Boodles speech

Alasdair Macleod – 14 Oct 2009

If, in the last decade, I had cooked up a plan to destroy Western Capitalism, I could not have improved on the destructive policies followed by Western governments and their central banks. Politicians and their economic advisers have ensured we face a depression at least as deep and at least as long as that of the 1930s.

Our economic suicide comes at a time when China and India are going in the opposite direction – they have improving prospects. China and India and also Brazil’s economic outlook is similar to Britain’s in the 1830s. They have an increasing industrial labour force, and they are deregulating. This is what we were doing from about 1825 onwards, leading us into the greatest economic period in our history.

Their population and regulation demographics are the right way round, precisely when ours are now the wrong way round. Our relative decline to these countries will now be extremely rapid. And we are talking about the two most populous nations on earth: 2.5 billion people representing 37% of the world total.

Russia has enormous reserves of natural resources, including oil & gas, timber metals, and gold. She is now a major exporter of grains. Russia has deregulated, albeit chaotically, and her standard of living is improving. She has a well educated population. Russia has a clear vision under Putin. And that is to control key global resources. Russia will grow wealthy on the back of China and India.

Putin is no fool; he can see how the West is destroying itself. So for that matter can China. China is already looking ahead and stockpiling the materials she needs. She is buying control of natural resources in Africa, and making major corporate acquisitions as well, if only to reduce her dependency on Russia. China is now the world’s largest producer of gold, which she is stock-piling.

If World War Three is to be an economic one, we are already on the loosing side.

It is no co-incidence that both China and Russia are sick of dollars. They have too many of them. They are actively seeking to reduce their exposure.

What these countries are doing with gold is an attempt to return to sound money, and there is a sense of urgency now we are printing dollars and pounds without restraint.

I now want to take you through the twin evils of Keynesianism and Monetarism, which our politicians and central banks are relying on to get us out of the economic downturn. And I want to show you how destructive these policies are.

Let’s look at this in the context of Keynesian economics.

In the broadest sense, we define Keynesian economics as the search for economic and price stability. This is meant to be achieved by increasing government spending in an economic downturn. The deficit created is balanced by a budget surplus during periods of economic growth. At the same time monetary policy targets price stability, in practice an inflation rate of one or two per cent.

This policy is based on two basic misconceptions: the inability of free markets to achieve economic stability on their own, and fear of deflation. However, not only are these fears misplaced, but Keynesianism is actually economically counter-productive. There are important reasons why this is so.

We have to understand that the difference between government spending and private sector spending is production. Remember that consumption is the other side of production. Taxation removes economic resources from the free market that would otherwise be used in production. Government is a burden on free markets.

We can all immediately see the benefits of government spending. Bridges are built, the motor industry is rescued. The unemployed are fed and housed. But we never properly assess the unseen economic costs. The art of economics is to consider the broader effects.

In the private sector individuals and businesses produce goods and services. Their spending and savings represent the surpluses they generate from what they do. It is they collectively who decide through the market what goods and services are in demand, at what price, and those which are not. Those goods and services not in demand represent unwanted surpluses. This productive capacity is redeployed into products the market needs. Free markets are the mechanism for this continuous process of adjustment. And individuals’ savings provide the finance for businesses to develop new and improved products for the market.

No other input is required. Free markets deliver continual improvement, not only of relevant products, but they give us rising living standards as well.

Unfortunately, government takes private sector funds both through tax and borrowing, and redeploys them for its favourite projects. Government always subsidises products in surplus or products that use resources inefficiently, particularly labour. Government therefore prevents the efficient deployment of economic resources towards products actually in demand. It taxes the right production to generate the wrong production. This is why the difference between private sector and public sector spending is production.

There is a second vital point. When government tries to provide a product or service, it does so inefficiently and often badly. Take an example where there is a private sector equivalent: primary school education. I estimate the taxpayer pays nearly 40% more to educate a primary school pupil in England than a parent pays at a private day school. Furthermore, the private education is better and generally preferred by parents. There are more sports facilities, better teaching. Discipline is better. In fact, if the financial cost is 40%, the economic cost is greater, because here is a service few would choose. They prefer the private sector alternative. Also the costs faced by private sector schools are greater than they need be, due to government red tape and regulation.

So we can say in the case of primary school education there is clear evidence that government is a wasteful producer when it tries to provide a service.

