“I am definitely concerned. When was [the cyclically adjusted P/E ratio or CAPE] higher than it is now? I can tell you: 1929, 2000 and 2007. Very low interest rates help to explain the high CAPE. That doesn’t mean that the high CAPE isn’t a forecast of bad performance. When I look at interest rates in a forecasting regression with the CAPE, I don’t get much additional benefit from looking at interest rates… We don’t know what it’s going to do. There could be a massive crash, like we saw in 2000 and 2007, the last two times it looked like this. But I don’t know. I think, realistically, stocks should be in someone’s portfolio. Maybe lighten up… One thing though, I don’t know how many people look at plots of the market. If you just look at a plot of one of the major averages in the U.S., you’ll see what look like three peaks – 2000, 2007 and now – it just looks to me like a peak. I’m not saying it is. I would think that there are people thinking – way – it’s gone way up since 2009. It’s likely to turn down again, just like it did the last two times.”
“Paid promoters have helped push CYNK [CYNK Technology Corp] market cap to $655 million after a 3,650% increase in the share price on Tuesday.
“CYNK had assets of just $39 (no zeroes omitted) as of March 31, 2014 and a cumulative net loss of $1.5 million. The “company” has no revenue.
“CYNK claims that it is “a development stage company focused on social media.” However, the “company” does not even have a website and has just one employee [who acts as President, Chief Executive Officer, Chief Financial Officer, Treasurer and Company Secretary].
“With no assets, no revenue and no product, CYNK has no value. Author expects that CYNK shares are worthless.”
Lord Overstone said it best. “No warning can save people determined to grow suddenly rich.” But there is clearly a yawning chasm between the likes of those folk cheerfully bidding up the share price of CYNK, and prudent investors simply trying to keep their heads above water. What has effectively united these two otherwise disparate communities is today’s central banker. Andy Haldane, the chief economist for the Bank of England, speaking at an FT conference last week, conceded that ultra-accommodative monetary policy had “aided and abetted risk-taking” by investors and that policy makers had wanted to use higher asset prices to try and stimulate the wider economy (that is to say, the economy) into a more robust recovery: “That is how [monetary policy] is meant to work. That’s why we did it.” If the Bank of England had not slashed interest rates and created £375 billion out of thin air, “the UK economy would have been at least 6 per cent smaller than it is today.” A curiously precise figure, given the absence of any counterfactual. But regardless of the economic “benefits” of quantitative easing, Haldane did have the grace to admit that
“That will mean, on average, that financial market volatility will be somewhat greater than in the past. I think it will mean, on average, that those greed and fear cycles in financial markets will be somewhat more exaggerated than in the past. That, for me, is the corollary of the risk migration.”
Which is a bit like an arsonist torching a wooden building and then shrugging his shoulders and saying,
“Well, wood will burn.”
Our central bankers, of course, will not be held accountable when the crash finally hits, even if the accumulated dry tinder of the boom was almost entirely of their own creation. Last week the Bank for International Settlements, the central banker’s central bank, issued an altogether more circumspect analysis of the world’s current financial situation, in their annual report. It concluded, with an entirely welcome sense of caution, that
“The [monetary] policy response needs to carefully consider the nature and persistence of the forces at work as well as policy’s diminished effectiveness and side effects. Finally, looking forward, the issue of how best to calibrate the timing and pace of policy normalisation looms large. Navigating the transition is likely to be complex and bumpy, regardless of communication efforts. And the risk of normalising too late and too gradually should not be underestimated.” (Emphasis ours.)
Translation: ZIRP (Zero Interest Rate Policy – and in the case of the ECB, which has taken rates negative, NIRP) is no longer working – if it ever did. Hyper-aggressive monetary policy has side effects. Getting out of this mess is not going to be easy, and it’s going to be messy. Forward guidance, which was meant to simplify the message, has instead hopelessly confused it. And there are big risks that central banks will lose the requisite confidence to tighten policy when it is most urgently needed, and allow an inflationary genie entirely out of the bottle.
The impact of central banks’ unprecedented monetary stimulus on financial markets is so overwhelming that it utterly negates any sensible analysis of likely macro-economic developments. On the basis that sometimes it’s simply best not to play some games, we no longer try. What should inform investors’ preferences, however, is bottom-up asset allocation and stock selection. The US equity market is clearly poor value at present. That doesn’t mean that it can’t get even more expensive, and the rally might yet have some serious legs. But overvaluation at an index level doesn’t preclude the existence of undervalued stocks well away from the braying herd. (We think the most compelling macro value is in Asia and, if we had to single out any one country, Japan.)
“The central thesis among investors at present is that they have no other choice but to hold stocks, given the alternative of zero short-term interest rates and long-term interest rates well below the level of recent decades..”
“Investment decisions driven primarily by the question “What other choice do I have ?” are likely to prove regrettable. What we now have is a market that has been driven to one of the four most extreme points of overvaluation in history. We know how three of them ended.”
The conclusion seems clear to us. If one chooses to invest at all, invest on the basis of valuation and not on indexation (the world’s largest stock market, that of the US, is one of the most seemingly conspicuously overvalued). As an example of the sort of valuations currently available away from the herd, consider the following. You can buy the US S&P 500 index today with the following metrics:
Price / earnings: 18.2
Price / book: 2.76
Dividend yield: 1.89%
Meanwhile, Greg Fisher in his Halley Asian Prosperity Fund (albeit currently closed) is buying quality businesses throughout Asia on somewhat more attractive valuations. (By geography, the fund’s largest allocations are to Japan, Vietnam and Malaysia.) The fund’s current metrics are as follows:
Average price / earnings: 7
Average price / book: 0.8
Average dividend yield: 4.5%.
But the realistic prospect of growth is also on the table. The fund’s average historic return on equity stands at 15%.
Pay money. Take choice.
[Editor's Note: this piece, by Steve H Hanke, Professor of Applied Economics and Co-Director of the Institute for Applied Economics, Global Health, and the Study of Business Enterprise at The Johns Hopkins University in Baltimore, was previously published at Cato.org and Globe Asia. Please also see our earlier postings here at The Cobden Centre on Mark Skousen's intrepid work on GDE. As Lord Kelvin said, "To measure is to know". ]
In late April of this year, the Bureau of Economic Analysis (BEA) at the U.S. Department of Commerce announced that it would start reporting a new data series as part of the U.S. national income accounts. In addition to gross domestic product (GDP), the BEA will start reporting gross output (GO). This announcement went virtually unnoticed and unreported — an unfortunate, but not uncommon, oversight on the part of the financial press. Yes, GO represents a significant breakthrough.
