Book Review: The Death of Money: The Coming Collapse of the International Monetary System by James Rickards
The title will no doubt give Cobden Centre readers a feeling of déjà vu, but James Rickards’ new book (The Death of Money: The Coming Collapse of the International Monetary System) deals with more than just the fate of paper money – and in particular, the US dollar. Terrorism, financial warfare and world government are discussed, as is the future of the European Union.
Though he quotes F.A. Hayek a few times, the Austrian School gets only one mildly disparaging mention in the entire book. This seems odd for an author who devotes a whole chapter to the benefits of the gold standard. His first bestselling book, Currency Wars, argues that currency wars are not just an economic or monetary concern, but a national security concern for the USA.
Rickards relies on emerging Chaos theories of economics and markets (1) to buttress his arguments in favour of sound money and prudent – limited – government. He uses the same insights, twinned with years of Wall Street experience, to explain why the “coming collapse of the dollar and the international monetary system is entirely foreseeable.”
One of Rickards’ key arguments is that exponential increases in the total size of credit markets mean exponential increases in risk. The gross size of derivative markets is the problem, irrespective of false assurances about netting, he claims. Politicians and central bankers have by and large learnt nothing from recent crises, and are still “in thrall to bank political contributions.”
He makes the case for the US federal government to reinstate Depression-era restrictions on banking activities and for most derivatives to be banned. As a former Federal Reserve Chairman, Paul Volcker, said in 2009, “the only useful thing banks have invented in 20 years is the ATM” – a sentiment Rickards would probably be sympathetic to.
The chapter dealing with the Fed’s hubris and what investment writer James Grant calls our “PhD Standard” of macroeconomic management will be familiar territory for readers of this site. The Fed is trapped between the rock of natural deflationary forces of excessive debt, an ageing population and cheap imports frustrating its efforts to generate a self-sustaining economic recovery and the hard place of annualised inflation of 2%. Rickards quotes extensively from eminent economist and Ben Bernanke mentor Frederic Mishkin, who noted in a 2013 paper titled Crunch Time: Fiscal Crises and the Role of Monetary Policy that “ultimately, the central bank is without power to avoid the consequences of an unsustainable fiscal policy.”
More interesting is the author’s attempt to map out what-happens-next scenarios. The chapter about the on-going transformation of the International Monetary Fund into the world’s central bank, and Special Drawing Rights (SDRs) into a global currency, is particularly insightful. Though Rickards doesn’t say it, Barack Obama’s former chief of staff (and current Mayor of Chicago) Rahm Emanuel’s dictum about never letting a crisis go to waste seems to apply here: hostile acts of financial warfare would lead to calls for more international regulation, and to more government intervention and monitoring of markets. Observers of the EU’s crab-like advance over the last half century will be familiar with the process.
Indeed, my only quibble with this book is Rickards’ starry-eyed take on the EU – soon to be “the world’s economic superpower” in his view. Though he makes a good argument – similar to Jesús Huerta de Soto’s – that relatively-tight European Central Bank monetary policy is forcing effective structural adjustments in the eurozone periphery, as well as in eastern states that wish to join the euro, his endorsement of other aspects of the EU seem too sweeping.
The author talks of the benefits of “efficiencies for the greater good” in supranational government, and how subsidiarity makes allowances for “local custom and practice”. But, as the regulatory débacle surrounding the Somerset floods has shown recently, EU rule frequently licenses bureaucratic idiocies that destroy effective, established national laws. Regulatory central planning for an entire continent is, I’d say, just as suspect as monetary central planning for one country.
The continent’s demographic problems are probably containable in the short-term, as Rickards says. But mass immigration is driving increasing numbers of white Europeans to far-right parties. And while there is consistently strong public support for the euro in the PIIGS (Portugal, Ireland, Italy, Greece and Spain), he’s silent on the broader question of the EU’s democratic legitimacy. No mention of those pesky ‘No’ votes in European Constitution, Maastricht and Lisbon Treaty referendums – or of the Commission’s own Eurobarometer polls, which show more and more Europeans losing faith in “the project”.
No matter I suppose: the eurocrats will rumble on regardless. But what was that quote about democracy being the worst form of government apart from all the others?
All in all though, this is a great book – even for someone like me who’s not exactly new to the economic doom ‘n’ gloom genre. As Rickards says at the end of his intro: “The system has spun out of control.”
(1) For example Juárez, Fernando (2011). “Applying the theory of chaos and a complex model of health to establish relations among financial indicators”. Procedia Computer Science 3: 982–986.
Editor’s note: This article was previously published here at Goldmoney.com. It is republished with thanks.
Geopolitical and market background
I have been revisiting estimates of the quantities of gold being absorbed by China, and yet again I have had to revise them upwards. Analysis of the detail discovered in historic information in the context of China’s gold strategy has allowed me for the first time to make reasonable estimates of vaulted gold, comprised of gold accounts at commercial banks, mine output and scrap. There is also compelling evidence mine output and scrap are being accumulated by the government in its own vaults, and not being delivered to satisfy public demand.
The impact of these revelations on estimates of total identified demand and the drain on bullion stocks from outside China is likely to be dramatic, but confirms what some of us have suspected but been unable to prove. Western analysts have always lagged in their understanding of Chinese demand and there is now evidence China is deliberately concealing the scale of it from us. Instead, China is happy to let us accept the lower estimates of western analysts, which by identifying gold demand from the retail end of the supply chain give significantly lower figures.
Before 2012 the Shanghai Gold Exchange was keen to advertise its ambitions to become a major gold trading hub. This is no longer the case. The last SGE Annual Report in English was for 2010, and the last Gold Market Report was for 2011. 2013 was a watershed year. Following the Cyprus debacle, western central banks, seemingly unaware of latent Chinese demand embarked on a policy of supplying large quantities of bullion to break the bull market and suppress the price. The resulting expansion in both global and Chinese demand was so rapid that analysts in western capital markets have been caught unawares.
I started following China’s gold strategy over two years ago and was more or less on my own, having been tipped off by a contact that the Chinese government had already accumulated large amounts of gold before actively promoting gold ownership for private individuals. I took the view that the Chinese government acted for good reasons and that it is a mistake to ignore their actions, particularly when gold is involved.
