That US debt ceiling and the Fed

We are now into a second week of a partial Federal Government shut-down, which is causing considerable concern, centred on the Government’s ability to finance its debt and pay interest without a budget agreed for the new fiscal year. Should this continue into next week and beyond, the Fed will have to enter damage-limitation mode if the Treasury cannot issue any more bonds because of the separate problem of the debt ceiling.

Most likely, QE will have to be switched from financing the government to buying Treasuries already owned by the private sector. Any attempt to reduce the monthly addition of raw money will simply result in bond yields and then interest rates rising. And indeed, already this week we have seen yields on short-term T-bills rise in anticipation of a possible default. The market is naturally beginning to discount the possibility that the Fed may not be able to control the situation.

The T-bill issue is very serious, because they are the most liquid collateral for the $70 trillion shadow banking system. And without the liquidity they provide securities and derivative markets, we can say that Round Two of the banking crisis could make Lehman look like a picnic in the park.

This is the sort of event deflationists have long been expecting. According to their analysis there comes a point where debt liquidation is triggered and there is a dash for cash as assets collapse. But they reckon without allowing for the fact that deposits can only be encashed at the margin; otherwise they are merely transferred, and only destroyed when banks go under. This is the risk the Fed anticipates, and we can be certain it will move heaven and earth to avoid bank insolvencies.

Furthermore the deflationists do not have a satisfactory argument for the effect on currency exchange rates. Iceland went through a similar deflationary event to that risked in the US today when its banking system collapsed and the currency halved overnight. Today a dollar collapse on the back of a banking crisis would also disrupt all other fiat currencies, forcing central banks to coordinate intervention to conceal the currency effect. This leaves gold as the only true reflector of loss of confidence in the dollar and therefore all other fiat currencies.

Those worrying about deflation ignore the fact that it is the fiat currency that takes it on the chin while gold rises – every time without exception. This was even the experience of the 1930s, when Roosevelt suspended convertibility, increased the price of gold by 40% to $35 per ounce, and the banking crisis was contained.

Of course there is likely to be some short-term uncertainty; but against the Fiat Money Quantity (FMQ) gold is down 30% compared with the price pre-Lehman crisis. This is shown in the chart below.

With gold at an extreme low in valuation terms, current events, whichever way they go, seem unlikely to drive it much lower. A wise man perhaps should copy the Asians, who know a thing or two about paper currencies, and are buying gold in ever-increasing quantities.

This article was previously published at


Taper (where?) party

“This took guts.”

- Comment by Steven Ricchiuto of Mizuho Securities in response to the Federal Reserve’s surprise decision to refrain from “tapering” its $85 billion monthly bond purchase programme, as reported by the Financial Times, 19 September.

Human beings are suckers for a story. The story peddled by mainstream economic commentators goes that the US Federal Reserve and its international cousins have acted boldly to prevent a second Great Depression by stepping in to support the banks (and not coincidentally the government bond markets) by printing trillions of dollars of ex nihilo money which, through the mechanism of quantitative easing, will mysteriously reflate the economy. It’s a story alright, but more akin to a fairy story. We favour an alternative narrative, namely that with politicians abdicating all real responsibility in addressing the financial and economic crisis (see this article), the heavy lifting has been left to central bankers, who have run out of conventional policy options and are now stoking the fire for the next financial crisis by attempting to rig prices throughout the financial system, notably in property markets, but having a grave impact on volatility across credit markets, government bond markets, equities, commodities.. As politicians might have told either them, or Steven Ricchiuto of Mizuho Securities, it’s quite easy to be brave when you’re spending other people’s money.

Before we get back to the Fed, it’s worth a minute recapping why it was created, namely as a private banking cartel with a monopoly over the country’s financial resources and the facility to shift losses when they occur to the taxpayers. Satire goes a long way here (not least because the reality is so depressing) – here is Punch’s take on the banks from April 1957*:

Q: What are banks for?

A: To make money.

Q: For the customers?

A: For the banks.

Q: Why doesn’t bank advertising mention this ?

A: It wouldn’t be in good taste. But it is mentioned by implication in references to reserves of $249,000,000 or thereabouts. That is the money they have made.

Q: Out of the customers?

A: I suppose so.

Q: They also mention Assets of $500,000,000 or thereabouts. Have they made that too ? A: Not exactly. That is the money they use to make money.

Q: I see. And they keep it in a safe somewhere?

A: Not at all. They lend it to customers.

Q: Then they haven’t got it?

A: No.

Q: Then how is it Assets?

A: They maintain that it would be if they got it back.

Q: But they must have some money in a safe somewhere?

A: Yes, usually $500,000,000 or thereabouts. This is called Liabilities.

Q: But if they’ve got it, how can they be liable for it?

A: Because it isn’t theirs.

Q: Then why do they have it?

A: It has been lent to them by customers.

Q: You mean customers lend banks money?

A: In effect. They put money into their accounts, so it is really lent to the banks.

Q: And what do the banks do with it?

A: Lend it to other customers.

Q: But you said that money they lent to other people was Assets?

A: Yes.

Q: Then Assets and Liabilities must be the same thing.

A: You can’t really say that.

Q: But you’ve just said it. If I put $100 into my account the bank is liable to have to pay it back, so it’s Liabilities. But they go and lend it to someone else, and he is liable to pay it back, so it’s Assets. It’s the same $100, isn’t it?

A: Yes, but..

Q: Then it cancels out. It means, doesn’t it, that banks don’t really have any money at all?

A: Theoretically..

Q: Never mind theoretically. And if they haven’t any money, where do they get their Reserves of $249,000,000 or thereabouts?

A: I told you. That is the money they’ve made.

Q: How?

A: Well, when they lend your $100 to someone they charge him interest.

Q: How much?

A: It depends on the Bank rate. Say five and a half percent. That’s their profit.

Q: Why isn’t it my profit ? Isn’t it my money ?

