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Last week I had an interesting discussion with Detlev Schlichter, who has recently published his book, Paper Money Collapse. For a comprehensive introduction to Austrian economics in the context of today’s economic events I can strongly recommend it. The podcast of the interview can be seen here: Greece has now defaulted, and other eurozone governments as well as agencies such as the International Monetary Fund, European Central Bank and European Investment Bank have retrospectively inserted themselves as senior creditors, a precedent that should be of great concern and which has profound implications for private sector banks. Furthermore, when a state defaults it is only a small part of the whole story, because governments today are major participants in their economies. The consequences of a central government default extend to state guarantees for other entities and related businesses: in the case of Greece its default has altered the assumptions behind all non-central government public-sector loans, such as railway bonds. And the private sector not directly dependent on government subsidies or contracts is also affected by the prospect of excessive taxes. For this reason, the consequence of Greece’s default goes considerably beyond the loans directly involved, and all other eurozone nations are in a similar position. The headline numbers are a fraction of the total involved. This brings us to a fundamental truth. Government debt is the basis for fiat money systems. This basis is now being questioned. It is the key component of the capital held by banks, as well as cash and deposits at central banks – both of which are also government creations ultimately backed by government debt. Ever since gold was legislated out of the monetary system, confidence has become totally dependent on the validity of government debt. The insolvent position of a number of eurozone nations invalidates the general assumption that government paper provides a solid foundation for eurozone banks. That the stronger euro-countries can underwrite the weak is now also doubtful. The precedent that has been set by the retrospective interposition by governments and their agencies as senior creditors undermines the value of government debt even further for private-sector banks, who become junior creditors. It is not surprising that they have re-deposited the bulk of the money lent to them by the ECB with the ECB itself. Euros held at the ECB only give refuge from exposure to specific government paper and is the best of a bad choice. Banks outside the region are exercising the option of opting out altogether. It may seem unnecessary to question the very basis of the European financial system in this way. But this is bound to be debated in boardrooms across the entire banking network, inside and outside the euro area, and banks will react. It is also the underlying reason why the situation remains so precarious regarding Europe’s debt crisis. The way Greece’s default has been handled brings an increased risk of capital flight from the region at the worst possible time. Funding for all eurozone nations has become a lot more difficult. The ECB will come under growing pressure to not only rescue banks, whose balance sheets are imploding, but also to directly bail out governments as well. Because of the systemic role of government debt, the crisis can be expected to spread rapidly from the insolvent weaker euro-nations to all the others. In short, the mishandling of Greece’s debt problems has made things worse. This article was previously published at GoldMoney.com. According to a story in Wednesday’s Wall Street Journal, the US Federal Reserve is considering buying long-term Treasury and mortgage bonds in return for deposits held at the Fed. There has been no comment from the Fed and the story might have been no more than a trial balloon, in which case Bernanke and Co may be considering skewing the yield curve so that long-term bonds are less attractive than the time-preferences set by the market. The deal the Fed appears to be thinking of is a reverse-repurchase agreement (a reverse repo), whereby it buys long-maturity bonds financed by credit drawn from the commercial banks. The important monetary distinction is that unused bank credit funds the deal, not hard cash. The Fed can always set the terms so that it is an attractive proposition for its counterparties. This being the case, upward pressure on short-term rates will be minimal while the Fed can manage long-term rates lower. And by buying bonds with long maturities, asset prices generally benefit which is why stocks rose on the story. More intriguing are the reasons why this option might be being explored. The answer is probably found in the rising yields of longer maturities, illustrated by the US 30 year Treasury yield shown below:
