“Central bankers control the price of money and therefore indirectly influence every market in the world. Given this immense power, the ideal central banker would be humble, cautious and deferential to market signals. Instead, modern central bankers are both bold and arrogant in their efforts to bend markets to their will. Top-down central planning, dictating resource allocation and industrial output based on supposedly superior knowledge of needs and wants, is an impulse that has infected political players throughout history. It is both ironic and tragic that Western central banks have embraced central planning with gusto in the early twenty-first century, not long after the Soviet Union and Communist China abandoned it in the late twentieth. The Soviet Union and Communist China engaged in extreme central planning over the world’s two largest countries and one-third of the world’s population for more than one hundred years combined. The result was a conspicuous and dismal failure. Today’s central planners, especially the Federal Reserve, will encounter the same failure in time. The open issues are, when and at what cost to society ?”

- James Rickards, ‘The death of money: the coming collapse of the international monetary system’, 2014. [Book review here]

“Sir, On the face of it stating that increasing the inheritance tax allowance to £1m would abolish the tax for “all except a very small number of very rich families” (April 5) sounds a very reasonable statement for the Institute for Fiscal Studies to make, but is £1m nowadays really what it used to be, bearing in mind that £10,000 was its equivalent 100 years ago ?

“A hypothetical “very rich” person today could have, for example, a house worth £600,000 and investments of £400,000. If living in London or the South East, the house would be relatively modest and the income from the investments, assuming a generous 4 per cent return, would give a gross income of £16,000 a year, significantly less than the average national wage.

“So whence comes the idea that nowadays such relatively modest wealth should be classified as making you “very rich” ? The middle-aged should perhaps wake up to the fact that our currency has been systematically debased, though it may be considered impolite to say so as it challenges the conventional political and economic wisdom. To be very rich today surely should mean you have assets that give you an income significantly higher than the national average wage ?”

- Letter to the editor of the Financial Times from Mr John Read, London NW11, 12 April 2014

“The former coach house in Camberwell, which has housed the local mayor’s car, was put on the market by Southwark council as a “redevelopment opportunity”. At nearly £1,000 per square foot, its sale value is comparable to that of some expensive London homes.”

- ‘London garage sells for £550,000’ by Kate Allen, The Financial Times, 12 April 2014.

“Just Eat, online takeaway service, slumped below its float price for the first time on Tuesday as investors dumped shares in a raft of recently floated web-based companies amid mounting concern about their high valuations..

“Just Eat stunned commentators last week when it achieved an eye-watering valuation of £1.47 billion, more than 100 times its underlying earnings of £14.1 million..

““They have fallen because the company was overvalued. Just Eat was priced at a premium to Dominos, an established franchise that delivers and makes the pizzas and has revenues of £269 million. Just Eat by comparison is a yellow pages for local takeaways where there is no quality control and no intellectual property and made significantly less revenues of £96.8 million. A quality restaurant does not need to pay 10 per cent commission to Just Eat to drive customers through the door,” Michael Hewson, chief market analyst at CMC Markets said.”

- ‘Investors lose taste for Just Eat as tech stocks slide’ by Ashley Armstrong and Ben Martin,

The Daily Telegraph, 8 April 2014.

Keep interest rates at zero, whilst printing trillions of dollars, pounds and yen out of thin air, and you can make investors do some pretty extraordinary things. Like buying shares in Just Eat, for example. But arguably more egregious was last week’s launch of a €3 billion five-year Eurobond for Greece, at a yield of just 4.95%. UK “investors” accounted for 47% of the deal, Greek domestic “investors” just 7%. Just in case anybody hasn’t been keeping up with current events, Greece, which is rated Caa3 by Moody’s, defaulted two years ago. In the words of the credit managers at Stratton Street Capital,

“The only way for private investors to justify continuing to throw money at Greece is if you believe that the €222 billion the EU has lent to Greece is entirely fictional, and will effectively be converted to 0% perpetual debt, or will be written off, or Greece will default on official debt while leaving private creditors untouched.”

In a characteristically hubris-rich article last week (‘Only the ignorant live in fear of hyperinflation’), Martin Wolf issued one of his tiresomely regular defences of quantitative easing and arguing for the direct state control of money. One respondent on the FT website made the following comments:

“The headline should read, ‘Only the EXPERIENCED fear hyperinflation’. Unlike Martin Wolf’s theorising, the Germans – and others – know only too well from first-hand experience exactly what hyperinflation is and how it can be triggered by a combination of unforeseen circumstances. The reality, not a hypothesis, almost destroyed Germany. The Bank of England and clever economists can say what they like from their ivory towers, but meanwhile down here in the real world, as anyone who has to live on a budget can tell you, every visit to the supermarket is more expensive than it was even a few weeks ago, gas and electricity prices have risen, transport costs have risen, rents have risen while at the same time incomes remain static and the little amounts put aside for a rainy day in the bank are losing value daily. Purchasing power is demonstrably being eroded and yet clever – well paid – people would have us believe that there is no inflation to speak of. It was following theories and forgetting reality that got us into this appalling financial mess in the first place. Somewhere, no doubt, there’s even an excel spreadsheet and a powerpoint presentation with umpteen graphs by economists proving how markets regulate themselves which was very convincing up to the point where the markets departed from the theory and reality took over. I’d rather trust the Germans with their firm grip on reality any day.”

As for what “inflation” means, the question hinges on semantics. As James Turk and John Rubino point out in the context of official US data, the inflation rate is massaged through hedonic quality modelling, substitution, geometric weighting and something called the Homeowners’ equivalent rent. “If new cars have airbags and new computers are faster, statisticians shave a bit from their actual prices to reflect the perception that they offer more for the money than previous versions.. If [the price of ] steak is rising, government statisticians replace it with chicken, on the assumption that this is how consumers operate in the real world.. rising price components are given less relative weight.. homeowners’ equivalent rent replaces what it actually costs to buy a house with an estimate of what homeowners would have to pay to rent their homes – adjusted hedonically for quality improvements.” In short, the official inflation rate – in the US, and elsewhere – can be manipulated to look like whatever the authorities want it to seem.

But people are not so easily fooled. Another angry respondent to Martin Wolf’s article cited the “young buck” earning £30K who wanted to buy a house in Barnet last year. Having saved for 12 months to amass a deposit for a studio flat priced at £140K, he goes into the estate agency and finds that the type of flat he wanted now costs £182K – a 30% price increase in a year. Now he needs to save for another 9 years, just to make up for last year’s gain in property prices.