A: It’s the theory of banking practice that..

Q: When I lend them my $100 why don’t I charge them interest?

A: You do.

Q: You don’t say. How much?

A: It depends on the Bank rate. Say half a percent.

Q: Grasping of me, rather?

A: But that’s only if you’re not going to draw the money out again.

Q: But of course I’m going to draw it out again. If I hadn’t wanted to draw it out again I could have buried it in the garden, couldn’t I ?

A: They wouldn’t like you to draw it out again.

Q: Why not? If I keep it there you say it’s a Liability. Wouldn’t they be glad if I reduced their Liabilities by removing it?

A: No. Because if you remove it they can’t lend it to anyone else.

Q: But if I wanted to remove it they’d have to let me?

A: Certainly.

Q: But suppose they’ve already lent it to another customer?

A: Then they’ll let you have someone else’s money.

Q: But suppose he wants his too.. and they’ve let me have it?

A: You’re being purposely obtuse.

Q: I think I’m being acute. What if everyone wanted their money at once?

A: It’s the theory of banking practice that they never would.

Q: So what banks bank on is not having to meet their commitments?

A: I wouldn’t say that.

Q: Naturally. Well, if there’s nothing else you think you can tell me..

A: Quite so. Now you can go off and open a banking account.

Q: Just one last question.

A: Of course.

Q: Wouldn’t I do better to go off and open up a bank?

*Cited in G. Edward Griffin’s history of the Fed, ‘The Creature From Jekyll Island’.

If only. In defending an insolvent banking system, central banks have now created a more absurd situation than Punch could ever have dreamed of. This commentator, for example, has a meaningful cash deposit with a UK commercial bank that is currently earning 0.0% interest (let’s say minus 3% in real terms). To put it another way, we have 100% counterparty and credit risk with a minus 3% annual return. Is it any wonder the UK savings rate is not higher ? Is it any wonder that savers are stampeding into risk assets ? But the likes of the Fed have muddied the pond further by attempting a policy of “forward guidance” that is little more than a sick joke, given the recent sell-off in government bond markets and the resultant rise in government bond yields, on fears of “tapering”. The Fed has lost control of the bond market. As Swiss investor Marc Faber puts it,

The question is when will it lose control of the stock market.

For several years we have been warning of the dangers of central banks becoming increasingly interventionist in the capital markets. We are old school free market libertarians: if bankers make bad decisions, let their banks fail. This is essentially the same perspective taken by Michael Lewis, recently interviewed in Bloomberg Businessweek. On the fifth anniversary of its bankruptcy, Lewis was asked whether he thought Lehman Brothers had been unfairly singled out when it was allowed to fail (given that every other investment bank was quickly rescued, courtesy of the US taxpayer). His response:

Lehman Brothers was the only one that experienced justice. They should’ve all been left to the mercy of the marketplace. I don’t feel, oh, how sad that Lehman went down. I feel, how sad that Goldman Sachs and Morgan Stanley didn’t follow. I would’ve liked to have seen the crisis play itself out more. The problem is, we would’ve all paid the price. It’s a close call, but I think the long-term effects would’ve been better.

But that is not what happened. We didn’t get runs on investment banks. We got bank bailouts, taxpayer rescues, QE1, QE2, QE3 and now QE-Infinity. The impact on the real economy has been questionable, to say the least:

But the impact on financial markets has been demonstrably beneficial to investment banks and their largest clients.

As Stanley Druckenmiller points out, the Fed didn’t act bravely, they bottled it. They had the opportunity to start, ever so gently, to reverse a policy of monstrous intervention in the capital markets, and they blew it. That makes it all the harder for them to “taper” next time round. When do capital markets free themselves from the baleful manipulation of the state? Marc Faber was similarly unimpressed:

The endgame is a total collapse, but from a higher diving board. The Fed will continue to print and if the stock market goes down 10% they will print even more. And they don’t know anything else to do. And quite frankly, they have boxed themselves into a corner where they are now kind of desperate.

The Fed may be desperate, but we’re not. We have our client assets carefully corralled into four separate asset classes. High quality debt (not US Treasuries or UK Gilts) offers income and a degree of capital protection given that the central banks have demolished deposit rates. Defensive equities give us some skin in the game given central bank bubble-blowing in the stock market – but this game ends in tears. Uncorrelated, systematic trend-followers give us a “market neutral” way of prospectively benefiting from any disorderly market panic. And real assets give us some major skin in the game in the event of an inflationary disaster. Since pretty much all of these assets can be marked to market on a daily basis, they are not free of volatility, but we are more concerned with avoiding the risk of permanent loss of capital, Cypriot bank-style. We have, in other words, Fed-proofed our portfolios to the best of our ability. And on the topic of gold alone, Marc Faber again:

I always buy gold and I own gold. I don’t even value it. I regard it as an insurance policy. I think responsible citizens should own gold, period.

Now that the Fed has blinked in the face of market resistance, it seems inevitable to us, as it does to people like Marc Faber, that at some point, possibly in the near future, traditional assets are at risk of loudly going bang. How close are you going to be to the explosion?

This article was previously published at The price of everything.


No tapering, no surprise

It was not too surprising that there is going to be no tapering for some very good reasons. The commencement of tapering would have led deliberately to bond yields rising, triggered by an increase in sales of government bonds to the public and at the same time escalating sales by foreign governments as they attempt to retain control over their own currencies and interest rates. This was the important lesson from floating the rumour of tapering in recent months.

The reason tapering was not going to happen is summarised as follows:

1.       Monetarists and therefore central bankers believe that rising bond yields and interest rates will strangle economic recovery. They want to see more robust evidence of recovery before permitting that to happen.

2.       Rising bond yields would have required the Fed to raise interest rates sooner rather than later to stem the flight of bank deposits from the Fed’s own balance sheet held as excess reserves, which only earn 0.25%.