A brief review of some history of economic thought will show just why GO is a big deal. The Classical School of economics prevailed roughly from Adam Smith’s Wealth of Nations time (1776) to the mid-19th century. It focused on the supply side of the economy. Production was the wellspring of prosperity.
The French economist J.-B. Say (1767-1832) was a highly regarded member of the Classical School. To this day, he is best known for Say’s Law of markets. In the popular lexicon — courtesy of John Maynard Keynes — this law simply states that “supply creates its own demand.” But, according to Steven Kates, one of the world’s leading experts on Say, Keynes’ rendition of Say’s Law distorts its true meaning and leaves its main message on the cutting room floor.
Say’s message was clear: a demand failure could not cause an economic slump. This message was accepted by virtually every major economist, prior to the publication of Keynes’ General Theory in 1936. So, before the General Theory, even though most economists thought business cycles were in the cards, demand failure was not listed as one of the causes of an economic downturn.
All this was overturned by Keynes. Kates argues convincingly that Keynes had to set Say up as a sort of straw man so that he could remove Say’s ideas from the economists’ discourse and the public’s thinking. Keynes had to do this because his entire theory was based on the analysis of demand failure, and his prescription for putting life back into aggregate demand — namely, a fiscal stimulus (read: lower taxes and/or higher government spending).
Keynes was wildly successful. With the publication of the General Theory, the supply side of the economy almost entirely vanished. It was replaced by aggregate demand, which was faithfully reported in the national income accounts. In consequence, aggregate demand has dominated economic discourse and policy ever since.
Among other things, Keynes threw economics into the sphere of macro economics. It is here where economic aggregates are treated as homogenous variables for purposes of analysis. But, with such innocent looking aggregates, there lurks a world of danger. Indeed, because of the demand-side aggregates that Keynes’ analysis limited us to, we were left with things like the aggregate sizeof consumption and government spending. The structure of the economy — the supply side — was nowhere to be found.
Yes, there were various rear-guard actions against this neglect of the supply side. Notable were economists from the Austrian School of Economics,such as Nobelist Friedrich Hayek. There were also devotees of input-out put analysis, like Nobelist Wassily Leontief. He and his followers stayed away from grand macroeconomic aggregates;they focused on the structure of the economy. There were also branches of economics — like agricultural economics– that were focused on production and the supply side of the economy. But,these fields never pretended to be part of macroeconomics.
Then came the supply-side revolution in the 1980s. It was associated with the likes of Nobelist Robert Mundell. This revolution was carried out, in large part, on the pagesof The Wall Street Journal, where J.-B.Say reappeared like a phoenix. The Journal’s late-editor Robert Bartley recounts the centrality of Say in his book The Seven Fat Years: And How to Do It Again (1992) “I remember Art Laffer telling me I had to learn Say’s Law. ‘That’s what I believe in’, he professed. ‘That’s what you believe in.’”
It is worth mentioning that the onslaught by Keynes on Say was largely ignored by many economic practitioners who attempt to anticipate the course of the economy. For them,the supply side of the economy has always received their most careful and anxious attention. For example, the Conference Board’s index of leading indicators for the U.S. economy is predominantly made up of supply-side indicators. Bloomberg’s supply-chain analysis function (SPLC) is yet another tool that indicates what practitioners think about when they conduct economic and financial analyses.
But, when it comes to the public and the debate about public policies, there is nothing quite like official data. So, until now, demand-side GDP data produced by the government has dominated the discourse. With GO, GDP’s monopoly will be broken as the U.S. government will provide official data on the supply side of the economy and its structure. GO data will complement, not replace, traditional GDP data. That said, GO data will improve our understanding of the business cycle and also improve the quality of the economic policy discourse.
So, what makes up the conventional measure of GDP and the new GO measure? And what makes up the gross domestic expenditures (GDE)measure, a more comprehensive, close cousin of GO? The accompanying two tables answer those questions. And for readers who are more visually inclined,bar charts for the two new metrics — GO and GDE — are presented.
Now, it’s official. Supply-side (GO) and demand-side (GDP) data are both provided by the U.S. government. How did this counter revolution come about? There have been many counter revolutionaries, but one stands out: Mark Skousen of Chapman University. Skousen’s book The Structure of Production, which was first published in 1990, backed his advocacy with heavy artillery. Indeed, it is Skousen who is, in part, responsible for the government’s move to provide a clearer, more comprehensive picture of the economy, with GO. And it is Skousen who is solely responsible for calculating GDE.
These changes are big, not only conceptually, but also numerically. Indeed, in 2013 GO was 76.4% larger, and GDE was 120.4% larger, than GDP. Why? Because GDP only measures the value of all final goods and services in the economy. GDP ignores all the intermediate steps required to produce GDP. GO corrects for most of those omissions. GDE goes even further, and is more comprehensive than GO.
Even though the always clever Keynes temporarily buried J.-B. Say, the great Say is back. With that, the relative importance of consumption and government expenditures withers away (see the accompanying bar charts). And, yes, the alleged importance of fiscal policy withers away, too.
Contrary to what the standard textbooks have taught us and what that pundits repeat ad nauseam, consumption is not the big elephant in the room. The elephant is business expenditures.
“Individuals who cannot master their emotions are ill-suited to profit from the investment process.”
– Ben Graham.
“What really broke Germany was the constant taking of the soft political option in respect of money..
“Money is no more than a medium of exchange. Only when it has a value acknowledged by more than one person can it be so used. The more general the acknowledgement, the more useful it is. Once no one acknowledged it, the Germans learnt, their paper money had no value or use – save for papering walls or making darts. The discovery which shattered their society was that the traditional repository of purchasing power had disappeared, and that there was no means left of measuring the worth of anything. For many, life became an obsessional search for Sachverte, things of ‘real’, constant value: Stinnes bought his factories, mines, newspapers. The meanest railway worker bought gewgaws. For most, degree of necessity became the sole criterion of value, the basis of everything from barter to behaviour. Man’s values became animal values. Contrary to any philosophical assumption, it was not a salutary experience.