Since then, Koos Jansen of ingoldwetrust.ch has taken a specialised interest in the SGE and Hong Kong’s trade statistics, and his dedication to the issue has helped spread interest and knowledge in the subject. He has been particularly successful in broadcasting market statistics published in Chinese to a western audience, overcoming the lack of information available in English.
I believe that China is well on the way to having gained control of the international gold market, thanks to western central banks suppression of the gold price, which accelerated last year. The basic reasons behind China’s policy are entirely logical:
- China knew at the outset that gold is the west’s weak spot, with actual monetary reserves massively overstated. For all I know their intelligence services may have had an accurate assessment of how much gold there is left in western vaults, and if they had not, their allies, the Russians, probably did. Representatives of the People’s Bank of China will have attended meetings at the Bank for International Settlements where these issues are presumably openly discussed by central bankers.
- China has significant currency surpluses under US control. By controlling the gold market China can flip value from US Treasuries into gold as and when it wishes. This gives China ultimate financial leverage over the west if required.
- By encouraging its population to invest in gold China reduces the need to acquire dollars to control the renminbi/dollar rate. Put another way, gold purchases by the public have helped absorb her trade surplus. Furthermore gold ownership insulates her middle classes from external currency instability which has become an increasing concern since the Lehman crisis.
For its geopolitical strategy to work China must accumulate large quantities of bullion. To this end China has encouraged mine production, making the country the largest producer in the world. It must also have control over the global market for physical gold, and by rapidly developing the SGE and its sister the Shanghai Gold Futures Exchange the groundwork has been completed. If western markets, starved of physical metal, are forced at a future date to declare force majeure when settlements fail, the SGE and SGFE will be in a position to become the world’s market for gold. Interestingly, Arab holders have recently been recasting some of their old gold holdings from the LBMA’s 400 ounce 995 standard into the Chinese one kilo 9999 standard, which insures them against this potential risk.
China appears in a few years to have achieved dominance of the physical gold market. Since January 2008 turnover on the SGE has increased from a quarterly average of 362 tonnes per month to 1,100 tonnes, and deliveries from 44 tonnes per month to 212 tonnes. It is noticeable how activity increased rapidly from April 2013, in the wake of the dramatic fall in the gold price. From January 2008, the SGE has delivered from its vaults into public hands a total of 6,776 tonnes. This is illustrated in the chart below.
This is only part of the story, the part that is in the public domain. In addition there is gold imported through Hong Kong and fabricated for the Chinese retail market bypassing the SGE, changes of stock levels within the SGE’s network of vaults, the destination of domestic mine output and scrap, government purchases of gold in London and elsewhere, and purchases stored abroad by the wealthy. Furthermore the Chinese diaspora throughout South East Asia competes with China for global gold stocks, and its demand is in addition to that of China’s Mainland and Hong Kong.
The Shanghai Gold Exchange (SGE)
The SGE, which is the government-owned and controlled gold exchange monopoly, runs a vaulting system with which westerners will be familiar. Gold in the vaults is fungible, but when it leaves the SGE’s vaults it is no longer so, and in order to re-enter them it is treated as scrap and recast. In 2011 there were 49 vaults in the SGE’s system, and bars and ingots are supplied to SGE specifications by a number of foreign and Chinese refiners. Besides commercial banks, SGE members include refiners, jewellery manufacturers, mines, and investment companies. The SGE’s 2010 Annual Report, the last published in English, states there were 25 commercial banks included in 163 members of the exchange, 6,751 institutional clients accounting for 81% of gold traded, and 1,778,500 clients of the commercial banks with gold accounts. The 2011 Gold Report, the most recent available, stated that the number of commercial bank members had increased to 29 with 2,353,600 clients, and given the rapid expansion of demand since, the number of gold account holders is likely to be considerably greater today.
About 75% of the SGE’s gold turnover is for forward settlement and the balance is for spot delivery. Standard bars are Au99.95 3 kilos (roughly 100 ounces), Au99.99 1 kilo, Au100g and Au50g. The institutional standard has become Au99.99 1 kilo bars, most of which are sourced from Swiss refiners, with the old Au99.95 standard less than 15% of turnover today compared with 65% five years ago. The smaller 100g and 50g bars are generally for retail demand and a very small proportion of the total traded. Public demand for smaller bars is satisfied mainly through branded products provided by commercial banks and other retail entities instead of from SGE-authorised refiners.
Overall volumes on the SGE are a tiny fraction of those recorded in London, and the market is relatively illiquid, so much so that opportunities for price arbitrage are often apparent rather than real. The obvious difference between the two markets is the large amounts of gold delivered to China’s public. This has fuelled the rapid growth of the Chinese market leading to a parallel increase in vaulted bullion stocks, which for 2013 is likely to have been substantial.
By way of contrast the LBMA is not a regulated market but is overseen by the Bank of England, while the SGE is both controlled and regulated by the People’s Bank of China. The PBOC is also a member of both its own exchange and of the LBMA, and deals actively in non-monetary gold. While the LBMA is at arm’s length from the BoE, the SGE is effectively a department of the PBOC. This allows the Chinese government to control the gold market for its own strategic objectives.
Identifiable demand is the sum of deliveries to the public withdrawn from SGE vaults, plus the residual gold left in Hong Kong, being the net balance between imports and exports. To this total must be added an estimate of changes in vaulted bullion stocks.
SGE gold deliveries
Gold deliveries from SGE vaults to the general public are listed both weekly and monthly in Chinese. The following chart shows how they have grown on a monthly basis.
Growth in public demand for physical gold is a reflection of the increased wealth and savings of Chinese citizens, and also reflects advertising campaigns that have encouraged ordinary people to invest in gold. Advertising the attractions of gold investment is consistent with a deliberate government policy of absorbing as much gold as possible from western vaults, including those of central banks.
Hong Kong provides import, export and re-export figures for gold. All gold is imported, exports refer to gold that has been materially altered in form, and re-exports are of gold transited more or less unaltered. Thus, exports refer mainly to jewellery which in China’s case is sold directly into the Mainland without going through the SGE, and re-exports refer to gold in bar form which we can assume is delivered to the SGE. Some imported gold remains on the island, and some is re-exported from China back to Hong Kong. This gold is either vaulted in Hong Kong or alternatively turned into jewellery and sold mostly to visitors from the Mainland buying tax-free gold.
