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By Alasdair Macleod, on 20 May 13
There has been a growing shift in favour of assets relative to bank deposits. This was initially encouraged by zero interest rates, but more recently there is little doubt that Cyprus’s bail-in has accelerated the trend. This explains the bull markets in bonds and equities, which conveniently underwrites the entire banking system. It is however too early to offer evidence of falling deposit balances held by non-banks and the general public because depositors as a whole have been remarkably complacent, but there is ample evidence that liquidity from monetary expansion is inflating financial assets faster than bank deposits.
This helps explain why, for example, Italian 10-year bonds are on a 4% yield. The reason, doubtless reaffirmed by the Cyprus bail-in, is that investors with cash balances think over-priced sovereign debt is less risky than adding to their euro deposits. However, the central banks are relaxed because weakness in deposits at any single bank is easily covered through the banking system, insulating individual banks from depositor-withdrawal systems. Presumably, banking counterparties are also complacent because they can be reasonably sure to be exempt from any bail-ins. They have the comfort of knowing the banking system is underwritten by all those complacent enough to leave money on deposit beyond the insured level.
However, some of depositors’ cash balances post-Cyprus will have gone into physical gold and silver, which explains why the bullion banks operating in the futures markets and the central banks behind them are so keen to dissuade us that gold and silver is a safe haven. I recently interviewed Ronnie Stoerferle, the Vienna-based analyst, who put his finger on it: since Cyprus, there has been a sharp rise in European demand for physical gold, with the pressure being felt by the bullion banks unable to deliver bullion.
At least one bank was recently reported to be only prepared to settle bullion liabilities in cash. Therefore the price knock-down in April was a logical response by the bullion banks, which had to defuse customer demand for physical delivery. But given that the driving factor was not speculation but a reluctance to add to deposits in the banking system, the jump in demand for bullion at lower prices was inevitable.
Where does this leave things? The crisis in bullion markets is worse than it was before. A good example of how little physical stock there is can be gained by tracking bullion deliveries on the Shanghai Gold Exchange. In the last few weeks they have dwindled to virtually nothing, having been a truncated 190 tonnes in April and 297 tonnes in March. Yet we know from reports that retail demand in China has taken off; so it is only a matter of time before prices are bid up on the Shanghai Gold Exchange enough to replace lost inventory.
It will be interesting to see how many more bullion banks are forced to admit the fiction behind their customer accounts in the coming weeks. For the moment the temporary solution amounts to rationing bullion supplies to the public.
This article was previously published at GoldMoney.com.
By Alasdair Macleod, on 6 May 13
Regular readers will know I am in the inflation, possibly hyperinflation camp; but there are those that think the future is more likely to be deflationary. In the main this is the view of neoclassical economists, Keynesians and monetarists, who generally foresee a 1930s-style slump unless the economy is stimulated out of it.
Rather than repeatedly go into the errors of their ways, we must accept that they are in charge. They have decided that prices must not fall, and they see moderate price inflation as a necessary stimulant to business: this is the reasoning behind Helicopter Ben Bernanke’s defining statement, when he made it clear that central banks could spray the economy with endless fiat money if need be.
Given this determination to stop prices falling, worries that the outlook is deflationary are unlikely to be realised. But there is a second group of commentators which believes that in a slump there will be an unstoppable credit contraction as banks are forced to foreclose on failing businesses. This, they say, will lead to a mad dash for cash to pay off debt, leading to fire-sales of assets as credit contraction spreads to otherwise sound businesses. The imperative to pay down debt will overwhelm central banks’ attempts to replace it with cash.
The error here is to misunderstand where we are in this sorry tale. The belief common to all deflationists, that the developed world has so far avoided a severe economic contraction, is wrong. The fact that this is not often recognised must be blamed on the irrelevance of nearly all government statistics. Not only are they self-serving, but they do not allow for the increasing meaninglessness of government money. The only hard statistics are unemployment, which despite official attempts to water them down, cannot conceal the fact that there has been a slump since the banking crisis.
The banking crisis marked a sudden increase in consumer preferences in favour of money, assuredly egged on by banks who switched almost overnight from risk-tolerant to risk-averse. This is why GDP numbers in most major countries took such a heavy knock, reflecting money being withdrawn from economic activity. That was the event deflationists are worrying about today.
So deflationists are forecasting an event that happened five years ago and their fears have already been disproved by massive monetary intervention. That is not to say the slump is over: far from it. Current indications are that things are about to get worse everywhere. But the nightmare cycle of falling asset prices becoming self-feeding and a dash for cash has already been prevented.
So successful was the Fed leading other central banks to save the world in 2009 that the precedent is established: if things take a turn for the worse or a systemically important financial institution looks like failing, Superman Ben and his cohort of central bankers will save us all again.
Call it kryptonite, or failing animal spirits if you like. It is closer to the truth to understand we are witnessing the early stages of erosion of confidence in government and ultimately its paper money. Ordinary people are finally beginning to suspect this, signalled by the world-wide rush into precious metals last month.
This article was previously published at GoldMoney.com.
By Alasdair Macleod, on 29 April 13
There is a new campaign to end austerity. First, the IMF lets it be known it has second thoughts about it; then we are told the threshold of 90% government debt to GDP which must not be crossed, set by Professors Reinhart & Rogoff, is based on an excel spread-sheet error. Lastly, Bill Gross of PIMCO, the largest bond fund in the world, tells us austerity is not working.
The new mood is spreading, to the relief of beleaguered countries like Spain and Italy. Austerity is painful, and politicians don’t like it because it makes them unpopular. Nor do Keynesian and monetarist economists, who see its failure as justification for more intervention.
