Back in 2006, as the debate was raging whether or not the US had a mortgage credit and housing bubble, I had an ongoing, related exchange with the Chief US Economist of a large US investment bank. It had to do with what is now commonly referred to as the ‘shadow banking system’.
While the debate was somewhat arcane in its specifics, it boiled down to whether the additional financial market liquidity created through the use of securities repo and other forms of collateralised lending were destabilising the financial system.
The Chief US Economist had argued that, because US monetary aggregates were not growing at a historically elevated rate, the Fed was not adding liquidity fuel to the house price inflation fire and that monetary policy was, therefore, appropriate. (Indeed, he denied that the rapid house price inflation at the time was cause for serious concern in the first place.) I countered by arguing that these other forms of liquidity (eg. securities repo) should be included and that, if they were, then in fact the growth of broad liquidity was dangerously high and almost certainly was contributing to the credit+housing bubble.
We never resolved the debate. My parting shot was something along the lines of, “If the financial markets treat something as a money substitute—that is, if the incremental credit spread for the collateral providing the marginal liquidity approaches zero— then we should treat it as a form of de facto money.”
He dismissed this argument although I’m not sure he really understood it; at least not until there was a run on money-market funds in the wake of the Lehman Brothers bankruptcy in November 2008. It was at that point that economic officials at the Fed and elsewhere finally came to realise how the shadow banking system had grown so large that it was impossible to contain the incipient run on money-market funds and, by extension, the financial system generally without providing explicit government guarantees, which the authorities subsequently did.
This particular Chief US Economist had previously worked at the Fed. This was and remains true, in fact, of a majority of senior US bank economists. Indeed, in addition to a PhD from one of the premiere US economics departments, a tour of duty at the Fed, as it were, has traditionally been the most important qualification for this role.
Trained as most of them were, in the same economics departments and at the same institution, the Fed, it should perhaps be no surprise that neither the Fed, nor senior economists at the bulge-bracket banks, nor the US economic academic and policy mainstream generally predicted the global financial crisis. As the discussion above illuminates, this is because they failed to recognise the importance of the shadow banking system. But how could they? As neo-Keynesian economists, they didn’t—and still don’t—have a coherent theory of money and credit.
FROM BLISSFUL IGNORANCE TO PARANOIA
Time marches on and with lessons learned harshly comes a fresh resolve to somehow get ahead of whatever might cause the next financial crisis. For all the complacent talk about how the “recovery is on ￼track” and “there has been much economic deleveraging” and “the banks are again well-capitalised,” the truth behind the scenes is that central bankers and other economic officials the world over remain, in a word, terrified. Of what, you ask? Of the shadow banking system that, I believe, they still fail to properly understand.
Two examples are provided by a recent speech given by Fed Governor Jeremy Stein and a report produced by the Bank of International Settlements (BIS), the ‘central bank of central banks’ that plays an important role in determining and harmonising bank regulatory practices internationally.
The BIS report, “Asset encumberance, financial reform and the demand for collateral assets,” was prepared by a “Working Group established by the Committee on the Global Financial System,” which happens to be chaired by none other than NYFed President William Dudley, former Chief US Economist for Goldman Sachs. (No, he is not the Chief US Economist referred to earlier in this report, although as explained above these guys are all substitutes for one another in any case.) 
In the preface, Mr Dudley presents the report’s key findings, in particular “evidence of increased reliance by banks on collaterised funding markets,” and that we should expect “[t]emporary supply-demand imbalances,” which is central banker code for liquidity crises requiring action by central banks.
He also makes specific reference to ‘collateral transformation’: when banks swap collateral with each other. This practice, he notes, “will mitigate collateral scarcity.” But it will also “likely come at the cost of increased interconnectedness, procyclicality and financial system opacity as well as higher operational, funding and rollover risks.”
Why should this be so? Well, if interbank lending is increasingly collateralised by banks’ highest quality assets, then unsecured creditors, including depositors, are being de facto subordinated in the capital structure and are highly likely to ‘run’ at the first signs of trouble. And if banks are holding similar types of collateral that suddenly fall in value, then they can all become subject to a run at the same time, for the same reason.
Collateral transformation is thus a potentially powerful FWMD. But don’t worry, the BIS and other regulators are on the case and doing the worrying. As a belated response to the financial crisis that they all failed to foresee, the latest, greatest trend in financial system oversight is ‘liquidity regulation’. Fed Governor Jeremy Stein explains the need for it thus:
[A]s the financial crisis made painfully clear, the business of liquidity provision inevitably exposes financial intermediaries to various forms of run risk. That is, in response to adverse events, their fragile funding structures, together with the binding liquidity commitments they have made, can result in rapid outflows that, absent central bank intervention, lead banks to fire-sell illiquid assets or, in a more severe case, to fail altogether. And fire sales and bank failures–and the accompanying contractions in credit availability–can have spillover effects to other financial institutions and to the economy as a whole. Thus, while banks will naturally hold buffer stocks of liquid assets to handle unanticipated outflows, they may not hold enough because, although they bear all the costs of this buffer stocking, they do not capture all of the social benefits, in terms of enhanced financial stability and lower costs to taxpayers in the event of failure. It is this externality that creates a role for policy. 
Ah yes, wouldn’t you know it, that ubiquitous, iniquitous enigma: market failure. Regulators have never found a market that doesn’t fail in some way, hence the crucial need for regulators to prevent the next failure or, at a minimum, to sort out the subsequent mess. In the present instance, so the thinking behind liquidity regulation goes, prior to 2008 the regulators were overly focused on capital adequacy rather than liquidity and, therefore, missed the vastly expanded role played by securitised collateral in the international shadow banking system. In other words, the regulators now realise, as I was arguing back in the mid-2000s, that the vast growth in shadow banking liquidity placed the stability of the financial system at risk in the event that there was a drop in securitised collateral values.
In 2007, house prices began to decline, taking collateral values with them and sucking much of the additional, collateral-based liquidity right back out of the financial system, unleashing a de facto wave of monetary+credit deflation, resulting in the subsequent financial crisis. But none of this was caused by ‘market failure’, as Governor Stein contends. Rather, there is another, simpler explanation for why banks were insufficiently provisioned against the risk of declining collateral values, yet it is not one that the regulators much like to hear, namely, that their own policies were at fault.
In one of my first Amphora Reports back in 2010 I discussed in detail the modern history of financial crises, beginning with the 1980s and concluding with 2008. A pattern rapidly becomes apparent:
[Newton’s] third law of universal motion was that for each and every action there is an equal and opposite reaction. While applicable to the natural world, it does not hold with respect to the actions of financial markets and the subsequent reactions of central banks and other regulators. Indeed, the reactions of regulators are consistently disproportionate to the actions of financial markets. In sinister dialectical fashion, the powers assumed and mistakes made by policymakers tend to grow with each crisis, ￼thereby ensuring that future crises become progressively more severe…
[W]as the Fed’s policy reaction to the 1987 crash proportionate or even appropriate? Was it “an equal but opposite reaction” which merely temporarily stabilised financial markets or did it, in fact, implicitly expand the Fed’s regulatory role to managing equity prices? Indeed, one could argue that this was merely the first of a series of progressively larger “Greenspan Puts” which the Fed would provide to the financial markets during the 18 years that the so-called “Maestro” was in charge of monetary policy and, let’s not forget, bank regulation…
By the late 1980s, a huge portion of the S&L industry was insolvent. The recession of 1990-91, made a bad situation worse. FSLIC funds were rapidly depleted. But a federal guarantee is supposed to be just that, a guarantee, so Congress put together a bailout package for the industry. A new federal agency, the Resolution Trust Corporation (RTC), issued bonds fully backed by the US Treasury and used the proceeds to make insolvent S&L depositors whole…
In retrospect, the entire S&L debacle, from its origins in regulatory changes and government guarantees, through the risky lending boom, bust, credit crunch and fiscal and monetary bailout can be seen as a precursor to the far larger global credit bubble and bust of 2003-2008: Just replace the S&Ls with Fannie/Freddie and the international shadow banking system. But there is no need to change the massive moral hazard perpetrated by incompetent government regulators, including of course the Fed, and the reckless financial firms who played essentially the same role in both episodes.
Notwithstanding this prominent pattern of market-distorting interest-rate manipulation, guarantees, subsidies and occasional bailouts, fostering the growth of reckless lending and other forms of moral hazard, the regulators continue their self-serving search for the ‘silver bullet’ to defend against the next ‘market failure’ which, if diagnosed correctly as I do so above is, in fact, regulatory failure.
Were there no moral hazard of guarantees, explicit or implicit, in the system all these years, the shadow banking system could never have grown into the regulatory nightmare it has now become and liquidity regulation would be a non-issue. Poorly capitalised banks would have failed from time to time but, absent the massive systemic linkages that such guarantees have enabled—encouraged even—these failures would have been contained within a more dispersed and better capitalised system.
As it stands, however, the regulators’ modus operandi remains unchanged. They continue to deal with the unintended consequences of ‘misregulation’ with more misregulation, thereby ensuring that yet more unintended consequences lurk in the future.
MIGHT COLLATERAL TRANSFORMATION BE THE CRUX OF THE NEXT CRISIS?
In his speech, Governor Stein also briefly mentions collateral transformation, when poor quality collateral is asset-swapped for high quality collateral. Naturally this is not done 1:1 but rather the low quality collateral must be valued commersurately higher. In certain respects these transactions are similar to traditional asset swaps that trade fixed for floating coupons and allow financial and non-financial businesses alike to manage interest rate and credit risk with greater flexibility. But in the case of collateral transformation, what is being swapped is the principal and the credit rating it represents, and one purpose of these swaps is to meet financial regulatory requirements for capital and, in future, liquidity.
An obvious consequence of such collateral transformation is that it increases rather than decreases the linkages in the financial system and thus in effect replaces firm-specific, idiosyncratic risk with systemic risk, exactly the opposite of what the regulators claim they are trying to do by increasing bank regulatory capital ratios. Liquidity regulation is an attempt to address this accelerating trend and the growing systemic risks it implies.
Those financial institutions engaging in the practice probably don’t see things this way. From the perspective of any one instution swapping collateral in order to meet changing regulatory requirements, they see it as necessary and prudent risk management. But within a closed system, if most actors are behaving in the same way, then the net risk is not, in fact, reduced. The perception that it is, however, can be dangerous and can also contribute to banks unwittingly underprovisioning liquidity and undercapitalising against risk.
Viewed system-wide, therefore, collateral transformation really just represents a form of financial alchemy rather than financial engineering. It adds no value in aggregate. It might even detract from such value by rendering opaque risks that would otherwise be more immediately apparent. So I do understand the regulators’ concerns with the practice. I don’t, however, subscribe to their proposed self-serving remedies for what they perceive as just another form of market failure.
PLAGARISED COPIES OF AN OLD PLAYBOOK
Already plagued by the ‘Too Big to Fail’ (TBTF) problem back in 2008, the regulators have now succeeded in creating a new, even more dangerous situation I characterise as MAFID, or ‘Mutual Assured FInancial Destruction.’ Because all banks are swapping and therefore holding essentially the same collateral, there is now zero diversification or dispersion of financial system risk. It is as if there is one massive global bank with thousands of branches around the world, with one capital base, one liquidity ratio and one risk-management department. If any one branch of this bank fails, the resulting margin call will cascade via collateral transformation through the other branches and into the holding company at the centre, taking down the entire global financial system.
Am I exaggerating here? Well, if Governor Stein and his central banking colleagues in the US, at the BIS and around the world are to be believed, we shouldn’t really worry because, while capital regulation didn’t prevent 2008, liquidity regulation will prevent the scenario described above. All that needs to happen is for the regulators to set the liquidity requirements at the right level and, voila, financial crises will be a thing of the past: never mind that setting interest rates and setting capital requirements didn’t work out so well. Setting liquidity requirements is the silver bullet that will do the trick.
Sarcasm aside, it should be clear that all that is happening here is that the regulators are expanding their role yet again, thereby further shrinking the role that the markets can play in allocating savings, capital and liquidity from where they are relatively inefficiently utilised to where they are relatively more so. This concept of free market allocation of capital is a key characteristic of a theoretical economic system known as ‘capitalism’. But capitalism cannot function properly where capital flows are severely distorted by regulators. Resources will be chronically misallocated, resulting in a low or possibly even negative potential rate of economic growth.
The regulators don’t see it that way of course. Everywhere they look they see market failure. And because Governor Stein and his fellow regulators take this market failure as a given, rather than seeking to understand properly how past regulatory actions have severely distorted perceptions of risk and encouraged moral hazard, they are naturally drawn to regulatory ‘solutions’ that are really just plagiarised copies of an old playbook. What is that definition of insanity again, about doing the same thing over and over but expecting different results?
 Neo-Keynesians will deny this, claiming that their models take money and credit into account. But they do so only to a very limited extent, with financial crises relegated to mere aberrations in the data. The Austrian economic school of Menger, Mises, Hayek, etc, by contrast, has a comprehensive and consistent theory of money and credit that can explain and even predict financial crises.
 The entire paper can be found at the link here (PDF).
 This entire speech can be found at the link here.
 FINANCIAL CRISES AND NEWTON’S THIRD LAW, Amphora Report Vol. 1 (April 2010). The link is here.
This article was previously published in The Amphora Report, Vol 4, 10 June 2013.
Back in mid-March I made the latest of my somewhat rare specific, near-term market predictions, in this case that a US stock market correction or even a crash was imminent. Now some six weeks and a further 5% rally later, I revisit this view. Why, amid surprisingly weak economic data, corporate profit warnings and continued softness in global commodity prices, has the stock market risen to fresh highs? A key explanation is not one that the bulls are going to like: Central banks are increasingly monetising equities, implying further currency debasement. Investors should thus now begin to deploy idle cash; not in allocations to stocks, however, but to a broad basket of relatively depressed commodities, in particular metals and certain agricultural products.
THE (ONGOING) ROAD TO RECORD HIGHS
All investors make mistakes but not all investors learn from them. Those that do make better investors. I like to consider myself in this latter category.
Therefore, the time has come for me to evaluate my most recent prediction, from mid-March, that the US stock market was likely to suffer a serious correction or even a crash over the coming weeks. While there was indeed a slight stumble and loss of momentum in April, this has not prevented a net 5% rally in the S&P500 index to 1,630 this week.
For those not familiar with my prediction, here follow some brief excerpts from the relevant Amphora Report, ASSUME THE BRACE POSITION:
Year to date, both broad money and private sector credit growth are outright negative even through the monetary base is growing at nearly a 70% annualised rate. The Fed is, therefore, pushing harder than ever before, but still pushing on a string.
Corporate insiders… are cashing out at the fastest rate in years. Many companies are raising new capital through either initial or secondary offerings. Such activity is a sign of a market top…
[F]orward earnings growth estimates are in the double-digits, even though profit margins are already at record highs. If history is a guide, profit margins are highly unlikely to remain this wide for long.
[T]he current rally has been characterised by steadily declining volumes. In other words, a relatively small number of transactions have been responsible for pushing up prices. This is in sharp contrast to much research suggesting that a ‘wall of cash’ has been pushing the market higher.
As it happens, each of these cited conditions continues. Alongside a further weakening of broad money and credit growth, leading economic indicators have, on balance, been surprisingly soft. (Remember: jobs data lag, not lead.) By some measures the balance of negative economic data is the worst it has been for over two years.
Second, realised corporate profits and guidance have continued to miss expectations across most sectors. While this had a negative impact on the specific names affected, the rest of the market shrugged it off quickly and, more recently, even the firms that disappointed, including bellwethers such as Caterpillar and FedEx, have rallied to new highs for the year. Corporate insiders, meanwhile, continue to sell holdings and raise new capital.
Finally, turning to trading volumes, these have continued to decline. Daily market turnover in recent weeks has been only a fraction of the average through the entire rally which began in early 2009.
In my opinion, in this last observation lies to key to understanding why the market has continued to post gains when so many negative factors have suggested at a minimum a pause in the rally and possibly the correction or crash that I predicted.
Normally, a steady decline in volume is understood as an indicator that a given trend, bullish or bearish, may be tiring and due a reversal. But we do not live in normal times. We live in an age of unprecedented policymaker activism. Thin volumes, other factors equal, make it even easier for official agents—primarily central banks—to manipulate markets as a policy tool.
There is nothing conspiratorial about this. After all, central banks set short-term interest rates. They also increasingly set long-term interest rates, both via QE purchases and more subtle mechanisms, such as the ‘duration paradox’ phenomenon associated with a zero-rate policy. (For more on this somewhat esoteric topic please see my report linked here.) From time to time they intervene in the foreign exchange markets. Central banks are also active buyers of gold, or sellers for that matter. But did you know that, in recent months, central banks have also been unusually large buyers of… wait for it… equities!
As reported by Bloomberg News and elsewhere, central banks around the world, including the Bank of Japan, the Bank of Korea and the Swiss National Bank have been unusually large buyers of equities:
Among central banks that are buying shares, the SNB has allocated about 12 per cent of assets to passive funds tracking equity indexes. The Bank of Israel has spent about 3 per cent of its $77 billion reserves on U.S. stocks.
In Asia, the BOJ announced plans to put more of its $1.2 trillion of reserves into exchange-traded funds this month as it doubled its stimulus program to help reflate the economy. The Bank of Korea began buying Chinese shares last year, increasing its equity investments to about $18.6 billion, or 5.7 per cent of the total, up from 5.4 per cent in 2011. China’s foreign-exchange regulator said in January it has sought “innovative use” of its $3.4 trillion in assets, the world’s biggest reserves, without specifying a strategy for investing in shares.
MARKET MANIPULATION IS THE NEW NORMAL
These reports may surprise some, but when you line up what amounts to creeping equity monetisation against all the other market-manipulating activities of central banks, including rhetoric expressly supporting rising asset prices as a useful policy tool, then it is just par for the pathological course: central bankers will stop at nothing to reflate their respective economies in order to avoid any meaningful debt deleveraging and restructuring in their respective financial systems. Yes, some in Germany and a handful of other creditor countries may be putting up some resistance around the margins but the general thrust of policy is clear. And while printing money to purchase government bonds is monetisation—unless it is subsequently reversed—printing money to purchase equities is monetisation on steroids: it comes closer to an outright ‘helicopter drop’ of money in that it largely bypasses the financial system by directly supporting equity market valuations, providing corporations with a form of ‘currency’ that can be spent on actual, real expansion, acquisitions and job creation.
