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Economics

Money, Macro & Markets

First it was the government’s miraculous ability to deliver on-target GDP growth that got the permabulls bellowing again, then it was the striking (world-beating, one might even say), 12% currency-adjusted rally in its stock market that got them triumphantly pawing the ground. Nor did the drop in interest rates serve in any way to dampen the eternal hope that China was once again deferring meaningful structural reform in the face of a threat to near-term output.

 

Quite what was actually behind the equity rally is not easy to say. There were whispers that the Russians (who else?) were piling in, now that their assets were subject to arbitrary seizure as part of Nova Roma’s vilification of their leader and proxy war against their homeland. There was also talk that the imminent linkage of the Shanghai and HK bourses was driving an arbitrage between the unusually-discounted mainland A-shares and their offshore H-share equivalents. Finally, in a typically neat piece of circular reasoning, the imminent rebound in the economy which we have even seen some brave (or foolhardy, according to preference) souls project at a startling 8.5% (sic) early next year was held to be at work to push up what was an otherwise under-owned and thus optically ‘cheap’ emerging market.

 

On the face of it, news that, over the first seven months of the year, the increase in SOE earnings had accelerated from June’s 8.9% YOY to July’s 9.2% – well up on the first quarter’s paltry 3.3% pace – may have seemed to have offered some much-needed confirmation of this optimistic thesis. However, a closer glance at the figures would not have proven quite so reassuring, had anyone bothered to actually take one.

 

Over the past, supposedly brighter three months, revenues advanced a modest 6.2% compared to the like period in 2013, though with as-reported profits up an ostensibly more creditable 12.1%. There, all grounds for positive spin, alas, were exhausted. For one, operating profits were, in fact, only up 4.0% like-for-like (a wide discrepancy which can only excite suspicion as to the nature of the headline surplus) while financing costs vaulted a fifth higher.

 

Worse still, in eking out even this degree of improvement since May, liabilities have soared by an incredible CNY2.320 trillion (around $125 billion a month) – an increment fully half as big again as that registered twelve months ago and a sum which is actually greater than the entire reported sum of ‘total social finance’ over the trimester (that latter ‘only’ managed CNY 2.240 trillion after last month’s thoroughly unexpected swoon).

 

And what did our proud commanders of the economic heights achieve for shouldering such a hefty weight of obligations? An addition to revenues of CNY719 billion (extra debt to extra ‘sales’ therefore coming in at a ratio of 3.2:1); a pick-up in ‘profit’ of CNY76 billion (d[Debt]:d[Income] = 30:1); and a blip up in operating profit of just CNY16 billion (at a truly staggering ratio of 144 to 1).

Reversing these latter relationships, we can see that while swallowing up all of the nation’s available new credit since the spring, China’s SOEs added 31 fen per one renminbi in sales, 3.3 fen in reported profit, and a bare 0.7 fen in the operating version of income. Just the sort of performance on which to base expectations of a significant coming rise in growth and prosperity!

 

Armed with such an underwhelming use of resources – both physical and financial – it is perhaps no wonder that MIIT is again trying to shut down swathes of superfluous capacity, issuing what are effectively cease-and-desist orders against 132 firms in a whole range of heavy industries – iron, steel, coke, ferroalloy, calcium carbide, aluminium, copper and lead smelting, cement, flat glass, paper, leather, printing and dyeing, chemical fibres, and lead-acid batteries. Shipbuilding may not be far behind, either, given that it formed the main topic of discussion at a meeting of the National Committee of the CPPCC this week.

 

The language used was, in some cases, pretty uncompromising, too: “Total industrial capacity in cement and plate glass is still growing, but the industry-wide sales rate is in decline and accounts receivable are increasing… there are to be no new projects in the sector for any reason,” thundered the MIIT communique.

 

This time around, given Chairman Xi’s rigorous ‘anti-corruption’ campaign, there might well be a little less of the back-sliding and wilful defiance which has greeted such edicts in the past. The emperor is no longer quite so fare away, nor the mountain quite so high, if you are a recalcitrant local cadre these days!

 

Even before this, the signs were there for those with eyes to see. Despite the much-bruited pick-up in activity, Chinese power use, excluding the residential component, SLOWED to 4.5% YOY in the three months to July from 8.1% in the preceding three months. Nor did this come without a significant deceleration in so-called ‘tertiary’ industry sector (loosely, that encompassing services and light indstry) which is henceforth supposed to be the torchbearer for growth and employment. Here, consumption dropped from the spring’s 10%-plus rates to just 7.4% YOY last month. Added buring of lights and turning of lathes in the secondary industry category – essentially manufacturing – was a tardy 4.2% even though growth in industrial production, we were told, had averaged 9.0% in that same period.

 

Hmmmm. No wonder the PMI seems to be shedding some of its recent, rather inexplicable exuberance.

 

Round and round the circle of vicious consequences swirls. As Wang Xianzheng, President of the China Coal Industry Association, admitted: ‘Currently, more than 50 percent of enterprises are in payment arrears and have delayed paying wages.’ Of 26 large companies spread across nine provinces, he revealed that 20 are making losses, only 9 are still in the black, and the remainder are hovering uneasily between (commercial) life and death.

 

Other obvious signs of distress are to be had among the loan guarantee networks which had everywhere come into being with the then-laudable aim of persuading constitutionally reluctant banks to lend to customers other than SOEs when times were good. Now trapped in flagging businesses which are more correlated than perhaps the participants had realised – and often having succumbed to the diversion of funds to less commendable ends in the interim – they are all going sour together and the same interconnectedness which was once their mainstay is proving instead a sheet anchor with which to drag them all under.

 

As Zhou Dewen, president of Zhejiang Federation of Private Enterprise Investment, told the Global Times, the rash of bankruptcies in Zhejiang and Jiangsu provinces has disrupted production and led to lay-offs, with 80% of all sour loans in the area associated with such mutual guarantee schemes. So elevated is the level of distrust, as bad debts have risen at an annualized 30% pace this year, that banks are now trying to call loans in early and obtaining court orders to freeze the assets of those firms that are unable to comply with their demands.

 

The banks themselves are beginning to accelerate write-offs dramatically – even though the official NPL ratios still look woefully understated. They are also drawing heavily upon the markets in order to bolster their capital as a precaution. As the WSJ reported, the four largest state-owned lenders have started raising a planned $73 billion in debt and equity this year – a call which is expected to jump to more than $300bn in the next five years, according to the banking regulator.

 

In addition, five local governments in the south and east of the country are setting up so-called ‘asset-management companies’ – effectively state-sponsored ‘bad banks’ – in a mirror of the system used by Zhu Rongji in the 1990s to shuffle the more toxic stuff off its originators’ balance sheets and thus allow them to continue to lend while the bitter fruits of their previous mistakes were hidden away elsewhere.

 

Though this only disguises and does not in any way alleviate the economic waste spawned by the boom, it might at least allow banks to issue new equity-like capital – perhaps to the insurers who are themselves being heavily promoted by Beijing as the next battalion of systemic saviours – at above notional book value and hence to enable them to remain a viable source of new credit. Note that the last time this was done, the losses were essentially fiscalized: banks simply swapped the bad loans on their books for what have since proven to be irredeemable – but nonetheless fully par-valued – loans to the state entities which, in turn, financed the obliging AMCs. Balance sheets will not shrink, therefore, only become sanitised, by the operation of this mechanism.

 

Here, however, is where it all gets fraught once more, because the same local governments who are being marshalled to assume the banks’ bad debts (many of them ensuing from extending credit to LGFPs) are themselves becoming desperate for funds given that all too many of their own, sure-fire investment gambits are turning out to be the dampest of damp squibs.

 

As the Economic Information Daily reported, an audit of 448 eastern township platform companies found that two-fifths of them were curently loss making, while a further thirty percent barely broke even. With these bodies so heavily dependent on land sales to generate the revenues needed to cover their current outlays, much less their ambitious capital expansion plans and ongoing debt service costs – and with such ‘sales’ only being possible in large part if the authorities extend the credit to the purchasers in the first place – a decidedly negative feedback loop has begun to tighten around their necks as the property market itself enters a slump.

 

Indeed, according to research conducted by brokerage company Centaline Property Agency, twenty major developers have between them spent CNY182.5 billion yuan so far this year to purchase new sites – a drastic 38% down on the like period last year.

 

‘Worsening property sales have undercut the willingness of developers to buy land. Their focus now is on raising cash from the sales of what they’ve already built. Few are in the mood to buy more,’ said Zhang Dawei who headed up the company’s research team.

 

In July alone, aggregate land sales revenue for 300 Chinese cities was off by a half from the same month in 2013, as reported by the China Index Academy. Sales in the four largest cities of Beijing, Shanghai, Guangzhou, and Shenzhen – normally a slam-dunk – sank by a staggering 70%.

 

‘The downturn means that the scale of land sales for the remainder of this year could continue to contract. Developers have pushed the “conservative” button,’ said Zhang with commendable understatement.

 

And quite right, too, as anecdotal evidence grows that formerly avid house-buyers are beginning to adopt that age-old American practice of ‘jingle mail’ – that is, they are simply walking away from properties they either cannot afford or do not believe will again appreciate in price.

 

At one end of the scale, one Nanjing online estate agent recorded a growing back-log of such defalcations and referred to the ‘unspeakable pain’ in the local market – an agony apparently shared in at least six other of the districts neighbouring his.