Austerity, as practised by Western governments, involves maintaining public spending at the cost of the private sector. It is therefore hardly surprising that it leads to the destruction of the wealth-creation necessary to support government finances. Its only, if questionable virtue, is statistical: the maintenance of government spending ensures that its share of GDP does not fall, thereby not undermining “growth”. But government spending is simply a constraint on the productive private sector, because any economic resource diverted from it to pay for government is effectively squandered.
If an economy is to progress at all, there has to be as much austerity as possible, aimed squarely and solely at the government sector. Give individuals and businesses a lighter tax burden, the result of smaller government, and economic prospects will rapidly improve. Instead, the new anti-austerity mood will translate into a new licence for governments to relax their spending restraints.
Anyway, central banks including the ECB have shown they are ready to underwrite government spending if the markets are not prepared to, at almost zero interest cost. This explains why the yield on Italian debt, for example, has fallen despite the political drift of its non-government away from spending restraint.
One reason this is tolerated by bond investors such as PIMCO is the simple assumption that inflation is only a problem if there is a pick-up in demand. With all major economies either slowing or moving into recession that fear is increasingly remote. But history tells us this is a mistake, and that prices are capable of rising even in a recession, and a proper understanding of price theory also demonstrates the falsity of the assumption.
For the moment, ordinary people and their banks are showing a preference for money over goods, and have been since the banking crisis five years ago, which is why demand remains subdued. However, increasing risks to bank deposits from bank failures are likely to trigger a flight into physical cash and goods. And with economies all over the world stalling under the burden of the cost of government, this risk to banks and bank deposits is both increasing and becoming more immediate.
Complacency over inflation and interest rates also has to face the new impetus given to the expansion of the money supply implied by the abandonment of austerity. And this is merely another reason for monetary expansion, added to all the others. What we are seeing played out in front of us is no more than the compelling political reasons behind nearly every hyperinflation in modern history, which will almost certainly end in the collapse of today’s paper currencies.
This article was previously published at GoldMoney.com.
By Alasdair Macleod, on 26 April 13
Introduction
In this article I will argue that the recent slide in the gold price has generated substantial demand for bullion that will likely bring forward a financial and systemic disaster for both central and bullion banks that has been brewing for a long time. To understand why, we must examine their role and motivations in precious metals markets and assess current ownership of physical gold, while putting investor emotion into its proper context.
In the West (by which in this article I broadly mean North America and Europe) the financial community treats gold as an investment. However, of the global pool of gold, which GoldMoney estimates to be about 160,000 tonnes, the amount actually held by western investors in portfolios is a very small fraction of this amount. Furthermore investor behaviour, which in itself accounts for just part of the West’s bullion demand, is sharply at odds with the hoarders’ objectives, which is behind underlying tensions in bullion markets. To compound the problem, analysts, whose focus incorporates portfolio investment theories and assumptions, have very little understanding of the economic case for precious metals, being schooled in modern neo-classical economic theories.
These economic theories, coupled with modern investment analysis when applied to bullion pricing, have failed to understand the growing human desire for protection from monetary instability. The result has for a considerable time been the suppression of bullion prices in capital markets below their natural level of balance set by supply and demand. Furthermore, the value put on precious metals by hoarders in the West has been less than the value to hoarders in other countries, particularly the growing numbers of savers in Asia.
These tensions, if they persist, are bound to contribute to the eventual destruction of paper currencies.
The ownership of gold
The amount of gold bullion that backs investor-driven markets is not statistically recorded, but we can illustrate its significance relative to total stocks by referring back to the time of the oil crisis of the mid-1970s. In 1974 the global stock of gold was estimated to be half that of today, at about 80,000 tonnes. Monetary gold was about 37,000 tonnes, leaving 43,000 tonnes in the form of non-monetary bullion, coins and jewellery. Let us arbitrarily assume, on the basis of global wealth distribution, that two thirds of this was held by the minority population in the West, amounting to about 30,000 tonnes.
This figure probably grew somewhat before the early 1980s, spurred by the bull market and growing fear of inflation, which saw investors buy mainly coins and mining shares. Demand for gold bars was driven by the rapid accumulation of dollars in the oil-exporting nations, as well as some hoarding by wealthy investors from all over the world through Switzerland and London.
The sharp rise in global interest rates in the Volcker era, the subsequent decline of the inflation threat and the resulting bear market for gold inevitably led to a reduction of bullion holdings by wealthy investors in the West. Swiss and other private banks, employing a new generation of fund managers and investment advisors trained in modern portfolio theories, started selling their customers’ bullion positions in the 1980s, leaving very little by 2000. In the latter stages of the bear market, jewellery sales in the West became a replacement source of bullion supply, but this was insufficient to compensate for massive portfolio liquidation.
So by the year 2000, Western ownership of non-monetary gold suffered the severe attrition of a twenty-year bear market and the reduction of inflation expectations. Portfolios, which routinely had 10-15% exposure to gold 40 years ago even today have virtually no exposure at all. Given that jewellery consumption in Europe and North America was only 400-750 tonnes per annum over the period, by the year 2000 overall gold ownership in the West must have declined significantly from the 1974 guesstimate of 30,000 tonnes. While the total gold stock in 2000 stood at 128,000 tonnes, the virtual elimination of portfolio holdings will have left Western holders with little more than perhaps an accumulation of jewellery, coins and not much else: bar ownership would have been at a very low ebb.
Since 2000, demand from countries such as India and more recently China is known to have increased sharply, supporting the thesis that gold has continued to accumulate at an accelerating pace in non-Western hands.
Western bullion markets have therefore been on the edge of a physical stock crisis for some time. Much of the West’s physical gold ownership since 2000 has been satisfied by recycling scrap originating in the West, suggesting that total gold ownership in the West today barely rose before the banking crisis despite a tripling of prices. Meanwhile the disparity between demand for gold in the West compared with the rest of the world has continued, while the West’s investment management community has been actively discouraging investment.
