Authors

Peace

Remember

An article by Cobden Centre fellow David Howden for Mises.ca.

Today many of us are wearing a poppy on our lapels in a show of remembrance. What exactly are we remembering?

The Great War from 1914-18 saw many changes to the world. Many of them were bad, though as we shall see some good did come from one of, if not the worst war of all time.

Over 64,000 Canadians lost their lives fighting in Europe, almost 1% of her population. A further 150,000 were injured. The comparable statistics today, updated for population growth, would be nearly 315,000 dead soldiers and almost 700,000 wounded. Remember that these are just Canadian soldiers. The final global death toll was 17 million (including the civilian deaths in the neutral countries of Scandinavia) and over 21 million wounded.

In fact, in this regard one could argue that Canadians came away relatively unscathed. Romania lost 10% of its population, Serbia 16%, and the great Ottoman Empire almost 14%. This latter figure excludes the additional 100,000 Turks who died fighting the subsequent Turkish War of Independence following the signing of the Armistice in 1918.

The First World War was not only the first war to be waged on a truly global scale, it was the first to inflict the magnitude of destruction it did. Soldiers of previous battles were felled by disease more often than in direct combat. Advances in technology changed that, and even though the 1918 outbreak of Spanish influenza killed many more (current estimates place the deaths from the flu at 50-100 million), the Great War killed more people in four short years than most of the previous European wars combined.

In remembering the Great War it is easy to focus on the deaths of those who sacrificed their lives, but it is also important to reflect on what caused the War and what it achieved.

It’s true that advances in modern warfare and logistics made the War able to be fought on a wider scale than ever before. It is also true that a series of alliances – both formal and informal – agreed upon prior to the War brought belligerents into the melee with only tangential interest in it. Canada’s allegiance to Great Britain at the time might be thought of in this way, as could any number of the other Dominions and Colonies including Australia, India, New Zealand and Newfoundland.

Some simple economics also played an important role. Prior to the War most countries of the world had a monetary system linked to the gold standard. Government deficit spending was curtailed under this system as borrowing would be limited by the extent of a country’s gold reserves. The expression “to have a war chest” has its origins in the necessity of a sovereign to carry a chest of gold to war to pay soldiers. Wars under the gold standard were quite limited affairs, curtailed by the supply of gold available to keep soldiers paid (and motivated).

The War brought with it the breakdown of the gold standard as all belligerents resorted to monetary inflation to finance the growing expenses. This one simple fact goes far in explaining why the scope of the War and the resources driven into it were so great. The lack of a spending anchor under a fiat money regime allowed countries to print money and run deficits in order to finance the increasingly expensive battles, expensive both in money and lives. While governments could print money to paper over the cost of the War, soldiers were much less reproducible. As we shall see, the use of conscription was the counterpart to inflation and allowed the War to continue being waged once volunteers ran out.

The Great War was supposed to be the war to end all wars. Unfortunately the signing of the Treaty of Versailles to officially settle it proved to be the peace to end all peace.

A not well-known 36-year old economist by the name of John Maynard Keynes found fame penning his The Economic Consequences of the Peace in 1919. Keynes had two profound criticisms of the Treaty. First, that Europe could not survive and prosper without an integrated economic system, something that the Treaty precluded. Second, that the Treaty violated many terms of the Armistice signed 95 years ago on the eleventh hour of the eleventh day of the eleventh month of 1918. The armistice included terms relating to war reparations, territorial adjustments and general even-handedness in economic matters.

Keynes presciently predicted that the Treaty of Versailles would be the cause of a future war, and 20 years later he was proven correct. Poor economic conditions in Germany as a result of war reparations and the loss of culturally and economically important territories set in motion a series of events that brought Adolph Hitler to power and resulted in the invasion of Poland by both Fascist Germany and Communist Russia in September 1939.

Six years and 50-85 million additional deaths later the world had a new Great War. This one necessitated a numbering system to distinguish the first Great War from the Second.

All of this death and destruction could easily be pegged on one person. The Bosnian Serb student Gavrilo Princip may have fired the shot that killed the heir to the Austo-Hungarian throne, the young Archduke Franz Ferdinand of Austria on June 28th, 1914. But Princip was not alone in his distaste for the ruling class of that Empire.

Indeed, general unease concerning many sovereigns and governance structures were warming like kindling, ready to ignite Europe at any time. Secession problems in the Austro-Hungarian Empire and brewing revolutions in both the Russian and Ottoman Empires were slowly creating the conditions for civil wars.

