Authors

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

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?

Economics

Don’t Shoot The Speculator!

Editor’s Note: This article was previously published in The Amphora Report, Vol 5, 09 May 2014.

“Capitalism is not chiefly an incentive system but an information system.” -George Gilder

“Don’t shoot the messenger” is an old aphorism taken primarily to mean that it is unjust to take out the frustrations of bad news on he who provides it. But there is another reason not to shoot the messenger: News, good or bad, is information, and in a complex economy information, in particular prices, has tremendous value. To suppress or distort the information industry by impeding the ability of messengers to do their jobs would severely damage the economy. As it happens, messengers in the price signals industry are normally referred to as ‘speculators’ and the importance of their economic role increases exponentially with complexity. So don’t shoot the speculator. Embrace them. And if you feel up to it, consider becoming one yourself. How? Read on.

IN ADMIRATION OF SPECULATION

Back in high school my sister had a boyfriend who was quite practical by nature and, by working odd jobs, saved up enough money for the down payment on a 4WD pickup truck before his 18th birthday. It was a powerful truck and as a result he was able to generate additional business doing landscaping and other work requiring off-road equipment transport.

His truck also had a winch, which was of particular use one night in 1982. A severe storm hit, flooding the primary commuting routes north of San Francisco. Hundreds of motorists got stranded in water on roads stretching all the way to the Sonoma County borders. The emergency services did their best but the gridlock severely curtailed their ability to reach many commuters, who ended up spending the night in the cars. Fortunately, it was not particularly cold, and the conditions, while unpleasant, were hardly life-threatening.

As word got round just how bad the situation was, among others, my sister’s boyfriend headed out in his truck and sought out stranded commuters to winch out of the water. Sure, he wanted to help. But he also had payments to make on his truck. And he needed money generally, not being from a wealthy family. So naturally he expected to get paid for his services. What he didn’t expect, at least not at first, was just how much he could get paid.

As he told the story the next day, at first he was charging $10 to winch a car to safety. But as it dawned on him just how much demand there was and how few motorists he could assist-attaching a winch to a car and pulling it to safety could take as long as 20mins-he began to raise his prices in response. $10 became $20. $20 became $50. By midnight, stranded drivers were willing to pay as much as $100 for his assistance (Marin County is a wealthy county so some drivers were not just willing but also able to pay this amount.)

I forget exactly, but I believe he earned nearly $3,000 that night, enough money to pay off the lease on the truck! He was thrilled, my sister was thrilled and my parents were duly impressed. Yet the next day the local papers contained stories disparaging of ‘price-gouging’ by those helping to rescue the stranded commuters, who also noted and complained about the lack of official emergency services.

This struck me as a bit odd. The way my sister’s boyfriend told the story, he thought he was providing a valuable service. At first he was charging very little but as people were obviously willing to pay more, he raised his prices in return. The price discovery went on into the wee hours and reached $100 in the end. Did he plan things that way? Of course he had no idea he would be in the right place, at the right time, to make nearly $3,000 and pay off the lease in one go. But to hear some of the stranded commuters talk as if he was a borderline criminal just didn’t fit.

I didn’t think of it at the time, but as I began the study of economics some years later and learned of the role that speculators play in a market-based economy, I recalled this episode as one that fit the definition rather well. Speculators provide essential price information. Yet their most important role, where they really provide economic value, is not when market conditions are simply ‘normal’-when supply and demand are in line with history-but rather when they help to determine prices for contingent or extreme events, such as capacity constraints. Without sufficient capacity for a rainy day-or a VERY rainy day such as that in 1982-consumers will find at critical times that they can’t get access to essential services at ANY price.

In that rare moment, when prices soar, it might be tempting to shoot the messenger-blame the speculator-but this is unfair. Sometimes they take big risks. Sometimes they take huge losses or reap huge rewards. But regardless, they provide essential price discovery signals that allow capacity to be built that otherwise might not exist.

