As recently as 9th January I wrote an article suggesting that 2015 would turn out to be the year of the slump. The title ended with a question mark, but today we are closer to removing it in favour of a definite statement.
In recent weeks, it has become clear that key economic blocs are indeed heading for a slump, including but not limited to China, the Eurozone and Japan (allowing for the distortions of her aggressive money-printing). Between them they account for nearly 40% of global GDP. We know this because of the collapse in commodity prices, which is reflected in a global shift of preference in favour of the US dollar.
For the avoidance of doubt, money should be regarded as a good, and each currency as a different good. When this point is grasped, the context of the dollar’s rise against both commodities and other currencies becomes clear. Both commodities and currencies are priced in dollars, so markets are showing that banks, consumers and businesses have been changing their preferences in favour of increasing their dollar balances.
Modern macroeconomics fails to adequately explain the importance of these developments. A quick look at the index in Keynes’s General Theory makes no mention of changes in preference for money versus other goods. It lists and defines liquidity preference which is a different topic. Once you accept money is a good, supply and demand will always balance as predicated in Say’s Law, otherwise known as the Law of the Markets.
Something has spooked consumers in markets around the world into spending less on other goods and to increase their holdings of dollars. The explanation can only be that prices for all other goods have been too high relative to dollars, so they have had to fall. There can be no clearer signal that there is a slump in global economic activity.
The largest source of exported physical goods is China. Demand from other countries for China’s goods is declining, confirmed by the Baltic Dry Index* which is plumbing new lows. This slow-down in economic activity could easily burst the bubble of bank credit, which is in danger of collapsing under the massive burden of bad debts. December’s slow-down in new loan demand coupled with declining trade flows can only be temporarily resolved by China devaluing the renminbi, thereby lowering her export prices. The breathing space this gives China is only as long as it takes for her manufacturing costs to rise to reflect the devaluation. If it occurs, a renminbi devaluation would quickly put more downward pressure on prices for local manufacturers in her export markets.
Turning to China’s trade partners, we see the Eurozone’s economy ex-Germany beginning to contract which is panicking the ECB into money-printing in a desperate attempt to maintain too-high prices. Japan has been doing this for some time, and is labouring under a mountain of debt that makes even Greece look responsible.
The signals are clear: the world has already entered a downturn in economic activity. Therefore we can expect accelerated money-printing and the imposition of more negative interest rates in a forlorn attempt to avert economic reality.
On Friday 6th February the American Bureau of Labor Statistics (BLS) released its employment estimates for January, which being better than the market expected, caused Treasury bond yields to rise and precious metals to be marked sharply lower.
Earlier that week Jim Clifton, Chairman of Gallop wrote “The official unemployment rate as reported by the US Department of Labor is extremely misleading.”
His comments attracted notice, not least because Gallop is an independent company whose business is statistics. Furthermore, it is unusual for a senior business figure to criticise a government department so openly. His basic point is that if you are unemployed and have stopped looking for work in the last four weeks you are no longer classified as unemployed.
Furthermore if you perform a minimum of one hour of work in a week and are paid at least $20, you are deemed to be employed. And so on.
This is hardly news to those of us who have been sceptical about official statistics. The fact is there are even on BLS numbers 102 million adults deemed not in the labour force or officially unemployed. Then there are those who are only partially employed, but counted by the BLS as employed. As Jim Clifton points out if we add these 34.7 million people to the BLS’s 102 million figure, only 44.2% of US adults are actually employed for 30 hours or more per week; in other words fully employed by any common-sense definition.
This is the true indication of the state of employment in the US. The BLS could be more up-front in presenting its numbers, but being a government department we have to accept that it presents these figures in the best possible light. However, they are completely open about their methodology, and any member of the public can make his own assessment. So assuming caveat emptor should apply, the fault for accepting the BLS headline without question lies with the investing public, careless enough to be egged on by sell-side analysts and the media.
The result is markets move on what amounts to state-sponsored disinformation. Unemployment statistics are only one example of the fodder for the groupthink that has become the bedrock of macroeconomics and financial analysis. Groupthink is “a psychological phenomenon that occurs within a group of people in which the desire for harmony or conformity in the group results in an irrational or dysfunctional decision-making outcome”. This definition from Wikipedia describes the relationship between US government statistics and financial markets to a tee.
It is a shame: employment statistics have the potential to be the one number in macroeconomics that tells us the true state of the economy. The two other major variables, GDP and price inflation, are badly flawed. Nominal GDP tells us the quantity of transactions, not quality, ranking wasteful government spending equally with consumer-driven economic progress. Furthermore, government statisticians use every trick in the book to under-record rising prices, otherwise no growth in real GDP would have been recorded since the Lehman crisis.