The result has been that nearly all new mine production and Western central bank supply has been absorbed by non-Western hoarders and their central banks. While post-banking crisis there has presumably been a pick-up in Western hoarding, as evidenced by ETF and coin sales and some institutional involvement, it is dwarfed by demand from other countries. So it is reasonable to conclude that of the total stock of non-monetary gold, very little of it is left in Western hands. And so long as the pressure for migration out of the West’s ownership continues, there will come a point where there is so little gold left that futures and forwards markets cease to operate effectively. That point might have actually arrived, signalled by attempts to smash the price this month.
This admittedly broad-brush assessment has important implications for the price stability essential to bullion banks operating in paper markets as well as for central banks attempting to maintain confidence in their paper currencies.
Precious metals in capital markets
In the West itself, the attitudes of the investment community are fundamentally different from even those of the majority of Western hoarders, who are looking for protection from systemic and currency risks as opposed to investment returns. Western investors are generally oblivious to the implications, the most fundamental of which is that falling prices actually stimulate physical demand. Before the recent dramatic slide in prices the investment community undervalued precious metals compared with Western hoarders, let alone those in Asia, encouraging physical bullion to migrate from financial markets both to firmer hands in the West as well as the bulk of it to non-West ownership. There is now irrefutable evidence that these flows have accelerated significantly on lower prices in recent weeks, as rational price theory would lead one to expect.
Pricing bullion is therefore not as simple as the investment community generally believes. It is being put about, mostly on grounds of technical analysis, that the bull markets in gold and silver have ended, and precious metals have entered a new downtrend. The evidence cited is that medium and longer-term moving averages have been violated and are now falling; furthermore important support levels have been breached.
These developments, which arise out of the futures and forward markets, have rattled Western investors who thought they were in for an easy ride. However, a close examination of futures trading shows the bearish case even on investment grounds is flawed, as the following two charts of official statistics provided by weekly Commitment of Traders data clearly show.
The Money Managers category is the clearest reflection in the official data of investor portfolio positions, representing sizeable mutual and hedge funds. In both cases, the number of long contracts is at historically low levels, and shorts, arguably the better reflection of money-manager sentiment, remain close to high extremes. On this basis, investor sentiment is clearly very bearish already, with the investment management community already committed to falling prices. Put very simplistically there are now more buyers than sellers.
Money Managers are in stark opposition to the Commercials, who seek to transfer entrepreneurial risk to Money Managers and other investor and speculator categories. The official statistics break Commercials down into two categories: Producer/Merchant/Processor/User, and Swap Dealers. Both categories include the activities of bullion banks, which in practice supply liquidity to the market. Because investors and speculators tend to run bull positions, bullion banks acting as market-makers will in aggregate always be short. A successful bullion bank trader will seek to make trading profits large enough to compensate for any losses on his net short position that arise from rising prices.
A bullion bank trader must avoid carrying large short positions if in his judgement prices are likely to rise. He will be more relaxed about maintaining a bear position in falling markets. Crucially, he must keep these opinions private, and the release of market statistics are designed to accommodate these dealers’ need for secrecy.
Bullion banks’ position details are disclosed at the beginning of every month in the Bank Participation Reports, again official statistics. They are broken down into two categories, based on the individual bank’s self-description on the CFTC’s Form 40, into US and Non-US Banks. Their positions are shown in the next two charts (note the time scale is monthly).
 
In both gold and silver, the bullion banks have managed to reduce their exposure from extreme net short over the last four months. The reduction of their market exposure suggests that they have been deliberately transferring this risk to other parties, and is consistent with an anticipation that bullion prices will rise. It is the other side of the high level of bearishness reflected in the Money Manager category shown in the first two charts. The bullion banks control the market; the Money Managers are merely tools of their trade.
There has been little reduction in open interest in gold and it has remained strong in silver, because risk has been transferred rather than extinguished. Daily official statistics on open interest are provided by the exchange and summarised in the next two charts (note that data is daily).
 
From these charts it can be seen that recent declines in the gold price are failing to reduce open interest further, and in silver open interest remains stubbornly high. Therefore, attempts by bullion banks to reduce their net short exposure by marking prices down are showing signs of failure.
We can therefore conclude that investor sentiment is at bearish extremes and the bullion banks have reduced their net short exposure to levels where it risks rising again. Therefore the downside for precious metals prices appears to be severely limited, contrary to sentiments expressed by technical analysts and in the media.
This market position is against a background of a growing shortage of physical bullion, which is our next topic.
Physical markets
Casual observers of precious metal prices are generally unaware that the headline writers focus on activity in the futures markets and generally ignore developments in physical bullion. This is consistent with the fact that market data is available in the former, while dealing in the latter is secretive. However, as with icebergs, it is not what you see above the water that matters so much as that which is out of sight below.
It is not often understood in investment circles that gold and silver are commodities for which the laws of supply and demand are not overridden by investor psychology. Therefore, if the price falls, demand increases. Indeed, the increase in demand has far outweighed selling by nervous investors; even before the price-drop, demand for both silver and gold significantly exceeded supply. Evidence ranges from readily available statistics on record demand for newly-minted gold and silver coins and the net accumulation of gold by non-Western central banks, to trade-based information such as imports and exports of non-monetary gold as well as reports from trade associations reporting demand in diverse countries such as India, China, the UK, US, Japan and even Australia.
All this evidence points in the same direction: that physical demand is increasing on every price drop. There is therefore a growing pricing conflict between futures and forward markets, which do not generally involve settlement but the rolling-over of speculative positions, and of the underlying physical metal. Furthermore, analysts make the mistake of looking at gold purely in terms of mining and scrap supply, when nearly all gold ever mined is theoretically available to the market, in the right conditions and at the right price. The other side of this larger coin is that if the price of gold is suppressed by activity in paper markets to below what it would otherwise be, the stimulus for physical demand, being based on a 160,000 tonne market, is likely to be considerably greater on a given price drop than analysts who are myopic beyond 2,750 tonnes of annual mine production might expect. The numbers that are available confirm this to have been the case, particularly over the last few weeks, with reports from all over the world of an unprecedented surge in demand.