The mainstream media has reported on the large quantities of gold flowing from Switzerland to Hong Kong, but this is only part of the story. In 2013, Hong Kong imported 916 tonnes from Switzerland, 190 tonnes from the US, 176 tonnes from Australia and 150 tonnes from South Africa as well as significant tonnages from eight other countries, including the UK. She also imported 337 tonnes from Mainland China and exported 211 tonnes of it back to China as fabricated gold.
Hong Kong is not the sole entry port for gold destined for the Mainland. The table below illustrates how Hong Kong’s gold trade with China has grown, and its purpose is to identify gold additional to that supplied via Hong Kong to the SGE. Included in the bottom line, but not separately itemised, is fabricated gold trade with China (both ways), as well as the balance of all imports and exports accruing to Hong Kong.
The bottom line, “Additional supply from HK” should be added to SGE deliveries and changes in SGE vaulted gold to create known demand for China and Hong Kong.
SGE vaulted gold
The increase in SGE vaulted gold in recent years can only be estimated. However, it was reported in earlier SGE Annual Reports to amount to 519.55 tonnes in 2008, 582.6 tonnes in 2009, and 841.8 tonnes in 2010. There have been no reported vault figures since.
The closest and most logical relationship for vaulted gold is with actual deliveries. After all, public demand is likely to be split between clients maintaining gold accounts at member banks, and clients taking physical possession. The ratios of delivered to vaulted gold were remarkably stable at 1.05, 1.03, and 0.99 for 2008, 2009 and 2010 respectively. On this basis it seems reasonable to assume that vaulted gold has continued to increase at approximately the same amount as delivered gold on a one-to-one basis. The estimated annual increase in vaulted gold is shown in the table below.
The benefits of vault storage, ranging from security from theft to the ability to use it as collateral, seem certain to encourage gold account holders to continue to accumulate vaulted metal rather than take personal possession.
Supply consists of scrap, domestically mined and imported gold
Scrap is almost entirely gold bars, originally delivered from the SGE’s vaults into public hands, and subsequently sold and resubmitted for refining. Consequently scrap supplies tend to increase when gold can be profitably sold by individuals in a rising market, and they decrease on falling prices. There is very little old jewellery scrap and industrial recycling is not relatively significant. Official scrap figures are only available for 2009-2011: 244.5, 256.3 and 405.8 tonnes respectively. I shall therefore assume scrap supplies for 2012 at 430 tonnes and 2013 at 350 tonnes, reflecting gold price movements during those two years.
Scrap is refined entirely by Chinese refiners, and as stated in the discussion concerning mine supply below, the absence of SGE standard kilo bars in Hong Kong is strong evidence that they are withheld from circulation. It is therefore reasonable to assume that scrap should be regarded as vaulted, probably held separately on behalf of the government or its agencies.
China mines more gold than any other nation and it is generally assumed mine supply is sold through the SGE. That is what one would expect, and it is worth noting that a number of mines are members of the SGE and do indeed trade on it. They act as both buyers and sellers, which suggests they frequently use the market for hedging purposes, if nothing else.
Typically, a mine will produce doré which has to be assessed and paid for before it is forwarded to a refinery. Only when it is refined and cast into standard bars can gold be delivered to the market. Broadly, one of the following procedures between doré and the sale of gold bars will occur:
- The refiner acts on commission from the mine, and the mine sells the finished product on the market. This is inefficient management of cash-flow, though footnotes in the accounts of some mine companies suggest this happens.
- The refiner buys doré from the mine, refines it and sells it through the SGE. This is inefficient for the refiner, which has to find the capital to buy the doré.
- A commercial bank, being a member of the SGE, finances the mine from doré to the sale of deliverable gold, paying the mine up-front. This is the way the global mining industry often works.
- The government, which ultimately directs the mines, refiners and the SGE, buys the mine output at pre-agreed prices and may or may not put the transaction through the market.
I believe the government acquires all mine output, because it is consistent with the geopolitical strategy outlined at the beginning of this article. Furthermore, two of my contacts, one a Swiss refiner with facilities in Hong Kong and the other a vault operator in Hong Kong, tell me they have never seen a Chinese-refined one kilo bar. Admittedly, most one kilo bars in existence bear the stamp of Swiss and other foreign refiners, but nonetheless there must be over two million Chinese-refined kilo bars in existence. Either Chinese customs are completely successful in stopping all ex-vault Chinese-refined one kilo bars leaving the Mainland, or the government takes all domestically refined production for itself, with the exception perhaps of some 100 and 50 gram bars. Logic suggests the latter is true rather than the former.
Since the SGE is effectively a department of the PBOC, it must be at the government’s discretion if domestic mine production is put through the market by the PBOC. Whether or not Chinese mine supply is put through the market is impossible to establish from the available statistics, and is unimportant: no bars end up in circulation because they all remain vaulted. It is material however to the overall supply and demand picture, because global mine supply last year drops to about 2,490 tonnes assuming Chinese production is not available to the market.
Geopolitics suggests that China acquires most, if not all of its own mine and scrap production, which accumulates in the vaulting system. This throws the emphasis back on the figures for vaulted gold, which I have estimated at one-for-one with delivered gold due to gold account holder demand. To this estimate we should now add both Chinese scrap and mine supply. This would explain why vaulted gold is no longer reported, and it would underwrite my estimates of vaulted gold from 2011 onwards.
Further comments on vaulted gold
From the above it can be seen there are three elements to vaulted gold: gold held on behalf of accountholders with the commercial banks, scrap gold and mine supply. The absence of Chinese one kilo bars in circulation leads us to suppose scrap and mine supply accumulate, inflating SGE vault figures, but a moment’s reflection shows this is too simplistic. If it was included in total vaulted gold, then the quantity of gold held by accountholders with the commercial banks, as reported in 2009-11, would have fallen substantially to compensate. This cannot have been the case, as the number of accountholders increased substantially over the period, as did interest in gold investment.
Therefore, scrap and mined gold must be allocated into other vaults not included in the SGE network, and these vaults can only be under the control of the government. It will have been from these vaults that China’s sudden increase in monetary gold of 444 tonnes in the first quarter of 2009 was drawn, which explains why the total recorded in SGE vaults was obviously unaffected. So for the purpose of determining the quantity of vaulted gold, scrap and mined gold must be added to the gold recorded in SGE vaults.