(For those sceptical that central bank equity purchases are highly relevant, consider the unusually strong relationship at present between central bank balance sheet expansion and the stock market: the correlation has reached 90%. Correlation is not causation but this is strong circumstantial evidence of an indirect link between central bank asset purchases and equity prices. If central banks are now switching to direct equity purchases then naturally the indirect link becomes direct and presumably more powerful.)
Still, as with money creation generally, there is no guarantee that the beneficiaries will choose to respond as the central banks desire. Indeed, corporations in most of the developed world are highly leveraged on average, face unusually high tax and regulatory regime uncertainty, and thus remain highly reluctant to invest. (As mentioned previously, some are even choosing to raise capital.)
So while there is zero guarantee that the corporate horses being led to water by outright central bank equity purchases and the elevated valuations they support will act as desired and increase investment, central banks are doing their part to repair what they see as a damaged monetary transmission mechanism by leapfrogging the impaired financial intermediaries.
But is the transmission mechanism in fact damaged at all, or does it largely just reflect a shift in the demand function for money? Keynesians and Monetarists argue the former; Austrian economists the latter. Regular readers of this report will know that I side with the Austrians in this matter and in all matters monetary. Indeed, I would go so far as to argue that the Austrian economic school is the only one that has a consistent or even coherent theory of money, notwithstanding the tangled web of abstruse equations proffered by the mainstream PhDs ensconced in the high ivory towers of academia and essentially non-accountable economic policy making.
In my opinion, the shifting demand function for money reflects the private sector’s efforts to rebuild savings following a series of bubbles, busts and the associated realised and as yet unrealised resource misallocations. Central banks wish at a minimum to halt or ideally outright reverse this reckoning process indefinitely. As I have written before, preventing the realisation of resource misallocations by introducing further resource misallocations merely accelerates the deterioration of the economy’s capital stock, leading to outright capital consumption and a permanently reduced standard of living. This is the road we are on.
In any case, as a direct result of unprecedented policymaker activism, the disconnect between lofty stock market valuations and the economic reality on the ground in the US, Europe, Japan and elsewhere grows and grows. Some still dare call this ‘capitalism’ but really, some who do are among those pulling the strings; you’d think they would know better. Perhaps they do and it simply remains their cover story to blame the supposedly ‘free’ market for the escalating failures of interventionism, thereby obfuscating their responsibility for the mess while excusing the next round of Hail-Mary interventionism.
For those who step outside the system and look back at it with unbiased eyes, the dysfunctionality is increasingly apparent. It also goes beyond ordinary politics. As I have written before, the addiction to fiscal deficits and monetary inflationism cross all major party lines in all major economies.
Around the margins, those who do understand the problems are beginning to get themselves organised. The US ‘Tea-Party’ revolt of 2010 was an inchoate example. The ‘Five Star’ movement in Italy has met with considerably greater success. In Germany, the ‘Alternative for Germany’ party has just got off the ground but with much potential. And in the UK, against all expectations, the alternative UKIP party’s support soared in the most recent local elections.
These are observations, not endorsements. None of the parties mentioned above could remotely be called a ‘sound money’ party. But they do demonstrate that the disgust with the inflationist status quo is growing rapidly. The terms of debate are shifting. This is a healthy if at times messy process and is likely to be regarded by future economic historians as an essential part of ending the current economic experiment with unsound, unbacked, manipulated fiat money. As I wrote way back in 2010, “Long may the activism continue.”
 To see just how dramatic these money and credit developments are please see the relevant charts from the St Louis Fed’s weekly US financial data publication here.
 For a discussion of this development please see this article from Zerohedge here.
David Stockman’s The Great Deformation is a tour de force of historical revisionism that demolishes the conventional economic and political wisdom prevailing both prior to and in the aftermath of the 2008 global financial crisis. Approaching his subject from many different angles, he demonstrates in thorough and specific detail, including much direct personal experience, that the roots of the crisis stretch back many decades. Few if any stones are left unturned; few if any major US political actors escape criticism; and all are subject to healthy scrutiny regardless of their orientation on the left-right spectrum. Indeed, Stockman makes clear that the facile left-right distinction of US politics obscures a deeper crisis of capitalism that spans the breadth of the American economic and political landscape. While he admits he has little hope that America can now change course, in closing he does offer a few specific policy recommendations that might, just might, lay the foundation for a Great American Reformation, were they to be implemented in future.
A most credible source
There is no more credible source for a book detailing the myriad policy failures collectively contributing to America’s decent into crony capitalism than David Stockman. Elected to Congress in the 1970s while still in his 20s, he was selected by President Reagan to be his first budget director at age 31 and was thus the youngest Cabinet-level US official to serve in the entire 20th century.
Bright-eyed and bushy-tailed in comparison to the seasoned older guard dominating the Reagan White House, Stockman became rapidly disillusioned by the striking contrast between Reagan’s lofty rhetoric on the one hand and the reality of White House policies on the other. He left politics in 1985 for the private sector and entered the world of private equity as a partner at the Blackstone Group.
As Stockman himself admits, however, he is not entirely above the criticism he levels repeatedly at others throughout the book. Three prominent examples include his admission of avoiding the Vietnam draft by enrolling in Harvard Divinity School; being repeatedly outmanoeuvred by highly experienced political operatives while serving in the Reagan White House; and bearing at least some responsibility for a handful of poor investment decisions while working at Blackstone.
This honest introspection only serves to make the book more credible. Stockman is an American taking a long look in the mirror and asking the tough questions that few in power will ask, associated as they all are, in some way, with the great tragedy he describes in thorough detail.
The first polemical punch
Stockman wastes no time in landing his first polemical punch: on the first page, he observes that the US ‘Fiscal Cliff’, around which there was such high political drama late last year, is both “permanent and insoluble,” and that the chronic US deficit and debt problem is “the result of capture of the state, especially its central bank, the Federal Reserve, by crony capitalist forces deeply inimical to free markets and democracy.”
What follows is page after page of shocking detail regarding the metastatising crony-capitalist cancer consuming the US economy’s once great potential. While primarily concerned with recent developments, a great strength of the book is that it seeks always to trace the roots of The Great Deformation back to their beginnings, for example, in early 20th century Progressivism; in President Roosevelt’s New Deal; or in the Republican Party’s fateful decision in the 1960s to sever its small-government roots.
Debunking the conventional wisdom
Throughout the book, Stockman relentlessly attacks the economic conventional wisdom. In one instance he reaches back into the Great Depression to demonstrate that numerous policy errors both in the United States and abroad contributed to the 1929 stock market crash and subsequent banking crises of the early 1930s. Moreover, he demonstrates convincingly that it was not the military Keynesianism of the 1940s that ended the Depression but rather a severe and prolonged household and corporate deleveraging facilitated by a combination of women entering the workforce en masse, a general shortage or outright absence of many consumption goods and the associated, unusually high national savings rate.
This goes directly against the mainstream interpretation that increased rates of savings only serve to make financial crises even worse. But Stockman does not stop there. He shows how the rapid public sector deficit reduction in the immediate postwar period and the general fiscal prudence of the Truman and Eisenhower years enabled the rapid, healthy, sustainable growth of the 1950s and 1960s to proceed absent any material increase in the public debt and absent inflationary pressures on prices.
This began to change during the Kennedy administration but it was under Johnson and Nixon that traditional American fiscal convervatism was shown the door for good. From this point forward, the tone of the book changes dramatically as Stockman initiates a devastating assault on the conventional wisdom: The entire left-right narrative of US politics is demonstrated to be a great charade. Even the early Reagan years in which Stockman was a direct policy participant are shown to be an exercise in the relentless growth of government, associated deficits and debt. As he explains it, “Rather than a permanent era of robust free market growth, the Reagan Revolution ushered in two spells of massive statist policy stimulation.” Indeed, Stockman characterises the Reagan and Bush years as a ‘Keynesian Boom’.
As Stockman explains, for all the talk to this day of Reagan’s fiscal conservatism, the only meaningful conservative policy victory of the time was achieved by the Fed, not the government. Paul Volcker did what was required to stabilise the dollar and bring down inflation following the disastrous stagflationary 1970s, the inevitable consequence of Johnson’s and Nixon’s fiscal largesse, the hugely expensive Vietnam war, soaring government deficits, de-pegging the dollar’s link to gold and the Fed’s accommodation of, among other associated phenomena, higher crude oil prices via OPEC.
As is the consistently the case throughout the book, however, Stockman highlights the links between failed economic policies and their unfortunate social consequences: The relentless growth of moral hazard and crony capitalism. Once Volker had left the stage, replaced by Alan ‘Bubbles’ Greenspan (sic), he explains how the Fed began de facto to target asset prices, in particular the stock and housing markets, and that “Under the Fed’s new prosperity management regime … the buildup of wealth did not require sacrifice or deferred consumption. Instead, it would be obtained from a perpetual windfall of capital gains arising from the financial casinos.” Wow.
That’s right, for decades the stock market has been a financial casino, rigged as desired by the Fed to (mis)manage the economy, and now all that is left is a “bull market culture” that has “totally deformed the free market.”
Stockman also points out how the decades leading up to 2008 were replete with ‘foreshocks’ of the eventual financial earthquake. For example, there was the S&L crisis of the late-1980s and early 1990s. There was the Long-Term-Capital debacle. And each and every time that the Fed’s economic management led, either directly or not, to near-calamity, the bailout beneficiaries were enriched anew.
With most of Stockman’s criticism is directed at Washington, Wall Street and the Fed, he nevertheless reserves some for the non-financial corporate sector. As he explains:
Alongside the Fed’s cheap credit regime, there arose a noxious distortion of the tax code best summarized as ‘leveraged inside buildup’. The linchpin was successive legislative reductions of the tax rate on capital gains that resulted in a wide gap between high rates on ordinary income and negligible taxes on capital gains. This huge tax wedge became a powerful incentive to rearrange capital structures so that ordinary income could be converted into capital gains.
In Stockman’s view there is thus plenty of blame to go around. On a few occasions he even criticises the defence establishment, holding up Eisenhower as the last example of Pentagon budgetary discipline. While he hardly comes across as a dove in foreign policy, he is certainly not as hawkish as recent administrations and he points out a handful of examples of failed defence policies and budgetary largesse past and present.
Beyond left and right
Readers who attempt to understand this book according to any variation of the current economic policy mainstream or through the obsolete left-right narrative of US politics will struggle to understand Stockman’s independent perspective. The Great Deformation is written by an old-school, small-government ‘Eisenhower Republican’ and champion of the free-market who perceives more clearly than most just how far the insidious crony-capitalist rot has spread, whether it be facilitated by purportedly left-leaning ‘regulation’ or encouraged by right-leaning tax-reform. As Stockman repeatedly demonstrates, the concept of ‘capture’ applies equally to both.
Perhaps unsurprisingly given the horrifying state of affairs he so cogently describes, Stockman is not sanguine about America’s future. The US is travelling down Hayek’s fabled ‘Road to Serfdom’ as the government and central bank respond to the damaging effects of failed interventionism with escalating interventionism. Indeed, since at least 2008, the evidence is overwhelming that America has been accelerating down that tragic road.
In closing, Stockman offers some ideas that might help the US to reverse course, although he strongly doubts that they will be adopted. If anything, the political winds from both left and right continue to blow in the other direction. No doubt his polemic will be rebuffed by those in power on both sides of the aisle in Congress and his recommendations for reform will go unheeded. That Stockman knows this, but wrote this book regardless, demonstrates his love for America. Anyone sharing that love should read it.
The Cyprus banking kerfuffle has ignited a blogosphere storm debating the likelihood that depositors elsewhere, perhaps even ‘guaranteed’ ones, may find themselves on the hook for recapitalising their domestic banks. Largely lost in this discussion however is the unpleasant reality that a substantial portion of the international financial sector has been undercapitalised or even insolvent since at least 2008, if not before. Policy responses to the financial crisis have not changed this fact. Indeed, as resource misallocations are the ultimate cause of bankruptcy or insolvency, the exponential increase in price-fixing distortions in the wake of the global financial crisis ensures that depositors in aggregate are now facing far greater losses than they were back in 2008. Someone has to pay for past resource misallocations even when central banks succeed in sweeping these under the rug of monetary inflation. Will it be you?
THE BANKS ARE (STILL) INSOLVENT
You don’t need to live in Cyprus to be aware that banks in numerous countries are woefully undercapitalised, in some cases to the point of insolvency. Sure, regulatory financial accounting conventions allow for a huge amount of smoke-and-mirrors obfuscation, delaying the day of reckoning, but an insolvent bank is insolvent regardless of the regulators’ choices of accounting conventions to apply from one day to the next.
Although the specific distinctions vary from country to country, large banks have multiple sources of capital in their liability structure with varying degrees of seniority. As losses are incurred they are absorbed by this structure, tranche by tranche. First goes the shareholder equity, then the subordinated debt (which includes a great number of interbank derivative positions, about which more later), then the senior debt, then uninsured deposits.
Back in 2008, however, government and central bank officials chose not to follow existing law and apportion losses to banks’ liability structures through appropriate insolvency proceedings. Rather, they chose to go straight to the taxpayers to bail out their respective financial systems, in some cases by outright nationalising institutions. This was done because the institutions in question were deemed ‘too big to fail’ (TBTF) and their insolvency would have threatened to derail the entire financial system.
THE BANKER BAILOUT BACKLASH
This policy (mis)judgement, that socialising bank losses served the interests of society, has been the subject of much dispute, including in previous Amphora Reports and, more recently, in David Stockman’s outstanding new book, The Great Deformation (available on Amazon here). Indeed, as one banker scandal after another has come to light since 2008 there has now been a huge banker bailout backlash. Politicians understand that, in the event another crisis hits and the TBTF banks are at risk of failure yet again, taxpayers may refuse to support another systemic rescue. What to do?
Well, behind the scenes, economic officials the world over have been busy putting together working frameworks for how to deal with future bank failures. One recent, prominent example is a joint paper by the US Federal Deposit Insurance Corporation and the Bank of England, in cooperation with the US Federal Reserve and the Financial Stability Board of the Bank for International Settlements, the international bank supervisory body based in Basle, Switzerland . Given its international character and the prominence of the institutions involved, this paper should be understood as a working template for how large international bank failures will be addressed in future. The paper begins with an explanation of the problem (emphasis added):
The financial crisis that began in late 2007 highlighted the shortcomings of the arrangements for handling the failure of large financial institutions that were in place on either side of the Atlantic. Large banking organizations in both the U.S. and the U.K. had become highly leveraged and complex, with numerous and dispersed financial operations, extensive off-balance-sheet activities, and opaque financial statements. These institutions were managed as single entities, despite their subsidiaries being structured as separate and distinct legal entities. They were highly interconnected through their capital markets activities, interbank lending, payments, and off-balance-sheet arrangements.
The paper then proposes what appears, at first glance, to be an entirely reasonable way to deal with a possible future failure of such an institution:
[R]esolution strategies should maintain systemically important operations and contain threats to financial stability. They should also assign losses to shareholders and unsecured creditors in the group, thereby avoiding the need for a bailout by taxpayers. These strategies should be sufficiently robust to manage the challenges of cross-border implementation and to the operational challenges of execution.
Fair enough. How reasonable to actually have a framework in place that allows banks to fail without placing taxpayers on the hook. But as with many apparently reasonable policy initiatives, the devil lurks in the details, specifically in paragraph 13 (an appropriate number perhaps?):
An efficient path for returning the sound operations of the [bank] to the private sector would be provided by exchanging or converting a sufficient amount of the unsecured debt from the original creditors of the failed company into equity. In the U.S., the new equity would become capital in one or more newly formed operating entities. In the U.K., the same approach could be used, or the equity could be used to recapitalize the failing financial company itself—thus, the highest layer of surviving bailed-in creditors would become the owners of the resolved firm. In either country, the new equity holders would take on the corresponding risk of being shareholders in a financial institution. Throughout, subsidiaries (domestic and foreign) carrying out critical activities would be kept open and operating, thereby limiting contagion effects. Such a resolution strategy would ensure market discipline and maintain financial stability without cost to taxpayers.
What this amounts to is a debt-for-equity swap arrangement for the “highest layer of surviving bailed-in creditors.” While in some cases the ‘highest layer’ might be that of the bondholders, in others it would include depositors, as is the case in Cyprus for example. Yet this is to be done while “subsidiaries carrying out critical activities would be kept open and operating, thereby limiting contagion effects.” So what, exactly, are these ‘critical activities’? And what is meant by ‘contagion effects’?
What the authors are referring to here is the interbank market, not only for wholesale lending in the money markets but also for all manner of financial derivatives and the underlying collateral on which they are, in some way, secured. This is what caught regulators by surprise in 2008: following the collapse of Lehman Brothers a fire-sale slump in collateral values led to a cascade of interbank margin calls and the market seized up, threatening relatively well-capitalised firms that had appeared previously not to be at risk. The paper thus implies that the way to prevent contagion in future is to prevent a sudden contraction in the interbank lending+derivatives market.
Think about this for a moment: The interbank market, a leveraged, inverted pyramid of subordinated debt built on top of a comparatively limited amount of senior debt collateral, is to be held intact by regulatory fiat while depositors are ‘bailed-in’ via a debt-for-equity swap. Do you see the sleight-of-hand at work here? Under the guise of protecting taxpayers, depositors of failing institutions are to be arbitrarily, de-facto subordinated to interbank claims, when in fact they are legally senior to those claims!
In other words, regulators are laying the operational groundwork for a new type of banker bailout deemed politically acceptable. The last time around, they went straight to the taxpayers. The next time around, they are going straight to the depositors.
Now it so happens that depositors are never explicity mentioned in the paper. They are always referred to as ‘unsecured creditors’. But the effective meaning of this term is belied by the fact that the proposal assigns the FDIC the job of resolving US-based institutions via the debt-for-equity swap mechanism mentioned earlier. Were the bondholders rather than depositors in primary focus this would not be the case as the FDIC has no direct responsibility for the wholesale, non-depositor sources of credit to US financial institutions.
Finally, consider the brutal, unjust irony of the entire proposal. Remember, its stated purpose is to solve the problem revealed in 2008, namely the existence of insolvent TBTF institutions that were “highly leveraged and complex, with numerous and dispersed financial operations, extensive off-balance-sheet activities, and opaque financial statements.” Yet what is being proposed is a framework sacrificing depositors in order to maintain precisely this complex, opaque, leverage-laden financial edifice!
