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Economics

Renewed estimates of Chinese gold demand

Editor’s note: This article was previously published here at Goldmoney.com. It is republished with thanks.

Geopolitical and market background

I have been revisiting estimates of the quantities of gold being absorbed by China, and yet again I have had to revise them upwards. Analysis of the detail discovered in historic information in the context of China’s gold strategy has allowed me for the first time to make reasonable estimates of vaulted gold, comprised of gold accounts at commercial banks, mine output and scrap. There is also compelling evidence mine output and scrap are being accumulated by the government in its own vaults, and not being delivered to satisfy public demand.

The impact of these revelations on estimates of total identified demand and the drain on bullion stocks from outside China is likely to be dramatic, but confirms what some of us have suspected but been unable to prove. Western analysts have always lagged in their understanding of Chinese demand and there is now evidence China is deliberately concealing the scale of it from us. Instead, China is happy to let us accept the lower estimates of western analysts, which by identifying gold demand from the retail end of the supply chain give significantly lower figures.

Before 2012 the Shanghai Gold Exchange was keen to advertise its ambitions to become a major gold trading hub. This is no longer the case. The last SGE Annual Report in English was for 2010, and the last Gold Market Report was for 2011. 2013 was a watershed year. Following the Cyprus debacle, western central banks, seemingly unaware of latent Chinese demand embarked on a policy of supplying large quantities of bullion to break the bull market and suppress the price. The resulting expansion in both global and Chinese demand was so rapid that analysts in western capital markets have been caught unawares.

I started following China’s gold strategy over two years ago and was more or less on my own, having been tipped off by a contact that the Chinese government had already accumulated large amounts of gold before actively promoting gold ownership for private individuals. I took the view that the Chinese government acted for good reasons and that it is a mistake to ignore their actions, particularly when gold is involved.

Since then, Koos Jansen of ingoldwetrust.ch has taken a specialised interest in the SGE and Hong Kong’s trade statistics, and his dedication to the issue has helped spread interest and knowledge in the subject. He has been particularly successful in broadcasting market statistics published in Chinese to a western audience, overcoming the lack of information available in English.

I believe that China is well on the way to having gained control of the international gold market, thanks to western central banks suppression of the gold price, which accelerated last year. The basic reasons behind China’s policy are entirely logical:

  • China knew at the outset that gold is the west’s weak spot, with actual monetary reserves massively overstated. For all I know their intelligence services may have had an accurate assessment of how much gold there is left in western vaults, and if they had not, their allies, the Russians, probably did. Representatives of the People’s Bank of China will have attended meetings at the Bank for International Settlements where these issues are presumably openly discussed by central bankers.
  • China has significant currency surpluses under US control. By controlling the gold market China can flip value from US Treasuries into gold as and when it wishes. This gives China ultimate financial leverage over the west if required.
  • By encouraging its population to invest in gold China reduces the need to acquire dollars to control the renminbi/dollar rate. Put another way, gold purchases by the public have helped absorb her trade surplus. Furthermore gold ownership insulates her middle classes from external currency instability which has become an increasing concern since the Lehman crisis.

For its geopolitical strategy to work China must accumulate large quantities of bullion. To this end China has encouraged mine production, making the country the largest producer in the world. It must also have control over the global market for physical gold, and by rapidly developing the SGE and its sister the Shanghai Gold Futures Exchange the groundwork has been completed. If western markets, starved of physical metal, are forced at a future date to declare force majeure when settlements fail, the SGE and SGFE will be in a position to become the world’s market for gold. Interestingly, Arab holders have recently been recasting some of their old gold holdings from the LBMA’s 400 ounce 995 standard into the Chinese one kilo 9999 standard, which insures them against this potential risk.

China appears in a few years to have achieved dominance of the physical gold market. Since January 2008 turnover on the SGE has increased from a quarterly average of 362 tonnes per month to 1,100 tonnes, and deliveries from 44 tonnes per month to 212 tonnes. It is noticeable how activity increased rapidly from April 2013, in the wake of the dramatic fall in the gold price. From January 2008, the SGE has delivered from its vaults into public hands a total of 6,776 tonnes. This is illustrated in the chart below.

This is only part of the story, the part that is in the public domain. In addition there is gold imported through Hong Kong and fabricated for the Chinese retail market bypassing the SGE, changes of stock levels within the SGE’s network of vaults, the destination of domestic mine output and scrap, government purchases of gold in London and elsewhere, and purchases stored abroad by the wealthy. Furthermore the Chinese diaspora throughout South East Asia competes with China for global gold stocks, and its demand is in addition to that of China’s Mainland and Hong Kong.

The Shanghai Gold Exchange (SGE)

The SGE, which is the government-owned and controlled gold exchange monopoly, runs a vaulting system with which westerners will be familiar. Gold in the vaults is fungible, but when it leaves the SGE’s vaults it is no longer so, and in order to re-enter them it is treated as scrap and recast. In 2011 there were 49 vaults in the SGE’s system, and bars and ingots are supplied to SGE specifications by a number of foreign and Chinese refiners. Besides commercial banks, SGE members include refiners, jewellery manufacturers, mines, and investment companies. The SGE’s 2010 Annual Report, the last published in English, states there were 25 commercial banks included in 163 members of the exchange, 6,751 institutional clients accounting for 81% of gold traded, and 1,778,500 clients of the commercial banks with gold accounts. The 2011 Gold Report, the most recent available, stated that the number of commercial bank members had increased to 29 with 2,353,600 clients, and given the rapid expansion of demand since, the number of gold account holders is likely to be considerably greater today.

About 75% of the SGE’s gold turnover is for forward settlement and the balance is for spot delivery. Standard bars are Au99.95 3 kilos (roughly 100 ounces), Au99.99 1 kilo, Au100g and Au50g. The institutional standard has become Au99.99 1 kilo bars, most of which are sourced from Swiss refiners, with the old Au99.95 standard less than 15% of turnover today compared with 65% five years ago. The smaller 100g and 50g bars are generally for retail demand and a very small proportion of the total traded. Public demand for smaller bars is satisfied mainly through branded products provided by commercial banks and other retail entities instead of from SGE-authorised refiners.

Overall volumes on the SGE are a tiny fraction of those recorded in London, and the market is relatively illiquid, so much so that opportunities for price arbitrage are often apparent rather than real. The obvious difference between the two markets is the large amounts of gold delivered to China’s public. This has fuelled the rapid growth of the Chinese market leading to a parallel increase in vaulted bullion stocks, which for 2013 is likely to have been substantial.