We cannot claim that the true state of the US labour market is concealed from us. We need to think for ourselves and not dismiss from our minds comments by the likes of Jim Clifton of Gallop. That we do is evidence that “irrational or dysfunctional decision-making outcomes” drive our statistical interpretation and therefore all financial markets, and is not to be confused with rational analysis.
Today’s obvious mispricing of sovereign bonds is a bonanza for spending politicians and allows over-leveraged banks to build up their capital. This mispricing has gone so far that negative interest rates have become common: in Denmark, where the central bank persists in holding the krona peg to a weakening euro, it is reported that even some mortgage rates have gone negative, and high quality corporate bonds such as a recent Nestlé euro bond issue are also flirting with negative yields.
The most identifiable reason for this distortion of free markets is bank regulation. Under the Basel 3 rules, a bank with sovereign debt on its balance sheet is regarded by bank regulators as owning a risk-free asset.
Unsurprisingly, banks are encouraged by this to invest in sovereign debt in preference to anything else. This leads to the self-fulfilling second reason: falling yields. Central bank intervention in the bond markets through quantitative easing and commercial bank buying leads to higher bond prices, which in turn give the banks enormous profits. It is a process that the banks wish would go on for ever, but logic says it doesn’t.
Don’t think that there is an economic justification for negative bond yields: there isn’t. Even if price inflation goes negative, interest rates in a free market will always remain positive. The reason for this cast-iron rule is interest rates are an expression of time-preference. Time preference is the solid reason that possession of money today is more valuable than a promise to give it to you at some time in the future. The future value of money must always be at a discount to cash-in-the-hand, or put the other way, to balance the value of cash today with cash tomorrow always requires a supplementary payment of interest. That is always true so long as interest rates are set by genuine market factors and not set by a market-monopolising central bank, and then distorted by banking regulations.
So we have arrived close to the logical end-point in falling yields, and in some cases we have gone beyond it. We must also conclude that negative yields are a signal that bond prices are so over-blown that they are vulnerable to a substantial correction. Furthermore, when the tide turns against bond markets the downside could be considerable. The long-term real yield on high quality government bonds has historically tended to average about three per cent, which implies that sovereign bonds would crash if central banks lost control of the market.
Bond bulls are on weak ground from another angle. If history tells us that real yields of three per cent are the norm, has government creditworthiness changed for the better, justifying a lower yield? Well, no: the accumulation of debt across all welfare economies is less sustainable than at any time in the past, and demographics, the number of retirees relative to those in work and paying taxes, are rapidly making the situation far worse.
Macroeconomists will probably claim that so long as central banks can continue to manage the quantity of money sloshing about in financial markets they can keep bond prices up. But this is valid only so long as markets believe this to be true. Put another way central banks have to continue fooling all of the people all of the time, which as we all know is impossible.
Despite the uncertainties ahead of the Greek general election, the European Central Bank (ECB) went ahead and announced quantitative easing (QE) of €60bn per month from March to at least September 2016.
What makes this interesting is the mounting evidence that QE does not bring about economic recovery. Even Jaime Caruana, General Manager of the Bank for International Settlements and who is the central bankers’ central banker, has publicly expressed deep reservations about QE. However, the ECB ploughs on regardless.
The Keynesians at the ECB are unclear in their thinking. They are unable to answer Caruana’s points, dismissing non-Keynesian economic theory as “religion”, and they sweep aside the empirical evidence of Keynesian policy failures. Instead they are panicking at the spectre of too little price inflation, the continuing fall in Eurozone bank lending and now falling commodity prices. To them, it is a situation that can only be resolved by monetary stimulation of aggregate demand applied through increased government deficit spending.
This is behind the supposed solution of the ECB’s QE, most of which will involve national central banks in the euro-system propping up their own national governments’ finances.
The increased socialisation of the weaker Eurozone economies, especially those of France, Greece, Italy, Spain and Portugal, will inevitably lead to unnecessary economic destruction. QE always transfers wealth from savers to financial speculators and other early receivers of the new money. Somehow, the impoverishment of the working and saving masses for the benefit of the central bankers’ chosen few is meant to be good for the economy.
Commercial banks will be corralled into risk-free financing of their governments instead of lending to private enterprise. This is inevitable so long as the Single Supervisory Mechanism (the pan-European banking regulator) with a missionary zeal is discouraging banks from lending to anyone other than governments and government agencies. So the only benefit to employment will come from make-work programmes. Otherwise unemployment will inevitably increase as the states’ shares of GDP grow at the expense of their private sectors as the money and bank credit shifts from the former to the latter: this is the unequivocal lesson of history.