3.       Importantly, the global banking system has too much of its collective balance sheet invested in fixed-interest bonds, and is also exposed to rising interest rates through interest rate swap derivatives. Tapering would almost certainly have precipitated a second bank crisis starting at the system’s weakest point.

4.       The cost of funding the US Government’s deficit would have risen, difficult when the debt ceiling has to be renegotiated yet again.

5.       Rising US interest rates will most probably destabilise emerging market currencies, risking a new Asian crisis.

6.       It is a bad time to shift the burden of government funding back into the markets, because foreign holders have shown they will sell into rising yields.

The Fed has reaffirmed that zero interest rates will be with us for some time to come. It simply has no choice: it has to play down the risk of inflation. The result will be more price inflation, which is bad for the dollar and good for gold.  This was reflected in the US Treasury yield curve, where prices of long maturities fell yesterday relative to the short end.

The markets had wrongly talked themselves into believing that tapering was going to happen, when the rumour was no more than an experiment. In the process precious metals were sold, driven by increasingly bearish technical talk every time a support level was breached. It is hardly surprising therefore that the recovery in gold and silver prices last night was dramatic, with gold moving up $70 and silver by $2 from intra-day lows. It looks like a significant second bottom is now in place above the June lows and the bear position, coupled with the shortage of physical metal will drive prices in the coming weeks.

The implications of the Fed not going ahead with tapering are bad for the dollar and won’t stop bond yields at the long end from rising. It shows that the whole US economy is in a massive debt trap that cannot be addressed for powerful reasons. The reality is the expansion of cash and deposits in the US banking system is tending towards hyperinflation and is proving impossible to stop. That is the message from this week’s FOMC meeting, and I expect it to gradually dawn on investors world-wide in the coming weeks.


Untangling gold at the Bank of England

From 2006 the Bank of England’s Annual Report has declared the quantity of gold in its custody, including the UK’s own 310 tonnes. Prior to that date a diminishing quantity of on-balance sheet gold (sight accounts) was recorded in the audited accounts, which then disappeared. This tells us that sight accounts (where the BoE acts as banker and not custodian) were dropped. This is sensible, because the BoE is no longer directly liable to other central banks while gold prices are rising.

Of course, the BoE doesn’t hold just central banks’ gold; it also holds gold on behalf of LBMA members. However, LBMA storage at the BoE is probably a fairly small part of the total, because the bulk of settled transactions are in unallocated accounts where the underlying owner does not own physical metal, and the majority of transactions are closed even before settlement is due. Furthermore LBMA members have their own storage facilities or use independent vaults. So to all intents we can regard the BoE’s custody gold as owned by central banks.

It should be borne in mind London is the most important market for physical delivery, particularly for central banks. For this reason most central banks buy, sell, swap or lease their monetary gold in London. The exceptions are Russia, China and the central Asian states who have been the main buyers of gold – always from their own mine output – and do not ship this gold to London; and having substantial foreign reserves from trade surpluses, they have no requirement to do so.

To add to our analytical difficulties, the custody figures presented are net of gold being leased, because leased gold is delivered out of custody. We know that the BoE encourages its central bank customers to pay for its expensive storage charges by earning leasing income, thanks to an unguarded admission from the Austrian central bank last year that it had defrayed its storage costs this way, and a Bundesbank statement that it withdrew gold from London rather than pay high storage fees. The BoE’s custody total is therefore a net figure, with significant quantities of gold out on lease and not actually in custody. However, we can derive some interesting information given the headline custody numbers and some reasonable assumptions.

We can therefore draw up a tentative table as follows:

The approach is to start with the declared gold in custody and subtract what we reasonably know exists to see what’s left. On reasonable assumptions (described in the notes to the table) we can account for all but 467 tonnes of the gold in the BoE’s custody in March 2006. However, remember this is a composite figure, because the BoE leases custodial gold by agreement with its customers – the majority of which will have been delivered out of custody to the market. We have no way of knowing whose gold is actually leased, but at least we more or less know what should be there.

We also know that the gold owned by the central banks represented in the table above plus that of Russia, China, the central Asian states and the US, totalled 12,361 tonnes in March 2006 according to the IMF/WGC statistics. The remaining central banks which are certain to keep gold in London between them owned 18,377 tonnes. To suggest that they had only 467 tonnes of this at the BoE is only true in the sense that some of their gold is out on lease. We can only speculate how much on the basis of what portion of 18,377 tonnes we would expect to be stored in London, but a figure in excess of 5,000 tonnes seems highly likely.

By March this year, the quantity of gold in custody had mysteriously risen from 3,532 tonnes to 6,284 tonnes, leaving a balance not-accounted-for in our table of 2,888 tonnes. Over the intervening years, western central banks officially sold 1,184 tonnes, most of which will have probably passed through the BoE’s vaults. This gold flow is not reflected in custody figures in the table.

The custody ledger is therefore more complicated than its face value. Gold is being leased and has gone out of the door. Gold is being held and not leased, and yet more gold has been shipped in from other centres to be sold, leased or swapped. The amount disclosed by the BoE is effectively a “float”: a net figure comprised of larger amounts. We can therefore assume that despite the rise in custodial gold, gold from the BoE vault has also been supplied to the market.

It is extraordinary that the BoE on behalf of other central banks has been arranging leasing contracts for gold that seems unlikely to return. The lessees may from time to time have been able to buy back the bullion to deliver to the lessor and re-deposited it back with the BoE; but most of bullion goes to India, China or South East Asia from whence it never returns. This may have been less of a problem before Chinese demand took off, people began buying ETFs, and there was a growing supply of scrap. But this has not been the case for several years now, and the remaining leasing agreements must have to be rolled forward, leaving central bank customers of the BoE semi-permanent creditors of bullion banks.