By way of contrast the LBMA is not a regulated market but is overseen by the Bank of England, while the SGE is both controlled and regulated by the People’s Bank of China. The PBOC is also a member of both its own exchange and of the LBMA, and deals actively in non-monetary gold. While the LBMA is at arm’s length from the BoE, the SGE is effectively a department of the PBOC. This allows the Chinese government to control the gold market for its own strategic objectives.

Quantifying demand

Identifiable demand is the sum of deliveries to the public withdrawn from SGE vaults, plus the residual gold left in Hong Kong, being the net balance between imports and exports. To this total must be added an estimate of changes in vaulted bullion stocks.

SGE gold deliveries

Gold deliveries from SGE vaults to the general public are listed both weekly and monthly in Chinese. The following chart shows how they have grown on a monthly basis.

Growth in public demand for physical gold is a reflection of the increased wealth and savings of Chinese citizens, and also reflects advertising campaigns that have encouraged ordinary people to invest in gold. Advertising the attractions of gold investment is consistent with a deliberate government policy of absorbing as much gold as possible from western vaults, including those of central banks.

Hong Kong

Hong Kong provides import, export and re-export figures for gold. All gold is imported, exports refer to gold that has been materially altered in form, and re-exports are of gold transited more or less unaltered. Thus, exports refer mainly to jewellery which in China’s case is sold directly into the Mainland without going through the SGE, and re-exports refer to gold in bar form which we can assume is delivered to the SGE. Some imported gold remains on the island, and some is re-exported from China back to Hong Kong. This gold is either vaulted in Hong Kong or alternatively turned into jewellery and sold mostly to visitors from the Mainland buying tax-free gold.

The mainstream media has reported on the large quantities of gold flowing from Switzerland to Hong Kong, but this is only part of the story. In 2013, Hong Kong imported 916 tonnes from Switzerland, 190 tonnes from the US, 176 tonnes from Australia and 150 tonnes from South Africa as well as significant tonnages from eight other countries, including the UK. She also imported 337 tonnes from Mainland China and exported 211 tonnes of it back to China as fabricated gold.

Hong Kong is not the sole entry port for gold destined for the Mainland. The table below illustrates how Hong Kong’s gold trade with China has grown, and its purpose is to identify gold additional to that supplied via Hong Kong to the SGE. Included in the bottom line, but not separately itemised, is fabricated gold trade with China (both ways), as well as the balance of all imports and exports accruing to Hong Kong.

The bottom line, “Additional supply from HK” should be added to SGE deliveries and changes in SGE vaulted gold to create known demand for China and Hong Kong.

SGE vaulted gold

The increase in SGE vaulted gold in recent years can only be estimated. However, it was reported in earlier SGE Annual Reports to amount to 519.55 tonnes in 2008, 582.6 tonnes in 2009, and 841.8 tonnes in 2010. There have been no reported vault figures since.

The closest and most logical relationship for vaulted gold is with actual deliveries. After all, public demand is likely to be split between clients maintaining gold accounts at member banks, and clients taking physical possession. The ratios of delivered to vaulted gold were remarkably stable at 1.05, 1.03, and 0.99 for 2008, 2009 and 2010 respectively. On this basis it seems reasonable to assume that vaulted gold has continued to increase at approximately the same amount as delivered gold on a one-to-one basis. The estimated annual increase in vaulted gold is shown in the table below.

The benefits of vault storage, ranging from security from theft to the ability to use it as collateral, seem certain to encourage gold account holders to continue to accumulate vaulted metal rather than take personal possession.

Supply

Supply consists of scrap, domestically mined and imported gold

Scrap

Scrap is almost entirely gold bars, originally delivered from the SGE’s vaults into public hands, and subsequently sold and resubmitted for refining. Consequently scrap supplies tend to increase when gold can be profitably sold by individuals in a rising market, and they decrease on falling prices. There is very little old jewellery scrap and industrial recycling is not relatively significant. Official scrap figures are only available for 2009-2011: 244.5, 256.3 and 405.8 tonnes respectively. I shall therefore assume scrap supplies for 2012 at 430 tonnes and 2013 at 350 tonnes, reflecting gold price movements during those two years.

Scrap is refined entirely by Chinese refiners, and as stated in the discussion concerning mine supply below, the absence of SGE standard kilo bars in Hong Kong is strong evidence that they are withheld from circulation. It is therefore reasonable to assume that scrap should be regarded as vaulted, probably held separately on behalf of the government or its agencies.

Mine supply

China mines more gold than any other nation and it is generally assumed mine supply is sold through the SGE. That is what one would expect, and it is worth noting that a number of mines are members of the SGE and do indeed trade on it. They act as both buyers and sellers, which suggests they frequently use the market for hedging purposes, if nothing else.

Typically, a mine will produce doré which has to be assessed and paid for before it is forwarded to a refinery. Only when it is refined and cast into standard bars can gold be delivered to the market. Broadly, one of the following procedures between doré and the sale of gold bars will occur:

  • The refiner acts on commission from the mine, and the mine sells the finished product on the market. This is inefficient management of cash-flow, though footnotes in the accounts of some mine companies suggest this happens.
  • The refiner buys doré from the mine, refines it and sells it through the SGE. This is inefficient for the refiner, which has to find the capital to buy the doré.
  • A commercial bank, being a member of the SGE, finances the mine from doré to the sale of deliverable gold, paying the mine up-front. This is the way the global mining industry often works.
  • The government, which ultimately directs the mines, refiners and the SGE, buys the mine output at pre-agreed prices and may or may not put the transaction through the market.

I believe the government acquires all mine output, because it is consistent with the geopolitical strategy outlined at the beginning of this article. Furthermore, two of my contacts, one a Swiss refiner with facilities in Hong Kong and the other a vault operator in Hong Kong, tell me they have never seen a Chinese-refined one kilo bar. Admittedly, most one kilo bars in existence bear the stamp of Swiss and other foreign refiners, but nonetheless there must be over two million Chinese-refined kilo bars in existence. Either Chinese customs are completely successful in stopping all ex-vault Chinese-refined one kilo bars leaving the Mainland, or the government takes all domestically refined production for itself, with the exception perhaps of some 100 and 50 gram bars. Logic suggests the latter is true rather than the former.

Since the SGE is effectively a department of the PBOC, it must be at the government’s discretion if domestic mine production is put through the market by the PBOC. Whether or not Chinese mine supply is put through the market is impossible to establish from the available statistics, and is unimportant: no bars end up in circulation because they all remain vaulted. It is material however to the overall supply and demand picture, because global mine supply last year drops to about 2,490 tonnes assuming Chinese production is not available to the market.