“What is precious is that which sustains life. When life is secure, society acknowledges the value of luxuries, those objects, materials, services or enjoyments, civilised or merely extravagant, without which life can proceed perfectly well but which make it much pleasanter notwithstanding. When life is insecure, or conditions are harsh, values change. Without warmth, without a roof, without adequate clothes, it may be difficult to sustain life for more than a few weeks. Without food, life can be shorter still. At the top of the scale, the most valuable commodities are perhaps water and, most precious of all, air, in whose absence life will last only a matter of minutes. For the destitute in Germany and Austria whose money had no exchange value left existence came very near these metaphysical conceptions. It had been so in the war. In ‘All Quiet on the Western Front’, Müller died “and bequeathed me his boots – the same that he once inherited from Kemmerick. I wear them, for they fit me quite well. After me Tjaden will get them: I have promised them to him.”
“In war, boots; in flight, a place in a boat or a seat on a lorry may be the most vital thing in the world, more desirable than untold millions. In hyperinflation, a kilo of potatoes was worth, to some, more than the family silver; a side of pork more than the grand piano. A prostitute in the family was better than an infant corpse; theft was preferable to starvation; warmth was finer than honour; clothing more essential than democracy; food more needed than freedom.”
– Adam Fergusson, ‘When Money Dies: the nightmare of the Weimar hyperinflation’.
“We are currently on a journey to the outer reaches of the monetary universe,” write Ronni Stoeferle and Mark Valek in their latest, magisterial ‘In Gold we Trust’. Their outstanding work is doubly valuable because, as George Orwell once wrote,
“In a time of universal deceit, telling the truth is a revolutionary act.”
Orwellian dystopia; Alice-Through-The-Looking-Glass World; state-sanctioned inflationist (deflationist?) nightmare; choose your preferred simile for these dismal times. The reality bears restating: as the good folk of Incrementum rightly point out,
“..the monetary experiments currently underway will have numerous unintended consequences, the extent of which is difficult to gauge today. Gold, as the antagonist of unbacked paper currencies, remains an excellent hedge against rising price inflation and worst case scenarios.”
For several years we have advocated gold as a (necessarily only partial) solution to an unprecedented, global experiment with money that can only end badly for money. The problem with money is that comparatively few people understand it, including, somewhat ironically, many who work in financial services. Rather than debate the merits of gold (we think we have done these to death, and we acknowledge the patience of those clients who have stayed the course with us) we merely allude to the perennial difficulty of investing, namely the psychology of the investor. In addition to being the godfather of value investing, Ben Graham was arguably one of the first behavioural economists. He wisely suggested that investors should
“Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it – even though others may hesitate or differ. You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”
Graham also observed,
“In the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand.”
Judgment has clearly been tested for anyone who has elected to hold gold during its recent savage sell-off. The beauty of gold, much as with a classic Ben Graham value stock, is that as it gets cheaper, it gets even more attractive. This should be self-evident, in that an ounce of gold remains an ounce of gold irrespective of its price. This puts gold (and value stocks) markedly at odds with momentum investing (which currently holds sway over most markets), where once a price uptrend in a given security breaks to the downside, it’s time to head for the hills.
A few highlights from the Incrementum research:
Since 1971, when President Nixon untethered the dollar from its last moorings to gold, “total credit market debt owed” in the US has risen by 35 times. GDP has risen by just 14 times. The monetary base, on the other hand, has risen by, drum roll please.. some 54 times.
If, like Incrementum and ourselves, you view gold primarily as a monetary asset and not as an industrial commodity, it has clearly made sense to have some exposure to gold during these past four decades of monetary debauchery.
They say a picture paints a thousand words. Consider the following chart of total US credit market debt and ask yourself: is this sustainable?
(Click image to view larger version)
To repeat, there are only three ways of trying to handle a mountain of unsustainable debt. The options are:
1) Maintain economic growth at a sufficient rate to service the debt. We believe this is grossly unlikely.
2) Repudiate the debt. Since we also operate within a debt-based monetary system (in which money is lent into being by banks), default broadly equates to Armageddon.
3) Inflate the debt away.
At the risk of pointing out the obvious, which path do we consider the most likely? Which path does it suit grotesquely over-indebted governments and their client central banks to pursue?
But it does not suit central banks to be caught with their fingers in the inflationary cookie jar, so they now have to pretend that deflation is Public Enemy Number One. Well, deflation is certainly a problem if you have to service unserviceable debts. So it should come as no surprise if this predicament is ultimately resolved through an uncontrollable and perhaps inevitable inflationary or stagflationary mess.
So we have the courage of our knowledge and experience. (In fact, of other people’s experience, too. As the title of Robert Schuettinger and Eamonn Butler’s book puts it, we have ‘Forty Centuries of Wage and Price Controls’ and their inevitable failure to draw upon. We know how this game ends, we just don’t know precisely when.) We have formed a conclusion based on facts and we know our judgment is sound. For the last two years, the crowd has disagreed with us on gold. We think we are right because we think our data and reasoning are right. Not that we don’t see value in other things, too: bonds of unimpeachable quality offering a positive real return; uncorrelated assets; value and ‘deep value’ stocks. And we ask a final question: if not gold, then what? Are we deceiving ourselves – or are our central bankers in the process of deceiving everyone?
[Editor's note: This article also appears on Detlev Schlichter's blog here. It is reproduced with kind permission and should NOT be taken to be investment advice.]
There is apparently a new economic danger out there. It is called “very low inflation” and the eurozone is evidently at great risk of succumbing to this menace. “A long period of low inflation – or outright deflation, when prices fall persistently – alarms central bankers”, explains The Wall Street Journal, “because it [low inflation, DS] can cripple growth and make it harder for governments, businesses and consumers to service their debts.” Official inflation readings at the ECB are at 0.7 percent, still positive so no deflation, but certainly very low.