This is at the root of a developing crisis of which few commentators are as yet aware. Demand for physical has accelerated the transfer of bullion from capital markets to hoarders everywhere and from the West’s capital markets to other countries, which has been the trend since the oil crisis in the mid-Seventies. This is what’s behind an acute shortage of physical gold in capital markets, explaining perhaps why bullion banks feel the need to reduce their short positions.
While we can detail their exposure in futures markets, meaningful statistics are not available in over-the-counter forward markets, particularly for London, which dominates this form of trading. Forwards are considerably more flexible than futures as a trading medium, generating trading profits, commissions, fees and collateralised banking business. The ability to run unallocated client accounts, whereby a client’s gold is taken onto a bank’s balance sheet, is in stable market conditions an extremely profitable activity, made more profitable by high operational gearing. The result is that paper forward positions are many multiples of the physical bullion available. The extent of this relationship between physical bullion and paper is not recorded, but judging by the daily turnover in London there is an enormous synthetic short physical position. For this reason a sharply rising price would be catastrophic and any drain on bullion supplies rapidly escalates the risk.
Overseeing this market is the Bank of England co-operating with other Western central banks and the Bank for International Settlements, whose combined interest obviously favours price stability. They have been quick to supply the market if needed, confirmed by freely-admitted leasing operations in the past, and by secretive supply into the market, which has been detected by independent supply and demand analysis over the last 15 years. Furthermore, as currency-issuing banks, central banks are unlikely to take kindly to market signals that suggest gold is a better store of value than their own paper money.
We can only speculate about day-to-day interventions by Western central banks in gold markets. In this regard it seems that the slide in prices on the 12th and 15th April was triggered by a very large seller of paper gold; if this market story and the amount mentioned are correct, it can only be central bank intervention, acting to deliberately drive prices lower. Given the market position, with Money Managers in the futures markets already short and highly vulnerable to a bear squeeze, the story seems credible. The objective would be to persuade holders of physical ETFs and allocated gold accounts to sell and supply the market, on the assumption that they would behave as investors convinced the bull market is over.
Conclusions
For the last 40 years gold bullion ownership has been migrating from West to elsewhere, mostly the Middle East and Asia, where it is more valued. The buyers are not investors, but hoarders less complacent about the future for paper currencies than the West’s banking and investment community. There was a shortage of physical metal in the major centres before the recent price fall, which has only become more acute, fully absorbing ETF and other liquidation, which is small in comparison to the demand created by lower prices. If the fall was engineered with the collusion of central banks it has backfired spectacularly.
The time when central banks will be unable to continue to manage bullion markets by intervention has probably been brought closer. They will face having to rescue the bullion banks from the crisis of rising gold and silver prices by other means, if only to maintain confidence in paper currencies. Any gold held by struggling eurozone nations, theoretically available to supply markets as a stop-gap, will not last long and may have been already sold.
This will likely develop into another financial crisis at the worst possible moment, when central banks are already being forced to flood markets with paper currency to keep interest rates down, banks solvent, and to finance governments’ day-to-day spending. Its importance is that it threatens more than any other of the various crises to destabilise confidence in government-backed currencies, bringing an early end to all attempts to manage the others systemic problems.
History might judge April 2013 as the month when through precipitate action in bullion markets Western central banks and the banking community finally began to lose control over all financial markets.
This article was previously published at GoldMoney.com.
By Alasdair Macleod, on 21 April 13
The following is a transcript of the “Adam Smith Lecture” I gave at a private gathering in London on 19 February.
For a long time governments have been redistributing peoples’ income and wealth in the name of fairness. They provide for the unemployed, the sick, and the elderly. The state provides. You can depend on the state. The result is nearly everyone in all advanced countries now depends on the state.
Unfortunately citizens are running out of accessible wealth. Having run out of our money, Governments are now themselves insolvent. They started printing money in a misguided attempt to manage our affairs for us and now have to print it just to survive. The final and inevitable outcome will be all major paper currencies will become worthless.
To appreciate the scale of these problems, we must understand the errors in economic and monetary policies. I shall start with economics.
Economics
Modern economists retreat into two comfort zones: empirical evidence and mathematics. They claim that because something has happened before, it will happen again. The weakness in this approach is to substitute precedence for the vagaries of human nature. We can never be sure of cause and effect. Human action is after all subjective and therefore inherently unpredictable.
The mathematicians like to think that economics is a physical science and is not a slippery social science. Economics is a branch of human psychology. It is plainly nonsensical to apply maths to human psychology.
The result is that much of the good work done by the classical economists like Adam Smith has been destroyed by modern economics. The classical economists explained the benefits of doing away with tariffs and the guilds. This revelation was instrumental to the industrial revolution. Then along came Marx who persuaded people that economics was a class interest, that free market economists were promoting the interests of the bourgeois businessman to the disadvantage of the worker. That became the justification for communism and socialism. Keynes and those that followed him never properly challenged Marxian fallacies. They were never involved in what became known as the socialist calculation debate.
It is not generally appreciated that Keynes was strongly socialistic. In the concluding remarks to his General Theory, Keynes looks forward to the euthanasia of the rentier (or saver) and that the State will eventually supply the resources for capital investment. He wanted the state to control profits.
Keynes was primarily a mathematician. Keynes was no more an economist than Karl Marx, whose beliefs led to the economic destruction of Russia and China; or John Law, who bankrupted France, with similar fallacies to those of Keynes.