So inflation is quiescent, other than in the prices of houses, shares, bonds, food, energy and a variety of other financial assets.

The business of rational investment and capital preservation becomes unimaginably difficult when central banks overextend their reach in financial markets and become captive to those same animal spirits. Just as economies and markets are playing a gigantic tug of war between the forces of debt deflation and monetary inflation, they are being pulled in opposite directions as they try desperately to anticipate whether and when central bank monetary stimulus will subside, stop or increase. Central bank ‘forward guidance’ has made the outlook less clear, not more. Doug Noland cites a recent paper by former IMF economist and Reserve Bank of India Governor Raghuram Rajan titled ‘Competitive Monetary Easing: Is It Yesterday Once More ?’ The paper addresses the threat of what looks disturbingly like a modern retread of the trade tariffs and import wars that worsened the 1930s Great Depression – only this time round, as exercised by competitive currency devaluations by the larger trading economies.

Conclusion: The current non-system [a polite term for non-consensual, non-cooperative chaos] in international monetary policy [competitive currency devaluation] is, in my view, a source of substantial risk, both to sustainable growth as well as to the financial sector. It is not an industrial country problem, nor an emerging market problem, it is a problem of collective action. We are being pushed towards competitive monetary easing. If I use terminology reminiscent of the Depression era non-system, it is because I fear that in a world with weak aggregate demand, we may be engaged in a futile competition for a greater share of it. In the process, unlike Depression- era policies, we are also creating financial sector and cross-border risks that exhibit themselves when unconventional policies come to an end. There is no use saying that everyone should have anticipated the consequences. As the former BIS General Manager Andrew Crockett put it, ‘financial intermediaries are better at assessing relative risks at a point in time, than projecting the evolution of risk over the financial cycle.’ A first step to prescribing the right medicine is to recognize the cause of the sickness. Extreme monetary easing, in my view, is more cause than medicine. The sooner we recognize that, the more sustainable world growth we will have.

The Fed repeats its 2% inflation target mantra as if it were some kind of holy writ. 2% is an entirely arbitrary figure, subject to state distortion in any event, that merely allows the US government to live beyond its means for a little longer and meanwhile to depreciate the currency and the debt load in real terms. The same problem in essence holds for the UK, the euro zone and Japan. Savers are being boiled alive in the liquid hubris of neo-Keynesian economists explicitly in the service of the State.

Doug Noland again:

“While I don’t expect market volatility is going away anytime soon, I do see an unfolding backdrop conducive to one tough bear market. Everyone got silly bullish in the face of very serious domestic and global issues. Global securities markets are a problematic “crowded trade.” Marc Faber commented that a 2014 crash could be even worse than 1987. To be sure, today’s incredible backdrop with Trillions upon Trillions of hedge funds, ETFs, derivatives and the like make 1987 portfolio insurance look like itsy bitsy little peanuts. So there are at this point rather conspicuous reasons why Financial Stability has always been and must remain a central bank’s number one priority. Just how in the devil was this ever lost on contemporary central bankers?”

Book Reviews

‘The system has spun out of control’

Book Review: The Death of Money: The Coming Collapse of the International Monetary System by James Rickards

The_Death_of_Money_Cover_ArtThe title will no doubt give Cobden Centre readers a feeling of déjà vu, but James Rickards’ new book (The Death of Money: The Coming Collapse of the International Monetary System) deals with more than just the fate of paper money – and in particular, the US dollar. Terrorism, financial warfare and world government are discussed, as is the future of the European Union.

Though he quotes F.A. Hayek a few times, the Austrian School gets only one mildly disparaging mention in the entire book. This seems odd for an author who devotes a whole chapter to the benefits of the gold standard. His first bestselling book, Currency Wars, argues that currency wars are not just an economic or monetary concern, but a national security concern for the USA.

Rickards relies on emerging Chaos theories of economics and markets (1) to buttress his arguments in favour of sound money and prudent – limited – government. He uses the same insights, twinned with years of Wall Street experience, to explain why the “coming collapse of the dollar and the international monetary system is entirely foreseeable.”

One of Rickards’ key arguments is that exponential increases in the total size of credit markets mean exponential increases in risk. The gross size of derivative markets is the problem, irrespective of false assurances about netting, he claims. Politicians and central bankers have by and large learnt nothing from recent crises, and are still “in thrall to bank political contributions.”

He makes the case for the US federal government to reinstate Depression-era restrictions on banking activities and for most derivatives to be banned. As a former Federal Reserve Chairman, Paul Volcker, said in 2009, “the only useful thing banks have invented in 20 years is the ATM” – a sentiment Rickards would probably be sympathetic to.

The chapter dealing with the Fed’s hubris and what investment writer James Grant calls our “PhD Standard” of macroeconomic management will be familiar territory for readers of this site. The Fed is trapped between the rock of natural deflationary forces of excessive debt, an ageing population and cheap imports frustrating its efforts to generate a self-sustaining economic recovery and the hard place of annualised inflation of 2%. Rickards quotes extensively from eminent economist and Ben Bernanke mentor Frederic Mishkin, who noted in a 2013 paper titled Crunch Time: Fiscal Crises and the Role of Monetary Policy that “ultimately, the central bank is without power to avoid the consequences of an unsustainable fiscal policy.”

More interesting is the author’s attempt to map out what-happens-next scenarios. The chapter about the on-going transformation of the International Monetary Fund into the world’s central bank, and Special Drawing Rights (SDRs) into a global currency, is particularly insightful. Though Rickards doesn’t say it, Barack Obama’s former chief of staff (and current Mayor of Chicago) Rahm Emanuel’s dictum about never letting a crisis go to waste seems to apply here: hostile acts of financial warfare would lead to calls for more international regulation, and to more government intervention and monitoring of markets. Observers of the EU’s crab-like advance over the last half century will be familiar with the process.

Indeed, my only quibble with this book is Rickards’ starry-eyed take on the EU – soon to be “the world’s economic superpower” in his view. Though he makes a good argument – similar to Jesús Huerta de Soto’s – that relatively-tight European Central Bank monetary policy is forcing effective structural adjustments in the eurozone periphery, as well as in eastern states that wish to join the euro, his endorsement of other aspects of the EU seem too sweeping.

The author talks of the benefits of “efficiencies for the greater good” in supranational government, and how subsidiarity makes allowances for “local custom and practice”. But, as the regulatory débacle surrounding the Somerset floods has shown recently, EU rule frequently licenses bureaucratic idiocies that destroy effective, established national laws. Regulatory central planning for an entire continent is, I’d say, just as suspect as monetary central planning for one country.