If you believe that what has happened recently in Cyprus is unlikely to happen elsewhere, think again. Economic policy officials in the US, UK and other countries are preparing for it. Remember, someone has to pay. Will it be you? If you are a depositor, the answer is yes.
WHAT ABOUT GUARANTEED DEPOSITS?
What if your deposits are ‘guaranteed’? Does this mean that you will be excluded from abribtrary subordination? Perhaps. Perhaps not. Once officials start changing the rules they have a naughty tendency to keep right on going. That said, perhaps ‘guaranteed’ deposits are indeed sacrosanct in certain countries, if not in Cyprus. (To clarify, ‘guaranteed’ depositors in Cyprus are not participating in the debt-for-equity swap arrangement being implemented there, but they are subject to strict and indefinite capital controls. At best this is a huge inconvenience; at worst, a holding pattern prior to a subsequent future bail-in in the event that the unguaranteed deposits are insufficient to recapitalise the banks. A distinct possibility in my opinion.)
But step back for a moment. What, exactly, is a deposit guarantee? Who provides it? Why, the taxpayer of course. So to the extent that guaranteed depositors do not directly recapitalise failing banks, they do so indirectly as taxpayers. Remember, someone has to pay.
Recall, however, that the entire shift in focus from taxpayer-funded bail-outs to depositor bail-ins originates in the political backlash against the banks. Taxpayers don’t like being on the hook for corrupt bankers’ past mistakes. That said, they don’t much like being on the hook for anything. Take a look around at those large and growing public sector deficits and debts. Guess how they came about. They exist because countries have been resorting to inflation to finance their bloated welfare states as well as banker bailouts.
Economic officials may not care to call this debt-financing inflation, but inflation it is. Those debts are being financed, directly and indirectly, by rapidly expanding central bank balance sheets and associated broad money and credit creation. At some point in future, this monetary inflation will show up in consumer prices. It is just a question of time .
So in the end, depositors, guaranteed or not, taxpayers, and anyone not benefiting from inflation is paying for the resource misallocations that caused the insolvency of much of the global financial system. Unless you work for a leveraged financial institution or a government that spends money it doesn’t have, that ‘someone’ who pays probably includes you.
DEPOSIT ‘INSURANCE’ IS JUST PART OF THE NEGATIVE-SUM GAME
Common sense informs us that real risks can only be insured with real savings. This is one explanation for why countries with low savings rates tend to inflate their way out of economic recessions, rather than to restructure and resume healthy growth through Schumpeterian creative destruction. History suggests that the inflationary process becomes a vicious cycle as inflation further disincentivises savings, resulting in an even lower savings rate, followed by even more counter-cyclical inflation down the road.
As it erodes wealth, however, inflation is not a form of insurance. It is merely a means of reducing the real burden of unserviceable debts by transferring economic resources from savers to borrowers. A nasty side effect of inflation is that it causes resource misallocations and subsequent crises. Neo-Keynesian economic models refuse to acknowledge this but economists of many stripes including Richard Cantillon, Hume, Marx, Lenin, von Mises, von Hayek, Alan Greenspan and even Keynes himself were aware of it. With the notable exceptions of Marx and Lenin they also warned of these hidden dangers. (Marx and Lenin actually encouraged inflation as a means to confiscate wealth from the capitalists and concentrate it in a central bank owned and run by the state. The establishment of a central bank was plank 5 of Marx’s Communist Manifesto.)
To expand on a previous point, to the extent that it is applied to an entire financial system, deposit ‘insurance’ is therefore a misnomer. The only way depositors system-wide can possibly be made whole is by the state issuing a sufficient amount of debt in order to raise the necessary funds from the central bank. But as this is inflation, the very depositors being bailed out are the depositors whose wealth is being confiscated through inflation! System-wide deposit insurance is robbing Peter to pay Peter, so to speak. But if Peter doesn’t notice, will he object?
Sadly, whether we notice or not, the result of this game of robbing ourselves is not zero-sum but rather negative-sum: a ‘dead-weight-loss’ in the economic jargon. This is because the financial system is a huge consumer of misallocated resources that could otherwise be directed toward fulfilling the actual needs and wants of consumers. That’s right: alongside bloated governments, the greatest resource misallocation in the world today is that of the financial system itself, which has grown like a cancer ever since central banks wrestled control of the money supply away from the ‘golden anchor’ that, prior to 1971, largely kept it in check.
In numerous countries there is now much evidence that depositors are re-evaluating their trust in their respective financial systems and voting with their wire transfers. This is entirely understandable. Indeed, although it may go against the conventional wisdom, I would argue that the threat of a bank run is a healthy thing. How else to keep bankers in check, when the present system gives them every incentive to leverage up as much as possible, thereby concentrating profits in their hands yet socialising losses on the depositors and taxpayers via bail-outs, bail-ins and inflation?
How refreshing it would be to see banks competing on claims of depositor security for a change, as opposed to which bank has the friendliest image, the most fashionable logo, is the ‘greenest’, or occupies the tallest building in London or New York? Indeed, such faux competition highlights that banking is an industry sorely lacking in real competition.
Notwithstanding all the evidence to the contrary, some still call the bankers ‘capitalists’. While they’re at it, they might as well call the Communist Manifesto a capitalist work.
 The Amphora Report has tackled this issue on multiple occasions. Probably the most extensive discussion was in A TALE OF TWO CRISES, Amphora Report vol. 2 (December 2011). The link is here.
 The entire proposal is worth reader can be found at the link here.
 For a more thorough discussion of this deflation-into-inflation tangent please see FROM DEFLATION PUSH TO INFLATION SHOVE, Amphora Report vol. 3 (June 2012). The link is here.
On rare occasions I make specific, near-term market predictions, most recently in Q3 last year, when I called for a modest equity market correction. As it happened, only a tiny correction occurred, followed by a large subsequent rally taking the S&P500 index to 1,550 this week. Now I am making a similar if bolder prediction: A larger correction, possibly a crash (20%+), appears imminent. There are various fundamental and market technical reasons for this view but these all follow from the same ultimate cause: policymaker activism. The Fed and other major central banks ‘own’ this rally. If a crash occurs, and takes the global economy down with it, let’s place blame where it belongs.
The road to record highs
The old adage, “Don’t fight the Fed,” is one that many investors learn first-hand by taking losses. The printing press can be a powerful thing. But like most if not all powerful things, it has its limits. Think of a chess player able to choose which piece goes where. That might seem quite a power until faced with checkmate, when no further moves are possible.
Having stimulated a large increase in money and credit growth through QE in the second half of last year, the Fed now faces checkmate. Why is this so? Because the surge has now reversed as velocity has plummeted. Year to date, both broad money and private sector credit growth are zero even through the monetary base is growing at nearly a 70% annualised rate . The Fed is, therefore, pushing as hard as ever, but still pushing on a string. Moreover, following on by far the largest amount of artificial fiscal and monetary stimulus ever thrown at the US economy, including during the Great Depression, the string is far longer than that which existed back in 2008.
THE MONETARY BASE HAS SURGED OF LATE…
…BUT BROAD MONEY AND CREDIT GROWTH HAVE SUDDENLY SLOWED TO ZERO
Although they will not admit this, the Fed is now essentially out of options. Recent talk about negative interest rates is just that: talk. As the NY Fed research staff have already noted, they could not work in practice . Some will argue that there remains an arrow in the quiver, namely the power to outright monetise debt, public and private, and pro-actively debase the dollar. But this would end the dollar’s reserve currency status, something that would greatly reduce the Fed’s power in any case, and it would most probably lead quickly back to some form of global gold standard . (While I and many other sound money advocates would endorse such a policy, I am well aware that the current Fed leadership abhors the thought of wearing a monetary straightjacket.)
It would not be accurate to claim, however, that the previous surge in money and credit growth did not impact the economy. Most probably it prevented the H2 2012 global growth slowdown from being larger than it was. More obvious is that strong growth in money and credit balances changed investors’ risk preferences, such that they decided to hold proportionately more equities than bonds. This has pushed up valuations for the former. Rotation out of bonds has had relatively little impact on prices, however, as the Fed has been buying large amounts of Treasuries and, importantly, primarily in longer maturities, where their buying activities have a much greater price impact as this compresses term premia. (Short-maturity bond prices are primarily a function of short-term interest rates, which are set by the Fed and which have been essentially zero since 2008.)
Celebration on Liberty Street?
So notwithstanding the slowing economy, the Fed has engineered a large stock market rally. No doubt Fed officials are celebrating. Some investors might also be pleased, but it primarily benefits those who want to cash out at high valuations. Corporate insiders, for example, are selling at the fastest rate in years. Many companies are raising capital through either initial or secondary offerings. Such activity is a sign of a market top, however, and should concern the far larger ‘buy-and-hold’ crowd seeking to increase their wealth through a sustained rally.
There are several other reasons to be seriously concerned. First, consider valuations. Naturally a crash is more likely from elevated valuations than from depressed ones. Where are we now? Well, at 1,550, the S&P500 index is valued at around 14x forward earnings. That is not far above the post-1980 average, so may not appear lofty to some, but consider: This historical period includes many years of bubble-like valuations, including 1987, 1997-2000 and 2005-07. Depressed years, such as 1981-82 are less well represented in this sample.
Second, relying on forward earnings may be problematic as they are notoriously overstated relative to realised reality. In the present instance, forward earnings growth estimates are in the double-digits, even though profit margins are already at record highs. If history is a guide, profit margins are highly unlikely to remain this wide for long .
ELEVATED PROFIT MARGINS UNSUSTAINABLE
Third, the current rally has been characterised by steadily declining volumes. In other words, a relatively small number of transactions have been responsible for pushing up prices. This is in sharp contrast to some research suggesting that a ‘wall of cash’ has been pushing the market higher. (In any case, cash cannot directly push prices higher as for every cash buyer there is also a seller.)
Finally, let’s return to our starting point: Money and credit growth were strong in H2 2012 but this got little traction in actual economic activity. So what has this money and credit been used for? There is much evidence that it has been used as leverage to purchase shares. For example, margin interest on the NYSE is unusually high, at a level associated with previous market crashes.
What credit giveth, it can take away
Applying a little logic, if it is true that, courtesy of activist central bankers, the money and credit growth surge last year is behind the ongoing if increasingly low-volume rally in equities, then a sharp slowing or contraction of money and credit growth should trigger a sharp reversal. If accompanied by corporate profit warnings or other negative headlines, it could precipitate a crash.
As discussed, profit warnings are highly likely to continue in the current environment. Given that there has been nearly zero US household disposable income growth over the past year—in part due to the recent increase in payroll+Obamacare taxes—it is difficult to see how forward earnings expectations of 10%+ can possibly be met. Yes, the foreign sector might be doing better but recent dollar strength will depress those profits when accounted for in dollar terms. Slowing or contracting money and credit plus profit warnings could crash the market. Soon.
The bulls counter these arguments in various ways. Perhaps the most common bullish argument at present is that interest rates are low and will stay low as long as US unemployment remains elevated. After all, this is explicit Fed policy and I began this edition with “Don’t fight the Fed”. But if I’m right and the Fed and other central banks now face checkmate, it makes no difference. The Fed may try to stop a crash but short of trashing the dollar I doubt it can succeed. Of course, if the Fed does intervene and the dollar falls sharply, equity investors will still lose wealth in real if not nominal terms. Checkmate is checkmate.
At this point, the risk/reward for owning equities is tilted in favour of cash. Better still, if you believe that the Fed would at least try to arrest or reverse a crash with additional stimulus measures, would be to acquire safe haven real assets and liquid commodities that cannot be arbitrarily devalued by desperate central banks, including of course gold.
Speaking of gold, it has performed poorly of late. In my view the decline in the gold price is the mirror image of the decline in the equity risk premium. Once risk preferences shifted in favour of equities, yet money and credit growth slowed abruptly, it was absolutely necessary that certain other prices would decline. Not only gold, but copper, crude oil and most agricultural products have also fallen in price. By contrast, the Fed has directly prevented a material decline in bond prices through increased intervention.
Central banks probably have continued buying gold however, just as they were buying at a record pace last year. But as with all things, just because one sector of the market is buying doesn’t mean that prices can’t decline. For example, there are numerous recent reports of commodity hedge fund redemptions, implying forced liquidations of commodity positions. While some commodity hedge funds purport to be ‘market-neutral’, in my experience advising and working with such funds, I can assure you that most retain a long bias. Fund liquidations therefore imply net selling, not net buying.
I don’t disparage holding a commodity long bias, however. Regular readers of the Amphora Report know why: A long position in commodities is in effect a short position in currencies at risk of devaluation: Not just the dollar, but the euro, yen, sterling … you name it. Excessive debts and currency devaluation go hand in hand historically and I see no reason why this time should be different, other than devaluations will be more global than at any time since the 1930s. Indeed, there are reasons to believe they may be larger. Poor demographics and large public sectors in the developed economies imply unusually low productivity growth. This does not bode well for these economies’ abilities to service their vast accumulated debts without resort to large devaluations .
In closing, whether or not I am proven right by events, I would encourage my readers to ponder what, exactly, a rising stock market implies when it decouples from the real economy. In my view it is yet more evidence that resource misallocations are widespread; that investment decisions are being heavily distorted via manipulated interest rates and bond markets; that fundamental, value-driven investment is being ‘crowded out’ by raw, undisciplined speculation . This is not the way to grow a healthy economy, although it can, and clearly has, provided short-term stimulus from time to time.
Investors think longer-term than speculators. They also think longer-term than politicians. What is happening now is that the short-termism for which politicians are frequently and rightly criticised has come to dominate the financial markets, the economy and, quite possibly, society generally. History is not kind to societies that operate in an arbitrary, risk-it-all and get-rich-quick way. Long-term investment, savings, thrift and the rule of law tend to result in better outcomes. Central banks are doing far, far greater damage than they realise.
 To see just how dramatic these money and credit developments are please see the relevant charts from the St Louis Fed’s weekly US financial data publication here.
 For a thorough discussion of the NY Fed paper on negative interest rates please see PAR FOR THE PATHOLOGICAL COURSE, Amphora Report vol. 3 (September 2012). The link is here.
 This is, in fact, the central thesis of my 2012 book, THE GOLDEN REVOLUTION, available on Amazon here.
 For an excellent discussion of the dangers of relying on forward earnings estimates please see this article by John Hussman here.
 The US devalued the dollar vs gold by some 60% in 1934.
 This topic was explored at length in a previous Amphora Report, THE ASSET PRICING IMPLICATIONS OF THE GREAT BAILOUT, linked here.
This article was previously published in The Amphora Report, Vol 4, 13 March 2013.
The evidence of a major breakdown in global economic and monetary cooperation continues to mount. Just yesterday, the G7 released a statement regarding foreign exchange policies, only to be followed by a corrective statement that the market reaction was undesirable. This indicates escalating tensions within the G7. But if the G7 cannot cooperate, how on earth will the G20 do so? Or other countries? We are witnessing in real time a descent into economic nationalism that increasingly resembles the 1920s and 1930s. Then, as now, such nationalism resulted in major economic damage, with every single currency devaluing sharply versus gold, and with every single stock market underperforming gold. History is rhyming, loud and clear.
WHAT WE HAVE HERE IS A FAILURE TO COMMUNICATE
On several occasions I have predicted a breakdown in international economic and monetary cooperation, most extensively in my book, The Golden Revolution (link here), but also in the pages of this report and in several TV interviews, including an appearance on the Keiser Report just last week (watch here). But I must admit even I was taken by surprise by the astonishing behaviour of G7 officials yesterday.
To much anticipation, the G7 countries (US, Canada, UK, Germany, France, Italy and Japan) released an official communique early in the morning European time regarding their foreign exchange policies. Among other things the statement said that the G7 “will not target exchange rates.”
So far, so clear. The entire statement was also entirely consistent with the previous G7 communique from September 2011, which read in part that “We reaffirmed…our support for market-determined exchange rates.”
Given this degree of consistency between the two statements and lack of any specific mention of the yen, the foreign exchange markets determined that the G7 was giving tacit approval for Japan to continue to weaken the yen, which has declined by 10-15% versus all major global currencies in the past few months. The yen declined by another 1% versus the dollar and euro in the hours following the release of the statement.
Apparently, however, this was not the reaction all G7 members in fact desired. As the yen continued its decline, an unidentified G7 official came out with a highly unusual (and possibly unprecedented) qualifying statement, saying that:
The G7 statement signaled concern about excess moves in the yen. The G7 is concerned about unilateral guidance on the yen. Japan will be in the spotlight at the G20 in Moscow this weekend.
Whoa! Well G7 members are either concerned specifically about the yen or they are not. So it would seem that certain members of the G7 desired to include a specific comment on the yen but that certain other members vetoed this. Now who might that have been? Japan itself comes to mind and, given that Japan has been the biggest single purchaser of US Treasury securities over the past year, it seems reasonable to assume that the US supported Japan with the veto. The UK and Canada have now both said they made no such comment.
Taking the other side would logically have been the euro-area countries. While Germany is widely known to compete with Japan in a broad range of global export markets, there is also a degree of such competition with France and Italy. Indeed, on a per-capita basis, northern Italy is as large a world exporter as Germany, producing a huge range of manufactured goods, including precision machinery vital to many global industries. There are also such pockets in France, including around Paris, Lyon, Lille and Strasbourg. (I am excluding agricultural products here, although both Italy and France are wine and cheese export powerhouses.)
Yesterday’s unusual G7 drama thus appears to confirm what I claimed in my last report, COUNTDOWN TO THE COLLAPSE (link here), that Japan broke a temporary ‘cease-fire’ in the ‘currency wars’ with the sharp weakening of the yen in Q4 last year. In that report I also indicated that the UK was likely the next country to join hostilities.
Sure enough, in a press conference earlier today, Bank of England Governor Mervyn King said that “it’s very important to allow exchange rates to move,” and that “when countries take measures to use monetary stimulus to support growth in their economy, then there will be exchange rate consequences, and they should be allowed to flow through.” These bold comments could be interpreted as embracing rather than eschewing the escalating currency wars. They also indicate that the UK desires a weaker sterling.
If even the relatively closely-knit G7 can’t cooperate in foreign exchange matters, why should we be confident that the G20 can? Well, we shouldn’t be. Quite the opposite.
