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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

John Butler’s interview with Jim Rickards

When it comes to the world of international finance, Jim Rickards has quite nearly seen it all. As a young man, he worked for Citibank in Pakistan, of all places. In the 1990s, he served as General Counsel for Long-Term Capital Management, Jim Merriwether’s large, notorious hedge fund that collapsed spectacularly in 1998. In recent years, he has been a regular participant in Pentagon ‘wargames’, in particular those incorporating financial or currency warfare in some way, and he has served as an advisor to the US intelligence community.

Yet while his experiences are vast in breadth, they have all occurred within the historically narrow confines of a peculiar international monetary regime, one lacking a gold- or silver-backed international reserve currency. Yes, reserve currencies have come and gone through history, but it is the US dollar, and only the US dollar, that has ever served as an unbacked global monetary reserve.

Nevertheless, in CURRENCY WARS and THE DEATH OF MONEY, Jim does an excellent job of exploring pertinent historical parallels to the situation as it exists today, in which the international monetary regime has been critically undermined by a series of crises and flawed policy responses thereto. He also applies not only economic but also complexity theory to provide a framework and deepen understanding.

As for what happens next, he does have a few compelling ideas, as we explore in the following pages. To begin, however, we explore what it was that got him interested in international monetary relations in the first place.

 

BACK TO THE 1970S: THE DECADE OF DISCO AND DOLLAR CRISES

JB: Jim, you might recall the rolling crises of the 1970s, beginning with the ‘Nixon Shock’ in 1971, when the US ‘closed the gold window’, to the related oil shocks and then the de facto global ‘run on the dollar’ at the end of the decade. At the time, as a student, did you have a sense as to what was happening, or any inclination to see this as the dollar’s first real test as an unbacked global monetary reserve? Did these events have any influence on your decision to study international economics and to work in finance?

 

JR: I was a graduate student in international economics in 1972-74, and a law student from 1974-77, so my student years coincided exactly with the most tumultous years of the combined oil, inflation and dollar crises of the 1970s. Most observers know that Nixon closed the gold window in 1971, but that was not considered the end of the gold standard at the time. Nixon said he was ‘temporarily’ suspending convertibility, but the dollar was still officially valued at 1/35th of an ounce of gold. It was not until 1975 that the IMF officially demonitised gold although, at French insistence, gold could still be counted as part of a country’s reserve position. I was in the last class of students who were actually taught about gold as a monetary asset. Since 1975, any student who learns anything about gold as money is self-taught because it is no longer part of any economics curriculum. During the dark days of the dollar crisis in 1977, I spoke to one of my international law professors about whether the Deutschemark would replace the dollar as the global reserve currency. He smiled and said, “No, there aren’t enough of them.” That was an important lesson in the built-in resilience of the dollar and the fact that no currency could replace the dollar unless it had a sufficiently large, liquid bond market – something the euro does not yet have to this day. From law school I joined Citibank as their international tax counsel. There is no question that my academic experiences in a period of borderline hyperinflation and currency turmoil played a powerful role in my decision to pursue a career in international finance.

 

JB: As you argued in CURRENCY WARS and now again in THE DEATH OF MONEY, the US debt situation, public and private, is now critical. It would be exceedingly difficult for another Paul Volcker to arrive at the Federal Reserve and shore up confidence in the system with high real interest rates. But why has it come to this? Why is it that the ‘power of the printing press’ has been so abused, so corrupted? Is this due to poor federal governance, as David Stockman argues in THE GREAT DEFORMATION? Is it due to the incompetence or ignorance of the series of Federal Reserve officials who failed to appreciate the threat of global economic imbalances? Or is it due perhaps to a fundamental flaw in the US economic and monetary policy regime itself?

 

JR: It is still possible to strengthen the dollar and cement its position as the keystone of the international financial system, but not without costs. Reducing money printing and raising interest rates would strengthen the dollar, but they would pop the asset bubbles in stocks and housing that have been re-created since 2009. This would also put the policy problem in the laps of Congress and the White House where it belongs. The problems in the economy today are structural, not liquidity-related. The Fed is trying to solve structural problems with liquidity solutions. That will never work, but it might destroy confidence in the dollar in the process. Federal Reserve officials have misperceived the problem and misapprehend the statistical properties of risk. They are using equilbirium models in a complex system. (Ed note: Complexity Theory explores the fundamental properties of dynamic rather than equilibrium systems and how they react and adapt to exogenous or endogenous stimuli.) That is also bound to fail. Fiat money can work but only if money issuance is rule-based and designed to maintain confidence. Today’s Fed has no rule and is destroying confidence. Based on present policy, a complete loss of confidence in the dollar and a global currency crisis is just a matter of time.