Despite the widespread belief that Chinese buyers are sitting on a typical equity cushion of 30-40% of the property value – and hence, unlike their less well-endowed US, Irish, and Spanish cousins, are impervious to all bar the most extreme events in the market – the scary truth is that much of the real estate to which they do hold title has been, how shall we say, ‘rehypothecated’ – i.e., pledged as collateral for a range of business loans as well as for the more speculative use of funds.

 

‘In the past few years, many small business owners blindly invested in real estate, mining and other industries. These industries are now suffering from overcapacity and falling asset prices, so business owners are unable to pay their debts,’ said one general manager of a Wenzhou microfinance company.

 

‘Many [of these] use the house as collateral when business loans go wrong,‘ Ge Ningbo, a county bank manager, told a journalist.

 

To get a feel for the scale of the problem, consider press reports that in Wenzhou, 1,000 homes were abandoned as a result of the decline, homes with an ostensible market value of more than Y6.4 Billion – or roughly $1 million a pop! No scrabbling rural migrants, these, but possibly members of an increasingly scrutiny–shy party apparatus! Clearly, the banks will need to suck in even more money from their gullible preference shareholders if this phenomenon starts to spread and, in the meanwhile, it is hard to see how they will be empowered to make sufficient revenue-positive new loans to keep the whirligig in motion in such a climate of confusion and disabusal.

 

Sadly, we have not finished our tale of woe there because there are also stories circulating in the official media that those same local governments, who are in many ways the lynchpins of the whole merry-go-round, may be far deeper into the mire than has been recognised to date.

 

As the articles detail, a member of the relevant NPC standing committee confided to a press contact that when hidden liabilities are taken into account alongside those uncovered in a recent audit, the true total of LG debt almost doubles to a wince-inducing Y30 trillion. Just for sheer size – some 50% of national GDP – this would be a matter of concern, but it also should not be overlooked that far too much of that monstrous total is comprised of short-term obligations against which are held long-term, illiquid, and often economically redundant ‘assets’.

 

Given that the last NAO study showed that are some 3,700 governmental bodies across various categories which had debts in excess of 100% of their local GDP, something patently needs to be done if the mad Chinese juggler is to keep his profusion of balls bobbing in the air.

 

So, welcome to local scrip issues. Yes, it seems that ingenious local cadres have dusted off their depression-era news clippings and revisited the age of the mediaeval mint and simply started using their own IOUs as media of exchange wherever their writ may run.

 

Economic Information Daily reported that in Hubei, Hunan and Guangdong, among others, government IOUs have become a ‘discount currency.’ In fact, commentary on Caijing suggests that not only are even small, rural communities now doing likewise, but that some companies, too, are paying their workers in scrip – just as in the early days of the Western factory age when resort by employers to what was called the ‘truck’ or ‘Tommy’ system was widespread.

 

As the early 19th century English radical, William Cobbett noted, ‘… when this tommy system… makes its appearance where money has for ages been the medium of exchange, and of payments for labour; when this system makes its appearance in such a state of society, there is something wrong; things are out of joint; and it becomes us to inquire into the real cause of its being resorted to…’

 

His answer? The state of economic depression brought about by the costs imposed upon entrepreneurs by the dead-weight of government:-

 

‘It is not the fault of the masters, who can have no pleasure in making profit in this way: it is the fault of the taxes, which, by lowering the [net] price of their goods, have compelled them to resort to this means of diminishing their expenses, or to quit their business altogether, which a great part of them cannot do without being left without a penny… Everything was on the decline… I was assured that shop-keepers in general did not now sell half the quantity of goods in a month that they did in that space of time four or five years ago… need we then wonder that the iron in Staffordshire has fallen, within these five years, from thirteen pounds to five pounds a ton [metal-bashers were similarly bearing the brunt, it appears]… and need we wonder that the iron-masters, who have the same rent and taxes to pay that they had to pay before, have resorted to the tommy system, in order to assist in saving themselves from ruin!’

 

‘Here is the real cause of the tommy system; and if [we wish] to put an end to it… prevail upon the Parliament to take off taxes to the amount of forty millions a year.’

 

Caijing devoted quite some space to ‘netizen’ comments on this state of affairs, several of which reflected a considerable degree of awareness that this had come about because of the unbridled spending and lavish self-indulgence of the relevant officials, while some were also aware that such an emission of fiat money was a direct parallel of the official money-creation process and further that it could only persist for so long as some minimal degree of trust resided in the councils’ ability one day to redeem the claims. Moreover, it was noted that since people ultimately expect the discount between township paper and that issued by the PBOC to widen, they were using the former preferentially to buy and sell and clinging on to the latter – a classic, Gresham’s Law example of bad money driving out good.

 

If the localities are in such dire straits as these, then it is hard to resist the temptation to believe that we are approaching some sort of end-game. But what, we should ask ourselves, might be the trigger for its no-doubt jarring denouement?

 

Well, here we come full circle with the latest act of Xi Jinping’s grand ‘anti-corruption’ drive. For, as well as Our Glorious Leader’s insistence at last week’s Leading Group get-together that everyone must ‘truly push forward reform with real guns and knives’ (ulp!), news has come out that the National Audit Commission will next conduct a full, ‘rigorous’ check of all land sales and related transactions carried out between 2008-13 and that, moreover, the results will be to hand when the top men convene for their next Plenum this coming October.

 

One can only imagine the consternation in the ranks which this announcement has unleashed. After all, there is unlikely to be overmuch evidence that any of these deals were conducted transparently, competitively, honestly, and legally, in the absence of any and all inducements, kickbacks, or displays of favouritism, not only since such was the accepted practice during the reign of Wen and Hu – especially during the infamous, no questions asked, frenzy of post-Crash stimulus – but also because this is a sphere notoriously subject to peculation in what we fondly imagine to be our more enlightened polities, too.

 

We can therefore not only expect the bodycount to rise substantially as officials fearful of censure seek to avoid their imminent disgrace and subsequent punishment, but we should also be prepared for the possibility that when this most capacious of all cylindrical metallic containers of vermiform invertebrae is opened, it will be accompanied by a blast of sufficient megatonnage to bring the whole flawed edifice crashing to the ground.

 

Under such circumstances, we find it very hard to shake off the presentiment that, on the one side, some commentators’ touching faith in an incipient re-acceleration are horribly misplaced while, on the other, the tired old ‘Goldilocks’ scenario whereby all bad news is good because it presages the launch of another round of sustained, indiscriminate ‘stimulus’ seems equally out of key with what Xi tells us he is trying to achieve.

 

 

Having dealt at such length with China, let us try and dispose of the rest of the globe in as short a space as possible.

 

Japan: Abenomics is still a horrible failure as drooping machine orders, frozen store sales, and exports back at 4 ½ year (currency-adjusted), one-quarter-from-the-peak lows reveal. So, guess what? As the PM’s approval ratings slip, another ‘stimulus’ package is said to be in the offing (sigh!)

 

Europe: Even one of Hollande’s own ministers confided to the press a couple of weeks back, ‘the truth is, he thinks we don’t have a chance’ – who are we to disagree? Meanwhile, the chap at the head of the other Sick Man, Matteo Renzi, has undergone a moment of almost Caligulan delusion, assuring supporters that the hour had come for Italy ‘to tow Europe out of the crisis’ and ‘to assume… the leadership’ of the Continent.

 

And what of his first steps to make good on such a vaunting claim? Why, in an Onion-like act of farce, to insist that ISTAT no longer releases the GDP numbers a week ahead of its peers and thereby afford underemployed analysts and commentators more opportunity to be critical of the country’s performance! And then there’s the Neocon-inspired catastrophe unfolding on the bloc’s eastern fringe from which the emergence of a bout of renewed economic difficulty is the very least of our worries.

 

USA: Chairperson Yellen is currently holding court at Jackson Hole as the US numbers continue their rebound from the winter’s retardation. What a moment for her to take the stage. Non-financials (large cap-led) are at new records, Tech at new, post-Bubble highs; junk spreads have narrowed sharply; vol has again crashed, correlations fallen, and put-call ratios evaporated. With the Bund-UST spread at a 15-year high and equities outperforming, the USD stands on the verge of a break out and up from what is already its best level in a year. The cycle is still running in favour of the States on a comparison basis, no matter how ninety-Nth percentile many of its valuations are when considered in isolation.

 

With money supply still swelling rapidly – and amid hints that it is being more actively utilised than of late—it is hard to see quite what will bring that run to an end in the near term. Were we to really be critical, one of the few clouds ‘no bigger than a man’s hand’ is that the growth of both inventories and payroll expenses are outstripping sales in the durable goods sector. Thus, while US assets are hardly ‘investible’ in the Benjamin Graham sense, they are also a tough short in the Sell’em Ben Smith one.

 

Britain: While MPC member David Miles saw fit to describe the EU as ‘dead in the water’ as a trade partner, closer to home some of the gloss is finally coming off the reputation of one of the country’s most expensive recent imports, its egregious Bank governor.