THE G20 COUNTRIES INCLUDE THE BRICS
The G20 is arguably the most important forum when it comes to maintaining international economic cooperation, or potentially revealing the lack thereof. I also mentioned in my last report that a key event to watch will be the upcoming BRIC summit held on March 26-27 in Durban, South Africa. Now as with all such international diplomatic gatherings, discussions and negotiations around key topics and issues begin many weeks or even months in advance. By the time the G20 meet in Moscow this weekend, you can be confident that the official BRIC position on foreign exchange matters is already under discussion.
It is therefore possible that, in one or more statements by BRIC member countries at the G20, we receive a hint or two as to the evolving BRIC position. But what is it likely to be? How do the BRICs feel about the weaker yen, for example? About the fact that the South Korean won and Taiwan dollar have recently weakened and, just this week, have been joined by the Malaysian ringitt? China, for one, finds itself suddenly surrounded by sharply weaker currencies. China is also embroiled in some escalating territorial disputes with Japan and other neighbours regarding sovereignty over the South China Sea. (Note the name!) In this context, should we be surprised that China appears to have ceased allowing the yuan to rise versus the dollar of late?
If China ceases to allow the yuan to rise, what are the chances that the other BRICs fall in line with China in the ‘currency wars’ and do the same? And if so, how is the US likely to respond? With the labour market still very weak and yet president Obama is now pushing for a rise in the minimum wage to $9/hr, is the US going to tolerate a strong dollar? The combination of higher payroll and ‘Obamacare’ taxes, a higher minimum wage and a stronger dollar would go a long way toward reversing the modest decline in the unemployment rate over the past year.
The euro-area may have even more immediate issues with the strong euro. With Greece, Spain and Portugal still mired in a deep recession, Italy teetering on the edge and France and Germany now entering at a minimum a mild recession and possibly something worse, further euro strength will be considered unwelcome.
(The German Bundesbank is an important exception here. President Weidmann said earlier this week that, “If more and more countries try to depress their currency, it will end in a depreciation competition, which will only produce losers.” He also specifically criticised politicians for weighing in on currency policy, saying that “politicians should hold on to the established division of labour.”)
Now the issue of whether euro-area politicians or the ECB should be in charge of currency policy has long been in dispute. Even before the euro came into existence it was hotly contested. As it happens, the ECB has intervened in the foreign exchange markets before, back in 2000, but to strengthen the euro. The ECB has never intervened to weaken it.
This unwillingness to intervene to weaken the euro is understandable given that, since the introduction of the euro in 1999, the rate of euro-area CPI has only once strayed materially below the ECB’s 2% reference level for any period of time. It would seem at odds with the ECBs mandate to maintain price stability were the ECB to intervene to weaken the euro unless the rate of CPI fell well below 2% and policy rates were already very low, implying a limited ability to prevent a further decline. As the chart of euro-area CPI below shows, there has been only one such period and, it so happens, this was primarily a base effect resulting from a previous spike. At present, the rate is 2.2%.
THE LOOMING DANGERS AHEAD
So where does this leave us? We have ample evidence that what is happening is not just a failure to communicate but a failure to cooperate. What are the implications for the financial markets?
First, foreign exchange markets are likely to become unusually volatile. This may present a headache for policymakers but when markets sense that major policy disputes are escalating they begin to force the issue by building positions.
Second, if FX volatility becomes severe enough policymakers may resort to extreme actions that spill over into other markets. For example, following a huge surge in the Swiss franc on safe-haven buying in 2011, the Swiss National Bank (SNB) chose to put in a floor of 1.20 on the EUR/CHF exchange rate, committing to ‘unlimited’ purchases of euro assets if so needed. This has resulted in an explosion of the SNB balance sheet, something that could become hugely inflationary under certain circumstances.
More dramatic would be for countries to raise trade barriers in an effort to protect domestic industries and jobs. For all the talk of ‘free-trade’ in the world, the reality is far different. A great many industries and products are subject to various kinds of frequently minor trade barriers, some of which are quite well hidden to those not involved in a particular industry or product. A political response to currency devaluations by competitors could well be to increase existing barriers or erect entirely new ones.
As I have written before, trade barriers can be hugely damaging to corporate profitability. Imagine if all of a sudden euro-area countries or US states sought to protect domestic firms and jobs by charging a 10% tariff on any goods crossing the border. With few exceptions, corporate profit expectations would collapse and the stock markets would immediately follow suit. Now extrapolate this to the global level and imagine what a trade war would do to the multinational companies that comprise the vast bulk of major world stock market capitalisation. It would make the crash of 2008 seem tame by comparison.
Third, countries might enact capital controls to stabilise their exchange rates but at the expense of preventing capital from moving efficiently across borders. Capital controls are to capital flows what trade barriers are to exports and imports and would also crush corporate profitability. Imagine trying to raise capital, rollover debt, or redeem multinational corporate debt or shares in a world of capital controls. Global financial markets in general would largely seize up. Risk premia would soar. Valuations would collapse.
Were the US itself to take the lead in any one of these extreme actions, the dollar would from that day forward cease to enjoy its long-held dominant reserve currency status and the comparatively low borrowing costs this confers. Given the huge, escalating federal, state and municipal debts, even small increases in debt servicing costs could spiral into a public debt crisis. The Fed would no doubt come under pressure to buy the bonds required to bring such a crisis under control but with global savers less able to absorb these new dollars due to capital controls, the dollars would circulate primarily domestically, leading to a potentially huge surge in price inflation.
COMMODITIES PROVIDE CHEAP INSURANCE
The colossal global debt problem, associated currency wars, looming trade wars and possible capital controls collectively threaten the real value of financial assets generally through some combination of devaluation, default and inflation. In this unusual and unfortunate situation, commodities provide a form of insurance. They cannot be ‘printed’ or otherwise arbitrarily devalued. They cannot default. They will always find some demand. Indeed, amid trade barriers and capital controls some basic commodities taken for granted today may command a large premium due to supply shocks.
As it stands now, however, commodities appear cheap relative to financial assets. Equity markets have risen strongly of late, leaving commodities the most undervalued in relative terms since 2008. Bond markets may have sold off slightly in recent weeks but in any reasonable historical comparison remain extremely expensive as a result of unprecedented and unsustainable central bank buying.
It is impossible to know just which commodities are most likely to rise in price. As a form of alternative money, gold and silver are likely to rise, in particular if there is even a partial official remonetisation of these metals as a replacement for highly unstable fiat currencies. But trade barriers could restrict the flow of oil and foodstuffs, pushing up their prices to unprecedented levels.
The best action investors can take is to diversify their exposure across a broad range of essential commodities and those companies that produce them domestically and abroad. These companies are likely to retain their pricing power amid trade wars, although they may be subject to nationalisation in extreme cases.
This article was previously published in The Amphora Report, Vol 4, 12 February 2013.
 For more details please see this Bloomberg News story here.
 This was reported by Bloomberg News here.
 These statements were reported here.
 President Weidmann’s comments were reported by Bloomberg News in the article linked here.
 I use the term ‘reference’ here because the ECB lacks a formal target. The ECB’s mandate is to maintain price stability as the ECB so defines it. The ECB has long held that a rate of 2% is consistent with price stability and so 2% is a reference only, not a target.
 There is still much nonsense out there about how there is “too little gold or silver” in the world to serve as money. As I am fond of pointing out, the amount of gold and silver may be relatively fixed by weight and volume but not by price, which need only rise sufficiently.
On multiple fronts there appears to have been a resumption of hostilities in the global currency wars. A subtle indication of this is the recently released report, ‘Gold, the Renminbi and the Multi-Currency Reserve System’ (PDF), which I believe is highly significant for two reasons: First, it demonstrates that major global actors are now keenly aware and frightened of the possibility of a major breakdown in international monetary relations. Second, it suggests that these same actors are trying to contain the growing demand for gold as an alternative reserve asset and pre-empt an uncontrolled gold remonetisation. These efforts will fail. A collapse of the current, unstable global monetary equilibrium is inevitable. Recent events indicate that the countdown has begun.
BREAKING THE CEASE-FIRE
Curiously, in the second half of 2011 and through most of 2012, notwithstanding the escalating euro-crisis, US ratings downgrade, Japan’s protracted nuclear disaster and sharply divergent global growth rates, there was surprisingly little volatility in foreign exchange markets. EUR/USD traded mostly in the historically narrow range of 1.40-1.25. USD/JPY was in a range of from 76-82. The Chinese renminbi held between 6.4 and 6.2. GBP/USD moved within 1.54-162. The Swiss franc was also steady at around 1.20 versus the euro, although this was the result of an explicit Swiss policy of capping the franc at that level.
In retrospect, it appears that this period was characterised by a general ‘cease-fire’ in the global currency wars ignited by the global financial crisis of 2008. Rather than attempt directly to devalue currencies to stimulate exports at trading partners’ expense, the focus during this period was primarily on measures to support domestic demand.
There has now been a resumption of hostilities. The first shots were fired by the Japanese, where national elections were held in December. The victorious LDP party campaigned on a platform that, if elected, they would increase the powers of the Ministry of Finance to force the Bank of Japan into more aggressive monetary easing. The LDP also has voiced support for either a higher BoJ inflation target or a nominal GDP growth target.
Combined with poor economic data, this had a dramatic impact on the yen, which has subsequently declined by about 10% versus the dollar and 15% versus the euro. This is the weakest the yen has been in broad, trade-weighted terms since 2011.
Now it is understandable that Japan should desire a weaker yen. Japan is no longer running a trade surplus, in part because it is importing a record amount of energy following the decision to scale back the production of nuclear energy. Moreover, demographics are such that the proportion of retired Japanese is growing rapidly. As Japan’s ageing population draws down its savings to fund retirement, this implies that Japan will be saving less and consuming more relative to the rest of the world.
But while Japan has an interest in a weaker yen, many other countries have an interest in weaker currencies too. Much of Asia has been following a classic, mercantilist growth model ever since the Asian credit/currency crises of 1997-98, seeking to export more than they import. They are still inclined to follow this model, as it has succeeded in the past.
Of course it is impossible for all countries to be net exporters. The US is by far the world’s biggest importer. But given structural economic problems and associated high unemployment, US policymakers also have reasons to desire a weaker currency to stimulate exports and jobs. Much the same is true of the UK, arguably the leading candidate for the next big devaluation. Then there is the euro-area, which is suffering under a huge debt burden and desires to stimulate exports abroad to offset ‘austerity’ at home.
The BRICs (Brazil, Russia, India, China, South Africa) and other developing economies are well aware of mature economies’ problems and do not want to be the ones that pay for what they perceive, quite justifiably, as economic hypocrisy. Just who has been living beyond their means? Who has been borrowing and consuming, rather than saving?
It does, of course, take two to tango. The BRICs have been financing mature economies’ largesse—including financial bailouts—with their surpluses. But as the BRICs have stated on multiple occasions, they would far prefer for the developed economies to take their necessary economic medicine at the local, structural, supply-side level rather than to try and pass the pain of adjustment off on them.
A recent sign of such concern includes some rather provocative statements by Russian central banker Alexyi Ulyukayev. Russia is currently the Chair of the G-20 countries who seek to cooperate on global economic matters. Back in 2009 the G-20 agreed not to engage in competitive currency devaluations. Well they’re not exactly cooperating at present according to Mr Ulyukayev, who has specifically accused Japan of breaking the cease-fire: “Japan is weakening the yen and other countries may follow,” he said recently. South Korea, one of Japan’s closest competitors in several major industries, has warned of possible retaliation for the weaker yen and both South Korea’s and Taiwan’s currencies weakened sharply this week. Even Norway, with a healthy economy at present, has recently indicated that it is concerned by the strength of the krone.
The sad fact of the matter is, currency wars (ie competitive devaluations) are ‘zero-sum’ at best. At worst, they severely distort global price signals, thereby misallocating resources, and eventually morph into trade wars, in which economic protectionism destroys the international division of labour and capital, making economic regression all but certain. The 1920s/1930s are a classic case in point but there were similar such episodes in the 18th-19th centuries, the era of mercantilist economic policy debunked by, among others, Adam Smith and David Ricardo. (While the classicists were right about mercantilism, it should be noted that classical economic theory is deeply flawed in key respects.)
Given the destructive power of currency and trade wars, it should come as no surprise that policymakers in the developed economies are increasingly desperate to find a way to de-escalate and contain the conflict. But is this possible?
IS THE OMFIF REPORT AN OLIVE BRANCH TO THE BRICS?
Perhaps the best indication of growing policymaker desperation is a recent report prepared by the Official Monetary and Financial Institutions Forum (OMFIF), on behalf of the World Gold Council. In the report, the OMFIF argues that the international monetary system is approaching a transformation from a mostly ‘unipolar’ system centred around the dollar, to a ‘multipolar’ one of multiple reserve currencies, including the Chinese renminbi, which at present comprises only a tiny fraction of global FX reserves.
Most important, the report recognises that monetary regime change is fraught with uncertainty. History is clear on this point. Also clear is that, historically, periods of global monetary uncertainty have been associated with central bank (and private) accumulation of gold reserves and, by association, a rising price of gold.
According to the OMFIF, this is the explanation for why central banks are accumulating gold today. It boils down to increasing uncertainty or, if you prefer, decreasing trust between countries, a natural consequence of the currency wars. OMFIF assumes that, in the coming years, uncertainty and associated gold accumulation will continue to increase, placing further upward pressure on the gold price.
It is difficult to argue with any of that. Indeed, in my book, The Golden Revolution (available here), I illustrate how the 2008 global financial crisis critically destabilised the international monetary system. In particular, the dollar is losing its dominant reserve currency status, yet there is no other existing fiat currency that can replace it. The euro has issues, the yen has issues and the renminbi has issues, although it is the ‘rising star’ in this group.
The OMFIF report then makes a recommendation that the best way to reduce the unavoidable monetary uncertainty ahead is to acknowledge that there should be a more formal role for gold to play in the international monetary order, in particular, that it should be included in the Special Drawing Rights (SDR) basket as calculated by the International Monetary Fund (IMF). The SDR is a global reference point for currency valuation and IMF member countries’ capital shares are denominated in SDRs.
This is a formalisation of what was first proposed by World Bank president Robert Zoellick back in 2010. In a Financial Times article that I believe will be noted by monetary historians in future, he wrote that gold was already being treated as an “alternative monetary asset,” and that the international monetary system “should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values.”
The OMFIF report also suggests expanding the SDR basket to include all the ‘r’ currencies, not only the renminbi but also the Indian rupee, the Russian rouble, the Brazilian real and the South African rand. This would be a formal recognision of the rising economic power of all the BRICs, not just China, and pave the way for their currencies’ use as reserves.
A BUREAUCRATIC PIPE-DREAM
Bureaucrats are naturally drawn to bureaucratic ‘solutions’ to problems. But cooperative solutions become unworkable when cooperation breaks down, as is increasingly the case in global monetary relations. In this context, the OMFIF report, while it sounds nice on paper, is a futile attempt to hold an unstable equilibrium together. The fact is the BRICs no longer trust the mature economies in monetary affairs. Lacking such trust, the only viable way forward is to ‘de-nationalise’ money for international trade, thereby disarming those who would opportunistically engage in currency wars.
Gold is the only such non-national money, a currency that cannot be printed or otherwise manipulated by one country at the expense of another. Its supply is strictly limited by that which can be got out of the ground at economic cost within a given period of time. Thus gold stands in sharp contrast to all unbacked fiat currencies, the weapons of the currency wars. The OMFIF report dances around this fundamental difference between the two but ultimately stumbles. Yes, the OMFIF report recognises that:
[T]he previously dominant western economies have attempted to dismantle the yellow metal’s monetary role, and – for a variety of reasons – this has comprehensively failed. Gold thus stands ready to fill the vacuum created by the evident failings of the dollar and the euro, and the not-yet requited ambitions of the renminbi.
But notwithstanding the recognised failings of fiat currencies and persistence of gold, the report then moves on to recommend that gold and the major fiat currencies be treated as equals in the future monetary order, specifically, by:
…extending the SDR to include the R-currencies – the renminbi, rupee, real, rand and rouble – with the addition of gold. This would be a form of indexation to add to the SDR’s attractiveness. Gold would not need to be paid out, but its dollar or renminbi or rouble equivalent would be if the SDR had a gold content. By moving counter-cyclically to the dollar, gold could improve the stabilising properties of the SDR. Particularly if the threats to the dollar and the euro worsen, a large SDR issue improved by some gold content and the R-currencies may be urgently required. (Emphasis added.)
From ‘dance’ to ‘stumble’ may be the wrong metaphor here, unless the stumble is meant to serve as a distraction for some slight-of-hand on the stage. Did you catch the subtle trick of logic in the above?
Allow me to explain. The “failings of the dollar and the euro” vis-à-vis gold are indeed “evident”: This is why central banks everywhere are in a scramble to acquire more gold and, in some cases (eg Germany, Venezuela, Turkey) to strengthen their custody of it through repatriation and changes in regulations. The dollar and the euro are no longer trusted as stores of value, at least not to anywhere near the degree that they were in years past.
But if your agenda is to try and contain the scramble for gold and prevent it from further displacing fiat currencies in reserves, how convenient if you implemented an international monetary system that would limit, through official, global arrangements, the degree to which gold could compete as an international money while still allowing for whatever amount of fiat inflation policymakers believe is required to devalue their excessive debts.
If gold “need not be paid out” then, as the price of gold rises, you just print more paper currencies as required to make up the difference! In other words, gold would be unable to serve as a brake on a general global monetary inflation. And “if the threats to the dollar and the euro indeed worsen”, then yes, just print more of those SDRs—a basket of dollars, euros, renminbi, etc—and who cares if the price of gold rises in tandem? You’re still inflating!
In context of the changed global economic landscape, the OMFIF report thus reads as a desperate attempt to sue for a compromise peace in the currency wars, to find a basis for agreement between the US, euro-area, Japan, and China and the other BRICs, to inflate in coordinated fashion thorugh SDR issuance, while at the same time keeping the golden genie in the bottle where, according to central-planning inflationists, it belongs.
Of course, just because an olive branch is extended does not mean it will be accepted. Is it really in China’s or the BRICs’ interest to participate in such an arrangement? Does China really want the ‘failing’ dollar and euro to keep depreciating? Or might China want to get paid for its exports in hard currency for a change?