The misconceptions of Keynesianism are so many that the great Austrian economist von Mises said that the only true statement to come out of the neo-British Cambridge school was “in the long run we are all dead”.
Let me define economics for you at the simplest level. We divide our labour. Each one of us is a consumer; an entrepreneur whether for wages or profit; and a saver for the future. We invest savings to improve production. Each of us discharges these three functions in the proportions we choose as individuals, we interact with others doing the same thing. We exchange our goods at mutually agreed prices using money to facilitate the exchange. We use money to keep score, and that money has to be sound for our calculations to mean anything. Together we are society itself, each providing things others want and will pay for.
The state has no role in this process. Instead it is a cost to society, because it takes some of our spending and savings to support itself. The more the state takes the greater the burden. It destroys society’s potential wealth. But it has not stopped there. Socialism forces the vast majority of people to give up saving and rely on the state to provide. Governments everywhere are now encumbered with obligations they cannot possibly discharge.
Money
On the money side our mistakes go back to the Bank Charter Act of 1844.
The Bank Charter Act gave the Bank of England a note-issuing monopoly backed by gold and government debt. It failed to stop other banks issuing bank credit. This led to credit-driven business cycles which were socially destabilising, adding fuel to the various brands of communism and socialism that developed in the late nineteenth century.
Gold backing for the Bank of England’s notes was gradually eroded, starting in the late 1890s, with a number of countries, including Britain, abandoning it altogether in the interwar years. A gold-exchange standard was adopted for central banks at Bretton Woods. And finally President Nixon in August 1971 abandoned gold altogether.
Ever since then, the expansion of money supply has been increasing exponentially. Quantitative easing is now required to keep the pace of printing up, lest interest rates begin to rise.
Monetary policy from the 1920s has been used to manage an increasingly unstable global economy. The irony is that this instability has its origins in the expansion of money and credit itself. The growth of money supply and bank credit has as its counterpart debt. Few are the assets not encumbered with this debt. Asset prices need more money and credit to sustain them. It is a finite process that ended with the credit crunch five years ago.
That is the background. Now I shall look at the situation today, five years on from the credit crunch. There are four interlinked problems that cannot be resolved: the economy, the banks, government finances and population demographics.
The economy
The advanced economies have been progressively undermined by government intervention and unsound money. They are taxed and regulated to such a degree that laissez-faire hardly exists anymore.
Government spending typically amounts to 50% of GDP in the advanced economies; sometimes more, sometimes less. For productive businesses it is like running a marathon carrying a bureaucrat on your back who tells you how to run.
The misallocation of economic resources which is the result of decades of increasing government intervention cannot go on indefinitely. Businesses have stopped investing, which is why big business’s cash reserves are so high. Money is no longer being invested in production; it is going into asset bubbles. Dot-coms, residential property, and now on the back of zero interest rates government bonds and equities. These booms have hidden the underlying malaise. There can be no economic recovery. Our bureaucrat-carrying marathon runner is finally collapsing under his burden.
The burden of government is now too great to be sustained.
Banks
Banks are geared 25 to 30 times, which is fine if you can grow your way out of problems. That is no longer the case. They are vulnerable to existing but unrecognised bad debts, and now a fall in government bond prices. All that’s needed to trigger a collapse in the banks is absence of economic recovery. If we have a downturn it will be quicker. All that’s needed is a rise in interest rates, to reduce collateral values. All that’s needed is a fall in asset prices.
Then there is the shadow banking system, which the Bank for International Settlements reckoned amounts to over $60 trillion, of which $9 trillion is in the UK. If an investment bank goes under, the shadow banking system could make it virtually impossible to ring-fence the others.
Another area of risk is cross-border exposure. Cross border loans in Europe amount to EUR3.5tr. France is 1.2tr. Italy 700bn. Spain 500bn. These are only the obvious risks. Much of this is cross-border within the eurozone, meaning a default in any of those three is certain to wipe out the European banking system, and then everyone else’s.
For this not to happen requires the central banks to make available unlimited funds in the form of credit and raw money. As Mario Draghi said, whatever it takes. His solution is to print enough fiat currency to save the system.
Government finances.
From the time of the banking crisis, government finances have deteriorated sharply, and their debts rocketed. No country, except some in the Eurozone has managed to cut government spending, and only those which did, did so under extreme financial pressure and because they couldn’t print money. The fact is that everywhere government spending is increasingly mandated into pensions, social services and healthcare, which makes spending cuts extremely difficult.
Until recently it was assumed that economic recovery would generate the taxes to balance the books. That has not happened, nor can it happen. In the Eurozone governments are now taking on average over half of every working man’s income and deploying it unproductively. Take France. Government is 57% of GDP. The population is 66m, of which the employed working population is about 25m, 17m in the productive private sector. The taxes collected on 17m pay for the welfare of 66m. The taxes on 17m pay all government’s finances. The private sector is simply over-burdened and is being strangled.
The interest rates at which governments borrow are entirely artificial, made artificial by their own intervention in the debt markets. They are financing themselves by printing money to buy their own debt. The moment this ends, and it will, money will flow out of bonds, equities and even property priced on the back of low interest rates. The pressure for interest rates to rise will have to be met with yet more money printing, because governments cannot afford to pay higher interest rates, nor can they afford to see private sector asset values fall. Price inflation will create a real crisis, perhaps later this year.
Population demographics
Populations in the US, the UK, Japan and Europe are growing older. This is bad news for government finances. When someone retires, he stops paying income taxes and becomes a cost. High unemployment is also costly, because the unemployed are not funding future liabilities. Professor Kotlikoff of Boston University has calculated that in fiscal 2012 the net present value of the US Government’s future liabilities increased $11 trillion to $212tr. The whole US economy is only $15 trillion. Europe is worse, far worse: Europe has more pensioners as a proportion of the working population, high rates of unemployment and a large government relative to the private sector, which funds it all. The UK, taking these factors into account, is slightly worse off than the US. Japan has worse birth rates and longevity. They sell more nappies for the incontinent than they do for new-borns. The solution already is to issue increasing amounts of unsound currency.