Geopolitics suggests that China acquires most, if not all of its own mine and scrap production, which accumulates in the vaulting system. This throws the emphasis back on the figures for vaulted gold, which I have estimated at one-for-one with delivered gold due to gold account holder demand. To this estimate we should now add both Chinese scrap and mine supply. This would explain why vaulted gold is no longer reported, and it would underwrite my estimates of vaulted gold from 2011 onwards.

Further comments on vaulted gold

From the above it can be seen there are three elements to vaulted gold: gold held on behalf of accountholders with the commercial banks, scrap gold and mine supply. The absence of Chinese one kilo bars in circulation leads us to suppose scrap and mine supply accumulate, inflating SGE vault figures, but a moment’s reflection shows this is too simplistic. If it was included in total vaulted gold, then the quantity of gold held by accountholders with the commercial banks, as reported in 2009-11, would have fallen substantially to compensate. This cannot have been the case, as the number of accountholders increased substantially over the period, as did interest in gold investment.

Therefore, scrap and mined gold must be allocated into other vaults not included in the SGE network, and these vaults can only be under the control of the government. It will have been from these vaults that China’s sudden increase in monetary gold of 444 tonnes in the first quarter of 2009 was drawn, which explains why the total recorded in SGE vaults was obviously unaffected. So for the purpose of determining the quantity of vaulted gold, scrap and mined gold must be added to the gold recorded in SGE vaults.

Though it is beyond the scope of this analysis, the existence of government vaults not in the SGE network should be noted, and given cumulative mine production over the last thirty years, scrap supply and possibly other purchases of gold from abroad, the bullion stocks in these government vaults are likely to be very substantial.

Western gold flows to China

We are now in a position to estimate Chinese demand and supply factors in a global context. The result is summarised in the table below.

Chinese demand before 2013 had arrived at a plateau, admittedly higher than generally realised, before expanding dramatically following last April’s price drop. Taking the WGC’s figures for the Rest of the World gives us new global demand figures, which throw up a shortfall amounting to 9,461 tonnes since the Lehman crisis, satisfied from existing above-ground stocks.

This figure, though shocking to those unaware of these stock flows, could well be conservative, because we have only been able to address SGE deliveries, vaulted gold and Hong Kong net flows. Missing from our calculations is Chinese government purchases in London, demand from the ultra-rich not routed through the SGE, and gold held by Chinese nationals abroad. It is also likely that demand from the Chinese diaspora in SE Asia and Asian is also underestimated by western analysts.

There are assumptions in this analysis that should be clear to all. But if it only serves to expose the futility of attempts in western capital markets to manage the gold price, the exercise has been worthwhile. For much of 2013 commentators routinely stated that Asian demand was satisfied from ETF redemptions. But as can be seen, ETF sales totalling 881 tonnes covered only one quarter of the west’s shortfall against China, the rest coming mostly from central bank vaults. Anecdotal evidence from Switzerland is that the four major refiners have been working round-the-clock turning LBMA 400 ounce bars into one kilo 9999 bars for China. They are even working with gold bars that are battered and dusty, which suggests the west is not only digging into deep storage to satisfy Chinese demand at current prices, but digging a hole for itself as well.

Economics

Speech to the Brazilian Chamber of Commerce in London

Last week I spoke to a small group in London about the current monetary situation and the outlook for gold. The speech lasts about 20 minutes and the video can be found here:

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Economics

All currencies are an inverse pyramid based on the dollar

When US money supply measured by M2 stood at $11 trillion in December 2013, I calculate that total broad money of the next largest 50 countries ranked by GDP amounted to the equivalent of a further US$67 trillion at current exchange rates. And that’s only on-balance sheet: we must add in global shadow banking, estimated by the Financial Stability Board to have been an extra $67 trillion in 2011, probably about $75 trillion today, given its recent rapid growth in China. So when we look at US broad money supply, we should be aware there is a further mountain of money thirteen times as big ultimately based on the dollar.

As long as bank lending, industrial investment and consumption are all expanding, the sun smiles. It’s when it stops that problems arise, and why markets reacted badly to the idea of tapering and are increasingly nervous about China’s credit bubble and attempts to rein it in.

More specifically the danger arises from a slow-down and possible reversal of cross-border investment, particularly with emerging economies. Between 2000 and 2007 investment from advanced economies into emerging markets grew at an annual compound rate of about 18%, and between 2008 and 2011 it slowed to about 5% (McKinsey, 2013). The beneficiaries of this investment, global financial assets (all equities, bonds and loans) averaged growth of only 1.9% annually in dollar terms between 2007 and 2011. If we could measure it today the overall return would probably be a big fat zero.

So whatever analysis of individual countries might tell us, it has been easy to miss the threat of a deepening global recession, a risk increased by diminishing cross-border flows. What a time for the Fed and the Peoples Bank of China to decide to reduce the rate of monetary expansion for the two largest economies! These actions are too late to achieve the hoped-for orderly exit from excessive monetary expansion.

If cross-border investment flows reverse, as they are now threatening to do, banks and multinational businesses will run for cover and the carry-trade will rapidly unwind. And when fear of losses finally triumphs over greed for profits the weaker currencies are usually the first to suffer.

The relationship between these currencies and the dollar is now being tested in the markets. Eventually, of course, the Fed will have to resume unlimited monetary expansion to buy off a global economic and financial crisis. In doing so it will probably take comfort in the precedent set when dealing with Lehman. We cannot be so certain of the effects of China’s future monetary policy, other than knowing that in troubled times Chinese citizens turn to gold, along with all the other Asian peoples acutely aware of gold’s ability to store wealth through difficult times.

The last crisis was just the banks. This time we are looking at a potential popping of a full-blown global currency bubble, which was generated as the solution to the last crisis. And this new bubble is all supported on an inflated US monetary base of $3.8 trillion. That’s bubbly gearing of nearly 40 times, or 163 times the monetary base on the eve of the Lehman crisis.

Economics

Emerging markets, interest rates and tapering

Thanks to the Fed’s tapering, a wider public is becoming aware of currency instability in diverse economies, from Turkey to Argentina, and India to Indonesia. Indeed, on Tuesday night Turkey raised overnight interest rates by a whopping 4.5% to 12% in an attempt to stop a run on the lira.

Turkey has her own political problems, perhaps strong enough to knock the stuffing out of her currency on their own, and Argentina seems to be permanently fighting off hyperinflation. But it is a mistake to think that the idiosyncrasies of each currency are solely the cause of their downfall. The fact that these countries’ currency problems are all happening at the same time tells us the common factor is currency itself.