While the Fed has been able to anchor short-term rates, long-term rates have started to rise. This is perfectly normal and ordinarily nothing too much to worry about when the economy shows early signs of improvement. Importantly, it suggests we are moving into a more inflationary environment which rules out raw quantitative easing as a policy option, because printing money would now quickly undermine the dollar. Therefore, it is in the Fed’s interest to seek a disguised form of quantitative easing that expands bank credit and not raw money. There are two underlying motives that come to mind other than just bolstering asset prices. Firstly, on balance central bankers are still worried about a possible deflationary collapse, and while there may be early signs of economic recovery, commercial banks remain risk-averse when it comes to lending. Also low mortgage rates are seen as vital to the housing market, which is still mired in its own debt-deflation: this is why the Fed might want to buy mortgage debt as well as Treasuries. Secondly, there is the cost of government borrowing, and any rise in interest rates wrecks budget deficit assumptions. These are already alarming enough. Furthermore, US Treasury debt maturities are skewed heavily and dangerously towards the short-term: hence the importance of keeping long-term bond yields low, so that the Treasury can issue longer-dated bonds. To summarise, the Fed is still trying to avoid deflation and it needs to assist the Treasury by buying long-term debt at artificially low bond yields. Growing public concerns about the inflationary effects of quantitative easing calls for a different approach, perhaps using reverse-repos funded by an expansion of bank credit. While this might satisfy some, all that happens is that the engine of monetary inflation becomes expanding bank credit, rather than quantitative easing: the long-term effects on prices are exactly the same. This article was previously published at GoldMoney.com. Last Monday night, before the US markets opened after President’s Day, bailout terms for Greece were announced. The detail is secondary to assessing whether or not it will work, or whether only a little time has been bought. Theoretically the deal can work, but it is extremely unlikely that it will. Almost everyone knows or suspects this, but the survival of the European political system is at stake, and this systemic priority is more important than hard economic reality. The sceptics are right for the wrong reasons. Few analysts correctly define the problem and how it might best be resolved, because they only understand intervention. Some insist that Greece should leave the euro and allow a new drachma to float lower, so that the cost of Greek labour becomes competitive. The fallacies in this argument are numerous and obvious; suffice it to say that a new drachma backed by nothing more than misplaced hope would immediately collapse, ensuring complete chaos, while euro-denominated debts would remain unpaid. Others say that GDP is falling at whatever-rate-per-cent and that cutting government spending will make it fall even faster: by postponing economic growth, Greece’s ability to pay down the debt will be severely limited. This confused argument ignores the economic burden of excessive government and consequently the benefits of cutting it to the bone. The idea that government has resources not raised from its citizens is a Santa Claus fable, elevated to the dignity of an economic doctrine and endorsed by all those expecting a personal benefit. A government can only spend what it takes from its citizens, and the more a government spends the greater the burden it imposes upon them. Therefore, if the creditor-imposed unwinding of government spending results in the net transfer of resources (net, that is, of debt repayments) back to the private sector it will have a chance of success. However, all those citizens banking on hand-outs from the government will need persuading that it is for the best. This is a difficult task, and given decades of interventionism no one is equipped to argue a cohesive case for reversing government expansion. It has been successfully done before, most notably by Britain after the Napoleonic Wars. The difference then was that public opinion was not entrenched in a benefits mentality. Unwinding economic distortions, the result of the public sector’s intrusion into and imposition upon the productive economy, will be a very difficult political task. At the end of the day a prosperous private sector is Greece’s only hope, and it requires sound money to support capital investment, radical cuts in the public sector, and the lowest taxes possible consistent with sound government finance. The instincts of the interventionists are to do the exact opposite. The chances of the powers-that-be getting it right are frankly, very slim. It can only be done by giving up all pretentions that intervention has economic benefits, and convincingly arguing the case in front of a sceptical public which is now minded to rebel against all authority. Unfortunately, the Greek crisis is far from resolved, and will most probably worsen. This article was previously published at GoldMoney.com. In the past, insurance companies and pension funds have been keen to advertise the benefit of compounding arithmetic for savings. Over the last 30 or 40 years the rate has been lifted by inflation, but to understand the cost inflation brings you have to consider the whole savings cycle: not just the accumulation stage, but also annuity values in retirement. Furthermore, the historical experience of a typical working life should be compared with a theoretical sound-money alternative. Let us assume a man works for 40 years, during which time he invests a fixed amount annually. This is invested mostly in bonds for a return that gives him a lump sum on retirement. The marketing folk stop at that point, but we shall go on. This lump sum is applied to an annuity to give a fixed income for the retiree’s life expectancy. Let us also assume that $1,000 is invested annually, and we shall use the average return on the 10-year US Treasury bond as our yardstick. The result is shown in the table below under the heading of Paper Money.