Again, it all comes down to trust. Currency basket arrangements such as the euro or, as the OMFIF proposes, a global SDR with a token role for gold, only hold together as long as all the major players perceive that they serve their interest. The moment a player perceives otherwise, the system, lacking sound money foundations, falls apart. If the OMFIF report is indicative of the next step in the evolution of the global monetary system, then the past and current failures of the dollar and euro are destined to become the future failures of the SDR.
China must know this. I suspect the other BRICs do too. And numerous small countries, hardly irrelevant in the matter, are watching intently to see where this goes, while accumulating gold in the meantime, unsure of the outcome.
WHY A RETURN TO GOLD IS THE INEVITABLE RESULT OF THE CURRENCY WARS
If the developments discussed above seem unprecedented, think again. We have been here before, namely, in the mid- to late 1960s, when the US and other Bretton Woods participating countries were struggling to maintain the gold price at $35/oz. There was lots of monetary inflation in the US and elsewhere by the mid-1960s and it was assumed by many that this would lead to price inflation in time.
European central banks, most of whom had accumulated substantial dollar reserves, were beginning to swap these for gold. Private investors sought to protect themselves with gold purchases. By 1967, while the official price for gold remained $35/oz, there was steady upward pressure on the market price in London. ‘Two-tier’ markets create arbitrage opportunities and, as more speculators got in on the game, the upward pressure on the gold price intensified.
In 1967, France, already having indicated from early 1965 that it was dissatisfied with the dollar-centric Bretton Woods system, abruptly withdrew from the pool. While this was a clear message to all that the official $35/oz gold price was unsustainable, encouraging yet more speculation, at the same time it meant that the remaining London gold pool participants had to cover for France’s significant absence by making even more gold available to the growing number of buyers.
This unsustainable arrangement lasted less than a year, with the pool collapsing entirely in 1968. The situation was now critical as the monetary system was without solid foundation. The upward pressure on the price of gold intensified yet again. The Federal Reserve was now frightened that a run on the dollar was imminent, with the pound sterling already under renewed attack. At one Fed meeting that year it was claimed that, “the international financial system was moving toward a crisis more dangerous than any since 1931.”
By 1971 the day of reckoning had arrived. The US had continued to sell gold into the market to suppress the price and to convert foreign reserves on demand into gold since 1968 but when even the UK was asking for a substantial portion of its gold back in summer 1971, it was clear that this effort was futile. Either the US would run out of gold or it would allow the gold price to rise and the dollar to ‘float’, that is, to devalue substantially.
President Nixon opted for the latter course, as he announced to the world on 15 August that year. The dollar was devalued and gold convertibility suspended indefinitely as a ‘temporary’ measure. But why did the world continue to use dollars as reserves when these were unbacked by gold? Because the US was still by far the largest economy in the world, the biggest importer and exporter. And while US finances were deteriorating at the time, they were in far, far better shape than they are today, with trade and budget deficits tiny as a percentage of GDP. Today, the picture is the complete opposite. US finances are in a far worse state than those of the BRICs.
The US and the other developed economies are thus no longer in a position to dictate terms in international monetary matters. The BRICs have made the point clear. They are going to begin to demand hard currency in exchange for their exports. A plan to this effect could be announced as early as their annual spring summit, held this year in Durban, South Africa, on March 26-27.
KEEP CALM, BUY GOLD, GET OUT OF BONDS
If the recommendation to accumulate gold in advance of its remonetisation for use as an international money seems obvious, perhaps less obvious is to reduce holdings of bonds. Why should a remonetisation of gold lead to higher bond yields/falling bond prices? After all, the economic dislocations associated with international monetary regime change could well tip the world into yet another recession as the associated economic rebalancing takes place.
While we have come to associate rising yields with economic recoveries and falling yields with recessions, in fact, on a sound money foundation this relationship does not hold. Back when the world was on the gold standard, for example, yields sometimes rose in recessions and declined in recoveries. This is because the central bank was unable to manipulate the bond market with monetary policy.
Take the euro-area today as a contemporary case in point. As Greece, Portugal and Spain have tipped into deep recessions, their bond yields have risen as they lack national central banks which can buy their bonds with printed money. And investors have a choice whether to hold these bonds, or to hold the bonds of sounder euro-area governments, such as Germany, hence the wide spreads that investors demand in compensation.
A return to gold-backed international money will have much the same effect but at the global level. US Treasuries and other bonds will need to compete more directly with gold itself as a store of value or as official reserves. Interest rates will therefore need to rise to compensate investors for the very real possibility that the supply of bonds will just keep on growing to finance endless government deficits while the supply of gold remains essentially fixed.
Now I am under no illusions here. If the US, euro-area, UK and Japan face sharply higher borrowing costs in future, they are going to have debt crises similar to those faced by Greece, Portugal and Spain today. Indeed, with no one willing or able to bail them out, the associated crises may be more severe. The US and other indebted countries may resort to capital controls and even to selective default on their debt, such as that held by foreigners abroad.
If so, this will be another major escalation in the currency wars, one that will begin to resemble the 1920s and 1930s in its intensity. Those were sad decades, to be sure, in which much of the global middle class saw its savings wiped out at least once and, in some cases, twice. They didn’t care whether this occurred via inflation/devaluation or via deflation/default. Investors today shouldn’t care either. They should accumulate gold and certain other real assets in limited supply. These are the ultimate insurance policy against inflation, deflation, devaluation, currency and trade wars, financial crises, monetary collapse … you name it. The time to do so is running out.
 In the Amphora Report I have long followed the ‘currency wars’. My first take on the subject, BEGUN, THE CURRENCY WARS HAVE, dates from September 2010. The link is here.
 These various statements were reported in this Bloomberg News article that can be found here.
 Robert Zoellick, “The G20 Must Look Beyond Bretton Woods II,” Financial Times, 7 November 2010.
 Please see THE BUCK STOPS HERE: A BRIC WALL, Amphora Report vol. 3 (April 2012). The link is here.
 GOLD, THE RENMINBI AND THE MULTI-CURRENCY RESERVE SYSTEM, OMFIF, January 2013, p. 4.The link is here.
 Amateur historians take note: Federal Reserve Open Market (FOMC) minutes may be tedious for the most part but occasionally there are real gems to unearth, as is the case here. However, the transcripts are only released with a five-year lag. It will be interesting to see what was discussed—and not redacted—from transcripts from 2008 and 2009, when the Fed was involved in bailing out the bulk of the US financial system.
This article was previously published in The Amphora Report, Vol 4, 30 January 2013.
Not your typical Cobden Centre interview, but hopefully thought-provoking …
John Llewellyn is one of the most highly regarded economists in Europe, having worked in the private sector, academia, and national and supranational policy institutions. He now runs his own consultancy, advising governments, multinational corporations, and institutional and private investors. He was educated in the neo-Keynesian tradition but, on becoming an applied economist, he became what he terms “an evidence-based eclectic”. As such John recognises the potential explanatory limitations of the Keynesian paradigm for a world of excessive debt and unprecedented policy activism. At present, he is concerned about what appears to be an unfolding, synchronised global cyclical downturn amidst what remains a structurally weak growth environment. The consensus is in his view too complacent in believing that recent policy stimulus actions will either lift growth rates or reduce debt burdens meaningfully over the coming 1-2 years.
BY WAY OF BACKGROUND…
Born in England, but raised in New Zealand, John Llewellyn attended The Victoria University of Wellington for his BA (Hons) degree and then Oxford University, where he obtained his DPhil. He then researched and taught at Cambridge University for nearly ten years, and was a Fellow of St John’s College. Thereafter, he moved to Paris to the Organisation for Economic Cooperation and Development (OECD), the supranational economic policy analysis and forecasting organisation, where he rose from Head of Economic Forecasting to Deputy Director for Employment, and finally Chef de Cabinet to the Secretary General. In 1995 he moved to London, where he was Global Chief Economist for Lehman Brothers until 2005, when he became the firm’s Senior Economic Policy Adviser. Following the bankruptcy of Lehman Brothers he set up his own firm in 2009, Llewellyn Consulting, which specialises in thematic macro research (e.g. demographics, technological innovation, climate change) and economic risk assessment.
I came to know John during my time at Lehman Brothers in the mid-2000s, where I was the European Head of Interest Rate Strategy. We worked closely together to link economic forecasts and risks with practical, implementable strategies for the global interest rate and currency markets.
We both became deeply concerned by developments in global housing and credit markets in the mid-2000s, in particular in the US, agreeing that a dangerous bubble was forming in association with global trade and capital flow imbalances. On numerous occasions we presented our counterparts and other colleagues in New York with this view. It was not well received.
When the crisis began to unfold in 2007, and then intensified in 2008, neither of us was particularly
surprised. We did not, however, predict that not only Lehman Brothers but also a number of major financial institutions would fail. The intensity of the crisis and the aftermath of tepid growth, together with lingering structural problems and global imbalances, have caused both of us, each in our own way, to change the way we think about the world, and question some core assumptions. In general, this process has led us to become decidedly less optimistic in how we see the economic future.
John and I continue to speak on a weekly basis, and get together at least once a month to review global economic developments and assess the risks, as we see them. Recently, John identified an associated set of economic risks that could well result in a much sharper downturn in global growth over the coming year than the consensus expects. What follows below is a rough amalgamation of several informal, recent conversations between us about how John came to this view; about the risks associated with excessive debts and so-called ‘financial repression’; the future of the euro and possible alternatives to the current set of national economic policy choices. The conversation then turns to the financial markets.
THE GATHERING STORM
JB: John, in your most recent economic risks publication, you write that, in 2013, economic activity in nearly every part of the world is likely to slow. That is highly unusual. Normally there are at least a few pockets of strength that support demand for weaker economies. If that is not going to be the case, does this raise the risk of a generally sharper downturn across the world?
JL: It does. Conventional, single-economy, economic models assume stable and reasonably large fiscal ￼and monetary multipliers. These are derived from historical observation. But there is little evidence about synchronised global downturns, so most of the data are irrelevant, or at least potentially misleading: policymakers are therefore likely to underestimate the size of the coming slowdown. This analytic point used to be one of the major reasons for, and messages from, the OECD; but the message is heard less these days. Were the US, the EU, or China to get traction with new stimulus in the near-term, then the slowdown would be less likely to be synchronised, and the consensus, as best I can tell, would be more likely to be correct that 2013 growth will be similar to 2012. On the other hand, if there is a further move toward outright tightening of policy, say due to the fiscal cliff in the US, or enhanced austerity in Europe, things could get worse.
JB: Let’s step back for a moment. Neither the fiscal cliff nor austerity would be an issue if debt burdens were lower, or growth higher, or both. Manageable debts are a nonissue. How did the developed world get into this mess? Is it purely a result of the financial crisis, or were there longer-term, structural forces at work, largely unseen by the policy mainstream?
JL: To some extent the answer differs from country to country. Some, like Greece and Portugal, were simply consuming beyond their means, and had to rein in total expenditure. Others, like Spain and Ireland, as well as the UK and the US, let leverage in their financial systems build up to such an extent that, when assets prices collapsed, the authorities had little option but, in effect, to nationalise the resulting private sector debt in order to keep the financial system functioning. But overlaying this in virtually all economies was, and is, a set of promises made by generations of politicians that they will be unable to meet, not least given the ageing of populations.
JB: Doesn’t this bring a central tenet of Keynesian economics into doubt, that you can borrow your way to prosperity? While countercyclical government borrowing and spending seems reasonable on paper, we now have quite a bit of empirical evidence that these debt burdens accumulate over time, that governments embrace deficit spending but eschew the offsetting surpluses required to keep finances in balance. Going forward, should we have faith that policy can be more responsible?
JL: The central tenet of Keynesianism is subtler than the bastardised version that came to be taught later. I was taught what I would term ‘classical Keynesianism’ in New Zealand, and had it reinforced at Cambridge by former colleagues of Keynes, such as Joan Robinson, Austin Robinson, Richard Kahn, Nicholas Kaldor, as well as more recent luminaries, such as Geoff Harcourt and John Eatwell. This central tenet is that borrowing works if it takes GDP back towards full employment, and fairly quickly, and if it kindles, or re-kindles, Keynes’ ‘animal spirits’ – the entrepreneur’s intrinsic faith such that he or she is willing to incur the certain cost of borrowing now in the expectation that he or she will earn a return in an unavoidably uncertain future. In other words, as Robin Matthews pointed out in the 1960s, Keynesianism works only if people believe it will work. Or, as Keynes observed, economies are held up by their own bootstraps.
FINANCIAL REPRESSION PAST, PRESENT AND FUTURE
JB: Returning to the fix we appear to be in, I know you have thought extensively about policies that limit financial freedom in order to subsidise government debt service and reduction, collectively termed in the jargon as ‘financial repression’. Could you elaborate on this and how you see it developing going forward?
JL: Basically in such circumstances, governments do four things: they encourage inflation; they instruct the central bank to keep short rates and bond yields along the curve low; they oblige savers (including pension companies and insurance companies) to hold an increased proportion of their assets in government bonds; and they impose capital controls to prevent savers from taking their capital abroad in search of higher real yields.
JB: But does it work? Recall that Carmen Reinhart made explicit that ‘financial repression’ is historically associated with failing third-world governments desperate for public revenue. What does this imply about the developed world today? Are you troubled by this? Does it not seem, potentially, to be a road to ‘financial tyranny’? A road to Argentina, to name an obvious case in point?
JL: It does work; but of course it is troubling. The West has used these policies before. The UK, the US, and France amongst others did exactly what I have summarised to reduce public debt as a proportion of GDP after WWII. But there was a difference then: As various people of that generation have told me, they were completely aware at the time that the war bonds that they were buying would not be worth much, if anything, after the War. But they bought them nevertheless, because that was the price for having a chance to defeat tyranny. I am not sure that the younger generation will be so tolerant today with politicians and political parties who made promises only to get elected, and which they knew they could not fulfil.
PRESENT AT THE CREATION
JB: You were, to use a colloquial term, present at the creation of the euro. You knew some of the architects. You observed, indeed contributed to, some of the planning, as well as the implementation. And now you have observed the crisis unfolding. You have always held that the euro is a political project, and remains so. You are also on record as having more confidence than most that the euro will not only survive but that it will in time prove its detractors wrong, that it will enhance European economic performance through greater stability and integration.
￼Given recent developments, this seems a bold view to some. Would you care to elaborate?
JL: All economists involved in the creation of the euro knew that its initial institutional arrangements contained a number of important flaws. But those ‘present at the creation’ also knew that Chancellor Kohl and President Mitterrand knew this too. The Kohl / Mitterrand calculation was that they were the last generation fully able to appreciate the enormity of war in Europe; that they would bind their two economies together by ‘a thousand silken threads’; and that they would hope that when, in the future, the project ran into problems, their successors would choose to fix them rather than allow the union to break up. So far, the gamble has paid off. Of course, the British do not see it that way. They were told by Edward Heath that this was an economic union, and they believed him. And British economists in turn analyse the union purely in economic terms. That is a generalisation: but you get the point.
JB: You also hold, and rightly so I believe, that there is far too much focus on the troubles of the euro-area and not enough on those elsewhere. As a case in point, consider Japan, which has comparatively larger demographic issues with which to deal and which is, following a multi-decade period of sub-par growth, slipping out of trade surplus and into deficit. In my opinion, this is an issue not only for Japan but for the entire world. How do you feel about Japan?
JL: Under US guidance, Japan did a brilliant job after WWII in adapting its manufacturing sector to the Western (initially US) market which the US opened to it, and then widened further by admitting Japan to the OECD. But Japan’s policymakers drew a wrong conclusion: That the only way to grow was to sell goods to foreigners. As a result they never allowed any real competition, nor any structural reform, to take place in the service sector: They did not realise that they could get rich also by selling to themselves. To this day, they have not learned that lesson.
JB: It is so easy to forget that no single economy is a closed system. Especially today, given how globalised the world has become. Even the US, which has a comparatively small external sector, is today far more widely integrated into the global economy that it has ever been. There is also the non-trivial matter of the US providing the world’s reserve currency. Some argue that this ‘exorbitant privilege’, to use a term coined by former French President Valery Giscard d’Estaing, is not at risk. I know you disagree that the US is a ‘safe-haven’ in the way normally portrayed in the financial press. Could you please elaborate?
JL: A country is a safe haven right up until the moment when investors decide that it is not. The US economy produces a vast array of goods and services. If since WWII one had to hold monetary assets denominated in any currency, that currency would be the US dollar. Dollars can be converted into anything that one might conceivably want. But alternatives are emerging: The euro. The renminbi. At the least, investors will want to diversify; and indeed they are so doing. And if the US does not deal with its fiscal problem, the move away from the dollar will likely accelerate.
JB: But that is precisely the point: The US is not a safe haven. A safe haven cannot be a country that is at risk of devaluation, default, or some combination of the two. But that does leave a rather small list of countries, and I would suggest that none of them is realistically the provider of a dominant reserve currency, or the provider of sufficient additional aggregate demand to provide for Keynesian stimulus to bail the world out of its excessive debts. If this is the road we’re on, where does it lead? Can the economics profession continue to act as if the policy tools and actions that got us into this mess can get us out? Or does the solution lie elsewhere?
JL: Just as reflating one’s own economy requires that entrepreneurs and investors have faith in the future, so does reflating the world economy require that entrepreneurs and investors have faith in the currency or currencies that are attempting the reflating. I shudder to think what the world economy will look like of investors’ faith in the dollar declines, rather than revives.
FROM DEBT CRISES TO CURRENCY CRISES
JB: When a debt crisis becomes a currency crisis you have a problem that is an order of magnitude greater, because at that point you are not only distorting macro price signals via ‘financial repression’ but as there is now so little confidence in the stability of the currency, and households and businesses no longer have confidence in their ability to manage their time preferences effectively. Austrian economists would argue that this is so damaging that, if sustained, it will destroy an economy’s capital stock through severe resource misallocation. Do you have some sympathy with this view or is it too pessimistic?
JL: I have some sympathy, but also some humility. When economies are so far away from where they have even been in modern economic history; when the structure of our economies, with their much, much larger government sectors, is so unprecedented; and when we have been told so confidently what will happen by economists who engage in a priori theorising only to be proved wrong later, I am, I confess, rather more humble.