Consider those who speculate in electricity prices as another example. Electricity demand naturally fluctuates. But electricity providers are normally contractually required to meet even unusually large surges in peak demand. Occasionally, due to weather or other factors, there are extreme spikes in demand and capacity approaches its limit. If there is a tradable market, the price then soars. At the limit of capacity, the last kw/hr goes to the highest bidder, much as at the end of an auction for a unique painting. Such is the process of price discovery.

Absent the unattractive option of inefficient and possibly corrupt central planning, how best to determine how much capacity should be made available? Who is going to finance the infrastructure? Who will assume the risks? Well, as long as there is a speculative market in the future price of electricity, the implied forward price curve provides a reference for determining whether or not it is economically attractive to add to available capacity or not, with capacity being an option, rather than the obligation, to produce power at a given price and point in time.

My sister’s boyfriend’s truck thus represented an undervalued ‘option’ with which to winch cars to safety. Under normal conditions this option had little perceived value. But on the occasion of the flood, it had tremendous value and the option was ‘exercised’ at great profit. Valuing the truck without speculating on the possibility of such a windfall would thus be incorrect. And failing to appreciate the essential role that speculators play in building and maintaining economic capacity generally, for all goods and services, can result in a temptation to shoot the messenger, rather than to get the message.(1)

HOW DO SPECULATORS SURVIVE?

If speculators are the ‘messengers’ of market economies, how are they compensated? Obviously, those who are consistently right generate trading profits. But what of those on the other side who are consistently wrong? How can speculators as a group, right and wrong, make money? And if they can’t, how can they exist at all? (Of course, if they are too big to fail, they can count on getting bailed out. But I’ve already flogged that dead horse in many a report.)

This was once one of the great mysteries of economics, but David Ricardo, Ludwig von Mises and others eventually figured it out. Speculators do more than just speculate, although from their perspective that is what they see. Speculators also provide liquidity for hedgers, that is, those who wish NOT to speculate. And they charge a small implied fee for doing so, in the form of a ‘risk premium’. This risk premium is what keeps them going through the inevitable ups and downs of markets. They assume risks others don’t want to take and are compensated for doing so. In practice, it is impossible to determine precisely what this implied fee is, although economists do have ways to approximate the ‘liquidity risk premium’ that exists in a market.

Hedgers can be those who have a natural exposure to the underlying economic good. Take wheat for example. A highly competent farmer running an efficient farm might want to concentrate full-time on his operations and leave the price risk of wheat to someone else. He can do so by selling his estimated production forward in the futures markets. On the other side, a baked goods business might prefer to focus on their operations too. In principle, the farmer and the baker could deal directly with one another, but this arrangement would give them little flexibility to dynamically adjust hedging positions as estimated wheat production or the demand for bread shifted, for example. With speculators sitting in the middle, the farmer and the baker needn’t waste valuable time seeking out the best counterparty and can easily hedge their risk dynamically. Yes, they will pay a small liquidity risk premium to the speculators by doing so, but advanced economies require a high degree of specialisation and thus the professional speculator is an essential component.

While it is nice to receive a small risk premium in exchange for providing essential price information and liquidity, what speculators most want is to be right. Sadly, pure speculation (ie between speculators themselves, not vis-à-vis hedgers) is a zero sum game. For every ‘right’ speculator there is a ‘wrong’ speculator. While there is an extensive literature regarding why some traders are more successful than others, I will offer a few thoughts.

THE UNWRITTEN ‘RULES’ OF SUCCESSFUL SPECULATION

There are several unwritten rules in speculation, and I would confirm these through my own experience. The first is that it is the rare trader who is right more than 60% of the time, so most successful traders are right within the narrow range of 51-60%. Then there is the second rule, that 20% of traders capture 80% of the available profits. Combining these two rules, what you have is that 20% of traders are correct 51-60% of the time: So 0.2 * 0.5 or 0.6 = 0.10 to 0.12 or 10-12% of all trades initiated are winning trades for winning traders. The remaining 88% are either losing trades or they are winning trades spread thinly amongst the less successful traders.

These numbers should make it clear that successful traders are largely just risk managers: Yes, they succeed in identifying the 10-12% of trades that really matter for profits but they are also wrong 40%+ of the time so they must know how to manage their losses as well as when to prudently take profits on the 10-12% of winning trades.