Over the last decade it has been fashionable to invest increasing quantities of money in these economies. Financial flows have also been instrumental in accelerating the growth of local domestic credit. Money flows are now in the process of reverting back to base and the chart below of the Indian rupee is a good example in which this effect on a currency can be observed.

Between 2002 and 2008 the rupee rose against the dollar (i.e. fewer to the dollar) reflecting inward investment, and after the Lehman Crisis it started to fall as the money-tide reversed. Since then the rupee has lost almost 40% of its value. It is also clear from this chart that the primary trend for the rupee has been firmly down for some time.

The same is true of most other emerging market currencies: before the Lehman Crisis investment flows into them fuelled both economic growth and the expansion of bank credit. Since Lehman, these flows have reversed mostly offset by yet more expansion of domestic credit.

Over much of the last century US dollar cash and deposits expanded on the back of a gold standard; in the same way today’s emerging markets have expanded on the back of a dollar standard. Therefore, the redemption of these currencies into the US dollar mirrors pre-WW1 bank runs, except on a global scale. And In every bank run a bank pretends there is no problem until it is too late.

Central banks cannot escape the fact that currencies depend entirely on confidence. Markets are now painfully reminding us of this truism, following the Fed’s second tapering announcement. A whisper in New York becomes a storm in Delhi, Ankara, Sao Paulo, Buenos Aires and Pretoria.

It is an important point. In the same way that under a gold standard a central bank had to have sufficient gold stocks to maintain confidence in its currency, an emerging market central bank has to have sufficient dollar reserves on hand. And this is why from a monetary perspective a desperate central bank is compelled to increase interest rates when Keynesian text books tell us such a move is certain to drive these economies into a deflationary slump.

The screw is now tightening. Having added unprecedented amounts of liquidity into its own economy through quantitative easing, the Fed is now reducing the pace of its expansion of narrow money. Unfortunately this is bad news for emerging market countries, who will surely conclude that international monetary co-operation has broken down.

This article was previously published at GoldMoney.com.

Economics

Why the West sells gold and China buys it

A number of readers and bloggers have recently suggested there must be collusion between America and China over the transfer of physical gold from Western capital markets. They assume that governments know what they are doing, so there is a bigger game afoot of which we are unaware.

The truth is that China and Western capital markets view gold very differently. You will hardly find anyone in the London Bullion Market who regards gold as money; and for them if gold is no longer money Chinese demand for it is not a monetary issue. Instead it threatens the bullion banks’ business that a useful financial asset, capable of earning many times its physical value in fees, commissions, turns and interest, is being leeched out of the market by Chinese aunties.

It is clear that nearly all Western central bankers share this view, believing that gold will never play a monetary role again. We also know that Marxist-educated government advisers in China have been sheltered from the Keynesians’ antipathy against gold and instead have been brought up on Marx’s belief that Western capitalism will eventually destroy itself. It therefore follows they believe that western paper currencies will probably be destroyed as well.

Otherwise we can only speculate, but the following conclusions about why the Chinese are accumulating gold seem to make most sense:

  • There is a fundamental view in China that gold is ultimately money, so it is always worth accumulating by selling potentially worthless foreign currency.
  • Encouraging her citizens to accumulate gold achieves two objectives: if they have real wealth to protect it makes them potentially less rebellious in difficult times; and secondly private buying of gold reduces the trade surplus, which in turn reduces the accumulation of foreign currency reserves.
  • Gold is generally accepted as superior money throughout Asia, which is China’s long-term regional interest.
  • The Chinese Government (and/or the Communist Party) is buying gold for itself. Assumptions it will use gold to beef up the renminbi makes little practical sense, beyond perhaps some window-dressing for currency credibility. Instead she appears to be accumulating gold for unstated strategic reasons.
  • Keeping the West short of gold gives China huge leverage in today’s cold currency war, and even more if the currency war heats up.

The idea that America is colluding with China in the gold market must therefore be nonsense. The truth has everything to do with different philosophies about gold.

Advanced western economies have survived without using gold as money for a considerable time. Currency and credit inflation have created a modern finance industry wholly dependent on fiat paper and everyone in mainstream finance is conditioned to believe in the profitable world of fiat currencies. They are therefore predisposed to dismiss gold as never being money again.

That is why the West is less worried about losing physical gold than it should be, and China is glad of the opportunity to buy it. And she can be expected to continue to do so whatever the price, because she knows that in the final analysis gold is the only true money.

This article was previously published at GoldMoney.com.

Economics

Precious metals in 2014

“Now the New Year reviving old desires
The thoughtful Soul to Solitude retires”
- Rubaiyat of Omar Khayyam

Yes folks, it’s that time of year again; but unlike old Khayyam who reflected bucolically on the continuing availability of wine, we must turn our thoughts to the dangers and opportunities of the coming year. They are considerable and multi-faceted, but instead of being drawn into the futility of making forecasts I will only offer readers the barest of basics and focus on the corruption of currencies. My conclusion is the overwhelming danger is of currency destruction and that gold is central to their downfall.

As we enter 2014 mainstream economists relying on inaccurate statistics, many of which are not even relevant to a true understanding of our economic condition, seem convinced that the crises of recent years are now laid to rest. They swallow the line that unemployment is dropping to six or seven per cent, and that price inflation is subdued; but a deeper examination, unsubtly exposed by the work of John Williams of Shadowstats.com, shows these statistics to be false.

If we objectively assess the state of the labour markets in most welfare-driven economies the truth conforms to a continuing slump; and if we take a realistic view of price increases, including capital assets, price inflation may even be in double figures. The corruption of price inflation statistics in turn makes a mockery of GDP numbers, which realistically adjusted for price inflation are contracting.

This gloomy conclusion should come as no surprise to thoughtful souls in any era. These conditions are the logical outcome of the corruption of currencies. I have no doubt that if in 1920-23 the Weimar Republic used today’s statistical methodology government economists would be peddling the same conclusions as those of today. The error is to believe that expansion of money quantities is a cure-all for economic ills, and ignore the fact that it is actually a tax on the vast majority of people reducing both their earnings and savings.

This is the effect of unsound money, and with this in mind I devised a new monetary statistic in 2013 to quantify the drift away from sound money towards an increasing possibility of monetary collapse. The Fiat Money Quantity (FMQ) is constructed by taking account of all the steps by which gold, as proxy for sound money, has been absorbed over the last 170 years from private ownership by commercial banks and then subsequently by central banks, all rights of gold ownership being replaced by currency notes and deposits. The result for the US dollar, which as the world’s reserve currency is today’s gold’s substitute, is shown in Chart 1.