How low inflation cripples growth is not clear to me. “Very low inflation” was, of course, once known as “price stability” and used to invoke more positive connotations. It was not previously considered a health hazard. Why this has suddenly changed is not obvious. Certainly there is no empirical support – usually so highly regarded by market commentators – for the assertion that low inflation, or even deflation, is linked to recessions or depressions, although that link is assumed to exist implicitly or explicitly in the financial press almost daily. In the twentieth century the United States had many years of very low inflation and even outright deflation that were not marked by recessions. In the nineteenth century, throughout the rapidly industrializing world, “very low inflation” or even persistent deflation were the norm, and such deflation was frequently accompanied by growth rates that would today be the envy of any G8 country. To come to think of it, the capitalist economy with its constant tendency to increase productivity should create persistent deflation naturally. Stuff becomes more affordable. Things get cheaper.
“Breaking news: Consumers shocked out of consuming by low inflation!”
So what is the point at which reasonably low inflation suddenly turns into “very low inflation”, and thus becomes dangerous according to this new strand of thinking? Judging by the reception of the Bank of England’s UK inflation report delivered by Mark Carney last week, on the one hand, and the ridicule the financial industry piles onto the ECB on the other – “stupid” is what Appaloosa Management’s David Tepper calls the Frankfurt-based institution according to the FT (May 16) -, the demarcation must lie somewhere between the 1.6 percent reported by Mr. Carney, and the 0.7 that so embarrasses Mr. Draghi.
The argument is frequently advanced that low inflation or deflation cause people to postpone purchases, to defer consumption. By this logic, the Eurozonians expect a €1,000 item to cost €1,007 in a year’s time, and that is not sufficient a threat to their purchasing power to rush out and buy NOW! Hence, the depressed economy. The Brits, on the other hand, can reasonably expect a £1,000 item to fetch £1,016 in a year’s time, and this is a much more compelling reason, one assumes, to consume in the present. The Brits are in fact so keen to beat the coming 2 percent price hikes that they are even loading up on debt again and incur considerable interest rate expenses to buy in the here and now. “Britons are re-leveraging,” tells us Anne Pettifor in The Guardian, “Net consumer credit lending rose by £1.1bn in March alone. Total credit card debt in March 2014 was £56.9bn. The average interest rate on credit card lending, [stands at] at 16.86%.” Britain is, as Ms. Pettifor reminds us, the world’s most indebted nation.
I leave the question to one side for a minute whether these developments should be more reason to “alarm central bankers” than “very low inflation”. They certainly did not alarm Mr. Carney and his colleagues last week, who cheerfully left rates at rock bottom, and nobody called the Bank of England “stupid” either, to my knowledge. They certainly seem not to alarm Ms. Pettifor. She wants the Bank of England to keep rates low to help all those Britons in debt – and probably yet more Britons to get into debt.
Ms. Pettifor has a highly politicized view of money and monetary policy. To her this is all some giant class struggle between the class of savers/creditors and the class of spenders/debtors, and her allegiance is to the latter. Calls for rate hikes from other market commentator thus represent “certain interests,” meaning stingy savers and greedy creditors. That the policy could set up the economy for another crisis does not seem to trouble her.
Echoing Ms. Pettifor, Martin Wolf flatly stated in the FT recently that the “low-risk-seeking saver” no longer served a useful purpose in the global economy, and he approvingly quoted John Maynard Keynes with his call for the “euthanasia of the rentier”. “Interest today rewards no genuine sacrifice,” Keynes wrote back then, obviously in error: Just ask Britons today if not spending their money now but saving it for a rainy day does not involve a genuine sacrifice. Today’s rentiers do not even get interest for their sacrifices, thanks to all the “stimulus” policy. And now the call is for an end to price stability, for combining higher inflation with zero rates. It is not much fun being a saver these days – and I doubt that these policies will make anyone happy in the long run.
Euthanasia of the Japanese rentier
What the “euthanasia of the rentier” may look like we may have chance to see in Japan, an ideal test case for the policy given that the country is home to a rapidly aging population of life-long savers who will rely on their savings in old age. The new policy of Abenomics is supposed to reinvigorate the economy through, among other things, monetary debasement. “In as much as Abenomics was intended to generate strong nominal growth, I have been a big believer,” Trevor Greetham, asset allocation director at Fidelity Worldwide Investment, wrote in the FT last week (FT, May 15, 2014, page 28). “Japan has been in debt deflation for more than 20 years.”
Really? – In March 2013, when Mr. Abe installed Haruhiko Kuroda as his choice of Bank of Japan governor, and Abenomics started in earnest, Japan’s consumer price index stood at 99.4. 20 years earlier, in March 1994, it stood at 99.9 and 10 years ago, in March 2004, at 100.5. Over 20 years Japan’s consumer prices had dropped by 0.5 percent. Of course, there were periods of falling prices and periods of rising prices in between but you need a microscope to detect any broad price changes in the Japanese consumption basket over the long haul. By any realistic measure, the Japanese consumer has not suffered deflation but has enjoyed roughly price stability for 20 years.
“The main problem in the Japanese economy is not deflation, it’s demographics,” Masaaki Shirakawa declared in a speech at Dartmouth College two weeks ago (as reported by the Wall Street Journal Europe on May 15). Mr. Shirakawa is the former Bank of Japan governor who was unceremoniously ousted by Mr. Abe in 2013, so you may say he is biased. Never mind, his arguments make sense to me. “Mr. Shirakawa,” the Journal reports, “calls it ‘a very mild deflation’ [and I call it price stability, DS] that had the benefit of helping Japan maintain low unemployment.” The official unemployment rate in Japan stands at an eye-watering 3.60%. Maybe the Japanese have not fared so poorly with price stability.
Be that as it may, after a year of Abenomics it turns out that higher inflation is not really all it’s cracked up to be. Here is Fidelity’s Mr. Greetham again: “Things are not as straightforward as they were….The sales tax rise pushed Tokyo headline inflation to a 22-year high of 2.9 percent in April, cutting real purchasing power and worsening living standards for the many older consumers on fixed incomes.”
Mr. Greetham’s “older consumers” are probably Mr. Wolf’s “rentiers”, but in any case, these folks are not having a splendid time. The advocates of “easy money” tell us that a weaker currency is a boost to exports but in Japan’s case a weaker yen lifts energy prices as the country is heavily dependent on energy imports.