JB: The alternative to printing your way out of a debt burden is to allow for bankruptcy, restructuring and reorganisation of the capital stock to take place instead. Josef Schumpeter called this ‘creative destruction’, and he believed that it was not only helpful but in fact essential for economic progress. Might a severe recession be exactly the bitter medicine required at this point to save the patient, rather than more of the palliative to date that appears not to be working, or perhaps even making the problems worse? Would you argue that Britain’s ￼basket case economy of the 1970s could only have been turned around in this way? Or could there have been a more mainstream, Keynesian way to go about it, such as an even larger currency devaluation?
JL: I have never liked ‘severe recession’ as the cure for anything. The spectre of all that lost output always appalls me. It smacks of the same mentality that advocated bloodletting and leeches. It has always seemed to me that more useful things could be done with potential output than just letting it flow out to sea. The state could build toll roads, harbours, airports, even certain types of housing, and sell them off later to the private sector when confidence returned. Surely that ought to be possible.
JB: Let’s move a bit closer to your current home. What about the UK of today? Does the UK need to undergo another Thatcher-like experience, something beyond timid ‘austerity’, including more meaningful structural reforms to make it more competitive internationally in exports? If so, would that be easier to accomplish were the UK to leave the EU? You have said that there is a distinct possibility of that in the coming few years.
JL: I think that leaving the EU is a distraction from the real issue, which is that UK companies are sitting on a pile of cash and are so uncertain about the future that they will not invest. Meanwhile households are trying to reduce their borrowing; and so is the government. The only thing to be done, in my view, would have been for the government to have undertaken the type of investment that companies otherwise would have done, and sell it on later. But that idea ran straight up against political dogma.
JB: But if the UK economy needs to rebalance, doesn’t the US need to as well? And on the other side of these trade deficits are trade surpluses elsewhere. Can the world continue to grow without first correcting these imbalances to at least some degree? And doesn’t history suggest that imbalances this large are ultimately corrected only in periods of unusually weak growth?
JL: Here you are putting your finger on a problem that Keynes highlighted at the end of WWII, but which Harry Dexter White, the senior US Treasury official at the 1944 Bretton Woods conference, refused to acknowledge. Surpluses and deficits are mirror images of one another. Two sides of the same coin. There cannot be one without the other. Hence being in surplus is just as contributory to imbalances as being in deficit. In a properly run global world, policies would bear down on surplus economies and deficit economies equally. But they never do.
ON FINANCIAL MARKET VALUATIONS AND THE MONETARY FUTURE
JB: Taking into account our discussion so far, I think there are ample reasons why the stock market should appear ‘undervalued’ to many. P/E ratios may not be particularly high, even if profit margins are. The fact is, however, revenues simply cannot grow rapidly in this environment, at least not in real terms. And record profit margins cannot survive a proper global rebalancing as the cheap labour of emerging markets converges on the developed world. In my opinion, given the structural macroeconomic headwinds we have discussed, stock market valuations should, in fact, be at generational lows, perhaps below where they were in the early 1980s or early 1960s. Your thoughts?
JL: I think that that argument is correct as far as it goes. But given that investors are starting to lose confidence in paper assets, and particularly government paper, they want to hold something real: and that includes shares in companies. And it is not as if there is a stock market bubble – so far at least. PEs in the US and the UK are not far from their historical averages.
JB: But if stock market valuations need to adjust even lower from here, perhaps much lower if policymakers don’t embrace more meaningful structural reforms, and if bond markets are overvalued due to the risks of currency devaluations, where, exactly, is an investor to hide? I lean toward a diversified exposure to real assets, including raw commodities. Could you perhaps share your thoughts on that?
JL: Clearly, commodities, industrial, food, and of course gold, are obvious contenders.
JB: Speaking of gold, you are aware that I believe that there has now been so much global economic confidence lost that it will not be properly restored absent a return to some form of gold standard, if only for international rather than domestic commerce. While I know you are sceptical, you don’t disregard the idea entirely. You have mentioned before the possibility of an international pricing convention based on a ‘bancor’, a currency based on a fixed basket price of globally traded commodities. How might that work? And are you confident that there would be sufficient support for such a regime, given that global economic cooperation is endangered by the threat of competitive devaluation, trade wars and the rise of economic nationalism generally?
JL: It would work by governments setting fixed rates for converting currencies into a basket of commodities. I think that it makes logical sense; and it could help in spurring the production of commodities that would later be in demand as activity picked up. Kaldor thought a lot about this, and we discussed it when I worked under him. But equally, I am sure that it is a non-starter. Two decades of life in the OECD has shown me just how hard it is for countries to agree about anything so fundamental.
JB: Some economists simply dismiss the idea of a gold standard as archaic and unworkable. I don’t think you hold that strong an opinion. But what would you see as the primary disadvantages of a gold standard, or relative advantages of the current dollar reserve standard. Does it come down to how much confidence you have in policymakers?
￼JL: It is possible to have confidence in individual policymakers at the national level, while nevertheless having little confidence about their ability to agree to reforms to the international system as a whole. And that is where I come from. In any international negotiation of this sort, two types of country have disproportionate influence: the biggest; and those in current account surplus. Today, that would mean the US and China: and I doubt that they would agree on any reform that proved to be in the global interest.
IF JOHN WERE IN CHARGE
JB: Now I’m really going to put you on the spot. An economist of your stature must always be considered a potential candidate for a senior policy role, say as a senior advisor to a finance minister, or a member of a central bank policy committee. Were you to be appointed to a role in which you had a broad mandate to design and implement fiscal and monetary policy, say for the euro-area or the UK, what would you do? If hard choices need to be made and if you had the mandate to make them, what would these be?
JL: In the UK, about which I thought particularly as an adviser to the Treasury from 2009 to 2012, I would have “thrown everything at the 2008 crisis, including the kitchen sink” as my friend William Keegan put it and as, in fact, Alistair Darling did. And I would thereafter have set out on much the same course of fiscal consolidation as Darling did, and Osborne continued. I think that Paul Krugman and Ed Balls understate the risk that would attach to the government borrowing substantially more. But, as I indicated above, I would also have embarked on finding ways to support private-sector-like investment. My proposition throughout has been that the government should have been willing to underwrite, or undertake, investment that produces marketable output – ports; airports; toll roads; certain types of housing, etc. These could be valued and entered as an explicit, verifiable, line in the National Accounts, and could later be sold to the private sector. The ratings agencies would, on my understanding, have been open to such a plan being explained to them.
JB: I’m pleased to hear that there are things that might yet be done within the existing policy framework to help, at least if people listen to you a bit more! Thanks so much for your time; I’m certain that Amphora Report readers will appreciate it.
JL: Thank you John.
JB: Perhaps we can do this again in a year or so to see how things are panning out?
JL: It would be my pleasure. Perhaps you will even eventually win our bet that Greece withdraws from the euro-area.
JB: Well as you recall that bet expires on 31 December. It appears I will need to treat you to dinner in the New Year.
JL: Ah yes. Well as you strategists sometimes say, all views are potentially correct; the timing, however, is always uncertain.
JB: Indeed. Well Happy Holidays!
JL: To you too John.
POST-SCRIPT: FROM RISK TO UNCERTAINTY
My many conversations with John, including those recent ones merged into the transcript above, were an important input into my 2012 Amphora Reports. While the primary purpose of these reports is to interpret contemporary economic and financial market developments through the lens of Austrian economics (and occasional, plain common sense), it is essential to continuously check assumptions, however strongly held. As I’m certain is clear from the conversation(s) above, John has provided an invaluable source of such checking.
This is not to say that we agree on most things. Far from it. For example, as alluded to briefly in closing, I am of the opinion that the euro-area cannot survive in its current form. John believes that it is indeed salvageable, although he does doubt the willingness of policymakers to do what is necessary.
This brings us, I believe, to the crux of the risks the lie ahead. Policymaker activism continues to escalate across economies. This is not going to change in the near-term, nor absent another crisis that clearly and plainly discredits economic central planning generally, be it in fiscal or monetary matters. As has increasingly been the case in recent years, future risks are going to originate primarily from policy decisions. They will, in other words, be qualitative rather than quantitative in nature.
This article was previously published in The Amphora Report, Vol 3, 09 January 2013.
In the spirit of the holidays and hope for a more prosperous 2013, I thought my readers might appreciate a little humour to partially offset the relentless doom and gloom associated with the Amphora Report. So please, don’t take this edition too seriously. But if you happen to stumble across a ‘paperbug’ or two over the holidays, perhaps you could share some of the points made here. Humour sometimes helps people realise just how hopelessly misguided they are. Cheers!
NUMBER 10: THERE IS NOT ENOUGH GOLD (or silver) IN THE WORLD TO SERVE AS MONEY
Let’s begin with the obvious. We know that central banks the world over have printed money at exponentially growing rates for years. There is now so much paper and electronic money floating around the world that gold (or silver) can not possibly be expected to keep up. You can’t print gold, after all, you need to find it, dig it out of the ground, refine it, etc, a hugely expensive and time-consuming process which practically ensures a stable rather than exponentially growing supply of the stuff.
Of course, we know that an exponentially growing supply of money is a good thing. How else can an economy hope to grow, especially one bearing an exponentially rising debt burden! We need all that new money to pay all that new interest, don’t we? And don’t forget, most things keep getting more expensive, like food and fuel. Don’t we need more money to pay for all that too? What about government entitlements that keep growing in size? If we didn’t have a constant flow of new money, how on earth would we pay for all of that? It is essential that we keep the printing presses rolling.
NUMBER 9: GOLD AND SILVER ARE OLD-FASHIONED, CUMBERSOME MONEY
Here’s another obvious one for you: Gold is HEAVY! Who wants to carry gold coins around? They might be nice and shiny, but to me, gold looks even prettier around a lady’s neck or wrist.
The more you think about it, in an age of electronic, plastic or internet money, the whole concept of coinage begins to seem a bit anachronistic. Who even uses small denomination coins anymore, except as household poker betting tokens? I suppose larger coins are still of some use, but let’s face it folks, even those are almost worthless anymore. Coinage is just so passé.
Sure, coins used to have some value. When I was young and I watched Little House on the Prairie and The Waltons I was amazed that at the general stores or other retail establishments a penny actually bought a range of items and with a few nickels and dimes you could purchase much of what was on offer!
But why bother with coins today? I use plastic or electronic money for almost everything. Sure, that money still references dollars, or euros, or sterling, or yen balances of a bank account. But hey, it would be just so barbaric to reference a gold or silver account instead, wouldn’t it? As if banks even hold enough cash on hand for large withdrawals anymore, much less gold or silver. Oh and an ounce of gold, at a whopping $1,700 is just way too expensive for most commerce. So not only is there not enough gold in the world as per Number 10 above; what gold there is, is too expensive to serve as a useful money! Oh I suppose we could use fractions of ounces of gold instead of full ounces, but most people struggle with fractions, including me. Silver might be more useful, but at over $30/oz, it wouldn’t really work for making change now, would it?
NUMBER 8: GOLD RESTRAINS GROWTH
OK, this reason is a little bit wonkish, but if you’ll bear with me I’ll explain why gold-backed money would put the brakes on the healthy growth the world has been experiencing all through this prosperous modern period of an exponentially rising money supply and might even send us back to the poor house. We already touched on this with Number 10 but let’s go off on a tangent here. You see, back when gold was money, people were poorer. Way poorer. And economic growth was often much weaker.
I mean, before the industrial revolution, we didn’t even have machines to do basic work like farming, so people had to have loads of children just to get basic work done, resulting in a cycle of poverty. Sure, a handful of landed aristocrats held most of the wealth, and they did just fine, but really, do we want to go back to that sort of wealth disparity?
Oh and as for the industrial revolution, it was such a fluke. Sure it led to the most rapid economic growth in history in most of Europe, North America and Japan, but it would probably have been way more rapid had money growth been exponential instead of stable at the time. That said, inflation didn’t actually work out so well in France, where exponential money growth destroyed much of the economy in the late 18th and early 19th centuries. But hey, how else to finance that Revolution of theirs?
The American Revolution was also hugely inflationary, you know, those worthless continentals and all. But wasn’t it a huge overreaction for the US federal government to choose silver coinage as the inaugural US federal money? For that matter, had Napoleon just kept on inflating, rather than paying his soldiers in silver coin, he might have won the wars against those Brits and others who refused to inflate their currencies. And why did the Americans experiment with gold- and silver-backed money for so long? Imagine how much faster they would have industrialised had they just kept on printing continentals instead! Ah well, hindsight is 20:20.
Perhaps technology wouldn’t exactly regress if we went back to gold- or silver-backed money but you never know. Some people talk like that. And certainly most of the innovations of modern times would never have taken place had we been on gold-backed money. Think about all those green technologies that promise to solve our energy problems someday. Things were just fine before we started consuming all the carbon stuff and now we’ve got to get back on track. Only exponentially growing money can fund these programmes that aren’t yet profitable. Imagine what would happen if money were backed by gold? We would be dependent on energy and other technologies that actually made fundamental economic sense. No, that would be a huge mistake.
NUMBER 7: THE GOLD STANDARD CAUSED THE GREAT DEPRESSION
This is related to the above but hugely important in its own right so I’m treating it as a separate critique of gold- or silver-backed money.
Milton Friedman is famous in part for blaming the Federal Reserve for causing the Great Depression. This runs contrary to what many believe, however, that the gold standard itself caused the Depression. Of course, they are right. Let me show you why by way of a little historical background.
We all know that WWI was hugely inflationary as Britain, Germany and other belligerents went off the gold standard in order to finance the war by printing money. Following years of printing, in Europe prices for just about everything skyrocketed. It didn’t help, of course, that much industrial capacity was destroyed by the war, limiting supply. In Russia, most of the capital stock was seized by the government as part of their anti-capitalist revolution. So there was loads more money chasing far fewer goods in Europe, which is one way Milton Friedman and other so-called ‘monetarists’ like to explain inflation.
In some places like Weimar Germany, interwar Austria and Hungary, there was outright hyperinflation and currency collapse in the 1920s. Impoverished, these countries ended up with highly competitive labour costs, similar to various poor emerging markets today. Britain, however, had gone back on the gold standard in 1925 and thus had the strongest currency in Europe. This made British labour highly uncompetitive, resulting in persistently high unemployment and massive strikes, some turning violent.
In 1927, the Bank of England kindly requested that the US Federal Reserve stimulate demand for UK exports by expanding the US money supply. The Fed obliged. This contributed to a huge stock market bubble in the US, but unfortunately it crashed under its own weight in 1929. Meanwhile, Britain’s economy remained mired in a depression unknown to most Americans today.
Finally, in 1931, Britain decided to devalue its currency. The US was already slipping into depression at the time and suddenly found it had by far the least competitive wages in the world. It was now in a situation comparable to Britain in 1927, yet without another country to which it could turn for help.
The Federal Reserve had already accumulated a huge amount of gold from Britain but, as Milton Friedman observed, didn’t do as it was supposed to do and expand the domestic money supply in line with the swelling gold reserves. Why? No one knows. Perhaps the Fed was spooked by the stock market boom and bust that it had created in 1927-29 and didn’t want to risk a repeat. But whereas the 1927 monetary expansion was not linked to an inflow of gold reserves, in 1930-31 the Fed could have hugely expanded the money supply in line with growing gold reserves, thereby preventing many bank failures.
To make matters worse, President Hoover was advised by some prominent, proto-Keynesian economists of the day that a drop in aggregate demand had to be avoided at all costs and that the best way to accomplish this was to support wages, notwithstanding rising unemployment. As a result, US wages were by far the highest in the world by 1931, labour was uncompetitive, and unemployment was thus far higher than it would otherwise have been, had Hoover left things alone.
So, it is blindingly obvious that the gold standard was the cause of the Great Depression. Not WWI. Not the massive inflation to pay for WWI. Not the widespread destruction of European industry. Not the Russian Revolution and industrial collapse. Not the 1920s hyperinflations and revolutions in central Europe. Not the Fed’s stock market bubble of 1927-29. Not the Fed’s failure to allow the money supply to expand naturally with gold reserves in 1930-31. Not the artificial wage supports introduced by President Hoover and continued by FDR. No, the gold standard caused the Great Depression. Really. It did.
NUMBER 6: RULES CAN BE BROKEN
Returning to the obvious, this reason is so simple a child can understand it. Rules are nice on paper but we all know they can be broken. Just because a country is on a gold standard doesn’t mean it can’t just devalue and leave. Britain and Germany did so in 1914 and inflated like crazy to pay for WWI as explained above. The US devalued the dollar some 60% versus gold in 1934 and left the gold standard entirely in 1971.
Let’s face it, if rules can be broken, what’s the point having them in the first place? The claim that gold-backed money is stable and prevents runaway inflation is just hogwash. Whenever governments choose, they can ditch gold-backed money, devalue and create as much inflation as they desire. They can even hyperinflate if they like. What’s to stop them? They set the rules. Gold advocates are just so naïve!
NUMBER 5: GOLD-BACKED MONEY FAVOURS THE US VERSUS THE REST OF THE WORLD
Now for those of us residing outside the USofA, we’re sometimes concerned that the US has the largest gold reserves in the world. If the world went back on a gold standard, then the US would be even more powerful than it already is. It would throw its weight around even more, use that gold to pay for an even larger military and open up more bases abroad, including where they aren’t even wanted, like in Bulgaria. The US might even start more wars, as if it hasn’t started enough already, finananced as they are with the Fed’s printing press.
Now history does suggest that war and inflation go hand in hand. Certainly this was the case in the 20th century. The French Revolution and Napoleonic Wars were hugely inflationary in continental Europe. The 30 years’ war was hugely inflationary too, ruining the previously prosperous Habsburg economies. Then there was the American Revolution, financed with those paper continentals. But today things are different. Really, they are. If the world were on a gold standard, there would be more wars, notwithstanding that these would be far more difficult to finance.
On another note, the US economy imports far more than it exports. Wonks call this a ‘trade-deficit’. Really wonkish types have a more expanded term called a ‘current-account deficit’. If the world went back onto a gold standard, then the US would need to use its gold reserves to pay for net imports, instead of just printing more dollars. And at current gold prices, the US would not even be able to cover one year of its current-account deficit!
Imagine, the US would be unable to keep importing more than it exported! It would be forced to become a more competitive economy and it would need to save and produce more and consume less! The horror! We all know that the US consumer is the only thing keeping the global economy afloat. To whom would China or others export if not to the US consumer? What a ridiculous idea!
