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Financial storm clouds gather

By James Cumes - posted Wednesday, 10 April 2013


We are confronted right now and in the coming weeks with one of the most fascinating situations in modern monetary history. That is global monetary history and global monetary evolution. It promises to be the most abrupt and far-reaching change in monetary history since the imposition of higher interest rates

by the American Federal Reserve Board in 1969 and the departure from gold by the United States in 1971.

That was in President Nixon's first term.

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I was in New York in the autumn of 1970 attending the United Nations General Assembly as Australian Representative on the Second - Economic and Financial - Committee.

I spoke my piece for half an hour or so and then was required to listen to half-hour speeches by more than one hundred representatives who told us all what their problems and expectations were. I already knew what they would say so I was able to spend my time writing a book while I appeared to listen to my "Distinguished Colleagues."

That book was published in June 1971. It was called "The Indigent Rich: A Theory of General Equilibrium in a Keynesian System." Its principal theme was that a hike in interest rates by a country's central bank did not reduce consumer-price inflation in

that country. On the contrary, higher interest rates stimulated and intensified inflation.

Central banks around the world ignored what I wrote and continued to "fight inflation" by raising interest rates. They do much the same thing to this day - or will when they can shake themselves free of the impact of the Global Financial Crisis. Indeed, their main duty has been and is now to commit themselves to a highly disciplined watch for signs of consumer-price inflation coming back and raise the key central-bank interest rate when it does. Their faith in such an unassailable strategy is rock-solid.

In my turn, I continued to suggest that the contrary was the case: higher interest rates would boost, not bust consumer-price inflation. Of course the real world, over the more than forty years since, has provided the most convincing evidence that my thesis is sound.

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That brings us close to the area of today's dilemma.

More than thirty years ago, Japan was hit by a series of bubbles particularly in real estate and equity markets. Those bubbles were turned into busts by the central bank raising interest rates which did effectively bring bubbling asset-price

inflation to its knees.

The question then was how to get the economy up off its knees and operating "normally" again.

So effective had the bust been that the Japanese economy - the real economy - just couldn't get up again. Growth, fixed-capital investment and employment remained slumped despite persistent injection of masses of money to stimulate them.

Japan was then the world's second largest economy, efficient, sophisticated and admired for its miraculous recovery from the devastation of World War Two . To restore growth would seem to be a simple matter: lower interest rates and apply quantitative stimuli. The latter had been called Open-Market Operations by the British in an earlier period and were to be called Quantitative Easing especially after the advent of the Global Financial crisis.

The Japanese central bank duly lowered interest rates and applied Quantitative Easing. The situation remained stubbornly subdued. Growth failed to make a robust appearance despite repeated variations and huge volumes of monetary stimuli. The central bank lowered its cash rate to zero. All it got was more deflation.

Deflation?

That was a word that had virtually disappeared from the dictionary of the post-war economist, especially after Nixon hiked interest rates in 1969; but Japan went on from the busts of the late 1980s and early 1990s to be acutely aware of deflation and its impact on the economy right up to the present day.

It is still struggling to get a hold on a monetary evil that can be even more devastating in many ways than the evil of inflation whether of assets or consumer goods and services. So Japan's misery of deflation has gone on for more than twenty years while the United States and most other major developed economies have struggled with the opposite, inflation.

Why is this?
In "America's Suicidal Statecraft" I referred to a President - later Emperor - of the Central African Republic/Empire

throwing money in the air when he went on walkabout with his poverty-stricken citizens. At a more sophisticated level, Fed Chairman Bernanke, who is a distinguished student of the Great Depression and modern Japan, was reported to favour dropping money from helicopters to stimulate the American economy.

He has not used helicopters but he has thrown trillions of dollars to bankers and other favoured "financiers" in the years since the Lehman collapse of 2008. The amounts have been so

staggeringly high as to be unprecedented in monetary history; and they continue still.

During virtually the whole period, interest rates have been kept at historic lows, near zero. From time to time, virtual guarantees have been given that rates will remain "accommodative" for long periods in the future.

What has been the result?

The United States economy has been proclaimed by some to be in "recovery" or on the road to recovery; but growth has been minimal if at all; unemployment is high - and, in actual fact, much higher than official figures pretend; the budget deficit is a trillion or so dollars a year; the external payments deficit is about $50 billion a month and there is hardly any convincing evidence that any genuine "recovery" is an early or even mid-term prospect.

In short, trillions of dollars have been spent by the Fed and the Treasury, the base interest rate is virtually zero and only a phoney "recovery" is the result.

Despite all this, our experience suggests that those in charge of global and national macroeconomic policy are apt to follow wrong or substantially misguided policies to the point at which the agony of their mismanagement compels change and a genuine quest for new and effective economic and financial approaches.

This stubbornness has been demonstrated recently by the Japanese Government and central bank returning to the most extravagant monetary stimuli yet.

This has brought the United States, Japan and the European Community into a partnership of kinds: a partnership of flinging trillions of paper currency at their economic, financial and monetary failures in the hope that it will bring more benefits than the Emperor of the Central African Empire brought his people by flinging money in the air several decades ago.

They are doing this without any clear notion that the money will be spent on solid fixed-capital investment, that it will contribute to increased productivity and that it will, of course, deliver increased production for the market.

This is despite the low interest rates. This is despite the fact that a rise in interest rates is assumed to fight inflation and a cut in interest rates is supposed to enliven inflation. According to the embedded theory, an interest rate of zero should give us inflation of formidable proportions. However, the Japanese have set what would ordinarily have seemed the modest goal of 2% inflation for their zero interest-rate and helicopter drops; and they are doubtful that even this goal can be realised.

Could it be that the basic monetary theory is wrong: a hike in interest rates does not fight consumer-price inflation; instead it inflames it? A zero interest rate would then kill consumer-price inflation stone dead. It would give us deflation, no growth, much joblessness and gathering despair.

The experience since the Lehman collapse suggests this is the picture now and that its character is likely to become even more embedded in our troublesome situation.

The next few weeks are likely to provide evidence whether that is right or wrong. There are likely to be dramatic developments in relative values of currencies including the American dollar whose reserve currency status is at risk and the price of gold. There will be drama elsewhere, in the European Community, in the Euro zone and in the entire structure of the global monetary system. Nationalisation of the banks could swell into a cry on the lips of many. A fair deal for the ordinary individual saver, investor and depositor might become an imperative for a large majority in many countries. Cyprus has opened up issues for virtually everyone everywhere that will not easily be set aside.

Banks and the "financial industry" have little respectability left. They have shown themselves to be gamblers - and not even good gamblers or "speculators." Their incompetence, market immorality and even criminality call for at least a re-enactment of the Glass Stiegel Act; but reform needs to go much further than that. If we are to rescue ourselves nationally and globally from financial catastrophe and its resultant social, political and strategic chaos, we must undertake a transparent review of the entire global financial system and establish institutions and regulations to give us effective reform.

Against this background, that mystifying interest-rate experience, its impact on inflation and deflation and its encouragement of real investment must surely be examined more closely than at any other time in the last forty to fifty years.

Whoever gets it right deserves his or her reward - perhaps to be paid by the zombie bankers and "financiers" who got us into much of the financial mess we have suffered and who are still making fortunes out of speculation of the kind characterised by derivatives.

No one has yet nominated anyone for any such reward, but I expect that, if there's money in it - I repeat, if there's money in it - news of such a nomination or nominations won't be long in coming down the road. That is a can that could for once be profitably left un-kicked.

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About the Author

James Cumes is a former Australian ambassador and author of America's Suicidal Statecraft: The Self-Destruction of a Superpower (2006).

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