The Japanese were previously thought to not consume enough because prices weren’t rising fast enough, now they may not consume enough because prices are rising. The problem with going after “nominal growth” is that “real purchasing power” may get a hit.
If all of this is confusing, Fidelity’s Mr. Greetham offers hope. We may just need a bigger boat. More stimulus. “The stock market may need to get lower over the next few months before the government and Bank of Japan are shocked out of their complacency…When domestic policy eases further, as it inevitably will, the case for owning the Japanese market will be compelling once again.”
You see, that is the problem with Keynesian stimulus, you need to do ever more of it, and make it ever bigger, in an effort to outrun the unintended consequences.
Whether Mr. Greetham is right or not on the stock market, I do not know. But one thing seems pretty obvious to me. If you could lastingly improve your economy through easy money and currency debasement, Argentina would be one of the richest countries in the world today, as it indeed was at the beginning of the twentieth century, before the currency debasements of its many incompetent governments began.
No country has ever become more prosperous by debasing its currency and ripping off its savers.
This will end badly – although probably not soon.
What does it all mean? – I don’t know (and I could, of course, be wrong) but I guess the following:
The ECB will cut rates in June but this is the most advertised and anticipated policy easing in a long while. Euro bears will ultimately be disappointed. The ECB does not go ‘all in’, and there is no reason to do so. My hunch is that a pronounced weakening of the euro remains unlikely.
In my humble opinion, and contrary to market consensus, the ECB has run the least worst policy of all major central banks. No QE thus far; the balance sheet has even shrunk; large-scale inactivity. What is not to like?
Ms Pettifor and her fellow saver-haters will get their way in that any meaningful policy tightening is far off, including in the UK and the US. Central banks see their main role now in supporting asset markets, the economy, the banks, and the government. They are positively petrified of potentially derailing anything through tighter policy. They will structurally “under-tighten”. Higher inflation will be the endgame but when that will come is anyone’s guess. Growth will, by itself, not lead to a meaningful response from central bankers.
Abenomics will be tried but it will ultimately fail. The question is if it will first be implemented on such a scale as to cause disaster, or if it will receive its own quiet “euthanasia”, as Mr. Shirakawa seems to suggest. At Dartmouth he claimed “to have the quiet support of some Japanese business leaders who joined the Abe campaign pressuring the Shirakawa BoJ. ‘One of the surprising facts is what CEOs say privately is quite different from what they say publicly,’ he said….’in private they say, No, no, we are fed up with massive liquidity – money does not constrain our investment.’”
Editor’s note: The Cobden Centre is happy to republish this commentary by Alasdair Macleod, the original can be found here.
At the outset I should declare an interest. In the 1980s I was a member of the UK’s Society of Technical Analysis and for a while I was the society’s examiner and lecturer on Elliott Wave Theory. My proudest moment as a technician was calling the 1987 crash the night before it happened and a new bull market two months later in early December. Before anyone assumes I have a gift for technical analysis, I hasten to add I have also made many wrong calls using it, so to be so spectacularly right on that occasion was almost certainly down to a large element of luck. I should also mention that the most successful investors I have observed over 40 years are those who recognise value and disdain charts altogether.
Technical analysts assume past prices are a valid basis for predicting what investors will pay tomorrow. The Warren Buffetts of this world act differently: they care not what others think and use their own judgement of value. This means that value investors often buy when the trend is down and sell when the trend is up, the opposite of technically-driven decisions. A bear market ends when value investors overcome the trend.
Technical analysts go with the crowd and give any trend an added spin. This explains the preoccupation with moving averages, bands, oscillators and momentum. Speculators, who used to be independent thinkers, now depend heavily on technical analysis. This is not to deny that many technicians make a reasonable living: the key is to know when the trend ends, and the difficulty in that decision perhaps explains why technical analysts are not on anyone’s rich list.
Value investors like Buffett rely on an assessment of the income that an investment can generate, and the opportunity-cost of owning it. This may explain his well-known views on gold which for all but a small coterie of central and bullion banks does not generate any income. So where does gold, a sterile asset in Buffett’s eyes stand in all this?
Value investors in gold who buy on falling prices are predominately Asian. For Asians the value in gold comes from the continual debasement of national currencies, a factor rarely considered by western investors who measure investment returns in their home currency with no allowance for changes in purchasing power.
The financial system discourages a more realistic approach, not even according physical gold an investment status. Using technical analysis with the false comfort of stop-losses leads to more profits for market-makers. Furthermore, gold’s replacement as money by unstable national currencies makes economic and investment calculation for anything other than the shortest of timescales unreliable or even impossible. But then this point goes over the heads of the trend-followers as well as the fundamental question of value.
Technical analysis is a tool for idle investors unwilling or unable to understand true value. It dominates price formation in western markets and distorts investor behaviour by exaggerating any natural bias towards trends. It is this band-wagon effect that is the root of trend-following’s success, but also its ultimate weakness. A better strategy is to make the effort to value gold properly and then act accordingly.
“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?”
Editor’s note: This article was previously published here at Goldmoney.com. It is republished with thanks.
Geopolitical and market background
I have been revisiting estimates of the quantities of gold being absorbed by China, and yet again I have had to revise them upwards. Analysis of the detail discovered in historic information in the context of China’s gold strategy has allowed me for the first time to make reasonable estimates of vaulted gold, comprised of gold accounts at commercial banks, mine output and scrap. There is also compelling evidence mine output and scrap are being accumulated by the government in its own vaults, and not being delivered to satisfy public demand.
The impact of these revelations on estimates of total identified demand and the drain on bullion stocks from outside China is likely to be dramatic, but confirms what some of us have suspected but been unable to prove. Western analysts have always lagged in their understanding of Chinese demand and there is now evidence China is deliberately concealing the scale of it from us. Instead, China is happy to let us accept the lower estimates of western analysts, which by identifying gold demand from the retail end of the supply chain give significantly lower figures.
Before 2012 the Shanghai Gold Exchange was keen to advertise its ambitions to become a major gold trading hub. This is no longer the case. The last SGE Annual Report in English was for 2010, and the last Gold Market Report was for 2011. 2013 was a watershed year. Following the Cyprus debacle, western central banks, seemingly unaware of latent Chinese demand embarked on a policy of supplying large quantities of bullion to break the bull market and suppress the price. The resulting expansion in both global and Chinese demand was so rapid that analysts in western capital markets have been caught unawares.
