One for the weekend …
A work of brilliance from Dominic Frisby:
Economists and journalists often point to the danger of external public debts — in contrast to internal debts, which are regarded as less troublesome. Japan is a case in point. Japan has an enormous public-debt-to-GDP ratio of more than 200 percent. It is argued that the high ratio is not a problem, because the Japanese save a lot and government bonds are held mostly by Japanese citizens; it is internal debt.
In contrast, Spain with a much lower public-debt-to-GDP ratio (expected to be at 80 percent at the end of this year) is regarded as more unstable by many investors. One reason given for the Spanish fragility is that about half of Spanish government bonds are held by foreigners.
At first sight, one may doubt this line of reasoning. In fact, as an individual living in Spain, I do not care if I get a loan from a Spanish or a German friend. Why would the Spanish government be different? Why care if loans come from Spaniards or from Germans?
Governments are ultimately based on physical violence or the threat of physical violence. The state is the monopolist of violence in a given territory. And in violence lies the difference. Internally held debts generate income for citizens, which can be taxed by the threat of violence. This implies that part of the interest paid on internal debt flows back to the government through taxes. Interest paid on external debt, in contrast, is taxed by foreign countries.
There is another, even more compelling, reason why the monopoly of violence is important: I can force neither my Spanish nor my German friend to roll over his loan to me when it comes due. While the government cannot force individuals outside its territory to roll over loans, it can force citizens and institutions within its jurisdiction to do so. In a more subtle form, governments can pressure their traditional financiers, the banks, to roll over public debts.
Banks and governments live in a relationship akin to a symbiosis. Governments have granted banks the privilege to hold fractional reserve and have given them implicit and explicit bailout guarantees. Further support is provided through a government’s controlled central bank, which may help out in times of liquidity problems. In addition, governments control the banking system through a myriad of regulations. In return for the privilege to create money out of thin air, banks use this power to finance governments buying their bonds.
Due to this intensive relationship and the government’s monopoly of violence, the Japanese government can pressure its banks to roll over outstanding debt. It can also pressure them to abstain from abrupt selling and encourage them to take even more debt onto their books. Yet the Japanese government cannot force foreigners to abstain from selling its debt or to accumulate more of it. Here lies the danger for governments with external public debts such as the Spanish one.
While Spanish banks and investment funds will not flush the market with Spanish government bonds, foreign institutions may well do so. The Spanish government cannot “persuade” or force them not to do so as they are located in other jurisdictions. The only thing that the Spanish government can do — and the peripheral governments are actually doing — is to pressure politicians in fellow countries to pressure their own banks to keep bonds on their books and roll them over.
External public debts also pose a danger for the US government. Foreign central banks such as the Bank of China or the Bank of Japan hold important sums of US government bonds. The threat, credible or not, to throw these bonds on the market may give their governments, especially the Chinese one, some political leverage.
What about a Trade Deficit?
In regard to the stability of a currency or the sustainability of government debts, the balance of trade (the difference between exports and imports of goods and services) is also important.
An export surplus (abstracting from factor income and transfer payments) implies that a country accumulates foreign assets. As foreign assets are accumulated, the currency tends to be stronger. Foreign assets can be used in times of crisis to pay for damages. Japan again is a case in point. After the earthquake in March 2011, foreign assets were repatriated into Japan, paying for necessary imports. Japanese citizens sold their dollars and euros to repair damage at home. There was no need to ask for loans denominated in foreign currencies, thereby putting pressure on the yen.
Japan’s export surpluses manifest themselves also on the balance sheet of the Bank of Japan. The Bank of Japan has bought foreign currencies from Japanese exporters. These reserves could be used in a crisis situation to reduce public debts or defend the value of the currency on foreign exchange markets. In fact, the net level of Japan’s public debts falls 20 percent taking into account the foreign exchange reserve holdings of the Bank of Japan (over $1 trillion). Thus, export surpluses tend to strengthen a currency and the sustainability of public debts.
On the contrary, import surpluses (abstracting from factor income or transfers) result in net foreign debts. More goods are imported than exported. The difference is paid for by new debts. These debts are often held in the form of government bonds. A country with years of import deficits is likely to be exposed to large holdings of external public debts that may pose problems for the government in the future as we have discussed above.
The balance of trade may also be an indicator for the competitiveness of an economy, and, indirectly, for the quality of a currency. The more competitive an economy, the more likely the government can support its fiat currency by expropriating the real wealth created by this competitive economy and will not get into public-debt problems. Further, the more competitive the economy, the less likely that public-debt problems are solved by the production of money.
While an export surplus is a sign of competitiveness, an import surplus may be a sign of a lack thereof. Indeed, long-lasting import deficits may be the sign of a lack of competitiveness, and often go hand in hand with high public debts, exacerbating the lack of competitiveness.
Economies with high and inflexible wages — as in southern Europe — may be uncompetitive, running a trade deficit. The uncompetitiveness is maintained and made possible by high government spending. Southern eurozone governments hired people into huge public sectors, arranged generous and early retirement schemes, and offered unemployment subsidies, thereby alleviating the consequence of the unemployment caused by inflexible labor markets. The result of the government spending was therefore not only a lack of competitiveness and a trade deficit but also a government deficit. Therefore, large trade and government deficits often go hand in hand.
In the European periphery, imports were paid with loans. The import surplus cannot go on forever, as public debts would rise forever. A situation of persisting import surpluses such as in Greece can be interpreted as a lack of political will to reform labor markets and to regain competitiveness. Therefore, persisting import surpluses may cause a currency or public-debt sell-off. In this sense, the German export surplus supports the value of the euro, while the periphery’s import surplus dilutes its value.
In sum, high public (external) debts and persisting import surpluses are signs of a weak currency. The government may well have to default or to print its way out of its problems. Low public (external) debts and persisting export surpluses, in contrast, strengthen a currency.
 Another important reason is that the Spanish government cannot use the printing press at its will, because it is shared by other Eurozone governments that might protest. Japan, however, controlls its central bank and thereby the printing press.
 It should be noted that ever more new Spanish debt is held exclusively by Spanish banks, because other investors are progressively less interested in financing a government that simply refuses to enact real and effective austerity measures.
This article was previously published at Mises.org.