Internalising this negative skew in trading returns is an essential first step toward becoming a good trader. Just accept that something on the order of 50% of trades are going to go against you, possibly even more. Accept also that only 10-12% of your trades are going to drive your profits. Focus on finding these but keep equal focus on minimising exposure to the other 88-90% of trades that either don’t matter, or that could overwhelm the 10-12%.

At Amphora, we have an investment process that we believe is particularly good at identifying and isolating the most attractive trades in the commodities markets. Sure, we make mistakes, but our investment and risk management processes are designed to keep these mistakes to a minimum. Indeed, we miss out on many potentially winning trades because we are highly selective. So while speculation may have a cavalier reputation of bravado trading, day in and day out, the Amphora process is more patient; an opportunistic tortoise rather than a greedy, rushed hare.

CURRENT OPPORTUNITIES IN THE EQUITIES AND COMMODITIES MARKETS

In my last Report discussing the financial and commodities markets outlook, 2014: A YEAR OF INVESTING DANGEROUSLY, I took the view that the equity market correction (or crash) that I anticipated from spring 2013 was highly likely to occur in 2014, for a variety of reasons (2). While I did not anticipate that the Ukraine crisis would escalate as much as it did, as quickly as it did, thereby causing some concern, I did expect that corporate revenues and profits would increasingly disappoint, as they most certainly have done year to date. This is due in part to weaker-than-expected economic growth, with the drag from excessive inventory growth plainly visible in the Q1 US GDP data. But the news is in fact much worse than that, because labour productivity growth has gone sharply negative due to soaring costs. These costs may or may not be specifically associated with the ‘(Un?)Affordable Care Act’ depending on who you ask, but the fact that productivity has plunged is terrible news for business fixed investment, which is the single most important driver of economic growth over the long-term. While a recession may or may not be getting underway, the outlook is for poor growth regardless, far below what would be required to justify current corporate earnings expectations, as implied by P/Es, CAPEs and other standard valuation measures. For those who must hold an exposure to equities, my key recommendation from that previous Report holds:

[I]t is time to rotate into defensive, deep-value, income-generating shares. These could include, for example, infrastructure, consumer non-discretionary and well-capitalised mining shares, including gold miners. That may seem an odd combination, but it so happens that even well-capitalised miners are trading at distressed levels at present, offering unusually good value.

Turning to the commodities markets, I expressed a preference for ‘defensive’ commodities in the Report (Although I did recommend taking initial profits in coffee). Indeed, basic foodstuffs, in particular grains, have outperformed strongly of late, continuing their rise from the depressed levels reached last year. However, the large degree of such outperformance now warrants some rotation out of grains and into industrial metals, including copper, aluminium, iron and nickel. Yes, these are exposed to the business cycle, which does appear to be rolling over in the US, China, Japan, Australia and most of Asia, but the extreme speculative short positioning and relative cheapness of industrial metals at present makes them an attractive contrarian play.

Precious metals have not underperformed to the same degree and they are normally less volatile in any case, but given the nearly three-year bear market, attractive relative valuations and the potential for a surge in risk-aversion, I would add to precious metals. Silver in particular looks cheap, although gold is highly likely to be the better performer in a risk-off environment. My recommendation would be to favour gold until the equity markets suffer at least a 15-20% correction. At that point, incremental rotation into silver would be sensible, with a more aggressive response should equity markets suffer a substantial 30%+ decline.

Turning to the platinum group metals, palladium is unusually expensive due to Russian supply concerns. While this is entirely reasonable due to the Ukraine crisis, the fact is that near-substitute platinum is much cheaper. And the on-again, off-again strikes at the large platinum mines in South Africa could escalate in a heartbeat, providing ample justification for platinum prices to catch up to palladium. Alternatively, should the Ukraine crisis de-escalate meaningfully, palladium is highly exposed to a sharp downward correction, and I would recommend a strong underweight/short position at present.

