Markets and Central Banks

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The financial world experienced its equivalent of a major earthquake this month when the Swiss National Bank (SNB), the central bank of Switzerland, made a dramatic and unexpected change in policy. In 2011, concerned by the rapid appreciation of the Swiss Franc and, thus, damage to Switzerland’s exporting industries and commercial banks, the SNB instigated a policy of maintaining a peg with the Euro at 1.20 Francs to the Euro. If ever the price of Euros declined against this mark then the SNB would obligate itself to sell Swiss Francs and accumulate Euros to maintain the parity. This policy therefore created a seemingly impenetrable price floor for the Euro against the Franc. Whenever the Euro declined to the 1.20 area traders could take a sure bet that they could sell Francs and use them to buy Euros (technically referred to as “shorting the Franc”), knowing that the SNB would take action to depreciate the value of the Franc and thus increase the value of the Euros that these traders now held. Indeed, that was precisely what was happening and what was expected on January 15th of this year when many traders had just opened long EUR/CHF positions as the currency pair was hovering around the 1.20 area. In recent months, however, the increasingly lax monetary position of the European Central Bank in order to ward off deflation and sluggish growth in the Eurozone – leading to a QE programme announced on January 22nd – led the SNB to maintain an increasingly expensive policy of depreciation of its own currency that risked fuelling bubbles and malinvestments within its borders. Clearly they were spooked by something as no one seemed to be prepared for the sudden announcement, on January 15th, that the SNB would, with immediate effect, abolish the peg against the Euro and the Franc would again be permitted to fluctuate freely. The market was suddenly awash with sell orders for the Euro and buy orders for the Franc that, within the space of a few minutes following the announcement, the Euro depreciated against the Swiss Franc from about 1.20 to around 0.75 – a dramatic drop of 37.5% – and eventually settling around the 1.00 mark. The movement happened so fast that any liquidity between these two points completely evaporated and anyone hoping for an entry or exit between them was pursuing a lost cause. Needless to say, anybody who owned the Euro against the Franc lost an awful lot of money, with some large institutions, such as Citibank, Barclays and Deutsche Bank, losing tens, if not hundreds, of millions of dollars. Particularly hardest hit, however, was the retail foreign exchange market, which in recent years has seen considerable growth amidst relatively lax regulation. Several of these outlets went bust while the largest, FXCM, had to be bailed out by an investment bank with $300m. Retail traders to whom these institutions cater are those who trade “on margin”, in other words, they borrow money to fund their positions. Thus their own equity amounts to only a proportion of the total cost of any trade, often as small as 0.5%. Therefore, a small movement in favour of any particular trade can lead to large profits, while a small movement in the opposite direction threatens not only to wipe out the client’s capital but to leave them owing money to their broker if the trade continues to sink and is not closed out. If this is the consequence of a small adverse movement, imagine the effects of an extremely large move such as that seen on the 15th. The movement was so sudden that stop losses, the trader’s conventional protection against risk, were useless and FXCM was particularly hard hit, being left with $225m worth of client accounts with negative equity. Needless to say, of course, there were also big winners on the other side, particularly those who were either skilful or fortunate enough to own put options on the Franc against the Euro with a strike price close to the former peg.

Standing aside from this entire calamity, what should the Austro-libertarian make of the situation? Profits and losses are supposed to be the result of superior entrepreneurial judgment in directing scarce resources available to the ends most urgently desired by consumers. Those whose judgements are more accurate than anyone else’s will walk away with profits, those who whose are not will be lumbered with losses. In financial markets, this is manifest in, say, the purchase of a stock which demonstrates the willingness to invest capital in the underlying enterprise and that the enterprise is one which will meet the ends of consumers with its trade; or a speculation in, say, the futures market is an attempt at “price discovery” and to prevent the emergence of false prices that would cause resources to be wasted1. However, the overwhelming fact that was laid bare on January 15th is that entrepreneurial fortunes are not made and lost in the financial markets through correct foresight of the desires of consumers – they are made and lost based on the whim of central banks. People are no longer rewarded for best estimating the desires of consumers but for guessing the motivations of the financial lords and masters sitting on their thrones of paper money. The stock market is no longer a place to rationally allocate resources amongst industries but a place to make bets on monetary policy. Indeed most of the significant shifts in a given stock market are made on days when the relevant central bank makes an important announcement. Those who clap their hands with glee when parasitic “gamblers” burned their hands on the day of the SNB announcement and “got what they deserved” should ask the logically prior question of why the financial markets have become such a casino in the first place. For years, central banks have maintained artificially low interests supported by monetary expansion which have made it profitable to plough funds into assets such as stocks at extraordinarily low cost – buoyed up by the, not unreasonable, belief that central banks will act to correct any dips in asset prices. Indeed with interest rates so low, borrowing money to buy assets has become an almost costless affair. Why should anyone follow other, riskier entrepreneurial ventures when this one has almost no chance of failure? Indeed, the SNB’s own commitment to maintain the peg seemed to promise free profit to anyone wishing to buy Euros and sell Francs near the peg, knowing full well that the SNB would be doing the same and hence buoying the value of the Euro against the Franc. Given that central banks have been creating fortunes for years it should come as no surprise when they take them away again, albeit in one, spectacular blow.