Throughout the European debt crises, Germany and its allies in the austerity camp have been urged by financial commentators, particularly in the United Kingdom and the United States, to show more “flexibility” to help the high-debt countries in the periphery of the single currency union.
Such flexibility first took the form of a bailout for Greece when it teetered on the brink of sovereign default in 2010. When that failed to stem the crisis, European leaders were urged to create a bailout fund for in case other nations would find it difficult to borrow on financial markets as well. They did. Ireland and Portugal subsequently tapped into that bailout fund, the European Financial Stability Facility.
When that failed to stem the crisis, the prevailing wisdom became that the bailout fund was too small and only temporary, raising concern about Germany’s willingness to bankroll peripheral eurozone nations in the long term. So Europe’s leaders devised a bigger, permanent bailout fund, the European Stability Mechanism.
Yet the crisis goes on and the new solution floated by commentators is the pooling of sovereign debt in the eurozone in the form of eurobonds. As with the Greek bailout and the erection of the bailout funds, Germany is hesitant. It fears that financial support for troubled eurozone economies removes the incentive on their part to improve their competitiveness relative to stronger European economies which Germany sees as the way to ensure long term stability in the euro area.
Moreover, there has been growing weariness in core eurozone countries like Germany and the Netherlands to bailing out weaker euro states. The political leaders of these countries can ill afford electorally to advance schemes for further European integration, which is increasingly unpopular.
This has been seized upon by those favouring, for instance, eurobonds as proof that their solutions to Europe’s debt woes are perfectly valid. The only reason they aren’t implemented—even if, so far, they usually have been, only maybe not very fast—is that Europe’s leaders are afraid of their voters who stop them from doing what’s right.
It turns out, the proponents of further European integration are quite afraid of the European electorate as well. Writes Martin Wolf, the Financial Times‘ chief economics commentator, in a recent blog post:
Wolf even invokes the rise of Adolf Hitler which he claims had nothing to do with hyperinflation during the Weimar Republic but was entirely due to the economic hardships of the 1930s Depression. “Deep economic collapses are dangerous.”
Indeed they are, as they often lead policy makers to experiment with unconventional economic policies because they haven’t the patience to let the market correct itself, which is exactly what should have happened after the credit crunch of 2008. Instead, by repeated government interventions in the private economy, the recession has been prolonged and the sort of creative destruction that has to take place before there can be a true and sustainable recovery has not been allowed to occur.
Notice the panic that arises whenever a single bank is about to go under. Tens of billions of euros doled out to Spain so the country can save its troubled banks. There can be no failures because the financial industry is so interconnected — it is feared that the collapse of one bank will drag others down with it, resulting in widespread financial panic.
So we have malaise instead until Germany pulls out the “bazooka” and makes clear that it will pay everyone’s bills. That is what Wolf means when he writes that “the creditworthy country has to lend freely if a fixed exchange rate system (or in this case a currency union) is to survive.”
If Chancellor Angela Merkel announces next week that she wants to quadruple the bailout fund, that she’s willing to underwrite every bad loan both German and peripheral banks ever made, will it end the crisis?
Maybe. Or maybe markets will come to their senses soon thereafter and wonder whether the German voters wouldn’t tear up such a commitment in the next election?
Maybe they’ll even realize that it doesn’t matter as long as Greece, Italy and Spain don’t change their ways and implement the sort of regulatory, labour market and entitlement reforms that are needed to move their economies away from clientalism and protectionism toward entrepreneurship and free trade.
Wolf doesn’t seem to particularly care about the longer term imperatives. He ominously writes of “populist politics” unless a short term solution is found. Without one, he believes, “the eurozone may never reach the long term”. It’s not so much an argument as it is a threat — integrate now or the “populists” win!
In fact, the push for European integration in spite of the clear wishes of voters in core eurozone countries is exactly what fuels the anti-European sentiment that Wolf despises.
But what’s more concerning is that Wolf apparently seeks deeper European integration for political reasons, not economic ones. Which raises the question: does he want want an even bigger bailout fund, does he want eurobonds and does he want to keep the euro together because it makes economic sense for Germany and the other countries in the euro, or because he wants this political project to succeed?
This article was previously published at Atlantic Sentinel.
When currencies and monetary arrangements have broken down it has always been because the currency issuer can no longer fight the lure of the seigniorage to be gained by over issue of the currency. In the twentieth century this age-old impulse was allied to new theories that held that economic downturns were caused or exacerbated by a shortage of money. It followed that they could be combated by the production of money.
Based on the obvious fallacy of mistaking nominal rises in wealth for real rises in wealth, this doctrine found ready support from spendthrift politicians who were, in turn, supported by the doctrine.
Time and again over recent history we see the desire for seigniorage allied with the cry for more money to fight a downturn pushing up against the walls of the monetary architecture designed to protect the value of the currency. Time and again we see the monetary architecture crumble.
The classical gold standard
At the start of the twentieth century much of the planet and its major economic powers were on the gold standard which had evolved from the 1870s following Britain’s lead. This was based on the twin pillars of (1) convertibility between paper and gold and (2) the free export and import of gold.
With a currency convertible into gold at a fixed parity price any monetary expansion would see the value of the currency relative to gold decline which would be reflected in the market price. Thus, if there was a parity price of 1oz gold = £5 and a monetary expansion raised the market price to 1oz = £7, it would make sense to take a £5 note to the bank, swap it for an ounce of gold and sell it on the market for £7.
The same process worked in reverse against monetary contractions. A fall in the market price to 1oz = £3 would make it profitable to buy an ounce of gold, take it to the bank and swap it for £5.
In both cases the convertibility of currency into gold and vice versa would act against the monetary expansion or contraction. In the case of an expansion gold would flow out of banks forcing a contraction in the currency if banks wished to maintain their reserve ratios. Likewise a contraction would see gold flow into banks which, again, in an effort to maintain their reserve ratios, would expand their issue of currency.
The gold standard era was one of incredible monetary stability; the young John Maynard Keynes could have discussed the cost of living with Samuel Pepys without adjusting for inflation. The minimisation of inflation risk and ease of convertibility saw a massive growth in trade and long term cross border capital flows. The gold standard was a key component of the period known as the ‘First era of globalisation’.
The judgement of economic historians Kenwood and Lougheed on the gold standard was
The gold exchange standard and devaluation
The First World War shattered this system. Countries printed money to fund their war efforts and convertibility and exportability were suspended. The result was a massive rise in prices.