 

JB: Thinking more internationally, the dollar is in quite good company. ‘Abenomics’ in Japan appears to have failed to confer any meaningful, lasting benefits and has further undermined what little confidence was left in the yen; China’s bursting credit and investment bubble threatens the yuan; the other BRICS have similar if less dramatic credit excess to work off; and while the European Central Bank and most EU fiscal authorities have been highly restrained for domestic political reasons in the past few years, there are signs that this may be about to change. Clearly this is not a situation in which countries can easily trust one another in monetary matters. But as monetary trust supports trust in trade and commerce generally, isn’t it just a matter of time before the currency wars of today morph into the trade wars of tomorrow? And wouldn’t a modern-day Smoot-Hawley be an unparalleled disaster for today’s globalised, highly-integrated economy?

 

JR: Currency wars can turn into trade wars as happened in the 1920s and 1930s. Such an outcome is certainly possible today. The root cause is lack of growth on a global basis. When growth is robust, large countries don’t care if smaller trading partners grab some temporary advantage by devaluing their currencies. But when global growth in anemic, as it is now, a positive sum game becomes a zero-sum game and trading partners fight for every scrap of growth. Cheapening your currency, which simultaneously promotes exports and imports inflation via the cross rate mechanism, is a tempting strategy when there’s not enough growth to go around. We are already seeing a twenty-first century version of Smoot-Hawley in the form of economic sanctions imposed on major countries like Iran and Russia by the United States. This has more to do with geopolitics than economics, but the result is the same – reduced global growth that makes the existing depression even worse.

 

JB: You may recall that, in my book, THE GOLDEN REVOLUTION, I borrow your scenario of how Russia could, conceivably, undermine the remaining international trust in the dollar with a pre-emptive ‘monetary strike’ by backing the rouble with gold. Do you regard the escalating situation in Ukraine, as well as US policies in much of the Black Sea/Caucasus/Caspian region generally, as a potential trigger for such a move?

 

JR: There is almost no possibility that either the Russian rouble or the Chinese yuan can be a global reserve currency in the next ten years. This is because both Russia and China lack a good rule or law and a well-developed liquid bond market. Both things are required for reserve curreny status. The reason Russia and China are acquiring gold and will continue to do so is not to launch a new gold-backed currency, but rather to hedge their dollar positions and reduce their dependence on dollar reserves. If there is a replacement for the dollar as the leading reserve currency, it will either be the euro, the special drawing right (SDRs), or perhaps a new currency devised by the BRICS.

 

JB: Leaving geo-politics aside for the moment, you mention right at the start of THE DEATH OF MONEY, citing the classic financial thriller ROLLOVER, that even non-state actors could, perhaps for a variety of reasons, spontaneously begin to act in ways that, given the fragility of the current global monetary order, cascade into a run on the dollar and rush to accumulate gold. If you were to do a remake of ROLLOVER today, how would you structure the plot? Who could be the first to begin selling dollars and accumulating gold? Who might join them? What would be the trigger that turned a trickle of dollar selling into a flood? How might the US government respond?

 

JR: If Rollover were re-made today, it would not be a simple Arab v. US monetary plot. The action would be multilateral including Russia, China, Iran, the Arabs and others. Massive dumping of dollars might be the consequence but it would not be the cause of the panic. A more likely scenario is something entirely unexpected such as a failure to deliver physical gold by a major gold exchange or dealer. That would start panic buying of gold and dumping of dollars. Another scenario might begin with a real estate collapse and credit crash in China. That could cause a demand shock for gold among ordinary Chinese investors, which would cause a hyperbolic price spike in gold. A rising gold price is just the flip side of a collapsing dollar.