The nominal value of our pension-pot on retirement is an attractive $224,150, but during its accumulation price inflation has averaged 4.44%, so its inflation-adjusted value is only $74,056, implying that the difference ($150,094) is a hidden inflation tax, leaving our saver with only one-third of his savings in real terms. Assuming the lump sum is then turned into an annuity at a continuing bond yield of 7.18% for a retirement of 25 years, this inflation-adjusted figure gives an annual income of $6,458, and if inflation continues to average the historic rate, the final payment will only be worth $2,075 in inflation-adjusted terms. Note how the purchasing power of the annuity falls over time while our retiree’s health and care expenses can be expected to increase when he can least afford them. The reason for taking inflation out of the equation is so we can compare the inflationary past with a sound-money alternative. This calculation is dramatically different under the reasonable assumptions in the table’s last column: an average bond yield of 2.5% and price deflation of 1% annually. The deflation-adjusted outcome is significantly better than the paper-money example. Furthermore, the purchasing power of the annuity increases, in tune with the health and care needs of an aging retiree. Our example is simplistic: bond yields have varied hugely since 1971, and we have ignored management fees and taxes. We have not considered bond yields that are exceptionally low today, so annuities taken out now will yield considerably less than our example shows. The bottom line is the saver is impoverished by inflation to a greater extent than generally realised. The state has benefited from the transfer of wealth from its citizens’ savings, the result of monetary inflation, but at considerable future cost. The state is left with the welfare, health and care costs for an aging population unable to support itself and with an increasing life expectancy. The cost of looking after growing numbers of impoverished retirees will become apparent in coming years, increasing government deficits more rapidly than expected. What we don’t know is when the markets will reflect the enormity of these future obligations. This article was previously published at GoldMoney.com. The most important objective for any government is to achieve economic growth. Out of this growth develops employment and taxes to fund government itself. It is in other words the primary focus of all economic planning. Much effort is also spent perfecting the statistics deemed vital to quantifying everything that might contribute to the attainment of this end. Furthermore, “independent” monetary policy long ago migrated from the principal objective of controlling inflation to stimulating the economy into more growth. Almost everyone in developed economies knows and supports this objective, even if they argue over the means. However, not only have governments consistently failed to achieve this fundamental objective, they are now increasingly worried that government spending cuts will propel us all into a deep economic contraction. But are we right to think in terms of economic growth or contraction? The concept is essentially Keynesian and stems from mainstream economic analysis. It presupposes that governments actually have a positive interventionist role and can improve economic outcomes, a supposition that is on examination completely flawed. Instead, an economy that successfully delivers the products and services people actually want does so in an unplanned, random fashion. It is the sum of all activity, which organises the production of goods and services by entrepreneurs and business proprietors in the considered belief they will be wanted. The strength behind a free-market economy is the randomness of productive actions, and progress of mankind’s condition is the result. It only expands if the factors of production expand; otherwise the distribution of available resources depends on entrepreneurial anticipation of people’s needs and wants. When government intervenes in this unplanned but productive chaos it destroys this random quality, harnessing economic actions into in a common direction. Destructive cycles of boom and bust have always been the result. Governments seek to co-ordinate randomness for an outcome they commonly call growth, and for a short time they might appear to succeed. But it is not long before these co-ordinated economic actions inevitably drive up prices, because extra factors of production (raw materials, labour and capital goods) only become available at higher price levels. Higher prices inevitably lead to higher interest rates, to the point where those who have fallen for the bait of artificially cheapened credit have to cut and take their losses. Capital theory predicts this outcome, events always confirm it, yet mainstream economists continually ignore it[i]. Intervention is as likely to succeed as water is to run uphill. Economic growth or the lack of it, the success or failure by which it is measured, is its child. The question then arises as to whether or not we can have economic growth without intervention. The logical answer is no. A free-market economy in the absence of external factors does not grow: it progresses, which is a very different thing. It discards those things consumers do not want and produces things they are likely to want. It adjusts the price of products to a level which satisfies the consumer and is at the same time profitable. Overproduction is punished and underproduction invites competition. No one knows what the consumers will buy tomorrow