NOTES
(1) Perhaps one reason why many fail to appreciate the essential role that speculators play in a market economy is that mainstream, neo-Keynesian economics treats speculation as mere ‘animal spirits’, to borrow their classic depiction by Keynes himself.

(2) This report can be accessed here.

Economics

Technical analysis versus value in gold

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

At the outset I should declare an interest. In the 1980s I was a member of the UK’s Society of Technical Analysis and for a while I was the society’s examiner and lecturer on Elliott Wave Theory. My proudest moment as a technician was calling the 1987 crash the night before it happened and a new bull market two months later in early December. Before anyone assumes I have a gift for technical analysis, I hasten to add I have also made many wrong calls using it, so to be so spectacularly right on that occasion was almost certainly down to a large element of luck. I should also mention that the most successful investors I have observed over 40 years are those who recognise value and disdain charts altogether.

Technical analysts assume past prices are a valid basis for predicting what investors will pay tomorrow. The Warren Buffetts of this world act differently: they care not what others think and use their own judgement of value. This means that value investors often buy when the trend is down and sell when the trend is up, the opposite of technically-driven decisions. A bear market ends when value investors overcome the trend.

Technical analysts go with the crowd and give any trend an added spin. This explains the preoccupation with moving averages, bands, oscillators and momentum. Speculators, who used to be independent thinkers, now depend heavily on technical analysis. This is not to deny that many technicians make a reasonable living: the key is to know when the trend ends, and the difficulty in that decision perhaps explains why technical analysts are not on anyone’s rich list.

Value investors like Buffett rely on an assessment of the income that an investment can generate, and the opportunity-cost of owning it. This may explain his well-known views on gold which for all but a small coterie of central and bullion banks does not generate any income. So where does gold, a sterile asset in Buffett’s eyes stand in all this?

Value investors in gold who buy on falling prices are predominately Asian. For Asians the value in gold comes from the continual debasement of national currencies, a factor rarely considered by western investors who measure investment returns in their home currency with no allowance for changes in purchasing power.

The financial system discourages a more realistic approach, not even according physical gold an investment status. Using technical analysis with the false comfort of stop-losses leads to more profits for market-makers. Furthermore, gold’s replacement as money by unstable national currencies makes economic and investment calculation for anything other than the shortest of timescales unreliable or even impossible. But then this point goes over the heads of the trend-followers as well as the fundamental question of value.

Technical analysis is a tool for idle investors unwilling or unable to understand true value. It dominates price formation in western markets and distorts investor behaviour by exaggerating any natural bias towards trends. It is this band-wagon effect that is the root of trend-following’s success, but also its ultimate weakness. A better strategy is to make the effort to value gold properly and then act accordingly.

Book Reviews

‘The system has spun out of control’

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Events

Bitcoin entrepreneurs meet in Paris this week

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

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

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

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

Society

I predict a riot

It is with no feelings of joy that we republish this article, first posted on 8 February 2010

Guest contributor Anita Acavalos, daughter of Advisory Board member Andreas Acavalos, explains the political and economic predicament in Greece.

In recent years, Greece has found itself at the centre of international news and public debate, albeit for reasons that are hardly worth bragging about. Soaring budget deficits coupled with the unreliable statistics provided by the government mean there is no financial newspaper out there without at least one piece on Greece’s fiscal profligacy.

Although at first glance the situation Greece faces may seem as simply the result of gross incompetence on behalf of the government, a closer assessment of the country’s social structure and people’s deep-rooted political beliefs will show that this outcome could not have been avoided even if more skill was involved in the country’s economic and financial management.

The population has a deep-rooted suspicion of and disrespect for business and private initiative and there is a widespread belief that “big money” is earned by exploitation of the poor or underhand dealings and reflects no display of virtue or merit. Thus people feel that they are entitled to manipulate the system in a way that enables them to use the wealth of others as it is a widely held belief that there is nothing immoral about milking the rich. In fact, the money the rich seem to have access to is the cause of much discontent among people of all social backgrounds, from farmers to students. The reason for this is that the government for decades has run continuous campaigns promising people that it has not only the will but also the ABILITY to solve their problems and has established a system of patronages and hand-outs to this end.