The continent’s demographic problems are probably containable in the short-term, as Rickards says. But mass immigration is driving increasing numbers of white Europeans to far-right parties. And while there is consistently strong public support for the euro in the PIIGS (Portugal, Ireland, Italy, Greece and Spain), he’s silent on the broader question of the EU’s democratic legitimacy. No mention of those pesky ‘No’ votes in European Constitution, Maastricht and Lisbon Treaty referendums – or of the Commission’s own Eurobarometer polls, which show more and more Europeans losing faith in “the project”.

No matter I suppose: the eurocrats will rumble on regardless. But what was that quote about democracy being the worst form of government apart from all the others?

All in all though, this is a great book – even for someone like me who’s not exactly new to the economic doom ‘n’ gloom genre. As Rickards says at the end of his intro: “The system has spun out of control.”

(1) For example Juárez, Fernando (2011). “Applying the theory of chaos and a complex model of health to establish relations among financial indicators”. Procedia Computer Science 3: 982–986.


ECB embraces QE faulty logic

Editor’s note: this article, under the title “No end to central bank meddling as ECB embraces ‘quantitative easing’, faulty logic” appears on Detlev Schlichter’s site. It is reprinted with kind permission.

The 2nd edition of his excellent Paper Money Collapse is available for pre-order.

“Who can print money, will print money” is how my friend Patrick Barron put it succinctly the other day. This adage is worth remembering particularly for those periods when central bankers occasionally take the foot off the gas, either because they genuinely believe they solved the problem, or because they want to make a show of appearing careful and measured.

The US Federal Reserve is a case in point. Last year the Fed announced that it was beginning to ‘taper’, that is, carefully reduce its debt monetization program (‘quantitative easing’, QE), and this policy, now enacted, is widely considered the beginning of policy normalization and part of an ‘exit strategy’. But as Jim Rickards pointed out, the Fed already fully tapered twice – after QE1 and after QE2 – only to feel obliged to ‘qe’ again some time later. Whether Ms Yellen is going to see the present ‘taper’ through to its conclusion and whether the whole project will in future be remembered as an ‘exit strategy’ remains to be seen.

So far none of the big central banks has achieved the ‘exit’ despite occasional noises to the contrary. Since the start of the financial crisis in the summer of 2007, the global trend has been in one direction and one direction only: From easy money we moved to easier money. QE has been followed by more QE. As I mentioned before, the Fed’s most generous year in its 100-year history was 2013, any talk of ‘tapering’ notwithstanding.

ECB mistrusted by Keynesian consensus

Whenever the European Central Bank reduces its money printing and scales back its market rigging, it invariably unleashes the fury of the Keynesian and inflationist commentariat. In the eyes of its numerous critics, the ECB lacks the proper money-printing credentials of the more pro-active and allegedly more ‘modern’ central banks. It still has a whiff of the old Bundesbank about it, although a few years back, when the ECB flooded the European banking system with cheap liquidity, its balance sheet was larger as a share of GDP than those of its comrades, the Fed and the Bank of England.

The ECB went through two periods of restraint since the crisis: In early 2011 it began to hike interest rates, and in 2013, after the eurozone debt crisis died down, the ECB allowed its balance sheet to shrink by more than €700 billion as banks repaid cheap loans from the central bank. This stood in stark contrast to the Fed’s balance sheet expansion of about $1,000 billion over the same period. The first episode of restraint came to an end in 2012 when the ECB reversed its rate hikes and then cut rates further, ultimately to a new low of just 0.25 percent. Presently, we are still in the second period of restraint, although it too appears to be about to end soon as the ECB’s boss Mario Draghi hinted in his press conference last week at a newfound willingness to embrace unconventional policies to combat ‘deflation’ or even ‘long periods of low inflation’. (The ECB’s harmonized index of consumer prices stood probably at just 0.5% last month.) This means the ECB is likely to cut rates to zero or below soon, or to start asset purchases (‘QE’), or probably both.

Poor logic

This move is hardly surprising in the big scheme of things as outlined above, and the ECB will explain it officially with its mandate to keep inflation below but close to 2 percent, from which it does not want to deviate in either direction. This target itself is silly as it assumes that inflation of 1.8 percent is inherently better than inflation of zero (true price stability, if it ever was attainable), or inflation of minus 1.8 percent (deflation). This is, of course, precisely the argument that has been relentlessly and noisily trumpeted by the easy-money advocates in the media, the likes of Martin Wolf and Wolfgang Münchau in the Financial Times, and the reliably shrill Ambrose Evans-Pritchard in The Daily Telegraph, among others. A certain measure of inflation is deemed good, very low inflation is bad, and anything below zero, even mild deflation, potentially a disaster. But why should this be the case?

Moderate deflation, that is, slowly declining money prices, may or may not be a symptom of problems elsewhere in the economy, but that slowly declining money prices as such constitute an economic problem lacks any foundation in economics and can easily and quickly be refuted by even a cursory look at economic history. In the 19th century we find extended periods of ongoing, moderate deflation in many economies that simultaneously experienced solid growth in output and substantial rises in living standards, a “coincidence”, wrote Milton Friedman and Anna Schwartz in their influential A Monetary History of the United States, 1867 – 1960, that “casts serious doubts on the validity of the now widely held view that secular price deflation and rapid economic growth are incompatible.”

Many commentators advance the argument that falling prices depress consumption as purchases get constantly deferred. Even the usually more sober FT-writer John Authers seems to have succumbed to this argument as he explained to his readers last Saturday that prices “fall, thanks to sluggish economic activity. Consumers do not buy now, as goods will be cheaper in future. This lack of consumption slows growth further, and pushes prices down even further.” (John Authers, “Draghi has to back his QE words with action” Financial Times, Saturday April 5/ Sunday April 6 2014, page 24)

This argument, constantly regurgitated by the cheerleaders of money-printing, is weak. First of all, it is certainly no argument in the present environment of close to zero but still positive inflation. If the ECB plans to fight even very low inflation, as Draghi stated at the ECB press conference, than this argument does nothing to support that policy. Certainly, no one defers any purchases when prices are just stable. However, and more importantly, even in a mildly deflationary environment of let’s say 1 to 2 percent per annum, the argument does appear to be a stretch.