It may be that by passing government financing to the national central banks, the newly-elected Greek government can be bought off. It will be hard for this rebelling government to turn down free money, however angry it may be about austerity. But this is surely not justification for a Eurozone-wide monetary policy. While the Greek government might find it easier to appease its voters, courtesy of easy money through the Bank of Greece, hard-money Germans will be horrified. It may be tempting to think that the ECB’s QE relieves Germany from much of the peripheral Eurozone’s financing and that Germans are therefore less likely to oppose the ECB’s QE. Not so, because the ECB is merely the visible head of a wider euro-system, which includes the national central banks, through which there are other potential liabilities.
The principal hidden cost to Germany is through the intra-central bank settlement system, TARGET2, which should only show minor imbalances. This was generally true before the banking crisis, but since then substantial amounts have been owed by the weaker southern nations, notably Italy, to the stronger northern countries. Today, the whole of the TARGET2 system is being carried on German and Luxembourg shoulders as creditors for all the rest. Germany’s Bundesbank is owed €461bn, a figure that is likely to increase as the debtors’ negative balances continue to accumulate.
The currency effect
The immediate consequence of the ECB’s QE has been to weaken the euro against the US dollar, and importantly, it has forced the Swiss franc off its peg. The sudden 20% revaluation of the Swiss franc has generated significant losses for financial institutions which were short of the franc and long of the euro, which happens to have been the most important carry-trade in Europe, with many mortgages in Central and Eastern Europe denominated in Swiss francs as well. The Greek election has produced a further problem with a developing depositor run on her banks. Doubtless both the carry-trade and Greek bank problems can be resolved or covered up, but problems such as these are likely to further undermine international confidence in the euro, particularly against the US dollar, forcing the US’s Fed to defer yet again the day when it permits interest rates to rise.
This was the background to the Fed’s Open Market Committee (FOMC) meeting this week, and the resulting press release can only be described as a holding operation. Statements such as “the Committee judges that it can be patient in beginning to normalise the stance of monetary policy” are indicative of fence-sitting or lack of commitment either way. It is however clear that despite the official line, the US economy is far from “expanding at a solid pace” (FOMC’s words) and external events are not helping either. For proof of that you need look no further than the slow-down of America’s overseas manufacturing and production facility: China.
The consequences for gold
Until now, central banks have restricted monetary policy to domestic economic management; this is now evolving into the more dangerous stage of internationalisation through competitive devaluations. We now have two major currencies, the yen and the euro, whose central banks are set to weaken them further against the US dollar. Sterling, being tied through trade with the euro, should by default weaken as well. To these we can add most of the lesser currencies, which have already fallen against the dollar and may continue to do so. The Fed’s 2% inflation target will become more remote as a consequence, and this is bound to defer the end of zero interest rate policy. So from all points of view competitive devaluations should be good for gold prices.
This is so far the case, with gold starting to rise against all major currencies, including the US dollar, with the price above 200-day and 50-day moving averages in bullish formation. To date from its lows gold has risen by up to 13% against the USD, 18% against the pound, 30% against the euro, and 32% against the yen. The rise against weaker emerging market currencies is correspondingly greater, fully justifying Asian caution about their government currencies as stores of value.
We know that Asian demand for bullion has absorbed all mine production, scrap and net selling of investment gold from advanced economies for at least the last two years. Indeed, the bear market in gold has been a process of redistribution from weak western into stronger eastern hands. So if there is a revival in physical demand from the public in these advanced economies it is hard to see how it can be satisfied at anything like current prices, with physical bullion now in firm hands.
The gold price is an early warning of future monetary and currency troubles, and it is now becoming apparent how they may transpire. The ECB move to give easy money to profligate Eurozone politicians is likely to have important ramifications well beyond Europe, and together with parallel actions by the Bank of Japan, can now be expected to increase demand for physical gold in the advanced economies once more.
2014 ended with two ominous developments: the strength of the US dollar and a collapse in key commodity prices.
It is tempting to view both events as one, but the continuing fall in oil prices through December reveals they are sequential: first there was a greater preference for dollars compared with other currencies and this still persists, followed by a developing preference for all but the weakest currencies at the expense of raw materials and energy. These are two steps on a path that should logically lead to a global slump.
Dollar strength was the first warning that things were amiss, leading to higher interest rates in many of the emerging economies as their central banks sought to control investment outflows. Since this followed a prolonged period of credit expansion these countries appear to be entering the bust phase of the credit-driven boom-and-bust cycle; so for them, 2015 at a minimum will see a slump in economic activity as the accumulated malinvestments from the past are unwound. According to the IMF database, emerging market and developing economies at current prices account for total GDP of over $30 trillion, compared with advanced economies’ GDP totalling $47 trillion. It is clear that a slump in the former will have serious repercussions for the latter.
As the reserve currency the dollar is central to the exchange value of all other currencies. This is despite attempts by China and Russia to trade without it. Furthermore and because of this dependency, the global economy has become more geared to the dollar over the years because it has expanded relative to the US. In 2000, the US was one-third of global GDP; today it is about one-fifth.