or how much they are prepared to pay, but randomly-acting entrepreneurs are generally pretty good at guessing, because they put their own time and money on the line. They have to anticipate levels of demand and also prices for their output for at least as far in advance as it takes to plan, produce and market any product. This is progress, not growth. Progress is about better products and services tomorrow than today, using the resources actually available. Progress is about better value for money tomorrow, which means that prices tend to fall. And as prices tend to fall, more things can be bought for the same money. What governments do instead is destroy this process of progression in an attempt to replace it with statistical growth. The statistics devised to measure it, principally gross domestic product, cannot measure anything other than the money in the productive economy, which it does imperfectly. Government spending, which is an economic cost, is included pari-passu with valued production. Efficient producers such as the manufacturers and suppliers of electronic goods and services, who reduce their prices over time, see their output diminished as a proportion of the statistical whole, while those that maintain their prices by monopolistic or subsidised means keep and even increase their weightings. This is simply the result of the indiscriminate use of a money-aggregate to measure the fallacious concept of economic growth. So GDP and related statistics do not measure progress: if anything they promote economic regression. Instead, we must conclude that GDP is an approximation of the amount of money deployed in an economy. It is equal to a combination of measured production, government spending and price changes. Let us assume for a moment that extra factors of production at a given price level are not available, so production only progresses depending on how existing factors of production are redeployed. Let us further assume government spending and regulation of the private sector is also unchanged. These two conditions being the case, economic growth must be a reflection of price changes, which in turn is the result of changes in the quantity of money deployed in the economy. And in recording “real” economic growth, that is economic growth adjusted by a price-inflation index, statisticians avoid recording most of the effects of monetary inflation. Therefore, economic growth is not growth at all: it is just an alternative and flawed measure of unreported monetary inflation. We would not take the central planners’ flawed attempts to manipulate an economy and the statistical outcomes seriously were it not for the ultimate consequences. Not only have they completely deceived the public over economic growth, but they deceive themselves. For this reason they are unequipped to deal with the developing crises, which are the result of earlier interventions. They now claim that economic growth, the ultimate source of tax revenue and government solvency is jeopardised by spending cuts. Statistically, this is obviously true, because if you take away government costs and support for unwanted economic activities, GDP will fall. But the important point that is commonly missed is that a government which stops draining an economy of its private sector resources actually releases them to be deployed more effectively for the common benefit by those randomly-acting entrepreneurs. [i] There are some excellent analyses of Capital Theory, but the error of converting random actions into common objectives, central to understanding the destructive effects of central planning, gets little attention. This is a mistake. This article was previously published at FinanceAndEconomics.org Mainstream economists seem to have a problem understanding prices. They might draw supply and demand curves and talk about elasticity. They are sure to have been taught the quantity theory of money. These are merely concepts, debating points in a classroom, with limited practical value. The consequence of replacing price concepts for price reality is that modern economists do not appreciate the consequences of monetary policy. The most common error is to associate rising prices only with an increase in demand for goods and services, making it hard to imagine price inflation without economic growth. Stagflation, or inflation in a stagnating economy, becomes an unwelcome surprise, but is easily explained at the transactional level. In the pricing of anything, both the supply of the goods in question and the quantity of money available will have a fundamental bearing in setting the price. However, these factors are not necessarily considered when goods are sold and are often ignored. Crucially, consumers assume that a dollar is a dollar and they never, for the purpose of day-to-day spending, question the value of paper money. People will say they are aware that the purchasing power of paper money declines over time, but they still expect the prices of everyday goods to be the same tomorrow as they are today. If they rise, they normally blame the retailer or perhaps some specific shortage, never realising that they are the victims of what they are otherwise aware of, the declining purchasing power of money. As monetary inflations progress there comes a point where this understanding changes. Increasing numbers of consumers will become aware that fiat money is losing purchasing power rather than the prices of goods rising. Trust in paper money begins to evaporate and the move into physical goods commences, gradually at first but then at an