Though it is beyond the scope of this analysis, the existence of government vaults not in the SGE network should be noted, and given cumulative mine production over the last thirty years, scrap supply and possibly other purchases of gold from abroad, the bullion stocks in these government vaults are likely to be very substantial.
Western gold flows to China
We are now in a position to estimate Chinese demand and supply factors in a global context. The result is summarised in the table below.
Chinese demand before 2013 had arrived at a plateau, admittedly higher than generally realised, before expanding dramatically following last April’s price drop. Taking the WGC’s figures for the Rest of the World gives us new global demand figures, which throw up a shortfall amounting to 9,461 tonnes since the Lehman crisis, satisfied from existing above-ground stocks.
This figure, though shocking to those unaware of these stock flows, could well be conservative, because we have only been able to address SGE deliveries, vaulted gold and Hong Kong net flows. Missing from our calculations is Chinese government purchases in London, demand from the ultra-rich not routed through the SGE, and gold held by Chinese nationals abroad. It is also likely that demand from the Chinese diaspora in SE Asia and Asian is also underestimated by western analysts.
There are assumptions in this analysis that should be clear to all. But if it only serves to expose the futility of attempts in western capital markets to manage the gold price, the exercise has been worthwhile. For much of 2013 commentators routinely stated that Asian demand was satisfied from ETF redemptions. But as can be seen, ETF sales totalling 881 tonnes covered only one quarter of the west’s shortfall against China, the rest coming mostly from central bank vaults. Anecdotal evidence from Switzerland is that the four major refiners have been working round-the-clock turning LBMA 400 ounce bars into one kilo 9999 bars for China. They are even working with gold bars that are battered and dusty, which suggests the west is not only digging into deep storage to satisfy Chinese demand at current prices, but digging a hole for itself as well.
Editor’s note: We’re grateful to Tim Price of PFP Group for this article. PFP has made this document available for your general information.
“10th March 2000: NASDAQ closes at a record 5048.62, up 24.1% for the year to date — after gaining 86.5% in 1999. A conference on optical fibre stocks sells out nearly every hotel room in Baltimore, the biggest stocks on NASDAQ trade at an average of 120 times earnings, and 15% of NASDAQ’s value is made up of companies less than two years old that have never earned a profit. James J. Cramer, author of the eponymous column “Wrong!” for TheStreet.com, writes that a revival of value stocks “will only happen when the Brocades and Broadcoms blow up. And I don’t see that happening any time soon.” In fact, says Cramer, he’s tempted to short-sell Warren Buffett’s Berkshire Hathaway, betting that the great value investor’s shares are “ripe for the banging.” BancOne fund manager Chris Guinther sums it all up: “In today’s market, it pays to be aggressive.” Today is the absolute peak of the market bubble: In one of the worst crashes in history, NASDAQ plunges 60.6% over the next 12 months. And Cramer’s “Red Hots”? Brocade unravels by 67.1%, Broadcom collapses by 84.1%. Meanwhile, Berkshire Hathaway gains 72.2% over the year to come.” ￼
- ‘This day in financial history’ on JasonZweig.com.
“The Fed and the other major central banks have been planting time bombs all over the global financial system for years, but especially since their post-crisis money printing spree incepted in the fall of 2008. Now comes a new leader to the Eccles Building who is not only bubble-blind like her two predecessors, but is also apparently bubble-mute. Janet Yellen is pleased to speak of financial bubbles as a “misalignment of asset prices,” and professes not to espy any on the horizon.
“Let’s see. The Russell 2000 is trading at 85X actual earnings and that’s apparently “within normal valuation parameters.” Likewise, the social media stocks are replicating the eyeballs and clicks based valuation madness of Greenspan’s dot-com bubble. But there is nothing to see there, either–not even Twitter at 35X its current run-rate of sales or the $19 billion WhatsApp deal. Given the latter’s lack of revenues, patents and entry barriers to the red hot business of free texting, its key valuation metric reduces to market cap per employee–which computes out to a cool $350 million for each of its 55 payrollers.” - ‘Yellenomics: the folly of free money’ by David Stockman.
Trying to time the markets is either next to impossible, or simply impossible. Either way, we think it’s impossible, so we don’t try. And since we don’t short stocks, the path of least resistance when it comes to equity market investing is
￼a) Avoid obvious overvaluation, and
b) Concentrate on apparently dramatic undervaluation.
￼If in doubt, the best policy is always to ask ‘What would Ben Graham have done ?’ and then just do that. (And conversely, if Ben Graham would never have done it, then don’t do it either.) And David Stockman isn’t the only person who detects evidence of a bubble in Big ‘Tech’. V. Prem Watsa of Fairfax Financial Holdings points to the highly speculative valuations currently on offer in the ‘social media’ and ‘other tech / web’ space. For example:
It’s fairly safe to assume that Ben Graham would not have given ownership of these companies at current valuations his uninhibited endorsement. Indeed, as he once said,
“Investors do not make mistakes, or bad mistakes, in buying good stocks at fair prices. They make their serious mistakes by buying poor stocks, particularly the ones that are pushed for various reasons. And sometimes — in fact, very frequently — they make mistakes by buying good stocks in the upper reaches of bull markets.”
So in summary, here are the cardinal errors:
i) Buying rubbish (or speculative nonsense);
ii) Overpaying for quality.
Avoiding the first error is relatively easy, subject to the vagaries of subjective judgment. Avoiding the second, however, may be difficult, perhaps impossibly so, when our monetary overlords at the central banks are hopelessly distorting the price of money. The prudent response, we feel, is to lean that much more heavily on the side of caution by only even considering out-and-out deep value – at least within the context of the listed equity markets. And it is worth repeating Graham and Dodd’s 1934 definition from ‘Security Analysis’:
“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” [Emphasis ours.]
Quite which operations in today’s marketplace will turn out to be speculative is not yet known to anybody. But the law of gravitation, egged on by the madness of crowds, will doubtless reveal its secrets to us before too long. The ‘social media and other tech / web space’ seems as good a place as any to expect to see investment operations smashed against the rocks before the year is out.