There is, however, a glimmer of light that has emerged from the situation – that the reputation of central banks and their pronouncements may have received lasting damage. First, the fact that the SNB reiterated, in no uncertain terms, its policy to maintain the peg a mere month before it was removed indicates that what central banks say cannot be trusted or taken as gospel. Second, the fact that it did so abandon its policy reveals the fact that these institutions do not possess the omnipotence and invincibility that they have led us to believe. In the long run, central banks cannot outwit reality and the market cannot be fought. By accumulating depreciating Euro assets at the same time as appreciating Franc liabilities the SNB was driving itself towards bankruptcy with a ludicrously expensive policy. Perhaps, therefore, the sudden realisation that the emperor has no clothes will cause bankers, economists, investors and speculators to look at central banks with a more critical and sceptical eye. May be there will then be a chance that the fatality of the pursuits of the more important central banks, such as the US Federal Reserve, will achieve widespread realisation.

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1DuncanWhitmore, Speculation, duncanwhitmore.com

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Economic Myths #12 – The Deflation Danger

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Politicians and mainstream economists have been warning us again lately of the so-called “deflation danger” – the idea that falling prices is calamitous for economic growth and that a perpetual and ceaseless price inflation is needed in order to bring us back to prosperity. With price deflation, so these sages tell us, lower prices today cause people to expect prices to be lower tomorrow so that, as a result, they put off their purchases until a later date, which causes prices to fall further and further. Hence we end up in an endless downward spiral of depression and impoverishment. Inflating prices, however, cause people to buy today so that they may insulate themselves from future price rises, thus bringing about economic growth and an increase in the standard of living. This fresh round of deflation warnings comes in the wake of the news that prices in the Eurozone were 0.2% lower than at the same time the previous year – something of an hilarious travesty when, regardless of the merits of the deflation thesis, this figure amounts to little more than a rounding error.

In basic economic theory, a price will fall as a response to the fact that demand is insufficient to meet supply at the current price. For some reason – say, as a result of the revelation of malinvestments – the demand curve for a particular asset or good shifts sharply to the left, meaning that prices now have to fall in order for the inventory to be sold to a willing level of demand. It will eventually settle at such a level. Indeed, all of the talk of “illiquid” and “toxic” assets on the balance sheet of banks following the 2008 financial crisis resulted from the unwillingness to find these lower prices and to, instead, retain assets at the old, inflated prices. Any asset, however, is surprisingly liquid when you offer a low enough price for it. However, the deflation thesis rests on the proposition that the initial fall in price, based on some exogenous factor, will then in and of itself cause a further shift in the demand curve to the left so that prices have to fall further. And then that this second price fall will cause yet another shift in the demand curve and prices will fall even further. Hence the thesis requires repeated, fresh rounds of shifting demand curves which are caused by nothing other than a previous shift in the demand curve.

