The ECB Targets 1752 (Part 2)

(New Gold Supra-Theory Salon des Refus├ęs - Post 2)





 

Let’s take a look at the ECB’s TARGET2 system. Here’s a very brief outline of the similarities between the ECB and the Federal Reserve system from the blogger ‘DP’.

Now let’s play spot-the-difference between them. The ‘Fed’ was created to deal with the kind of liquidity crisis that almost brought down the financial system in America in 1907. It’s brief wasn’t to “create a payments system”. According to the ECB (here) TARGET2 was developed in close cooperation with its future users. One of those users’ main requests was that the new system would offer a harmonised, state of the art payment service.”

So the ECB wears at least two hats. It’s a central bank for the Eurosystem central banks and it operates the payment system in the EU. Now I have to digress here. One area where the “fathers” of the Euro differ markedly from the classical economists and Professor Viner is in their attitude to price indexes and statistics. Alexandre Lamfalussy, one of the “fathers of the Euro”, stated: “Nothing is more important for monetary policy than good statistics.”

The classical economists rejected the notion of indexes being used as a proxy for the real world. Jacob Viner also lamented the difficulty in providing conclusive evidence of the benefits of free trade using statistical analysis. So Viner also had deep reservations about its value (back in 1937). Obviously this was a long time before super-computers and the arrival of this highly, digitally-integrated world we now live in. Perhaps today we can put aside these reservations and rely on prices and statistics to give us an accurate insight into the state of an economy.

Now let’s take a closer look at the Eurostat "Harmonized Index of Consumer Prices" (HICP). The HICP only uses final consumption prices in the index. In their words, “household final monetary consumption expenditure" The focus of this index is not “intermediate goods”. Goods that are in the process of being combined with other goods to produce final consumption goods for households. Cars are in the HICP but components in the process of becoming a car aren’t the focus of the HICP.

The HICP also excludes owner-occupied housing (OOH).  That is extremely unusual in a consumer price index (CPI). Housing costs are estimated in different ways around the world but an estimate is usually included in a CPI. I think it isn’t included in the HICP because the treatment of OOH in other CPIs can’t be used in a system designed around Hume’s mechanism. As Viner points out: "It is not purchases, or transactions, in general which are significant for the mechanism of adjustment, but only purchases of certain kinds." (You can search the PDF I linked in Part 1 if you want to check the accuracy of any quotes.)

Jacob Viner actually uses houses as a specific example of the kind of things that need to be excluded when you are trying to identify the operation of the mechanism: “If, for instance, a particular house has changed ownership as between dealers through purchase and sale three times in one year, and not at all in the next year, neither the transactions in one year nor their absence in the next year have any direct significance for the international mechanism." (Simply replace “international mechanism” with “Eurozone mechanism”.)

In order to zero in on the adjustment mechanism we need know three things. Firstly we need to know the size of the portion of the overall money supply that is being used to facilitate final consumption expenditure. Secondly we need to know the velocity of the money used for this purpose and lastly we need to know the prices of household consumption goods. (It’s also worth noting that HICP isn’t based on a “typical household” approach. It aims to capture the actual consumption expenditure of all Eurozone households.)

I don’t think it is a mere coincidence that Jacob Viner’s preferred measure of velocity is the “final purchases velocity of money”. He describes this as the ratio of final purchases per unit of time to the amount of specie in the country”. We can replace specie with Euro here. We would expect velocity to be stable most of the time. In most households the consumption patterns are fairly consistent for long stretches of time.

As mentioned above only part of the money pool is involved in these final consumption expenditures. There is no need to get bogged down in discussions about how much consumption is funded with credit. We’ll divide the money supply into two pools and then I’ll justify that assertion about the credit component. The pools are a consumption goods money pool and a non-consumption goods money pool.

If we had access to the range of data that the ECB has access to, we could obtain a reasonable estimate of the size of the consumption goods money pool through trial and error. One indicator of the size of this pool would be the total value of all of the simultaneous consumption expenditure transactions taking place across the Eurozone at a point in time. We could then test our estimate against observations of consumers actual behaviour and through the huge data feed the ECB has access to. Then over time we could refine the estimate. Now let’s assume these ‘tools’ work and examine how they might have been used in a situation that actually occurred.
 
When the SHTF in Ireland a few years back the ECB was pouring billions of Euro into the Irish banking system. Try to put yourself into the mindset of a central banker with “good statistics”. The Irish are pulling Euro out of their banks like there’s no tomorrow. However, final purchase velocity is stable and so are the prices of consumption goods. TARGET2 is wired into the FX market as well so you know that most Irish people aren’t exchanging Euro for another currency.

The statistics are telling you that this money is going into “mattresses”. The confidence crisis is people-banks not people-Euro so you can supply a huge amount of Euro without worrying about prices getting out of control. The prices+>money>flow mechanism will automatically correct the imbalances after people calm down. A central banker would have been monumentally stupid to restrict the supply of Euro under these circumstances.

The beauty of a system like TARGET2 is that it allows the prices+>money>flow mechanism to function smoothly. This mechanism is usually an auto-correcting monetary policy tool that only requires intervention infrequently. It does not resolve problems in fiscal policy, taxation policy and other areas of government policy. If you expect it to do that your expectations are unrealistic.

I think that by using this two-tiered approach and disaggregating credit* (described here and here) it could help to explain a “two-speed” economy. One where the prices of consumption goods aren’t indicating high inflation but the prices of some asset classes are looking bubbly. A banking union in the Eurozone is a natural progression toward giving the ECB “good statistics” on the non-consumption money pool and what people are doing with it.

PS - Here’s a link to an interesting discussion about “disaggregated credit” and gold with ‘Victor The Cleaner’. A big hat tip to DP and VtC for the feedback in the comments here that helped to crystallize this post. But don’t blame them if you think it’s rubbish. If it is, it’s down to me alone.

37 comments:

costata said...