Chart1FMQ_311213

The graphic similarities with expansions of currency quantities in the past that have ultimately resulted in monetary and financial destruction are striking. Since the Lehman crisis the US authorities have embarked on their monetary cure-all to an extraordinary degree. We are being encouraged to think that the Fed saved the world in 2008 by quantitative easing, when the crisis has only been concealed by currency hyper-inflation.

Are we likely to collectively recognise this error and reverse it before it is too late? So long as the primary function of central banks is to preserve the current financial system the answer has to be no. An attempt to reduce the growth rate in the FMQ by minimal tapering has already raised bond market yields considerably, threatening to derail monetary policy objectives. The effect of rising bond yields and term interest rates on the enormous sums of government and private sector debt is bound to increase the risk of bankruptcies at lower rates compared with past credit cycles, starting in the countries where the debt problem is most acute.

With banks naturally reluctant to take on more lending-risk in this environment, rising interest rates and bond yields can be expected to lead to contracting bank credit. Does the Fed stand aside and let nature take its course? Again the answer has to be no. It must accelerate its injections of raw money and grow deposits on its own balance sheet to compensate. The underlying condition that is not generally understood is actually as follows:

The assumption that the Fed is feeding excess money into the economy to stimulate it is incorrect.
Individuals, businesses and banks require increasing quantities of money just to stand still and to avoid a second debt crisis.

I have laid down the theoretical reasons why this is so by showing that welfare-driven economies, fully encumbered by debt, through false employment and price-inflation statistics are concealing a depressive slump. An unbiased and informed analysis of nearly all currency collapses shows that far from being the product of deliberate government policy, they are the result of loss of control over events, or currency inflation beyond their control. I expect this to become more obvious to markets in the coming months.

Gold’s important role

Gold has become undervalued relative to fiat currencies such as the US dollar, as shown in the chart below, which rebases gold at 100 adjusted for both the increase in above-ground gold stocks and US dollar FMQ since the month before the Lehman Crisis.

gold_adjusted_311213

Given the continuation of the statistically-concealed economic slump, plus the increased quantity of dollar-denominated debt, and therefore since the Lehman Crisis a growing probability of a currency collapse, there is a growing case to suggest that gold should be significantly higher in corrected terms today. Instead it stands at a discount of 36%.

This undervaluation is likely to lead to two important consequences. Firstly, when the tide for gold turns it should do so very strongly, with potentially catastrophic results for uncovered paper markets. The last time this happened to my knowledge was in September 1999, when central banks led by the Bank of England and the Fed rescued the London gold market, presumably by making bullion available to distressed banks. The scale of gold’s current undervaluation and the degree to which available monetary gold has been depleted suggests that a similar rescue of the gold market cannot be mounted today.

The second consequence is to my knowledge not yet being considered at all. The speed with which fiat currencies could lose their purchasing power might be considerably more rapid than, say, the collapse of the German mark in 1920-23. The reason this may be so is that once the slide in confidence commences, there is little to slow its pace.

In his treatise “Stabilisation of the Monetary Unit – From the Viewpoint of Monetary Theory” written in January 1923, Ludwig von Mises made clear that “speculators actually provide the strongest support for the position of notes (marks) as money”. He argued that considerable quantities of marks were acquired abroad in the post-war years “precisely because a future rally in the mark’s exchange rate was expected. If these sums had not been attracted abroad they would have necessarily led to an even steeper rise in prices on the domestic market”.

At that time other currencies, particularly the US dollar, were freely exchangeable with gold, so foreign speculators were effectively selling gold to buy marks they believed to be undervalued. Today the situation is radically different, because Western speculators have sold nearly all the gold they own, and if you include the liquidation of gold paper unbacked by physical metal, in a crisis they will be net buyers of gold and sellers of currencies. Therefore it stands to reason that gold is central to a future currency crisis and that when it happens it is likely to be considerably more rapid than the Weimar experience.

I therefore come to two conclusions for 2014: that we are heading towards a second and unexpected financial and currency crisis which can happen at any time, and that the lack of gold ownership in welfare-driven economies is set to accelerate the rate at which a collapse in purchasing power may occur.

Economics

Tapering – join the dots and end up with ZIRP

Now we know: The Fed is going to purchase $75bn of assets, a reduction of $10bn a month. The two other bits of information that came from the FOMC meeting were that purchases of US Treasuries and mortgage bonds are to be cut by $5bn each, and interest rates will be held at zero for even longer. And to justify zero interest rates, the unemployment target is being shifted from 7% to 6.5%.

In my opinion the Fed showed through its FOMC statement it has little control over events, something that should dawn on markets in the coming days. To debate this we must put aside the question as to whether or not quantitative easing is sensible in the first place and only focus on this FOMC compromise. There is an argument that any reduction in QE should be confined to purchases of Treasuries, because the budget deficit is reducing and the market probably needs more of this paper for collateral purposes. If that argument had been presented it would have made sense and the Fed’s stock would have likely soared. Instead the tapering is to be split between mortgage bonds and Treasuries, which suggests a “pluck a figure out of the air” approach rather than a more reasoned one. The scale of tapering is in the lower range of expectations, so presumably was intended to be market-neutral. This tells us that the FOMC probably came to its decision based on what was expected of it rather than from a sense of conviction that the policy is correct. But the greater inconsistency is over forward interest rate guidance.

When a central bank holds interest rates below their natural market level, it stands there to provide however much liquidity is required to keep the rate suppressed. This in practice is the result of a number of factors including overall demand for money, and on the supply side changes in the quantity of narrow money, bank credit expansion and required reserves. QE is one form of this liquidity, and the extent to which QE is reduced must be compensated for by other means if interest rates are going to be kept at the target level.

This simple fact makes changes in QE meaningless in the broader monetary context, and on this vital point the Fed keeps silent. Instead it attempts to offset the deflationary implications of tapering by increasing its commitment to zero interest rate policy (ZIRP) and for longer. We are left wondering how long it will be before this contradiction is generally understood. Furthermore, those that link QE to prospective prices for gold and silver are ignoring the commitment to interest rates and are effectively pushing a one-sided argument.

It is not just precious metals that are mispriced. Government bond yields, particularly for the weaker eurozone states do not reflect credit risk. Equity markets are priced on the back of ZIRP. Fixed assets, particularly housing and motor vehicles are being financed on the back of this unreality. The important point is not tapering, but that ZIRP continues indefinitely.