 

JB: This entire discussion all follows from the fragility of the current international monetary system. Were the system more robust, we could leave the dollar crisis topic to Hollywood for entertainment rather than to treat it with utmost concern for personal, national or even international security. But what is it that makes systems fragile? Authors ranging from George Gilder (KNOWLEDGE AND POWER), to Joseph Tainter (THE COLLAPSE OF COMPLEX SOCIETIES) and even Edward Gibbon (THE RISE AND FALL OF THE ROMAN EMPIRE) have applied such thinking to ancient and modern economies and societies. They all conclude that, beyond a certain point, centralisation of power is destabilising. Does this mean that a robust monetary system would ‘de-centralise’ monetary power? Isn’t this incompatible with any attempt by the G20 and IMF to transform the Special Drawing Right (SDR) from a unit of account into a centrally-managed, global reserve currency?

 

JR: Yes. Complex systems collapse because increases in complexity require exponential increases in energy to maintain the system. Energy can take many forms including money, which can be thought of as a form of stored energy. We are already past the point where there is enough real money to support the complexity of the financial system. Elites are now resorting to psuedo-money such as deriviatives and other forms of leverage to keep the system going but even that will collapse in time. The proper solution is to reduce the complexity of the system and restore the energy/money inputs to a sustainable level. This means reducing leverage, banning most derivatives and breaking up big banks. None of this is very likely because it cuts against the financial interests of the power elites who run the system. Therefore a continued path toward near-term collapse is the most likely outcome.

 

JB: In CURRENCY WARS you make plain that, although you are highly critical of the current economic policy mainstream for a variety of reasons, you are an agnostic when it comes to economic theory. Yet clearly you draw heavily on economists of the Austrian School (eg Hayek) and in THE DEATH OF MONEY you even mention the pre-classicist and proto-Austrian Richard Cantillon. While I doubt you are a closet convert to the Austrian School, could you perhaps describe what it is about it that you do find compelling, vis-à-vis the increasingly obvious flaws of current, mainstream economic thinking?

 

JR: There is much to admire in Austrian economics. Austrians are correct that central planning is bound to fail and free markets produce optimal solutions to the problem of scarce resources. Complexity Theory as applied to capital markets is just an extension of that thinking with a more rigorous scientific foundation. Computers have allowed complexity theorists to conduct experiments that were beyond the capabilities of early Austrians. The results verify the intuition of the Austrians, but frame the issue in formal mathematical models that are useful in risk management and portfolio allocation. If Ludwig von Mises were alive today he would be a complexity theorist.

 

JB: You may have heard the old Irish adage of the young man, lost in the countryside, who happens across an older man and asks him for directions to Dublin, to which the old man replies, unhelpfully, “Well I wouldn’t start from here.” If you were tasked with trying, as best you could, to restore monetary stability to the United States and by extension the global economy, how would you go about it? You have suggested devaluing the dollar (or other currencies) versus gold to a point that would make the existing debt burdens, public and private, credibly serviceable. But does this solve the fundamental systemic problem? What is to stop the US and global economy from printing excessive money and leveraging up all over again, and in a decade or two facing the same issues, only on a grander scale? Is there a better system? Could a proper remonetisation of gold a la the classical gold standard do the trick? Might there be a role for new monetary technology such as cryptocurrency?

 

JR: The classic definition of money involves three functions: store of value, medium of exchange and unit of account. Of these, store of value is the most important. If users have confidence in value then they will accept the money as a medium of exchange. The unit of account function is trivial. The store of value is maintained by trust and confidence. Gold is an excellent store of value because it is scarce and no trust in third parties is required since gold is an asset that is not simultaneously the liability of another party. Fiat money can also be a store of value if confidence is maintained in the party issuing the money. The best way to do that is to use a monetary rule. Such rules can take many forms including gold backing or a mathematical formula linked to inflation. The problem today is that there is no monetary rule of any kind. Also, trust is being abused in the effort to create inflation, which is form of theft. As knowledge of this abuse of trust becomes more widespread, confidence will be lost and the currency will collapse. Cryptocurrencies offer some technological advantages but they also rely on confidence to mainatin value and, in that sense, they are not an improvement on traditional fiat currencies. Confidence in cryptocurrencies is also fragile and can easily be lost. It is true that stable systems have failed repeatedly and may do so again. The solution for individual investors is to go on a personal gold standard by acquiring physical gold. That way, they will preserve wealth regardless of the monetary rule or lack thereof pursued by monetary authorities.

 

JB: Thanks Jim for your time. I’m sure it is greatly appreciated by all readers of the Amphora Report many of whom have probably already acquired a copy of THE DEATH OF MONEY.