At some point I need to flesh out the reasons why incorporating owner-occupied housing into the final consumption index is such a big challenge. Jacob Viner's explanation is accurate but it isn't very informative.

If you look at the statistics on housing in, for example, the USA you will see that the cost of new houses tracks the rate of price inflation. It's the land component of a dwelling that has the boom-bust price pattern.

The built component of a dwelling is consumed over time. It depreciates. You have to repair and maintain a house or it becomes unlivable. So you could treat the built component as a consumption item provided you can separate the land value from the cost.

To do this all of the countries in the Eurozone would need to adopt an unimproved land valuation (UIV) system and revalue all of the land in their country at regular intervals. So that's problem number one.

Problem number two is that the depreciation rate on a house and the inflation rate are most likely moving in lock step. So that's a wash unless the owner does their own repairs and maintenance. How do you capture that data?

If you separate the purchase price of a new house from the land value then you run into problem number three. How do you factor in that the dwelling is consumed over 40 years? Do you record the price of the house as fully consumed in year one? What if the house is sold 5 years later? How do you factor that in as a consumption item by the new owner?

So there's probably no right answer. Welcome to Eurostat's OOH statistical methodology nightmare. Once the banking union is in place and the ECB is the regulator you could probably put a data mining regime in place that could help you to come up with a way of dealing with OOH but it would still be a huge challenge.

And BTW this is a huge blind spot for most of the analysts who are bitching about the "malinvestment" in China's real estate market. The built component is a consumption item not an investment. No one seems to have a handle on this.

Piripi said...

costata,

Based upon the ECB's stated objective (stability), its ongoing modus operandi (anything outside that objective is outside their mandate/responsibility), and the remarkable consistency to these they have displayed, I suggest that the ECB might consider your two disaggregated monetary pools/circuits to be 'consumptive' and 'speculative'.

Clearly the consumptive circuit is the one in which stability is desired, while the speculative is outside their mandate and therefore not the ECB's responsibility but that of those using it (due diligence, risk-reward, caveat emptor etc.).

While the 'speculative' circuit contains many vehicles potentially considered 'stores of value', there are no absolute SoVs: these all merely occupy positions at the less risky end of the speculative spectrum. Even gold. The value they are required to store is found in the final analysis in the utility inherent to those items in the consumptive circuit, is it not?

Of course if the ECB can demonstrate over the longer term that they have both the will and the means to fulfil their mandate and supply stability to the euro's purchasing power, then they really do control the degree to which their currency can be an absolute SoV, don't they?

I agree with your analysis that OOH is mostly a consumer good of longer than average durability. As you point out, it does to some degree straddle the divide between/is a hybrid of the two circuits, so does not qualify for inclusion in the HICP (and in any case many of the factors which make up construction costs (primarily the consumptive element of OOH) already are included). So I don't agree that there is a methodological nightmare, as it appears to already be included to the appropriate degree, thus the ECB actually do have a handle on this (albeit an inferred one).

I also agree with your assessment of TARGET2, esp. "It does not resolve problems in fiscal policy, taxation policy and other areas of government policy. If you expect it to do that your expectations are unrealistic.". This assessment strikes me as being exactly in line with the words and actions of the ECB.

In the environment you have described, the disaggregation of money into two circuits allows the ECB to supply both comparative stability for everyday consumptive activities for all euro users (everyday life unaffected by 'speculators'), and banking system stability via judicious application of 'informed' liquidity. Concurrently an uninhibited risk-reward circuit, one of the prerequisites of capitalism, is restored.

In theory, this should (greatly) assist the functioning of a market economy. The severance of the link between money and the state appears to me to have been the crucial step in facilitating this. I further suggest that as this system comes into its own other currency zones will need to emulate it in order to remain competitive.

This is all of course no more than my own assessment, whatever that's worth, and possibly taking this thread a bit far from your original intent.

Whether or not you find value in my thoughts I thank you for posting yours.

costata said...

Hi Piripi,

Thank you.

This is all of course no more than my own assessment, whatever that's worth, and possibly taking this thread a bit far from your original intent.

I appreciate your assessment. And you have an open invitation to take the conversation in any direction that you think has merit.

The value they are required to store is found in the final analysis in the utility inherent to those items in the consumptive circuit, is it not?

I think this conforms with a human welfare perspective on trade/exchange. I want to explore that further when I get back to the trade settlement series.

...in any case many of the factors which make up construction costs (primarily the consumptive element of OOH) already are included.

I think this is a good point. They may already have enough of that sector included in the HICP. Their statement about OOH may simply be a response to those who question why most of the other CPIs have OOH explicitly included in them and HICP doesn't. I think the key issue is to keep land out of the HICP.

Once the final agreements on the banking union are in place it will tell us a lot. The tools they put in place should tell us a lot about their attitude toward this circuit. (I'm guessing you are well versed in circuit theory.)

...as this system comes into its own other currency zones will need to emulate it in order to remain competitive...

Regardless of what the Euro critics say I think the ECB Eurosystem is an evolutionary leap forward in central banking.

I was closely following the debate with Hans-Werner Sinn about the implications of Germany's TARGET2 balances. This paper may be of interest to you if you haven't seen it already:

http://www.voxeu.org/article/target2-scapegoat-german-errors

I'm flirting with the notion that the test of foreign investment is "will the investment pay out in goods and services". So I'm leaning toward a strict utility view of trade.

Piripi said...

" I think the key issue is to keep land out of the HICP."

Yes; it just does not belong in that circuit. It is part of the speculative circuit, prone to bubbles. That's fine in and of itself, but we cannot establish systemic stability if we define our money in terms of goods of such variable utility. Both their relative value and velocity are too variable. If we wish the value of our money to be relatively constant, then we need to define it in terms of goods whose supply and demand is relatively constant. Disaggregating goods into circuits relative to such stability achieves this, hence the HICP.