Conclusion
The world’s economic problems have been building for a long time. Economic fallacies have been pursued first by Marx and then by Keynes in the 20th century, and monetary policy first took a wrong turn with the Bank Charter Act of 1844. The progressive replacement of sound money by fiat currency has destroyed economic calculation, and has destroyed private sector wealth. These policies were deliberate. We have now run out of accessible wealth to transfer from private individuals to governments. That is our true condition.
Governments will still seek to save themselves at the continuing expense of their citizens, and in the process destroy what wealth is left.
There can only be one outcome: the bankruptcy of governments. This means that their fiat currencies will inevitably lose all their purchasing power.
How soon? I’m afraid sooner than most people think. Japan is already entering the black hole, with her currency beginning its collapse. The UK is on the precipice and cannot afford further falls in sterling without triggering the rise in inflation that will force a rise in interest rates and a spiral into insolvency. Europe could go at any time. The US is probably the best of a very bad bunch, but even her economy is looking bad.
I do not make these statements because I am gloomy. I make them because I approach economics without emotion and without political bias. I make them because I have considered our true economic and monetary position using as far as I am able sound aprioristic theory applied to our current position.
Thank you.
This transcript was previously published at GoldMoney.com.
By Alasdair Macleod, on 3 April 13
It has been obvious for some time that banks in many jurisdictions are insolvent and that they are simply too big for governments to rescue. Furthermore, while some governments feel they have a reasonable chance of muddling through, they are all aware that a crisis in one major nation, such as Spain or Italy would most probably lead to a chain of defaults beyond anyone’s control. It should come as no surprise that central bankers have been considering how to deal with this problem and that they have resolved a solution.
That solution, as we saw clumsily applied in Cyprus, is for central banks to use creditors’ funds to rescue banks in difficulty, which includes uninsured deposits, instead of taxpayers’ money. What this means is that if you have deposits greater than the level guaranteed by your government, the unguaranteed portion (in the eurozone, over €100,000) is free to be used to recapitalise the bank.
This is a major departure from past assumptions, that central banks would do their utmost to rescue banks without raiding any deposits. As many ordinary savers in Cyprus found to their cost, this is no longer true. The new approach has been agreed at the highest levels, at the Bank for International Settlements, the central bankers’ central bank. It has been a topic under consideration since the publication by the Financial Stability Board (a BIS committee) of a paper, Key Attributes of Effective Resolution Regimes for Financial Institutions in October 2011, which was endorsed at the Cannes G20 summit the following month. This was followed by a consultative document in November 2012, Recovery and Resolution Planning: Making the Key Attributes Requirements Operational. In this latter document it is stated in the introduction that “Reforms are now underway in many jurisdictions to align national resolution frameworks more closely with the Key Attributes (i.e. the October 2011 paper). In other words any changes to law have been or are being made.
This confirms that G20 members are ensuring that they can legally override the rights of creditors, including uninsured depositors. This outcome is not difficult to achieve when the alternative in almost all cases of bank failure is for uninsured deposits to be wiped out completely.
The status of deposits
It is commonly assumed that money on deposit belongs to the depositor. This is not true, because the depositor lends his money to the bank, so the money becomes the bank’s property and merely owes it to the depositor. The depositor is usually the most senior class of unsecured creditor. There are however three broad classes of deposit to consider:
- Insured deposits, guaranteed by a government or government agency. These protect smaller deposits up to a limit set by government;
- Uninsured deposits owed to non-monetary and non-financial institutions (non-MFIs); and
- Wholesale deposits owed to monetary and financial institutions (MFIs).
The BIS proposals being enacted throughout the G20 allow for different treatment for these deposit classes in a bank rescue. The government or its agency is going to have to pay out for insured deposits anyway, so it makes sense for them to remain untouched. Wholesale deposits, which are not the focus of the BIS proposal, are unlikely to be touched except in the case of very small bank failures, because of the risks spreading to other banks and financial institutions. This leaves the full burden of depositor contributions to a bank rescue falling on the shoulders of uninsured non-MFIs. In other words any deposit in excess of the insured amount owned by individuals, companies, trusts, pension funds and other savings vehicles, and any segregated client accounts operated by business lawyers and brokers acting as agents for its customers is likely to be raided where there is a risk of bank failure. Any business receiving payments into its bank account in excess of the insured limit is similarly at risk.
Anyone in this position is simply being negligent if he or she assumes deposits are safe. The smaller a bank’s uninsured non-MFI depositor base is relative to the other depositor classes the greater the amount these depositors will lose in a bank rescue. Therefore non-insured deposits are particularly vulnerable in retail and high street banks targeting small savers, such as mortgage and savings banks, as well as banks with a large element of wholesale funding.
What are the alternatives?
Uninsured non-MFI depositors have three broad choices.
- They can move their deposits to a bank they feel is safe. This may reduce a specific risk, but does not eliminate depositor risk, bearing in mind that all G20 jurisdictions will substitute uninsured non-MFI deposits for tax-payers funds in a bank rescue.
- They can spread their deposits between several unrelated banks so that each one is insured. This may be a practical solution for deposits up to two or three times the insured level.
- They can reduce their deposits by acquiring something else.
The first two options need little further comment, but the third must be explored further. Physical cash is an option but impractical except for relatively small amounts, because most governments have moved to restrict its use by the imposition of anti-money laundering and other rules. The two further alternatives are to invest in securitised alternatives, such as government bonds and other instruments, or in precious metals. And in the case of precious metals, there are mining shares, ETFs and possession of physical metal.