The second development, falling energy and commodity prices, while initially driven by the same factors as dollar strength, confirms the growing likelihood of a global slump. If falling prices were entirely due to increased supply of the commodities involved, we could rejoice. However, while there has been some increase in energy and commodity supply the message is clear, and that is demand at current prices has unexpectedly declined, and prices are now trying to find a new equilibrium. And because we are considering world demand, this development is being missed or misread by economists who lack a global perspective.
The price of oil has approximately halved in the last six months. The fall has been attributed variously to the west trying to bankrupt Russia, or to Saudi Arabia driving American shale production out of business. This misses the bigger picture: according to BP’s Statistical Review 2014, at the beginning of last year world oil consumption comfortably exceeded supply, 91.3million barrels per day compared with 86.8. This indicates that something fundamental changed in 2014 to collapse the price, and that something can only be a sudden fall in demand in the second half.
Iron ore prices have also halved over the last six months, but other key commodities, such as copper which fell by only 11% over the period, appear to have not yet adjusted to the emerging markets slump. This complies with business cycle theory, because in the early stages of a slump businesses remain committed to their capital investment plans in the vain hope that conditions will improve. This being the case, the collapse in demand for energy can be expected to deepen and spread to other industrial raw materials as manufacturers throw in the towel and their investment plans are finally abandoned.
Therefore the economic background to the financial outlook for the global economy is not encouraging. Nor was it at the beginning of 2014, when it was obviously going to be a difficult year. The difference a year on is that the concerns about the future are more crystallised. This time last year I wrote that we were heading towards a second (to Lehman) and unexpected financial and currency crisis that could happen at any time. I only modify that to say the crisis has indeed begun and it has much further to go this year. This is the background against which we must briefly consider some of the other major currencies, and precious metals.
Japan and the yen
The complacency about Japan in the economic and investment communities is astonishing. Japan is committed to a scale of monetary inflation that if continued can only end up destroying the yen. The Bank of Japan is now financing the equivalent of twice the government deficit (¥41 trillion) by issuing new currency, some of which is being used to buy Japanese equity ETFs and property REITs. By these means pricing in bond, equity and commercial property markets has become irrelevant. “Abenomics” is about financing the government and managing the markets under the Keynesian cover of stimulating both the economy and animal spirits. In fact, with over ¥1.2 quadrillion of public sector debt the government is caught in a debt trap from which it sees no escape other than bluff. And since Abenomics was first embarked upon two years ago, the yen has fallen from 75 to the US dollar to 120, or 37%.
Instead of learning the lessons of previous hyperinflations, mainstream economists fall for the official line and ignore the facts. The facts are simple: Japan is a welfare state with an increasing and unsustainable ratio of retirees to tax-paying workers. She is the leading advanced nation on a debt path the other welfare nations are closely following. Consensus forecasts that the Japanese economy will be stimulated into recovery in 2015 are wide of the mark: instead she is destroying her currency and private sector wealth with it.
Eurozone and the euro
In the short-term the Eurozone is being revisited by its Greek problem. Whether or not the next Greek government backs off from confronting the other Eurozone members and the ECB remains to be seen. The problems for the Eurozone lie considerably deeper than Greece, made worse by politicians who have been reluctant to use the time bought by the ECB to address the structural difficulties of the 19 Eurozone members. The result is the stronger northern bloc (Germany, Netherlands, Finland and Luxembourg) is being crippled by the burden of the Mediterranean states plus Portugal plus France. And Germany and Finland have suffered the further blow of losing valuable export business from Russia.
In the coming months the Eurozone will likely face gas shortages from Russia through the trans-Ukrainian pipeline, and price deflation driven by energy and other commodity prices. Price deflation spurs two further points to consider, one false and the other true: lower prices are deemed to be recessionary (false), and falling prices increase the burden of real debt (true). The consequence is that the ECB will seek ways to expand money supply aggressively to stop the Eurozone from drifting into an economic crisis. In short, the Eurozone will likely develop its own version of Abenomics, the principal difference being the Eurozone’s timeline is behind Japan’s.
US and UK
Japan and the Eurozone account for total GDP of $18.3 trillion, slightly more than the US and added to the emerging and developing economies, gives a total of $48 trillion, or 62% of global GDP for nations leading the world into a slump. So when we consider the prospects for the US and the UK, together producing $20.4 trillion or 26% of the world’s GDP, their prospects are not good either. The UK as a trading nation exposed to the Eurozone has immediate risk, while the US which is not so dependent on international trade, less so.
The foregoing analysis is of the primary economic drivers for 2015 upon which all else will ultimately depend. The risk of a global slump can be called a first order event, while the possibility of a banking crisis, derivatives default or other market dislocation brought on by a slump could be termed a second order event. There is no point in speculating about the possibility and timing of second order events occurring in 2015, because they ultimately depend on the performance of the global economy.