But as we suggest, overpaying for quality may be an inevitable risk in a financial world in which hopes and fears over QE, Zero Interest Rate Policies and banking system solvency (and the threat of depositor bail-ins) dominate more objective fundamentals such as corporate profits growth (or lack thereof). Groupthink alone is sufficient to cause unhealthy dislocations when gravitational forces ensue. We suspect that global megacap consumer brands may now be an unhealthily crowded trade – the sort of investment that makes sense at first glance given the problems highlighted at the beginning of this paragraph, but unhealthily crowded nevertheless. They certainly have been before. Take the ‘nifty fifty’ growth stocks of the early 1970s. Coca-Cola was one such stock. When the forces of recession arrived on the back of the
Russian gas embargo Arab oil embargo, Coke’s stock managed to lose over two thirds of its value.
The real thing: Coca-Cola share price, 1973-1974
Coke wasn’t alone. Over the same period, Disney also lost over two thirds of its value. Blue-chip IBM survived relatively unscathed: it only lost 57%. Note that this isn’t a prediction for the next￼￼ bear phase – but we would suggest that the social media sector, being inherently more flimsy, has that much further to fall.
Where are we currently finding ‘deep value’ ? In pockets of the mid-cap market throughout Asia, notably in Japan, and also, ahem, in Russia, which we note has now replaced gold as the most reviled part of the global asset marketplace. But we also note that gold seems to have turned a corner after its annus horribilis in 2013. As does its kissing cousin, silver. Since we bought both for very specific reasons, and the underlying fundamentals for holding both have if anything only strengthened even as their prices melted last year, we’re unlikely to be selling either any time soon. And of course the miners of each have also seen their share prices recover some, though so far only some, of the ground they lost, but again we’re in the sector for the long haul. We think money printing is in and of itself inflationary. We also think that central banks may soon have to go ‘all-in’ in their fight against deflation. We think they are destined to lose control of the markets before they are ultimately proved wrong in any case, but who knows ? This is what happens when you allow economic policy wonks unfettered power to experiment on complex markets with unproven (and unprovable) models and make-it-up-as-you-go-along monetary policy on the hoof. Since this is destined to end badly, apart from diversifying sensibly into non-equity assets, it makes sense to seek shelter – in equity terms – in those things most worthy of Ben Graham’s affection. Or in the words of Ben Graham’s most celebrated acolyte, Warren Buffett,
“We don’t have to be smarter than the rest. We have to be more disciplined than the rest.”
“We don’t get paid for activity, just for being right. As to how long we’ll wait, we’ll wait indefinitely.”
I am something of a gold bug, believing that gold (and silver) represent the best way to preserve wealth in inflationary times as well as representing a fantastic opportunity for speculation.
So, I was delighted a couple of years ago when George Soros bought a whole load of the stuff. “Great minds etc…”
But then, the other week, came the news that he had sold it all. The silence amongst gold bugs has been deafening. About the only response I have seen was to the effect that although Soros was small in bullion, he was big in mining. But my back-of-an-envelope calculations tell me that this is gibberish – his mine holdings are nothing like the size of his former bullion holdings. The truth is that Soros has sold.
It is possible that what he has done is to get out of ETFs (a sort of fund) and into actual physical metal (a certain sort of gold bug will tell you there is a crucial difference). But I would have thought that would show up in exactly the sort of records that told us he had sold. (I am not an expert here so I would love to know).
It is also possible that he thinks there is going to be a confiscation like 1933. But wouldn’t he be bigger into mining stocks? And anyway, what are the chances of a confiscation with a divided Congress? Sure, the Republicans in the House seem to be reluctant to do anything sensible (like keeping the debt ceiling where it is) but equally they don’t seem too keen on doing anything stupid either. There might be a confiscation here, in Britain, but not in the US.
I suppose it could all be a bluff to depress the price. Maybe, but so far it doesn’t seem to have worked.
Or maybe Soros is simply stupid. But I don’t think Soros does stupid. I may not agree with his politics, but his reading of finance is normally spot on.
Perhaps he’s looking at the situation in Greece. Perhaps he thinks Greece is about to default. Greece defaulting is likely to be very like Lehman going bust – just bigger. When Lehman went bust just about all asset classes (including gold) fell as people got desperate for cash. If Greece goes the same way there are going to be some wonderful fire sales. Only later will governments carpet-bomb the planet with out-of-thin-air cash leading to a further boost to the gold price.
Maybe, maybe, but I really don’t know. Any ideas?
We are indebted to Ewen Stewart of Arden Partners for permission to publish his report: A Game of Two Halves – Equities to Win. Please see that report for full detail.
2009 was a remarkable year for the global economy and a remarkable year for equities. In this note we try to explain why 2009 turned out as it did and examine the prospects for 2010 and beyond.
We have called this note ‘A Game of Two Halves – Equities to Win’ because we believe that although the short-term trends for the UK economy are improving the longer-term forecast looks troubled indeed. Despite this, we believe the outlook for UK equities remains positive.
The first few months of 2010 may well surprise on the upside in terms of employment, house prices, consumer-spend and even, ultimately, GDP. But this is no ‘V’ shaped recovery.
We argue that trend growth, longer term, is likely to significantly disappoint. We argue that the UK’s superior growth, relative to many other developed nations, in the noughties was largely an illusion and we struggle to find the dynamo for growth over the next few years. We believe that the unwinding of the extraordinary fiscal and monetary stimulus, is a necessity, but will also be very difficult to achieve painlessly.
We believe the markets are still underestimating the structural problems with the public sector deficit and that politicians of all colours will be forced to deal with it. The consequences of not doing so would result in rising interest rates and a collapse in international confidence. The deficit remains the key issue for the UK and it may well bring substantial political challenges in itself. Indeed perhaps we should not have called this ‘A Game of Two Halves’ but a ‘Back to the Future – Welcome Mr Heath and the 1970s’?
Despite this, we are not bears of equities. It is true that current valuations are not particularly cheap by historic standards but the UK stock market is fairly defensive and internationally diverse. We believe equities look attractive against cash, bonds and, ultimately, real estate. We are concerned about a potential rise in inflation and again equities are a good hedge.
We have set a year end target of 5750 for the FTSE 100. Sector valuations do not follow a clear pattern and we believe this offers a number of anomalies. We have outlined our suggested sector weights below. As a generalisation, we seek overseas earnings – especially the US$, moderate leverage and strong cash flow as the place to be in 2010 with a return to M&A being more pronounced than perhaps expected.
The extreme cannot become the norm?