If we apply this information across all goods and services provided by government, we can see that this inefficiency is a significant burden on the economy and not a benefit. Government expenditure is now over half the total economy, so this burden is very large indeed.

In the UK, the Treasury’s borrowing forecasts for this and the following four fiscal years total over £700bn, about 50% of today’s GDP. Some of that deficit will finance inefficient government production at the expense of private sector production as I have just described. Some will finance government itself, and some will finance people not to work. Financing government and the out-of-work is total loss of production, the rest is inefficient production.

So how anyone can think that government intervention is good for the economy is illogical. In a recession savings are taken from the private sector when the private sector can least afford to loose them. Taking savings is nearly as bad as taking extra taxes from the private sector, because they are badly deployed.

Be clear what I am saying: government inefficiencies and waste retard economic growth, not enhance it. This is contrary to the effect intended, and the more government spends, the worse the effect. Think Russia when communist, which is logically where government intervention eventually takes us. We are half way there.

Keynes’s optimism about the ability of politicians to manage things over the cycle was totally misplaced. So were his hopes that an enlightened democratic government would be an improvement on free markets. He misunderstood the causes of economic cycles, and he placed too much trust in politicians.

Unfortunately for us, he won the intellectual argument, and we have been paying the price ever since. It has given the politicians the intellectual justification for all their spending, and has absolved them of responsibility for the consequences.

Monetarists

I now turn to the monetarists. Monetary manipulation is one of the two pillars of Keynesianism, but monetarism per se gained popularity forty years ago in Chicago with Milton Friedman, and is today represented by helicopter Ben Bernanke and pretty much all central bankers.

There is probably one thing we can agree on with monetarists, the quantity theory of money in its simple form. “Inflation is everywhere a monetary phenomenon.” All other things being equal, if you double the quantity of money, this will lead to a doubling of prices. It is this fundamental fact that encourages monetarists to advocate managing the supply of money to achieve price stability.

But as a weapon in the arsenal of economic management, it is invariably useless, and in fact there is evidence it is counter-productive.

Let us look at the track record. In 1927 the American Fed lowered interest rates to help stop the run on the pound. The pound had been unrealistically pegged at pre-war gold parity even though Britain had printed too much money during the war for it to be feasible. Low interest rates and the Fed’s purchases of government debt fuelled the Wall Street bubble. The Fed subsequently raised interest rates to a high of 6%. Three days after Black Tuesday in October 1929 the Fed started cutting rates aggressively, down to a record low of 1.5% in May 1931. The Fed flooded the market with as much liquidity as it could in an attempt to end the slump.

This did not stop the depression from being the longest in history.

Note that the Fed created the bubble with excess credit, and failed to resolve the depression with even more excess credit. These monetary events of the late twenties and thirties are an alarming copy of what is happening to us today. This is not a good precedent. In fact, Kindleburger in his Manias Panics and Crashes found that pretty well all manias panics and crashes were preceded by an expansion of credit. And Kenneth Rogoff, in a paper written about 18 months ago found that pretty much all these financial events were followed by an economic downturn.

What is not generally known is that there are precedents that support the proposition that printing money and credit to avoid a prolonged recession is precisely the wrong thing to do.

During the Napoleonic wars, Britain had expanded money in circulation as one would expect. In 1819, Peel was appointed chairman of the Bullion Committee, to restore the pre-war gold standard. The severe contraction of the note issue imposed by his committee was during the post-war slump in 1820-21, but that was it. The return to sound money was quickly followed by economic recovery and marked the starting point of Britain’s subsequent economic greatness.

In America 100 years later, the same war-induced monetary problem was tackled in 1920, when the Fed raised interest rates in the middle of America’s post-war slump. It did not extend the slump. It marked the beginning of a period of technology and innovation, as economic resources were refocused from the past to the future.

Monetarists have never been able to explain why Peel’s bullion reform and the Fed’s strategy in 1920 did not deepen and prolong these slumps – slumps that were already underway.

Japan is particularly instructive. Zero interest rates, and massive fiscal deficits have achieved nothing. The know-alls in the West say they haven’t done enough, or the stimulus has been badly executed. Rubbish! The most massive fiscal and monetary stimulus in peace-time history has simply not worked.