 

POST-SCRIPT

In a world of rapidly escalating crises in several regions, all of which have a clear economic or financial dimension, Jim’s answers to the various questions above are immensely helpful. The world is changing rapidly, arguably more rapidly that at any time since the implosion of the Soviet Union in the early 1990s. Yet back then, the changes had the near-term effect of strengthening rather than weakening the dominant US position in global geopolitical, economic and monetary affairs. Today, the trend is clearly the opposite.

Jim’s use of Complexity Theory specifically is particularly helpful, as the balance of power now shifts away from the US, destabilising the entire system. Were the US economy more robust and resilient, perhaps a general global rebalancing could be a gradual and entirely peaceful affair. But with the single most powerful actor weakening not only in relative but arguably in absolute terms, for structural reasons Jim explains above, the risks of a disorderly rebalancing are commensurately greater.

The more disorderly the transition, however, the less trust will exist between countries, at least for a time, and as Jim points out it is just not realistic for either the Russian rouble or Chinese yuan to replace the dollar any time soon. As I argue in THE GOLDEN REVOLUTION, this makes it highly likely that as the dollar’s share of global trade declines, not only will other currencies be competing with the dollar; all currencies, including the dollar, will increasingly be competing with gold. There is simply nothing to prevent one or more countries lacking trust in the system to demand gold or gold-backed securities of some kind in exchange for exports, such as oil, gas or other vital commodities.

Jim puts the IMF’s SDR forward as a possible alternative, but here, too, he is sceptical there is sufficient global cooperation at present to turn the SDR into a functioning global reserve currency. The world may indeed be on the path to monetary collapse, as Jim fears, but history demonstrates that collapse leads to reset and renewal, and in this case it seems more likely that not that gold will provide part of the necessary global monetary foundation, at least during the collapse, reset and renewal period. Once trust in the new system is sufficient, perhaps the world will once again drift away from gold, and perhaps toward unbacked cryptocurrencies such as bitcoin, but it seems unlikely that a great leap forward into the monetary unknown would occur prior to a falling-back onto what is known to have provided for the relative monetary and economic stability that prevailed prior to the catastrophic First World War, which as readers may note began 100 years ago this month.

 

Economics

Has Fractional-Reserve Banking Really Passed the Market Test?

[Editor's note: the following piece was originally published by World Dollar at zerohedge.com]

In 2003, Jörg Guido Hülsmann, a senior fellow of the Mises Institute, published the essay “Has Fractional-Reserve Banking Really Passed the Market Test?” in a Winter edition of The Independent Review. The key conclusion drawn was that it is the obfuscation of the difference between fractional-reserve IOUs and genuine money titles which preserves the the practice of fractional-reserve banking.

It is the belief of this author that this essay has not received the acclaim that it so richly deserves. Indeed, its implications for the future of money and banking are monumentous. If those who advance the Austrian School of economics, the Mises Institute and Zero Hedge most prominently among them, were to grant its ideas a great renaissance, the worldwide return to sound money may happen far sooner than most could have believed possible.

J.G. Hülsmann 
explains why “in a free market with proper product differentiation, fractional-reserve banking would play virtually no monetary role” (p.403). The incisive reason given is that genuine money titles are valued at par with money proper, while fractional-reserve IOUs + RP (Redemption Promise) would be valued below par, due to default risk.

Here is the deductive argument being made:

1.    Debt (IOUs + RP) is promised money.
2.    A promise has the risk of not being kept (default risk).
3.    Therefore, promised money, debt (IOUs + RP), is less valuable than genuine money titles (/money proper).

J.G. Hülsmann goes on to explain why the mispricing of fractional-reserve debt (IOUs + RP) persists. The reasons given include the outlawing of genuine money titles and deceptive language (“deposits”).  This author would like to add one more reason, namely the myth that the government could actually “guarantee” deposits in the event of a systemic run. Systemic runs mean, by definition, most if not all money proper exiting the fractional reserve banking system, meaning the money proper with which the “guarantees” could be fulfilled doesn’t exist, short of unprecedented levels of new money printing and financial repression. This point is acknowledged on p.22 of the otherwise unexceptional “The Chicago Plan Revisited” by Jaromir Benes and Michael Kumhof.

The history of fractional reserve banking is, then, defined by informational inefficiency. Market participants have failed to reflect the price differential between fractional reserve debt (IOUs + RP) and genuine money titles.

Let us now extend the deductive argument:

4.    Therefore, an arbitrage opportunity exists. All holders of Debt (IOUs + RP) have an economic incentive to make the redemption request for genuine money titles (/money proper).