The case for precious metals
The fact that the BIS feels it has been necessary to co-ordinate G20 nations into a common approach to bank rescues using uninsured non-MFI deposits is evidence that bank failures capable of threatening the global financial system are definitely an ongoing risk. The central banks will have calculated that raiding this category of deposits is a matter of expediency, and any run on deposits out of vulnerable banks can be contained by central banks acting as lender of last resort. This is based on the simple fact that either deposits are moved around the system, or when they are drawn down in favour of something else, the money released remains in the banking system. However, raiding these deposits is only an interim solution, because the underlying assumption is that the financial condition of the whole banking system does not deteriorate further.
It is not the intention of this article to argue for or against this assumption, beyond pointing out that the BIS approach is merely a stop-gap solution that does not deal with underlying economic and financial problems. The difficulties governments face cannot be resolved by just applying sticking plaster on insolvent banks.
Depositors are learning that governments, acting in the name of the tax-payer, will do anything for their own survival, debasing savings to cover state spending and now raiding deposits to maintain the status quo. Many depositors take the view that holding short-dated government bonds and similar assets priced on interest rates is risky, which is why they have money on deposit. It is therefore very likely that deposit money will flow into precious metals.
A version of this article was previously published at GoldMoney.com.
By Alasdair Macleod, on 1 April 13
Almost certainly prices for goods in Cyprus will rise as a result of its banking crisis, because the imposition of capital controls will restrict imports, leading to supply bottlenecks. In addition residents will no longer be complacent about keeping money on deposit, but seek other alternatives. Large depositors may be trapped, but smaller local depositors will draw them down for cash to stock up on things needed tomorrow while they are available.
Cypriots will therefore change their preferences from money in the bank in favour of goods. And the lessons from Cyprus are not being lost on ordinary folk across the eurozone, so bank depositors elsewhere are likely to alter their preferences away from bank deposits as well, depending on how they view the soundness of their own banks.
The purpose of this article is to draw attention to the price effect of the likely change in preferences between bank deposits and goods. Prices change either as a result of monetary inflation, which is a gradual process, or as a result of changes in money-preference, which is often substantial and sudden in its effect.
The most recent example of the effect of a change in money-preference was the global banking crisis five years ago, when it went the other way. Banks quickly switched to being risk-averse, and consumers did the same thing. On this occasion it was a change in preference in favour of money, the consequence being prices of goods and services needed to fall significantly to restore the balance between supply and demand. This was why so many manufacturers were in trouble.
When preferences for goods increase, as seems certain in Cyprus, the price effect could also be alarming, exacerbated by those capital controls on import payments. A price boom is created, rapidly driving up local prices against supply constraints.
We must now consider to what extent a decline in money-preference in favour of goods might take hold in other countries in the eurozone, where private citizens become concerned about the security of their deposits. The indications are that depositors are already looking to withdraw deposits in the weaker eurozone states, confirming that a change in money-preference is spreading. This being the case, the surprise for observers will be the sudden strength of price inflation, the root of which is eroding confidence in the eurozone’s banks. What is remarkable is the clumsy way in which it is being precipitated, in an apparent desire to punish little Cyprus.
This punitive action is therefore likely to develop into a withdrawal of deposits large and small around the eurozone. With it will go an increasing preference for goods, pushing prices sharply higher, particularly in Spain, Portugal, Greece, Italy and even elsewhere as the effect spreads. The question then becomes how will the ECB respond: will it raise interest rates to curb this unexpected price inflation, or keep them low for fear of precipitating a collapse of insolvent banks and governments?
At stake is an eventual loss of confidence in the euro itself, as larger deposits flee for safety. In the short-term the US dollar and Swiss franc should benefit, but that doesn’t get your money out of the banks, because if the eurozone’s banks fail no bank and no paper currency is safe and their depositors might be raided. The only safety is in true money that has stood the test of time: gold and silver.
By Alasdair Macleod, on 17 March 13
Many of us are aware of Professor Laurence Kotlikoff of Boston University’s calculation that the net present value of the US Government’s future liabilities rose by $11 trillion in fiscal 2012 to $222 trillion. These are principally welfare, healthcare and social security costs.
This is admittedly a high-end estimate, dependent on variables such as longevity, demographics and the interest rate at which future liabilities are discounted. It is an escalating problem, because baby-boomer retirees suddenly stop paying income and social security taxes and instead draw down on the system. The implication is that these costs are impacting government finances at an increasing rate, potentially undermining the creditworthiness of the US Government.
According to OECD figures other countries appear to be in far worse positions, as shown in the table below, where they are ranked by cash pension costs faced by governments in 2011.
 However, pensions are only part of the story, with all these countries providing healthcare and other social services, which with aging populations is a substantial and increasing cost. And while some state healthcare provisions are better than others, when healthcare is run by the state it is more likely to be better as the result of higher spending than greater efficiency. Furthermore, the OECD figures are for cash benefits, excluding benefits in kind; so in Ireland’s case, where pension benefits in kind are estimated by the OECD to be three times the cash amount, the true cost works out at closer to 15% of her GDP.
Japan’s demographic crisis has been well publicised, which is reflected in the figure of 35.5% for pensioners as a percentage of the working population, and presumably worse than that today. However, the financial press is less familiar with the enormous future commitments of European governments, which are truly alarming. And these figures do not even fully expose the difficulties for governments to deliver their welfare obligations.
Eurozone unemployment is over 10% on average. This means that 10% of tax contributors are out of the picture and become a welfare burden, so Spain and Greece where unemployment is at 26% are in immediate trouble with their welfare budgets. Another unfavourable factor is the dominance of the state.