Well, it’s just not going to happen. Keynesians like Paul Krugman know that there is just no other way to grow economies than with exponential money growth to finance consumption. Saving is the quick road to the poor house. Borrowing your way to prosperity has worked so well in the past, why would anyone possibly want to stop now? After all, savings is the four-letter word of Keynesian economics. Let’s just not go there.
NUMBER 4: GOLD FAVOURS GOLD-MINING COUNTRIES OVER OTHERS
Here’s another simple one: If you go back to gold- or silver-backed money, you are providing a huge subsidy for those countries producing the money. Why give them the printing press, when we can keep it for ourselves? Remember, the power to print exponentially rising amounts of fiat currency is the key to ecomomic prosperity. We don’t want countries rich in natural resources to benefit at our expense now, do we?
Sure, many countries rich in gold are in Africa or other underdeveloped regions. They’re poor. They’re backward. Some are near-dictatorships. Many dictators depend on us and our foreign aid, financed as it is with our printing presses. Why, if we could no longer print that foreign aid into existence, these poor countries would have to help themselves instead! No, they’re just too backward for that.
Imagine that the value of gold and silver mines in Africa and other poor parts of the world soared as these metals were re-monetised. Why it would be like what happened to the Persian Gulf countries when oil became a highly valuable commodity back in the 1970s. They became rich! Today those economies are among the wealthiest in the world. They mostly export far more than they import and they have built up huge sovereign wealth funds for the future.
But Africa being as screwed up as it is, they can’t be expected to spend their wealth responsibly. They need the US, UK and other countries to show them how to do it. Like what gas-guzzlers to buy. Or how many flat-screen TVs per McMansion to have. Or how to administer a post office, or a national railway system, or quality state education. No, rebalancing global wealth toward Africa and other poor regions is bad enough. Giving them control over their own wealth is just plain irresponsible. We shouldn’t do it and so we shouldn’t return to gold-backed money. (Please don’t think I’m racist BTW, I promise you I have at least one black friend. Or I did once. Really. I’m sure the same is true of all those politicians and bureaucrats who believe that, without foreign aid, many African countries would end up like Argentina. Or Greece even.)
NUMBER 3: GOLD FAVOURS THE RICH
Notwithstanding the observation above, that gold- and silver-backed money would bestow greater wealth on countries rich in those particular natural resources, the fact is, today most gold and silver privately held is in the hands of the wealthy. They’re already rich, why should we make them even more so? Wealth inequality is a serious problem, why make it worse?
We all know that exponential fiat money growth in recent decades has helped to prevent even greater wealth disparity. Sure, in the US, the wealth of the top 1% has risen exponentially relative to the middle-class since the 1970s, when the US went off the gold standard and the age of exponential money growth began, but that is mere coincidence.
It is true that real wages grew quickly under the gold standard, which created the largest middle-class in history, but even then there were those nasty Robber Barons who became far richer than they deserved. Some of them were enlightened enough to realise this, like Andrew Carnegie, who gave away most of his fortune. Economic progress is OK as long as people don’t get too rich from it. So let’s keep creating wealth by printing money but make certain that those that get too rich give it away. Or else.
We shouldn’t be too concerned that the banks and owners of capital are the primary beneficiaries of money expansion, as they have first access to the new money. After all, we want our undercapitalised banks to start lending again so we can continue on our borrowing and consumption binge. How else are the banks going to lend us money if we don’t create it in the first place? Sure we have to pay them interest on it, but rates are low so we shouldn’t care.
Yes, inflation is historically associated with wealth disparity and sound money is associated with a growing middle class. But that was before we came up with the modern welfare state that automatically transfers money from the wealthy to the poor, that is, unless the wealthy find ways around the tax code by creating trusts and endowments, purchasing tax-exempt securities or acquiring assets that tend to rise in price with inflation. But they don’t really want to avoid tax, do they?
Warren Buffett, for one, says he wants to pay more tax. Of course he is allowed to do that, as the IRS has a special facility for those who wish to pay more than their mandated share. Sometimes I wonder why he doesn’t. He could dump his tax-exempt munis and hold taxable bonds, for example. Or he could pay out dividends, taxed as ordinary income, rather than purchasing outstanding shares through buy-backs. Or he could live in a state with high taxes, rather than in low-tax Nebraska. Given the complexity of the tax codes in most developed countries, I suspect there are thousands of ways that Warren or other rich people could pay more tax if they wished. Maybe actions speak louder than words.
Of course middle-class families don’t have access to fancy tax planning, as it tends to be rather expensive. Really fancy tax planning requires writing new items into the tax code, something that tax lobbyists do full-time on behalf of the wealthy. No, middle-class folks just have to pay up to compensate for all those loopholes that most never hear about until the government decides that they are no longer politically expedient. In practice, this means that the welfare state is primarily a redistribution from the middle-class to the poor. But no, I don’t think this is the reason for the shinking middle class. I think it is because, notwithstanding clearly herioic attempts, we are still not printing enough money.
NUMBER 2: PHDS KNOW WHAT’S GOOD FOR US
Back to the obvious, we all know that someone with a PhD is smarter than we are. They’ve got the degree to prove it. Some PhDs even have degrees in economics, which is unbelievably complicated. How else could one understand how exponential money growth creates wealth? How you can borrow your way to prosperity and save your way into the poor house? How importing more than you export is sustainable? How coercive central planning is superior to voluntary, free-market exchange?
Let’s face it, we may all be equal, but PhDs are more equal than others. If we didn’t have them telling us what the price of money should be—or the rate of interest if you prefer—we would just lurch from one economic calamity to the next. The Great Depression would seem a cake walk by comparison, as would our current economic malaise, which they say isn’t a depression, even if it feels like it to most.
If you need more proof, just look at those fancy buildings that central bankers work in. They’re impressive. So are the headquarters of the big private banks. These guys are obviously successful and important, so there is no good reason why they shouldn’t be telling us what to do. They even have a name for what they tell us to do: Free-Market Capitalism. I’m not entirely sure what the ‘Free’ part of that means, as most things aren’t free, except of course those provided by the government.
The problem with gold- or silver-backed money, you see, is that the PhDs would no longer have the ability to manipulate money for our benefit. And since they know precisely what the supply of money should be, we shouldn’t be concerned that they might create too much of it, or too little for that matter. The exponential amounts they’ve been creating since 2007 are ‘just right’, as Goldilocks might say.
Also, PhDs have all sorts of fancy statistics that only they understand. This is because they create them in the first place. PhDs are smart enough to do that, you see. So when they tell you that consumer price inflation is 2.43%, they don’t mean 2.42%. Or 2.44%. No, they mean 2.43%. This precision is important as it determines how many billions of new money they need to give to the banks to ensure price stability and full employment. If they’re having trouble doing that, however, it’s not their fault. They’re PhDs.
Speaking of ‘price stability’, since when is 2.43% growth in prices ‘stability’? Wouldn’t that be 0.00%? They designed the statistics, so why on earth did they choose to set ‘stability’ at 2.43%? I suppose I would need a PhD to understand that.
NUMBER 1: IF GIVEN A CHOICE, WE WOULD ALL PREFER FIAT OVER GOLD-BACKED MONEY
As I’m not a PhD, I’m not qualified to go around telling people what to do. Sure, I make suggestions from time to time, because I have a Master’s degree. I even make strong recommendations on rare occasion, because I have an honours degree. (If I only had an undergraduate degree, I wouldn’t even make suggestions. Without any degree, I suppose I wouldn’t open my mouth.)
One suggestion I wouldn’t make, however, is that people be allowed to choose the money they use. I mean, what would be the point of that? We might all choose to use a different money, no one would accept these monies from each other, and so we would never engage in commerce except through direct barter. We all know how inefficient barter is. It is why money was created in the first place. And who created money? Well seeing how they control it, I suppose it must have been PhDs. There were no doubt PhDs in ancient Lydia, where coinage originated, no?
The Lydian PhDs may have had the original idea but it was the Greek PhDs who supplied most of the coinage for the Hellenistic world. They knew just how much to mint. Even non-Greeks used the Greek coinage, because they liked it.
(Here’s a puzzle: Were the myriad non-Greeks who chose to use Greek coinage also PhDs? If they were so clever, why didn’t they mint their own coins instead? Are some PhDs cleverer than others? I’ll have to revisit this at some point when I haven’t been drinking wine.)
Then there were the Romans. Now these guys were clever. So clever that they built a huge empire, with lots of impressive buildings, roads and aqueducts. They were so clever they even discovered how to manipulate money through debasement. This really got going in the 3rd century, which happens to correspond with their decline. But that’s just coincidence.
My more educated readers might know that the Roman Empire eventually split in two and that while currency debasement continued in the Western Empire, which all but collapsed entirely by the 5th century, the Eastern Empire maintained sound coinage and lasted until the Turkish siege of Byzantium in 1453, roughly a thousand years later. But that’s just coincidence too. Empires that debase money tend to last longer. Really.
Anyway, back to this topic about choice in money. We really don’t need it. We also don’t want it. If we did, we wouldn’t have legal tender laws that prevent choice in money in the first place, would we? After all, is choice a good thing? I try to do some shopping for my family once a week. My wife makes out a helpful shopping list with various staple items like ‘butter’. Then I go to the market and find my way to the butter section and suddenly I’m facing a wall of butter. It’s unbelievable. There’s salted and unsalted; Irish, British or Continental. There’s varying sizes, shapes, qualities, type of cow involved, oh my. And all my wife wrote was ‘butter’. So now I’ve got to get on the phone, I’ve got to ask her to be more specific, and so I call her and she’s changing the baby’s nappy, and she can’t talk, and she’s tired and can’t believe that this is the umpteenth time I’ve gone to do the shopping and yet I always call asking for some clarification, be it for ‘butter’ or ‘detergent’ or ‘kitchen roll’ or God knows what. Look, I’m not a PhD and my wife knows it. So why does she expect me to be able to read her mind?
Anyway, I’m sure I’ve made the point clear that choice is a bad thing. It is just a source of confusion. So in the same way that my wife should just tell me what to purchase (as long as she is specific BTW) the government should tell us what money to use.
But just for the sake of argument, let’s entertain the fantastical notion that legal tender laws were repealed and we could use whatever we desired as money. Nothing would change. I mean, come on, we would just go on using dollars, or euros, or pounds, or yen, or whatever. Who in their right mind would actually bother to evaluate the relative merits of all of these different currencies, or of gold and silver as alternatives? Are some better stores of value than others? Perhaps. But I tell you, for most of us it would be just like looking at that intimidating ‘butter wall’ in the supermarket. We would take one look at it, shudder, and walk away.
Quantitative easing changes nothing. Remember, the PhDs are in charge of our economies and they know exactly how much our money should be worth. Those of us concerned that our money might lose purchasing power are just being paranoid. Choice is dangerous. Think Adam and Eve and you’ll get my point. Those arguing in favour of monetary freedom, of choice in money, of repealing legal tender laws, they’re just like that nasty snake Lillith in the Garden of Eden, the source of all trouble I tell you.
So there you have it. Nowhere would choice be so harmful to commerce as with money itself. Even if legal-tender laws were repealed no doubt we would all continue to prefer using the stuff we already are. So for all you gold bugs out there, go ahead and purchase some jewelry for your loved ones as holiday gifts. But please, drop all the nonsense about using it as money. Imagine you gave your spouse, or your children, or your relatives, gold and silver coins instead. They wouldn’t be able to use them as legal tender; they wouldn’t be able to wear them as jewelry. Their only ‘use’ would be as that four-letter word for Keynesians: Saving: What a way to show a lack of holiday spirit. ‘Tis the season to borrow and spend folks, as indeed it has been since 1971.
HAPPY HOLIDAYS TO ALL READERS OF THE AMPHORA REPORT!
Is reserve currency status an economic blessing or a curse? The answer might seem obvious, as reserve currencies have been shown to confer lower borrowing costs on their issuers. But what of the borrower who, enticed by low interest rates, borrows more than they can pay back? Naturally the result will be a default. However, for the issuer of a reserve currency that is unbacked by a marketable commodity, such as gold, in the event that they borrow too much, they can just print more currency. While this avoids default indefinitely, it also hollows out the economy, erodes the capital stock, reduces the potential growth rate and, eventually, leads to a dramatic devaluation of the currency and loss of reserve status. History has not been kind to countries that have followed this path. In my view, the grave investment risks associated with the US dollar’s inevitable and potentially imminent loss of reserve status are not priced into financial markets.
RESERVE CURRENCIES, TRADE IMBALANCES AND THE ‘TRIFFIN DILEMMA’
Having written a book about international monetary regime change past, present and future, I weigh in again in this Amphora Report on what is gradually becoming a more mainstream debate about whether or not the US dollar is at risk of losing reserve currency status; what currencies might replace it; and, should it happen, what general economic and financial market implications this would likely have.
As it happens, I have a rather strong opinion on all of these matters. But first, let’s consider what a reserve currency is and what it is not. Second, let’s distinguish carefully between reserve currencies that are backed by a marketable commodity, such as gold or silver, and those that are not. Third, let’s take a look at shifting global economic power and monetary arrangements. Then we can move into what I think is going to happen in future, what this implies for financial and commodities markets, and what investors can and should do to prepare.
What, exactly, is a reserve currency? It is an international money that is used to pay for imports from abroad and is then subsequently held in ‘reserve’ by the exporting country, as it does not have legal tender status outside of its country of issuance. In the simple case of two countries trading with one another, with one being a net importer and one a net exporter, over time these currency ‘reserves’ will accumulate in the net-exporting country. In practice, as reserves accumulate, they are invested in some way, for example, in bonds issued by the importing country. In this way the currency reserves earn some interest, rather than sit as paper scrip in a vault.
Beyond a certain point, however, accumulated reserves will be perceived as ‘excessive’ by some in the exporting country, in that they would prefer to purchase something with this accumulated savings instead. In this case they have a choice: either they can purchase more imports from the net-importing country, thereby narrowing the trade imbalance, or they can exchange their reserves with another entity at some foreign-exchange rate. For this reason, other factors equal, as reserves accumulate, the reserve currency will depreciate in value.
As trade imbalances and reserve balances grow, so does the natural downward pressure on the value of the reserve currency as described above. This leads to what Belgian economist Robert Triffin called a ‘dilemma’: for unbalanced trade to continue to expand, the supply of reserves must increase. Yet this implies a chronically weak reserve currency, which leads to price inflation. Indeed, under the Bretton Woods system of fixed exchange rates, the supply of dollar reserves grew and grew, price inflation increased and, eventually, as one European central bank after another sought to exchange its ‘excess’ dollar balances for gold, this led to a run on the official US gold stock and the demise of that particular monetary regime.
While hailed as an important insight at the time, Triffin was pointing out something rather intuitive: Printing a reserve currency to pay for net imports is akin to owning an international ‘printing press’, the use (or abuse) of which causes net global monetary inflation and, by association, some degree of eventual, realised price inflation.
‘CANTILLON EFFECTS’ AND THE NON-NEUTRALITY OF INTERNATIONAL RESERVES
Now let’s combine Triffin’s insight with that of Richard Cantillon, a pre-classical 18th century economist, that money is not ‘neutral’: new money enters the economy by being spent. But the first to spend it does so BEFORE it begins to lose purchasing power as it expands the existing money supply. The money then gradually permeates the entire economy, driving up the overall price level. Those last in line for the new money, primarily everyday savers and consumers, eventually find that, by being last in line for the new money, their accumulated savings are being de facto ‘diluted’ and the purchasing power of their wages diminished.
Extropolated to the global level, this non-neutrality of money implies that an issuer of a reserve currency is the primary beneficiary of the ‘Cantillon effect’. First in line for the new international money you have the owners of capital in the reserve issuing countries, who use the new money to accumulate more global assets, and at the end you have workers the world over who receive the new money last, after it has placed general upward pressure on prices. Greater global wealth disparity is the inevitable result.
Another way to think about the benefits of issuing the reserve currency is that it generates global seignorage income. Federal Reserve notes pay no interest. However, they can be used to purchase assets that DO bear interest. No wonder the Fed always turns a profit: it issues dollars at zero interest and collects seignorage income on the assets it accumulates in return. But in a globalised economy, with the US a large net importer and issuer of the dominant reserve currency, this seignorage income is partially if indirectly sourced from abroad, via the external accounts.
This becomes particularly notable in the event that domestic credit growth is weak relative to abroad. The Fed may print and print to stimulate domestic credit growth but if that printing does not get traction at home, it will instead stimulate credit growth abroad and, eventually, contribute to higher asset and consumer price inflation around the world.
Over time, this will impact the relative competitiveness of other economies, where nominal wage growth is likely to accelerate, eventually making US labour relatively more competitive. That may sound like good news, but all that is really happening here is that US wages end up converging on those elsewhere, something that should happen in any case, over time, between trading partners as their economies become more highly integrated. But to the extent that this wage convergence process is driven by reserve currency inflation, rather than natural, non-inflationary economic integration, the Cantillon effects discussed earlier result in wages converging downward rather than upward, implying a global wealth transfer from ‘owners’ of labour—workers—to owners of capital.
So-called anti-globalists disparaging of free trade are thus not necessarily barking mad—well, perhaps some are—but they are barking up the wrong tree. The problem is not free trade; the problem is trade distorted by monetary inflation. If you want workers around the world to get fairer compensation for their labour, shut down the reserve currency printing press. And if you also want them to have access to the largest possible range of consumer goods at the lowest possible cost, remove trade restrictions, don’t raise them.
RESERVE CURRENCIES: GOLD-BACKED, AND UNBACKED
Prior to the First World War, the bulk of the world was on the classical gold standard. Although the British pound sterling was the dominant reserve currency, it was not possible to print an endless amount of pounds to pay for endless imports, as external reserve currency balances were regularly settled in gold. The British pound thus held its value over time, as did other currencies on the gold standard, and there was not a ‘Triffin Dilemma’ resulting in growing, unsustainable trade imbalances. Moreover, absent monetary inflation, there were no insidious Cantillon effects taking place. Industrial wages were generally stable through these decades, which were characterised by mild consumer price deflation. This implied an increase in workers’ purchasing power and standards of living. So while there are certain similarities between sterling’s previous, gold-backed role as a reserve currency and that of the unbacked, fiat dollar today, there are even greater differences.
(For those curious how such a stable international economic order could break down so completely in such a short period of time, please turn to the extensive literature on the causes and consequences of WWI, arguably the greatest tragedy ever to befall western civilisation.)
