The Signal Fire
It was the end of 1720 when the Mississippi Bubble finally popped, one of the first central bank-induced bubbles in the younger history. It marked the end of one of the first paper money experiments right before the industrial revolution and its initiator, the Brit John Law, saved himself a place in the history books.
Back then, John Law was already a glorious figure. In his young years, he was a professional gambler in London, known for his brilliant calculation skills. Within seconds he was able to calculate winning probabilities.
After he was sentenced to death in the UK, his flight led him all around Europe before he finally reached Paris. Soon after his arrival, he made a fortune in gambling, and in 1715 his friend, French regent Philipps of Orleans, made him chief of what should soon transform into the Banque Generale. Finally, in 1719, he became chief controller within the French empire.
Even prior, Law had some things to say about political economics. In his 1705 writing, Money and trade considered: With a proposal for supplying the Nation with money, he argued that Scottland (where he lived back then) should implement a paper money system. It should take ten years until he could finally test his theory in France, while Scottland dismissed the idea back then.
The reason why Law called for a paper money standard instead of a precious metal standard lies in several economic crises of the 16th Century. Back then, gold wildly fluctuated in price because of the enormous inflows of gold from the new world, mainly by the Spanish crown. That led to price inflation across the continent, and because of that, Law argued that land instead of precious metals should be reserve money.
However, when Law finally became head of the Banque Royale, he decided that it was the time when his theory should be tested. The reign of Louis XIV shattered the French finances. To cover the expenses, the government steadily reduced the gold content of its coins so that it could issue debt obligations at a higher nominal value. That ended when Law finally took office, and the Banque Royale started to give loans on a paper-money basis.
In the beginning, the bank restored trust in the currency, although the Banque Royale’s equity comprised 3/4 of worthless state paper. Nevertheless, the real tragedy started when Law founded the Mississippi Company, which soon unified all colonial societies under its watch. By artificially tightening supply, Law managed to increase the value of the shares of the Company and attracted capital, while the Banque Royale issued more and more currency.
With a brilliant marketing campaign, Law attracted more foreign capital and, combined with new currency units issued by his banks, could further blow up the share price. However, the pain started when foreign investors secretly withdrew capital in 1720, and the stock price crashed. Law’s paper money experiment abruptly ended, and he died only nine years later because of pneumonia in Venice.
The history of Law’s Banque Royale should remind us of the current monetary experiment we experience. Artificially low interest rates and central bank bond-buying programs inflated the prices of government bonds, stock prices, and other financial assets. The policies led to substantial economic imbalances, and more and more money flew into financial markets instead of the real economy. While financial markets celebrated, economic growth stagnated.
Additionally, the reoccurring interventions by central banks had another effect: investors loaded up on risk to earn yield. And why would they not, as central banks always came to the rescue and reflated the everything bubble when things went wrong? Because of weak consumer price inflation, central banks hardly had to worry as long as the money was kept within financial markets.
However, the central bank-induced steady prosperity regime caused market participants to take even more risks. If one knows the Austrian School, this period would be the artificially created boom. The term steady prosperity regime is known from Hyman Minsky, a polish, Keynesian economist.
In his theory, Minsky describes the consequences of a steady prosperity regime. As risks diminish on the surface, investors take elevated risks, and they start to use leverage. Finally, when asset prices fall, their asset earnings are too low to cover the debt, and they are forced to liquidate assets to cover the expenses, which leads to further drawdowns of asset prices.
That leads to financial instability, and only the lender of last resort, the central bank, can restore stability. However, this restarts the problem of moral hazard, and investors are encouraged to retake risks because they are assured that they do not have to bear the total costs of their actions if things go wrong. A doom loop, so to speak.
Recent turbulence in the GILT market is a perfect example of such a situation. While it is understandable that the Bank of England had to intervene to guarantee financial stability, this will not solve the problem.
In times of low inflation, such interventions only affect financial markets. However, in a high inflation regime, they bear enormous risks. This week we got the September inflation numbers in the Eurozone and the United States. While Eurozone inflation increased to another cycle-high, US inflation increased less than in the previous month, but only slightly.