Mervyn King, ex-governor of the Bank of England, once claimed that it is irrational to start a bank run, but rational to participate in one once it has started. While the second part of the claim is correct, the first is not. It is irrational not to start a bank run, due to the arbitrage opportunity that exists.

This, of course, holds the assumption that the market will become informationally efficient, and will therefore capitalise on the mispricing. But the holding of this assumption is only credible if this idea is spread. We live in a time with an unprecedented level of competing voices wanting to be heard, the unfortunate consequence of which is that we drown out the voices that are truly exceptional. It is no exaggeration to say that “Has Fractional-Reserve Banking Really Passed the Market Test?” may prove to be the most revolutionary essay in the history of monetary economics and banking, if only it  receives the level of appraisal and promotion it deserves.

On this matter, the reasons given for the persistence of the mispricing of fractional-reserve debt (IOUs + RP) are unsustainable in the long run. The lack of legal protection for genuine money titles is no more than a technicality, for there is nothing in practice that can sustainably prevent the existence of full reserve banks. Awareness that “deposits” are not actually money being held for safekeeping is a matter of educating the public, as is awareness that government’s deposit “guarantees” are not actually credible in the event of a systemic run.

If we assume, then, that fractional-reserve banking will come to its logical ending, there is good reason to believe that the shock will herald the endgame for fiat money. It is in fact the case that all fiat money is the liability of the central bank, which also carries the risk of non-repayment (default risk). This, again, means an arbitrage opportunity for market participants to withdraw the fiat money from the fiat money banking system. This confirms that the original basis for fiat money is destroyed, for its repayment to the central bank is not credible.

Finally, at long last, we have a worldwide return to sound money. Will there be a new 21st century Gold Standard? Will we recourse to cryptocurrencies such as Bitcoin? Will we see the rise of the Equal Opportunity Standard, with everyone in the world being issued once with an equal amount of World dollars? Or will there be another innovation to come? What we must defend, as proud advocates of freedom, is that the free market will decide. That governments finally learn to stop their oppressive, damaging interference with the monetary system.

Economics

A tale of two certainties

It is common knowledge that Japan is in extreme financial difficulties, and that the currency is most likely to sink and sink. After all, Government debt to GDP is over 250%, and the rate of increase of retirees has exceeded the birth rate for some time. A combination of population demographics, escalating welfare costs, high government debt and the government’s inability in finding a solution to Japan’s ongoing crisis ensures for international speculators that going short of the yen is a no-brainer.

 
Almost without being noticed, the Japanese yen has already lost about 30% against the US dollar and nearly 40% against the euro over the last two years. The beneficiaries of this trend unsurprisingly are speculators borrowing yen at negligible interest rates to speculate in other markets, expecting to add the yen’s depreciation to their profits. Thank you Mr Abe for allowing us to borrow yen at 1.06 euro-cents two years ago to invest in Spanish 10-year government bonds at 7.5%. Today the bonds yield 2.65% and we can buy back yen at 0.72 euro-cents. Gearing up ten times on an original stake of $10,000,000 has made a clear profit of some $300,000,000 in just two years.

 
Shorting the yen has not been profitable this year so far, with the US dollar falling against the Japanese yen from 105.3 on December 31st to 101.5 at the half-year, an annualised loss of 7.2%. This gave a negative financing return on all bond carry trades, which in the case of Spanish government debt deal cited above resulted in annualised losses of over 5%, or 50% on a ten times geared position. The trader can either take the view it’s time the yen had another fall, or it’s time to cut the position.

 
These returns, though dependant on market timing, are by no means unique. Consequently nearly everyone in the hedge fund and investment banking communities has been playing this lucrative carry game at one time or another.

 
Not only has a weak yen been instrumental in lowering bond yields around the world, it has also been a vehicle for other purchases. On the sale or short side, another commonly agreed certainty has been the imminent collapse of the credit-driven Chinese economy, which will ensure metal prices continue to fall. In this case, gearing is normally obtained through derivatives.

 
However, things don’t seem to be going according to plan for many investment banks and hedge funds, which might presage a change of strategy. Copper, which started off as a profitable short by falling 12.5% to a low of $2.93 per pound, has recovered sharply this week to $3.26 in a sudden short-squeeze. Zinc is up 6.4% over the last six months, and aluminium up 6%. Gold is up 11%, and silver 8.5%. So anyone shorting a portfolio of metal futures is making significant losses, particularly when the position is highly geared.