One can only surmise that the central banking community of North America and Europe see gold as an increasing embarrassment. Nevertheless it is hard to understand why central banks continue to lease gold, particularly after the banking crisis when central banks must have become more aware of systemic risks and the possibility their lessees might go bankrupt. More recently, leasing will have almost certainly been a source of finance for cash-strapped eurozone states, and might help explain how they have survived in recent months. However, this cannot go on for ever.

Since the Cyprus debacle

We now turn to the last column dated June this year. The figure for custodial gold of 4,977 tonnes is “at least 400,000 400-ounce bars” taken from tour-note 2 of the new virtual tour of the gold vaults on the BoE’s website. Tour-note 3 gives us the date the information was collated as June this year. This compares with the figure at February 28 from the BoE’s Annual Report of the equivalent of 505,117 bars. So it appears that at least 100,000 bars have disappeared in about four months.

Is the difference of 100,000 bars a mistake? The wording suggests not. The Bank appears to have thought that if it said in the virtual tour, “over 400,000 bars in custody” it would be sufficiently vague to be without meaning; but it is so much less than the figure in the Annual Report dated only four months earlier that it is unlikely to be a mistake. We must therefore conclude that they meant what they said, and that some 1,300 tonnes has left the vault since 1 March.

We now consider where this gold has gone. Gold demand in Europe began to accelerate after the Cyprus debacle at a time when Chinese and Indian demand was also growing rapidly. Meanwhile mine production was steady and scrap sales in the West were diminishing. This was leading to a crisis in the markets, with the bullion banks caught badly short. Hence the need for the price knock-down in early April.

The price knock-down appears to have been engineered on the US futures market, triggering stop-loss orders and turning a significant portion of ETF holders bearish. However, the lower price of gold spurred unprecedented demand for physical gold from everywhere, considerably in excess of ETF sales. The fact the gold price did not stage a lasting recovery tells us that someone very big must have been supplying the market from mid-April onwards, and therefore keeping the price suppressed.

So now we have the answer. The BoE sold about 1,300 tonnes into the London market, which given the explosion in demand for physical at lower prices looks about right.

This leaves us with two further imponderables. It seems reasonable given the acceleration in global demand that the bulk of the gold supplied by the BoE has gone to the non-bank sector around the world. In which case, the bullion banks in London still have substantial uncovered liabilities on their customers’ unallocated accounts, on top of the leases being rolled. The second is a question: how much of the remaining 1,580 tonnes not-accounted-for last month been sold since June?

Conflating these two imponderables, unless the BoE can ship in some more gold sharpish, there is unlikely to be enough available to supply the market at current prices and bail out the bullion banks in London, so they must still be in trouble. The supply of gold for lease seems to have diminished, because the Gold Forward Rate has gone persistently negative indicating a shortage.

It appears the leasing scheme, whereby central bank gold is supplied into the market, has finally backfired. Prices have risen over the period being considered and leased gold has disappeared into Asia at an accelerating rate never to return. While the bullion banks operating in the US futures market have got themselves broadly covered, the bullion banks in London appear to have passed up on the opportunity to gain protection from rising bullion prices.

The final and fatal mistake was to misjudge the massive demand unleashed as the result of price suppression. This was a schoolboy-error with far-reaching consequences we have yet to fully understand.

This article was previously published at


Fed tightens control over banks activities

On Tuesday July 2, US central bank policy makers voted in favour of the US version of the global bank rules known as the Basel 3 accord. The cornerstone of the new rules is a requirement that banks maintain high quality capital, such as stock or retained earnings, equal to 7% of their loans and assets.

The bigger banks may be required to hold more than 9%. The Fed was also drafting new rules to limit how much banks can borrow to fund their business known as the leverage ratio.

We suggest that the introduction of new regulations by the Fed cannot make the current monetary system stable and prevent financial upheavals.

The main factor of instability in the modern banking system is the present paper standard which is supported by the existence of the central bank and fractional reserve lending.

Now in a true free market economy without the existence of the central bank, banks will have difficulties practicing fractional reserve banking.

Any attempt to do so will lead to bankruptcies, which will restrain any bank from attempting to lend out of “thin air”.

Fractional reserve banking can, however, be supported by the central bank. Note that through ongoing monetary management, i.e., monetary pumping, the central bank makes sure that all the banks can engage jointly in the expansion of credit out of “thin air” via the practice of fractional reserve banking.

The joint expansion in turn guarantees that checks presented for redemption by banks to each other are netted out, because the redemption of each will cancel the other redemption out.

By means of monetary injections, the central bank makes sure that the banking system is “liquid enough” so that banks will not bankrupt each other.

The consequences of the monetary management of the Fed as a rule are manifested in terms of boom-bust cycles.

As times goes by this type of management runs the risk of severely weakening the wealth generation process and runs the risk of severely curtailing so called real economic growth.

We maintain that as long as the present monetary system stays intact it is not possible to prevent a financial crisis similar to the one we had in 2007-9. The introduction of new tighter capital requirements by banks cannot make them more solvent in the present monetary system.

Meanwhile, banks have decided to restrain their activity irrespective of the Fed’s new rules. Note that they are sitting on close to $2cg trillion in excess cash reserves.  The yearly rate of growth of banks inflationary lending has fallen to 4.1% in June from 4.2% in May and 22.4% in June last year.

Once the economy enters a new economic bust banks are likely to run the risk of experiencing a new financial crisis, the reason being that so called current good quality loans could turn out to be bad assets once the bust unfolds.

A visible decline in the yearly rate of growth of banks inflationary lending is exerting a further downward pressure on the growth momentum of our monetary measure AMS.

Year-on-year the rate of growth in AMS stood at 7.7% in June against 8.3% in May and 11.8% in June last year.

We suggest that a visible decline in the growth momentum of AMS is expected to bust various bubble activities, which sprang up on the back of the previous increase in the growth momentum of money supply.

Remember that economic bust is about busting bubble activities. Beforehand it is not always clear which activity is a bubble and which is not.