The British Empire under the rule of King George V was also going through its own coming of age problems, though nothing severe enough to spark bloody revolution. Indeed, the Great War ushered in an era that saw Britain’s Colonies and Dominions reorganise into a peaceful and voluntary structure. In few places was this push more apparent than in Canada.

A bloody Battle of the Somme resulted in Prime Minster Robert Borden’s pledge to send 500,000 soldiers to Europe by the end of 1916, despite a population in Canada of only 8 million at the time. Conscription was enacted to offset the dwindling supply of volunteers to join the War cause.

Almost all French Canadians opposed conscription, feeling no allegiance or duty to aid either England or France. The Conscription Crisis of 1917 was primarily a backlash of Francophone Canadians against the forced military service imposed by Ottawa to aid his Majesty’s war. Uneasiness about being Catholic soldiers under predominantly Protestant commanding officers also fuelled the flames.

The Conscription Crisis exposed Ottawa to many difficult questions. One problem was that by forcing labour, the Canadian government had no knowledge who would be the best soldier, toolmaker or farmer. Someone had to stay back and supply those who went to fight, but the government lacked any rational way to make this decision. More importantly, there was the apparent rights issue. Canada had never before enacted conscription, and the idea of forcing someone to fight in a war against their wishes is morally repugnant. More to the point, fighting a war in a distant land to aid a government which one never voted for created its own problems. The problem lives on today for pacifists around the globe, as well as those who choose to refrain from political participation.

Indeed, in a bid to garner support for conscription the Military Service Act of January 1st 1918 included exemptions to remove oneself from the forced call of duty. By autumn of that year these exemptions were removed, in a move that offended not only the French but also English-speaking Canadians. This move by Robert Borden not only shut the Conservative Party out of Quebec for over 50 years, but also caused them to lose the next general election in 1921 to the Liberal’s of William Lyon Mackenzie King.

At the very least, the Conscription Crisis put in motion a debate as to what role and duty, if any, the Dominions and their citizens had in regards to the United Kingdom. The culmination of these debates was the Statute of Westminster, signed into law by the Parliament of the United Kingdom in 1931 and passed on to all realms within the Commonwealth for ratification shortly thereafter. Amongst other things, the Statute legislated equality and self-governance for the Dominions that ratified it. (Not all colonies did so: Newfoundland Colony did not ratify the Statute, and remained a Dominion of the British Empire until joining Canada in 1949.)

The Commonwealth of Nations today survives as an organisation of 53 countries, most of which were territories of the British Empire. It represents a quarter of the world’s land mass, almost a third of its population and 15% of the globe’s GDP. It is a voluntary group which exists due to some loosely shared values paired with some established statutes.

Racial equality is a requirement for inclusion, and this was tested with the withdrawal of South Africa under apartheid, as well as its eventual readmission after its end. Not all member states recognise the Queen as the head of State, though some (like Canada) do. We have a shared history, heritage and traditions (like wearing a poppy on Remembrance Day). Chief among these is obedience to the common law, one of the greatest forces of civilisation in history. A dedication to peace, liberty and free trade are all points for inclusion, secured by the values of the 1971 Singapore Declaration.

There are no formal laws dictating that member countries must trade or associate with one another, but they do. The voluntary nature of this institution is apparent in the immigrants that flow between Commonwealth nations as well as the fact that Commonwealth members trade up to 50% more with other Commonwealth members than with non-members.

Inclusion in the Commonwealth does not yet instil by law the free movement of goods, people or money across borders, but it would be wise to do so. Some countries give preferential treatment to immigrants or investors from other Commonwealth countries, and the benefits are clear. Economic prosperity reigns when people, goods and money go to where they are treated best. Informal preferences within the Commonwealth promote this.

There is discussion of making the Commonwealth into a broader free trade union, as is the case with the European Union. This should be welcomed as it would solidify into law those benefits which heretofore are only informally recognised.

A word of caution is in order.  Should the Commonwealth choose to formalise its union it must do so in its own way and according to its founding principles. Liberty and freedom are among these, and the voluntary nature of the union must also be upheld. (This in distinction to the mandatory nature of the European Union which now results in ill feelings of coercion or otherwise being forced to behave in ways undesired by many citizens of the member states.) Infringements to freedom and liberty, such as those occurring in South Africa under apartheid must be met swiftly and surely with exclusion from the union.

United we stand, but only if you want. Countries can choose to break the rules that have promoted peace and prosperity for so long, but must do so of their own accord and separately of Commonwealth benefits.