increasing pace. This is what the Austrian economist von Mises called “Katastrophenhausse” – the crack-up boom. Today, with paper money unbacked by anything other than public confidence in it, we are logically exposed to a new katastrophenhausse at any time, if that confidence is challenged. Besides confidence, the interest that fiat money earns is the only true support it has. Unfortunately, the remedy of deliberately raising interest rates is impractical, because of the very high levels of public and private sector debt. Jacking up interest rates will only bankrupt insolvent governments and other borrowers, and the interest costs would end up being covered by the creation of yet more fiat money. At some stage, the excesses of monetary inflation will undermine prices, irrespective of economic conditions, raising fundamental questions about purchasing power and confidence in fiat currency. So what does a central banker do? If he keeps a lid on interest rates a crack-up boom results. And if he raises interest rates, monetary inflation accelerates even faster, leading again to a crack-up boom. It is a classic debt trap: you are damned if you do and damned if you don’t. The important point for owners of gold and silver is that rising interest rates should drive prices higher, and not suppress them as commentators might expect. The consolidation of gold’s bull phase from October 2008 to the peak last September was a classic three-leg correction: an initial slide, rally, and final sell-off. Silver followed a similar but more violent pattern. The psychology was there too, with the final sell-off convincing many investors the game was finally over. Those who sold will most probably be kicking themselves. Consolidations that break established trends, such as 200-day moving averages, shake out weak holders who will buy again higher up when they are more confident. The big traders in the futures market know this: your losses are simply their gains. And as a result both gold and silver are on a far sounder footing with these weak holders out of the way. It is lethal for your savings to play this game. Instead it is more sensible to understand what is happening in simple economic terms. To do this you must turn your normal thinking upside down, and realise that what is happening to precious metals prices is only a reflection of what is actually happening to paper money. Put simply, governments all over the world are debasing their paper monies at an accelerating rate. Printing euros to rescue the banks has been in the headlines, but this process has only just begun. America, which has to be the focus of monetary attention, is committed to zero interest rates for the next three years, which is unprecedented. The result is that the price of gold has been left behind by exceptional monetary events. You can see this clearly in the chart below.
This chart shows US dollar True Money Supply (cash, instant deposits and checking accounts plus a few other minor cash balances) expressed in official gold reserves held at the US Treasury. This has soared over the years, and we can expect it to accelerate further from December’s figure of $31,600 per ounce of gold. Meanwhile, the percentage of TMS actually backed by gold stood at 4.8% at the year-end, and this is shown by the blue line. The chart clearly shows that while gold has risen dramatically over the last decade in nominal dollar terms, adjusted for the extra money in the system it has only risen 150%. Amazingly, the price of gold measured in these TMS terms has only risen to where it was in late 1991, when the nominal price was $360. Gold’s valuation is therefore still at exceptionally low levels. The sense of perspective charts like this imparts is vital for understanding the dangers from the tsunami of paper money and debt. Conventional portfolio managers have missed this point entirely, being hampered by the legacies of portfolio management theory and Keynesian economics. But there is a growing band of private individuals around the world who do get it and are accumulating physical gold and silver. They are beginning to understand that paper money is falling rather than gold and silver rising. The message is if you think like an investor, you will probably lose your investment. Be aware of what is happening to paper money and you probably won’t. This article was previously published at GoldMoney.com. Both the US Federal Reserve and the European Central Bank are now offering limitless quantities of new money – the ECB to support the banks, and the Fed for reasons (despite explanations) that are not entirely clear. The Fed in its press release announced that it expected interest rates to “warrant exceptionally low levels for the Federal Funds Rate at least through late 2014.” The fact that the central banks governing the two most important currencies in the world are issuing money to all-comers at very little interest cost for up three years has not been lost on gold and silver, whose prices shot up in response to the Fed’s announcement. The Fed has effectively extended its zero interest rate policy (ZIRP) for another 18 months. The reason stated is “low rates of resource utilisation and a subdued outlook for inflation in the medium run”. More important perhaps and unsaid is the presidential election due later this year and the need to finance a deficit that seems impossible to cut. The Fed is running huge risks with its extended ZIRP, principally with monetary inflation morphing into price inflation. To help achieve its low inflation target the Fed uses the Personal Consumption