 

No doubt, dear reader, you too were shocked – shocked! – to hear local Tory Mark Field, the Honourable Member for the Cities of London and Westminster, opine to his mates in Grub Street that “…from the moment Mark Carney became governor in July 2013, it was pretty clear forward guidance was an indication rates would not rise this side of the election – for all the talk of Bank of England independence, there was a clear bargain between him and George Osborne.” Be that as it may, it is surely not too cynical to note that Fred Carney’s Army will not want to contibute to a possible defeat by Alex the Bruce’s forces in the coming Scottish independence vote.

 

You can just hear it now, that ringing oration:-

 

‘Aye, vote ‘Yes’ and interest rates may rise. Vote ‘No’ and they’ll stay as is … at least a while. And dying in your beds, many years from now, would you be willin’ to trade ALL the days, from this day to that, for one chance, just one chance, to come back here and tell our neighbours that they may take our pound and their nuclear subs, but they’ll never take… OUR FREEDOM!

 

Commodity Corner

 

Truth be told, it has not been the kindest of summers for commodities. Since reaching their late June peak, returns have suffered a 7.5% slump to touch six month lows even as US equities have added 2%. For the record, in that crumbling eight week stretch EM stocks put on 4.7%, US bonds were up 1% and junk was flat.

 

Within commodities themselves, what some commentators have been calling a ‘Garden of Eden’ summer in the US grain belt has ensured that the corn is as high as an elephant’s eye almost everywhere you look, while oilseeds and wheat have been similarly profuse. A loss of 11.3% and, in fact, the casting into jeopardy of the entire cyclical bull market in prices has been the result.

 

Energy, too, has suffered, as the record longs in oil finally began to liquidate, triggering the biggest 6-week sell-off of positions in WTI on record. IN notional value terms, net spec longs in Brent and WTI combined crashed from close to $97 billion worth of contracts to $59 billion. It is possible to read the charts to declare that this swoon has violated the uptrend in place for the last five years, as well as breaking all major MAs. Against that, we are arguably a touch oversold and the last four years’ sideways stationary, Arab Spring range remains intact. Tacticians, Faites vos jeux!

 

Dollar strength, the subsidence of financial market anxieties alluded to above, and the cessation of labour unrest in SA have hardly been conducive to higher PM prices (palladium — and Russia—excepted). Gold has also broken 200, 100, 50-day MAs and is threatening the uptrend drawn from the June 30-Dec 31 $1180 double bottom and June 3rd’s $1240 probe. Lease rates remain positive and net specs—at 43% of total O/I – as long as they have been on average throughout the last 12 years’ bull market.

 

Only Base metals seem to offer any hope (they rallied 4.2% while everything else was collapsing). Strength has partly been predicated upon what we think are decidedly ephemeral signs of a Chinese renaissance, but also on evidence of dwindling stockpiles and the litany of capex cuts and asset disposals emanating from the mining industry. They appear, therefore, to offer the least dirty shirt in the laundry basket.

Economics

Stagflation is, always and everywhere, a Keynesian phenomenon

Although it might seem odd for a school of economics to largely ignore the role of money in the economy, this is indeed the case with traditional Keynesian economics. Declaring in 1963 that, “Inflation is, always and everywhere, a monetary phenomenon,” Milton Friedman sought to place money at the centre of economics where he and his fellow Monetarists believed it belonged. Keynesian policies continued to dominate into the 1970s, however, and were blamed by the Monetarists and others for the ‘stagflation’ of that decade—weak growth with rising inflation. Today, stagflation is re-appearing, the inevitable result of the aggressive, neo-Keynesian policy responses to the 2008 global financial crisis. In this report, I discuss the causes, symptoms and financial market consequences of the new stagflation, which could well be worse than the 1970s.

 

THE GOLDEN AGE OF KEYNESIANISM

During the ‘Roaring 20s’, US economists mostly belonged to various ‘laissez faire’ or ‘liquidationist’ schools of thought, holding that economic downturns were best left to sort themselves out, with a minimal role for official intervention. President Hoover’s Treasury Secretary Andrew Mellon (in)famously represented this view following the 1929 stock market crash when he admonished the government to stay out of private affairs and allow businesses and investors to “Liquidate! Liquidate! Liquidate!”

The severity of the Depression caught much of the laissez faire crowd off guard and thus by 1936, the year John Maynard Keynes published his General Theory, there was a certain open-mindedness around what he had to say, in particular that there was a critical role for the government to play in supporting demand during economic downturns through deficit spending. (There were a handful of prominent economists who did warn that the 1920s boom was likely to turn into a big bust, including Ludwig von Mises.1)

While campaigning for president in 1932, Franklin Delano Roosevelt famously painted Herbert Hoover as a lasseiz faire president, when in fact Hoover disagreed with Mellon. As Murray Rothbard and others have demonstrated, Hoover was a highly interventionist president, setting several major precedents on which FDR would subsequently expand.2 But all is fair in politics and FDR won that election and subsequent elections in landslides.

With the onset of war and the command war economy it engendered, in the early 1940s the economics debate went silent. With the conclusion of war, it promptly restarted. Friedrich von Hayek fired an early, eloquent shot at the Keynesians in 1946 with The Road to Serfdom, his warning of the longer-term consequences of central economic planning.

The Keynesians, however, fired back, and with much new ammunition. Beginning in the early 20th century, several US government agencies, including the Federal Reserve, began to compile vast amounts of economic statistics and to create indices to aggregate macroeconomic data. This was a treasure-trove to Keynesians, who sought quantitative confirmation that their theories were correct. Sure enough, in 1947, a new, definitive Keynesian work appeared, Foundations of Economic Analysis, by Paul Samuelson, that presented statistical ‘proof’ that Keynes was right.

One of Samuelson’s core contentions was that economic officials could and should maintain full employment (ie low unemployment) through the prompt application of targeted stimulus in recessions. As recessions ended, the stimulus should be withdrawn, lest price inflation rise to a harmful level. Thus well-trained economists keeping an eye on the data and remaining promptly reactive in response to changes in key macroeconomic variables could minimise the business cycle and prevent Depression.

For government officials, Samuelson’s work was the Holy Grail. Not only was this a theoretical justification for an active government role in managing the economy, as Keynes had provided; now there was hard data to prove it and a handbook for just how to provide it. A rapid, historic expansion of public sector macroeconomics soon followed, swelling the ranks of Treasury, Commerce, Labor Department and Federal Reserve employees.

 

CHICAGO AND THE ‘FRESHWATER’ DISSENT

Notwithstanding the establishment of this new economic mainstream and a public sector that wholeheartedly embraced it, there was some dissent, in particular at the so-called ‘freshwater’ universities of the American Midwest: Chicago, Wisconsin, Minnesota and St Louis, among others.

Disagreeing with key Keynesian assumptions and also with Samuelson’s interpretation of historical data, Monetarists mounted an aggressive counterattack in the 1960s, led by Milton Friedman of the Chicago School. Thomas Sargent, co-founder of Rational Expectations Theory, also took part.

The Chicago School disagreed that there was a stable relationship between inflation and employment that could be effectively managed through fiscal policy. Rather, Friedman and his colleagues argued that Keynesians had made a grave error in largely ignoring the role of money in the economy. Together with his colleague Anna Schwarz, Friedman set out to correct this in the monumental Monetary History of the United States, which re-interpreted the Great Depression, among other major events in US economic history, as primarily a monetary- rather than demand-driven phenomenon. Thus inflation, according to Friedman and Schwarz, was “always and everywhere a monetary phenomenon,” rather than a function of fiscal policy or other demand-side developments.

By the late 1960s the dissent played a central role in escalating policy disputes, due primarily to a prolonged expansion of US fiscal policy. Following Keynesian policy guidance, the government responded to the gentle recession of the early 1960s with fiscal stimulus. However, even after the recession was over, there was a reluctance to tighten policy, for reasons both foreign and domestic. At home, President Johnson promised a ‘Great Society’: a huge expansion of various programmes supposedly intended to help the poor and otherwise disadvantaged groups. Abroad, the Vietnam War had escalated into a major conflict and, combined with other Cold War military commitments, led to a huge expansion of the defence budget.

 

DE GAULLE AND INTERNATIONAL DISSENT

In the early 1960s a handful of prescient domestic observers had already begun to warn of the increasingly inflationary course of US fiscal and monetary policy (Henry Hazlitt wrote a book about it, What Inflation Is, in 1961.) In the mid-1960s this also became an important international topic. Under the Bretton-Woods system, the US was obliged to back dollars in circulation with gold reserves and to maintain an international gold price of $35/oz. In early 1965, as scepticism mounted that the US was serious about sustaining this arrangement, French President Charles De Gaulle announced to the world that he desired a restructuring of Bretton-Woods to place gold itself, rather than the dollar, at the centre of the international monetary system.

This prominent public dissent against Bretton-Woods unleashed a series of international monetary crises, roughly one each year, culminating in President Nixon’s decision to suspend ‘temporarily’ the dollar’s convertibility into gold in August 1971. (Temporarily? That was 43 years ago this month!)

The breakdown of Bretton-Woods would not be complete until 1973, when the world moved formally to a floating-rate regime unbacked by gold. However, while currencies subsequently ‘floated’ relative to one another, they collectively sank in purchasing power. The price of gold soared, as did the price of crude oil and many other commodities.