However, when it becomes clear to investors that the global economy is indeed entering a slump, financial and systemic risks are certain to escalate. Judging this escalation by monitoring markets will be difficult because central banks, exchange stability funds and sovereign wealth funds routinely intervene in markets, rendering them misleading as price signals.
Precious metals are the only assets beyond the long-term control of governments. They can distort precious metal markets in the short term by expanding the quantity of derivatives, and there is a body of evidence that these methods have been employed in recent years. But most price distortion today appears to have come from bullion and investment banks who are fully committed to partying in bonds, equities and derivatives, and for which gold is a spoiler. This complacency is bound to be undermined at some point, and a global economic slump is the likely catalyst.
The dangers of ever-inflating currencies are clearly illustrated by the Fiat Money Quantity, which has continued to expand at an alarming rate as shown in the chart below.
FMQ measures the amount of fiat currency issued as a replacement for gold as money, so is a measure of unbacked monetary expansion. At $13.52 trillion last November it is $5.68 trillion above the long-established pre-Lehman crisis growth path, stark evidence of a depreciating currency in monetary terms. Adjusting the price of gold for this depreciation gives a price today the equivalent of $490 in dollars at that time and quantity, so gold has roughly halved in real currency terms since the Lehman crisis.
There is compelling evidence that 2015 will see a global slump in economic activity. This being the case, financial and systemic risks will increase as evidence of the slump accumulates. It can be expected to undermine global equities, property and finally bond markets, which are currently all priced for economic stability. Even though these markets are increasingly controlled by central bank intervention, it is dangerous to assume this will continue to be the case as financial and systemic risks accumulate.
Precious metals are ultimately free from price management by the state. Furthermore, they are the only asset class notably under-priced today, given the enormous increase in the quantity of fiat money since the Lehman crisis.
In short, 2015 is shaping up to be very bad for fiat currencies and very good for gold and silver.
Last week I wrote that contrary to the prevailing mood US dollar strength could reverse at any time. This week I look at another aspect of the dollar, which almost certainly will become a significant source of supply: a global shift out of it by foreign holders.
As well as multinational corporations that account in dollars, there are non-US entities that use dollars purely for trade. And so long as governments intervene in currency markets, governments end up with those trade dollars in their foreign reserves. Some of these governments are now pushing hard to replace the dollar, having seen its debasement, which is beyond their control. This has upset nations like China, and that is before we speculate about any geopolitical angle.
The consequence of China’s currency management has been a massive accumulation of dollars which China cannot easily sell. All she can do is stop accumulating them and not reinvest the proceeds from maturing Treasuries, and this has broadly been her policy for at least the last year. So this problem has been in the works for some time and doubtless contributed to China’s determination to reduce her dependency on the dollar. Furthermore, it is why thirteen months ago George Osborne was summoned (that is the only word for it) to Beijing to discuss a move to urgently develop offshore renminbi capital markets, utilising the historic links between Hong Kong and London. Since then, it is reported that last month over 22% of China’s external trade was settled in its own currency.
Given the short time involved, it is clear that there is a major change happening in cross-border trade hardly noticed by financial commentators. But this is not all: sanctions against Russia have turned her urgently against the dollar as well, and together with China these two nations dominate and carry with them the bulk of Asia, representing nearly four billion rapidly industrialising souls. To this we should add the Middle East, most of whose oil is now exported to China, India and South-East Asia, making the petro-dollar potentially redundant as well.
In a dollar-centric currency system, China is restricted in what she can do, because with nearly $4 trillion in total foreign exchange reserves she cannot sell enough dollars to make a difference without driving the renminbi substantially higher. In the past she has reduced her dollar balances by selling them for other currencies, such as the euro, but she cannot rely on the other major central banks to neutralise the market effect of her dollar sales on her behalf. Partly for this reason China now intends to redeploy her reserves into international investment to develop her export markets for capital goods, as well as into major infrastructure projects, such as the $40bn Silk Road scheme.
This simply amounts to dispersing China’s dollars into diverse hands to conceal their disposal. Meanwhile currency markets have charged off in the opposite direction, with the dollar’s strength undermining commodity prices, most noticeably oil, very much to China’s benefit. And while the talking-heads are debating the effect on Russia and America’s shale, they are oblivious to the potential tsunami of dollars just waiting for the opportunity to return to the good old US of A.
There is a significant risk that the financial effects of the collapse in the oil price could spread through the financial system. Already there must have been significant transfers of value through OTC derivative markets, whose gross notional value is about $700 trillion. Roughly $300 trillion of this is with the top US banks as counterparty. A minority of this is with credit default swaps, but if there is problem here, it could easily spread to other derivative categories through counterparty risk.