It may be a blessing that Ben Bernanke made the study of the 1930s great depression his speciality. We say may because, while the unprecedented global response undoubtedly has alleviated economic implosion, it does remain to be seen if the ‘nationalisation’ of deficits, the eclipse of moral hazard and the unique policy of both near-zero global interest rates and, in many parts of the globe, with quantitative easing (QE), has succeeded in sending growth back on an inflation-free growth projectory or whether the underlying malaise has been merely kicked into the medium grass. These issues are global, with substantial government deficits, trade and growth imbalances impacting upon different regions.
Source: Bank of England Stability Report, December 2009.
The economic policy reaction in the UK has been greater and more prolonged than any G20 nation, which is partially demonstrated by the chart above. The Bank of England cut interest rates to 0.5% (the lowest since the foundation of the Bank in 1694); 2009 saw a programme of QE to the tune of £200bn (equivalent to 25% of all outstanding gilt stock) and government spending was accelerated, despite plummeting tax receipts. The fiscal deficit is forecast by the Treasury to peak at 12.6% of GDP – a figure roughly twice as large as the UK’s 1975-1977 IMF crisis, and on a par with Greece.
Read on: A Game of Two Halves – Equities to Win
This is the first in a series of articles taken from Mises, The Theory of Money and Credit (1934). Here, we introduce the function of money. Emphasis mine.
The Theory of Money and Credit is available from Amazon, as a PDF and online.
1 The General Economic Conditions for the Use of Money
Where the free exchange of goods and services is unknown, money is not wanted. In a state of society in which the division of labor was a purely domestic matter and production and consumption were consummated within the single household it would be just as useless as it would be for an isolated man. But even in an economic order based on division of labor, money would still be unnecessary if the means of production were socialized, the control of production and the distribution of the finished product were in the hands of a central body, and individuals were not allowed to exchange the consumption goods allotted to them for the consumption goods allotted to others.
The phenomenon of money presupposes an economic order in which production is based on division of labor and in which private property consists not only in goods of the first order (consumption goods), but also in goods of higher orders (production goods). In such a society, there is no systematic centralized control of production, for this is inconceivable without centralized disposal over the means of production. Production is “anarchistic.” What is to be produced, and how it is to be produced, is decided in the first place by the owners of the means of production, who produce, however, not only for their own needs, but also for the needs of others, and in their valuations take into account, not only the use-value that they themselves attach to their products, but also the use-value that these possess in the estimation of the other members of the community. The balancing of production and consumption takes place in the market, where the different producers meet to exchange goods and services by bargaining together. The function of money is to facilitate the business of the market by acting as a common medium of exchange.
2 The Origin of Money
Indirect exchange is distinguished from direct exchange according as a medium is involved or not.
Suppose that A and B exchange with each other a number of units of the commodities m and n. A acquires the commodity n because of the use-value that it has for him. He intends to consume it. The same is true of B, who acquires the commodity m for his immediate use. This is a case of direct exchange.
If there are more than two individuals and more than two kinds of commodity in the market, indirect exchange also is possible. A may then acquire a commodity p, not because he desires to consume it, but in order to exchange it for a second commodity q which he does desire to consume. Let us suppose that A brings to the market two units of the commodity m, B two units of the commodity n, and C two units of the commodity o, and that A wishes to acquire one unit of each of the commodities n and o, B one unit of each of the commodities o and m, and C one unit of each of the commodities m and n. Even in this case a direct exchange is possible if the subjective valuations of the three commodities permit the exchange of each unit of m, n, and o for a unit of one of the others. But if this or a similar hypothesis does not hold good, and in by far the greater number of all exchange transactions it does not hold good, then indirect exchange becomes necessary, and the demand for goods for immediate wants is supplemented by a demand for goods to be exchanged for others. 
Indirect exchange becomes more necessary as division of labor increases and wants become more refined. In the present stage of economic development, the occasions when direct exchange is both possible and actually effected have already become very exceptional. Nevertheless, even nowadays, they sometimes arise. Take, for instance, the payment of wages in kind, which is a case of direct exchange so long on the one hand as the employer uses the labor for the immediate satisfaction of his own needs and does not have to procure through exchange the goods in which the wages are paid, and so long on the other hand as the employee consumes the goods he receives and does not sell them. Such payment of wages in kind is still widely prevalent in agriculture, although even in this sphere its importance is being continually diminished by the extension of capitalistic methods of management and the development of division of labor. 
Thus along with the demand in a market for goods for direct consumption there is a demand for goods that the purchaser does not wish to consume but to dispose of by further exchange. It is clear that not all goods are subject to this sort of demand. An individual obviously has no motive for an indirect exchange if he does not expect that it will bring him nearer to his ultimate objective, the acquisition of goods for his own use. The mere fact that there would be no exchanging unless it was indirect could not induce individuals to engage in indirect exchange if they secured no immediate personal advantage from it. Direct exchange being impossible, and indirect exchange being purposeless from the individual point of view, no exchange would take place at all. Individuals have recourse to indirect exchange only when they profit by it; that is, only when the goods they acquire are more marketable than those which they surrender.
The theory of money must take into consideration all that is implied in the functioning of several kinds of money side by side. Only where its conclusions are unlikely to be affected one way or the other, may it proceed from the assumption that a single good is employed as common medium of exchange. Elsewhere, it must take account of the simultaneous use of several media of exchange. To neglect this would be to shirk one of its most difficult tasks.
3 The “Secondary” Functions of Money
The simple statement, that money is a commodity whose economic function is to facilitate the interchange of goods and services, does not satisfy those writers who are interested rather in the accumulation of material than in the increase of knowledge. Many investigators imagine that insufficient attention is devoted to the remarkable part played by money in economic life if it is merely credited with the function of being a medium of exchange; they do not think that due regard has been paid to the significance of money until they have enumerated half a dozen further “functions”—as if, in an economic order founded on the exchange of goods, there could be a more important function than that of the common medium of exchange.
This applies in the first place to the function fulfilled by money in facilitating credit transactions. It is simplest to regard this as part of its function as medium of exchange. Credit transactions are in fact nothing but the exchange of present goods against future goods. Frequent reference is made in English and American writings to a function of money as a standard of deferred payments.  But the original purpose of this expression was not to contrast a particular function of money with its ordinary economic function, but merely to simplify discussions about the influence of changes in the value of money upon the real amount of money debts. It serves this purpose admirably. But it should be pointed out that its use has led many writers to deal with the problems connected with the general economic consequences of changes in the value of money merely from the point of view of modifications in existing debt relations and to overlook their significance in all other connections.