(I would define a bubble something along the lines of being when any good trades not for its inherent value to the purchaser (to be clear I'm with Menger here, not Marx) but when its potential to be resold at a profit is also a/the only consideration (outside the normal supply chain that is). OOH is regularly appraised as such, as are stocks, bonds etc etc. Therefore many goods are permanently in a bubble to some degree or another (often negatively, when trading below their mean). These in aggregate would compose the 'speculative circuit'.)

"Regardless of what the Euro critics say I think the ECB Eurosystem is an evolutionary leap forward in central banking."

As do I… I haven't encountered a eurosceptic who doesn't appear to be viewing it through the wrong ($IMFS) lens. Faulty premises rather than faulty logic. The consequences of the severing of the state-money link don't seem to be considered at all by most commentators.

The article you linked seems to me a little beside the point because the issues discussed only become more than theoretical if the eurozone breaks up. Even in the article they appear to assign very little possibility to this. Assigning blame as they do also seems premature when events have not finished playing out. The various actors have taken actions for which the consequences have not yet entirely materialised. Lessons will be learned by all, but as with so much of this euro analysis consideration of alternative methods of resolution does not seem to have been made. I hardly need apprise you of the potential role of physical gold in such resolution.

Who was the sillier, the Germans or the PIGS? How could we say when we've only seen half the story, with the rest lying in the future? We can only speculate, and so can Sinn et al.

The euro crisis has apparently been described (by Sinn) as a balance of payments crisis, comparable to the Bretton Woods crisis. This is graphically illustrated in the TARGET2 balances. In my above comment I suggested:

"...as this [euro monetary] system comes into its own other currency zones will need to emulate it in order to remain competitive..."

… in the context of the eurozone's increasingly more efficient capital allocation resulting in higher net productivity vis-a-vis capital. This I see as being the result of cutting the state out of the monetary (inflation) business, and defining the monetary unit in terms of those goods in the 'consumptive circuit' i.e. goods whose utility is relatively stable.

These TARGET2 balances can, as we are both aware, be simply resolved if needs must via a gold revaluation and subsequent movement of physical gold already present inside the respective zones. It could be in the resolution/settlement of these TARGET2 balances that this gold revaluation is actually achieved, again if needs must. So in this context too, in order to remain competitive other currency zones will have to emulate the eurozone, this time in their use of physical gold reserves.

[contd…]

Piripi said...

[...contd]

In the eurozone Spain and Italy are situated (as shown in the TARGET2 chart) relative to Germany in a similar fashion to how in international terms the US is situated relative to China. Settlement is possible in both situations with gold valued higher vis-a-vis the goods of the 'consumptive circuit'.

Today, apparently, needs don't must, while in aggregate the world's creditor nations accumulate physical gold.

While gold has no inherent utility, it does have the most important settlement role. I'm not sure that I entirely agree with Say's Law that products are paid for with products… I think that products are paid for with products and credibility. We measure the credibility in gold.

Once needs must, gold is revalued vis-a-vis the goods of the consumptive circuit, gold physically moves in response and the dust settles… then we see where the credibility really lies.
Until then we all speculate.

And perhaps accumulate gold, if we are running a current account surplus.

costata said...

Hello again Piripi,

(to be clear I'm with Menger here, not Marx)

Understood.

the issues discussed only become more than theoretical if the eurozone breaks up

Yes, it was one of the last articles I read in the debate with Werner-Sinn where that possibility was given any credibility.

If the Eurozone creditor countries aren't increasing their consumption then that circuit is stable. What, if anything, are these persistent TARGET2 imbalances actually telling us?

Victor the Cleaner's thoughts on this would be appreciated.

I downloaded a paper from the BIS today called "Interpreting TARGET2 Balances" hoping to further my knowledge but I have been spending most of my spare time working on posts. If that paper sheds any light on important issues I'll share whatever I find. If you or anyone else has the time to read it it's here:

http://www.bis.org/publ/work393.pdf

VtC also alluded to the possibility of shuffling gold around within the Eurozone after a revaluation to correct any persistent TARGET2 imbalances.

If you post more comments I will respond at some point but the tyranny of the time zone is upon me and I have to log off. I will send you a direct message on Twitter when I post a response.

victorthecleaner said...

costata,

aren't house prices already accounted for properly?

If you purchase a new house, this is the same as purchasing the land and then hiring a contractor to build a house on it. The supplies and wages for the contractor are contained in the HICP while the land is not.

If you sell a used house to someone else, neither land nor construction enter the HICP. This is analogous to selling a used car. Used car sales don't enter the HICP either, nor do used TV sets or whatever else.

That's kind of a short-cut on the HICP statistics side, just including new stuff in the consumption basket, but it is even fine of you think about the velocity of money and the exchange equation.

If you purchase a new car and then sell it after a year, the value added that you have consumed is only the difference of the prices. Same for the next owner in line after you, and so on, until the car is eventually scrapped. So in effect, the purchase price of a single new car needs to be counted once.

Victor

victorthecleaner said...


Except for the movement of tangible cash from one Euro country to another, what's recorded in TARGET2 is the cumulative balance of payments since the launch of the Euro in 1999.

Historically, Germany (say) first exported goods to Greece (say). This did not lead to a non-zero balance of payments initially because German savers immediately purchased Greek debt assets, i.e. Germany exported goods to Greece while at the same time Greece exported capital assets (here: government debt) to Germany. The capital account balanced the trade account.

Then came the debt crisis, and (1) German savers sold some of their debt directly to the ECB (SMP); (2) the ECB accepted Greek bonds as collateral in bank refinancing operations but before these repos, the bonds were mainly held by Germany (LTRO). Both transactions reverse the previous balance of the capital account in favour of a balance of payments.

From the point of view of the Eurosystem, this is simply accounting, and as long as the Euro zone continues to operate - this includes the ECB targeting the same 2% inflation rate in *all* countries individually, these TARGET2 balances have little significance to the real economy.

