Issing Is Unhappy

The Swiss National Bank followed up on the measures it had taken last week to weaken the Swiss franc, by further increasing Swiss franc liquidity. My friend Vasan Sridharan correctly pointed out that these actions are not, per se, inflationary since they are merely counteracting the liquidity contraction that is happening or is accommodating the demand for Swiss franc cash by investors and others. He is right. In the absence of such responses, there may be a severe liquidity crunch. Avoiding the deflationary consequences of a severe liquidity crunch is not the same as actively courting inflation.

My counter to that is that this is how it is going to start. As it spreads globally, eventually the effects of this would be  convex. One little gentle extra liquidity push somewhere would then set off a global tidal wave of inflation. yes, I am dramatising or exaggerating. But, the point is we have no fine tuning mechanism that would tell Central banks when to stop. Persuaded by or being left with no options by the US, most central banks would end up overdoing it, eventually. That is the outcome towards which the world is heading.

Former Bundesbank Chief Economist Otmar Issing had written a classically German piece on the bailouts of the indebted countries in Europe through an expanded EFSF. It meets with his disapproval:

A common bond would also immediately relieve some countries of their burden of a record of fiscal irresponsibility. A stronger case of free riding can hardly be imagined. Lack of fiscal discipline is rewarded, while fiscal solidity is punished. The implied transfer of taxpayers’ money would also take place without the involvement of national parliaments – a clear violation of the fundamental democratic principle of “no taxation without representation”.

The rest of the article is along similar lines.

The road to redemption in Europe is paved with many landmines. It seems almost inevitable that the European single currency project – as it stands today – is doomed to fail largely due to faulty design and also undisciplined execution. As Mr. Issing points out, the violation of the Fiscal Stability Pact rules by Germany and France were the key to the irrelevance of those rules and the impunity with which they were flouted by others too, in practice.

European and US shares were down heavily yesterday, wiping out the gains made the day before on the US Federal Reserve announcing that they would keep the Federal funds rate at current levels up to mid-2013. Three members of the Federal Reserve Open Market Committee dissented. This open-ended promise is unusual. In other words, even if inflation were to rise, hypothetically, to 5%, the Federal Reserve will not act for the implicit promise is to drive real rates to ultra-negative levels.

Thanks to my friends in Switzerland, I could receive a copy of an email written by Andrew Lees of UBS Equity Derivatives Sales in London. This is what he has to say about real cost of capital:

The cost of money itself is hugely important. How negative were real rates? When people talk of borrowing from the future, surely the same logic applies to the cost of capital. If we have had low or negative rates that supported excessive consumption, we now need to have high real rates to direct capital back to innovation and gradually repair the balance sheet. The real cost of capital has to go up. No matter how much fighting the Fed and Treasury do, the real cost of capital will rise. The bond markets have to be allowed to clear some of the debt and thereby remove some of this misallocation of capital.

Does that mean we are trapped in a position whereby the Fed cannot raise rates? Quite frankly it doesn’t really matter what the Fed does; real rates have to go up, are going up and will go up. The more the Fed and the government misallocate capital, the more the real cost of capital will have to rise higher to compensate. The only thing that will get real rates down is either a massive new discovery of incredibly cheap fossil fuels or the innovation that delivers cheap fusion. Otherwise it is a case of the cost of capital rising and causing demand destruction.

So, you can see that what the Federal Reserve has done is the opposite of what this gentleman suggests. Of course, needless to add, I agree with this gentleman totally. But, given policymakers are locked into a different mindset and are unable to or unwilling to come out of it, the world is doomed to go through multiple contractions as he writes elsewhere in this email.

This post originally appeared at The Gold Standard and is reproduced here with permission.