This article was previously published at GoldMoney.com

Economics

Value versus momentum and the gold price

For many commentators there are two distinct camps in the gold market: investors in bullion and speculators in the paper market. With the two markets pulling in different directions some dealers think it is only a matter of time before derivatives fail completely and the price of gold will rocket on physical demand.

That two ends of one market are in conflict and one will win over the other is a tempting conclusion, but this is unhelpful. The conflict is more about two different types of investor: there are those who buy or sell on grounds of value and momentum investors who deal on the trend. It is the market structure that tends to corral them into different camps. Value investors generally go for physical metal, while momentum investors go for derivatives.

Their motivations are different. Value investors include buyers of physical gold from all over the world, commonly seeking value or security compared with holding fiat currency. Speculators in the futures markets rarely evaluate the price of gold, assuming the current price is the only valid reference point that matters. This bifurcation between value and momentum is a common feature from time to time in nearly all capital markets. We saw it in equities during the dot-com boom, when value investors were embarrassed before momentum investors were eventually crushed. However, both classes of investor always fish in the same pool.

Futures are the principal channel for momentum-chasers in gold, with very few of them interested in questioning value; and with the rise of the hedge fund industry the amount of money and credit available to this class is substantial. It is hardly surprising that critics feel derivative markets are depressing the gold price, but they ignore the fact that the current price in any market is the point where supply and demand finds a balance.

There are above-ground stocks of gold amounting to about 160,000 tonnes, and new mine supply increases this at about 1.7% per annum. Theoretically, all this gold is available for sale at some price; equally these quantities are an indication of the scale of underlying interest. If momentum investors think there is a case for lower gold prices they should make it after taking this into account. Trying to make this judgement in such an opaque market is never going to be simple, which is why they rarely try to do so.

The answer is to identify so far as possible the location of all investment gold as a first step to understanding prospects for the market. We can only conclude there is very little of it in investment form in private hands in the West, the bulk of it having been bought up by Asian buyers. The amount of ETF liquidation has been wholly insufficient to satisfy this demand, so by deduction central banks must have been supplying the markets with large quantities, because there is no other source of supply.

Therefore the key to future gold prices comes down to the point in time at which central banks stop supplying the market; not some sudden crisis between value investors in the East and momentum chasers in the West. That is to confuse cause with effect.

This article was previously published at GoldMoney.com.

Economics

There is too little gold in the West

Western central banks have tried to shake off the constraints of gold for a long time, which has created enormous difficulties for them. They have generally succeeded in managing opinion in the developed nations but been demonstrably unsuccessful in the lesser-developed world, particularly in Asia. It is the growing wealth earned by these nations that has fuelled demand for gold since the late 1960s. There is precious little bullion left in the West today to supply rapidly increasing Asian demand. It is important to understand how little there is and the dangers this poses for financial stability.

An examination of the facts shows that central banks have been on the back foot with respect to Asian gold demand since the emergence of the petrodollar. In the late 1960s, demand for oil began to expand rapidly, with oil pegged at $1.80 per barrel. By 1971, the average price had increased to $2.24, and there is little doubt that the appetite for gold from Middle-Eastern oil exporters was growing. It should have been clear to President Nixon’s advisers in 1971 that this was a developing problem when he decided to halt the run on the United States’ gold reserves by suspending the last vestiges of gold convertibility.

After all, the new arrangement was: America issued the petrodollars to pay for the oil, which were then recycled to Latin America and other countries in the West’s sphere of influence through the American banks. The Arabs knew exactly what was happening; gold was simply their escape route from this dodgy deal.

The run on U.S. gold reserves leading up to the Nixon Shock in August 1971 is blamed by monetary historians on France. But note this important passage from Ferdinand Lips’ book GoldWars:

Because Arabs did not understand bonds and stocks they invested their surplus funds in either real estate and/or gold. Since Biblical times, gold has been the best means to keep wealth and to transfer it from generation to generation. Gold therefore was the ideal vehicle for them. Furthermore after their oil reserves are exhausted in the distant future, they would still own gold. And gold, contrary to oil, could never be wasted.

According to Lips, Swiss private bankers, to whom many of the newly-enriched Arabs turned, recommended that a minimum of 10% and even as much as 40% should be held in gold bullion. This advice was wholly in tune with Arab thinking, creating extra demand for America’s gold reserves, some of which were auctioned off in the following years. Furthermore, Arab investors were unlikely to have been deterred by high dollar interest rates in the early eighties, because high interest rates simply compounded their rapidly-growing exposure to dollars.

Using numbers from BP’s Statistical Review and contemporary U.S. Treasury 10-year bond yields to gauge dollar returns, we can estimate gross Arab petrodollar income, including interest from 1965 to 2000, to total about $4.5 trillion. Taking average annual gold prices over that period, ten percent of this would equate to about 50,500 tonnes, which compares with total mine production during those years of 62,750 tonnes, over 90% of which went into jewellery.

This is not to say that 50,000 tonnes were bought by the Arabs; it could only be partly accommodated even if the central banks supplied them gold in very large quantities, of which there is some evidence that they did. Instead, it is to ram the point home that the Arabs, awash with printed-for-export petrodollars, had good reason to buy all available gold. And importantly, it also gives substance to Frank Veneroso’s conclusion in 2002that official intervention – i.e., undeclared sales of significant quantities of government-owned gold  was effectively being used to manage the price in the face of persistent demand for physical gold as late as the 1990s.

Transition from Arab demand

Arabs trying to invest a portion of their petrodollars would have left very little investment gold for the advanced economies. As it happened, U.S. citizens had been banned from holding bullion until 1974, and British citizens were banned until 1971. Instead, they invested mainly in mining shares and Krugerrands, continuing this tradition by using derivatives and unbacked unallocated accounts with bullion banks in preference to bullion itself. This meant that, until the mid-seventies, investment in physical gold in the West was minimal, almost all gold being held in illiquid jewellery form. Western bullion investors were restricted to mainly Germans, French, and Italians, mostly through Swiss banks. The 1970s bull market was therefore an Arab affair, and they continued to absorb gold through the subsequent bear market.

By the late-nineties, a new generation of Swiss investment managers, schooled in modern portfolio theory and less keen on gold, persuaded many of their European clients to reduce and even eliminate bullion holdings. At the same time, a younger generation of Western-educated Arabs began to replace more conservative patriarchs, so it is reasonable to assume that Arab demand for gold waned somewhat, as infrastructure spending and investment in equity markets began to provide portfolio diversification. This was therefore a period of transition for bullion, driven by declining Western investment sentiment and changing social structures in the Arab world.