Expenditures Price Index (PCEPI), which assumes that consumers switch spending from higher priced goods to those that are stable or falling. The result is that this index rises at about one-third less than the Consumer Price Index, which itself rises at less than half the CPI calculated on the more honest methodology used before 1980. The upshot is that the Fed uses inflation targets that are so heavily adjusted that they are effectively meaningless. To the Keynesians at the Fed, subdued inflation is linked with a sluggish economy, and here the Fed is very selective in its approach. It admits that employment is picking up, and household spending “continues to advance”; but instead chooses to worry over slowing fixed investment and a depressed housing sector. Surely, whatever your views, there are enough signs of economic stabilisation to justify sitting on the fence, instead of committing to ZIRP for an extra 18 months. I take the view that Gross Domestic Product is likely to surprise on the upside, as I wrote in an article for GoldMoney on 10 January. In that article I gave concrete reasons why, and suggested that money will begin to flow from capital markets into the economy. This is important, because GDP is only a money quantity and can rise without any underlying economic progression – the difference being reflected in the prices of goods and services. So GDP can actually rise with no underlying improvement in economic activity, it merely reflecting higher prices. Changes in the prices of goods and services are actually impossible to measure and so cannot be quantified. Under-reporting price increases by using an index approximation such as the GDP deflator, which represents price inflation similarly to the PCEPI, artificially inflates real GDP. It will be interesting to hear what excuse the Fed comes up with then for the continuing for even longer with ZIRP. The reality is that the Fed and other central bankers are cornered and have only one tool left: issue as much paper money as it takes to prevent systemic financial calamity. This realisation is only just dawning on individuals with savings to protect, which is why precious metals were right to rise so sharply. This article was previously published at GoldMoney.com. US unemployment figures came in better than expected last week at 8.5%. While noting that the figures under-represent actual unemployment, does this improvement mark the beginning of an American economic recovery? If so, it is the last thing the consensus expects. Let us assume for a moment that Europe’s banks are rescued from the crisis. This being the case, there is every possibility a US recovery will take place for two basic reasons: businesses are always keen to invest as soon as market conditions stop deteriorating, and secondly GDP should begin to reflect increased quantities of money flowing into the economy. I shall comment on each in turn. Businesses in the US have been accumulating cash in these uncertain times, and it is generally assumed, incorrectly, that managers are happy to just sit on this accumulating cash. It is not in the nature of business to sit idly waiting for the tide to turn: businessmen are entrepreneurs who continually seek profitable opportunities, recognising that wasting time is itself an expense. This is why the capitalist system survives despite and not because of the attempts of central bankers and governments to assist the entrepreneurial function. And once capital investment begins to recover, competition ensures it spreads. The conditions now exist for this recovery to take place, if only because the bad news is elsewhere and interest rates are extremely low. We can therefore assume (Europe and other systemic disasters permitting) that a business recovery should take place. How far this goes before rising commodity and energy prices derail it is another matter. Meanwhile the expansion of raw money since 2008 has been remarkable, but so far the bulk of this money has either gone back on deposit at the Fed, is being deployed for speculation in capital markets, or is funding the government. Very little of this money has actually added to the GDP statistic by being deployed in the economy, which will change when businesses go further than just reinvesting cash balances, and actually borrow to build capacity. Putting this together, in the earliest stages of economic recovery companies reinvest their own money. The benefit to the GDP statistic is marginal to begin with, but as economic recovery gains momentum and businesses begin to borrow, money will flow into the economy from capital markets, inflating the GDP money-value. So by the time it is confirmed at the GDP level, the recovery will actually be well under way. The political consequences in an election year of such a development are beyond the scope of this article. Rising interest rates will begin to be discounted, giving support to the dollar; but before that happens a bear squeeze should develop in energy and commodity futures, partly because markets are wrong-footed for economic recovery, partly because market liquidity has been reduced as a result of the MF Global scandal, and partly because the outlook for price inflation will change radically. Precious metals should fare well. Industry will want to build silver stocks to lock in low prices, conflicting with physical demand from investors, and gold should get a significant boost from the change in the inflationary outlook. This article was previously published at GoldMoney.com. |
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