Note that once a bust emerges seemingly good companies go belly up. Given that since 2008 the Fed has been pursuing extremely loose monetary policy this raises the likelihood that we have had a large increase in bubble activities as a percentage of overall activity.

Once the bust emerges this will affect a large percentage of bubble activities and hence banks that provided loans to these activities will discover that they hold a large amount of non-performing assets.

A likely further decline in lending is going to curtail lending out of “thin air” further and this will put a further pressure on the growth momentum of money supply.

In fractional reserve banking, when money is repaid and the bank doesn’t renew the loan, money evaporates. Because the loan was originated out of nothing, it obviously couldn’t have had an owner.

In a free market, in contrast, when money i.e. gold is repaid, it is passed back to the original lender; the money stock stays intact.

Since the present monetary system is fundamentally unstable it is not possible to fix it. The central bank can keep the present paper standard going as long as the pool of real wealth is still expanding.

Once the pool begins to stagnate – or worse, shrinks – then no monetary pumping will be able to prevent the plunge of the system.

A better solution is of course to have a true free market and allow the gold to assert its monetary role. As opposed to the present monetary system in the framework of a gold standard money cannot disappear and set in motion the menace of the boom-bust cycles.

Summary and conclusion

Last week US central bank policy makers voted in favour of tighter rules on banks’ activities. The essence of the new rules is that banks maintain high quality capital equal to 7% of their assets. The new rules are aimed at making banks more solvent and to prevent repetitions of the 2008-2009 financial upheavals. We suggest that in the present monetary system which involves the existence of the central bank and fractional reserve banking it is not possible to make the monetary system more stable and immune to financial upheavals. As long as the Fed continues to tamper with interest rates and money supply we are going to have boom-bust cycles and financial upheavals.


Bank reform demands monetary reform – an essay for Banking 2020

This article was published yesterday at

A vision for the future

Today sees the return of the Financial Services (Banking Reform) Bill to Parliament. It does not do enough.

In the book Banking 2020: A vision for the future, my essay summarises the institutional problems with our monetary and banking orthodoxy:

The features of today’s banking system

As Governor of the Bank of England Sir Mervyn King told us in 2010: ‘Of all the many ways of organising banking, the worst is the one we have today.’

Notes and coins are irredeemable: the promise to pay the bearer on demand cannot be fulfilled, except with another note or coin with the same face value. Notes and coins are tokens worth less than their face value and are issued lawfully and exclusively by the state. This is fiat money.

When this money is deposited at the bank it becomes the bank’s property and a liability. The bank does not retain a full reserve on demand deposits. In the days of gold as money, fractional reserves on demand deposits explained how banks created credit. Today, credit expansion is not bounded by the redemption of notes, coins, and bank deposits in gold.

Because banks are funded by demand deposits but create credit on longer terms, they are risky investment vehicles subject to runs in a loss of confidence. States have come to provide taxpayer-funded deposit insurance. This subsidises commercial risk, producing more of it and creating moral hazard amongst depositors who need not concern themselves with the conduct of banks.

The state also provides a privileged lender of last resort: the central bank. It lends to illiquid but solvent banks getting them through moments of crisis. In a fiat money system, central banks have the power to create reserves and otherwise intervene openly in the money markets. Today this is most evident in the purchase of government bonds with new money, so-called quantitative easing.

The central banks also manipulate interest rates in the hope of maintaining a particular rate of price inflation through just the right rate of credit expansion to match economic growth. That otherwise free-market economists and commentators support such obvious economic central planning is one of the absurdities of contemporary life.

Compounding these flaws is the limited liability corporate form. Whereas limited liability was introduced to protect stockholders from rapacious directors, its consequence today is ensuring no one taking commercial risks within banks stands to share in the downside. This creates further moral hazard.

Regulatory decisions have been taken to encourage banks to make bad loans and dispose of them irresponsibly. Among these are the US Community Reinvestment Act and the present government’s various initiatives to promote the housing market and further credit expansion.

Having insisted banks make bad loans, the regulatory state imposed the counterproductive International Financial Reporting Standards (IFRS) which can over-value assets and over-state the capital position of banks. This drives the creation of financial products and deals which appear profitable but which are actually loss-making. Since these notoriously involve vast quantities of instruments tied to default, the system is booby-trapped.

Amongst the many practical consequences of these policies was the tripling of the money supply (M4) in the UK from £700 billion in 1997 to £2.2 trillion in 2010. Credit expansion at this rate has had predictable and profound consequences including asset bubbles, sectoral and geographic imbalances, unjust wealth inequality, erosion of physical capital, excess consumption over saving, and the redirection of scarce resources into unsustainable uses.

Moreover, credit cannot be expanded without limit. Eventually, the real world catches up with credit not backed by tangible assets: booms are followed by busts.

The essay provides some objectives for monetary reform and sets out proposals from Dowd et al and Huerta de Soto.

I was pleased that the Parliamentary Commission on Banking Standards highlighted problems with incentives and accounting – the conversation is going in the right direction. At some point, when it becomes apparent that Mervyn King was right and we do have the worst possible banking system, I hope decision makers will realise that banks and the product in which they deal, money, are inseparable and that meaningful banking reform demands monetary reform.

You can download the book here.


Russia and China building their gold reserves

Western economic commentary on China and Russia is usually coloured by monetarist assumptions not necessarily shared in Moscow and Beijing. For this reason, Russian and Chinese fiscal and monetary policies are misunderstood in financial markets, as well as the reasons their governments buy gold.

China has been notably relaxed about her own people acquiring gold, and the government itself appears to be absorbing all of China’s mine output. Russia is also building her official reserves from her own mine supply. The result over time has been the transfer of aboveground gold stocks towards these countries and their allies. The geo-political implications are highly important, but have been ignored by western governments.

China and Russia see themselves as having much in common: they are coordinating security, infrastructure projects and cross-border trade through the Shanghai Cooperation Organisation. Furthermore, those at the top have personal experience of the catastrophic failings of socialism, which have not yet been experienced in Western Europe and North America. Consequently neither government subscribes to the economic and monetary concepts prevalent in the West without serious reservations.