I started following China’s gold strategy over two years ago and was more or less on my own, having been tipped off by a contact that the Chinese government had already accumulated large amounts of gold before actively promoting gold ownership for private individuals. I took the view that the Chinese government acted for good reasons and that it is a mistake to ignore their actions, particularly when gold is involved.
Since then, Koos Jansen of ingoldwetrust.ch has taken a specialised interest in the SGE and Hong Kong’s trade statistics, and his dedication to the issue has helped spread interest and knowledge in the subject. He has been particularly successful in broadcasting market statistics published in Chinese to a western audience, overcoming the lack of information available in English.
I believe that China is well on the way to having gained control of the international gold market, thanks to western central banks suppression of the gold price, which accelerated last year. The basic reasons behind China’s policy are entirely logical:
- China knew at the outset that gold is the west’s weak spot, with actual monetary reserves massively overstated. For all I know their intelligence services may have had an accurate assessment of how much gold there is left in western vaults, and if they had not, their allies, the Russians, probably did. Representatives of the People’s Bank of China will have attended meetings at the Bank for International Settlements where these issues are presumably openly discussed by central bankers.
- China has significant currency surpluses under US control. By controlling the gold market China can flip value from US Treasuries into gold as and when it wishes. This gives China ultimate financial leverage over the west if required.
- By encouraging its population to invest in gold China reduces the need to acquire dollars to control the renminbi/dollar rate. Put another way, gold purchases by the public have helped absorb her trade surplus. Furthermore gold ownership insulates her middle classes from external currency instability which has become an increasing concern since the Lehman crisis.
For its geopolitical strategy to work China must accumulate large quantities of bullion. To this end China has encouraged mine production, making the country the largest producer in the world. It must also have control over the global market for physical gold, and by rapidly developing the SGE and its sister the Shanghai Gold Futures Exchange the groundwork has been completed. If western markets, starved of physical metal, are forced at a future date to declare force majeure when settlements fail, the SGE and SGFE will be in a position to become the world’s market for gold. Interestingly, Arab holders have recently been recasting some of their old gold holdings from the LBMA’s 400 ounce 995 standard into the Chinese one kilo 9999 standard, which insures them against this potential risk.
China appears in a few years to have achieved dominance of the physical gold market. Since January 2008 turnover on the SGE has increased from a quarterly average of 362 tonnes per month to 1,100 tonnes, and deliveries from 44 tonnes per month to 212 tonnes. It is noticeable how activity increased rapidly from April 2013, in the wake of the dramatic fall in the gold price. From January 2008, the SGE has delivered from its vaults into public hands a total of 6,776 tonnes. This is illustrated in the chart below.
This is only part of the story, the part that is in the public domain. In addition there is gold imported through Hong Kong and fabricated for the Chinese retail market bypassing the SGE, changes of stock levels within the SGE’s network of vaults, the destination of domestic mine output and scrap, government purchases of gold in London and elsewhere, and purchases stored abroad by the wealthy. Furthermore the Chinese diaspora throughout South East Asia competes with China for global gold stocks, and its demand is in addition to that of China’s Mainland and Hong Kong.
The Shanghai Gold Exchange (SGE)
The SGE, which is the government-owned and controlled gold exchange monopoly, runs a vaulting system with which westerners will be familiar. Gold in the vaults is fungible, but when it leaves the SGE’s vaults it is no longer so, and in order to re-enter them it is treated as scrap and recast. In 2011 there were 49 vaults in the SGE’s system, and bars and ingots are supplied to SGE specifications by a number of foreign and Chinese refiners. Besides commercial banks, SGE members include refiners, jewellery manufacturers, mines, and investment companies. The SGE’s 2010 Annual Report, the last published in English, states there were 25 commercial banks included in 163 members of the exchange, 6,751 institutional clients accounting for 81% of gold traded, and 1,778,500 clients of the commercial banks with gold accounts. The 2011 Gold Report, the most recent available, stated that the number of commercial bank members had increased to 29 with 2,353,600 clients, and given the rapid expansion of demand since, the number of gold account holders is likely to be considerably greater today.
About 75% of the SGE’s gold turnover is for forward settlement and the balance is for spot delivery. Standard bars are Au99.95 3 kilos (roughly 100 ounces), Au99.99 1 kilo, Au100g and Au50g. The institutional standard has become Au99.99 1 kilo bars, most of which are sourced from Swiss refiners, with the old Au99.95 standard less than 15% of turnover today compared with 65% five years ago. The smaller 100g and 50g bars are generally for retail demand and a very small proportion of the total traded. Public demand for smaller bars is satisfied mainly through branded products provided by commercial banks and other retail entities instead of from SGE-authorised refiners.
Overall volumes on the SGE are a tiny fraction of those recorded in London, and the market is relatively illiquid, so much so that opportunities for price arbitrage are often apparent rather than real. The obvious difference between the two markets is the large amounts of gold delivered to China’s public. This has fuelled the rapid growth of the Chinese market leading to a parallel increase in vaulted bullion stocks, which for 2013 is likely to have been substantial.
By way of contrast the LBMA is not a regulated market but is overseen by the Bank of England, while the SGE is both controlled and regulated by the People’s Bank of China. The PBOC is also a member of both its own exchange and of the LBMA, and deals actively in non-monetary gold. While the LBMA is at arm’s length from the BoE, the SGE is effectively a department of the PBOC. This allows the Chinese government to control the gold market for its own strategic objectives.
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 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.
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.
Following his recent paper The law of opposites: Illusory profits in the financial sector, TCC Advisory Board member and founder of Cobden Partners Gordon Kerr appeared on Bloomberg. The video is here.
Click for video
Gordon dealt with the flaws in IFRS, the reasons for the debt crisis, the case for hardening money, the need for international money in support of trade and more.
Later in the day, I said in the Commons that the Government’s response to the ICB report seemed to take accounting for granted, asking the Chancellor to consider the issue seriously in the forthcoming white paper.
Another classic article, brought forward. This is a speech by James Tyler to the Adam Smith Institute Next Generation Group on 6 October 2009. This speech is also available on hedgehedge.com.