Anything can be done in Greece provided someone has political connections, from securing a job to navigating the complexities of the Greek bureaucracy. The government routinely promises handouts to farmers after harsh winters and free education to all; every time there is a display of discontent they rush to appease the people by offering them more “solutions.” What they neglect to say is that these solutions cost money. Now that the money has run out, nobody can reason with an angry mob.

A closer examination of Greek universities can be used as a good illustration of why and HOW the government has driven itself to a crossroad where running the country into even deeper debt is the only politically feasible path to follow. University education is free. However, classroom attendance is appalling and there are students in their late twenties that still have not passed classes they attended in their first year. Moreover, these universities are almost entirely run by party-political youth groups which, like the country’s politicians, claim to have solutions to all problems affecting students. To make matters worse, these groups often include a minority of opportunists who are not interested in academia at all but are simply there to use universities as political platforms, usually ones promoting views against the wealthy and the capitalist system as a whole even though they have no intellectual background or understanding of the capitalist structure.

This problem is exacerbated by the fact that there is no genuine free market opposition. In Greece, right wing political parties also favour statist solutions but theirs are criticised as favouring big business. The mere idea that the government should be reduced in size and not try to have its hand in everything is completely inconceivable for Greek politicians of all parties. The government promises their people a better life in exchange for votes so when it fails to deliver, the people naturally think they have the right or even the obligation to start riots to ‘punish’ them for failing to do what they have promised.

Moreover, looking at election results it is not hard to observe that certain regions are “green” supporting PASOK and others “blue” supporting Nea Dimokratia. Those regions consistently support certain political parties in every election due to the widespread system of patronages that has been created. By supporting PASOK in years where Nea Dimokratia wins you can collect on your support when inevitably after a few election periods PASOK will be elected and vice versa. Not only are there widely established regional patronage networks but there are strong political families that use their clout to promise support and benefits to friends in exchange for their support in election years.

Moreover, in line with conventional political theory on patronage networks, in regions that are liable to sway either way politicians have a built in incentive to promise the constituents more than everyone else. The result is almost like a race for the person able to promise more, and thus the system seems by its very nature to weed out politicians that tell people the honest and unpalatable truth or disapprove of handouts. This has led people to think that if they are in a miserable situation it is because the government is not trying hard enough to satisfy their needs or is favouring someone else instead of them. When the farmers protest it is not just because they want more money, it is because they are convinced (sometimes even rightly so) that the reason why they are being denied handouts is that they have been given to someone else instead. It is the combination, therefore, of endless government pandering and patronages that has led to the population’s irresponsible attitude towards money and public finance. They believe that the government having the power to legislate need not be prudent, and when the government says it needs to cut back, they point to the rich and expect the government to tax them more heavily or blame the capitalist system for their woes.

After a meeting in Brussels, current Prime Minister George Papandreou said:

Salaried workers will not pay for this situation: we will not proceed with wage freezes or cuts. We did not come to power to tear down the social state.

It is not out of the kindness of his heart that he initially did not want to impose a pay freeze. It was because doing so would mean that the country may never escape the ensuing state of chaos and anarchy that would inevitably occur. Eventually he did come to the realisation that in the absence of pay freezes he would have to plunge the country into even further debt and increase taxes and had to impose it anyway causing much discontent. Does it not seem silly that he is still trying to persuade the people that they will not pay for this situation when the enormous debts that will inevitably ensue will mean that taxes will have to increase in perpetuity until even our children’s children will be paying for this? This minor glitch does not matter, though, because nobody can reason with a mob that is fighting for handouts they believe are rightfully theirs.

Greece is the perfect example of a country where the government attempted to create a utopia in which it serves as the all-providing overlord offering people amazing job prospects, free health care and education, personal security and public order, and has failed miserably to provide on any of these. In the place of this promised utopian mansion lies a small shack built at an exorbitant cost to the taxpayer, leaking from every nook and cranny due to insufficient funds, which demands ever higher maintenance costs just to keep it from collapsing altogether. The architects of this shack, in a desperate attempt to repair what is left are borrowing all the money they can from their neighbours, even at exorbitant costs promising that this time they will be prudent. All that is left for the people living inside this leaking shack is to protest for all the promises that the government failed to fulfil; but, sadly for the government, promises will neither pay its debts nor appease the angry mob any longer. Greece has lost any credibility it had within the EU as it has achieved notoriety for the way government accountants seem to be cooking up numbers they present to EU officials.