 
It may be just coincidence, but stories about multiple rehypothecations of physical metal in China’s warehouses have emanated from sources involved with trading in these metals. These traders have had to take significant losses on the chin on a failed strategy, and may now be moving towards a more bullish stance, because China’s warehouse scandal has not played out as they expected.

 
So two certainties, the collapse of both the yen and of Chinese economic demand don’t seem to be happening, or at least not happening quickly enough. The pressure is building for a change of investment strategies which is likely to drive markets in new directions in the coming months.

 
Economics

First glance at MAex

The recent update to the MA compilation method revealed a sudden reduction in the growth rate. However this was driven by a mysterious “improvements in reporting at one institution”, which saw £85bn vanish in January 2014. I made a shadow M’ series which added this back in, but that’s not ideal.

I’ve just tried an alternative response, which is to strip MFI deposits from the measure. We can call this MAex, and here’s the series from April 1991:

If you want to see a more recent look, here it is from January 2001:

I’m continuing efforts to improve the measure.

Economics

New private monies can outcompete government monetary systems

[Editor's note: this article was originally published by the IEA here]

I would like to thank the IEA for today publishing my monograph, New Private Monies, which examines three contemporary cases of private monetary systems.

The first is the Liberty Dollar, a private mint operated by Bernard von NotHaus, whose currency became the second most widely used in the United States. It was highly successful and its precious metallic basis ensured it rose in value over time against the inflating greenback. In 2007, however, Uncle Sam shut it down, successfully charging von NotHaus with counterfeiting and sundry other offences. In reality, the Liberty Dollar was nothing like the greenback dollar. Nor could it be, as its purpose was to provide a superior dollar in open competition, not to pass itself off as the inferior dollar it was competing against, which has lost over 95 per cent of its value since the Federal Reserve was founded a century ago. For this public service of providing superior currency, Mr. von NotHaus is now potentially facing life in the federal slammer. As he put it:

‘This is the United States government. It’s got all the guns, all the surveillance, all the tanks, it has nuclear weapons, and it’s worried about some ex-surfer guy making his own money? Give me a break!’

The second case is e-gold, a private digital gold transfer business – a kind of private gold standard – run by Dr Doug Jackson out of Nevis in the Caribbean. By 2005, e-gold had risen to become second only to PayPal in the online payments industry. Jackson correctly argued that it was not covered by any existing US financial regulation, not just because of its offshore status but also because it was a payment system rather than a money transmitter or bank as then-defined, and not least because gold was not legally ‘money’. Yet despite its efforts to clarify its evolving regulatory and tax status, and despite helping them to catch some of the biggest cyber criminals then in operation, US law enforcement turned on the company: they trumped up charges of illegal money transmission and blackmailed its principals into a plea bargain.

Both these cases illustrate that there is a strong demand for private money and that the market can meet that demand and outcompete government monetary systems. Unfortunately, they also illustrate the perils of private money issuers operating out in the open where they are vulnerable to attack by the government. Perhaps they should operate undercover instead…

This takes us to the third case study: Bitcoin, a new type of currency known as crypto-currency, a self-regulating and highly anonymous computer currency based on the use of strong cryptography.

To quote its designer, Satoshi Nakamoto:

‘The root problem with conventional currency is all the trust that is required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust…

‘Bitcoin’s solution is to use a peer-to-peer network to check for double-spending…the result is a distributed system with no single point of failure.’

Bitcoin is produced in a kind of electronic ‘mining’ process, in which successful ‘miners’ are rewarded with Bitcoin. The process is designed to ensure that the amounts produced are almost exactly known in advance. Since its inception in 2009, the demand for Bitcoin has skyrocketed, albeit in a very volatile way, forcing its price from 3 cents to (currently) just under $600. Perhaps the best-known use of Bitcoin has been on the dark web drugs market Silk Road, the ‘Amazon.com of illegal drugs’, but Bitcoin is increasingly popular for all manner of mundane legal uses as well.

Bitcoin is a wonderful innovation, but the pioneers in any industry are rarely the ones who last. Despite Bitcoin’s success to date, it is doubtful whether being the first mover is an advantage in the longer term: design flaws in the Bitcoin model are set in concrete and competitors can learn from them. The crypto-currency market is also an open one and a considerable number of competitors have since entered the field. Most of these will soon fail, but no-one can predict which will be best suited to the market and achieve long-run success. Most likely, Bitcoin will eventually be displaced by even better crypto-currencies.