After the war all countries wished to return to the gold standard but were faced with a problem; with an increased amount of money circulating relative to a country’s gold stock (a problem compounded in Europe by flows of gold to the United States during the war) the parity prices of gold were far below the market prices. As seen earlier, this would lead to massive outflows of gold once convertibility was re-established.
There were three paths out of this situation. The first was to shrink the amount of currency relative to gold. This option, revaluation, was that taken by Britain in 1925 when it went back onto the gold standard at the pre-war parity.
The second was that largely taken by France between 1926 and 1928. This was to accept the wartime inflation and set the new parity price at the market price.
There was also a third option. The gold stock could not be expanded beyond the rate of new discoveries. Indeed, the monetary stability which was a central part of the gold standard’s appeal rested on the fixed or slow growth of the gold stock which acted to halt or slow growth in the currency it backed. So many countries sought to do the next best thing and expand gold substitutes to alleviate a perceived shortage of gold. This gave rise to the gold exchange standard which was put forward at the League of Nations conference in Genoa in 1922.
Under this system countries would be allowed to add to their gold reserves the assets of countries whose currency was convertible into gold and issue domestic currency based on this expanded stock. In practice the convertible currencies which ‘gold short’ countries sought as reserves were sterling and dollars.
The drawbacks were obvious. The same unit of gold could now have competing claims against it. The French took repeated advantage of this to withdraw gold from Britain.
Also it depended on the Bank of England and Federal Reserve maintaining the value of sterling and the dollar. There was much doubt that Britain could maintain the high value of sterling given the dire state of its economy and the dollar was weakened when, in 1927, the Federal Reserve lowered interest rates in order to help ease pressure on a beleaguered sterling.
This gold exchange standard was also known as a ‘managed’ gold standard which, as Richard Timberlake pointed out, is an oxymoron. “The operational gold standard ended forever at the time the United States became a belligerent in World War I”, Timberlake writes.
This was exacerbated in the United States by the Federal Reserve adopting the ‘real bills doctrine’ which held that credit could be created which would not be inflationary as long as it was lent against productive ‘real’ bills.
Many economists, notably Ludwig von Mises and Friedrich von Hayek, have seen the genesis of the Depression of the 1930s in the monetary architecture of the 1920s. While this remains the most debated topic in economic history there is no doubt that the Wall Street crash and its aftermath spelled the end of the gold exchange standard. When Britain was finally forced to give up its attempt to hold up sterling and devalue in 1931 other countries became worried that its devaluation, by making British exports cheaper, would give it a competitive advantage. A round of ‘beggar thy neighbour’ devaluations began. Thirty two countries had gone off gold by the end of 1932 and the practice continued through the 1930s.
Bretton Woods and its breakdown
Towards the end of World War Two economists and policymakers gathered at Bretton Woods in New Hampshire to design a framework for the post war economy. Looking back it was recognised that the competitive devaluations of the 1930s had been a driver of the shrinkage of international trade and, via its contribution to economic instability, to deadly political extremism.
Thus, the construction of a stable monetary framework was of the most utmost importance. The solution arrived at was to fix the dollar at a parity of 1oz = $35 and to fix the value of other currencies to the dollar. Under this Bretton Woods system currencies would be pegged to gold via the dollar.
For countries such as Britain this presented a problem. Any attempt to use expansionary fiscal or monetary policy to stimulate the economy as the then dominant Keynesian paradigm prescribed would eventually cause a balance of payments crisis and put downward pressure on the currency, jeopardising the dollar value of sterling. This led to so called ‘stop go’ policies in Britain where successive governments would seek to expand the economy, run into balance of payments troubles, and be forced to deflate. In extreme circumstances sterling would have to be devalued as it was in 1949 from £1 = $4.03 to £1 = $2.80 and 1967 from £1 = $2.80 to £1 = $2.40.
A similar problem eventually faced the United States. With the dollar having replaced sterling as the global reserve currency, the United States was able to issue large amounts of debt. Initially the Federal Reserve and Treasury behaved reasonably responsibly but in the mid-1960s President Lyndon Johnson decided to spend heavily on both the war in Vietnam and his Great Society welfare program. His successor, Richard Nixon, continued these policies.
As dollars poured out of the United States, investors began to lose confidence in the ability of the Federal Reserve to meet gold dollar claims. The dollar parity came under increasing pressure during the late 1960s as holders of dollar assets, notably France, sought to swap them for gold at the parity price of 1oz = $35 before what looked like an increasingly inevitable devaluation. Unwilling to consider the deflationary measures required to stabilise the dollar with an election due the following year, President Nixon closed the gold window on August 15th 1971. The Bretton Woods system was dead and so was the link between paper and gold.
Fiat money and floating exchange rates
There were attempts to restore some semblance of monetary order. In December 1971 the G10 struck the Smithsonian Agreement which sought to fix the dollar at 1oz = $38 but this broke down within a few months under the inflationary tendencies of the Federal Reserve. European countries tried to establish the ‘snake’, a band within which currencies could fluctuate. Sterling soon crashed out of even this under its own inflationary tendencies.
The cutting of any link to gold ushered in the era of fiat currency and floating exchange rates which lasts to the present day. Fiat currency gets its name because its value is given by governmental fiat, or command. The currency is not backed by anything of value but by a politicians promise.
The effect of this was quickly seen. In 1931 Keynes had written that “A preference for a gold currency is no longer more than a relic of a time when governments were less trustworthy in these matters than they are now” But, as D R Myddelton writes, “The pound’s purchasing power halved between 1945 and 1965; it halved again between 1965 and 1975; and it halved again between 1975 and 1980. Thus the historical ‘half-life’ of the pound was twenty years in 1965, ten years in 1975 and a mere five years in 1980”
In 1976 the pound fell below $2 for the first time ever. Pepys and Keynes would now have been talking at cross purposes.
Floating exchange rates marked the first public policy triumph for Milton Friedman who as long ago as 1950 had written ‘The Case for Flexible Exchange Rates’. Friedman had argued that “A flexible exchange rate need not be an unstable exchange rate” but in an era before Public Choice economics he had reckoned without the tendency of governments and central banks, absent the restraining hand of gold, to print money to finance their spending. World inflation which was 5.9% in 1971 rose to 9.6% in 1973 and over 15% in 1974.