Dismal as the situation may appear, there still is hope. The Greeks many times have shown that it is in the face of dire need that they tend to bond together as a society and rise to the occasion. Family ties and social cohesion are still strong and have cushioned people from the problems caused by government profligacy. For years, the appalling situation in schools has led families to make huge sacrifices in order to raise money for their children’s private tuition or send them to universities abroad whenever possible. This is why foreign universities, especially in the UK, are full of very prominent and hard working Greek students. Moreover, private (as opposed to public) levels of indebtedness, although on the rise, are still lower than many other European countries.

However, although societal bonding and private prudence will help people deal with the consequences of the current crisis, its resolution will only come about if Greek people learn to listen to the ugly truths that sometimes have to be said. They need to be able to listen to statesmen that are being honest with them instead of politicians trying to appease them in a desperate plea to get votes. The time for radical, painful, wrenching reform is NOW.

There are no magic wands, no bail-outs, no quick and easy fixes. The choice is between doing what it takes to put our house in order ourselves, or watching it collapse around us. This can only come about if Prime Minister George Papandreou uses the guts he has displayed in the past when his political stature and authority had been challenged and channels them towards making the changes the country so desperately needs. Only if he emerges as a truly inspired statesman who will choose the difficult as opposed to the populist solution will Greece be up again and on a path towards prosperity. He needs to display a willingness to clean up the mess made after years of bad government and get society to a point where they are willing to accept hard economic truths. One can only hope…

Further reading

Economics

The infantilisation of financial services

Via Bank plans to cap risky mortgages – Telegraph:

Mortgage lending would be “capped” to stop borrowers taking out risky loans under radical Bank of England plans to prevent a repeat of the credit crisis, a senior official has disclosed.

But why did borrowers wish to borrow so much, so riskily? And why did lenders wish to lend so much, at such risk?

In the first place, credit has been too cheap for too long. Low interest rates are bound to encourage people to borrow more and save less. Therefore, people saved less and borrowed more. This was the result of the Bank of England’s decisions.

House prices kept rising because people kept borrowing and pumping money into housing. Housing was excluded from the Bank’s measure of inflation, so rates stayed low.

The appearance of inevitable and uninterrupted house price rises gave the impression that we were in a new era within which the old rules did not apply: borrowing caps could be raised to excessively risky levels and borrowers could rely on price increases to deal with the capital.

Lenders used models which fundamentally understated risk. For example, markets do not behave within the Gaussian or “normal” distribution: extreme events happen more often than a normal distribution predicts. Furthermore, the risk of mortgage default correlates across similar mortgages when the economic environment changes. Still, the models said risks were lower than they were, so more credit could be extended.

Since the lenders were neither, on the whole, mutuals or partnerships with open-ended liabilities and since the employees making the decisions shared only in the upside, there was insufficient motivation to manage to the true level of risk.

Moreover, securitisation of mortgage pools and so forth palmed off the risk onto hapless investors who probably trusted the risk models and the market environment created by excessively cheap credit. And, “Hey, look at the returns!” The personal touch was missing from the relationships between borrowers, ultimate lenders and intermediaries, further corrupting the system.

Of course when the pantomime ended, the taxpayer was forced to pick up the bill. And still bonuses were paid in bailed-out banks!

Now, having created the boom with cheap credit and moral hazard, the Bank plans, not to fix the root problems, but to pile intervention upon intervention…

There is much else to be said, for which I recommend The Alchemists of Loss and Money, Bank Credit, and Economic Cycles. However, on the face of it, the Bank’s present proposals merely extend the infantilisation of the financial services sector.

Later this week, I will indicate ten serious plans for financial reform.

Economics

The Luvvie Tax

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.