Crypto-currencies have momentous ramifications. As one blogger put it:

‘As long as my encrypted [Bitcoin] wallet exists somewhere in the world, such as on an email account, I can walk across national borders with nothing on me and retrieve my wealth from anywhere in the world with an internet connection.’

This gives Bitcoin great potential as an internationally mobile store of value that offers a high degree of security against predatory governments. Bitcoin now fulfils the role once met by bank secrecy – the ability to protect one’s financial privacy.

There is no easy way in which the government can prevent the use of Bitcoin to evade its control. The combination of anonymity and independence means that governments cannot bring Bitcoin down by taking out particular individuals or organisations because the system has no single point of failure. They could shut down whatever sites they like, but the Bitcoin community would carry on.

Strong cryptography therefore offers the potential to swing the balance of power back from the state toward the individual. Censorship, prohibition, oppressive taxes and repression are being undermined as people increasingly escape into the cyphersphere where they can operate free from government harassment.

We now face the prospect of a peaceful crypto-anarchic society in which there is no longer any government role in the monetary system and, hopefully, no government at all.

Welcome to crypto-anarchy.

 

New Private Monies: A Bit-Part Player can be downloaded here.

Economics

Paul Volcker’s Call For A ‘New Bretton Woods’ Is Important

Seth Lipsky, the editor of the storied New York Sun (a brand distinguished by the long residency of Henry Hazlitt), recently, in the Wall Street Journal, brought to wider attention certain remarkable recent comments by Paul Volcker.  Volcker spoke before the May 21st annual meeting of the Bretton Woods Committee at the World Bank Headquarters in Washington, DC.  Volcker’s remarks did not present a departure in substance from his long-standing pro-rule position. They nonetheless were striking, newly emphatic both by tone and context.
 Volcker, asked by the conference organizer for his preferred topic, declared that he had said:

“What About a New Bretton Woods???” – with three question marks. The two words, “Bretton Woods”, still seem to invoke a certain nostalgia – memories of a more orderly, rule-based world of financial stability, and close cooperation among nations. Following the two disasters of the Great Depression and World War II that at least was the hope for the new International Monetary Fund, and the related World Bank, the GATT and the OECD.

No one here was actually present at Bretton Woods, but that was the world that I entered as a junior official in the U.S. Treasury more than 50 years ago. Intellectually and operationally, the Bretton Woods ideals absolutely dominated Treasury thinking and policies. The recovery of trade, the opening of financial markets, and the lifting of controls on current accounts led in the 1950’s and 60’s to sustained growth and stability.

The importance, especially from a speaker of Volcker’s stature presenting among the current heads of the two leading Bretton Woods institutions, the IMF’s Christine Lagarde, and the World Bank Group’s Jim Yong Kim, among other luminaries, potentially has radical implications.  Volcker provided a quick and precise summary of the monetary and financial anarchy which succeeded his dutiful dismantling of Bretton Woods:

Efforts to reconstruct the Bretton Woods system, either partially at the Smithsonian or more completely in the subsequent negotiations of the Committee of 20, ultimately failed. The practical consequence, and to many the ideological victory, was a regime of floating exchange rates. Somehow, the intellectual and convenient political argument went, differences among national financial and economic policies, shifts in competitiveness and in inflation rates, all could be and would be smoothly accommodated by orderly movements in exchange rates.

How’s that working out for us?  Volcker played an instrumental role in dutifully midwifing, as Treasury undersecretary for monetary affairs under the direction of Treasury Secretary John Connally the “temporary” closing of the gold window announced to the world on August 15, 1971 by President Nixon.  Volcker now unequivocally indicts the monetary regime he played a key role in helping to foster.

By now I think we can agree that the absence of an official, rules-based cooperatively managed, monetary system has not been a great success. In fact, international financial crises seem at least as frequent and more destructive in impeding economic stability and growth.
The United States, in particular, had in the 1970’s an unhappy decade of inflation ending in stagflation. The major Latin American debt crisis followed in the 1980’s. There was a serious banking crisis late in that decade, followed by a new Mexican crisis, and then the really big and damaging Asian crisis. Less than a decade later, it was capped by the financial crisis of the 2007-2009 period and the great Recession. Not a pretty picture.