It is highly uncertain if the Bank of England really stops its temporary intervention this week. I doubt that the struggling pension funds managed to minimize risks enough by then. If that is the case, I expect that aggressive rate hikes to fight inflation will lead to more problems down the road.
The Bank of England and the ECB are fighting on two fronts. On the one front, they have to fight inflation, but on the other hand, they have to keep an eye on the exchange rate. Since the beginning of the year, both currencies have significantly devalued against the dollar because of economic turbulence, the war in Ukraine, and the energy crisis.
The situation in foreign exchange markets could be as extreme as during the early 1980s when the DXY rose more than 50%. Back then, only a joint action by the central banks of the US, UK, Germany, France, and Japan could prevent the worse. However, this seems unlikely at the moment.
The Federal Reserve is in charge when it comes to monetary tightening policy. The other big central banks are only passengers in this game and can only react by raising rates or devaluing their currency, as the Bank of Japan does. However, as I mentioned last week, Japan has an enormous foreign exchange reserve if it wants to stop delaying the devaluation of the currency.
So, it is all about the Federal Reserve, and there is no pivot in sight. No one knows how inflation will develop further, and the war and the energy crisis did not make things easier. No one really knows how high the Federal Funds Rate needs to go and where the Fed will finally stop.
Last Week, Fed governor Christopher Waller talked about the illiquidity in the US Treasury market and pointed to the enormous sums of reserves that are currently parked in the NY Fed’s reverse repo facility (RRP), where market participants park cash at the Fed in exchange for US Treasuries where they earn 3.05 interest on it. Currently, the market parks more than 2 trillion US dollars daily at the Fed.
It is essential to understand that it is not the banks who do that. Banks earn more interest on their bank reserves if they just put it in their account at the Fed, currently 3.15%. The majority of the reserves in the RRP are from Money Market Funds. Waller argues that there is enough liquidity in the system, and it is just that it is parked in the RRP instead of at the banks.
MMFs are parking their cash at the RRP instead of the banks because, despite the rise in the Federal Funds Rate, banks have enough bank reserves because of QE and do not need to raise deposit rates to attract more deposits. Back in the days when the Fed did not flush reserves into the system, deposit rates reacted much faster when interest rates rose. But if the banks do not need deposits, they do not have to raise rates fast, and the same happened during the last hiking cycle.
If the banks need liquidity, they only need to raise interest rates on deposits, and the money currently at RRP will flow back to the banks. Thus, the Fed expects that QT will force the banks to raise deposit rates to rechannel the liquidity from the RRP back to them. Further, higher deposit rates should lead to cooler inflation.
In theory, raising interest rates fights inflation because investing becomes costlier, and consumers spend less because a higher interest rate is an incentive to save. However, as I just noted, if consumers should increase their savings, the banks need to offer a higher deposit rate.
While QE did not lead to higher inflation, I would argue that QT will hardly lead to lower inflation in the real economy. QT causes tighter liquidity conditions within financial markets. However, the Fed hopes that the liquidity comes from RRP and that the financial system remains stable.
During the last months, there have been a lot of discussions about R*, the natural rate of interest, where supply and demand are in equilibrium and no inflation exists. The problem with R* is that it is a theoretical concept, and only market participants can set R* because no one has all the information to know where R* should be.
Further, it is not the case that the equilibrium rate is equal in all markets. Artificially low-interest rates since 2008 led to economic imbalances. A NY-Fed paper discusses this problem in more detail.
Within the paper, the economists argue that there are two different equilibrium rates, R* and R**. While R* is the equilibrium rate in the real economy, R** is the equilibrium rate in the financial system. Because of the low-interest rate environment of the 2010s, the authors argue, R* is now much higher than R**. That seems logical because the 2010s can be described as a steady prosperity regime and investors’ increased risk (leverage). Remember the Minsky Moment?
The authors examine the Fed's last two interest rate hiking cycles (2004-06 % 2015-19) and argue that R* and R** were pretty close back then. Thus financial stress and a real economic downturn co-occurred, while inflation was much lower than today.
That is the core of the problem because we could very likely face a situation (and I think there are good arguments for that) where the financial system gets dysfunctional earlier than the inflation problem in the real economy gets under control. At least not to the point needed to bring inflation back down to 2 %.