Rather than maintain stable prices by slowing the growth rate of the money supply and raising interest rates, the US Federal Reserve fatefully facilitated the dollar’s general devaluation 

with negative real interest rates. While it took several years to build, in part because Nixon placed outright price controls on various goods, eventually the associated inflationary pressure leaked into consumer prices more generally, with the CPI rising steadily from the mid-1970s. Growth remained weak, however, as the economy struggled to restructure and rebalance. Thus before the decade was over, a new word had entered the economic lexicon: Stagflation.

 

STAGFLATION IS A KEYNESIAN PHENOMENON

Keynesians were initially mystified by this dramatic breakdown in the supposedly stable and manageable relationship between growth (or employment) and inflation. Their models said it couldn’t happen, so they looked for an explanation to deflect mounting criticism and soon found one: The economy had been hit by a ‘shock’, namely sharply higher oil prices! Never mind that the sharp rise in oil prices followed the breakdown of Bretton-Woods and devaluation of the dollar: This brazen reversal of cause and effect was too politically convenient to ignore. Politicians could blame OPEC for the stagflation, rather than their own policies. But an objective look at history tells a far different story, that the great stagflation was in fact the culmination of years of Keynesian economic policies. To generalise and to paraphrase Friedman, stagflation is, always and everywhere, a Keynesian phenomenon.

Why should this be so? Consider the relationship between real economic activity and the price level. If the supply of money is perfectly stable, then any negative ‘shock’ to the economy may reduce demand, but that will result in a decline rather than a rise in the general price level. The ‘shock’ might also increase certain prices in relative terms, but amidst stable money it simply cannot increase prices across the board, as is the case in stagflation.

They only way in which the toxic stagflationary mix of both reduced growth and rising prices can occur is if the money supply is flexible. Now this does not imply that a flexible money supply is in of itself a Keynesian policy, but deficit spending is far easier with a flexible money supply that can be increased as desired to finance the associated deficits. Yes, this then crowds out real private capital, with negative long-term consequences for economic health, but as we know, politicians are generally more concerned with the short-term and the next election.

 

CONTEMPORARY EVIDENCE OF STAGFLATION

Contemporary examples provide support for the reasoning above. It is instructive that two large economies, Japan and France, have been chronically underperforming in recent years, slipping in and out of recession. Both run chronic budget deficits in blatant Keynesian efforts to stimulate demand. In Japan, where the money supply is growing rapidly, inflation has been picking up despite weak growth: stagflation. In France, where the money supply has been quite stable, there is price stability: That is merely stagnation, not stagflation.

The UK, US and Germany have all been growing somewhat faster. Following the large devaluation of sterling in 2008, the UK experienced a multi-year surge in prices amidst weak growth, clearly a stagflationary mix. The US also now appears to be entering stagflation. Growth has been weak on average in recent quarters—outright negative in Q1 this year—yet inflation has now risen to 4% (3m annualised rate). Notwithstanding a surge in labour costs this year, the US Fed has, up to this point, dismissed this rise in CPI as ‘noise’. But then the Fed repeatedly made similar claims as CPI began to rise sharply in the mid-1970s.

In Japan, the UK and US, the stagflation is highly likely to continue as long as the current policy mix remains in place. (For all the fanfare surrounding the US Fed’s ‘tapering’, I don’t consider this terribly meaningful. Rates are still zero.) In France, absent aggressive structural reforms that may be politically impossible, the stagnation is likely to remain in place.

Germany is altogether a different story than the rest of these mature economies. While sharing the same, relatively stable euro money supply as France, the price level in Germany is also stable. However, Germany has been growing at a faster rate than most other developed economies, notwithstanding a smaller deficit. This is compelling evidence that Germany is simply a more competitive, productive economy than either the US or UK. But this is nothing new. The German economy has outperformed both the US and UK in nearly every decade since WWII. (Postwar rebuilding provided huge support in the 1950s and 1960s but those days are long past.)

The persistence of German economic outperformance through the decades clearly demonstrates the fundamental economic superiority of what is arguably the least Keynesian set of policies in the developed world. Indeed, Germans are both famed and blamed for their embrace of sound money and fiscal sustainability. ‘Famed’ because of their astonishing success; ‘blamed’ because of, well, because of their astonishing success relative to economic basket cases elsewhere in Europe and around the world. As I sometimes say in jest to those who ‘blame’ the Germans for the economic malaise elsewhere: “If only the Germans weren’t so dammed productive, we would all be better off!”

 

INVESTING FOR STAGFLATION

Stagflation is a hostile environment for investors. As discussed above, Keynesian policies require that the public sector siphon off resources from the private sector, thereby reducing the ability of private agents to generate economic profits. So-called ‘financial repression’, a more overt seizure of private resources by the public sector, is by design and intent hostile for investors. Regardless of how you choose to think about it, stagflation reveals previously unseen resource misallocations. As these become apparent, investors adjust financial asset prices accordingly. (Perhaps this is now getting under way. The Dow fell over 300 points yesterday.)

The most recent historical period of prolonged stagflation was the 1970s, although there have been briefer episodes since in various countries. Focusing here on the US, although there was a large stock market decline in 1973-4, the market subsequently recovered these losses and then roughly doubled in value. The bond market, by contrast, held up during the first half of the decade but, as stagnation gradually turned into stagflation, bonds sold off and were sharply outperformed by stocks.

That should be no surprise, as inflation erodes the nominally fixed value of bonds. Stock prices, however, can rise along with the general price level along as corporate revenues and profits also rise. It would seem safe to conclude, therefore, that in the event stagflationary conditions intensify from here, stocks will outperform bonds.

While that might be a safe conclusion, it is not a terribly helpful one. Sure, stocks might be able to outperform bonds in stagflation but, when adjusted for the inflation, in real terms they can still lose value. Indeed, in the 1970s, stock market valuations failed to keep pace with the accelerating inflation. Cash, in other words, was the better ‘investment’ option and, naturally, a far less volatile one.

Best of all, however, would have been to avoid financial assets and cash altogether and instead to accumulate real assets, such as gold and oil. (Legendary investors John Exter and John van Eck did precisely this.) The chart below shows the total returns of all of the above and the relative performance of stocks, bonds and cash appears irrelevant when compared to the soaring prices of gold and oil, both of which rose roughly tenfold.

 

REAL VS NOMINAL ASSETS IN STAGFLATION

(Jan 1971 = 100)

Real vs Nominal Assets in Stagflation

Source: Bloomberg; Amphora

Some readers might be sceptical that, from their current starting point, gold, oil or other commodity 

prices could rise tenfold in price from here. Oil at $100/bbl sounds expensive to those (such as I) who remember the many years when oil fluctuated around $20. Gold at $1,300 also seems expensive compared to the sub-$300 price fetched by UK Chancellor Brown in the early 2000s. In both cases, prices have risen by a factor of 4-5x. Note that this is the rough order of magnitude that gold and oil rose into the mid-1970s. But it was not until the late 1970s that both really took off, leaving financial assets far behind.

If anything, a persuasive case can be made that the potential for gold, oil and other commodity prices to outperform stocks and bonds is higher today than it was in the mid-1970s. Monetary policies around the world are generally more expansionary. Government debt burdens and deficits are far larger. If Keynesian policies caused the 1970s stagflation, then the steroid injection of aggressive Keynesian policies post-2008 should eventually result in something even more spectacular.

While overweighting commodities can be an effective, defensive investment strategy for a stagflationary future, it is important to consider how best to implement this. Here at Amphora, we provide investors with an advisory service for constructing commodity portfolios. Most benchmark commodity indices and the ETFs tracking them are not well designed as investment vehicles for a variety of reasons. In particular, they do not provide for efficient diversification and their weightings are not well-specified to a stagflationary environment. With a few tweaks, however, these disadvantages can be remedied, enabling a commodity portfolio to produce the desired results.

 

CURRENT COMMODITY OPPORTUNITIES

For those inclined to trade commodities actively, and relative to each other, there are an unusual number of opportunities at present. First, grains are now unusually cheap, especially corn. This is understandable given current global weather patterns supportive of high yields, but beyond a certain point producers are fully hedged and/or are considering withholding some production to sell once prices recover. That point is likely now close.

Second, taking a look at tropical products, cotton has resumed the sharp slide that began earlier this year. As is the case with grains, we are likely nearing the point where producer hedging and/or holding out for higher prices will support the price. By contrast, cocoa prices continue their rise and I note that several major chocolate manufacturers have recently increased prices sharply to maintain margins. That is a classic indication that prices are near a peak.

Third, livestock remains expensive. Hog prices have finally begun to correct lower but cattle prices are at record highs. There are major herd supply issues that are not easily resolved in the near-term but consumers are highly price sensitive in the current environment and substitution into pork or poultry products is almost certainly now taking place around the margins. Left to run for awhile, this is likely to place a lid on cattle prices, although I do expect them to remain elevated for a sustained period until herds have had a chance to re-build.

Fourth, following a brief correction lower several weeks ago, palladium prices have risen back near to their previous highs of just under $900/oz. Palladium now appears expensive relative to near-substitute platinum; to precious and base metals generally; and relative to industrial commodities. The primary source of demand, autocatalysts, has remained strong due to auto production, but recent reports of rising unsold dealer inventory in a handful of major countries, including the US, may soon weaken demand. In the event that the fastest growing major auto markets—the BRICS—begin to slow, then a sharp decline in palladium to under $700 is likely.