The experience of the era of floating exchange rates has been of one currency crisis after another punctuated by various attempts at stabilisation. The attempts can involve ad hoc international cooperation such as the Plaza Accord of 1985 which sought to depreciate the dollar. This was followed by the Louvre Accord of 1987 which sought to stop the dollar depreciating any further.
They may take more organised forms. The Exchange Rate Mechanism was an attempt to peg European currencies to the relatively reliable Deutsche Mark. Britain joined in 1990 at what many thought was too high a value (shades of 1925) and when the Bundesbank raised interest rates to tackle inflation in Germany sterling crashed out of the ERM in 1992 but not before spending £3.3 billion and deepening a recession with interest rates raised to 12% in its vain effort to remain in.
This brief look back over the monetary arrangements of the last hundred years shows that currency issuers, almost always governments, have repeatedly pushed the search for seigniorage to the maximum possible within the given monetary framework and have then demolished this framework to allow for a more ‘elastic’ currency.
Since the demise of the ERM the new vogue in monetary policy has been the independent central bank following some monetary rule, such as the Bank of England and its inflation target. Inspired by the old Bundesbank this is an attempt to take the power of money creation away from the politicians who, despite Keynes’ high hopes, have proved themselves dismally untrustworthy with it. Instead that power now lies with central bankers.
But it is not clear that handing the power of money creation from one part of government to another has been much of an improvement. For one thing we cannot say that our central bankers are truly independent. The Chairman of the Federal Reserve is nominated by the President. And when the Bank of England wavered over slashing interest rates in the wake of the credit crunch, the British government noisily questioned its continued independence and the interest rate cuts came.
Furthermore, money creation can reach dangerous levels if the central bank’s chosen monetary rule is faulty. The Federal Reserve has the awkward dual mandate of promoting employment and keeping prices stable. The Bank of England and the European Central Bank both have a mandate for price stability, but this is problematic. As Murray Rothbard and George Selgin have noted, in an economy with rising productivity, prices should be falling. Also, what ‘price level’ is there to stabilise? The economy contains countless different prices which are changing all the time; the ‘price level’ is just some arbitrarily selected bundle of these.
An extreme example, as noted by Jesús Huerta de Soto, is the euro. Here a number of governments agreed to pool their powers of money creation and invest it in the European Central Bank. The euro is now widely seen to be collapsing. So it may be, but is this, as is generally assumed, a failure of the architecture of the euro itself?
Let us remember that the purpose of erecting a monetary structure where the power to create money is removed from government is to stop the government running the printing presses to cover its spending and, in so doing, destroy the currency.
The problem facing eurozone states like Greece and Spain is presented as being that they are running up debts in a currency they cannot print at will to repay these debts. But is the problem here that these countries cannot print the money they need to pay their debts or that they are running up these debts in the first place? The solution is often offered that either these countries need to leave the euro and adopt a currency which they can expand sufficiently to pay their debts or that the ECB needs to expand the euro sufficiently for these countries to be able to pay their debts. But there is another solution, commonly called ‘austerity’, which says that these countries should just not run up these debts. As de Soto argues, the euro’s woes are really failures of fiscal policy rather than monetary policy.
It is thus possible to argue that the euro is working. By halting the expansion of currency to pay off debts and protecting its value and, by extension, preventing members from running up evermore debt, the euro is doing exactly what it was designed to do.
There is a growing clamour inside Europe and outside that ‘austerity’ alone is not the answer to the euro’s problems and that monetary policy has a role to play. The ECB itself seems to be keen to take on this role. But it is simply the age-old idea, based on the confusion between the real and the nominal, that we will get richer if we just produce more money. Germany is holding the line on the euro but history shows that far sounder currency arrangements have collapsed under the insatiable desire for a more elastic currency.
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The eurozone continues to keep us in suspense in the wake of the French elections, and pending the second Greek election in as many months, the underlying financial deterioration is accelerating. Funds are being withdrawn from banks in troubled countries, rapidly depleting their capital. At the same time collateral held against loans is often over-valued, so write-offs that should have been taken have not. The predictable result is a developing run on both individual banks and whole national banking systems.
It should be noted that there are two reasons depositors are fleeing banks: fear that the bank itself is insolvent, and fear that the relevant government might impose restrictions on the movement of money. Fear of bank insolvency is driving funds out of Spanish banks, while fear of government restrictions is driving funds out of Greek banks. To deal with these problems they must be recognised as distinct and different.
A potential banking crisis, as that faced by Spain, requires two further considerations. The first, of providing liquidity, has been addressed by the European Central Bank through its long-term refinancing operation (LTRO); but this is a stop-gap measure and requires the second consideration to be addressed: the reorganisation and recapitalisation of the banks. And here, the cost for Spain is impossible to meet at a time when she faces a combination of deteriorating government finances and escalating borrowing costs.
Greece’s difficulties are even greater, given that depositors are trying to discount the possibility she may leave the euro entirely and introduce exchange controls to manage a new drachma. The virtually unanimous consensus among Keynesians and monetarists is that such a move is both inevitable and desirable, but public opinion in Greece is increasingly in favour of sticking with the euro. Call it the difference between macro-economic theorising and on-the-ground micro-economic reality. For the fact of the matter is that neoclassical solutions that rely on devaluation as an economic remedy provide only temporary relief at best at greater eventual cost, and exiting the euro is neither a legal nor a practical option.
That is the monetary reality behind the eurozone’s crisis. The solution is not to ease the pressures on governments to address their excessive spending: if anything this pressure needs to be intensified, a point well made in a recent Cobden Centre article by Jesús Huerta de Soto. And the idea that more money should be made available for profligate governments through multi-government sponsored bond issues should be firmly rebutted. The banks, which should be allowed to fold, should be removed from the system in a controlled manner, that is to say that the ECB and the national central banks must devise a solution, perhaps a good bank/bad bank division, to give depositors sufficient confidence to keep their funds in the system.
Unfortunately, the political tide is running strongly against this two-pronged approach, with the developing rebellion against “austerity” from all European politicians, and the Keynesian and monetarist pressures from everyone else to reflate increasing. The chances of the ECB properly ring-fencing funds to deal with the banks and stopping them being used to prop up eurozone governments are becoming more remote by the day.
This article was previously published at GoldMoney.com.