The results are opposite to what monetary theory predicts. It does not bode well for the results of current monetary policy. There is a simple explanation. First we need to define monetarism. The best I can come up with is the following:

Monetarism is the removal of the pricing of money from the free market, where it finds a natural equilibrium, to central banks which have no idea where that equilibrium lies.

Put another way, the pricing of money – which is simply a commodity – can only be done by the market in common with all other commodities, not the central banks.

Interfere with that equilibrium, and you upset the balance between spending and savings. It is individuals who should allocate their savings to borrowers as they see fit. When a central bank takes on the production and pricing of money, it has a different agenda. A simple market mechanism is replaced by economic distortion.

Let us pause for a moment and think through the impact of zero interest rates. They should be considerably higher. Why? Counterparty risk, monetary inflation from QE. Result? No one saves. They pay down debt, maybe buy some gold, maybe take a punt on something, but there are no savings. Just loads of very nervous cash. This is why our Government has printed its deficit. The real business on bank balance sheets is contracting, so the banks have no option but to put money on deposit at the Bank of England. That is why zero interest rates are killing the economy, slowly but surely.

Monetarists have made the same mistake as Keynesians. The art of economics is to consider the broader effects. Central Banks think they can price our money for us, but they are in total ignorance of the wider consequences.

By their well intentioned manipulation they are preventing the private sector from reallocating resources from unwanted production to wanted production. No wonder the recession goes on and on and on. The central banks have put the free market’s self-correcting mechanisms on hold.

The correct approach is to let the economic distortions unwind, rather than hope they will go away.

Deflation, by which we mean falling prices, is not the danger monetarists, or the Keynesians for that matter, think. .In fact, if you have sound money, falling prices are normal and healthy, because the same quantity of money supports an expanding quantity of goods.

This was the situation from the 1820s until the First World War, when Britain gradually removed tariffs and promoted free trade, having first restored the gold standard by removing excess money after the Napoleonic Wars. Over all that time, we had the greatest economic advance in our history, and prices actually fell by about 16% over those ninety-odd years, in spite of the global inflation of gold through new discoveries in California, Canada and South Africa.

In recent times, this is exactly what has happened with computers and other electronic goods.

We all know that these goods have become better and cheaper. According to Keynes, deflation discourages these businesses from holding stock and raw materials, so deflation is a disincentive to production. Really? Manufacturers have responded by making themselves superbly efficient, so any such losses are minimal. According to Keynes, consumption is deterred by falling prices, as consumers put off purchases. Really? There is no evidence of that.

There is no reason why any product in a free economy cannot work in the same way as electronic goods. Of course falling prices make it harder for bad businesses or businesses selling the wrong product to survive. But this is no bad thing. It hastens the re-allocation of resources from unwanted product to product in demand.

So central banks mess it up. Ever since they started pricing and printing money they have failed. They puffed up credit by keeping interest rates too low in 1927-28. They raised rates to deal with the resulting asset inflation. They over-cooked it, Wall Street crashed. It is exactly the same today. Greenspan presided over massive expansion of money and credit, and when interest rates were raised too late, the credit crunch was triggered.

The solution, according to the central banks, is yet more credit. All precedent tells us this policy will fail.

So modern economists, Keynesian and monetarists, share two illusions: the belief that somehow government can allocate economic resources more effectively than free markets; and deflation is bad for you.

How does inflation affect government debt? Simplistically, people assume that it is easier to inflate this debt away, rather than increase its value through deflation. Inflation is better than deflation for the government. Not so.

The problem with high and rising inflation is that interest rates have to rise to very high nominal rates, making government finances considerably worse. Government’s problem is you can’t buck the market. I remember a Treasury stock with a 15½% coupon.

Deflation historically has been the better course. Government debt was repaid after the Napoleonic Wars from higher levels relative to GDP than we face today. Peel withdrew seven out of eight banknotes worth £5 or less. This is severe deflation – a reversal of war-time inflation.

But we do not have the luxury of time. Our economic demographics are totally different today. We are crippled by regulations; we have a falling working population relative to retirees. Repaying government debt will involve an extra effort and urgency, because of the demographic time-bomb. But it will require government to stop meddling with the free market and deliberately deregulate.

Which brings me on to regulation. The modern concept was developed to control privatised utilities, where there were concerns about their monopoly position. That was possibly valid. But the socialists have taken the concept considerably further, and it is now the means whereby large sections of the private sector are controlled by government. This is obviously detrimental to free markets. It amounts to nationalisation by stealth.