Argument ignores time preference

Consumers only contemplate buying something that they consider an economic good, that is, that they consider useful, that they want because it expends some (subjective) use-value to them. In deferring a purchase they can, in a deflationary environment, save money but at the cost of not enjoying the possession of what they want for some time. By not buying a toaster now you may be able to buy it 1 or 2 percent cheaper in a year’s time, or 2 to 4 percent cheaper in two years’ time (always assuming, of course, that the mild deflation persists that long, which nobody can guarantee), but even these small monetary gains come at the expense of not enjoying ownership of the toaster for two years. The small monetary gain obtained by delaying purchases is not for free, as the argument seems to assume, but comes at the cost of waiting. I suggest that only a very small number of items, and only those for which there is very marginal demand indeed, would be affected.

Time preference is not a concept of psychology, it is a constituting element of human action. It is a priori to human action, which means it exists independent of experience or of personal circumstances as it is already entailed in the very concept of what constitutes an ‘economic good’.

If you experienced no time preference in relation to a specific good you would be indifferent as to whether you enjoyed the possession of that good today or tomorrow. And tomorrow you would be indifferent as to whether you enjoyed it that day or the next, and so forth. Logically, you would be indifferent as to whether you enjoyed possession of it at all, and this means that the good in question is not an economic good for you. You do not care for it.

As George Reisman put is succinctly: To want something means, all else being equal, to want it sooner rather than later.

Be honest, how many purchases over the past 12 months would you not have made had you had a reasonable chance of obtaining the item in question at a 1 or 2 percent discount if you waited a year?


That the prospect of falling prices does not usually deter consumption can be readily seen today in the market for consumer electronics (mobile phones, computers), which has been in deflation – and considerable deflation – for quite some time.

Argument ignores opportunity costs of holding money

The argument also seems to ignore that holding one’s wealth in the form of money involves opportunity costs. Rather than sitting on cash you could enjoy the things you could buy with it. In a deflationary environment, your cash hoard’s purchasing power slowly rises and you can afford ever more nice things with your money, which means the opportunity cost of not spending it constantly goes up. (In a way, while you are waiting four years to buy your toaster at an 8 percent discount to today’s price, buying the toaster is also becoming marginally more attractive to others who are presently holding cash and who may initially not even had an interest in a toaster.)

I think that all that would follow from secular (that is ongoing, systematic but moderate) deflation is that cash would be a more meaningful competitor for other depositories of deferred consumption. Saving by simply holding money makes sense in a deflationary environment, so other vehicles to save with (bonds and shares) would have to offer a return reasonably above the expected deflation rate to attract savings. I think this is not an unreasonably high hurdle.

Furthermore, if what Authers and others describe were true for even marginal deflation, that is, if marginal deflation indeed led to more deflation and a progressively weakening economy, the reverse must logically be true for marginal inflation. Consumers would accelerate their purchases to avoid the 1 or 2 percent loss in purchasing power per annum, and this would quickly drive inflation higher. If two percent deflation led to cash hoarding and a collapse in consumption, would the 2 percent inflation advocated today as ‘price stability’ not lead to a spike in money velocity and an inflationary boom? Either scenario seems highly unrealistic.

Monetary causes versus non-monetary causes

If we use the economic terminology correctly, then inflation and deflation are always monetary phenomena, that is, they always have monetary causes. (As an aside, I here use the now standard definition of inflation as an ongoing, trending rise in the general price level, and deflation as the opposite, rather than the traditional meaning of inflation as an expansion of the money supply and deflation as a contraction.) However, the starting point of the present discussion is simply some low readings on the official inflation statistics in the eurozone. And that those could have non-monetary causes, that they could be the consequence of a crisis-driven drop in real demand in certain industries and certain countries is a realistic assumption and is in fact implied by the arguments of the QE-advocates. Outright deflation is presently being recorded in Greece, Cyprus, and Spain. And John Authers’ short statement on deflation in the FT also starts from the assumption that “prices fall thanks to sluggish economic activity.”

But to the extent that recorded deflation is not due to a general rise in money’s purchasing power (due to a general rise in money demand or an unchanged or falling money supply, to which I come soon) but the result of some producers slashing certain prices in certain industries and regions, and of those price drops not being fully compensated by rising prices somewhere else in eurozone, then this has various implications:

Consumers cannot simply assume that this is a lasting trend. The liquidation of capital misallocations and the discounting of merchandise to get it moving are crisis phenomena and cannot simply be extrapolated into the future the way consumers may have extrapolated the secular deflation of gold standard economies in the 19th century. But the straight extrapolation of very recent price changes into the future is at the core of the argument that even small deflation would be disastrous.

Furthermore, it would seem bizarre to advice merchants to not slash prices when demand drops as that would, according to the logic advanced by Authers et al, only lead to further postponement of consumption and a further drop in demand as consumers would simply expect price declines to continue. Would hiking prices be a better strategy to counter falling demand? Should we reconsider the concept of the “sale” and of “discounting” inventory to encourage buying?

To a considerable degree, the reduction in certain prices for ‘real’ economic reasons could be part of the economic healing process. It is a way for many producers, sectors of the economy, and economic regions, to regain competitiveness. It is true that falling wages in certain industries or regions make it more difficult for workers to repay mortgages and consumer loans but often the lower wage may be the only way to avoid unemployment, which would make repaying debt harder still. Behind the often-quoted headline inflation rate of presently 0.5% per annum lie numerous relative price changes by which the economy re-balances. All discussions about the ‘price index’ ignore these all-important changes in relative prices. It so happens that what goes on with the multitude of individual prices in the economy adds up, according to the techniques of the ECB statisticians, to a 0.5% harmonized inflation rate at the moment, and it may all add up to -0.5% next month or next year, or maybe even – 1 percent. To simply conclude from this one aggregate price number that the economy is getting progressively sicker would be wrong.

There is no escaping the fact that recent economic difficulties are the result of imbalances that accumulated during the credit boom that preceded the 2007/2008 financial crisis, of which the eurozone debt crisis was an after quake. Artificially cheap money created the credit boom and these imbalances. A period of liquidation, contraction, changing relative prices and occasionally falling prices is now necessary, and short-circuiting this process via renewed central bank intervention seems counterproductive and ultimately dangerous.

There is, of course, the possibility that proper monetary causes are behind the eurozone’s low inflation and soon deflation, and that those might persist. Banks still feel constrained in their ability to extend new loans and thus create new money. The growth in bank lending and thus in wider monetary aggregates may fall short of the growth in money demand. But it is an essential feature of money that any demand for it can be fully satisfied with a rise in its price. Demand for money is always demand for readily exercisable purchasing power, and by allowing the market to lift the purchasing power of money, that is, through deflation, that demand can be met. The secular, moderate and largely harmless deflation of 19th century gold standard economies had essentially the same origin. Money production did not keep pace with money demand, so money demand was satisfied via slowly falling prices.