Further Reading

Economics

A day of reckoning: how to end the banking crisis now

Drawing on the work of Nobel Laureates in economics from three traditions, plus numerous other distinguished scholars, Cobden Centre Chairman, economist and successful entrepreneur Toby Baxendale presents an informal introduction to our proposal for honest money and the benefits consequent on the reform. See also our precis of Irving Fisher’s 100% Money.

Fact

  • The average overhang of credit to money of all banks in the United Kingdom is 34 x to its reserves i.e. its actual money base1.
  • If more than one person in 34 walks into all banks simultaneously to withdraw their deposits, there will be a system wide bank run and a mass liquidity event with systematic default and insolvency.
  • We saw the start of this with Northern Rock in the summer of 2007.
  • We attempt to paper over the cracks and restore confidence in the banking system still today – with little success2.
Sterling Liquid Assets (BoE FSR, Jun 2009)

Sterling Liquid Assets (BoE FSR, Jun 2009)

A practical, politically-acceptable proposal

Our proposal is, as Irving Fisher wrote, “The opposite of radical”:

  • Require 100% cash reserves to be held against all demand deposits; there can never be a crisis if a bank always holds 100% cash against all its demand deposits.
  • Parliament can do this with one Act.

A similar Act took place in 1844. The Bank Charter Act or “Peel’s Act” established a 100% reserve requirement for bank notes that were issued claiming to be redeemable in gold. The reality was that there were 23 notes in issue for every one unit of gold at the time, creating instability, “panic” and general economic chaos. Not a too dissimilar situation from today where we have 34 claims on money to one unit of money. Politicians in the 19th century did not see the creation of unbacked credit through accounting entries as a problem, since it was only done on a very small scale. The problem then was rampant note issue (claims to real money) well over and above the monetary base, as this was the preferred method the bankers used at the time.

It is often forgotten but when you place £1m in a savings account (in cash) in say the Royal Bank of Scotland, which has no legal reserve requirement, they then lend £970k (in credit) , keeping on average 3% of cash back in reserves, to an entrepreneur in say HSBC, who then deposits that money in HSBC. We now have one claim to the original £1m and one claim to the £970k. The money supply has moved from £1m to £1.97m – just like magic! This is credit expansion.

The reality is that across all the banks in the United Kingdom licensed by the Bank of England, we have for every £1 of money (in cash), £34 in claims to money (credit)!

Peel’s problem was the over issue of notes to gold: our problem is the over issue of credit to money.

Continue reading “A day of reckoning: how to end the banking crisis now”

  1. See the Bank of England’s Financial Stability Report. Oral evidence from Sir Fred Goodwin (RBS) and Mr Andy Hornby (HBOS) to the Treasury Select Committee was at variance with our calculations:
    Q1864 Mr Love: Sir Fred, can I ask you, following on from those questions, how leveraged was RBS at the time of the Lehman’s dissolution?
    Sir Fred Goodwin: I think there would have been a variety of different ways of looking at the leverage ratio.

    Q1865 Mr Love: I am just looking for a rough idea, order of magnitude.
    Mr Fred Goodwin: Towards the higher end but there would be others higher than us. We would have loans to deposit.

    Q1866 Mr Love: What was the ratio?
    Sir Fred Goodwin: 110% but there would be others similar to that, there would be some higher and some lower. We were to the right of the middle, we were at the higher end of the middle.

    Q1867 Mr Love: Mr Hornby, can you tell us what it was for HBOS?
    Mr Hornby: Yes, our loans and advances were around £450 million, our customer deposits were about £250 million, therefore the percentage of one to the other was around 57%.

    See http://www.publications.parliament.uk/pa/cm200809/cmselect/cmtreasy/144/144i.pdf – Page EV246, Q1864 []

  2. See for example, Caithness, “My Lords, the Banking Bill which we are currently discussing in the House is very complex and detailed, but it does nothing to resolve the current banking crisis, which lies at the heart of our economic problems. The noble Lord, Lord Peston, has just said that it is the fault of the bankers. I agree with him up to a point, but would go further and say that the fault that really needs correcting is our whole banking system.” []