Returning to the present, countries that have been exporting to the US and accumulating dollars in return are increasingly getting the joke, but they aren’t laughing. Hardly a week goes by without some senior official in an up-and-coming country rich in natural resources or with competitive labour costs criticising US monetary policy while suggesting that gold should play a greater role in international monetary affairs. The BRICS (Brazil, Russia, India, China, now joined by South Africa), individually and together, have already made numerous official, public statements to this effect. One can only imagine what is being discussed in private, behind closed doors.
Recently, quite similar monetary concerns were expressed openly by Turkey, historically a ‘swing-state’ in its global orientation, yet currently a member of NATO and thus at least a nominal US ally. Prime Minister Erdoan, who is far more popular with the electorate in his country than most western leaders are in theirs, had this to say recently, in criticism of the International Monetary Fund (IMF):
The IMF extends aid on a who, where, how and on what conditions basis. For example, if the IMF is under the influence of any single currency then what, are they going rule the world based on the exchange rates of that particular currency?
Why do we not switch then to a monetary unit such as gold, which is at the very least an international constant and indicator which has maintained its honor throughout history. This is something to think about.
Historians will note that once upon a time, France was a full member of NATO, but following President De Gaulle’s decision to challenge the dollar-centric Bretton Woods system in the mid-1960s, there erupted a series of dollar crises that culminated in the collapse of the Bretton Woods regime in the early 1970s. Is history about to repeat?
(Incidentally, history has already nearly repeated once before, in 1979-80. While the mainstream historical economic narrative about this period is that the Fed resorted to punitively high interest rates to fight the high rate of domestic price inflation, one look at the behaviour of the dollar in 1979-80 tells a different story, that the air of crisis at the time had an important international dimension. FOMC meeting transcripts also reinforce this arguably ‘revisionist’ view that the dollar’s reserve status was at risk.)
Clearly there is growing dissatisfaction with the current set of global monetary arrangements, which allow the US to print the global reserve currency to pay for imports, an ‘exorbitant privilege’ as it was termed by another French president, Valery Giscard d’Estaing. Under the Bretton Woods system, France, or any participating country for that matter, could choose to exchange its accumulated dollars for gold. As predicted well in advance by French economist Jacques Rueff, a contemporary of Robert Triffin, the eventual exercise of this choice to exchange dollars for gold by not only France but a handful of other countries led to a run on the US gold stock in 1971 and an end to the dollar’s gold convertibility.
THE RESERVE CURRENCY CURSE IN DISGUISE
Let’s now turn to the question posed at the beginning of this report. Is reserve currency status a blessing, or a curse? The answer may seem obvious. After all, isn’t it nice to hold the power of the global printing press? To enjoy relatively low borrowing costs? To possess the ‘exorbitant privilege’, as it were? On the surface yes, but what lies beneath?
As Lord Acton is purported to have said, power tends to corrupt. By corollary, absolute power corrupts absolutely. And to the extent that an economic power that is held nationally is exercised internationally, then the corruption thereof has a deleterious international economic impact.
In the case of an unbacked reserve currency, the ‘benefits’ of lower borrowing costs accruing to the issuing country appear to result in overborrowing and overconsumption relative to the rest of the world, eroding the domestic manufacturing base over time and widening the rich-poor gap to levels that are socially destabilising. Trade wars, currency wars or other forms of economic conflict are the inevitable result. In some cases, actual wars follow. In others, they don’t. But in all cases, the reserve currency curse is recognised only too late, when an economy begins consuming its own capital in a desperate and counterproductive attempt to maintain its previous standard of living. Austrian economist Ludwig von Mises described capital consumption as akin to “burning the furniture to heat the home.” Sure, it might work for a time, but what comes next? The floorboards? The walls? The roof?
For those who think that a capitalist, free-market economy would never consume its own capital, outside of wartime, you may be right. But what of an economy that merely pretends to be capitalist and free market, but in fact sets the price of money by decree at an artificially low level so that there is little incentive to save? Well, take a look, this is what happens: Negative net investment!
US DOMESTIC INVESTMENT, NET OF DEPRECIATION, % OF GDP
It is highly intuitive to reason that, if an authority mandates a price ceiling below the natural, market-determined price for a given product, less of it will be produced and a shortage will result. Well here you see the empirical evidence: holding the ‘price’ of credit —the interest rate — artificially low over a sustained period of time leads to a shortage of savings, capital consumption and, therefore, a lower standard of living.
Notwithstanding basic economic common sense and clear evidence as presented above, the US Fed may still honestly believe that its neo-Keynesian models are right. Alternatively, like Galileo’s clerical inquisitors, it may be simply unwilling to admit that the models, or the entire theory, are wrong. The International Monetary Fund, for what it is worth, has already determined that its models are flawed, although they also admit they have little idea what to do about it other than to shoot in the dark, something that is not exactly reassuring.
THE TURKEY IN THE GOLD MINE
Today, as the dollar is not convertible into gold, there could not be a run on the official US gold stock. But there is no reason why central banks around the world can not diversify out of dollars and into gold, something that would have much the same result: the dollar would decline versus gold and real assets generally, US imports would become more expensive and economic growth would be highly ‘stagflationary’, just as was the case during the 1970s, in the aftermath of a substantial dollar devaluation.
As it happens, these developments are already underway. According to recent reports, many central banks are accumulating gold, including Russia, China, Brazil, India, Bangladesh, Mexico, South Korea, Kazakhstan, Turkey and Indonesia. While central banks must report their gold reserves to the IMF, the sovereign wealth funds of these countries are under no such obligation and, as sovereign wealth funds occasionally operate in effective if unofficial collaboration with their respective central banks, it is highly likely in my opinion that there is much more official gold accumulation taking place than is officially reported.
As they are not free-market, profit-maximising entities in the same sense as independent private investors, these official gold buyers are not as price sensitive. If they are instructed by their political leadership to diversify their reserves out of dollars in some amount, or at some regular rate, they are going to carry out that mandate, regardless of the price, until that policy changes. This is strategic, not tactical gold buying, as it were.
This is just one of many reasons why the gold price is going up. The most fundamental is simply that the values of currencies such as the dollar are going down as a result of endless quantitative easing (QE) or other forms of monetary expansion. That the agents swapping their dollars for gold happen in some cases to be price-insensitive official institutions is just one mechanism by which a global shift out of paper into hard assets is taking place.
I don’t pretend to know exactly what is going to happen from one day to the next. But when you step back and see the larger picture of one country after another expressing disapproval with the dollar reserve standard, you can’t help but notice that the game is changing. Central bank or other official forms of gold buying is but one aspect. Another is the growing official collaboration on monetary and other economic matters by the BRICS. Then there are the various bilateral currency arrangements between an increasing number of countries that allow them to reduce dependence on the dollar for bilateral trade.
At first glance, Turkey’s recent admission that it is paying for imports of Iranian natural gas with gold in order to avoid US sanctions may seem a small, insignificant development by comparison but within the larger context it could have a disproportionate impact. Indeed, Turkey may be only one of several countries monetising gold for use in importing Iranian gas or other goods. As a canary signals danger in a coal mine, might Turkey be signalling something rather more significant for international monetary relations?
Quite possibly. Game theory is highly instructive as to how international policy regimes, once destabilised by changing conditions or incentives, can suddenly shift to, or collapse into, a new equilibrium, sometimes in response to seemingly insignificant developments. When countries that comprise in aggregate about 1/3 of all global trade flows express dissatisfaction with the dollar and the IMF, the current international monetary regime is clearly unstable. When a medium-sized player such as Turkey moves from one side of the game board to the middle, or to the other side, there is always a chance that this represents the proverbial ‘tipping point’ from one equilibrium to another. In this case, if history is a guide, then as the world moves away from the current, dollar-centric reserve standard system it will move to one based on mulitiple currencies, yet with some degree of explicit gold backing for major currencies.
Why gold? Part I of my book, The Golden Revolution (available here), concludes with a discussion about why gold has by far the strongest claim to use as the future international monetary reserve replacement for the dollar. While historical precedent is important, there are also two important theoretical points to consider. First, there is no existing fiat currency alternative to the dollar at present, in the way that the US dollar provided an obvious alternative to the pound sterling following WWI. Second, given the increasingly obvious breakdown in cooperation in international monetary relations, it is highly unlikely that, as the dollar’s role diminishes, there could be a universal agreement about how to construct or implement a global currency alternative to the dollar. Yes, the IMF has proposed precisely this and (no surprise here) has put itself forward as the bureaucracy that could manage it, but as discussed above, Turkey, the BRICS and a handful of other nations don’t trust the IMF to act in their national interest. They apparently do trust in gold.
As a medium of exchange that cannot be printed or otherwise manipulated by any one country to somehow exploit another, gold holds more than just a historical claim to a future role as international money. It provides a basis for mutually-beneficial international trade when trust in monetary stability is lacking. The answer to the question of what currency or currencies can provide the future international reserve is thus as paradoxical as it is elegant: every currency, if linked to gold, and none, as gold itself provides the trust.
RECENT DEVELOPMENTS IN FINANCIAL AND COMMODITIES MARKETS
At time of writing, global equity markets have corrected modestly lower from the lofty valuations seen in early October. A series of corporate earnings disappointments and profit warnings was initially ignored but finally became so widespread across countries and industries that the selling pressure intensified sufficiently to reverse the big bull market that took place over the summer, in anticipation of yet another round of global monetary stimulus that arrived in September.
I expressed my concern with equity valuations back in October so I’m not exactly surprised by this development. However, I am hardly omniscient and for all I know equity markets will begin to move right back up again for reasons that may have nothing to do with earnings, or profit expectations, or anything else that, in a normal world at least, would be expected to determine prices.
I have written variations on this theme many times but it seems entirely appropriate to revisit it again here: we do not live in a world in which financial asset prices are driven by sensible value judgements but rather speculation enabled and encouraged by policy makers in a growing number of ways. Applying a traditional, value-based investment approach in this environment is fraught with peril.
There are some things about which we can be relatively certain, however. If the dollar continues to gradually lose reserve currency status, or does so abruptly in a future financial crisis, it will reinforce the stagflationary economic conditions already prevailing in the US and in many other countries. Import prices will rise, yet growth will remain subdued given that the capital base is being consumed.
Of course there are things that US politicians could do to encourage savings and investment rather than consumption, but these things are politically unpopular. For example, neither of the two presidential candidates in the recent election advocated even a small reduction in the size of the federal budget, even though the deficit remains near record highs and the so-called ‘fiscal-cliff’ approaches. The ‘debate’ was so narrow relative to the vast scale of US economic problems that it seems a stretch to call it a ‘debate’ at all.
My impression is that the election was fought primarily on social issues. Now I don’t want to belittle those who feel strongly about social issues, but it seems a bit odd that these should determine the election result for the highest political office in a country founded on the principle that the federal government should stay out of social issues. One could be forgiven for thinking that the electorate is by comparision relatively unconcerned about the economy. I suppose Americans are schizophrenic, as many peoples seem to be.
Turning to Europe, I note that the political winds are now shifting decisively against those who would use the current crisis to centralise yet even more power in Brussels or in the ECB. This can be seen at both the regional level (eg Catalonia, Scotland) and the national (eg Greece, the UK, Ireland). At the margin, such sentiments make coordinated bailouts more difficult to implement. Although I am hardly supportive of bailouts for weak euro-area sovereign borrowers (or their lenders, if you prefer), if they are not forthcoming, this will deal a serious blow to European equity markets.
Speaking of political winds, there are also disturbing developments in France, where the government has recently threatened to nationalise corporate assets in the event that their owners seek to reduce capacity and fire workers in response to the economic slowdown well underway. This is not exactly going to attract foreign investment into the country. In any case, European economic growth is going to be unusually weak as long as the deleveraging continues, which might be rather a long time given the starting point.
I would like to remind readers that, during the stagflationary 1970s, major stock markets did not perform well. Yes, I know the conventional wisdom, that stock prices tend to rise with inflation, but then they can also perform rather poorly, in particular in real, inflation-adjusted terms.
Now it is the case that, in a historical comparision, stock market valuations in both the US and Europe are not particularly high. But really, given the context, why aren’t they particularly low instead? Sure in some countries, such as Spain, trailing P/Es and other classic valuation measures are essentially distressed, indicating good value. But today’s Spain is tomorrow’s… well, I don’t know. Pick a country, any country. There are plenty of candidates. So notwithstanding the modest correction of late I believe it is still too early for a general return to the equity markets.
Turning to bond markets, the outlook is inextricably linked to what happens with currencies, including of course the dollar. When a currency devalues for whatever reason, it takes its bond market with it. Yes, in practice it is not quite as simple as that, but when it comes to the most overpriced bond markets of today, such as those for US Treasuries, German Bunds, UK gilts or Japanese government bonds (JGBs), any devaluation in these currencies is likely to have an even greater impact on bond holders than on those sitting in cash instead. (That said, I believe there are pockets of value in distressed corporate debt and would recommend that readers familiarise themselves with some of the instruments available for getting some diversified exposure.)
Cash itself, of course, is at constant risk of devaluation, regardless of currency of denomination. Policymakers have made it abundantly clear that the value of cash is a policy tool, perhaps the single most important one there is. I regard it as highly unlikely that this thinking will change absent a future financial crisis that not only results in the death of the neo-Keynesian economic paradigm but also one that shows the current economic policy elite the door.
That leaves commodities. They may not be the stuff that powers Wall Street and credit creation but that is where the excessive leverage in the global financial system resides. Commodities cannot be arbitrarily diluted, devalued or defaulted on. They do not go bankrupt. They cannot be created by policymaker whim, although it is true that misguided regulations or price controls can create artificial scarcity, which is price supportive. That said, there is no certainty that commodity prices are going to rise, but if they don’t, this is unlikely to be the direct result of government action. Indeed, a general decline in commodity prices would be an indication that governments are finally backing away from inflationary policies, something that would, eventually, set the stage for a sustainable economic recovery built on savings, rather than on debt.
Well I’m not holding my breath. I fully expect governments to continue to implement misguided inflationary ‘solutions’ to economic problems themselves caused by inflation. And therefore I am over- rather than underweight commodities in my portfolio. Yes, some of these are likely to do better than others in the current global climate and I take that into account when managing positions. But much of investing remains a guessing game no matter what anyone tells you, including me.
The ultimate response to uncertainty, natural or man-made, is to diversify across a broad range of assets. What holds true for assets generally holds true for commodities specifically. I do have a soft spot for gold, but as all good traders know, emotions are distracting and dangerous. Fortunately, one doesn’t need to feel emotionally about gold to understand, entirely through logic and reason, that if the primary source of uncertainty in the world is the very future of money itself, then gold is likely to outperform in the event that such uncertainty continues to rise.
POST-SCRIPT: A BRIEF COMMENT ON RECENT DEVELOPMENTS IN THE GOLD MARKET
As the topic of gold and gold investing has featured regularly in the Amphora Report, I am sometimes asked to comment on developments in the gold market. This has been unusually common of late, due to Germany’s decision to audit a portion of its gold holdings held abroad and Ecuador’s announcement that it will follow Venezuela’s initiative from last year and repatriate at least some portion of its gold reserves held in New York and London. (As an aside, don’t you ever find it ironic that those who shout the loudest that gold is but a ‘barbarous relic’ are those who live and work atop the bullion vaults under the NY Fed or the Bank of England, for example?)
Well, as it happens, I have long held that the act of physical repatriation of gold held on a custodial basis abroad is of more than just symbolic importance. As I wrote in an Amphora Report back in late summer 2011, following Hugo Chavez’s decision to repatriate Venezuela’s gold reserves:
Venezuela’s decision to take delivery of its gold places additional focus on the unique role that physical gold plays in the global economy. In recent months, the central banks of Mexico, South Korea, Bangladesh and Kazakhstan have bought gold on the open market. Others no doubt continue to accumulate gold less overtly. Why? If there was growing faith in the dollar-centric global financial system, would central banks be accumulataing gold reserves at the fastest pace since the 1970s?
No, on the contrary, this trend is a clear indication that global confidence in the dollar continues to erode. Should more countries line up to take physical delivery of their gold, rather than leave it in US custody, it would be a sign that confidence in the US itself, as a safe and reliable jurisdiction for global commerce, is also beginning to erode.
Are we to interpret recent developments in the gold market as signs that “confidence in the US itself, as a safe and reliable jurisdiction,” is eroding? As with a handful of other things discussed in this report, I leave that to the reader to decide.
 I previously discussed at length the causes and consequences of the dollar’s loss of reserve currency status in IT’S THE END OF THE DOLLAR AS WE KNOW IT (DO WE FEEL FINE?), Amphora Report vol. 2 (May 2011), available here.
 Prior to the global financial crisis of 2008 the Fed purchased primarily US government bonds. However, it has since purchased a broad range of assets, including those that were part of the deal the Fed made with JP Morgan regarding its takeover of failing investment bank Bear Stearns.
 The Fed would be earning seignorage income directly rather than indirectly were it to purchase interest-bearing foreign securities instead of domestic ones. Note that the amount of seignorage income generated rises in proportion to the devaluation of the dollar relative to the currencies of US trading partners. That devaluation increases income is a simple accounting identity, although some Keynesians argue that this income is ‘real’. It is not. It is inflation.
 For a thorough discussion of the official BRIC position on these matters please see THE BUCK STOPS HERE: A BRIC WALL, Amphora Report vol. 3 (April 2012) available here.
 A recent article in the Turkish press detailing his comments on this topic can be found at the link here.
 For a discussion of the IMF’s recent reconsideration of some of their economic forecasting models, please see THE KEYNESIANS’ NEW CLOTHES, Amphora Report vol. 3 (2 November 2012). The link is here.
 Please see the most recent statistics from the World Gold Council, available at this link here.
 This was reported by Dow Jones Newswires and is available at this link here.
 For convenience purposes, smaller countries could always peg their currencies to that of a major trading partner and, in this way, indirectly back their currencies with gold.
 Please see A VICIOUS CYCLE, Amphora Report Vol. 3 (October 2012), available here.
 For a discussion of distressed investing, please see WHY BANKRUPTCY IS THE NEW BLACK, Amphora Report Vol. 3 (April 2012). The link is here.
 THE BUTTERFLIES OF AUGUST, Amphora Report vol. 2 (September 2011). The link is here.
This article was previously published in The Amphora Report, Vol 3, 27 November 2012.