From the point of view of the German saver, a risky asset (Greek government bond) was replaced by a risk-free asset (TARGET2 balance which is central bank money). From the point of the Greek debtor, he now owes his debt via the Greek CB to the German CB rather than to someone in the German private sector directly.

So who is now paying the German exporter who accumulated a surplus in the first place? It is the Greek saver in aggregate who is subject to 2% inflation in spite of a collapsing real economy which would, without CBs, lead to some serious deflation.

So rather than the Greek importer or taxpayer having to pay off the German exporter in real terns, it is the Greek saver in aggregate who cannot reap the real gains from his savings that he would be able in an uncontrolled deflationary environment. So the Greek debt is socialized from the initial debtor to the Greek user of the currency in aggregate.

As long as the German surplus is turned from bonds (risky) into TARGET2 balances (risk-free), nothing changes for Germany in the real economy. (Then, in a second round, Greece will become more competitive, and *that* will eventually have some impact on the real economy of the German exporter).

Victor

victorthecleaner said...


So far, there is no "nice" internal adjustment mechanism in the Euro zone. The only existing mechanism is the "ugly" one, i.e. Greek consumers running out of funds, going bankrupt, collapsing demand, harsh downward adjustment on wages and prices of Greek made products.

This adjustment is "ugly" because it doesn't happen gradually whenever German exporters interact with Greek importers, but the adjustment is rather absent for many years and then, once trust in the Greek consumer debt is lost, all the adjustment is forced on Greece instantly.

The spur and break function of the real gold price pre-1922 that Jaques Rueff described, is missing inside the Euro zone.

Now I said that I think the remaining TARGET2 balances will eventually be settled in revalued gold. Settling the old balances won't make a difference (because all the events in the real economy have already happened at that point).

But settling any newly arising balance *will* make a difference. The gold will flow, and, by your interpretation of the Barsky-Summers mechanism, it will raise interest rates in the consumer country relative to the exporter country. Your interpretation of Barsky-Summers: If gold circulates (as opposed to being hoarded), this causes increasing real interest rates in the future. This is what would happen in the consumer country. If gold is hoarded, this causes decreasing real interest rates in the future.

So with all additional TRAGET2 balances settled in (physical) gold in the Euro zone AG (=after gold's function is restored), the Euro zone will regain an internal balancing mechanism. Caveat: Still, the ECB/regulator will have to monitor and if necessary limit any cross-border debt flows that are not currency.

How does this compare to the settlement in terms of gold certificates between the various district Federal Reserve banks? Answer: Like a proper (physical) gold standard compared with a gold exchange standard.

Victor


costata said...

Hi VtC

aren't house prices already accounted for properly?

I think that's Piripi's argument. And I think you set it out correctly. Assuming that depreciation and inflation are about the same you can treat the new house (excluding land) as being consumed in year 1.

Agreed, provided the secondary market transactions are excluded it doesn't matter. If the house lasts 40 years and a new owner takes possession every 10 years. it is still only 1 consumption event in year 1 of 1 new house with 40 years of utility.

It makes no difference that there are 4 owners over 40 years sharing 1/4 of the utility of that initial consumption event.

100% agree on the car analogy

Beautiful!!

I'll respond on your TARGET2 comment separately.

costata said...

Hi again VtC,

I think we have just about nailed this. Before I continue with this. When I said that argument about how HICP treats housing was "Piripi's argument". I meant credit to him. Kudos!

So far, there is no "nice" internal adjustment mechanism in the Euro zone.

Agreed it's messy right now. The system was designed to operate with gold. I think your description of the post-transition mechanism is excellent.

..it will raise interest rates in the consumer country relative to the exporter country...

You put into words something that I have been groping toward like a blind man for months. Post-transition the risk-free asset gold prices risk higher by increasing in price. As risk premium increases it is reflected in the increasing interest rates.

This dovetails nicely with something else I'm working on concerning dual currency systems.

So we have two circuits as Piripi rightly calls them. The HICP/consumption circuit with the adjustment mechanism being (consumption)prices+>Euro>flow.

Then we have the non-consumption goods circuit including various asset classes. The adjustment mechanism is gold>interest rate>(non-consumption)prices+.

And you clever fellow Mr. Cleaner I think you just opened up the opportunity to resolve the will-flow and won't-flow question. I have to give this some more thought but it may be resolved as:

1. Will-flow within currency zone; and
2. Won't flow between currency zones (except in emergencies).

There's no clear relationship between interest rates in two currency zones so perhaps we resolve the mechanism by replacing 'interest rate' with 'exchange rate'.

I have some more to add from that BIS paper I linked above that should help to shed more light on the TARGET2 balances over the past few years. But I have only skim read it thus far.

Cheers

PS. It just hit me. Every country joining the Eurozone is required to bring a specific quantity of gold to the table. How is that calculated? How do they determine how much gold is precisely enough?

Piripi said...

The absorption of imbalances (and thus the risk) up the hierarchy via TARGET2 to the CB level places both the timing and the means of resolving imbalances, should they deem it necessary, at the sole discretion of the ECB.

costata said...

In case anyone else is following this conversation I think it might be helpful to let you know where I think we are going with this.

If we can show that a critical adjustment mechanism of the ECB Eurosystem can't function correctly without gold fulfilling a specific role in their monetary and financial system then it follows that it was designed with the intention that at some point gold would be back in the system.

Why design something in a way that guaranteed it would fail? In other words, if you were certain that gold was never coming back your system was a dud from the outset.

In order for the Euro architects design to function properly either the Eurosystem must intend to reinstate gold to the system or the designers anticipated that some agency or event would do it for them.

As part of this investigation I'm also looking at some specific points of failure in the Eurozone system in the lead up to the GFC:

1. Interest rates failed to price risk on the sovereign debt of the Club Med countries of the Eurozone.

2. Policy failures in the admission process for Eurozone membership. (IMO Brussels should have listened to one of the fathers of the Euro - Robert Mundell.)