There is historical precedent for this. South Africa was forced to withdraw from the Commonwealth in 1961 under growing opposition from other members to legislated discrimination based on race. The Commonwealth reopened its arms at the fall of apartheid, and South Africa was readmitted in 1994 (less than one year after the fall of apartheid).  More recently Zimbabwe was suspended for its human rights violations, ignoring the rule of law and suspension of its constitution, and the country’s government decided to formally withdraw in 2003.

Zimbabwe – when your government gets its act together and restores the conditions for peace and prosperity so cherished by the rest of us we will be waiting with open arms.

The Commonwealth has no positive obligation to set straight those countries that pursue different policies than us; who are we to decide? But not playing by our rules will not be tolerated and will be costly for belligerent countries. This is established by the final article of the Singapore Declaration, which states:

These relationships we intend to foster and extend, for we believe that our multi-national association can expand human understanding and understanding among nations, assist in the elimination of discrimination based on differences of race, colour or creed, maintain and strengthen personal liberty, contribute to the enrichment of life for all, and provide a powerful influence for peace among nations.

Coercion is rejected as a policy tool to enforce these values. Even though the Millbrook Commonwealth Action Programme does set out that Commonwealth Nations must concern themselves with other members’ internal situations, it limits repercussions to sanctions, suspensions and expulsions from the group as punishments for persistent violations to its core values.

The continued voluntary nature of the Commonwealth sets it apart from other groups, such as the European Union, and goes far in explaining why this very large and diverse grouping of countries has stood together for almost 65 years. Countries have been free to leave in that period as well as apply for admission, but the core values shared by these member states – freedom and liberty – have not been altered. We are the better for it.

And so today we remember, not just the evils and injustices of 95 years ago but of the benefits that we have today as a result. The freedom and liberty that Canadians enjoy are in no small part the result of the injustices suffered during the Great War.

Canada’s Conscription Crisis in particular was a critical albeit costly coming of age moment. The Statute of Westminster that it resulted in freed Canada and the other Dominions from forced service to a Crown it never voted for. In its place was formed a voluntary Commonwealth of Nations, joined by certain principles and rights but not irrevocably so. Countries can choose to not adhere to these principles, but the Commonwealth will have nothing to do with them if they choose this path. Despite being a stalemate for many years the Great War did accomplish much. The formation of the voluntary union of the Commonwealth might not have been so without it.

And for this, in addition to the thoughts of those who perished and their families, we remember.

Economics

Finland’s gold

On Wednesday Finland gave in to public pressure and revealed where she stores her gold reserves. The statement followed a press release by the Bank of Sweden on similar lines released on Monday.

The totals (in tonnes) for these two Scandinavian countries are as follows:

Location Sweden Finland
Bank of England 61.4 25.0
Swedish Riksbank 15.1 9.8
New York Fed 13.2 8.8
Swiss National Bank 2.8 3.4
Bank of Finland - 2.0
Bank of Canada 33.2 -
Total 125.7 49.0

So far, so good. But then the Head of Communications for the Bank of Finland added some more information in Finnish in a blog run on the Bank’s website. It is not available in English, so I asked her for a translation, but I am still waiting.

Instead, a Finnish reader of my own blog and a Finnish journalist who has been following this topic have independently given me an English translation of a highly relevant and interesting paragraph, three from the end. This is the journalist’s:

Maximum half of the gold has been within investment activity over the years. Gold has been invested among other things in deposits similar to money market deposits and using gold interest rate swaps. Gold investment activity is common for central banks. The risks associated with gold investments are controlled using limits, investment diversification and limitations concerning duration.

And my reader’s translation:

Throughout these years no more than half of the gold has been invested. Gold has been invested in for example deposits similar to money market deposits and gold interest rate swap agreements. Gold investment activities are common for central banks. Risks related to gold investments are controlled with limits, decentralising investments and limits regarding run times.

Half Finland’s gold is stored at the Bank of England, and “no more than half” is “invested”. If any “investment” is to take place it would be in London. It is not immediately clear what is meant by invested, but presumably this is a result of translation of what has happened from English into Finnish plus explanation for a non-specialist readership. However if it has been invested, then by definition it is no longer in the possession of the Bank of Finland, and will most probably have been sold into the market in return for a promise to redeliver at a later date. This follows the Austrian National Bank’s admission to a parliamentary committee a year ago that it had earned EUR300m by leasing its gold through London.