Remember that the US economy is $17 trillion, so we are talking figures of a far greater magnitude than that.
We have had these scares in the past, notably with AIG, and the Lehman crisis, and also with the Eurozone crisis when Greece, Spain, Portugal and Italy were insolvent together. We could be on the verge of another such crisis, this time triggered by the collapse in the price of crude oil.
For me one event we cannot ignore is a clause slipped into the omnibus finance bill passed by Congress last week, whereby the FDIC, which insures small bank deposits in the event of a bank failure, will also take on responsibility for derivative contracts. The only possible reason this has been slipped in must be because the Wall Street banks are worried about counterparty risk for derivatives, which is totally beyond any individual bank’s control.
The fact that this is the subject of urgent legislation (the wording was put together by Citi and adopted word for word) instead of a more considered approach confirms to me that we have a real problem on our hands.
Each commodity market has its own story to tell: oil prices are falling because OPEC can’t agree production cuts, steel faces a glut from overcapacity, and even the price of maize has fallen, presumably because of good harvests.
In local currencies this is not so much the case. Of course, the difference between prices in local currencies and prices in US dollars is reflected in the weakness of most currencies against the dollar in the foreign exchange markets. This tells us that whatever is happening in each individual commodity and in each individual currency the common factor is the US dollar.
This is obvious perhaps, but the fall in commodity prices and the rise in the US dollar have to be seen in context. We should note that for most of the global population, the concern that we are facing global deflation (by which is commonly meant falling prices) is not yet true. Nor is a conclusion that the fall in the oil price indicates a sudden collapse in demand for energy. When the dollar price of oil began to slide, so did the exchange rates for all the other major currencies, confirming a significant part of oil’s price move came from dollar strength, which would have also been true of commodity prices generally.
All we can say is that on average there has been a shift of preferences towards holding dollars and away from holding commodities. Looked at in this light we can see that a trend of destocking can develop solely for financial rather than business reasons, because businesses which account in dollars face financial losses on excess inventory. It is the function of speculators to anticipate these decisions, which is what we have seen in recent months.
Macro-economists, who are Keynesian or monetarist by definition, are beginning to interpret falling commodity prices and a rising dollar as evidence of insufficient aggregate demand, which left unchecked will lead to deflation, increasing unemployment, bankruptcies, falling asset prices, and bank insolvencies. It is, they say, an outcome to be avoided at all costs by ensuring that aggregate demand is stimulated so that none of this happens.
Whether or not they are right in this assessment is not the point. They neglect to allow that some of the move in commodity prices is due to the currency itself as the numéraire of all prices.
For evidence of this we need look no further than the attitude of the Fed and every other central bank that targets price inflation as part of their monetary policy. In forming monetary policy there is no allowance for the possibility, nay likelihood, that in future there will be a change in preferences against the dollar, or any other currency for that matter, and in favour of anything else. The tragedy of this lack of market comprehension is that it’s a fair bet that monetary policy will not only succeed in limiting the rise of the dollar as it is designed to do, but end up undermining it when preferences shift the other way.
The moral of the story is that the Fed may be able to fool some of the people all of the time and all of the people some of the time, but worst of all they are fooling themselves. And we should bear in mind that dollar strength is only a trend which can easily reverse at any time.
The hypothesis that follows, if carried through, is certain to have a significant effect on gold and the relationship between gold and all government-issued currencies.
The successful remonetisation of gold by a major power such as Russia would draw attention to the fault-lines between fiat currencies issued by governments unable or unwilling to do the same and those that can follow in due course. It would be a schism in the world’s dollar-based monetary order.
Russia has made plain her overriding monetary objective: to do away with the US dollar for all her trade, an ambition she shares with China and their Asian partners. Furthermore, in the short-term the rouble’s weakness is undermining the Russian economy by forcing the Central Bank of Russia (CBR) to impose high interest rates to defend the currency and by increasing the burden of foreign currency debt. There is little doubt that one objective of NATO’s economic sanctions is to harm the Russian economy by undermining the currency, and this policy is working with the rouble having fallen 30% against the US dollar this year so far with the prospect of further falls to come.
Russia faces the reality that pricing the rouble in US dollars through the foreign exchanges leaves her a certain loser in a currency war against America and her NATO allies. There is a solution which was suggested in a recent paper by John Butler of Atom Capital, and that is for Russia to link the rouble to gold, or more correctly put it on a gold exchange standard*. The proposal at first sight is so left-field that it takes a lateral thinker such as Butler to think of it. Separately, Professor Steve Hanke of John Hopkins University has alternatively proposed that Russia sets up a currency board to stabilise the rouble. Professor Hanke points out that Northern Russia tied the rouble to the British pound with great success in 1918 after the Bolshevik revolution when Britain and other allied nations invaded and briefly controlled the region. What he didn’t say is that sterling would most likely have been accepted as a gold substitute in the region at that time, so running a currency board was the equivalent of putting the rouble in Russia’s occupied lands onto a gold exchange standard.