3. Risky assets were mispriced and malinvestment occurred in the Club Med countries and elsewhere.

Sorry for meandering around in the sequencing of posts. If I'm understanding STFU's Dean James correctly, we can resolve this later and put all of the pieces in the right sequence.

I do want to get back to the trade settlement series and complete it but I also want to explore issues that arise in the ongoing discussion. I don't want to overlook any gold nuggets in the comments.

Cheers

costata said...

Hi Piripi,

I'll be back tomorrow. Good night.

DP said...

Post-transition the risk-free asset gold prices risk higher by increasing in price.

AKA - currency devaluing in real terms.

If net-savers are choosing to dishoard currency in favour of gold, this elevates the price of gold in that economic zone — given that gold is a universal asset and isn't necessarily rising in price also in other zones, this implies the exchange rate of this domestic currency is going down against not just gold… but also other currencies. If the move is sustained, this will inevitably show up in elevated commodity prices, and ultimately consumer price inflation.

All of this resulting not from any increase in the amount of currency in circulation, but the increased velocity of circulation.

As risk premium increases it is reflected in the increasing interest rates.

Yes. Confidence in the currency wanes, its velocity is elevated, and its exchange value falls… unless the level of liquidity is effectively controlled by the central bank in some manner. Most effectively through buying back currency from the market with assets from the Central Bank's balance sheet (e.g.: FX or gold reserves, bonds, etc) when liquidity needs to be tightened (inflationary forces are seen).

Conversely, if there is insufficient liquidity (deflationary force) then more currency will be (is b eing!) injected through the Central Bank buying carefully-selected (based on what is thought to be the most effective in achieving the objectives at the time) assets from the market. AKA "Quantitative Easing".

If there is any Central Bank operating in this liquidity-managing fashion (there is), all others will be forced to emulate it as best they can for their currencies to be seen as a competitive store of value on the world stage.

A Central Bank could choose to ignore markets in the speculative circuit while they are going up and diverting demand from currency (not restricting liquidity in the consumption circuit, the object of primary concern to them). But if/when bubbles in these markets pop, the effects will inevitably show up in the liquidity of the currency as demand suddenly ramps. So they can't ignore this circuit completely when managing their currency.

This is why Greenspan made it clear, Central Banks can only stand aside and watch what may only later turn out to have been irrationally exuberant speculative manias, however they have no choice but to step in if and when these bubbles should indeed collapse from time to time.

DP said...

buying back currency from the market with assets from the Central Bank's balance sheet (e.g.: FX or gold reserves, bonds, etc) when liquidity needs to be tightened

Liquidity may be too tight, or too loose, either domestically or internationally (or both, or the opposite in the two). My point being, they are different circuits that are monitored and managed discretely. It may be appropriate at some time to, say, manage domestic liquidity by the CB selling gold for currency… while at the same time buying their own currency back in the FX market using other currencies (or gold) from reserves. (Or any other combination, as objectives demand within the two circuits.)

The great thing about thinking of things in separate circuits, is it makes it easier to conceptualise. But it would be impractical, as well as a gross over-simplification, to think events in one circuit can be isolated from events in another. If only life were so simple! :-)

victorthecleaner said...

costata,

Every country joining the Eurozone is required to bring a specific quantity of gold to the table. How is that calculated? How do they determine how much gold is precisely enough?

I am not 100% certain on this one, but here is what I think I remember. When a new country joins, they are required to have 15% of their foreign exchange reserves in gold. Some countries, I think Greece, Ireland, had to purchase gold in order to arrive at that ratio. Others (Germany, France, etc.) had way more than that.

This doesn't answer the question about how many reserves a country needs to have. Some (Italy, Portugal, France, Germany) entered with huge reserves per capital/per GDP/per whatever whereas others (Ireland) entered with little reserves. [all from memory, please correct if wrong] So apparently, there is no "minimum reserve requirement" for a new country joining the Euro system. (in other words: #brentry is always possible)

But your question opens up another can of worms. Have you ever wondered why France, for example, sold a considerable amount of gold under the Washington agreement, but Germany didn't sell anything (except a few kilos for commemorative coins).

Explanation? Sometimes I suspect they have always been operating a gold clearing system behind closed doors, i.e. Germany, the big net exporter, tends to acquire gold whereas net importers lose some, i.e. sell more. I find this idea rather tempting, but then Switzerland and the Netherlands don't fit into this picture.

Victor

victorthecleaner said...

As part of this investigation I'm also looking at some specific points of failure in the Eurozone system in the lead up to the GFC:

I occasionally quote Richard Werner on this one:

So when Greece joined the eurozone, it delegated monetary policy to the ECB. This has left Greece without monetary policy. But it does not mean that there was no monetary policy. Quite the contrary, the ECB has for most years since its creation pursued a policy to encourage governments in the southwestern periphery, especially Greece, Ireland, Spain and Portugal, to make unrealistically high revenue growth (and hence spending) projections. It did this by its perennial--though little- known--policy to boost commercial bank credit growth in these countries at an unsustainably fast pace in the double-digits (at times even exceeding 20 percent annual growth in these countries).

Bank credit is primarily determined by central bank policy. Stoking this massive credit bubble in Europe's periphery--like a "ring of fire"--has been the ECB's clandestine regional policy. Bank credit growth means money supply growth.

While in public the ECB would emphasize its interest rate policy--which is identical across the eurozone--unknown to the public, the ECB implemented regionally diverse credit growth policies: boom in the periphery, with banks encouraged to print money as if there was no tomorrow, and bust in Germany, where bank credit was almost entirely shut down, causing weak growth and rising unemployment. It is this ECB policy that is now coming back to haunt us.

Thus Greece is not solely to be blamed for its crisis. The institution it had entrusted monetary policy to, the ECB, also must share responsibility, for it was the ECB that created the unsustainable economic boom that encouraged an overoptimistic fiscal stance. It was also this ECB policy that rendered the Greek banking system fragile to the effects of the financial crisis, and this also added to the fiscal burden on Greece.