Additionally, the Fed is fighting structural changes, which will likely keep inflation elevated. Firstly, the latest flood of money tightened the labor market because more people retired. A lower supply of workers is pushing wage rates higher, ceteris paribus.
Secondly, the current geopolitical stress will lead to a re-shoring of production, away from (cheap) Asian countries to countries with higher wage rates, and thirdly, the age of cheap energy is over. Therefore, one should expect yields to rise, and multiples will fall.
So, the Fed needs to raise rates further to fight inflation, and other central banks need to follow if they do not want to accept a sharp devaluation of their currencies, which would also lead to higher import prices (energy), hence more sustained inflation. And if we consider the arguments from above, I would say that Powell is serious in his inflation fight.
Some may argue that consumers and banks are in much better shape than in 2008. But I believe that the risk lies in the sovereign bond market.
Recent turbulence in the GILT market showed the potential risk. However, the Fed will not consider this as it believes there is enough liquidity in the market, but in the wrong place. I assume the Fed will indeed keep raising rates until the yield curve exceeds the CPI rate across the spectrum.
Until the Fed throws the towel, equity prices will remain under pressure, although some crazy buying might occur, just as it did after the US CPI numbers. However, if equity prices continue to fall, so will tax receipts, and the US treasury would need to issue more bonds to cover expenditures.
If the government issues more bonds and the Fed does real QT (currently, they only have stopped reinvesting), the supply of bonds rises, and prices would need to fall/yields would have to rise. Therefore, I expect that the dollar will continue to appreciate because other banks would have to end their QT fantasies much sooner than the Fed because of a Minsky Moment, as we have seen with the Bank of England.
That moment exposes central banks' dramatic monetary policy failures after the GFC. Artificially lowering rates lowered R** so much that fighting inflation has become impossible without the resulting deleveraging putting the whole financial system at risk. I find it hard to believe that the Fed will push this through until the bitter end. However, as long as the US financial system remains more or less stable, there will not be a pivot.
The rate of interest is the most critical signal within an economy, and the way central banks manipulated it after 2008 led to enormous economic imbalances. I urge you not to mistakenly see the current situation as the problem, as Wall Street does. The problem was the crazy monetary policy in the first place, mainly implemented by the guy who received the Nobel Prize this week: Ben Bernanke.
Bernanke received the price because of his work on the Great Depression, arguing that a central bank needed to bail out the banks to prevent a reoccurring of the 1930s. However, most people forget that the Fed during those days was hardly restrictive, and it aggressively bought government securities and lowered the deposit rate.
It is somewhat comical that Bernanke receives the Nobel Prize nowadays when the world suffers from the problems he created when he was Fed chair, although he once said in a hearing that it would be easy to shrink the monetary base back to one trillion.
Bernanke never doubted the Fed's policies during his reign, and I doubt he will ever do. In this respect, the reserved Bernanke is surprisingly similar to John Law. The citation I would like to end this week’s Weekly Wintersberger is from Edward Chancellors’ The Price of Time.
The irrepressible Law nevert admitted to the flaws inherent in his System. The French ambassador Count de Gergy, who visited Law in Venice shortly before his death in 1729, reported that he had ‘never seen a man more stubborn than him about his cursed System, and in such a way that it is probable that from the start of its operations he really believed his projects to be infaillible. Central bankers, who resort to printing money, manipulating interst rates and fueling asset price bubbles, exude a similar air of infaillibility. They fail to heed [Richard] Cantillon’s warning that it’s all very well to embark on a grand monetary experiment, but there is no painless exit. ‘What central bankers are doing now is exactly what Law recommended,’ Law’s biographer Antoin Murphy wrote in the wake of the global financial crisis. ‘From this perspective, it may be argued that, notwithstanding the failure of the Mississippi System, Law’s banking successors have been Ben Bernanke, Janet Yellen and Mario Draghi
If there had been a Nobel Prize back in the 18th Century, John Law probably would have won it…
I wish you a splendid weekend!
Fabian Wintersberger
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Great write up. Really interesting history. One of the first (I think?) documented examples of financial engineering on a national scale. Certainly not the last, though the effects would appear to be consistent throughout...