It also marked the beginning of accelerating demand in emerging economies, notably India, but also in other countries such as Turkey and those in Southeast Asia, which were rapidly industrialising. In 1990, the Indian Government freed up the gold market by abolishing the Gold Control Act of 1968, paving the way for Indians to become the largest officially-recognised importers of gold until overtaken by China last year.

Lower prices in the 1990s stimulated demand for jewellery in the advanced economies, with Italy becoming the largest European manufacturing centre. At the same time, gold leasing by central banks increased substantially, as bullion banks exploited the differential between gold lease rates and the yield on short-term government debt. This leased gold satisfied jewellery demand as well continuing Asian demand for gold bars.

So, despite the fall in prices between 1997-2000, all supply was absorbed into firm hands. When gold prices bottomed out, Western central banks almost certainly had less gold than publicly stated, the result of managing the price until 1985, and through leasing thereafter. This was the background to the London Bullion Market Association, which was founded in 1987.

The LBMA

In 1987, the unallocated account system became formalized under London Bullion Market Association (LBMA) rules, allowing the bullion banks to issue gold IOUs to their customers, making efficient use of the bullion available. The ability to expand customer business in the gold market without having to acquire physical bullion is the chief characteristic of the LBMA to this day. Futures markets in the U.S. also expanded, and so derivatives and unallocated accounts became central to Western investment in gold. Today the only significant bullion held by Western investors is likely to be a small European residual plus exchange-traded fund (ETF) holdings. In total (including ETFs), this probably amounts to no more than a few thousand tonnes.

The LBMA was established in 1987 in the wake of the Financial Services Act in 1986. Prior to that date, the twice-daily gold fix had become the standard pricing mechanism for international dealers, whose ranks grew on the back of the 1970s bull market. This meant that international banks established their bullion dealing activities in London in preference to Zurich, which was the investment centre for physical bullion. The establishment of the LBMA was the formalization of an existing gold market based on the 400-ounce “good delivery” standard and the operation of both allocated and unallocated accounts.

During the twenty-year bear market, attitudes to gold diverged, with capital markets increasingly taking the view that the inflation dragon had been slain and gold’s bull market with it. At the same time, Asian demand  initially from the Arab oil exporters but increasingly from other nations led by Turkey, India, and Iran – ensured that there were buyers for all the physical gold available. Mine supply, which benefited from the introduction of heap-leaching techniques, had increased from 1,314 tonnes in 1980 to 2,137 tonnes in 1990 and 2,625 tonnes by 2000. Together with scrap supply, London was in a strong position to intermediate between a substantial increase in gold flows to Asian buyers, and it was from this that central bank leasing naturally developed.

Gold backed by these physical flows was the ideal asset for the carry trade. A bullion bank would lease gold from a central bank, sell the gold, and invest the proceeds in short-term government debt. It was profitable for the bullion bank, governments were happy to have the finance, and the lessor was happy to see an idle asset work up some extra income. However, leasing only works so long as the bullion bank can hedge by accessing future supply so that the lease can eventually be terminated.

Before 2000, this was a growing activity, fuelled further by Swiss portfolio disinvestment in the late 1990s. As is usual in markets with a long-term behavioral trend, competition for this business extended the risks beyond being dangerous. This culminated in a crisis in September 1999, when a 30% jump in the price threatened to bankrupt some of the bullion banks who were in the habit of running short positions.

Post-2000

Bull markets always start with very little mainstream and public involvement, and so it has proved with gold since the start of this century. So let us recap where all the gold was at that time:

  • Total above-ground gold stocks were about 129,000 tonnes, of which 31,800 tonnes were officially monetary gold. Of the balance, approximately 85-90% was turned into jewellery or other wrought forms, leaving only 10-15,000 tonnes invested in bar and coins and allocated for industrial use.
  • Out of a maximum of 15,000 tonnes, coins (mostly Krugerrands) accounted for about 1,500 tonnes and other uses (non-recovered industrial and dental), say, 1,000 tonnes. This leaves a maximum of 12,500 tonnes and possibly as little as 7,500 tonnes of investment gold worldwide at that time.
  • After Swiss fund managers disposed of most of the bullion held in portfolios for their clients in the late 1990s, there was very little investment gold left in European and American ownership.
  • Frank Veneroso in 2002 concluded, after diligent research, that central banks had by then supplied between 10-15,000 tonnes of monetary gold into the market. Much of this would have gone into jewellery, particularly in Asia, but some would have gone to the Middle East. This explains how extra investment gold may have been supplied to satisfy Middle Eastern demand.
  • Middle Eastern countries must have been the largest holders of non-monetary gold in bar form at this time. We can see that 10% of petrodollars invested in gold would have totalled over 50,000 tonnes, yet there can only have been between 7,500-12,500 tonnes available in bar form for all investor categories world-wide. This may have been increased somewhat by the addition of monetary gold leased by central banks and acquired through the market.

It was at this point that the second gold bull market commenced against a background of very little liquidity. Investment bullion was tightly held, the central banks were badly short of their declared holdings of monetary gold, and from about 2004 onwards, ETFs were to grow to over 1,500 tonnes. Asian demand continued to grow (led by India), and China began actively promoting private ownership of gold at about the same time.

Other than through physically-backed ETFs, Western investors were encouraged to satisfy their demand for bullion through derivatives and unallocated accounts at the bullion banks. There are no publicly available records detailing the extent of these unallocated accounts, but the point is that Western demand has not resulted in increased holdings of bullion except through securitised ETFs. Instead, the liabilities faced by the bullion banks on uncovered accounts will have increased to accommodate growth in demand. Therefore, the vested interests of the bullion banks and the central banks overseeing the gold market call for continued suppression of the gold price, so as to avoid a repeat of the crisis faced in September 1999 when the price increased by 30% in only two weeks.

Where are the sellers?

Price suppression can only be a temporary stop-gap, and there has never been sufficient supply to allow the central banks to retrieve their leased gold from the bullion banks. Therefore, Frank Veneroso’s conclusion in 2002 that there had to be existing leases totalling 10-15,000 tonnes is a starting point from which leases and loans have increased. There are two events which will almost certainly have increased this figure dramatically:

  1. When the price rose to $1900 in September 2011, there was a concerted attempt to suppress the price from further rises. The lesson from the 1999 crisis is that the bullion banks’ geared exposure to unallocated accounts was forcing a crisis upon them; if they had been forced to cash-settle these accounts, the gold price would almost certainly have risen further, risking a widespread monetary crisis.
  2. Through 2012, Asian demand, particularly from China, coinciding with continued investor demand for ETFs, was already proving impossible to contain. In February this year, the Cyprus bail-in banking crisis warned depositors in the Eurozone that all bank deposits over the insured limit risked being confiscated in the event of a wider Eurozone banking crisis. This drove many unallocated account holders to seek delivery of physical gold from their banks, forcing ABN-AMRO and Rabobank to suspend all gold deliveries from their unallocated accounts. This was followed by a concerted central- and bullion-bank bear raid on the market in early April, driving the price down to trigger stop-loss sales in derivative markets and subsequent liquidation of ETF holdings.