Finally, a quick word on silver and gold. While both have tremendous potential to rise in a stagflationary environment, it is worth noting that, following a three-year correction, they appear to have found long-term support. Thus I believe there is both near-term and well as longer-term potential and I would once again recommend overweighting both vs industrial commodities.

1Von Mises not only warned of a financial crash and severe economic downturn in 1929; he refused the offer of a prominent position at the largest Austrian bank, Kreditanstalt, around the same time, not wanting to be associated with what he correctly anticipated would soon unfold. A Wall Street Journal article discussing this period in von Mises’ life is linked here.

2A classic revisionist view is that of Murray Rothbard, AMERICAS GREAT DEPRESSION. More recent scholarship by Lee Ohanian has added much additional detail to Rothbard’s work. I briefly touch on this subject in my book and also in a previous Amphora Report, THE RIME OF THE CENTRAL BANKER, linked here.

 

 

Economics

Time for change in the London bullion market

[Editor’s note: The Cobden Centre is happy to republish this commentary by Alasdair Macleod, the original can be found here.]

 

The London bullion market is an over-the-counter unregulated market and has had this status since the mid-1980s. The disadvantage of an OTC market being unregulated is that change often ends up being driven by a cartel of members promoting their own vested interests. Sadly, this has meant London has not kept pace with developments in market standards elsewhere.

 

The current row is focused on the twice-daily gold fix. The fix has been giving daily reference prices for gold since 1919, useful in the past when dealing was unrecorded and over-the-counter by telephone. The London gold fix could be described as an antiquated deal-based version of the LIBOR fix that has itself been discredited.

 

It was with this in mind that the House of Commons Treasury Committee called witnesses before it to give evidence on the matter on 2nd July. This dramatically exposed the inconsistences in the current situation, and was summed up by the Chairman Andrew Tyrie as follows: “Is there any reason we should not be treating this as an appalling story?”

 

These were strong words and his question remains hanging over the heads of all involved. It would be a mistake to think the Financial Conduct Authority which was given a rough ride by the Committee can ignore this “appalling story”. The FCA will almost certainly seek significant reforms, and reform means greater market transparency and no fix procedure that does not comply with IOSCO’s nineteen principles.

 

The current fix is thought to comply with only four of them, which is a measure of how things have moved on while the London bullion market has stood still. London effectively remains a cartel between bullion banks and the Bank of England (BoE). It has worked well for London in the past, because the BoE has used its position as the principal custodian of central bank gold to enhance liquidity. And when bailouts are required, the Bank has provided them behind closed doors.

 

The world has moved on. IOSCO has provided a standard for behaviour not just to cherry-pick, but as a minimum for credibility. China, which we routinely deride for the quality of official information, has a fully functioning gold bullion market which provides turnover and delivery statistics, as well as trade by the ten largest participants by both volume and bar sizes. China has also tied up mine output in Asia, Australia and Africa which now bypasses London completely. Dubai also has ambitions to become a major physical market, being in the centre of middle-eastern bullion stockpiles and with strong links into the Indian market.

 

Even Singapore sees itself servicing South East Asia and becoming a global centre. These realities are reflected in the 995 LBMA 400oz bar being outdated and being replaced by a new Asian 1kg 9999 standard, with refiners working overtime to affect the transition. London cannot possibly meet these global challenges without major reform.

 

Central banks are now net buyers of bullion, withdrawing liquidity from the London market instead of adding to it. With the FCA as one of its new responsibilities, the ability of the BoE to act as ringmaster in the LBMA is changing from an interventionist to a regulatory role. If it is to retain the physical gold business, London’s standards, on which users’ trust is ultimately based, must be of the highest order with the maximum levels of information disclosure.

Economics

Signs Of The Gold Standard Emerging From Great Britain?

Comes now to respectful international attention a volume entitled War and Gold: A 500-Year History of Empires, Adventures, and Debt by Member of Parliament Kwasi Kwarteng.  This near-perfect volume appears with almost preternaturally perfect timing around the centenary of the beginning of World War I and, with that, the end of the classical gold standard.  It, along with the work of Steve Baker, MP (co-founder of the Cobden Centre), constitutes a sign of sophistication about the gold standard in the British House of Commons.

Kwarteng, the most historically literary Member of Parliament since Churchill, is an impressive figure.  As War and Gold‘s jacket flap biography summarizes, “Kwasi Kwarteng was born in London to Ghanaian parents in 1975.  …  After completing a PhD in history at Cambridge University, he worked as a financial analyst in London.  He is a Conservative member of parliament and author of Ghosts of Empire: Britain’s Legacies in the Modern World.”  Kwarteng thus possesses four crucial skill sets: an international, multicultural, perspective; rigorous training as an historian; direct experience in the financial markets; and the perspective of an elected legislator.  It shows.

Kwasi Kwarteng MP at Global Growth: Challenge ...
Kwasi Kwarteng MP at Global Growth: Challenge or opportunity for the UK (Photo credit: Policy Exchange)

War and Gold is a compelling successor to Liaquat Ahamed’s delightful and invaluable The Lords of Finance, awarded the 2010 Pulitzer Prize in history. Kwarteng delivers up a successor volume worthy of such a prize.  It extends Ahamed’s temporal framework by a factor of ten, to 500 years. Kwarteng, too, has compelling narrative virtuosity.  His book is full of  dramatic, charming, often wry vignettes of fascinating characters — heroes and villains, adventurers and knaves — spinning around, and off, the axis of the gold standard, in war and in peace.

Let us pause to pay tribute to Kwarteng’s Ghanian ancestry.  Ghana, once known as the “Gold Coast,” was part of the Ashanti Empire. Ghana is a too-often overlooked gem of civilization.   The most iconic piece of Ashanti regalia, as described by Wikipedia, was a Golden Stool:

The Golden Stool is sacred to the Ashanti, as it is believed that it contains the Sunsum viz, the spirit or soul of the Ashanti people. Just as man cannot live without a soul, so the Ashanti would cease to exist if the Golden Stool were to be taken from them. The Golden Stool is regarded as sacred that not even the king was allowed to sit on it, a symbol of nationhood and unity.

War and Gold provides a literary symphony in four movements.

Its first movement commences with the story of the Holy Roman Emperor whose wars bankrupted his empire.  This is counterpoised with stories of rapacious Conquistadors, especially Pizzaro plundering the Inca for their gold, “the sweat of the sun,” and silver, “the tears of the moon.”

Kwarteng thereupon moves smartly to the military, political and economic skirmishing between France and England; the upheavals produced by the American and French revolutions and their aftermaths; the prosperity and stability of the Victorian era… and the rise of the United States.  Many of our economic challenges have a long pedigree.  The fundamental things don’t change as times goes by.

Its second movement, describing the epic era of the first World War, notes that this war destroyed the classical international gold standard.  Chapter 9, “World Crisis,” contains the only significant point of confusion in this otherwise masterful work: the attribution to the gold standard of the Great Depression.  That error is widespread.  It is a crucial mistake to dispel for the discourse to move forward.  Call it the Eichengreen Fallacy.

Prof. Eichengreen, author of Golden Fetters, was and remains non-cognizant of a subtle but crucial aspect of world monetary history — and, apparently, of the works of Profs. Jacques Rueff and Robert Triffin elucidating the implications.  Eichengreen blundered by attributing the Great Depression to the gold standard.  This, demonstrably, is untrue. That claim has led the discourse astray.

The classical gold standard, as Kwarteng points out, collapsed under the pressure of the first World War, long before the Great Depression.  The classical gold standard was suspended when the Depression hit.

An attempt was made to resuscitate the gold standard in Genoa, in 1922, putting in place what that great French classical liberal economist Jacques Rueff called “a grotesque caricature” of the gold standard: the gold-exchange standard.  Genoa authorized a deformed pastiche of gold and paper currency as official central bank reserve assets.

Genoa set up a system mistaken (then as now) as equivalent to the classical gold standard.  The inclusion of (gold-convertible) currencies as an official reserve asset for central banks thwarted the ability of the system to extinguish excess liquidity balances. This, due to an intrinsic moral hazard not fully grasped even by many gold standard proponents, led to a systemic inflation — increasing all commodities except, of course, as monetized, gold.  Key classical gold standard advocates, such as Rueff protégé Lewis E. Lehrman (with whose Institute this writer has a professional association), consider this the key cause of the Great Depression.

FDR did not, despite his grandiose declaration to that effect, end the gold standard.  FDR performed an appropriate and crucial revaluation of the dollar from $20.67/oz to $35/oz.  This was utterly needed to adjust for distortions caused by the inherent defect of the gold-exchange standard.

The revaluation worked and to stunning (if temporary, likely due to a subsequent Treasury decision to sterilize gold inflows as suggested by Calomiris, et al) effect.  As described by Ahamed:

But in the days after the Roosevelt decision, as the dollar fell against gold, the stock market soared by 15%.  Even the Morgan bankers, historically among the most staunch defenders of the gold standard, could not resist cheering.  ‘Your action in going off gold saved the country from complete collapse,’ wrote Russell Leffingwell to the president.

Taking the dollar off gold provided the second leg to the dramatic change in sentiment… that coursed through the economy that spring. … During the following three months, wholesale prices jumped by 45 percent and stock prices doubled.  With prices rising, the real cost of borrowing money plummeted. New orders for heavy machinery soared by 100 percent, auto sales doubled, and overall industrial production shot up 50 percent.