Volcker fully recognizes the difficulties in restoring a rule-based well functioning system both in his speech and in this private comment to Lipsky made thereafter.  Lipsky: “It’s easy to say what’s wrong,” Mr. Volcker told me over the weekend, “but sensible reforms are a pretty tough thing.”

The devil, of course, is in the details.  What rule should prevail?  There is an almost superstitious truculence on the part of world monetary elites to consider the restoration of the gold standard.  And yet, the Bank of England published a rigorous and influential study in December 2011, Financial Stability Paper No. 13, Reform of the International Monetary and Financial System.  This paper contrasts the empirical track record of the fiduciary dollar standard directed by Secretary Connally and brought into being (and then later administered by) Volcker.  It determines that the fiduciary dollar standard has significantly underperformed both the Bretton Woods gold exchange standard and the classical gold standard in every major category.

As summarized by Forbes.com contributor Charles Kadlec, the Bank of England found:
When compared to the Bretton Woods system, in which countries defined their currencies by a fixed rate of exchange to the dollar, and the U.S. in turn defined the dollar as 1/35 th of an ounce of gold:
  • Economic growth is a full percentage point slower, with an average annual increase in real per-capita GDP of only 1.8%
  • World inflation of 4.8% a year is 1.5 percentage point higher;
  • Downturns for the median countries have more than tripled to 13% of the total period;
  • The number of banking crises per year has soared to 2.6 per year, compared to only one every ten years under Bretton Woods;

That said, the Bank of England paper resolves by calling for a rules-based system, without specifying which rule.  Volcker himself presents as oddly reticent about considering the restoration of the “golden rule.” Yet, as recently referenced in this column, in his Foreword to Marjorie Deane and Robert Pringle’s The Central Banks (Hamish Hamilton, 1994) he wrote:

It is a sobering fact that the prominence of central banks in this century has coincided with a general tendency towards more inflation, not less. By and large, if the overriding objective is price stability, we did better with the nineteenth-century gold standard and passive central banks, with currency boards, or even with ‘free banking.’ The truly unique power of a central bank, after all, is the power to create money, and ultimately the power to create is the power to destroy.

There is an active dispute in Washington between Republicans, who predominantly favor a rule-based monetary policy, and Democrats, who predominantly favor a discretion-based monetary policy.  The Republicans have not specified the rule they wish to be implemented.  The specifics matter.
There is an abundance of purely empirical evidence for the gold standard’s effectiveness in creating a climate of equitable prosperity.  The monetary elites still flinch at discussion the gold option.  That said, the slow but sure rehabilitation of the legitimacy of the gold standard as a policy option was put into play by one of their own, no less than the then World Bank Group president Robert Zoellick, in an FT op-ed, The G20 must look beyond Bretton Woods.   There he observed, in part, that “Although textbooks may view gold as the old money, markets are using gold as an alternative monetary asset today.”
There are many eminent and respectable elite proponents of the gold standard.  Foremost among these Reagan Gold Commissioners Lewis E. Lehrman (with whose Institute this writer has a professional association) and Ron Paul, and Forbes Media CEO Steve Forbes, coauthor of a formidable new book, Money, among them.  There are many more, too many to list here.
In the penultimate paragraph of his remarks to the Bretton Woods Committee Volcker observes:

Walter Bagehot long ago set out succinctly a lesson from experience: “Money will not manage itself”. He then spoke from the platform of the Economist to the Bank of England. Today it is our mutual interdependence that requires a degree of cooperation and coordination that too often has been lacking on an international scale.

As the great Walter Layton, editor of the Economist, wrote in 1925, “the choice which presents itself is not one between a theoretical standard on the one hand and gold with all its imperfections on the other, but between the gold standard … and no control at all.” “No control at all” anticipates Volcker’s own critique.

If Chairman Volcker overcame his aversion to considering the gold standard as a respectable option for consideration he just might find that his his stated concern “We are long ways from (a new Bretton Woods conference)” may be exaggerated. A golden age of equitable prosperity and financial stability is closer than Mr. Volcker believes.

The corollary to Volcker’s dictum, “ultimately the power to create is the power to destroy” is that the power to destroy is the power to create.  It is time, and past time, Mr. Volcker, to give full and respectful consideration to the gold standard which served the world very well indeed and would serve well again.

This article was previously published at Forbes.com

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

 

 

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.