However, there is no reason to suggest that prices falling as a result of a genuine, external change in valuation will, in and of themselves, cause further price falls. Indeed, every businessman will tell you that if you lower prices people will buy more and if you raise them people will buy less – precisely the opposite of the deflation thesis. More importantly, however, even if such price falls did result, there is no further reason to suggest that it would cause economic calamity. First, goods are, at the end of the day, evaluated for the ends that they meet. The fulfilment of these ends, as a result of the logic of human action, cannot be put off indefinitely and each individual will have to consume at some point. A person may simply be waiting for prices to bottom out before he purchases but there must come a time where he believes this to be. Taken to its logical extreme, the deflation thesis suggests that falling prices will cause people to simply stop acting altogether – that they cease seeking the fulfilment of ends through means. This will never happen so long as they remain human. Indeed, price deflation in entire industries – particularly in personal technology, such as computers and mobile phones – has not caused the collapse of this sector precisely because the value of owning a more expensive computer today is greater than that of waiting for a less expensive one in, say, three years. In other words, even if a person knows that a computer may cost £1000 today but only half as much in three years, he will still spend £1000 today if the benefit to be derived from the computer today is more valuable than saving £500 and waiting three years for that benefit. Second, viewed from the point of view of the satisfaction of each individual’s ends, there is no reason to suggest that artificially inflating prices, thus causing a person to buy sooner, will cause a greater fulfilment of that person’s ends compared to an economy where there is no deliberate price inflation. From that individual’s point of view, the earlier purchase may be wasteful compared to the later purchase he would have made had prices not been forcibly inflated. Third, even though the opposite of “catastrophic” deflation – namely, hyperinflation – in and of itself causes shifts in the demand curve to the right that accelerate the price rises, the motivation for this is not so much the rising prices as the realisation, on the part of the public, that the currency is worthless. Hence, a hyperinflation always ends in a flight to other currencies and stores of value. Indeed, following the recent Zimbabwean hyperinflation, the government there has gone as far as to recognise no fewer than nine foreign currencies as legal tender. No such realisation exists during falling prices and, funnily enough, people do not seem to be eager to flee to inflating currencies during a deflation! Fourth, there is no reason to suggest that falling prices will dampen business prospects. Nominal revenue will, of course, fall during a general price deflation. However, the success of a business – measured by its profit – depends not only upon the height of its revenue but also upon the height of its costs and these too are falling. Businesses would only put off purchasing and investing if revenue was predicted to remain constant while costs were predicted to fall, or fall further. If, however, falling revenue is met by falling costs then there still exists a profit motive, with every incentive to invest and trade today. Fifth, much of the deflation fear comes from the monetarist analysis of the Great Depression where, indeed, there was a monetary contraction1. However, the stagnation during that era was not due to the deflation per se but because of the widespread attempt to keep wages and prices high in spite of the monetary contraction. Had prices been allowed to fall then recovery would have been much swifter.

The real reason for the deflation scare is, of course, because perpetual inflation serves to protect the vested interests of the state and its corporate cronies and banker elites. The characteristic of any deflation is that the purchasing power of the monetary unit becomes stronger; all else being equal, therefore, assets that are merely quoted in the unit of currency and promise to pay no amount of fixed currency – such as shares, houses, precious metals, and so on – will fall in value. However, assets that are denominated in the unit of currency and promise to pay a fixed number of dollars, euros or whatever – such as bonds and debt instruments – will not lose value. Governments and banks, having benefited from borrowing cheap, printed money, used it to purchase assets that are mostly dollar quoted while their liabilities are dollar denominated2. Hence, a deflation would cripple the prices of the government’s or a bank’s assets while leaving its liabilities untouched. Hence not only large banks but entire states would be obliterated by bankruptcy. Clearly the political-banker elite cannot permit this to happen. The need for constant inflation is not, therefore, something that is necessary for economic growth and the wellbeing of the general public. Rather, it is necessitated by the asset-liability mix brought about by previous inflation which would threaten the existence of large, establishment institutions if it was to reverse. They need more cheap money, more theft of your purchasing power, in order to keep their assets rising and their liabilities from doing the same. The deflation myth, therefore, is nothing more than a part of the big statist fraud, benefitting a select few and the expense of everybody else.

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1Although the failure to overcome this was not from want of trying – see Murray Rothbard, America’s Great Depression, Part III, where he argues that the deflation was the result of factors that negated the inflationary response of the government and the Federal Reserve.

2Although mortgages, which were a heavy factor in the 2008 financial crisis, are dollar denominated, the security behind the loan – the amount the lender will receive in the event that the borrower can no longer pay – is the house that the mortgage has been used to purchase. This asset is merely dollar quoted and hence during a deflation the value of the security of a bad mortgage will dissipate and with it any chance of recovery at par for the mortgagee.