The dollar had not, in fact, been taken “off gold.”  As Kwarteng astutely notes, “The United States, as already stated, was still on gold, but it had devalued the dollar by over 50 per cent.”

Given Kwarteng’s current and, likely, future importance to the world monetary discourse it really would be invaluable were he to master the arguments of Jacques Rueff, and of Lewis Lehrman, as well as those of Triffin (who shared the same diagnosis while offering a different prescription).  It is important, for the long run, to recognize the innocence of the classical gold standard in the matter of the Great Depression and to grasp the insidious toxicity of the gold-exchange standard, which Rueff termed “an unbelievable collective mistake which, when people become aware of it, will be viewed by history as an object of astonishment and scandal.”

War and Gold’s third movement opens with America at its apogee:  “In 1945 the United States was by far the most powerful nation on earth.  It could also be argued that no nation has ever enjoyed such preponderant influence on the world’s affairs as did as the U.S. did at the close of the Second World War.”

Kwarteng then provides a vivid picture of an era in some ways nearly as distant as the 16th century. Quoting from a 1947 article in the Journal of Political Economy: “Some people are thinking in terms of only 18 or 20 billion dollars [of federal government spending] per year.  Others see a possibility that federal expenditures may run to 25 or 40 billions annually.” Uncle Sam lately spends over $10 billion per day.  While this sum is not adjusted for inflation or population growth, still it conveys a stunning difference of scale of government spending.

It is a pleasure to see the great Fed chairman William McChesney Martin given his due.  Kwarteng references a speech by the newly appointed Martin alluding to “the Frankenstein mechanics of an uncontrolled supply of money.”  If Frankenstein’s monster was an apt metaphor in the 1950s, surely Godzilla better fits the bill today.  “To be a sound money man was a moderately easy task for a Chairman of the Federal Reserve in the 1950s,” Kwarteng notes.  “The dollar, through the Bretton Woods Agreement, had preserved the all-important link to gold, which still held the almost magical value of US$35 an ounce.”

Kwarteng then presents a lucid presentation of post-war economic policies of Britain, Germany, and Japan.  This columnist took special pleasure in his resurrection of the role of unjustly obscure Joseph Dodge, a key architect of the resurrection of both Germany and Japan and who later balanced the budget of the Eisenhower administration.

Looping back to the United States, Kwarteng describes what might fairly be called the Götterdämmerung:

The final break with gold was dramatic and, as much as any other development of monetary system, can almost be entirely attributable to the action of one man, the President of the United States, Richard M. Nixon.  It was Nixon’s decision in August 1971 which substantially altered the course of monetary history and inaugurated a period, for the first time in 2,500 years, in which gold was effectively demonetized in most of what had been understood to be the Western world.

The world goes fast downhill from there.

The fourth movement delineates the chaos of, and various attempts to cope with, our current era of monetary anarchy.  He recounts the oil price shocks, Reagan and Thatcher, the creation of the Euro, the rise of China, the delusions of debt, and the emergence of crises and bailouts. He goes on to provide an epilogue on the Greek economic crisis and on precarious conditions in America. Kwarteng concludes:

Gold itself…remains embedded in the public’s consciousness as a monetary metal.  It is held most commonly by central banks and there remains an almost mysterious fixation with it.  Its value equally mysteriously can be reflected in the growth of the world economy. … [T]he value of gold, better than perhaps any currency, reflects this process most accurately.  The gold standard will never formally return, but movements in the price of gold may well suggest that investors, in their lack of faith in paper money, have informally adopted one.

Great Britain, and the world, hardly could be better served than by, in due course, elevating Kwarteng to the Exchequer. Notwithstanding his curious demurral that the “gold standard will never formally return,” gold, recovering from the false charge of blame for the Great Depression, slowly is becoming a fully respectable option.  Perhaps even, in the not too distant future, a movement to consider, and restore, the classical gold standard might be led by Kwasi Kwarteng and like-minded classical liberal-minded officials around the world.

Economics

Text of “The Death of French Savings, the Russian Bonds Story 1880-1996″

The following text is from the notes I made of a talk that I gave to the “End of The World Club” at the Institute of Economic Affairs on 18 April 2014.

If there is one feature of human society that makes it successful, it is the capacity that human beings have of choosing to satisfy short-term appetites or to defer gratification. This ability to distinguish between short term and long term interests is at the heart of economics.
Russian-bond-certificate-fr
But why defer consumption? Why save at all?

One reason is the transmission of wealth from one generation to the next. Another is to ensure security in hard times.

A complaint of American academics about French savings in the 19th century is that they were too conservative. Easy for them to say.

The population of France grew more slowly than any other industrialising nation in the 19th century (0.2% per year from 1870 to 1913, compared with 1.1% for Germany and 0.9% for Great Britain). The figures would be even worse if emigration from the British Isles were added to the headcount.

This slower rate of population growth would tend to mean a slower rate of economic growth: smaller local markets, fewer opportunities for mass production. This was well known to be a problem in France. In fact Jean-Baptiste Say was sent to England in 1815 to study the growth of English cities such as Birmingham and its effect on the economy (here in French).

The causes of low investment must surely include political and social instability.

Here are the changes of regime in France during the 19th century:
1800-1804: The Consulate
1804-1814: The Empire
1814: The First Restoration
1814-1815: The Return of Napoleon
1815-1830: The Return of the Restoration
1830-1848: The British Experiment
1848-1851: The Second Republic
1851-1852: The military coup-d’état
1852-1859: The Empire Strikes Back
1860-1870: The Free Trade Experiment (supported by Richard Cobden)
1870-1871: Three sieges of Paris, two civil wars, one foreign occupation
1870-1879: The State Which Dare Not Speak Its Name (retrospectively declared to be a republic)
1879-1914: La Belle Epoque (including the anarchist bombings 1892-1894 and the Dreyfus Affair 1894-1906)

If instability discourages savings, it is remarkable how much there actually was.

Five billion francs in gold, raised by public subscription to pay for the German army of occupation to leave France after the Franco-Prussian War. The amount was supposed to be impossible to pay and designed to provide an excuse for a prolonged German occupation. It was paid in full in two years. 80% of the money (equivalent to over two and half times the national government’s total annual spending, was raised in one day).

What the modern academics decried was that these sorts of sums weren’t invested in industry or agricultural technology. In 1880, French private investments amounted to 7.3 billion Francs, but this was less than half of all investments (48%), versus 52% for government bonds.

You can’t pick up your factory machines and run away from the Uhlans, or the Communards.
Gold was one preferred wealth storage option. It still is in France.

Government bonds were generally considered a good deal: backed by the power of taxation, and, unlike gold, they earned interest.

One constant concern of French governments in the 19th century was the diplomatic isolation enforced by the 1815 Congress of Vienna. Various attempts were made to break this, some successful like the split of Belgium from the Netherlands in 1830, the Crimean War (co-operation with the British), others failed (Napoleon III’s Mexican adventure, the Franco-Prussian War).

By 1882, Germany looked like getting economic and military supremacy in Europe, with an Triple Alliance with Austria-Hungary and Italy. With the British playing neutral, the best bet was to build up Russia.

The first Russian bonds sold in France were in 1867 to finance a railroad. Others followed, notably in 1888. At this point the French government decided on a policy of alliance with Russia and the encouragement of French savers to invest in Russian infrastructure. From 1887 to 1913, 3.5% of the French Gross National Product is invested in Russia alone. This amounted to a quarter of all foreign investment by French private citizens. That’s a savings ratio (14% in external investment alone) we wouldn’t mind seeing in the UK today!

A massive media campaign promoting Russia as a future economic giant (a bit like China in recent years) was pushed by politicians. Meanwhile French banks found they could make enormous amounts of commission from Russian bonds: in this period, the Credit Lyonnais makes 30% of its profits from it’s commission for selling the bonds.

In 1897, the ruble is linked to gold. The French government guarantees its citizens against any default. The Paris Stock Exchange takes listings for, among others: Banque russo-asiatique, la Banque de commerce de Sibérie, les usines Stoll, les Wagons de Petrograd.

The first signs of trouble come in 1905, with the post-Russo-Japanese War revolution. A provisional government announced a default of foreign bonds, but this isn’t reported in the French mainstream media or the French banks that continue to sell (mis-sell?).

During the First World War, the French government issued zero interest bonds to cover the Russian government’s loan repayment, with an agreement to sort out the problem after the war. However, in December 1917, Lenin announced the repudiation of Tsarist debts.

The gold standard was abolished, allowing the debasement of the currency, private citizens were required to turn over their gold for government bonds.

Income tax was introduced (with a top rate of 2%) after the assassination in Sarajevo of the Archduke Ferdinand and his wife.

In 1923, a French parliamentary commission established that 9 billion Francs had effectively been stolen from French savers in the Russian bonds affair. Bribes had been paid to bankers and news outlets to promote the impression of massive economic growth in Russia. Many of the later bonds were merely issued to repay the interest on earlier debt.
Russian-Bond-terms-English
For the next 70 years, protest groups attempted to obtain compensation, either from the Russian government or from the French government that had provided “guarantees”. You won’t be surprised to know that some banks managed to sell their bonds to private investors after 1917, having spread false rumours that the Soviets would honour the bonds.

