Amid all the outcries about quantitative easing in the US and the sovereign debt crisis in Europe, a small piece of news out of Germany almost went unnoticed. Let me correct that oversight, since it reinforces my view that we cannot trust governments when it comes to managing the printing presses for cash, or, in this particular case, the minting machines for coins.
Under the bureaucratic haze of a necessary "adaptation of technical parameters," Germany's Finance Ministry, which runs the country's mint, announced that it plans to massively reduce the silver content in its commemorative ten-euro coins. The last two commemorative German coins were minted earlier this year to mark 175 years of the German railway and the 2011 Downhill Ski World Cup. They weighed 18 grams and used an alloy of 92.5% silver and 7.5% copper. From next year on, new coins will consist of only 62.5% silver and 37.5% copper and they will weigh just 16 grams. Reducing the silver content of the alloy and the overall weight of the coins drops the total amount of silver per coin from 16.25 grams to 10 grams. That's nearly a 40% debasement in one go.
Since 16.25 grams of silver was worth 11.10 euros on 12 November, the German Finance Ministry was actually making a EUR 1.10 loss on the ten-euro coins. With the new coins, the Finance Ministry will garner a profit of EUR 3.20.
Debasing the silver value of its coins in this way, the German Finance Ministry is honoring an ancient tradition of minters, one that goes back to the dawn of cash money. The Roman denarius, a silver coin, was used as a means of exchange for over five hundred years. Originally, it constituted a day's wages for a soldier or a laborer but it too went on an extreme diet over the centuries. Its 4.5 grams of silver content in the third century BC, slipped to 3.8 grams under Emperor Augustus in 16 AD, 3.2 grams under Nero in 60 AD, 1.66 grams under Caracalla in 217 AD, and finally to 0.2 grams under Aurelian in 270 AD. From Augustus to Aurelian, the overall debasement of the denarius amounted to roughly 95%, corresponding to an average inflation rate over those 270 years of 1.1% per year.
However, inflation was rather volatile during this period, with periods of rapid debasement and even phases of re-basement, which would correspond to deflation in modern economics. The latter usually occurred when Rome enjoyed a rich conquest and could plunder the silver reserves of a vanquished foe. From 250-270 AD, debasement accelerated dramatically, leading to an equivalent average inflation rate of roughly 10% per year and launching some early attempts at an overall currency reform.
The French King Philip the Fair (1268-1314) was another legendary currency debaser ("fair" refers to his looks, not his business ethics). Always short of funds due to his numerous wars, he first expelled the Jews from France and then the Lombards, confiscating their assets; then he levied unprecedented and highly contentious taxes on the Catholic Church and finally he ravaged the Knights Templar monastic order, staging show trials and executing their leaders as heretics. In fact, he owed the Templars vast sums of money. Currency debasement was another tool he used to fund his government, with contemporary chroniclers suggesting that in some years half of the budget was financed through devaluing the currency. This led to violent social unrest and earned him another nickname for all eternity: the Philip the Forger.
Kings were well known for their debasement policies. Referring to Louis XIV of France, French Enlightenment philosopher Montesquieu wrote: “… the king is a great magician, for his dominion extends to the minds of his subjects; he makes them think what he wishes. If he has only a million crowns in his exchequer, and has need of two millions, he has only to persuade them that one crown is worth two, and they believe it. If he has a costly war on hand, and is short of money, he simply suggests to his subjects that a piece of paper is coin of the realm, and they are straightway convinced of it.”
Obviously, Germany's debasement of its silver commemorative coins is trivial compared with the giants of currency debasement throughout history. On the other hand, coinciding as it does with the US Federal Reserve's second round of quantitative easing, which creates another 600 billion US dollars out of thin air, it illustrates once again that one can never blindly trust a government to defend the value of its currency.
Friday, November 19, 2010
Friday, November 5, 2010
05/11/2010: Who's in charge here?
Who is in charge of monetary policy? At a first glance this is a simple question with an obvious answer: the central bank. But managing market expectations now also belongs to the Fed’s brief and some key lines of authority have been blurred.
In many countries, the central bank enjoys full independence from the government. This has proven itself to be a wise arrangement, since it ensures that the power of the printing press – of money creation – is not abused for political purposes. History offers ample evidence that when this function is in the hands of a government, money will be over-supplied. And too much money inevitably sends inflation out of control. Given our world of fiat money – backed only the confidence we have in it – central bank independence is vital. Or so we have been led to believe.
In fairness, central bankers have one of the toughest jobs around. They often take decisions that would surely fail in a public referendum. And as the warrantor of monetary stability, a central bank is not only accountable today but will also be judged harshly by future generations.
While they serve, central bankers rarely if ever get recognition for their good deeds. Paul Volcker, the Fed’s chairman between 1979 and 1987, was vilified during his time in office, even blamed for the double-dip recession of the early 1980s. Today he is universally hailed for reversing the era’s high inflation. And Alan Greenspan’s once impeccable reputation has certainly been tarnished by the financial crisis that followed his unprecedented five terms as Fed chairman, in 2006.