There is a big shift in political sentiment among G8 leaders towards less austerity and more emphasis on economic growth, which was evident at their meeting last weekend. The triggers are the election of Francois Hollande, the threatened collapse of the eurozone, and the impending US presidential election. The obstacle in the eurozone is Germany, whose citizens are being asked to pay up, throwing their limited savings at a seemingly unlimited problem. The IMF also opined on the United Kingdom last Tuesday, saying further UK quantitative easing may be necessary.
Putting G8 politics to one side, the eurozone’s problems have reached a critical point: it is clear that either a lot more money is needed to buy some time, or it faces systemic collapse. Greece’s problems are bad enough, but Spain, Italy, Belgium, Ireland and Portugal are also ensnared in debt traps from which there is no obvious escape. Even France has a developing banking problem, with a large state-backed mortgage lender downgraded by Moody’s having difficulties funding its balance sheet. France’s commercial banks are also horribly exposed to Italy, Spain and Belgium.
We often focus on state finances and forget the impact on the private sector of the systemic crisis. Higher government borrowing costs push up mortgage lending rates, which are bound to undermine over-leveraged property markets, particularly in Portugal, Spain and Ireland. The French lender mentioned above, Caisse Centrale du Credit Immobilier, is in danger of needing a state rescue, and this in a country not thought to have residential property problems. Mortgage rates in the UK are also rising, as lenders tighten their lending criteria, and houses aren’t shifting. And the effect of rising interest rates on other property markets is obvious. It is early days, but it appears that these property markets are stalling again, which will worry central banks.
Their overriding fear has always been a debt-deflation collapse, where falling asset prices trigger self-perpetuating collateral liquidation. Central banks must think that the risk of this happening is increasing again. It all adds up to pressure on the European Central Bank to join with the Fed and the Bank of England in a renewed expansion in monetary policy.
Historians may look back at the G8 meeting last week and see it as the point in the continuing crisis when central banks were given the green light for a final, catastrophic monetary easing. It is game-on again for the Keynesians, and is an opportunity for them to push hard for a Roosevelt-type expansion of money and spending. Both Obama and Hollande favour this approach, and more conservative politicians who might argue against it do not have sufficient understanding of sound economic theory to put forward a valid counterargument. But the Roosevelt stimulus failed to stop a renewed downturn in 1938 nine years after the Wall Street Crash of 1929, and is not a happy precedent for today’s situation.
A new wave of stimulus seems certain to undermine confidence in the dollar, and now also the euro. And as Germans wake up to the possibility of their third currency wipe-out in a century, there is only one escape route for them: the accumulation of gold.
This article was previously published at GoldMoney.com.
In recent weeks, while the eurozone has suffered escalating levels of systemic stress in government bond markets and its banking system, the gold price has fallen under $1,600. One would have thought that – but for the occasional fat-finger trade – gold would rise in all this instability, not fall. Putting aside short-term considerations, the simple reason has to be that the investment establishment, which has bought into the bond market bubble, does not believe that gold is any longer an alternative to paper money.
We can understand why they think this. Though the Keynesian vs Austrian economic debate is attracting increasing attention, financial services companies recruit economists who have been trained in the traditions of Keynes and Friedman. They are thus immersed in economic disciplines that assume gold is old-fashioned and has no meaningful place in a modern economy. While they might accept that gold has an historical attraction for some investors, they see it as a “risk-on” investment. This is jargon for something you buy when you want to take risks, the opposite of gold’s traditional role.
For further proof, you need look no further than the average level of portfolio exposure, which across the global investment management industry is said to average less than one per cent. This is certainly not compatible with the level of risk in today’s markets, with many nations on the edge of bankruptcy. The result is that flaky gold bulls are experiencing the discomfort of rising panic.
Let us go back to fundamentals. The Keynesians and Friedmanites are oblivious to the debt trap faced by all major currencies. Central banks are printing money to fund government deficits at the lowest possible interest cost. The inevitable consequence of printing money is price inflation, and price inflation always leads to higher interest rates. Higher interest rates exacerbate budget deficits.
You cannot put it more simply than that. The alternative is to stop printing the money and jack up interest rates, but in that event at the head of the insolvency queue is government itself, so this can be ruled out as a deliberate policy. That is what a debt trap is all about: whichever way you turn, there is only one outcome: bankruptcy.
When a government goes bust, its paper is valueless: not just its bonds, but its fiat currency as well. On the surface it is different in Euroland, because the nation states do not issue their own currency. On this basis the demise of the euro is an event one step removed from the bankruptcy of individual nation states. The relationship with the other major fiat currencies is direct.
The destruction of fiat currencies themselves is becoming more likely by the day. Meanwhile, the weakness of “risk-on” gold has led to a serious mispricing in the market. This has happened because the financial community, sucked into the bond market bubble, has not even begun to discount the debt threat to government paper from sovereign bankruptcies.
When this mispricing is inevitably resolved, it is unlikely to be gradual. It will be so swift that those old-fashioned enough to own gold for insurance purposes will have the protection they sought. Those that fall for modern neo-classical economics will learn a very sudden lesson about what gold is actually for.
This article was previously published at GoldMoney.com.
Surprise, surprise, the Euro Zone debt crisis is back. Or was it never gone?
As yields on Spanish and Italian government bonds are heading higher once again, I am reminded of the old saying, you can’t fool all of the people all of the time. Not even with a trillion euros.
I previously described the relationship between banks and states as that of two drowning sailors who desperately cling to one another, and I still think it is an apt description of the charade that is being orchestrated in Europe and that is already wearing thin. Here is the Wall Street Journal Europe from March 29:
So bankrupt banks bail out bankrupt governments, which then bail out the bankrupt banks. All funded by the printing press. Hey, who needs those pesky savers or who even needs capital markets? We make our own prices!
But it was never going to last, was it? I would have given it a few more months but even that appears you have been too optimistic. Maybe the number of the hopelessly gullible and wilfully delusional is smaller than I thought.
No prize for guessing what the establishment wants. – You got it! More free money.
But then, of course he would say that. Alfredo Saenz Abad is a member of Europe’s financial elite. In 2007, his total compensation as Santander CEO was €9,604,000.00. Well, you may say, that was in 2007 when Spain’s real estate boom was still in full flow and the country enjoyed a triple-A rating. That’s true, and indeed by 2010, Senior Saenz’ total compensation had dropped to €9,179,000.00. I guess his paycheck is doing precisely what Spanish banking is doing, that is, not deleveraging. And why should they? As long as the free money is gushing out of the ECB, let’s pretend and extend. Mr. Draghi, new chips please!