Why did the ECB adopt such irresponsible and regionally diverse credit policies? We have to ask them--though ECB staff tend to remain silent on this issue.

When I asked ECB President Jean-Claude Trichet at Davos in 2003 about this regionally diverse credit creation policy, he merely replied: "I don't know what you mean with 'credit creation.' We use interest rates as our policy tool."


...

victorthecleaner said...


This was part of a newspaper article in Japan in 2010.

I offer you two options:
(1) Trichet is dumb. He did not understand what Werner was referring to.
(2) Werner was spot on, but Trichet couldn't reply "yes, we do" for political reasons.

I suppose you can already guess my choice. Then you ask "why?", and this is a another road to "Free Fiat":

They knew they needed 2% consumer price inflation, simply because they expected the dollar system to last another decade or longer. Without that inflation and with currency exchange rates in the long run approximately at purchasing power parity, the Euro would have risen a lot compared with the dollar. (2% inflation from 1999 to 2011 gives you a price index of about 1.33 or, in other words, without that inflation, the Euro would be worth $1.80 rather than $1.35 today.

You know the Euro zone was designed to have a balanced current account (this is rather obvious, but usually not talked about much). The Euro zone is a major trade hub. They import energy and other resources and export industrial and consumer goods. The balanced current account has the huge advantage of making the Euro zone "dollar indifferent". As long as they receive for their exports the same currency they need for their imports, the Euro zone will always be fine.

...

Victor

victorthecleaner said...


With the Euro today at $1.80 instead of $1.35, however, they might have lost a substantial share of their exports and have ended up a net importer of energy. As such, they would be hostage to the U.S.-Saudi oil price policy who could simply hike the oil price and take Europe hostage and force them to support the dollar system (otherwise Europe would lose currency/gold reserves or be starved off essential energy).

So the Eurosystem needed to create 2% consumer price inflation for a decade, say. How do you do this? By the work of the very same Richard Werner, you have the following options or a combination of them:
1) print base money faster than GDP grows and make sure it is used for consumption (rather than being hoarded as "savings")
2) have your commercial banks expand consumer credit faster than GDP growth
3) have your CB lend base money to commercial banks against consumer debt (e.g. government debt) as the collateral

What the Eurosystem did 2001 to 2010 was basically create 2% inflation in the least harmful way, by deliberately leaving the industrial core countries undamaged. (They could, of course, have mailed CB drawn checks to the governments to spend, but how do you introduce such a practice without making it impossible to end).

Next thought:
1) When will the ECB stop blowing bubbles in order to create consumer price inflation?
2) How is this related to the switch of the oil currency?

Victor

victorthecleaner said...

DP,

"Post-transition the risk-free asset gold prices risk higher by increasing in price."

AKA - currency devaluing in real terms.


Wrong. Gold increasing in real terms.

All of this resulting not from any increase in the amount of currency in circulation, but the increased velocity of circulation.

Presently, all the "saved" currency is not held as CB reserves, but rather as bonds. The difference is that CB money is claim on the delivery of actual cash whereas a bond may default or drop in price.

The correct conclusion is:
(a) if your CB purchases all unwanted bonds and other debt (front lawn dump), your currency will go down in real terms
(b) if a significant share of the bonds defaults, however, there is no need to expect a pick up in the velocity of money and therefore no reason to expect inflation.

Gold will increase in real terms either way.

The Eurosystem has the choice between (a) and (b). They have clearly announced they will go for (b). The dollar in its present form does not have any such choice, simply because of the lopsided net foreign investment position. As expected, the U.S. have clearly announced they chose (a).

#FFFTW

Victor

victorthecleaner said...

DP,

This is why Greenspan made it clear, Central Banks can only stand aside and watch what may only later turn out to have been irrationally exuberant speculative manias, however they have no choice but to step in if and when these bubbles should indeed collapse from time to time.

Don't agree either. This is what the Eurosystem's banking union is about and why they will eventually control credit volume. Btw this is how Germany and Japan, for example, operated shortly after WW2. (source: R Werner's book)

Victor

victorthecleaner said...

DP,

It may be appropriate at some time to, say, manage domestic liquidity by the CB selling gold for currency…

Don't agree either. AG, the only condition under which the CB is allowed to enact gold open market operations is to sterilize capital flows in the financial plane (that would undermine the trade adjustment mechanism if left unchecked).

If the CB engages in gold open market operations to manage liquidity, to influence bank lending, or to target consumer prices, you have a soft-peg gold exchange standard, and we all know why this would ultimately fail.

Victor

DP said...

Thank you for taking the time to share your thoughts on my thoughts, Victor. It's getting late, so I will try to give your thoughts the proper consideration they deserve tomorrow. ;-)

However, looking very briefly at the first part of your first response to me, it would appear either:

You disagree with my qualification of what I meant by "real terms" (given that gold is a universal asset and isn't necessarily rising in price also in other zones, this implies the exchange rate of this domestic currency is going down against not just gold… but also other currencies.)

Or there is a semantic issue, where we are applying different interpretations of what "real terms" might mean exactly? Perhaps you preferred to think of general consumer goods/services prices, presumably stable in domestic currency terms but at the same time falling relative to gold/foreign currencies? If so, that might mean the same consumer goods/services present in both the domestic and foreign markets were falling in price within the other currency zones? Now my mind is wandering… [slap]

If the move is sustained, this will inevitably show up in elevated commodity prices, and ultimately consumer price inflation.

I'm hoping these thoughts will bring a new learning experience!

Sincerely,

DP :-)

Piripi said...

costata said: "If we can show that a critical adjustment mechanism of the ECB Eurosystem can't function correctly without gold fulfilling a specific role in their monetary and financial system then it follows that it was designed with the intention that at some point gold would be back in the system."

This is only circumstantial, I know, however…

Salvatore Rossi, director general of the Banca d'Italia, told delegates at the London Bullion Market Association's annual conference on Monday that "Gold underpins the independence of central banks in their ability to (act) as the ultimate bearer of domestic financial stability."