Professor Hanke has successfully advised several governments to introduce currency boards over the years, but we can probably rule it out as an option for Russia because of her desire to ditch US dollar relationships. However, on further examination Butler’s idea of fixing the rouble to gold is certainly feasible. Russia’s public sector external debt is the equivalent of only $378bn in a $2 trillion economy, her foreign exchange reserves total $429bn of which over $45bn is in physical gold, and the budget deficit this year is likely to be roughly $10bn, considerably less than 1% of GDP. These relationships suggest that a rouble to gold exchange standard could work so long as fiscal discipline is maintained and credit expansion moderated.
Once a rate is set, the Russians would not be restricted to just buying and selling gold to maintain the rate of gold exchange. The CBR has the power to manage rouble liquidity as well, and as John Butler points out, it can issue coupon-bearing bonds to the public which would be attractive compared with holding cash roubles. By issuing these bonds, the public is in effect offered a yield linked to gold, but higher than gold’s interest rate indicated by the gold lease rates in the London market. Therefore, as the sound-money environment becomes established the public will adjust its financial affairs around a considerably lower interest rate than the current 9.5%-10% level, but in the context of sound money it must always be repaid. Obviously the CBR would have to monitor bank credit expansion to ensure that lower interest rates do not result in a dangerous increase in bank lending and jeopardise the arrangement.
In short, the central bank could easily counter any tendency for roubles to be cashed in for gold by withdrawing roubles from circulation and by restricting credit. Consideration would also have to be given to roubles in foreign ownership, but the current situation for foreign-owned roubles is favourable as well. Speculators in foreign exchange markets are likely to have sold the rouble against dollars and euros, because of the Ukrainian situation and as a play on lower oil prices. The announcement of a gold exchange standard can therefore be expected to lead to foreign demand for the rouble from foreign exchange markets because these positions would almost certainly be closed. Since there is currently a low appetite for physical gold in western capital markets, longer-term foreign holders of roubles are unlikely to swap them for gold, preferring to sell them for other fiat currencies. So now could be a good time to introduce a gold-exchange standard.
The greatest threat to a rouble-gold parity would probably arise from bullion banks in London and New York buying roubles to submit to the CBR in return for bullion to cover their short positions in the gold market. This would be eliminated by regulations restricting gold for rouble exchanges to legitimate import-export business, but also permitting the issue of roubles against bullion for non-trade related deals and not the other way round.
So we can see that the management of a gold-exchange standard is certainly possible. That being the case, the rate of exchange could be set at close to current prices, say 60,000 roubles per ounce. Instead of intervention in currency markets, the CBR should use its foreign currency reserves to build and maintain sufficient gold to comfortably manage the rouble-gold exchange rate.
As the rate becomes established, it is likely that the gold price itself will stabilise against other currencies, and probably rise as it becomes remonetised. After all, Russia has some $380bn in foreign currency reserves, the bulk of which can be deployed by buying gold. This equates to almost 10,000 tonnes of gold at current prices, to which can be added future foreign exchange revenues from energy exports. And if other countries begin to follow Russia by setting up their own gold exchange standards they likewise will be sellers of dollars for gold.
The rate of increase in the cost of living for the Russian population should begin to drop as the rouble stabilises, particularly for life’s essentials. This has powerfully positive political implications compared with the current pain of food price inflation of 11.5%. Over time domestic savings would grow, spurred on by low welfare provision by the state, long-term monetary stability and low taxes. This is the ideal environment for developing a strong manufacturing base, as Germany’s post-war experience clearly demonstrated, but without her high welfare costs and associated taxation.
Western economists schooled in demand management will think it madness for the central bank to impose a gold exchange standard and to give up the facility to expand the quantity of fiat currency at will, but they are ignoring the empirical evidence of a highly successful Britain which similarly imposed a gold standard in 1844. They simply don’t understand that monetary inflation creates uncertainty for capital investment, and destroys the genuine savings necessary to fund it. Instead they have bought into the fallacy that economic progress can be managed by debauching the currency and ignoring the destruction of savings.
They commonly assume that Russia needs to devalue her costs to make energy and mineral extraction profitable. Again, this is a fallacy exposed by the experience of the 1800s, when all British overseas interests, which supplied the Empire’s raw materials, operated under a gold-based sterling regime. Instead, by not being burdened with unmanageable debt and welfare costs, by maintaining lightly-regulated and flexible labour markets, and by running a balanced budget, Russia can easily lay the foundation for a lasting Eurasian empire by embracing a gold exchange standard, because like Britain after the Napoleonic Wars Russia’s future is about new opportunities and not preserving legacy industries and institutions.