And here the same conclusion applies: a more restrained approach to lending, credit risk, and financial leverage, now adopted by banks and the public at large as a consequence of the crisis, may be a good thing, and for the central bank to mess with this process and to use ‘unconventional’ means to force more bank lending and money creation onto the system, out of some misguided commitment to the arbitrarily chosen statistical goal of ‘2-percent inflation’ seems foolish. If successful in raising the headline inflation rate it may succeed in creating the same imbalances (excessive leverage, misallocations of capital and distorted asset prices) that have created the recent crisis.

One commentator recently said the eurozone could ill afford deflation considering the size of its bloated banking sector. But the question is if it can afford the level of lending to attain 2 percent inflation considering the size of its bloated banking sector.

The fallacy of macroeconomics and macroeconomic policy

Let me be clear: I do not recommend a zero-inflation target or a target of moderate deflation. Moderate deflation in and of itself is a little a solution as moderate inflation in and of itself is a problem. I recommend no target as I reject the entire concept of ‘monetary policy’, of the notion that a state agency could conceivably enhance, through clever manipulation of interest rates and bank reserve policy, the coordinating powers of the market that help people realize their personal economic objectives through free trade.

We should remember that no one participates in the economy and in trade and commerce because his or her goal is that the general price level goes up by 2 percent, or that nominal GDP increases by 5 percent. People have their own personal objectives. The market is simply a powerful tool for voluntary and decentralized plan-coordination among independent individuals and groups of individuals that pursue their own goals. It is best left undisturbed. This entire project of ‘monetary policy’ is absurd in the extreme, regardless of what the target is.

It is the fallacy of macroeconomics that certain statistical aggregates, such as CPI, GDP or nominal GDP, are deemed reliable representatives of what goes on in a complex market economy, and it is dangerous hubris to believe that the state should define ‘targets’ for these statistical aggregates and then use policy intervention to achieve them. This might be an approach intellectually suitable for the ruler of a communist or fascist society. It is fundamentally at odds with free trade and a free market, and it must and will fail. That should have been a clear lesson from the financial crisis.

Instead, the mainstream consensus, deeply influenced by Keynesianism and macroeconomics, continues to embrace policy activism and intervention. I fully expect central banks to continue on their path towards more aggressive meddling and generous fiat money production. It won’t take long for the ECB to take the next step.


Money derivative creation in the modern economy

It isn’t often that a Bank of England Quarterly Bulletin starts “A revolution in how we understand economic policy” but, according to some, that is just what Money creation in the modern economy, a much discussed article in the most recent bulletin, has done.

In the article Michael McLeay, Amar Radia, and Ryland Thomas of the Bank’s Monetary Analysis Directorate seek to debunk the allegedly commonplace, textbook understanding of money creation. These unnamed textbooks, they claim, describe how the central bank conducts monetary policy by varying the amount of narrow or base money (M0). This monetary base is then multiplied out by banks, via loans, in some multiple into broader monetary measures (e.g. M4).

Not so, say the authors. They begin by noting that most of what we think of as money is actually composed of bank deposits. These deposits are created by banks when they make loans. Banks then borrow the amount of narrow or base money they require to support these deposits from the central bank at the base rate, and the quantity of the monetary base is determined that way. In short, the textbook argument that central bank narrow or base money creation leads to broad money creation is the wrong way round; bank broad money creation leads to central bank narrow money creation. The supposedly revolutionary connotations are that monetary policy is useless, even that there is no limit to the amount of money banks can create.

In fact there is much less to this ‘revolution’ than meets the eye. Economists and their textbooks have long believed that broad money is created and destroyed by banks and borrowers(1). None that I am aware of actually thinks that bank lending is solely or even largely based on the savings deposited with it. Likewise, no one thinks the money multiplier is a fixed ratio. It might be of interest as a descriptive datum, but it is of no use as a prescriptive tool of policy. All the Bank of England economists have really done is to describe fractional reserve banking which is the way that, these days, pretty much every bank works everywhere.

But there’s an important point which the Bank’s article misses; banks do not create money, they create money derivatives. The narrow or base money issued by central banks comprises coins, notes, and reserves which the holder can exchange for coins and notes at the central bank. The economist George Reisman calls this standard money; “money that is not a claim to anything beyond itself…which, when received, constitutes payment”.

This is not the case with the broad money created by banks. If a bank makes a loan and creates deposits of £X in the process, it is creating a claim to £X of standard money. If the borrower makes a cheque payment of £Y they are handing over their claim on £Y of reserve money. The economist Ludwig von Mises called this fiduciary media, as Reisman describes it, “transferable claims to standard money, payable by the issuer on demand, and accepted in commerce as the equivalent of standard money, but for which no standard money actually exists”. They are standard money derivatives, in other words.

Banks know that they are highly unlikely to be called upon to redeem all the fiduciary media claims to standard money in a given period so, as the Bank of England economists explain, they expand their issue of fiduciary media by making loans; they leverage. Between May 2006 and March 2009 the ratio of M4 to M0, how many pounds of broad money each pound of narrow money was supporting, stood around 25:1.

But because central banks and banks create different things consumer preferences between the two, standard money or standard money derivatives, can change. In one state of affairs, call it ‘confidence’, economic agents are happy to hold these derivatives as substitutes for standard money. In another state of affairs, call it ‘panic’, those same economic agents want to swap their derivatives for the standard money it represents a claim on. This is what people were doing when they queued up outside Northern Rock. A bank run can be described as a shift in depositors’ preferences from fiduciary media to standard money.

Why should people’s preferences switch? In the case of Northern Rock people came to doubt that they would be able to actually redeem their fiduciary media for the standard money it entitled them to because of the vast over issue of fiduciary media claims relative to the standard money the bank held to honour them. Indeed, when Northern Rock borrowed from the Bank of England in September 2007 to support the commitments under its broad money expansion it increased the monetary base just as the Bank of England economists argue.