We saw evidence of this from Russia recently, with Putin’s appointment of his own personal economic adviser, Elvira Nabiullina, as the new head of Russia’s central bank. Ms Nabiullina is on record admiring, among others, the writings of Robert Higgs – a leading US economist of the Austrian School. She is therefore likely to take a strong line against the expansion of bank credit, which is confirmed by Russian commentators who believe she will prioritise reforms to strengthen bank balance sheets.

She is not alone. The People’s Bank of China recently let overnight money-market rates soar to over 20%. The message is clear for those prepared to look for it: they are not going to fuel an extended credit bubble. The two countries have learned how damaging a bank-credit-fuelled business cycle can be, and are determined to restrict bank lending. Western commentators find this hard to understand because it does not conform to the way western monetary policy works.

It seems that the leaders of both Russia and China are also painfully aware of the importance of currency stability in a way the West is not. The comparison with the West’s reckless monetary policies is stark. It follows that Russia and China are increasingly concerned about the major currencies, given both countries have substantial trade surpluses. Their exposure to this currency risk explains their keenness for gold. Furthermore, they know that if the renminbi and the rouble are to survive a western currency crisis, they must have the sound-money credibility provided by a combination of monetary restraint and gold backing. And the reason China is happy to let her citizens plough increasing amounts of their savings into gold is consistent with ensuring her people buy into sound money as well.

While the Chinese and Russian governments are authoritarian mercantilists, there are elements of the Austrian School’s economics in their approach. The tragedy for the West and Japan is they have embarked on the opposite weak-money course that can only end in the ultimate destruction of their currencies, leaving Russia and China as the dominant economic powers.

This article was previously published at


Roubini attacks the gold bugs

Earlier this month, in an article for “Project Syndicate” famous American economist Nouriel Roubini joined the chorus of those who declare that the multi-year run up in the gold price was just an almighty bubble, that that bubble has now popped and that it will continue to deflate. Gold is now in a bear market, a multi-year bear market, and Roubini gives six reasons (he himself helpfully counts them down for us) for why gold is a bad investment. Roubini does not quite go so far as to tell his readers that there is no role whatsoever for the yellow metal. Investors should have a “very modest” share of gold in their portfolios, as a hedge against extreme risks, which, the good professor assures us, are almost so negligibly small that they are “irrational fears”, really, but beyond that there is little reason to bother with gold.

Interestingly, “very modest” is indeed a good description of gold’s share in the global asset mix. According to some studies gold accounts for only around 1 percent of global asset holdings. In terms of asset breakdown we already are where Roubini thinks we should be. So why bother? Those of us – such as yours truly – who hold a more pessimistic outlook as to the efficiency of current policies and the sustainability of the current monetary infrastructure, and who accordingly hold a bigger share of their wealth in gold, are evidently “paranoid”, and as they now reap the deserved reward for their dreadful negativity courtesy of a declining gold price, why not ignore them? It is, after all, a tiny minority. But it is evident from Roubini’s essay that he not only considers the gold bugs to be wrong and foolish, they also annoy him profoundly. They anger him. Why? – Because he thinks they also have a “political agenda”. Gold bugs are destructive. They are misguided and even dangerous people.

Roubini’s case against gold

But let’s first look at his arguments for a continued bear market in gold. They range, in my view, from the indisputably accurate to the questionable and contradictory to the simply false and outright bizarre. Here is the list (with some of my commentary. Apologies to Professor Roubini.):

1)   Gold is only useful in extreme economic scenarios (such as 2008/2009) but even then its price is highly volatile (and so it was in 2008/2009).

2)   Gold is only useful when there is risk of rising inflation. Despite unprecedented policy measures, such as multiple rounds of QE, there is no inflation, according to Roubini. – Why is there no inflation?- Because the newly created money is stuck in the banking system and the wider financial system where it finances a happy merry-go round of asset trading without boosting broader monetary aggregates. Outside finance (and government, I might add) nobody wants to take on more debt. The normal transmission mechanism is not working. – Additionally, Roubini makes some heroic assumptions about there being no pricing power and no wage inflation.

3)   Gold produces no running income and will thus be at a disadvantage in a recovering economy when equities and bonds do better. – Wait a minute. Recovering economy? Where did that come from? I thought none of the monetary stimulus was getting through to the real economy and hence failed to ignite inflationary pressures? How can it then stimulate real activity? Or are the two somehow unrelated?

4)   Gold does best when interest rates are low or negative but the present recovery – recovery, again! – will allow central banks to unwind their present easy monetary policy stance and to hike interest rates. –- OK. Good luck with that. But again we are asked to take the present talk of recovery at face value. On the one hand Roubini cites ubiquitous deleveraging pressures, “lack of pricing power” and “excess capacity” (these are his words!) as reasons for why the extraordinary expansion in base money supply is not translating into money growth in the wider aggregates that usually drive the wider economy, and why therefore standard inflation measures remain benign and, on the other hand, evidently sees none of this as an obstacle to the self-sustained recovery story. — And if the economy indeed does recover without the help from easy money then, maybe, monetary policy is easy for other reasons, such as keeping an overstretched banking system from collapsing. In that case, better growth momentum as such may not be sufficient to allow central bankers to exit their present policy program.