As William McChesney Martin, Jr., a previous Fed chairman, observed that the job of a central bank is “to take away the punch bowl just as the party gets going.” Obviously, this is not a job for people with a strong need for approval.
Over the past thirty years or so, following the overthrow of Keynesian activism in the late 1970s, central banks and monetary policy have evolved to become instruments of economic policy. In the process, they have acquired some new tasks, including that of smoothing out the rough edges of the business cycle. And most recently they have been tasked with managing market expectations.
But market expectations turn out to be rather hard to manage. Ultimately, it can become a game of who is managing whom? Who wields the real, decisive influence?
This dynamic has come to characterize the Fed during the Greenspan and Bernanke eras. By flooding the economy with liquidity after the stock market crash of 1987, the former Fed chairman enshrined the “Greenspan Put,” where the government essentially props up sagging markets by lowering interest rates. This cure-all was prescribed in response to the first Gulf War, financial crises in Mexico and Asia, the LTCM debacle, the Y2K tempest in a teapot, the burst Tech Bubble, the 9/11 attacks and the second Gulf War.
It worked reliably; that is, until it stopped working. It finally came apart when the housing market bubble burst and the banking system went into cardiac arrest. We are still in intensive care from this medicine.
But our infatuation with quick fixes endures. The latest iteration of the Greenspan Put, in our view, is the second round of money creation by the Fed called quantitative easing (QE2). According to Bloomberg, two weeks before announcing the size of its interventions, the Fed surveyed investors and bond traders, asking them how big a package QE2 would (or should) be. This can be seen as a form of reverse engineering, managing market expectations by asking market participants what to do.
But whatever it is, such efforts call the independence of this particular central bank into question. Who is ultimately in charge of setting US monetary policy? One thing is clear: a central bank that is too predictable is a powerless central bank; and a powerless central bank is obviously not in charge.
In many countries, the central bank enjoys full independence from the government. This has proven itself to be a wise arrangement, since it ensures that the power of the printing press – of money creation – is not abused for political purposes. History offers ample evidence that when this function is in the hands of a government, money will be over-supplied. And too much money inevitably sends inflation out of control. Given our world of fiat money – backed only the confidence we have in it – central bank independence is vital. Or so we have been led to believe.
In fairness, central bankers have one of the toughest jobs around. They often take decisions that would surely fail in a public referendum. And as the warrantor of monetary stability, a central bank is not only accountable today but will also be judged harshly by future generations.
While they serve, central bankers rarely if ever get recognition for their good deeds. Paul Volcker, the Fed’s chairman between 1979 and 1987, was vilified during his time in office, even blamed for the double-dip recession of the early 1980s. Today he is universally hailed for reversing the era’s high inflation. And Alan Greenspan’s once impeccable reputation has certainly been tarnished by the financial crisis that followed his unprecedented five terms as Fed chairman, in 2006.
As William McChesney Martin, Jr., a previous Fed chairman, observed that the job of a central bank is “to take away the punch bowl just as the party gets going.” Obviously, this is not a job for people with a strong need for approval.
Over the past thirty years or so, following the overthrow of Keynesian activism in the late 1970s, central banks and monetary policy have evolved to become instruments of economic policy. In the process, they have acquired some new tasks, including that of smoothing out the rough edges of the business cycle. And most recently they have been tasked with managing market expectations.
But market expectations turn out to be rather hard to manage. Ultimately, it can become a game of who is managing whom? Who wields the real, decisive influence?
This dynamic has come to characterize the Fed during the Greenspan and Bernanke eras. By flooding the economy with liquidity after the stock market crash of 1987, the former Fed chairman enshrined the “Greenspan Put,” where the government essentially props up sagging markets by lowering interest rates. This cure-all was prescribed in response to the first Gulf War, financial crises in Mexico and Asia, the LTCM debacle, the Y2K tempest in a teapot, the burst Tech Bubble, the 9/11 attacks and the second Gulf War.
It worked reliably; that is, until it stopped working. It finally came apart when the housing market bubble burst and the banking system went into cardiac arrest. We are still in intensive care from this medicine.
But our infatuation with quick fixes endures. The latest iteration of the Greenspan Put, in our view, is the second round of money creation by the Fed called quantitative easing (QE2). According to Bloomberg, two weeks before announcing the size of its interventions, the Fed surveyed investors and bond traders, asking them how big a package QE2 would (or should) be. This can be seen as a form of reverse engineering, managing market expectations by asking market participants what to do.
But whatever it is, such efforts call the independence of this particular central bank into question. Who is ultimately in charge of setting US monetary policy? One thing is clear: a central bank that is too predictable is a powerless central bank; and a powerless central bank is obviously not in charge.
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