But there are limits to this. A bank will need some quantity of standard money to support its fiduciary media issue, either to honour withdrawals by depositors or settle accounts with other banks. If it perceives its reserves to be inadequate it will need to access new reserves. And the price at which it can access those reserves is the Bank of England base rate. If this base rate is relatively high banks will constrain their fiduciary media/broad money issue because the profits earned from making new loans will not cover the potential cost of the standard/narrow money necessary to support it. And if the base rate is relatively low banks will expand their fiduciary media/broad money issue because the standard/narrow money necessary to support it is relatively cheap.

Some commentators need to calm themselves. As the Bank of England paper says, the central bank does influence broader monetary conditions but it does so via its control of base rates rather than the control of the quantity of bank reserves. The reports of the death of monetary policy have been greatly exaggerated.

(1) “Banks create money. Literally. But they don’t do so by printing up more green pieces of paper. Let’s see how it happens. Suppose your application for a loan of $500 from the First National Bank is approved. The lending officer will make out a deposit slip in your name for $500, initial it, and hand it to a teller, who will then credit your checking account with an additional $500. Total demand deposits will immediately increase by $500. The money stock will be larger by that amount. Contrary to what most people believe, the bank does not take the $500 it lends you out of someone else’s account. That person would surely complain if it did! The bank created the $500 it lent you” – The Economic Way of Thinking by Paul Heyne, Peter Boettke, and David Prychitko, 11th ed., 2006, page 403. Perhaps the Bank of England economists need to read a better textbook?


“Everything we are told about deflation is a lie”

“The European Central Bank has given its strongest signal yet that it is prepared to embrace quantitative easing to prevent the euro zone from sliding into deflation or even a prolonged period of low inflation.”
- ‘Draghi strengthens QE signal’, Financial Times, April 4, 2014.

Yes, heaven protect Europe’s embattled citizens and savers from a prolonged period of low inflation. How could they possibly survive it ?

If history is any guide, probably quite well. As Chris Casey points out in his essay ‘Deflating the deflation myth’, the American economy during the 19th Century twice experienced deflationary periods of roughly 50 percent:
price level
Source: McCusker, John J. “How Much Is That in Real Money?: A Historical Price Index for Use as a Deflator of Money Values in the Economy of the United States.” Proceedings of the American Antiquarian Society, Volume 101, Part 2, October 1991, pp. 297-373.

This during a period of “sustained and significant economic growth”. But just think of all those poor consumers, having to make the best of constantly falling everyday low prices.

In their research article ‘Deflation and Depression: Is There an Empirical Link?’ of January 2004, Federal Reserve economists Andrew Atkeson and Patrick Kehoe found that “..the only episode in which we find evidence of a link between deflation and depression is the Great Depression (1929-1934). We find virtually no evidence of such a link in any other period.. What is striking is that nearly 90% of the episodes with deflation did not have depression. In a broad historical context, beyond the Great Depression, the notion that deflation and depression are linked virtually disappears.”

In his 2008 essay ‘Deflation and Liberty’, Jörg Guido Hülsmann writes as follows:

“In the present crisis, the citizens of the United States [he could have added: and of the UK, and Europe] have to make an important choice. They can support a policy designed to perpetuate our current fiat money system and the sorry state of banking and of financial markets that it logically entails. Or they can support a policy designed to reintroduce a free market in money and finance. This latter policy requires the government to keep its hands off. It should not produce money, nor should it appoint a special agency to produce money. It should not force the citizens to use fiat money by imposing legal tender laws. It should not regulate banking and should not regulate the financial markets. It should not try to fix the interest rate, the prices of financial titles, or commodity prices.

“Clearly, these measures are radical by present-day standards, and they are not likely to find sufficient support. But they lack support out of ignorance and fear.

“We are told by virtually all the experts on money and finance – the central bankers and most university professors – that the crisis hit us despite the best efforts of the Fed [..and the Bank of England, and the ECB..]; that money, banking and financial markets are not meant to be free, because they end up in disarray despite the massive presence of the government as a financial agent, as a regulator, and as money producer; that our monetary system provides us with great benefits that we would be foolish not to preserve. Those same experts therefore urge us to give the government an even greater presence in the financial markets, to increase its regulatory powers, and to encourage even more money production to be used for bailouts.”

But as Hülsmann goes on to argue, all of these contentions are wrong, and have been proven to be wrong since the times of Adam Smith and David Ricardo. A paper money system is not beneficial “from an overall point of view”. (Nor has any unbacked paper money system ever lasted.) A paper money system does not create real resources on which our welfare depends. “It merely distributes the existing resources in a different manner; some people gain, others lose. It is a system that that makes banks and financial markets vulnerable, because it induces them to economize on the essential safety valves of business: cash and equity.”

The conventional view of deflation is that if it sets in, “the banking industry, the financial markets, and much of the rest of the economy will be wiped out in a bottomless deflationary spiral.” But as Hülsmann goes on to argue, such a spiral would not prove fatal to the lives and welfare of the general population. Rather, it would destroy “essentially those companies and industries that live a parasitical existence at the expense of the rest of the economy, and which owe their existence to our present money system.”

Let us be more explicit. Severe deflation threatens at an existential level bankrupt banks and the bankrupt governments that perpetuate their existence. Deflation is a mortal enemy to the heavily indebted state and its embedded parasites, but it is a friend to the saver and to anyone with a positive net worth. Because it is so dangerous to the debtor, (unelected) central bankers clearly feel they have no option but to incinerate savers at the altar of perpetuating an unsustainably indebted banking and political elite.

So it would seem that the euro zone, under Mario Draghi, is on the verge of outright quantitative easing, and that the ECB is also committed to using “unconventional instruments” in an increasingly desperate attempt to revive the corpse through explicit inflationism, not least by actually buying sovereign debt of dubious underlying value, rather than merely pledging to. The financial markets certainly appear to think so: the yields on Spanish 5-year government paper fell below those of their US equivalents last week. Spanish bonds yielded more than 7% above US paper as recently as 2012. And as Bloomberg pointed out, the yields on Spanish and Italian five year paper, and the yield on 10 year Irish government debt, all fell to record lows last Friday.

Whether in terms of goosed bond markets or inflated stock markets, inflated higher not necessarily by any improvement in corporate prospects but primarily by expectations of more ex nihilo money courtesy of the world’s major central banks, these are false markets. They cannot entirely be trusted – assuming that markets ever can. Fund manager Seth Klarman has written well on the artificiality of today’s markets:

“The Fed and the Treasury openly discuss the aims of their policies: to manipulate financial markets higher and to generate reported economic “growth” and a “wealth effect”. Inside the giant Plexiglas dome of modern capital markets, just about everyone is happy, the few doubters are mocked and jeered, bad news is increasingly ignored… The artificiality of today’s markets is pure Truman Show. According to the Wall Street Journal, the Federal Reserve purchased about 90% of all the eligible mortgage bonds issued in November.”