Take France, whose general government is 57% of GDP. Her working population is 28 million out of a total population of 66 million; 3 million are unemployed, which leaves 25 million, of which 8 million are employed by government. We can disregard government employees, since they are a net government liability, not a source of revenue.
That leaves only 17 million productive taxpayers who have to pay for the welfare and pensions for 66 million in a heavily state-controlled economy. Furthermore, a significant proportion of private sector employees are working in nationalised or government-supported industries, so the true figure of real taxpayers is significantly less than 17 million.
We can draw two conclusions about the European states: their welfare, health and social service liabilities are, unless they ditch the majority of their welfare commitments, going to bankrupt them; and because their true taxpaying base to fund this largess is smaller than generally realised, taxes are going to have to rise to the point where it is not worth genuinely productive people working.
This article was previously published at GoldMoney.com.
By Alasdair Macleod, on 11 March 13
The quantity theory of money and its accompanying equation of exchange are generally accepted as defining the relationship between money and prices. The equation has been expressed a number of ways, always including “velocity of circulation”, which is a variable essential to balance the equation.
Few disagree with the simple premise that an increase in the quantity of money tends to increase prices; the mistake is to try to tie the relationship mathematically, because it rides roughshod over what actually happens. Not all prices rise at the same time, nor do they rise evenly. Furthermore, the equation of exchange cannot differentiate between price changes that emanate from demand for goods and those that emanate from changes in preference for money – two effects that can produce very different results. These unknowns are effectively wrapped up in that catch-all, velocity of circulation.
Aprioristic theory tells us where the error lies. People make a choice to allocate their income between current consumption and savings for the future. The most they can do without incurring debt is spend their earnings once. In practice most income is spent on consumption, but some is put aside for savings, and those savings are lent on through financial intermediaries to businesses for investment. Savings end up being spent on capital goods and working capital, instead of immediate consumption, but they are still spent.
If there is an increase in the quantity of money it is spent by those that first obtain it, but the same rule applies: they can only spend their money once. How that increase is spent determines which prices will tend to rise. Furthermore demand for goods can change as the quantity of currency and bank credit changes and consumers can also change their preference for money by hoarding or dishoarding only marginal amounts of cash. It is these factors that govern the relationship between money and prices. Therefore, the number of times a unit of account circulates over a given time is a red herring.
The fallacies behind the equation of exchange are more fully exposed in the case of a fiat currency, which unlike gold has no intrinsic value at all. What it will buy is set by its domestic acceptability as a money substitute amongst those that use it for transactions, and by its external value in the foreign exchanges set by those that don’t. Its purchasing power boils down to a matter of confidence and nothing else; therefore velocity is meaningless.
Consider the Icelandic krona’s dramatic fall in purchasing power in October 2008. According to the equation of exchange, the sharp increase in domestic prices that followed must be the result of an expansion in the quantity of money and/or an acceleration of velocity of circulation. What actually happened was simply a collapse in the purchasing power of the krona that originated in the markets, which had nothing to do with any monetary equation.
Velocity is an invention by economists to balance an equation conjured out of their own imagination, instead of understanding that the purchasing power of today’s fiat currencies is governed solely by the confidence placed in them. And because they have no intrinsic value, the quantity theory itself is a wholly inadequate explanation of the relationship between fiat money and prices.
This article was previously published at GoldMoney.com.
By Alasdair Macleod, on 5 March 13
The London Bullion Market is the global trading centre for physical gold, and the Bank of England holds gold on behalf of other central banks. There are a number of historical reasons the Bank has this privileged role, but the most important are that the Bank is trusted, and it oversees the largest bullion market by far. Therefore a significant portion of the world’s monetary gold should be stored at the Bank of England.
This does not appear to be the case. First, we must try to get an idea of how much unidentified central bank, or monetary gold, is in London at the Bank of England.
Table 1 shows the derived figures for February 2006 and 2012 (The Bank’s accounting year-end).
Subtracting the known or reasonably estimable quantities listed in the table leaves 2,220 tonnes unidentified in 2006, which rose to 4,691 in 2012. To see how these figures stack up in a global context, we need to compose a second table (Table 2).
China, Russia and the middle-Asian states are taken out on the basis that their gold reserves are mostly from local mine production, and for political reasons they can be deemed unlikely to hold gold in London. The United States is assumed to hold all its gold on its own territory.
Immediately we can see a disparity, with unidentified central bank holdings in Table 2 declining by 464 tonnes, whereas the Bank of England reports an increase of 2,471 tonnes in custody. The explanation – taking the World Gold Council/IMF figures at face value – is that either central banks have been shipping their gold to London, or much more likely, the increase is not monetary gold at all. If the latter is correct, and given that the unidentified gold figures in Table 2 declined over the period, the maximum figure for monetary gold has to be within the 2,220 tonnes recorded in 2006.
This 2006 figure includes an undeclared quantity of gold held on behalf of bullion banks, but comparing the LBMA’s clearing statistics at the two dates suggests little overall variation in LBMA stocks. Logically the balance must be non-monetary gold held on behalf of governments and sovereign wealth funds, on the basis that no one else would be eligible for a bullion account with the Bank. Given the political instability in the Middle East and elsewhere over the last decade, it is very likely that this is the origin of the ownership of much of this custodial bullion. And if that is the case, we can assume that these holdings began to accumulate in the Bank’s custody before 2006.
This being the case, a significant portion of the 2006 figure of 2,220 tonnes must also be non-monetary gold. Therefore, on the basis of reasonable supposition it appears that the total amount of monetary gold at the Bank of England, including that of Germany, Austria and Mexico and the UK’s own stock, cannot be more than 3,320 tonnes, perhaps significantly less. The belief that the world’s central banks store a significant amount of their gold in London is therefore incorrect.
This raises two interesting questions: where is it all, and does it actually exist?
This article was previously published at GoldMoney.com.
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