The evidence is mounting that Western central banks through the Bank of England have been feeding monetary gold into the market through leasing operations. Indeed, the Finnish blog says as much: “Gold investment activities are common for central banks”.

This explains in part how the voracious appetite for gold by China, India and South-East Asia is being satisfied, without the gold price rising to reflect this demand. It is also consistent with my disclosure earlier this year of the discrepancy of up to 1,300 tonnes between the gold in custody as recorded in the Bank of England’s Annual Report, dated 28th February 2013 and the amount recorded on the virtual tour on the Bank’s website the following June.

This article was previously published at GoldMoney.com.

Economics

Money printing: not what it was

There are lots of reasons why QE hasn’t yet created inflation in the rich West…

SO HEADLINE writers everywhere got to say money really does grow on trees today.

Gold, in fact, has been found in minute quantities in eucalyptus trees in Australia. Analyzing tree leaves and bark could now unearth gold deposits up to 30 metres below ground elsewhere in the world, geochemists say.

Good news perhaps for the mining sector. But unearthing that ore won’t be easy like picking a leaf. Making money is never cost-free. And not even money-printers are making as much profit as you might imagine right now. 

UK firm De La Rue today gave its second profits warning of the year. Weird as it sounds, there is over-capacity in note printing worldwide, it claims. That may seem hard to believe, what with quantitative easing still rolling ahead at record levels. But money printing isn’t what it used to be, even without the US Fed daring to taper its $85 billion per month. And De La Rue is lagging profit targets set back in 2010, when asset purchases with newly-minted central bank cash was hitting its stride.

De La Rue Plc is the world’s largest independent printer of banknotes. It has printed 150 different currencies over the last 5 years, and designed two-fifths of all new banknotes issued anywhere in the world since 2008. 

You might think that was (ahem) a license to print money. But volumes actually fell this year, De La Rue says, down 10% in the first half of 2013.

Surely quantitative easing means there’s more money around? Near-zero interest rates are also bringing more credit and spending to the economy, right? And what about the revival of real estate prices, most notably in UK housing but also worrying German politicians as even Berlin rents soar?

All that money, however, is electronic, not physical paper. Indeed, the central banks’ printing presses are today an “electronic equivalent” as current Fed chair Ben Bernanke put it way back in 2002. Urging the Japanese to debauch the Yen just as he’s since attacked the Dollar, Bernanke only used “printing” as analogy, however. Whereas it was paper money, not photons blinking on a bank-account balance, which fired inflation in the basket-case economy of Zimbabwe when Bernanke spoke a decade ago, and in Argentina today.

Digitized cash, in contrast, is now the real thing, as military strategist, historian and consultant Edward Luttwak noted this month in an aside on Italian gangsters. Starting in the 1990s, says Luttwak, the Calabrian family gangs pushing cocaine north into Europe as far as the new markets of the old Soviet states found their “Colombian [cocaine] suppliers refused to accept cash, because it was no good for investing in Miami real estate or local hotels or restaurants. The Calabrians needed real money: not bundles of paper but deposits in bank accounts that could be wired.”

Fact is, legitimate businesses cannot use cash. And worldwide, reckons Mastercard (with a vested interest, of course), business transactions now account for 89% of the value of payments. Consumers, meantime, are also moving away from cash (at least, outside the black economy they are; and those immoral earnings still need laundering into the “real money” of digitized bank databases in the end). As a proportion of retail transactions by number, cashless payments now make up 80% in the United States, 89% in the UK, and all but 7% in Belgium according to Mastercard. Even ignoring the plastic PR team, nearly half of UK consumer transactions are now done without cash, with currency payments sinking almost 10% by value in 2012 from the year before, according to the British Retail Consortium. The bulk of non-cash growth came from “alternative” methods, notably PayPal, with “new ways to pay and new ways to shop shaping the retail landscape like never before.”

Might this explain why consumer price inflation hasn’t taken off in the developed West? Yes, there’s lots more money around. Yes, people keep buying gold as protection. Because basic economics says this should push the general price level higher, as the value of each monetary unit is shrunk. But all this extra money sits on hard drives, servers and in the cloud, rather than in purses and wallets. That’s where money is transacted too, in intangible code. Lacking a physical presence, perhaps this wall of money loses its impact.