I have spent the best part of the last two decades pitting my wits against the market. It’s an unforgiving game: I’ve seen ups and downs, and many of my rivals buried under an avalanche of hubris, passion, illogical thought and unchecked emotion.
I have witnessed the sheer folly of the ERM crisis, the Asian crisis, the failure of the Gods at Long Term Capital Management and the insanity of the tech boom.
I have enjoyed the ‘NICE’ decade (Non-Inflationary Constant Expansion), and scared myself silly during the credit crisis.
I am a trader.
I risk my own money and live or die by my decisions, and face the threat of personal bankruptcy every time I switch my screens on. I get no salary – indeed I turn up at the start of the month with a large office overhead – a ‘negative’ salary. I have no fancy company pension scheme, no lucrative monopoly or franchise.
I eat what I kill.
Mistakes cost me my livelihood, so, above all, my decisions have to be rooted in practical and logical decision making.
Some have called my kind parasitic, but I would have said that I bring order, efficiency, predictability, stability and deep liquidity to a crucial process: a process that makes the whole world keep ticking.
I make money work.
I make the market in interest rate derivatives: a market born out of the neo classical revolution in finance fostered in Chicago during the 1970s. I am a child of Friedman, Fisher Black, Myron Scholes and the modern international financial system.
My analysis was steeped in the neo-classical, efficient markets paradigm.
Friedman’s ideal was working. Enlightened central bankers guided the free market with gentle nudges and short term liquidity infusions, free floating currencies gently adjusted themselves to the constant flow of new information and efficient and rational markets took all in their stride.
Credit flowed, people got wealthier, economies developed and all was well.
And then the crisis struck.
Continue reading “My Journey to Austrianism via the City”
In September of last year, I placed this article up on our web site detailing the theoretical errors behind the policy of quantitative easing. Clearly, as the MPC has now been given the green light by our chancellor, we expect this currency debasement to be starting soon. All it will “achieve” is a wealth transfer from those lucky enough to get the newly minted money, from those not luckily enough. I aimed to expose the faulty crank-economics that lies behind such thought processes last year and did not think a Tory government would be so foolish to let this happen under their watch, especially as they condemned it under a Labour government. Sadly, articles like this one need to be reproduced so that a new set of readers can hopefully have influence on the present administration.
The mainstream economists hold that the volume of money in circulation, times its velocity is equal to the prices of all goods and services added up. This is the famous Theory of Exchange, MV=PT, or the mechanistic Quantity Theory of Money, where:
- M is the stock of money,
- V is the velocity of circulation: the number of times the monetary unit changes hands in a certain time period,
- P is the general price level,
- and T is the “aggregate” of all quantities of goods and services exchanged in the period.
It is held by the overwhelming majority of all economists, that if the velocity of money falls, the price level will fall and thus it is the duty of government, the monopoly issuer of money, the chief Central Planner of the Money Supply, to create more money to keep the price level where it is and thus preserve the existing spending habits of the nation.
Error One — the stock of money
It is held that if you can count the monetary units in the economy and their velocity, you can say what the price level is. As people find it very difficult to count the money in an economy, they cannot see the statistical relationship showing up mechanistically in the price level as expected: the authorities do not have a measure of the money supply which correlates to economic activity.
Working from a sound theoretical basis, I and my colleague Anthony Evans can show you how to count money exactly and how that measure of the money stock correlates to economic activity:
Note that changes in the mainstream measures — M0 and M4 — are quite different to changes in our measure — MA. However, it is MA which shows the best correlation to economic activity and not the measures used by the Bank of England and HM Treasury:
The monetary authorities do not have an adequate measure of the money supply.
Error Two — the velocity of circulation
Velocity is defined as the average number of times during a period that a monetary unit (I will call this MU) is exchanged for a good or service. It is said that a 5% increase in money does not necessarily show itself up with a 5% increase in the price level. It is argued that this is because the velocity of money changes. The trick is to measure by how much the velocity has declined and then create new money — cross your fingers, pray to the Good Lord, do a rain dance around a fire, and hope that the new money will be spent — to fill in this gap left by the fall in velocity.
When you buy a house, we do not say it “circulates”: money is exchanged against real bricks and mortar. The printer who sold me books would have had to sell printed things (i.e. real goods) and saved (forgone consumption) for the future purchase (act of consumption) of the house. Imagine selling your house backwards and forwards between say you and your wife 10 times: the mainstream would argue that the velocity of circulation had risen!
Yes as daft as it sounds, this is the present state of economics.
Thus, if the velocity has gone up by a factor of 10, the price level has increased by the same factor. Here is the suggested rub: therefore, when the velocity of circulation falls, if you increase the money supply by the same factor that the velocity of circulation has fallen by, the price level will stay the same.
Note, as explained above and in detail here, the mainstream do not actually know what money is. Well, let us be clear: it is the final good for which (all) other goods exchange. All of us who are productive make things for sale or sell services, even if it is only our own labour. We sell goods and services which we produce or offer for other goods and services we need. The most marketable of all commodities, money, is accepted by you and other citizens and facilitates exchange of your goods and services for other goods and services. Note that, at all times, money facilitates the exchange of real goods for other real goods.
Party one and a counterparty exchanging or “selling” the house between one another 10 times causing an “increase in velocity” and thus an increase in the price level as an idea is utter garbage. If one party had sold real goods and saved in anticipation of buying the house — real bricks and mortar via the medium of money — this would facilitate a transaction of something (the party’s saved real goods) for something (the counterparty’s real house). Printing money to make sure the price level stays stable to facilitate the “circulating” house in the first example will facilitate a transfer of nothing (the paper) for something (the house). This is commonly called counterfeiting.
This may be another helpful example of why velocity is utterly meaningless. Consider a dinner party: Guest A has a £1. He lends it to Guest B at dinner, who lends it to Guest C who lends it to Guest D. If Guest D pays it back to Guest C, who pays it back to Guest B pays Guest A, the £1 is said to have done £4’s worth of work. The bookkeeping of this transaction shows that £1 was lent out 4 times and they all cancel each other out! Just to be clear, £1 has done £1’s work and not £4’s work. No real wealth or value is created.
The velocity of circulation makes no economic sense.
