that it, buying highly geared companies with weak fundamentals. It makes sense, because these are stocks ​​where a cost of capital improvement -its discount rate- is much more important for the share price than the deterioration of its profits, which, let’s not forget, will continue.

– On the other hand, makes stocks exposed in revenues to an inflationary environment to trade at higher multiples.

Obama or Romney against the fiscal cliff

What worries me is that the Fed might seek to mitigate the short-term potential problems that arise from the fiscal cliff in December with a deficit of $1.5 trillion annually. If Obama wins, it is likely that he will not renew the Bush tax incentives when they become due in December, increasing income tax to 39 percent for high income. But the fiscal cliff also could impose drastic budget cuts that could potentially be very difficult under a new mandate from the current administration. On the opposite side, Mitt Romney seeks to lower taxes offset by reducing some tax deductions, while seeking to cut a trillion dollars in public spending and reduce the state to 16 percent of GDP in ten years.

The impact of tax increases and spending cuts, according to Credit Suisse, can generate a fall of 2.2 percent of GDP during the period from the third quarter of 2012 to the end of 2013, with a rise in unemployment to 10 from 8 percent now. The problem may be worse if the United States takes the decision to implement tax increases that have proved so ineffective in Europe.

In general, the problem of monetary expansion policies is very simple. When the global economy is exhausted, adrenaline injections cause nothing more than spasms, but these injections cost hundreds of billions to future generations in debt. And with each additional unit of debt, the marginal effect on the economy diminishes. The United States, like Europe, needs less debt, austerity, less intervention and more private investment, which creates jobs.

3 Respuestas a The Myths of Paper Money

  1. Vincent Boiteau 21 septiembre, 2012 a 8:51 am

    Interesting as usual Daniel. I do share your view in general but i perhaps try to see some silver lining in the dumb money inflow we are witnessing. One positive aspect of high inflation though, is that it favors people who work over people who save thereby operating a wealth transfer from older people to younger ones. Let’s not forget it older people are the very group that got us into this mess. It is true, though, that all this cheap cash increases the overall risk in the system, the very opposite of what we need. When will a leader emerge that will do what has to be done: cut government spending and taxes drastically.

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  2. Daniel Lacalle 26 septiembre, 2012 a 8:45 am

    I doubt that it creates a transfer of wealth from older generations to younger, as it has not been proven. What it proves is a transfer of wealth from the savers to the highly indebted, making the perverse incentives of taking higher risk and more debt even worse.

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  3. Vincent Boiteau 26 septiembre, 2012 a 9:18 am

    Agreed, savers have a career, kids and a retirement plan, not the best segment to create demand. Spender seek opportunities to increase their wealth. Taking on higher risks and more cheap capital should result in more startups, more innovation and more failures, but on the net, ought to be positive. If not, then the root cause is outside of economics, it’s human nature.

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