Successive French governments found themselves caught between the requirements of “normal” relations with the USSR and the clamour of dispossessed savers and their relatives.

In November 1996, the post-Soviet Yelstin government agreed a deal to settle the Russian bonds for $400 million. The deal covered less than 10% of the families demanding compensation. Despite this, 316,000 people are thought to have received some compensation, suggesting that over 3 million families were affected by the Russian bonds scandal.

There are similarities with the present day but also significant differences.

First, the role of government guarantees and links with favoured banks, ensuring savers were complacent.

Second the manipulation of economic data by the Russian government, which looks a lot like what’s been happening in China.

Third the fragility of the situation: war can break out. All sorts of assumptions we can make about safe investments go out of the window.

One specifically French response to all this is something I would like to see an academic study of. What changes to consumption and savings would follow from growing up in a family where savings have been wiped out by government action (Russian or one’s own)? If three million people were directly involved, most French people would have known someone who had deferred consumption and been robbed. To what extent does the post-1945 explosion in mass consumption in France reflect a view that deferring consumption is foolish when savings can be stolen with the connivance or lack of concern of one’s own government?

Book Reviews

Paper Money Collapse 2nd edition teaser

One of the interesting things that happened at the End of the World Club on Monday evening, was a teaser of what’s new about Detlev Schlichter‘s Paper Money Collapse (2nd edition). We are promised some discussion about Bitcoin (which really got going about the time PMC first appeared on bookshelves).

Also promised is an update of Detlev’s views and he hopes to include discussions that have taken place in various forums (such as on his blog).

Further updates as we get them.
9781118877326.pdf

 

 

Economics

Madness!

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

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

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

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

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

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

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

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

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

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

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

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

The Daily Telegraph, 8 April 2014.

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

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

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

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

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

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

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

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

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

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

Doug Noland again:

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

Book Reviews

‘The system has spun out of control’

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Events

Bitcoin entrepreneurs meet in Paris this week

I’m open-minded about Bitcoin and digital currencies in general. Which is to say I want 10 million people to use it for 10 years before I consider it a store of value.

Events like Paris Bitcoin Startups On Wednesday 16th April reinforce my attentisme or ‘wait-and-see’ policy.

On the one hand, if the digital currency can overcome French bureaucratic hostility and prosper there, that speeds up my adoption date.

On the other hand, it looks a lot like venture capitalists playing with ‘out-of-the-box’ business ideas. Exciting, but not safe. For now, gold wins.

Economics

Renewed estimates of Chinese gold demand

Editor’s note: This article was previously published here at Goldmoney.com. It is republished with thanks.

Geopolitical and market background

I have been revisiting estimates of the quantities of gold being absorbed by China, and yet again I have had to revise them upwards. Analysis of the detail discovered in historic information in the context of China’s gold strategy has allowed me for the first time to make reasonable estimates of vaulted gold, comprised of gold accounts at commercial banks, mine output and scrap. There is also compelling evidence mine output and scrap are being accumulated by the government in its own vaults, and not being delivered to satisfy public demand.

The impact of these revelations on estimates of total identified demand and the drain on bullion stocks from outside China is likely to be dramatic, but confirms what some of us have suspected but been unable to prove. Western analysts have always lagged in their understanding of Chinese demand and there is now evidence China is deliberately concealing the scale of it from us. Instead, China is happy to let us accept the lower estimates of western analysts, which by identifying gold demand from the retail end of the supply chain give significantly lower figures.

Before 2012 the Shanghai Gold Exchange was keen to advertise its ambitions to become a major gold trading hub. This is no longer the case. The last SGE Annual Report in English was for 2010, and the last Gold Market Report was for 2011. 2013 was a watershed year. Following the Cyprus debacle, western central banks, seemingly unaware of latent Chinese demand embarked on a policy of supplying large quantities of bullion to break the bull market and suppress the price. The resulting expansion in both global and Chinese demand was so rapid that analysts in western capital markets have been caught unawares.

I started following China’s gold strategy over two years ago and was more or less on my own, having been tipped off by a contact that the Chinese government had already accumulated large amounts of gold before actively promoting gold ownership for private individuals. I took the view that the Chinese government acted for good reasons and that it is a mistake to ignore their actions, particularly when gold is involved.

Since then, Koos Jansen of ingoldwetrust.ch has taken a specialised interest in the SGE and Hong Kong’s trade statistics, and his dedication to the issue has helped spread interest and knowledge in the subject. He has been particularly successful in broadcasting market statistics published in Chinese to a western audience, overcoming the lack of information available in English.

I believe that China is well on the way to having gained control of the international gold market, thanks to western central banks suppression of the gold price, which accelerated last year. The basic reasons behind China’s policy are entirely logical:

  • China knew at the outset that gold is the west’s weak spot, with actual monetary reserves massively overstated. For all I know their intelligence services may have had an accurate assessment of how much gold there is left in western vaults, and if they had not, their allies, the Russians, probably did. Representatives of the People’s Bank of China will have attended meetings at the Bank for International Settlements where these issues are presumably openly discussed by central bankers.
  • China has significant currency surpluses under US control. By controlling the gold market China can flip value from US Treasuries into gold as and when it wishes. This gives China ultimate financial leverage over the west if required.
  • By encouraging its population to invest in gold China reduces the need to acquire dollars to control the renminbi/dollar rate. Put another way, gold purchases by the public have helped absorb her trade surplus. Furthermore gold ownership insulates her middle classes from external currency instability which has become an increasing concern since the Lehman crisis.

For its geopolitical strategy to work China must accumulate large quantities of bullion. To this end China has encouraged mine production, making the country the largest producer in the world. It must also have control over the global market for physical gold, and by rapidly developing the SGE and its sister the Shanghai Gold Futures Exchange the groundwork has been completed. If western markets, starved of physical metal, are forced at a future date to declare force majeure when settlements fail, the SGE and SGFE will be in a position to become the world’s market for gold. Interestingly, Arab holders have recently been recasting some of their old gold holdings from the LBMA’s 400 ounce 995 standard into the Chinese one kilo 9999 standard, which insures them against this potential risk.

China appears in a few years to have achieved dominance of the physical gold market. Since January 2008 turnover on the SGE has increased from a quarterly average of 362 tonnes per month to 1,100 tonnes, and deliveries from 44 tonnes per month to 212 tonnes. It is noticeable how activity increased rapidly from April 2013, in the wake of the dramatic fall in the gold price. From January 2008, the SGE has delivered from its vaults into public hands a total of 6,776 tonnes. This is illustrated in the chart below.

This is only part of the story, the part that is in the public domain. In addition there is gold imported through Hong Kong and fabricated for the Chinese retail market bypassing the SGE, changes of stock levels within the SGE’s network of vaults, the destination of domestic mine output and scrap, government purchases of gold in London and elsewhere, and purchases stored abroad by the wealthy. Furthermore the Chinese diaspora throughout South East Asia competes with China for global gold stocks, and its demand is in addition to that of China’s Mainland and Hong Kong.

The Shanghai Gold Exchange (SGE)

The SGE, which is the government-owned and controlled gold exchange monopoly, runs a vaulting system with which westerners will be familiar. Gold in the vaults is fungible, but when it leaves the SGE’s vaults it is no longer so, and in order to re-enter them it is treated as scrap and recast. In 2011 there were 49 vaults in the SGE’s system, and bars and ingots are supplied to SGE specifications by a number of foreign and Chinese refiners. Besides commercial banks, SGE members include refiners, jewellery manufacturers, mines, and investment companies. The SGE’s 2010 Annual Report, the last published in English, states there were 25 commercial banks included in 163 members of the exchange, 6,751 institutional clients accounting for 81% of gold traded, and 1,778,500 clients of the commercial banks with gold accounts. The 2011 Gold Report, the most recent available, stated that the number of commercial bank members had increased to 29 with 2,353,600 clients, and given the rapid expansion of demand since, the number of gold account holders is likely to be considerably greater today.

About 75% of the SGE’s gold turnover is for forward settlement and the balance is for spot delivery. Standard bars are Au99.95 3 kilos (roughly 100 ounces), Au99.99 1 kilo, Au100g and Au50g. The institutional standard has become Au99.99 1 kilo bars, most of which are sourced from Swiss refiners, with the old Au99.95 standard less than 15% of turnover today compared with 65% five years ago. The smaller 100g and 50g bars are generally for retail demand and a very small proportion of the total traded. Public demand for smaller bars is satisfied mainly through branded products provided by commercial banks and other retail entities instead of from SGE-authorised refiners.

Overall volumes on the SGE are a tiny fraction of those recorded in London, and the market is relatively illiquid, so much so that opportunities for price arbitrage are often apparent rather than real. The obvious difference between the two markets is the large amounts of gold delivered to China’s public. This has fuelled the rapid growth of the Chinese market leading to a parallel increase in vaulted bullion stocks, which for 2013 is likely to have been substantial.

By way of contrast the LBMA is not a regulated market but is overseen by the Bank of England, while the SGE is both controlled and regulated by the People’s Bank of China. The PBOC is also a member of both its own exchange and of the LBMA, and deals actively in non-monetary gold. While the LBMA is at arm’s length from the BoE, the SGE is effectively a department of the PBOC. This allows the Chinese government to control the gold market for its own strategic objectives.