Error Three — the general price level
Since the monetary authorities have no means to sum the price and quantity of every individual transaction, they must work instead with the “general price level”, ignoring the vital role of changes in relative prices.
As early as 1912, Ludwig von Mises demonstrated that new money must change the structure of relative prices. As anyone who has lived through the past year could tell you, new money is not distributed equally to everyone in the economy. It is injected over time and in specific locations: new money redistributes income to those who receive it first. This redistribution of income not only alters people’s subjective perception of value, it also alters their weight in the marketplace. These factors can only lead to changes in the structure of relative prices.
Mainstream economists believe that “money is neutral in the long run”. They do not have a theory of the capital structure of production which can account for the effects of time and relative prices. They believe increases in the money supply affect all sectors uniformly and proportionately. This is manifestly untrue: look at changes in the Bank of England’s balance sheet and your bank statement.
Hayek wrote that his chief objection to this theory was that it paid attention only to the general price level and not to the structure of relative prices. He indicated that, in consequence, it disregarded the most harmful effects of increasing the money supply: the misdirection of resources and specifically unemployment. Furthermore, this wilful ignorance of relative prices explains the mainstream’s lack of an adequate theory of business cycles, something Hayek provided.
The general price level aggregates away a vital factor: the relative structure of prices.
Error Four — the aggregate quantities of goods and services sold
Since the sum of price times quantity for every individual transaction is not available, the authorities must use the “aggregate quantity of goods and services sold”. This is nonsense: the quantities to be added together are incompatible. It makes no sense to add a kilogram of potatoes to a kilogram of copper to a litre of petrol to a day’s software consultancy to a 30-second television advert.
The aggregate quantity of goods and services sold is an impossible sum.
Error Five — the equation is no more than a tautology
Consider this, if I buy 10 copies of Adam Smith’s Wealth of Nations from a printing company for 7 monetary units (or MU), an exchange has been made: I gave up 7 MU’s to the printer, and the printer transferred 10 sets of printed works to me. The error that the mainstream make is that “10 sets of printed works have been regarded as equal to 7 MU, and this fact may be expressed thus: 7 MU = 10 printed works multiplied by 0.7 MU per set of printed works.” But equality is not self-evident.
There is never any equality of values on the part of the two participants in exchange. The assumption that an exchange presumes some sort of equality has been a delusion of economic theory for many centuries. We only exchange if each party thinks he is getting something of greater value from the other party than he has already. If there was equality in value, no exchange would happen! Value is subjective and utility is marginal: each party values the other’s goods or services more highly than their own.
Thus, while the mainstream believe that there is a causal link between the “money side” of the equation and the “value of goods and services side”, it is just a tautology from which no economic knowledge can be gained. All we are saying, if the Quantity Theory holds, is that “7 MU’s = 10 sets of printed works X 0.7 MU’s per set of printed works”: in other words, “7 MU = 7 MU”. Thus what is paid is what is received. This is like announcing to the world that you have discovered the fabulous fact that 2=2.
The mechanistic Quantity Theory of Money is not a causal relation but a tautology.
The mechanistic Quantity Theory only provides us with a tautology and every term of “MV = PT” is seriously flawed. Public policy should not rest on the foundation of this bad science.
If the money supply contracts as it has done so spectacularly since late 2008 (see the chart above), you will have less goods and services supporting less economic activity. This for sure is bad. We now have less money and less exchanging of real goods and services for other real goods and services.
The only way to get more goods and services offered for exchange is if entrepreneurs get hold of their factors of production — land, labour and capital — and reorganise them to meet the new demands of the consumers in a more efficient way than before. The only thing that the government can do is to make sure it provides as little regulatory burden as possible and the lightest tax regime that it can run in order to allow entrepreneurs to facilitate this correction.
Certainly in my business of the supply of fish and meat to the food service sector — www.directseafoods.co.uk — I have never witnessed such an abrupt change in consumption patterns as people have traded down from more expensive species and cuts to less expensive ones. Thus I have to reorganise my offer to my customers and potential customers. No amount of fiddling about with the level of newly minted money in the economy will help this reorganisation of my factors of production: they need to be retuned to the new needs and desires of my customers.
Quantitative easing, as I have said before, is firmly based on a belief in the so called “internal truths” held in the Quantity Theory of Money. I hope any reader can see that this belief is based on very faulty logic. Bad logic gives us bad policy. A policy of QE says that because the velocity of circulation has fallen, we can print newly minted money, out of thin air, at the touch of a computer key, and create more demand for the exchange of goods and services.
Money has been historically rooted in gold and silver because these cannot “vanish” overnight as we are seeing under our present state monopoly of money — fiat money, money by decree, i.e. bits of paper we are forced to use as legal tender. Remember, since 1971 when Nixon broke the gold link, money is just bits of paper, notwithstanding a promise to pay the bearer on demand. In the near future, this will no doubt remain the case. Indeed, anyone who dares to mention that the final good, for which all goods exchange, should be a real good that is scarce (hard to manipulate it, hard to destroy it) unlike paper and electronic journal entries (easy to manipulate, easy to destroy) is considered a lunatic!
On a point of history, it is worthwhile remembering that, as we have mentioned here, the 1844 Peel Act did remove the banks’ practice of issuing promissory notes (paper money) over and above their reserves of gold (the most marketable commodity i.e. money) as this was causing bank runs, “panic”, boom and bust. They did not resolve the issues of demand deposits to be drawn by cheque. Both features allow banks to issue new money — i.e. certificates that have no prior production of useful economic activity such as our printer printing books or my selling of meat and fish — while retaining real money — claims to the printing of books and selling of my meat and fish — only to a percentage of the deposited money, i.e. the Reserve Requirement of the bank. In the UK, there is no Reserve Requirement anymore as far as I am aware, hence banks going for massive levels of leverage. It is no surprise that the house of cards has fallen down.
Our proposal for a 100% reserve requirement is offered for discussion as the only sure-fire way of delivering lasting stability. Listening to economists talking about the “velocity of circulation” falling and thus suggesting that we should conduct large scale Quantitative Easing to hold the price level is not economics, but the policy of the Witch Doctor and the Mystic.
It is staggering that so much garbage, posing as sound knowledge, hinges on these grave errors.