John Phelan of the Cobden Centre writes well that “the Federal Reserve has become an enabler of the financial havoc it was designed (a century ago) to prevent.”

Messrs Yellen, Draghi et al should be careful what they wish for. Inflation targeting is hardly a precise science. Achieving an entirely arbitrary 2% inflation level is bad enough for savers on fixed incomes when deposit rates are close enough to zero as to make no difference, but markets have a tendency to overshoot. Most government bond markets are clearly overbought – but in a QE world given fresh impetus by the looming arrival of the ECB, overbought markets can become even more overbought. When we don’t claim to understand the underlying dynamics (political) or the final destination (though we have our own fears), it’s much better simply not to play. From an asset allocation perspective, classic, benchmark-unconstrained Benjamin Graham-style ‘deep value’ equity is, we now believe, pretty much the only game in town – and that is where we now focus our attention, almost exclusively.

Meanwhile, we watch in disbelief as market distortions become even more untenable.


Renewed estimates of Chinese gold demand

Editor’s note: This article was previously published here at 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 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 consists of scrap, domestically mined and imported gold


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.


Are economic sanctions behind a possible recession in Russia?

According to commentators, sanctions imposed by the US and the European Union are pushing Russia towards a recession. However, we hold that some key Russian economic data have been displaying weakening prior to the annexation of Crimea to Russia. This raises the likelihood that sanctions might not be the key factor for an emerging recession.

The yearly rate of growth of monthly real gross domestic product (GDP) eased to 0.3% in February from 0.7% in January and 1.8% in July last year. After closing at 12.2% in March last year the yearly rate of growth of retail sales fell to 7.7% in January before settling at 9.6% in February.

Russia real GDP

Russia retail sales

We suggest that the key factor behind any emerging slowdown and a possible recession is a sharp decline in the yearly` rate of growth of money supply (AMS) from 67.1% in May 2005 to minus 12.2% by September 2009. We hold that the driving force behind this sharp decline is a strong decline in the growth momentum of the central bank’s balance sheet during that period (see chart).

Graphs 3 4 Russia

There is a long time lag from changes in money supply and its effect on economic activity. We suspect that it is quite likely that the effect from a fall in the growth momentum of money during May 2005 to September 2009 is starting to dominate the present economic scene.

This means that various bubble activities that emerged on the back of the prior strong increase in money supply are at present coming under pressure. So from this perspective irrespective of sanctions, the Russian economy would have experienced a so-called economic slowdown, or even worse a recession.
Now, to counter a further weakening in the ruble against the US$ the Russian central bank has raised the seven day repo rate by 1.5% to 7%. The price of the US$ in ruble terms rose to 36.3 in March from 30.8 rubles in March last year – an increase of 18%.

Russia graphs 5 6

Whilst a tighter interest rate stance can have an effect on the present growth momentum of money supply this is likely to have a minor effect on the emerging economic slowdown, which we suggest is predominately driven by past money supply.

There is no doubt that if sanctions were to become effective they are going to hurt economic activity in general i.e. both bubble and non-bubble activities.

On this one needs to exercise some caution given the possibility that major world economies are heading toward a slower growth phase.

Hence from this perspective, regardless of sanctions the pace of the demand for the Russian exports is likely to ease.

We hold that it is quite likely that the Euro-zone, an important Russian trading partner, is unlikely to enforce sanctions in order to cushion the effect of the possible emerging economic slowdown in the Euro-zone. (Sanctions are likely to have a disruptive economic effect not only on Russia but also on the Euro-zone). Observe that Russia’s export to the Euro-zone as a percentage of its total exports stood at 54.1% in 2013 against 52.9% in 2012. In contrast Russia’s export to the US as a % of total stood at 2.1% in 2013. As a percentage of total imports Euro-zone imports from Russia stood at 8% in January whilst American imports from Russia as a percentage of total imports stood at 0.8%. Note that the Euro-zone relies on Russia for a third of its energy imports. Hence it will not surprise us if the Europeans are likely to be more reluctant than the US in enforcing sanctions.

Russia 7 8

Russia’s foreign reserves have weakened slightly in February from the month before. The level of reserves fell by 1.1% to $493 billion after declining by 2.1% in January. The growth momentum of reserves also remains under pressure. Year-on-year the rate of growth stood at minus 6.2% in February against a similar figure in January. A possible further weakening in China’s economic activity and ensuing pressure on the price of oil is likely to exert more pressure on foreign reserves.

Russia 9 10

Meanwhile, the growth momentum of the Russian consumer price index (CPI) displays a visible softening. The yearly rate of growth stood at 6.2% in February against 6.1% in January. Observe that in February last year the yearly rate of growth stood at 7.3%. Based on the lagged growth momentum of our Russian monetary measure AMS we can suggest that the yearly rate of growth of the Russian CPI is likely to weaken further in the months ahead.

Russia 11 12

Summary and conclusion

According to some experts sanctions imposed by the US and the European Union are likely to push Russia into a recession. We suggest that the key factor which is likely to push Russia into a recession is not sanctions as such but a sharp decline in the growth momentum of money supply between May 2005 and September 2009. Given the possibility that major world economies are heading towards a renewed economic slowdown, we suggest that regardless of sanctions the pace of the demand for Russia’s exports is likely to ease. Now, given that the Euro-zone relies on Russia for a third of its energy imports it will not surprise us if the Euro-zone proves likely to be more reluctant than the US in enforcing sanctions.


Lured by plausible nonsense

“One of the peculiar sins of the twentieth century which we’ve developed to a very high level is the sin of credulity. It has been said that when human beings stop believing in God they believe in nothing. The truth is much worse: they believe in anything.”
- Malcolm Muggeridge.

Finding a cure for cancer always makes for a good story. So the New York Times runs it:

“Within a year, if all goes well, the first cancer patient will be injected with two new drugs that can eradicate any type of cancer, with no obvious side effects and no drug resistance..”

Cancer experts, including a Nobel Laureate, are reported to be “electrified” by the results. While existing treatments can only slow the disease, the new trials are said to eradicate tumours completely. The company that holds the licence for the treatments is mentioned as well. Its name is Entremed. The stock price responds immediately, and rises by 600%. The news is extraordinary, and extremely exciting.