The functions of money as a transmitter of value through time and space may also be directly traced back to its function as medium of exchange. Menger has pointed out that the special suitability of goods for hoarding, and their consequent widespread employment for this purpose, has been one of the most important causes of their increased marketability and therefore of their qualification as media of exchange.  As soon as the practice of employing a certain economic good as a medium of exchange becomes general, people begin to store up this good in preference to others. In fact, hoarding as a form of investment plays no great part in our present stage of economic development, its place having been taken by the purchase of interest-bearing property.  On the other hand, money still functions today as a means for transporting value through space.  This function again is nothing but a matter of facilitating the exchange of goods. The European farmer who emigrates to America and wishes to exchange his property in Europe for a property in America, sells the former, goes to America with the money (or a bill payable in money), and there purchases his new homestead. Here we have an absolute textbook example of an exchange facilitated by money.
Particular attention has been devoted, especially in recent times, to the function of money as a general medium of payment. Indirect exchange divides a single transaction into two separate parts which are connected merely by the ultimate intention of the exchangers to acquire consumption goods. Sale and purchase thus apparently become independent of each other Furthermore, if the two parties to a sale-and-purchase transaction perform their respective parts of the bargain at different times, that of the seller preceding that of the buyer (purchase on credit), then the settlement of the bargain, or the fulfillment of the seller’s part of it (which need not be the same thing), has no obvious connection with the fulfillment of the buyer’s part. The same is true of all other credit transactions, especially of the most important sort of credit transaction—lending. The apparent lack of a connection between the two parts of the single transaction has been taken as a reason for regarding them as independent proceedings, for speaking of the payment as an independent legal act, and consequently for attributing to money the function of being a common medium of payment. This is obviously incorrect. “If the function of money as an object which facilitates dealings in commodities and capital is kept in mind, a function that includes the payment of money prices and repayment of loans…there remains neither necessity nor justification for further discussion of a special employment, or even function of money, as a medium of payment.” 
The root of this error (as of many other errors in economics) must be sought in the uncritical acceptance of juristical conceptions and habits of thought. From the point of view of the law, outstanding debt is a subject which can and must be considered in isolation and entirely (or at least to some extent) without reference to the origin of the obligation to pay. Of course, in law as well as in economics, money is only the common medium of exchange. But the principal, although not exclusive, motive of the law for concerning itself with money is the problem of payment. When it seeks to answer the question, What is money? it is in order to determine how monetary liabilities can be discharged. For the jurist, money is a medium of payment. The economist, to whom the problem of money presents a different aspect, may not adopt this point of view if he does not wish at the very outset to prejudice his prospects of contributing to the advancement of economic theory.
Please see our literature for a range of further reading.
Where’s the market reaction? Yawns the prophet of Princeton, Paul Krugman in response to the passage of Obama’s health care bill.
In totally separate and completely unrelated news on the same day, the yield of the 10 Year US Government bond rose to 2.5 basis points above the 10 year interest rate swap rate (the rate at which banks can fix their lending rates to each other). (h/t zero hedge).
Allow me to explain how Obama’s passage of trillions of dollars of liabilities onto America’s children has no link at all to the fact that US government debt now requires a higher interest rate than the equivalent rate of interest charged between all of those bankrupt banks.
Er, hold on, something doesn’t quite compute here….
The serious point here, given that uncle Sam needs to pay roughly the same rate as its banks to attract finance, is that the next crisis is likely to be a governmental one (Sovereign risk in market parlance) rather than the banking system that created the risk in the first place.
The banking system is now a fully fledged arm of the state.
Some people doodle pictures, but I’m the type who mucks around random bits of historical price data just to see where it goes. For example, I love charts of the Dow Jones Stock index in the 1920s – it me it tells a vivid story of hopes and dreams and pain mixed with desperation. The wild fluctuations in the early 20’s, the solid gains of the mid 20’s then the euphoria and ensuing panic, well.. you know the rest.
A while a go, I came across a quote;
With an ounce of Gold, a man could buy a fine suit of clothes in the time of Shakespeare, in that of Beethoven and Jefferson…
What does a ‘fine suit’ cost today? Well, an ounce of Gold is just short of £700. If you went into Harrods, and asked for a fine suit, would that see you into an Armani or Zegna number? I think so.
So, the maxim seems to ring as true today as it ever did.
So my mind got to thinking – if an ounce of gold seems to buy the same stuff over the centuries as it does today, then it would seem to be a great proxy for true purchasing power.
The problem with looking at historical charts of stock movements, especially if you are trying to learn the lessons of history, is that the picture is muddied by the fact that the unit of account – i.e. money, does not do a very good job. It is rapidly decaying so when you compare over time, it just gives the wrong impression of what is going on.
For example, look at the stock market over the whole of the 70’s, and you think that equities didn’t do too badly. But adjust for inflation, and you soon realize that stocks lost over three quarters of their value in the first half of the 70′s!
So, the idea dawned on me: the price of stocks and shares are only represented in terms of money. What if you priced them in Gold instead of pounds and dollars?
Firstly: what data? Well, I stuck to the UK, and I chose the FTSE all share index. I took the index value for each day, going back a few decades. I then converted them into ounces of gold. The chart gave me a pretty shocking picture.
But then I realised I’d missed something pretty important. Stocks pay dividends. So, I added a 5% annual dividend return, and then reinvested it into my index. Surely that’d make my chart look less ridiculous? Erm, a bit… but not by very much.
What I was left with was a completely different view of history, and some pretty worrying revelations.
Firstly, my chart had nothing to say until the 70’s. This is because until then, money was gold – therefore priced in money or gold – it didn’t make a difference. In essence, the chart had no surprises.
But in the 1970’s, money was cut loose from gold, with some pretty shocking results.
FTSE All Share in terms of in oz of Gold (click to enlarge)
Some salient observations.
1. The mayhem of the early 70′s had some pretty catastrophic consequences for the world, and recovery only came in the 1980′s. From over 12 ounces of gold, down to nearly 1 ounce of gold is a pretty insane move.