Quantifying demand

Identifiable demand is the sum of deliveries to the public withdrawn from SGE vaults, plus the residual gold left in Hong Kong, being the net balance between imports and exports. To this total must be added an estimate of changes in vaulted bullion stocks.

SGE gold deliveries

Gold deliveries from SGE vaults to the general public are listed both weekly and monthly in Chinese. The following chart shows how they have grown on a monthly basis.

Growth in public demand for physical gold is a reflection of the increased wealth and savings of Chinese citizens, and also reflects advertising campaigns that have encouraged ordinary people to invest in gold. Advertising the attractions of gold investment is consistent with a deliberate government policy of absorbing as much gold as possible from western vaults, including those of central banks.

Hong Kong

Hong Kong provides import, export and re-export figures for gold. All gold is imported, exports refer to gold that has been materially altered in form, and re-exports are of gold transited more or less unaltered. Thus, exports refer mainly to jewellery which in China’s case is sold directly into the Mainland without going through the SGE, and re-exports refer to gold in bar form which we can assume is delivered to the SGE. Some imported gold remains on the island, and some is re-exported from China back to Hong Kong. This gold is either vaulted in Hong Kong or alternatively turned into jewellery and sold mostly to visitors from the Mainland buying tax-free gold.

The mainstream media has reported on the large quantities of gold flowing from Switzerland to Hong Kong, but this is only part of the story. In 2013, Hong Kong imported 916 tonnes from Switzerland, 190 tonnes from the US, 176 tonnes from Australia and 150 tonnes from South Africa as well as significant tonnages from eight other countries, including the UK. She also imported 337 tonnes from Mainland China and exported 211 tonnes of it back to China as fabricated gold.

Hong Kong is not the sole entry port for gold destined for the Mainland. The table below illustrates how Hong Kong’s gold trade with China has grown, and its purpose is to identify gold additional to that supplied via Hong Kong to the SGE. Included in the bottom line, but not separately itemised, is fabricated gold trade with China (both ways), as well as the balance of all imports and exports accruing to Hong Kong.

The bottom line, “Additional supply from HK” should be added to SGE deliveries and changes in SGE vaulted gold to create known demand for China and Hong Kong.

SGE vaulted gold

The increase in SGE vaulted gold in recent years can only be estimated. However, it was reported in earlier SGE Annual Reports to amount to 519.55 tonnes in 2008, 582.6 tonnes in 2009, and 841.8 tonnes in 2010. There have been no reported vault figures since.

The closest and most logical relationship for vaulted gold is with actual deliveries. After all, public demand is likely to be split between clients maintaining gold accounts at member banks, and clients taking physical possession. The ratios of delivered to vaulted gold were remarkably stable at 1.05, 1.03, and 0.99 for 2008, 2009 and 2010 respectively. On this basis it seems reasonable to assume that vaulted gold has continued to increase at approximately the same amount as delivered gold on a one-to-one basis. The estimated annual increase in vaulted gold is shown in the table below.

The benefits of vault storage, ranging from security from theft to the ability to use it as collateral, seem certain to encourage gold account holders to continue to accumulate vaulted metal rather than take personal possession.

Supply

Supply consists of scrap, domestically mined and imported gold

Scrap

Scrap is almost entirely gold bars, originally delivered from the SGE’s vaults into public hands, and subsequently sold and resubmitted for refining. Consequently scrap supplies tend to increase when gold can be profitably sold by individuals in a rising market, and they decrease on falling prices. There is very little old jewellery scrap and industrial recycling is not relatively significant. Official scrap figures are only available for 2009-2011: 244.5, 256.3 and 405.8 tonnes respectively. I shall therefore assume scrap supplies for 2012 at 430 tonnes and 2013 at 350 tonnes, reflecting gold price movements during those two years.

Scrap is refined entirely by Chinese refiners, and as stated in the discussion concerning mine supply below, the absence of SGE standard kilo bars in Hong Kong is strong evidence that they are withheld from circulation. It is therefore reasonable to assume that scrap should be regarded as vaulted, probably held separately on behalf of the government or its agencies.

Mine supply

China mines more gold than any other nation and it is generally assumed mine supply is sold through the SGE. That is what one would expect, and it is worth noting that a number of mines are members of the SGE and do indeed trade on it. They act as both buyers and sellers, which suggests they frequently use the market for hedging purposes, if nothing else.

Typically, a mine will produce doré which has to be assessed and paid for before it is forwarded to a refinery. Only when it is refined and cast into standard bars can gold be delivered to the market. Broadly, one of the following procedures between doré and the sale of gold bars will occur:

  • The refiner acts on commission from the mine, and the mine sells the finished product on the market. This is inefficient management of cash-flow, though footnotes in the accounts of some mine companies suggest this happens.
  • The refiner buys doré from the mine, refines it and sells it through the SGE. This is inefficient for the refiner, which has to find the capital to buy the doré.
  • A commercial bank, being a member of the SGE, finances the mine from doré to the sale of deliverable gold, paying the mine up-front. This is the way the global mining industry often works.
  • The government, which ultimately directs the mines, refiners and the SGE, buys the mine output at pre-agreed prices and may or may not put the transaction through the market.

I believe the government acquires all mine output, because it is consistent with the geopolitical strategy outlined at the beginning of this article. Furthermore, two of my contacts, one a Swiss refiner with facilities in Hong Kong and the other a vault operator in Hong Kong, tell me they have never seen a Chinese-refined one kilo bar. Admittedly, most one kilo bars in existence bear the stamp of Swiss and other foreign refiners, but nonetheless there must be over two million Chinese-refined kilo bars in existence. Either Chinese customs are completely successful in stopping all ex-vault Chinese-refined one kilo bars leaving the Mainland, or the government takes all domestically refined production for itself, with the exception perhaps of some 100 and 50 gram bars. Logic suggests the latter is true rather than the former.

Since the SGE is effectively a department of the PBOC, it must be at the government’s discretion if domestic mine production is put through the market by the PBOC. Whether or not Chinese mine supply is put through the market is impossible to establish from the available statistics, and is unimportant: no bars end up in circulation because they all remain vaulted. It is material however to the overall supply and demand picture, because global mine supply last year drops to about 2,490 tonnes assuming Chinese production is not available to the market.

Geopolitics suggests that China acquires most, if not all of its own mine and scrap production, which accumulates in the vaulting system. This throws the emphasis back on the figures for vaulted gold, which I have estimated at one-for-one with delivered gold due to gold account holder demand. To this estimate we should now add both Chinese scrap and mine supply. This would explain why vaulted gold is no longer reported, and it would underwrite my estimates of vaulted gold from 2011 onwards.

Further comments on vaulted gold

From the above it can be seen there are three elements to vaulted gold: gold held on behalf of accountholders with the commercial banks, scrap gold and mine supply. The absence of Chinese one kilo bars in circulation leads us to suppose scrap and mine supply accumulate, inflating SGE vault figures, but a moment’s reflection shows this is too simplistic. If it was included in total vaulted gold, then the quantity of gold held by accountholders with the commercial banks, as reported in 2009-11, would have fallen substantially to compensate. This cannot have been the case, as the number of accountholders increased substantially over the period, as did interest in gold investment.

Therefore, scrap and mined gold must be allocated into other vaults not included in the SGE network, and these vaults can only be under the control of the government. It will have been from these vaults that China’s sudden increase in monetary gold of 444 tonnes in the first quarter of 2009 was drawn, which explains why the total recorded in SGE vaults was obviously unaffected. So for the purpose of determining the quantity of vaulted gold, scrap and mined gold must be added to the gold recorded in SGE vaults.

Though it is beyond the scope of this analysis, the existence of government vaults not in the SGE network should be noted, and given cumulative mine production over the last thirty years, scrap supply and possibly other purchases of gold from abroad, the bullion stocks in these government vaults are likely to be very substantial.

Western gold flows to China

We are now in a position to estimate Chinese demand and supply factors in a global context. The result is summarised in the table below.

Chinese demand before 2013 had arrived at a plateau, admittedly higher than generally realised, before expanding dramatically following last April’s price drop. Taking the WGC’s figures for the Rest of the World gives us new global demand figures, which throw up a shortfall amounting to 9,461 tonnes since the Lehman crisis, satisfied from existing above-ground stocks.

This figure, though shocking to those unaware of these stock flows, could well be conservative, because we have only been able to address SGE deliveries, vaulted gold and Hong Kong net flows. Missing from our calculations is Chinese government purchases in London, demand from the ultra-rich not routed through the SGE, and gold held by Chinese nationals abroad. It is also likely that demand from the Chinese diaspora in SE Asia and Asian is also underestimated by western analysts.

There are assumptions in this analysis that should be clear to all. But if it only serves to expose the futility of attempts in western capital markets to manage the gold price, the exercise has been worthwhile. For much of 2013 commentators routinely stated that Asian demand was satisfied from ETF redemptions. But as can be seen, ETF sales totalling 881 tonnes covered only one quarter of the west’s shortfall against China, the rest coming mostly from central bank vaults. Anecdotal evidence from Switzerland is that the four major refiners have been working round-the-clock turning LBMA 400 ounce bars into one kilo 9999 bars for China. They are even working with gold bars that are battered and dusty, which suggests the west is not only digging into deep storage to satisfy Chinese demand at current prices, but digging a hole for itself as well.