The independence he speaks of - from the state and accompanying politics - could also be expressed as 'monetary sovereignty'. When he says gold underpins that independence he is clearly corroborating that the system as it is currently arranged can't function correctly without gold, but he has neither identified any critical adjustment mechanism nor specifically how gold otherwise acts to underpin CB independence.

As far as I can tell, gold never actually left the system per se (although there was an IMF/SDR attempt to supplant it during the early-mid 1970s), but rather the system appears instead to have been attempting to remain operational whilst avoiding recourse to gold, at least partially via a series of gentlemen's or off the record agreements, so it seems logical to presume that CBs, in continuing to hold (and expand in some cases, predominantly those underweight relative to their peers) gold reserves, have done so because recourse to gold will inevitably be required (if not, how or why would it 'underpin' CB independence?), and that gold will function in the future not dissimilar to how it did in the past - as the conclusive adjustment mechanism.

In other words, we had to wait for a currency system that could accommodate functioning gold, and Rossi, an upper-echelon insider, says that we have it.

Piripi said...

In a roundabout way DP's initial remark above concerning a higher valuation of gold, "AKA - currency devaluing in real terms", illustrates how functioning gold will perform such an adjustment - by increasing in value in real terms (specifically against the goods in the 'consumptive circuit', the real goods and services we constantly consume), while concurrently the currency of an independent monetary authority can theoretically be kept relatively stable in those same real terms.

I agree that this is simplifying somewhat, perhaps accounting for why such stability is targeted over the medium rather than short term. I have at no point intended to suggest that events in either theoretical circuit could or should be isolated from one another.

Oil belongs in (or at least is a very significant input cost to) the 'consumptive circuit' (that basket of goods the independent monetary authority measures the purchasing power of its currency against, in the case of ECB this is the HICP). The dollar system cannot handle the rise of gold vis-a-vis oil, because the Federal Reserve does not have the independence the ECB enjoys - the ECB having severed its link to the nation-state while the Fed is ultimately controlled by the USG - so under the dollar system gold simply could not be allowed to rise vis-a-vis oil, period. US monetary policy would be subjugated to US fiscal policy, causing exactly as DP said: "AKA - currency [USdollar] devaluing in real terms", (and in a feedback loop). Austerity is avoidable via that subjugation (for a time).

Functioning gold belongs to the 'speculative circuit' (perhaps as that circuit's closest good to an absolute SoV, depending upon one's timeframe), but due to the ongoing actions to avoid recourse to its function it has to a great degree been banished to the 'consumptive circuit', until such time as it is actively required to underpin CB independence.

costata said...

Hi Piripi,

I think the ECB's discretion is limited by their mandate and (post-transition to a new IMFS) by the mechanisms in place.

That quote from Rossi is more than "circumstantial" evidence IMO. It's literally true because CBs generally can't issue bonds. That is usually a Treasury function.

A CB can solve this problem to some extent by dealing in bonds with its commercial banks but that is a two-way street. Gold is a CB's ace in the hole. Their bank clients can have a different and potentially conflicting agenda. A CB issuing currency can always print money to buy gold and the gold market is always liquid for a seller at some price.

..we had to wait for a currency system that could accommodate functioning gold..

That's my intuition and it speaks to FOFOA's thoughts about support being withdrawn. I'm beginning to wonder if the Euro sponsors needed more time, if kicking the can down the road was part of the Euro sponsors agenda rather than being some kind of favour to the Americans.

I think the banking union may have been the missing link for the ECB. Would a commercial bank induced disaster in the Club Med countries and Eastern Europe be a small price to pay if it was the last one instead of one more in an ongoing boom-bust cycle?

..concurrently the currency of an independent monetary authority can theoretically be kept relatively stable..

This may be how they isolate policy responses in each of the two circuits and reduce spillover effects. I also acknowledge DP's caveat on this. Everything is connected and some spillover is inevitable but probably within tolerance after all of the finetuning tools are in place.

Cheers

costata said...

Hi DP,

The great thing about thinking of things in separate circuits, is it makes it easier to conceptualise.

I agree it has its limits but I don't think we have reached them. By putting this Barsky-Summers causation reversal into concrete terms I think we have two (relatively) cleanly separated circuits and two definite adjustment mechanisms to analyse.

I think we also need to now consider time lags and extend/regress the sequence of causation e.g. let's say gold moves in price setting off a reaction in interest rates. The question is: What moved gold?

Then I think we are looking at things like the risk perception of investors in an overheating asset class. Stabilising the currency through the consumption circuit changes the meaning of "taking profits" and "taking money off the table".

Instead of RE>cash to take a profit it might be RE>cash>gold. And gold>cash>asset when an investor anticipates appreciation in an asset class. Do you see what I'm driving at? Sitting in "cash" could mean sitting in gold in this new regime. Investors and speculators may spend no time holding cash in any other "currency" except gold. That would make the separation in the circuits cleaner.

My reply to VtC may also also touch on some of the other points you made in the exchange with him.

costata said...

Hi VtC,

I'm going to do some spade work on this gold contribution. I agree it does open up a can of worms.

I still haven't had the opportunity to do mone than a skim read of that BIS paper on TARGET2 interpretation. I also downloaded that paper on ECB liquidity measures that DP linked.

I have to rethink this whole issue of why certain policies were adopted in the lead up to the GFC. It may have been, as you say, driven by the inflation target. Werner's interpreation always seemed too black-and-white to me.

Perhaps as I suggested to Piripi they could see that it was going to be another train crash but it would also be a crisis that should not be wasted. Resulting in the banking union and regulatory oversight that they wanted.

So it may have been simply pragmatism at work here. Alternatively intervening may have led to criticism of the ECB if it was seen as interfering in the fiscal policy of the sovereign states in the Eurozone.