Unlimited and never-ending!
Poor ECB. On many measures, the Frankfurt-based central bank is already the most aggressive monetizer on the planet, its waistline expanding faster than that of anyone else. Yet, funding every dodgy bank in its jurisdiction and accepting even the old carpets with the beer stains from the last office party as collateral has not convinced its doubters that the ECB is doing its fair share of market manipulation. No matter how many euros are raining from the ECB helicopters, the Telegraph’s Ambrose Evans-Pritchard is perennially whinging about the ECB’s tightfistedness and suspects the sinister dealings of some nasty German Bundesbankers in the background. His latest column quotes Guy Mandy of Nomura who stresses that the ECB’s ‘long term refinance operation’
Ah, you see? The accumulated toxic waste on the balance sheets of nominally private banks – such as Mr. Saenz’ – not only should be funded at zero cost forever but should be socialized wholesale. All past errors must be forgiven, the cost to be borne by the masses of fiat-money-users, so that another round of lending can commence. Hooray, we are to borrow ourselves out of a debt crisis.
And here is David Owen of Jefferies Fixed Income in the same piece:
I get it. Printing ever more money is the solution. It just has to be never-ending and unlimited to really work!
Of course, this is complete economic lunacy. Economics is the science of how we use social institutions such as private property and voluntary exchange on free markets to make the best use of scarce resources. These alleged financial ‘experts’ want to do away with scarcity. For them the printing press allows scarcity to disappear. Money has to be ‘unlimited’ and ‘free’ for the economy to work but these are two words that have no place in economics.
We are in this mess because our financial system has artificially cheapened credit for too long. These ‘experts’ tell us the solution is to cheapen credit further and ever more aggressively. There is never too much old debt, only too little new money.
Be that as it may, Evans-Pritchard, Mandy, Owen and Saenz Abad will get their way. The money-printing will not end because it cannot end. Nobody wants to take the pain. This is why I do not believe the deflationary forces that undeniably exist and that many of my readers worry about, will be allowed to get the upper hand. We are on the road to complete monetary meltdown, and no, my friends, we do not have another 20 years.
The Paper Aristocracy
Coming back to Banco Santander’s Senior Saenz: I was somewhat reluctant to mention his compensation as it can easily and unfairly associate me with the many habitual banker-bashers out there, a group that is already heavily populated with the economically illiterate and the perennially envious and, what’s worse, the many statists who believe that the solution to all our ills is more government intervention, more regulation and more taxation. Nothing could be further from my position.
I have absolutely no problem with people earning a lot of money, even millions or billions. As I have explained elsewhere, I am an advocate of 100-percent capitalism, of what Hans-Hermann Hoppe calls a private law society, in which the same rules apply to everybody (no legal privileges and no state authority) and where everything is based on voluntary, private, contractual cooperation.
In a free market, there is only one way to make money and to keep your accumulated wealth, which is to produce and keep producing something that your fellow citizens voluntarily spend money on. Bill Gates, Steve Jobs and Mark Zuckerberg didn’t steal the billions that made them rich (at least not to the best of my knowledge), and they did not and could not rely on ‘government stimulus’ or the backstop of a lender-of-last-resort. Like thousands of other and less well-known entrepreneurs and capitalists out there, who keep our economy going and who create the real wealth that makes our high living standards possible, they earned money in the marketplace by serving the ever-fickle consumer with his constantly changing tastes and desires, and if they had gotten it wrong at some step on the way, they would have potentially lost everything – and that can indeed still happen. They did not take from us. We, the consumers, made them rich by buying their products. And if you want to be rich yourself you may want to take a close look at their example and create something that many people want – and if you want to be really rich, that hundreds of millions of people want.
Of course, most of us do not have it in us to be entrepreneurs. We contribute by working for entrepreneurs or investing with them. And by doing so, we play our part in bringing about a striving, wealth-creating economy.
Our financial system, however, has little to do with capitalism. This is what the banker-bashers don’t get: our financial system is not bankrupt because we’ve got bad bankers. We got bad bankers because of a corrupt financial system. The unholy alliance between states and banks that has brought this crisis about, and that will make it still worse, is the direct result of our fiat money system. Under a state-fiat-money franchise administered by lender-of-last-resort central banks that are tasked with cheapening credit through constant monetary debasement, banks cannot be capitalist enterprises subject to the controlling forces of the marketplace. In such a system, banks are essentially extensions of the central bank. They are conduits for monetary policy. Of course, the banks happily play this role as long as possible because their participation in the money-creation process is profitable to them, and it comes with an extra safety-net that all truly capitalist firms have to do without. But this monetary socialism only lasts until it chokes on its accumulated imbalances. That is when the overleveraged banks and debt-addicted governments finally stare into the abyss.
To call our fiat-money-based financial system ‘capitalist’ is not only incorrect, it is a dangerous misrepresentation. It gives capitalism a bad name. We should not let those who benefit from the fiat money privilege adopt the label ‘capitalists’ for themselves. So what should we call them?
The late Howard S. Katz coined the phrase the ‘paper aristocracy’ in his book of the same name. He wrote it in 1976, five years after Nixon closed the gold window and ushered in the period of unlimited money creation. Katz proved prophetic:
In the early 21st century there still is a place called the United States of America but I doubt that anybody in the mid-1970s, maybe not even Howard S. Katz, would have guessed that millions of ‘free’ Americans would be lining up at airports to be searched and x-rayed by members of a giant, 216,000-employee strong Department of Homeland Security.
Americans are supposed to believe that all of this will protect them from Islamist terrorists and ensure their freedom. But I reckon that this organization could come in handy for other domestic emergencies once the fiscal house of cards comes crashing down and America does a Greece – and given the country’s by now well-established fiscal trajectory of $1-trillion-plus federal deficits per annum, mainly funded by the Fed, that is only a question of time. Pointedly, the Department of Homeland Security has recently ordered 450 million new rounds of ammo to protect a domestic population of 313 million.