It is widely assumed that the unexpected rise in demand for bullion that resulted from the April take-down was satisfied through ETF sales, but an examination of the quantities involved shows they were insufficient. The table below includes officially reported demand for China and India alone, not taking into account escalating demand from the Chinese diaspora in the Far East and from elsewhere in Asia:

gold-demand-chart1

These figures do not include Chinese and Indian purchases of gold in foreign markets and stored abroad, typically carried out by the rich and very rich. Nor do they include foreign purchases by the Chinese Government and its agencies. Despite these omissions, in 2012, recorded demand from these two countries left the world in a supply deficit of 131 tonnes. Furthermore, ahead of the April smash-down in the first quarter of this year, the deficit had jumped to 88 tons, or an annualised rate of 352 tonnes.

Demands for delivery by panicking Europeans in the wake of the Cyprus fiasco could only provoke one reaction. On Friday 12th April, 400 tonnes of paper gold were dumped on the market in two orders, triggering stop-loss sales and turning market sentiment bearish in the extreme. Western investors started to think about cutting their losses, and they sold down ETF holdings to the tune of 325 tonnes in 2013 by the end of May. However, this triggered record demand among those who looked on gold as insurance against currency and systemic risks.

Later that year, in July, Ben Bernanke told the Senate Banking Committee he didn’t understand gold. That was probably a reference to the April gold price smash orchestrated by the central banks and how it unleashed record levels of demand. It was an admission that he thought everyone would follow the new trend by acting like portfolio investors, forgetting that if you lower the price of a commodity, you merely unleash demand. It was also an important admission of policy failure.

Since those events in April, someone has been supplying the market with significant quantities of gold to keep the price down. We know it is not Arab gold, because I have discovered through interviewing a director of a major Swiss refiner that Arab gold is being recast from LBMA specification bars into one-kilo .9999 bars, which has become the new Asian standard. Arab gold does not appear to be being sold, only recast, and anyway, it is only a small part of their overall wealth. We also know from our long-term analysis that any European gold bullion is relatively small in quantity and tightly held. There can only be one source for this gold, and that is the central banks.

I discovered that there was a discrepancy in the Bank of England’s custodial gold of up to 1,300 tonnes between the date of its last Annual Report (28th February) and mid-June, when a lower figure was given out to the public on the Bank’s website. This fits in well with the additional amount of gold needed to manage the price between those months. Furthermore, the Finnish Central Bank recently admitted that all its gold held at the Bank of England was “invested”  i.e., sold  and further added that the practice “was common for central banks.”

Bearing in mind Veneroso’s conclusion in 2002 that there must be 10,000-15,000 tonnes out on lease and loan from the central banks at that time, one could imagine that this figure has increased significantly. Officially, the signatories of the Central Bank Gold Agreement, plus the U.S. and U.K. own 20,393 tonnes. A number of other central banks are likely to have been persuaded to “invest” their gold, but this is bound to exclude Russia, China, the Central Asian states, Iran, and Venezuela. Taking these holders out (amounting to about 3,000 tonnes) leaves a balance of 8,401 tonnes for all the rest. If we further assume that half of that has been deposited in London, New York, or Zurich and leased out, that means the total gold leased and available for leasing since 2002 is about 12,000 tonnes. And once that has gone, there is no monetary gold left for the purpose of price suppression.

Could this have disappeared since 2002 at an average rate of 1,000 tonnes per annum? Quite possibly, in which case, the central banks are very close to losing all control over the gold price.

This article was previously published at PeakProsperity.com.

Economics

Cooperation between central banks

Zerohedge recently drew attention to the growing level of foreign bank cash deposits, tucked away at the bottom of the Fed’s H.8 statement.

Foreign banks’ cash balances have increased by $518.7bn since September 2012, accounting for almost all of the increase in these banks’ total assets in the H.8 table. The implication is that these cash balances are held as reserves on the Fed’s balance sheet, the counterpart of quantitative easing.

This naturally raises the reasonable question posed by Zerohedge’s article as to why the Fed appears to be benefiting foreign banks with QE. The answer is either these deposits have been transferred to them from US banks in the normal course of business or the Fed is prepared to provide liquidity to foreign banks: after all the US dollar is the reserve currency. And this liquidity is most needed by the weakest banks in the international banking system, many of which are in the eurozone.

The ECB’s room for manoeuvre with respect to money-printing is more limited, and it is the only central bank of the big four not to have overtly quantitatively eased. Furthermore, the eurozone is still in trouble even though it has disappeared from the headlines. The chart below of bank lending figures supplied by the ECB illustrates the problem.

 

total-loans-euro-area-eur

 

Bank lending peaked in mid-2012, and by mid-2013 it had contracted over €1 trillion. By now, the ECB should have advance knowledge of the yet-to-be-released Q3 bank lending total, which if it has continued the downward trend explains why the ECB unexpectedly reduced interest rates recently.

Meanwhile, the Bank of England has finally admitted that the UK’s economy is growing. Conventional wisdom suggests the BoE should permit interest rates to return to more normal levels, but it refuses to do so for at least another year. The fact that the UK continues with current interest rate polices is due in part to policy coordination with the Fed, the ECB and to a lesser extent perhaps the Bank of Japan.

The logical implication from the Fed’s and the BoE’s actions is that interest rate policies are being managed with the weakest in mind. Therefore the course of prices and bank lending in the eurozone could be regarded as the current determinant of when tapering will be introduced by the Fed.

However there is still an overriding problem: if the stimulant of monetary inflation is reduced, rates along the yield curve will rise rapidly from today’s wholly artificially suppressed levels. The two cannot be divorced. The Fed knows this, and it is central to its internal debate.

The fact of the matter is that just as zero interest rates flatter bank balance sheets and government borrowing costs, the reverse is also true. Add into the mix the deflationary implications of more normal interest rates and it is obvious that the Fed and the BoE are trapped. They will not be looking forward to the day when they run out of excuses for this dilemma. But for now at least there is a rescue mission in place for the eurozone, and the Fed will continue to lend its support to foreign banks.

This article was previously published at GoldMoney.com.