5)   Fears of sovereign default have been driving people into gold but now the greater risk is that struggling sovereigns may sell their gold holdings. – This is potentially a risk but I would counter that while selling from official sources could affect the gold market in the short-term, liquidating the family silver (no pun intended!) and removing the remaining smidgeons of hard assets at the bottom of the inverted pyramid of the über-leveraged paper money economy and replacing it with government IOUs is not going to instil a lot of confidence on the part of the public. Gold liquidation is a further sign of stress, of a check-mated policy elite running out of options, and the public may end up scooping up willingly whatever desperate politicians sell. But I guess that reasonable people can disagree on this point. – But now it gets really interesting:

6)   In large parts the gold bull market was the work of, wait for this, “extreme” political conservatives, of the “far-right fringe” and conspiracy theorists. That hype is now coming undone. According to Roubini gold is not simply another asset but an indicator of political extremism, of an unhealthy mistrust of the established order. Roubini: “These fanatics also believe that a return to the gold standard is inevitable as hyperinflation ensues from central banks’ ‘debasement’ of paper money.” – Well, I guess it is time for the IRS to conduct a couple of customized tax audits!

Monetary policy prevents economic healing

Roubini does not provide much explanation for his claim that we are now in a self-sustained recovery that will allow central bankers to exit the extreme policy positions they adopted in recent years. He seems to rely on the healing forces of the market. I am the first to agree that these forces do exist in a capitalist economy and that they are incredibly powerful. That is why the market should always be left to its own devices, be allowed to unwind and liquidate accumulated dislocations that are now barriers to renewed growth, and to bring the economy back into balance. But these are precisely the very processes that present monetary policy sabotages with all its might: zero interest rates and unlimited bank funding, plus ongoing asset price manipulations, numb the market’s power to cleanse and heal and re-adjust, and instead allow banks and other financial operators to continue in their policy of pretend and extend, to keep on their books underperforming, bad or even toxic assets at unrealistic prices. Policy makers have to decide whether they want the market to operate its healing powers (even if some of the healing imposes near-term pain on the patient), or whether they rather trust their own powers to continuously drive the economy, imbalances and all, to higher levels of performance with their money-printing, market manipulation and deficit spending. We know which path they have followed so far, and that is why placing your hope on self-healing market forces is naïve. Strangely, Roubini himself has on numerous occasions warned against a strategy of kicking the can down the road and has repeatedly warned of new credit bubbles. I wonder which Roubini wrote this article.

At the core of Roubini’s argument is a paradox: easy money – the monetary ‘stimulus’ – is stuck in the banking industry and the wider financial system, and that is his explanation – together with excess capacity, deleveraging and the absence of ‘pricing power’ – for why the standard measures of inflation – consumer price inflation in particular – have not risen more dramatically. Unless you are a derivatives trader or a hedge fund manager you have not seen any of the money. But when you will, finally, believe me, then the prices that matter to you will also go up. Roubini cannot have it both ways: easy money has no effect on inflation but a stimulating one on growth – not even his funny New Keynesianism can square that circle.

But the real criticism of present policies is not that they will lead to instant hyperinflation – I believe they will eventually lead to much higher inflation and probably hyperinflation – but that they don’t solve anything but make economic imbalances much worse. They do not have an exit, and this is why they will ultimately destroy money. Roubini is overstating the ‘healing’ argument considerably, and in the course makes some big blunders: “Ongoing private and public debt deleveraging has kept global demand growth below that of supply.” – This is evidently not supported by the facts. As I have argued before, private sector deleveraging is minor, and in most countries, governments are issuing massive amounts of new debt, certainly in the US, the UK (contrary to what the public debate there would make you believe), and Japan.

Are owners of gold ‘extremists’?

But what is most worrying, and most disturbing, is Roubini’s pathetic attempt to label gold bugs political extremists. Central banks run policies today that only a few years ago would have set the average middle-of-the-road central banker’s hair on fire. Of course, the public is worried, scared and skeptical. Because the political and monetary elite, the establishment of which Roubini – senior economist for the Council of Economic Advisors under Bill Clinton and senior economic advisor to Timothy Geithner when at the United States Treasury Department – is a member, has lost the plot. The paper money bureaucracy has painted itself into a corner. The public has very good reasons to be worried, skeptical and scared.

Early in his article, Roubini makes the following observation: “During the global financial crisis, even the safety of bank deposits and government bonds was in doubt for some investors.” [my emphasis.] – What does he mean, for some investors? Banks did fail and governments did go bankrupt in the crisis. Was that just a figment of the imagination of some investors? – The only reason that not more banks went under (yet) and more governments went bankrupt is unlimited money printing. Unless monetary policy changes meaningfully we won’t even know which entities are truly solvent and which are not. And then we might find out the hard way.

Of course, people who are already predisposed to skepticism towards the political elite and their ongoing meddling with the free market will be more inclined to buy gold. But that only makes them libertarians, or individualists, or simply people who are suspicious of power and politics. I have met many of them and have yet to meet anyone who deserves the label ‘far right’, with all the connotations that Roubini invokes here, deliberately, I assume. — I am the first to acknowledge that the pro-gold community – and it is not even a real community – has its fair share of eccentrics but the majority of those who piled into gold is simply worried about where our unhinged monetary system will take us next – and justifiably so.

Roubini simply resorts to smear tactics. The same approach has been shamelessly employed for many years by Paul Krugman. The idea is to unilaterally determine the acceptable parameters of enlightened economic debate. The high gospel of John Maynard Keynes is not to be questioned, and the wisdom of having highly-trained academicians running a central bureaucracy in charge of monetary policy, administratively setting interest rates, creating bank reserves at will, and manipulating the prices of a growing number of assets to the benefit of the greater good, a system that not only did not exist 50 years ago but that back then nobody even advocated, is not to be challenged under any circumstances. Those who do are not worthy of debate. They are evidently members of the Montana Militia. They are crackpots and dangerous subversives. As Roubini stated: advocates of a gold standard are fanatics.

This is, of course, utter gibberish. A well-articulated, rational and sophisticated theory exists for why paper money systems are unstable and why they fail, and why hard money systems work better. The Austrian School of economics explains this convincingly. Its leading intellectual light was Ludwig von Mises (1881 – 1973) – urbane, sophisticated, highly intelligent, and a man of principle, one of the greatest economists of the twentieth century, who lived and taught in Vienna, Geneva and New York. – Not your average backwoodsman.