Already Americans are subject to de-facto capital controls. If you are an American and you don’t believe me, try opening a Swiss bank account. And with FATCA coming up – the Foreign Account Tax Compliance Act, by which the US government arrogantly co-opts the entire global financial system into the service of the IRS – it will get harder to open an account anywhere in the developed world. And by the way ‘they’ are already working on new laws that prohibit you from travelling abroad if you owe money to the IRS.
These trends are not confined to the US but can be detected everywhere in the developed world. As the state fiat money system approaches its endgame, the state and its lackeys in the media are doing everything to blame the mess on the wealthy in general and on too much freedom. More controls, more state power, more restrictions – the recipes are the same everywhere. It is just that we libertarians understand what America once stood for and we naively still hold it to a higher standard, as indeed America did herself once.
In the meantime, the debasement of paper money continues.
This article was previously published at Paper Money Collapse.
Following on from last Saturday’s article …
There is a general belief that government finances are somehow immune from the financial reality faced by everyone else – an illusion fostered by bond markets and supported by the public’s wishful thinking. Look no further than the plight of the eurozone for evidence of the reality. Not only that, but history tells us that countries regularly default, yet we continue to buy government bonds in the belief they are less risky than any private sector debt. And if we begin to question the status quo, we are even told by financial regulators that government debt is less risky than anything else. Banking regulation enshrines it in Basel Committee guidelines, and modern portfolio theory – which guides securities regulation – casts it in stone.
The reality is different. If you are considering lending money to someone, you will want to be sure that the money will be used to generate a return, otherwise both the interest and the principal will not be covered. The borrower knows this as well, and he will make his case to the lender accordingly. The point is that money leant to a businessman has to be put to productive use. Conversely, money leant to governments is rarely put to productive use, and when it is, production is less efficient than the private sector equivalent anyway, because bureaucracy and political motivations replace entrepreneurial imperatives. Nationalised industries are therefore less able to pay interest on their borrowings, and require a government guarantee, actual or implied, to secure funds at attractive rates.
But when the state merely borrows to cover a budget deficit, it is actually destroying capital, because the capital is being spent, not invested. That is the situation facing most mature economies. And since this capital is being destroyed, the interest and the principal can only be funded from further destructive borrowing. It is truly amazing that governments and their advisers are completely blind to this simple fact.
Sooner or later governments run out of their citizens’ money, leaving nothing but impoverishment for all. Reducing interest rates is the first deliberate step on this road, advocated by Keynes no less in his General Theory. He put forward an idea whereby the state acts to saturate the economy with capital equipment “to get rid of many of the objectionable features of capitalism” (by which he means capitalists themselves: see Observations on the Nature of Capital – Pages 220-221). The destruction of savings, and therefore the impoverishment of savers, if not a deliberate policy, has caused no heartache in Keynesian circles. And now that countries like Greece need every cent they can get, the destruction of domestic savings and savers is in its final stages.
Deficit nations are unable to promise the return of savers’ money; instead, they tell us to expect economic recovery and improving government finances. Like Greece, they are all destroying savings at an increasing pace, making any lasting economic recovery impossible through the lack of necessary capital. Furthermore, the pace of money creation will have to accelerate, not only to fund continuing deficits, but also to pay the compounding interest cost of debt already incurred.
This article was previously published at GoldMoney.com.
Contrary to the conventional wisdom of the current economic mainstream that the gold standard is but a quaint historical anachronism, there has been an unceasing effort by prominent individuals in the US and also a handful of other countries to try and re-establish a gold standard ever since President Nixon abruptly ended gold convertibility in August 1971. The US came particularly close to returning to a gold standard in the 1980s. This was understandable following the disastrous stagflation of the 1970s and severe recession of the early 1980s, at that time the deepest since WWII. Indeed, Ronald Reagan campaigned on a platform that he would seriously study the possibility of returning to gold if elected president.
Once successfully elected, he remained true to his word and appointed a Gold Commission to explore both whether the US should and how it might reinstate a formal link between gold and the dollar. While the Commission’s majority concluded that a return to gold was both unnecessary and impractical – Fed Chairman Paul Volcker had successfully stabilised the dollar and brought inflation down dramatically by 1982 – a minority found in favour of gold and published their own report, The Case for Gold, in 1982. Also around this time, in 1981, future Fed Chairman Alan Greenspan proposed the introduction of new US Treasury bonds backed by gold as a sensible way to nudge the US back toward an explicit gold link for the dollar at some point in future.
In the event, the once high-profile debate in the US about whether or not to return to gold eventually faded into relative obscurity. With brief exceptions, consumer price inflation trended lower in the 1980s and 1990s, restoring confidence in the fiat dollar. By the 2000s, economists were talking about the ‘great moderation’ in both inflation and the volatility of business cycles. The dollar had been generally strong versus other currencies for years. ‘Maestro’ Alan Greenspan and his colleagues at the Fed and their counterparts in many central banks elsewhere in the world were admired for their apparent achievements.
We now know, of course, that this was all a mirage. The business cycle has returned with a vengeance with by far the deepest global recession since WWII, and the global financial system has been teetering on the edge of collapse off and on for several years. While consumer price inflation might be low in the developed economies of Europe, North America and Japan, it has surged into the high single- or even double-digits in much of the developing world, including in China, India and Brazil, now amongst the largest economies in the world.
The economic mainstream continues to struggle to understand just why they got it so wrong. They look for explanations in bank regulation and oversight, the growth of hedge funds and the so-called ‘shadow banking system’. They wonder how the US housing market could have possibly crashed to an extent greater than occurred even in the Great Depression. Some look to global capital flows for an answer, for example China’s exchange rate policy. Where the mainstream generally fails to look, however, is at current global monetary regime itself. Could it be that the fiat- dollar-centred global monetary system is inherently unstable? Is our predicament today possibly a long-term consequence of that fateful decision to ‘close the gold window’ in 1971?
I believe that it is. But what that implies, given the damage now done to the global financial system, is that there is no way to restore a sufficient degree of credibility and trust in the dollar, or other major currencies for that matter, without a return to some form of gold standard. This may seem a rather bold prediction, but it is not. The evidence has been accumulating for years and is now overwhelming.