With the Euro today at $1.80 instead of $1.35, however, they might have lost a substantial share of their exports..

Japan's exports held up just fine with a 20% appreciation against the US dollar over a shorter time frame. It's the pace of adjustment not the amount of the adjustment that matters most. Look at the rise in the Euro since launch versus the US dollar and other currencies.

1) When will the ECB stop blowing bubbles in order to create consumer price inflation?

2) How is this related to the switch of the oil currency?


Good questions. I will ponder them when I get back to completing posts later this week.

I agree with your comment to DP about gold increasing rather than devaluation of the currency occurring.

I have to agree with DP here:

Perhaps you preferred to think of general consumer goods/services prices, presumably stable in domestic currency terms but at the same time falling relative to gold/foreign currencies? If so, that might mean the same consumer goods/services present in both the domestic and foreign markets were falling in price within the other currency zones? Now my mind is wandering… [slap]

He should be slapped! No, just joking. There are a lot of levers here. I have to log off now.

Cheers and thank you to everyone for making so much effort. Great responses IMVHO.

DP said...

The correct conclusion is:
(a) if your CB purchases all unwanted bonds and other debt (front lawn dump), your currency will go down in real terms
(b) if a significant share of the bonds defaults, however, there is no need to expect a pick up in the velocity of money and therefore no reason to expect inflation.


I agree with your conclusion - either way gold will rise, but as a result of different emotions sweeping the market.

As you rightly generalised, Presently, all the "saved" currency is not held as CB reserves, but rather as bonds. Once they are defaulted, that's it game over for those holding that bag. But I'm pretty sure they will see it coming before it actually happens(?) and therefore most will be trying to sell these assets to get out, initially sucking up Money from the markets (deflationary) … before then dumping that Money back into the markets to trade it for "other stuff".

Isn't it true that you were here discussing not choosing between increasing (or not) Velocity, but [base] Money stock? Velocity may be affected as a result of that choice, of course.

If the Money stock is increased to avoid defaults, there will be no panic over the potential to lose what you thought you already had (but didn't). However, there will then be more liquidity flowing through the markets and, all other things remaining equal, this will inevitably show up in higher Prices - even if confidence is maintained and Velocity of each Money unit remains stable.

If it becomes clear defaults will be allowed to occur and the Money stock won't be increased (no front lawn dump) to avoid this, there will be panic to get clear of this somehow. (Perhaps mass dumping of assets for "cash", bank deposit liabilites, which are then used to buy something else - gold, or FX, or "other"?) all other things remaining equal, this will inevitably show up in higher Prices. I guess it is possible that the bond-dumpers will simply hold the bank deposits instead of moving through that to something else… but I would imagine the FX markets seeing sovereign defaults as a reason to short the relevant currency, and I also question faith in bank deposit liabilities too, so I struggle to picture it happening like that. It might have been more rational in the final analysis to hold the currency, if you stop to run the numbers. But who's got time for that shit in the heat of the moment? ;D

The Central Banks are going to have their hands pretty full, trying to optimise liquidity (to meet their mandate for consumer price stability) while this, potentially rather emotionally charged, event plays out.

BTW I also think the BIS/ECB are still not quite ready for prime time, as you indicated, costata. I think they are stepping in to prevent collapse lately, until they have their artillery as lined up as it's ever going to be.

The question is: What moved gold?

Emotional shifts.

Investors and speculators may spend no time holding cash in any other "currency" except gold.

That would be an ecumenical matter. I don't think you can regulate that they do this, or not do this, in order to make the separation in your circuits cleaner, or for any other reason… but they might, at times, choose to do so — regardless of what anyone else may wish.

I look forward to receiving my slap(s)! ;D

Piripi said...

costata,

"...let's say gold moves in price setting off a reaction in interest rates. The question is: What moved gold?"

Is this a serious question?

Piripi said...

DP,

Was "Emotional shifts." a serious reply?

DP said...

I think you know me better than to take anything I say too seriously, Piripi? ;-) I daresay you can be replied upon to provide a more serious response to costata.

I also suspect you can offer a more serious question — or perhaps, a better way of expressing where you believe costata was really going?

costata said...

Hi DP,

Me: Investors and speculators may spend no time holding cash in any other "currency" except gold.

You: That would be an ecumenical matter. I don't think you can regulate that they do this, or not do this, in order to make the separation in your circuits cleaner, or for any other reason..

I have the first draft of a post on this two-circuit concept. I wasn't thinking of some kind of regulatory initiative. I think it could happen naturally. A fuller explanation will have to wait until the post is closer to completion.

Cheers

costata said...

Hi Piripi,

I know (and like) DP's style.

When I posed the question "What moves gold?" I was simply throwing that question out to gather input for the post I'm working on.

Any households with a disposable income that exceeds their consumption expenditure will have a foot in two camps. If they are saving or investing they will have an impact in the second circuit (but not as householders per se).

So at this point I guess my answer to that question would be - "investors". But if it's reduced to one word then investor has to be intepreted quite loosely.

That would give us a household consumption circuit and an investment circuit. And DP I hear you on this issue of separation but at this stage I want to try to clearly define the second circuit before attempting to look at interaction.

At the moment the separation is looking quite clean if you treat householders as two discrete economic agents - consumer and investor.

Not sure if that makes any sense. I'm dog tired right now and looking forward to having some time over the next couple of days to spend on the post. I really appreciate the feedback and input from you guys. The dual economic agent distinction only crystallized in my mind as I was writing this reply.

Cheers

Piripi said...

"Because gold has capabilities to absorb external economic shocks, growth of its use in the international monetary system will be imminent."

Last line in a translation of an analysis from The Agricultural Bank of China, discussing gold as an international reserve and the repatriation of German gold reserves, dated Jan 28 2013.

Translation via Koos Jansen found here.

costata said...

Hello Piripi,

That's an interesting 'find'. I'm working on a follow up post to this one right now but I'll look forward to reading this translation after I have the new post up.

Cheers