2. Real growth took off in the 80′s, but something happened in the mid 90′s – the internet. This was a period of real economic growth, that morphed into a bubble, thanks to some pretty silly policy mistakes by Greenspan et al.
3. What happened in the 00′s? Wasn’t that supposed to be the ‘NICE’ decade? Wasn’t the stock market supposed to have risen back to its peaks?
My answer to this is that the noughties were a period of stagnation, economic misalignment, and we were all swamped by a money fraud.
The authorities were in such a blind funk in 2001, with the overriding perception that we were facing a 1929 style collapse, that they turned on the money gusher, and flooded the whole world with liquidity. This found its way into the greatest worldwide property bubble the world has ever seen.
But… this was not true growth – at least for the Western economies. Sure, great advances were made in some sectors of their economies, but huge misalignments of capital were occurring, and this decade of false signals to producers, but especially to Western consumers, is why we had the economic crisis of 2008.
Look where we stand now. In ruinous debt. Shackled to low interest rates and nervously watching retail sales and property prices. This is a direct consequence of our societies living the high life for ten years, without actually realising we were in decline.
We have been living like cannibals. Hollowing out ourselves out, yet living the high life. And this is all down to a pseudo neo-Keynesian/monetarist aggregate kabala fetish.
I feel a sense of panic looking at this chart, so what is the solution?
Free markets built on the bedrock of honest money.
I see the panel of economic experts that is the acting industry have latched onto the Tobin tax, now re-branded the ‘Robin Hood Tax’. Never mind that Robin Hood fought against unjust taxes by tyrants: the modern day bogey man is the banker.
Now funny thing is, I do agree with a lot of the sentiment expressed by the morally indignant of Primrose Hill.
Yes, the financial world has grown out of all proportion to the real world
Yes, the rewards for participation in this job seem ludicrously high
Yes, bankers have been bailed out by tax payers and are now furiously spinning the wheels of casino capitalism faster than ever before.
Yes, we should do something about it.
But. Not this.
Firstly, why financial markets are important. The good that these things do is provide a price on the future. They allow us all to insure ourselves against the unknown, whether that be a fixed rate mortgage to buy your house, or a bond issue that allows a company to grow.
Financial markets provide sellers for the shares you want to buy, insurers for risks you want to avoid and lenders when you need to borrow.
Attack the market, and you attack its ability to do this job efficiently. The price will be paid by you.
It is said that the market will absorb the Tobin/Hood/Luvvie tax. Anyone who says this clearly underestimates the ability of a bank to pass on its increased costs. You will either pay directly by higher fees, or indirectly, as the cost of everyday things get more expensive.
And more expensive they will be as the Luvvie tax will infect its way through the whole system. At every stage of production, financial markets are used to quantify and reduce costs. Commodity futures allow manufacturers to fix input costs, freight derivatives allow shippers to control cash flow, forward foreign exchange allows import/export companies to insure against wild market swings, credit insurance allow insurance against default and so on and on.
But surely a tiny transactional tax would pass unnoticed? Well, it may seem tiny, but to many market participants this Luvvie tax will be huge. What people fail to understand is that a regular and competitive price in many instruments come from institutions that are prepared to turn over huge volumes in order to make a net margin often much smaller than the Luvvie tax. In one fell swoop, you make a huge proportion of this trading unprofitable, therefore you take away the ability of the market to provide a price. It’s always the way of ill thought out taxes: unintended consequences. Some arbitrary decision is made, and a myriad of economic activity suddenly becomes futile.
So what? Who needs them? Well, you do. Every time you want to invest in your pension, you will (indirectly) need to buy a bond or some shares. Where do you think the seller comes from? Charity? No, it is the myriad of active traders that act as the buffer between ‘real’ buyers and sellers of these things.
In the end, you will pay by being poorer as a pensioner, by paying more interest on your mortgage and by generally being gouged more by the banks.
And so, we turn to the banks. The true villain of the piece.
The problem with financial markets is that banks are allowed to actively participate in this trading game. It would be less problematic if banks used the markets merely to reduce their risks, but this is not what they do. They see markets as a lucrative opportunity to enhance their profits, and they seize it with both hands.
Why is this bad? Because they punt their customer’s demand deposits. They take the money set aside to pay your gas bill, multiply it up tenfold, then wade onto the casino floor. What allows them to do this with some level of (misplaced) confidence is the myriad of legislative favours, monopoly rights, tax payer protection and political pressure arrayed to support them.
Here at the Cobden Centre, we’ve bleated on time and time again about how fractional reserve banking conjures money out of thin air, but it is worth repeating. You deposit £100 of notes and coin in your current account, and this becomes the property of the bank to do with as they wish. You sign it over to the bank, who lend most of it out. £100 of cash, becomes £197 of purchasing power. Whomever gets £97 loan, deposits it at their bank, and the same happens again and again.
Are you happy that the £100 you think is being safely held aside for your weekly food shopping is being used to fund £1000 of credit default swaps? I thought not.
At the end of the day, what consenting adults do in the privacy of their own bedrooms is of no concern to you. What hedge funds do with their willing clients’ money does not concern anyone but the investor. What pure trading companies do with their retained capital is of no worry to you.
The problem is the banks. An the best way to put a stop to their nefarious influence is not by taxing them and innocent parties. Not by robbing pension funds. Not by forcing you to pay higher fees to manage your financial affairs (as you surely will). No, they way to deal with the problem that banking has become is simple:
Free markets built on the bedrock of honest money.
- Huerta de Soto, Money, Bank Credit and Economic Cycles
- Baxendale, A day of reckoning: how to end the banking crisis now
- What is wrong with banking, part 1: the legal nature of banking contracts
- Frank Whitson Fetter, Development of British Monetary Orthodoxy 1797 – 1875
- F. A. Hayek, Denationalisation of Money: The Argument Refined
- Gordon Kerr, How To Destroy the British Banking System and Bailing out the Banks – Glaring Evidence of Moral Hazard
- James Tyler, My Journey to Austrianism via the City, Money is not working and How to avoid future encounters with financial meltdown
- Irving Fisher, 100% Money, 1935
On inflation, unemployment, especially desperate youth unemployment, and the stimulus. Consider, in the lows of the first years of the century, there were 2.8 people seeking every job; the ratio is now 6.3.
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