It just isn’t new. As Thomas Schuster points out in his study of financial markets and their relationships with mass media (you can read it here), the New York Times had itself reported the same story in an article half a year earlier. The original copy contained all the ‘active ingredients’ repeated in the more recent cover story: the amazing research results; the breathless enthusiasm of experts; the name of the licensee, Entremed. CNN and CNBC also happened to report the story. Economically speaking, the cover story is news without any information content: the market already knew the pertinent facts six months ago. If the efficient market hypothesis were valid, the republication of the story should have had little or no effect on Entremed’s share price. But it did.

“Isn’t it funny,” said a senior portfolio manager once, “when you walk into an investment firm and you see all of the financial advisers watching CNBC. That gives me the same feeling of confidence I would have if I walked into the Mayo clinic or Sloan Kettering and all the medical staff were watching General Hospital.”

The media structure content by selection and evaluation. But the weighting of information in the media, suggests Schuster, never corresponds to the distribution of information in reality:

“The media produce explanations by establishing logical links and causal relations; these interpretations, though, are only more or less adequate to reality. The media enrich information by adding new elements such as “emotion” or “suspense”; through this process, however, the character of the information is altered. The media can even create their own events where nothing would happen otherwise – or they can encourage others to do so. In short: the media select, they interpret, they emotionalize and they create facts.”

Pity the poor journalist who must make a daily market report trying to explain price movements with (necessarily) imperfect knowledge of what really triggered them.

“A typical stock market report looks like this: Stock X increased because.. Index Y crashed due to.. Prices Z continue to rise after.. Most of these explanations are post-hoc rationalizations. Correlations which do not really exist are established. Reasons are constructed which can be interchanged arbitrarily. The explanations, as it seems, are quite obvious, even if they are far- fetched. In a nutshell: an artificial logic is created, based on a simplistic understanding of the markets, which implies that there are simple explanations for most price movements; that price movements follow rules which then lead to systematic patterns; and of course that the news disseminated by the media decisively contribute to the emergence of price movements.”

Just as nature abhors a vacuum, so humanity abhors uncertainty. The tragedy of flight MH370 shows this human characteristic in spades. The families of the passengers are wholly justified in wanting to know the truth. But for the rest of us, we find it extraordinarily difficult to live with the uncertainty of a missing plane. We demand answers. And human beings are suckers for narrative. We would rather grasp onto the most fanciful theorizing than accept that some things may never be known to us. In a world of uncertainty, we crave concrete certitude. So we are inevitably setting ourselves up for disappointment; we are invariably going to be fooled, at least some of the time, lured by plausible nonsense.

Speaking of plausible nonsense, there must have been some reason for investors to have been buying shares of newly listed King Digital (makers of the online game Candy Crush) in the secondary market this week, but we’re not aware of any compelling ones. Certainly not on valuation grounds. But then valuations in the US equity market as a whole seem to have got somewhat ahead of themselves. Value investor Tobias Carlisle (along with Tocqueville Funds’ François Sicart, and Farnam Street Investments) points out that the distribution of price / earnings multiples within the S&P 500 index is at its tightest level for 25 years. Or to put it in plainer English, this is the worst value opportunity set within the US stock market for a quarter of a century. James Montier of GMO agrees, calling it a “hideous opportunity set” for investors.

“…a reflection of the central bank policies around the world. They drive the returns on all assets down to zero, pushing everybody out on the risk curve. So today, nothing is cheap anymore in absolute terms. There are pockets of relative attractiveness, but nothing is cheap or even at fair value. Everything is expensive. As an investor, you have to stick with the best of a bad bunch.”

We’re not quite as downbeat as Montier, but perhaps only because, since we manage less money than GMO, we’re completely unconstrained as to benchmarks, markets and indices, and have no pressure whatever to own US stocks when they don’t offer compelling value – which they don’t appear to, today. Such is the curse of indexation and benchmarking – when you have to own a market irrespective of whether you like it. (This is also the curse of the asset gatherer versus the asset manager.) Since we’re not obligated to fish for stocks in US waters, we can take advantage of deep value opportunities in smaller and mid-cap markets throughout Asia (and notably Japan), where Ben Graham-style deep value opportunities still exist offering some semblance of a margin of safety.

The 1,000 lb gorilla in the room remains the Fed. Can the US central bank really end QE without material consequences across asset markets ? Place your bets. There is not much evidence of the ‘worry gene’ prevalent in financial media, which have a vested interest in delivering positive, reassuring news. Robert Shiller in his celebrated ‘Irrational Exuberance’ noted that:
“Many news stories.. seem to have been written under a deadline to produce something – anything – to go along with the numbers from the market.. Sometimes the article is so completely devoid of genuine thought about the reasons for the bull market and the context for considering its outlook that it is hard to believe that the writer was other than cynical in his or her approach.”

If it’s any consolation (either to Shiller or to ourselves), those market updates are increasingly being written by machines. Stupid or cynical they are not, unless programmed to be so. But trustworthy?


Eggs in two baskets

Supporters of sound currency have a pretty good idea about what’s wrong with the present paper currency and banking arrangements. They also have clear views on what should replace it, although some put more emphasis on gold, others on baskets of commodities.

I remember the excitement I felt as I first read Friedrich Hayek’s The Denationalisation of Money. My preference was for gold, though the fluctuations of the early 1980s made me aware that reintroducing the Gold Standard could be turbulent. It would be politically “courageous” if not a sure election loser.

After grasping the idea that a basket of goods could be more stable than gold on its own, I eagerly turned to the last page. I hoped to find a compelling step-by-step guide to how to bring this “standard” currency into existence.

To put it mildly, I was disappointed.
Continue reading “Eggs in two baskets”


More Bread and Circuses

Editor’s note: We’re grateful to Tim Price of PFP Group for this article. PFP has made this document available for your general information.

“Lower borrowing and a smaller deficit mean less debt.”
- George Osborne, British Chancellor, in his 2014 Budget Speech.

“Bingo ! Cutting the bingo tax and beer duty – To help hardworking people do more of the things they enjoy.”
- Asinine Conservative post-budget advertisement.

“Bingo ! I say, you there ! How is your whippet ? Jolly good, jolly good. Carry on.”
- Inevitable twitter response via #torybingo.

“, and above all gambling, filled up the horizon of their minds. To keep them in control was not difficult.”
- George Orwell, ‘1984’.

“Mad piece of theatre over the petty cash”
- Headline to Matthew Engel’s budget review in the Financial Times.

Continue reading “More Bread and Circuses”