Money can function as such only if there is sufficient trust in the monetary unit as a stable store of value. Lose this trust and that form of money will be abandoned, either suddenly in a crisis or gradually over time in favour of something else. History is replete with examples of ‘Gresham’s Law’, that ‘bad’ money drives ‘good’ money out of circulation; that is, that when faith in the stability of a money is lost, it may still be used in everyday transactions – in particular, if it is the mandated legal tender – but not as a store of value. The ‘good’ money is therefore hoarded as the superior store of value until such time as the ‘bad’ money finally collapses entirely and a return to ‘good’ money becomes possible. This monetary cycle, from good to bad to good again, has been a central feature of history.
In the present instance, we find a growing number of countries expressing concern about the stability of the dollar amid relentlessly expansionary US monetary policy, excessive dollar reserve accumulation and the associated surge in inflation, including China, India and Brazil. The ‘Arab Spring’ of 2011 originated in part from soaring food price inflation.
Concern is increasingly giving way to action. China has entered into bilateral currency swap arrangements with Russia, Brazil, Argentina, Japan, South Korea and Thailand as all these countries seek to reduce their dependence on the dollar as a transactional currency. As the dollar’s role gradually declines, global monetary arrangements are likely to become increasingly multipolar, as there is no single currency that can realistically replace the dollar as the pre-eminent global monetary reserve. The euro area has major issues with unsustainable sovereign debt burdens and an undercapitalised financial system. Japan’s economy is too small and too weak to provide a dollar substitute. And while China’s economy has been growing rapidly, its financial system is not yet mature or robust enough to instil the necessary global confidence in the yuan as the dominant reserve currency. Yet growth in global trade continues apace, to the benefit of nearly all economies. A global currency facilitates global trade.
It was precisely a multipolar world amid rapidly growing international trade that ushered in the classical gold standard in the 1870s. Although gold had been in the ascendant in global monetary affairs for several years, growing German political and economic clout provided an important tipping point as Germany favoured gold for settlement of international balance of payments. While the Bank of England was the dominant central bank of its day, reflecting British economic power, it never sought to impose a gold standard on its trading partners. Rather, it accepted the gold standard as an international fait accompli.
The US Federal Reserve may find it plays a similar role in the near future. While it is certainly possible that, in order to restore confidence and trust in the dollar, the US relinks the dollar to gold on its own initiative, more likely is that another country, or group of countries, where economic power is in the ascendant, where there are large and growing current account surpluses, and where a meaningful amount of gold has already been accumulated, will be the first movers. All of the BRICs are potential candidates, as are certain oil-producing countries and, possibly, Germany and Japan.
When presented with a fait accompli, the US will have little choice but to go along or find that the dollar not only loses reserve currency status entirely, but also is no longer accepted for international transactions. In the event, we believe a decision to accept the new global gold standard will be rather easy to reach. While it is unclear just what kind of gold standard will prevail – history provides a range from which to choose, some of which worked better than others – the key point is that, whatever form of standard prevails, it must restore a sufficient degree of credibility and trust in global monetary affairs. That requires that, simultaneously and alongside the return to gold, there must be a dramatic deleveraging of the undercapitalised financial system in the US, euro area, UK, Japan and also a handful of other countries. Fortunately, this is easily accomplished. All that is required is that the rate of gold convertibility is set at a gold price sufficiently high to imply that existing debt burdens, now clearly excessive, are reduced to levels that can be credibly serviced from existing levels of national income and, in the case of sovereign debts, from tax revenues.
However, given just how overleveraged financial systems are, and how large sovereign debt burdens are becoming amid unprecedented peacetime deficit spending, the rise in the price of gold will need to be an order of magnitude higher than it is today. That may surprise some, given that the price of gold has been rising for years. But what should really surprise us is that the growth of money and credit has been far greater. Simply taking the numbers as they are and allowing the gold price to rise sufficiently to compensate for decades of cumulative, excessive money and credit growth implies that a credible gold conversion price in dollars would be above $10,000. The credible, sustainable conversion prices in euros, yen, sterling and other developed world currencies would also lie far higher than where they are today.
From an investor’s perspective, there are far greater implications of a return to a gold standard than merely the large rise in the gold price. The dynamics and determinants of interest and exchange rates, and risk premia for the entire range of assets, are going to change. For example, for those countries that return to gold, exchange rates will become essentially fixed. Interest rates, however, while nominally still under the control of central banks, will need to be set at market-determined levels, not below, or gold reserves will be depleted, eventually leading to a funding crisis. Risk premia for most assets will need to rise, primarily because, constrained by the gold standard, both monetary and fiscal authorities will have less flexibility to provide stimulus during economic downturns. As such, cyclical profit swings will tend to be larger, as will the number of bankruptcies.
While a lack of policymaker flexibility and increased risk of corporate bankruptcy might concern some investors, consider that it was precisely an excess of policymaker flexibility – chronically loose monetary and fiscal policy – which got the developed world into its current predicament. This point is clear: poorly managed fiat currencies and the financial systems built upon them caused the global credit crisis, not gold. And what a world of ‘too big to fail’ needs are reforms that indeed allow large firms to go bankrupt from time to time, so that capitalism can in fact work as intended.
It is worth considering why bankruptcy has become such a bad word. While no investor wants to lose money on a bankrupt enterprise, when looking at a capitalist economy as a whole, bankruptcy is absolutely essential to economic progress. Josef Schumpeter’s ‘creative destruction’, unlocking resources in unproductive enterprises and moving them to where they can be more efficiently employed, or mixed with new technologies or business techniques, is what capitalism is all about. Real long-term economic progress depends on it.
There are other reasons not to fear gold but rather embrace it. A gold standard will reward savings, something that is sorely lacking in much of the developed world. It will rationalise government finances, in particular by making it difficult if not impossible for countries to incur large debts and then try to pass these off on future generations, something of dubious morality. Absent easy money, it will force economies to become more flexible, and labour and capital to become more mobile. By implication, financial leverage will also be limited and ‘too big to fail’ will instead become ‘too big to bail’. Indeed, absent easy money or bailouts, the financial sector will only grow to the extent that it actually serves the broader, productive economy. Huge numbers of engineers and other quants who went to the City looking for outsize bonuses will make their way back into real industries making real things, where they will be joined by fresh graduates and lay the groundwork for what is likely to be an era of great industrial innovation.
Investors should not fear the golden revolution. Rather, they should welcome it. After all, they don’t call particularly prosperous historical episodes ‘Golden Ages’ for nothing.