That in a nutshell is the domestic case for Russia to consider such a step; but if Russia takes this window of opportunity to establish a gold exchange standard there will be ramifications for her economic relationships with the rest of the world, as well as geopolitical considerations to take into account.
An important advantage of adopting a gold exchange standard is that it will be difficult for western nations to accuse Russia of a desire to undermine the dollar-based global monetary system. After all, President Putin was more or less told at the Brisbane G20 meeting, from which he departed early, that Russia was not welcome as a participant in international affairs, and the official Fed line is that gold no longer plays a role in monetary policy.
However, by adopting a gold exchange standard Russia is almost certain to raise fundamental questions about the other G20 nations’ approach to gold, and to set back western central banks’ long-standing attempts to demonetise it. It could mark the beginning of the end of the dollar-based international monetary system by driving currencies into two camps: those that can follow Russia onto a gold standard and those that cannot or will not. The likely determinant would be the level of government spending and long-term welfare liabilities, because governments that leech too much wealth from their populations and face escalating welfare costs will be unable to meet the conditions required to anchor their currencies to gold. Into this category we can put nearly all the advanced nations, whose currencies are predominantly the dollar, yen, euro and pound. Other nations without these burdens and enjoying low tax rates have the flexibility to set their own gold exchange standards should they wish to insulate themselves from a future fiat currency crisis.
It is beyond the scope of this article to examine the case for other countries, but likely candidates would include China, which is working towards a similar objective. Of course, Russia might not be actively contemplating a gold standard, but Vladimir Putin is showing every sign of rapidly consolidating Russia’s political and economic control over the Eurasian region, while turning away from America and Western Europe. The fast-track establishment of the Eurasian Economic Union, domination of Asia in partnership with China through the Shanghai Cooperation Organisation, and plans to set up an alternative to the SWIFT banking payments network are all testaments to this. It would therefore be negligent to rule out the one step that would put a stop to foreign attempts to undermine the rouble and the Russian economy: by moving the currency war away from the foreign exchanges and into the physical gold market were Russia and China hold all the aces.
*Technically a gold standard is a commodity money standard in which the commodity is gold, deposits and notes are fully backed by gold and gold coins circulate. A gold exchange standard permits other metals to be used in coins and for currency and credit to be issued without the full backing of gold, so long as they can be redeemed for gold from the central bank on demand.
G20 gatherings of world leaders on the surface are all the same: they conclude with a meaningless anodyne statement that everyone can agree with. But these meetings do serve a purpose: they allow the world leaders to meet informally and exchange views.
Since the last G20 in St Petersburg in 2013 when there was a high degree of conviction that economic growth would return, the global economic outlook has instead deteriorated significantly. Instead of last time’s mutual bonhomie over the prospect of their collective success, the world’s leaders this time are almost certainly worried. They would have learned about the failure of monetary policy everywhere. They would have had this first-hand from Japan’s delegation, which is on its way to financial and currency destruction. The despair in the European delegations would have been obvious as well.
The problem is that post-war monetary theories have failed to deliver. Lower interest rates and increased quantities of money in order to promote economic growth no longer work. The abandonment of the laws of the markets in favour of stimulating consumer demand by monetary means has turned out to be a blind alley. Time will tell, but if the global economy is heading for a slump, the banking system will become overburdened with defaulting borrowers, and government deficits will rise uncontrollably, especially in the welfare nations. This cannot be permitted to happen under any circumstances. It is therefore quite likely that the alternative to monetary-driven policy, accelerated government deficit spending as a pre-emptive measure, will be tried instead. And in this respect the relative success of the British and American economies will be attributed to their large budget deficits, while the misery of austerity is identified with the problems in France and the southern Eurozone.
These are bad and confused arguments, but they will be emotionally attractive to the political class, while the central bankers probably feel it is time the politicians took responsibility for economic management. Furthermore, it is surely becoming obvious that monetary solutions only enrich the bankers. And the most effective way of countering deflation, economists will argue, will be for demand-led price rises for consumer products, which have a better chance of coming about through increased government spending. And do not be surprised if economists argue that governments need to take over the debt-creation process to kick-start the business cycle.
We might look back on Brisbane as a milestone in global economic policy, when governments and central banks changed the emphasis of economic management from monetary stimulation through the financial system towards a greater emphasis on direct government intervention. In the process two things are likely to happen: currencies will begin to lose their purchasing power with respect to everyday goods, and government bond yields are likely to rise, undermining financial asset valuations.
This will certainly puff up GDP, because government spending is a significant part of it. But the idea that controlled price inflation can be engineered flies in the face of all experience. If the emphasis does shift from monetary solutions towards more aggressive government spending the risk will also shift towards an uncontrollable decline in purchasing power for currencies. It will be very good for inflation hedges like gold.