In financial services, regulation is at the seat of global financial problems. The mistake was to choose a principals-based model and not an agency-based model. By this I mean a system where the investment banks act as both jobber and broker, rather than acting in separate capacities. An agency brokers’ interest is directly aligned to their clients, a jobber’s is diametrically opposed.

The principals-based model was adopted at the behest of the big banks, and besides the obvious conflict of interest between their trading books and their recommendations to their customers, it introduced several disadvantages:

  • Greater profits accrue to the bank’s own dealing account. This is a fundamental conflict of interest between the bank and its clients. Clients become the feedstock for the book.
  • The banks are so powerful with their huge balance sheets that they can and do manipulate markets, guaranteeing substantial trading profits.
  • The system encourages banks to develop financial instruments purely for their own profit, and not for the benefit of market users. There is no way regulators could understand the risks of these exotic products.
  • And crucially, it is so easy for these banks to make money, that banks which should stick to commercial lending are attracted to the honey-pot, bringing extra risks to the system.

So,

  1. You create a system, where you give the banks easy profits.
  2. Central banks then extend massive amounts of credit. It is hardly surprising that the combination brews a speculative bubble.
  3. You create an environment riddled with crookedness. If the starting point is dual capacity, it is incapable of being properly regulated.

Many years ago, the stock exchange understood the conflicts of interest between market making and agency brokers. That is why they were physically and financially separated. The system of self regulation was not flawless, because it allowed the stock exchange to act as a quasi-monopoly. But that should have been easier to address, and would have been the better approach.

Modern financial regulation will never be effective; in fact, it becomes a shield behind which clever crooks can hide. Vide Madoff.

Regulation played a key role in concealing the dangers. Without the false comfort of regulation, counterparty risk in the wholesale markets would have been assessed with more rigour and very differently, particularly if the “too big to fail” concept never took hold. If counterparties carried risk of failure, I believe neither of the two Scottish banks would have been able to finance their ambitions through the markets to the degree they did.

Regulation has become socialism by the back door. It has corrupted the basic functions of free markets to the detriment of us all.

Europe is a fount of regulations. I saw a statistic somewhere that the EU has brought in a total of 11,000 regulations. Each new regulation strangles us a little more.

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So we have three basic misconceptions to deal with. Keynesianism, monetarism and regulation. Only when we reverse our views on these policies will we have a chance of prosperity.

Will we do it? I am afraid not willingly.

The Chancellor is at least as likely to make the mistake of squeezing more taxes out of the private sector, when he should be cutting spending drastically. Tax rises are destructive to the private sector’s regeneration. Why burden it with extra costs when it can least afford it? Public spending cuts are good for private sector recovery. I do not see this distinction being understood.

It is more likely we will muddle through this crisis, prolonging it and making it worse. That’s what Hoover and FDR did, and that’s what Obama is doing now. This time, there is no gold standard to give a semblance of price stability. We are sliding into the early stages of accelerating inflation. And do not think that inflation only happens with a growing economy. That is always minor. Serious inflation is always a function of a failing economy.

The only thing that seems to motivate politicians besides the pork barrel is big strategic thinking. So perhaps we can hope that the ascendancy of China, Russia, India and Brazil while we are descending in the fast lift might just jolt them into action.

Gentlemen, I am sorry to have been so gloomy, particularly in such enjoyable company in one of my favourite clubs. I only hope that Adam Smith whose spirit I am sure is in this building still, would have agreed with my analysis. I have tried to demonstrate as straightforwardly as I can that he was, after all, right.

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Alasdair started his career as a stockbroker in 1970 on the London Stock Exchange. In those days, trainees learned everything: from making the tea, to corporate finance, to evaluating and dealing in equities and bonds. They learned rapidly through experience about things as diverse as mining shares and general economics. It was excellent training, and within nine years Alasdair had risen to become senior partner of his firm. Subsequently, Alasdair held positions at director level in investment management, and worked as a mutual fund manager. He also worked at a bank in Guernsey as an executive director. For most of his 40 years in the finance industry, Alasdair has been de-mystifying macro-economic events for his investing clients. The accumulation of this experience has convinced him that unsound monetary policies are the most destructive weapon governments use against the common man. Accordingly, his mission is to educate and inform the public in layman’s terms what governments do with money and how to protect themselves from the consequences.

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