Roubini may be right on one thing: maybe gold will go down to $1,000. So what? – It won’t stay there. For whatever happens next to the gold price, or whatever the Fed does next, Roubini’s over-geared paper money economy will not survive in its present form.

In the meantime, good luck with that ‘exit strategy’!

This article was previously published at


Bank balances and gold

There has been a growing shift in favour of assets relative to bank deposits. This was initially encouraged by zero interest rates, but more recently there is little doubt that Cyprus’s bail-in has accelerated the trend. This explains the bull markets in bonds and equities, which conveniently underwrites the entire banking system. It is however too early to offer evidence of falling deposit balances held by non-banks and the general public because depositors as a whole have been remarkably complacent, but there is ample evidence that liquidity from monetary expansion is inflating financial assets faster than bank deposits.

This helps explain why, for example, Italian 10-year bonds are on a 4% yield. The reason, doubtless reaffirmed by the Cyprus bail-in, is that investors with cash balances think over-priced sovereign debt is less risky than adding to their euro deposits. However, the central banks are relaxed because weakness in deposits at any single bank is easily covered through the banking system, insulating individual banks from depositor-withdrawal systems. Presumably, banking counterparties are also complacent because they can be reasonably sure to be exempt from any bail-ins. They have the comfort of knowing the banking system is underwritten by all those complacent enough to leave money on deposit beyond the insured level.

However, some of depositors’ cash balances post-Cyprus will have gone into physical gold and silver, which explains why the bullion banks operating in the futures markets and the central banks behind them are so keen to dissuade us that gold and silver is a safe haven. I recently interviewed Ronnie Stoerferle, the Vienna-based analyst, who put his finger on it: since Cyprus, there has been a sharp rise in European demand for physical gold, with the pressure being felt by the bullion banks unable to deliver bullion.

At least one bank was recently reported to be only prepared to settle bullion liabilities in cash. Therefore the price knock-down in April was a logical response by the bullion banks, which had to defuse customer demand for physical delivery. But given that the driving factor was not speculation but a reluctance to add to deposits in the banking system, the jump in demand for bullion at lower prices was inevitable.

Where does this leave things? The crisis in bullion markets is worse than it was before. A good example of how little physical stock there is can be gained by tracking bullion deliveries on the Shanghai Gold Exchange. In the last few weeks they have dwindled to virtually nothing, having been a truncated 190 tonnes in April and 297 tonnes in March. Yet we know from reports that retail demand in China has taken off; so it is only a matter of time before prices are bid up on the Shanghai Gold Exchange enough to replace lost inventory.

It will be interesting to see how many more bullion banks are forced to admit the fiction behind their customer accounts in the coming weeks. For the moment the temporary solution amounts to rationing bullion supplies to the public.

This article was previously published at


Gold is money not because it is scarce but because it is abundant

The Honorable Ron Paul says:

Why is gold good money? Because it possesses all the monetary properties that the market demands: it is divisible, portable, recognizable and, most importantly, scarce – making it a stable store of value.

True. Yet those properties are not the most relevant today. The most important characteristic that makes gold a good reference point for money today is its enormous stock to flow ratio as the recent gold report by Erste Bank points out.

By neglecting the stock to flow ratio argument and using other, less important ones, it is much easier for anti-gold economists to confuse the public. For instance, Paul Krugman and others mercilessly criticize gold by conflating deflation with contraction and inflation with expansion.

Gold is money not because it is scarce but because it is abundant (relative to its production and consumption). This factor makes for a huge buffer that stabilizes its value against other things.

The same can be said about water. Water is abundant on Earth. Water evaporates from the land and oceans, falls down as rain and snow, rivers bring it back to oceans – at widely volatile rates.

Approximately 505,000 km3 of water falls as precipitation each year. But the world’s water supply is estimated at 1,386,000,000 km3 (97 per cent of which is stored in oceans). A huge stock to flow ratio that makes for a useful reference point.

The Erste Bank’s Gold Report concludes:

We believe that gold is not precious because it is scarce, but because the opposite is true: gold is precious because the annual production is so low relative to the stock. The aggregate volume of all the gold ever produced comes to about 170,000 tonnes. This is the stock. Annual production was close to 2,600 tonnes in 2011. That is the flow. Dividing the former by the latter, we receive the stock-to-flow ratio of 65 years (which is far more than for any other good offered in the world economy).

Gold has acquired this feature over centuries, and cannot lose it anymore.

Most commodities are consumed, whereas gold stocks are augmented, gradually.

Let’s suppose then that production of gold increases twofold or is cut in half. No big deal. There is a huge reserve to make up for difference. This does not really apply to any other commodity.

It should be also noted that CPI is a sum of two different and separate things.

CPI has a monetary component and a component related to business cycle.

When too much money is created the prices rise – prices of gold first, then other commodities and liquid assets. The prices of goods that are included in CPI rise thereafter.

But there may be other reasons for a rise in CPI. Let us assume that monetary policy in a given country is OK, but the economy is growing really fast, as was Ireland and Estonia before the crisis. CPI had been rising there due to the (relatively) huge inflow of capital – there was more demand than supply for everything, especially immovable property. Symmetrically, one can get a drop of CPI in a recession.

This is how adjusting interest rates works. Interest rates are not a monetary instrument, but an instrument to effect business cycle. By raising interest rates central banks depress economic activity and force marginal firms out of business. This reduces CPI. Symmetrically, central banks try to revive growth by reducing interest rates in an attempt to bring about an increase in CPI.

Why was there no surge in CPI after such a huge injection of money after September 2008?

There appear two things working in opposite directions here: too much money pushing prices up and severe recession bringing them down. Taken together they made, and are making, for modest CPI increases. In 1970 monetary expansion was much stronger (23X rise in gold prices against 3 fold now) and real economic growth as weak as it was, was stronger than it has been.

This article was previously published at The Gold Standard Now.