There are lots of other reasons you could give for why inflation hasn’t surged with the money supply. It’s all locked up in banking reserves, for instance, instead of reaching the “real” economy. Increased spending power since 2008 has gone almost entirely to the richest households, who use it to buy shares, property and fine art rather than Doritos and donuts. Or perhaps central bankers really have kept that credibility which they fought to attain after the 1970s’ inflation. Western households are now sure that the cost of living will never be let loose again.

But the birth of physical money back in ancient Greece changed our brains and our world. Coins made kings of anyone holding them, with the “universal equivalent” marking the beginning of the end of feudal society just as it created an independent yard-stick for all values – mercantile, religious and personal. This is what the myth of King Midas is about, after all.

The human brain and how it conceives of the world is being changed again by digitization today. Just ask a 20-year old (go on, ask them. Ask them anything, and see if they can answer without checking online. Ask a 45-year old come to that). Plenty of people worry that it’s all changing us for the worse, twiddling their fears about the internet by writing, of course, on the internet. Plenty of other idiots think the posthuman world will prove a new joy, with the internet’s jibber-jabber of lies, confusion and stupidity taking us back to some forgotten Eden where everyone’s views are equal. Like, y’know, in the way opinions were freely allowed to medieval peasants who couldn’t read? Today’s infotainment and readers’ comments let knowledge morph and shift just like knowledge was shared and communal pre-Gutenberg. Who needs the Enlightenment?!

Either way, perhaps our brave new digital world also revokes the iron law of money. Perhaps our flood of new cash will never end in higher living costs in the way it always has – always has – in the past. Because money we cannot touch cannot in turn touch prices as surely as paper or metal did.

Yeah right. And money really does grow on trees.

This article was previously published at BullionVault.com.

Economics

China and gold

China is now overtly pushing for the US dollar to be replaced as the world’s reserve currency.

Xinhua, China’s official press agency on Sunday ran an op-ed article which kicked off as follows:

As U.S. politicians of both political parties are still shuffling back and forth between the White House and the Capitol Hill without striking a viable deal to bring normality to the body politic they brag about, it is perhaps a good time for the befuddled world to start considering building a de-Americanized world.

China does have a broad strategy to prepare for this event. She is encouraging the creation of an international market in her own currency through the twin centres of Hong Kong and London, side-lining New York, and she is actively promoting through the Shanghai Cooperation Organisation (SCO) non-dollar trade settlement across the whole of Asia. She has also been covertly building her gold reserves while overtly encouraging her citizens to accumulate gold as well.

There can be little doubt from these actions that China is preparing herself for the demise of the dollar, at least as the world’s reserve currency. Central to insuring herself and her citizens against this outcome is gold. China has invested heavily in domestic mine production and is now the largest producer at an estimated 440 tonnes annually, and she is also looking to buy up gold mines elsewhere. Little or none of the domestically mined gold is seen in the market, so it is a reasonable assumption the Government is quietly accumulating all her own production without it becoming publicly available.

Recorded demand for gold from China’s private sector has escalated to the point where their demand now accounts for significantly more than the rest of the world’s mine production. The Shanghai Gold Exchange is the mainland monopoly for physical delivery, and Hong Kong acts as a separate interacting hub. Between them in the first eight months of 2013 they have delivered 1,730 tonnes into private hands, or an annualised rate of 2,600 tonnes.

The world ex-China mines an estimated 2,260 tonnes, leaving a supply deficit for not only the rest of gold-hungry South-east Asia and India, but the rest of the world as well. It is this fact that gives meat to the suspicion that Western central bank monetary gold is being supplied keep the price down, because ETF sales and diminishing supplies of non-Asian scrap have been wholly insufficient to satisfy this surge in demand.

So why is the Chinese Government so keen on gold? The answer most likely involves geo-politics. And here it is worth noting that through the SCO, China and Russia with the support of most of the countries in between them are building an economic bloc with a common feature: gold. It is noticeable that while the West’s financial system has been bad-mouthing gold, all the members of the SCO, including most of its prospective members, have been accumulating it. The result is a strong vein of gold throughout Asia while the West has left itself dangerously exposed.

The West selling its stocks of gold has become the biggest strategic gamble in financial history. We are committing ourselves entirely to fiat currencies, which our central banks are now having to issue in accelerating quantities. In the process China and Russia have been handed ultimate economic power on a plate.

This article was previously published at GoldMoney.com.

Economics

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 GoldMoney.com.

Economics

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.

Economics

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.

Economics

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 GoldMoney.com.

Economics

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.

Economics

Bank reform demands monetary reform – an essay for Banking 2020

This article was published yesterday at stevebaker.info.

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.