Understanding Argentina’s Coming Default

[Editor’s note: this piece first appeared on]

At the time of this writing, Argentina is a few days away from formally defaulting on its debts.How could this happen three times in just twenty-eight years?

Following the 2001 default, Argentina offered a debt swap (a restructuring of debt) to its creditors in 2005. Many bondholders accepted the Argentine offer, but some of them did not. Those who did not accept the debt swap are called the “holdouts.” When Argentina started to pay the new bonds to those who entered the debt swap (the “holdins”), the holdouts took Argentina to court under New York law, the jurisdiction under which the Argentine debt has been issued. After the US Supreme Court refused to hear the Argentine case a few weeks ago, Judge Griesa’s ruling became final.

The ruling requires Argentina to pay 100 percent of its debt to the holdouts at the same time Argentina pays the restructured bonds to the “holdins.” Argentina is not allowed, under Griesa’s ruling, to pay some creditors but not others. The payment date was June 30. Because Argentina missed its payment, it is now under a 30-day grace period. If Argentina does not pay by the end of July it will, again, be formally in default.

This is a complex case that has produced different, if not opposite, interpretations by analysts and policy makers. Some of these interpretations, however, are not well-founded.

How Argentina Became a Bad Debtor

An understanding of the Argentine situation requires historical context.

At the beginning of the 1990s, Argentina implemented the Convertibility Law as a measure to restrain the central bank and put an end to the hyperinflation that took place in the late 1980s. This law set the exchange rate at one peso per US dollar and stated that the central bank could only issue pesos in fixed relation to the amount of US dollars that entered the country. The Convertibility Law was, then, more than just a fixed-exchange rate scheme. It was legislation that made the central bank a currency board where pesos were convertible to dollars at a “one to one” ratio. However, because the central bank had some flexibility to issue pesos with respect to the inflow of US dollars, it is better described as a “heterodox” rather than “orthodox,” currency board.

Still, under this scheme, Argentina could not monetize its deficit as it did in the 1980s under the government of Ricardo Alfonsín. It was the monetization of debt that produced the high inflation that ended in hyperinflation. Due to the Convertibility Law during the 1990s, Carlos Menem’s government could not finance the fiscal deficit with newly created money. So, rather than reduce the deficit, Menem changed the way it was financed from a money-issuance scheme to a foreign-debt scheme. The foreign debt was in US dollars and this allowed the central bank to issue the corresponding pesos.

The debt issued during the 1990s took place in an Argentina that had already defaulted on its debt six times since its independence from Spain in 1816 (arguably, one-third of Argentine history has taken place in a state of default), while Argentina also exhibited questionable institutional protection of contracts and property rights. With domestic savings destroyed after years of high inflation in the 1980s (and previous decades), Argentina had to turn to international funds to finance its deficit. And because of the lack of creditworthiness, Argentina had to “import” legal credibility by issuing its bonds under New York jurisdiction. Should there be a dispute with creditors, Argentina stated it would accept the ruling of New York courts.

Many opponents of the ruling today claim that Argentina’s creditors have conspired to take away Argentine sovereignty, but the responsibility lies with the Argentine government itself, which has established a long record of unreliability in paying its debts.

The Road to the Latest Default

These New York-issued bonds of the 1990s had two other important features besides being issued under New York legal jurisdiction. The incorporation of theparipassu clause and the absence of the collective action clause. The paripassuclause holds that Argentina agrees to treat all creditors on equal terms (especially regarding payments of coupons and capital). The collective action clause states that in the case of a debt restructuring, if a certain percentage of creditors accept the debt swap, then creditors who turn down the offer (the “holdouts”) automatically must accept the new bonds. However, when Argentina defaulted on its bonds at the end of 2001, it did so with bonds that included theparipassu clause but which did not require collective action by creditors.

Under the contract that Argentina itself offered to its creditors, which did not include the collective action clause, any creditor is entitled to receive 100 percent of the bonus even if 99.9 percent of the creditors decided to enter a debt swap. And this is precisely what happened with the 2001 default. When Argentina offered new bonds to its creditors following the default, the “holdouts” let Argentina know that under the contract of Argentine bonds, they still have the right to receive 100 percent of the bonds under “equality of conditions” (paripassu) with those who accepted the restructuring. That is, Argentina cannot pay the “holdins” without paying the “holdouts” according to the terms of the debt.

The governments of Nestor Kirchner and Cristina Kirchner, however, in another sign of their contempt for institutions, decided to ignore the holdouts to the point of erasing them as creditors in their official reports (one of the reasons for which the level of debt on GDP looks lower in official statistics than is truly the case).

It could be said that Judge Griesa had to do little more than read the contract that Argentina offered its creditors. In spite of this, much has been said in Argentina (and abroad) about how Judge Griesa’s ruling damages the legal security of sovereign bonds and debt restructuring.

The problem is not Judge Griesa’s ruling. The problem is that Argentina had decided to once again prefer deficits and unrestrained government spending to paying its obligations. Griesa’s ruling suggests that a default cannot be used as a political tool to ignore contracts at politician’s convenience. In fact, countries with emerging economies should thank Judge Griesa’s ruling since this allows them to borrow at lower rates given that many of these countries are either unable or unwilling to offer credible legal protection to their own creditors. A ruling favorable to Argentina’s government would have allowed a government to violate its own contracts, making it even harder for poor countries to access capital.

We can simplify the case to an analogy on a smaller scale. Try to explain to your bank that since it was you who squandered your earnings for more than a decade,you have the right to not pay the mortgage with which you purchased your home. When the bank takes you to court for not paying your mortgage, explain to the judge that you are a poor victim of evil money vultures and that you have the right to ignore creditors because you couldn’t be bothered with changing your unsustainable spending habits. When the judge rules against you, try to explain to the world in international newspapers how the decision of the judge is an injustice that endangers the international banking market (as the Argentine government has been doing recently). Try now to justify the position of the Argentine government.


Is Paul Krugman Leaving Princeton In Quiet Disgrace?

Professor Paul Krugman is leaving Princeton.  Is he leaving in disgrace?

Not long, as these things go, before his departure was announced Krugman thoroughly was indicted and publicly eviscerated for intellectual dishonesty by Harvard’s Niall Ferguson in a hard-hitting three-part series in the Huffington Post, beginning here, and with a coda in Project Syndicateall summarized at  Ferguson, on Krugman:

Where I come from … we do not fear bullies. We despise them. And we do so because we understand that what motivates their bullying is a deep sense of insecurity. Unfortunately for Krugtron the Invincible, his ultimate nightmare has just become a reality. By applying the methods of the historian – by quoting and contextualizing his own published words – I believe I have now made him what he richly deserves to be: a figure of fun, whose predictions (and proscriptions) no one should ever again take seriously.

Princeton, according to Bloomberg News, acknowledged Krugman’s departure with an extraordinarily tepid comment by a spokesperson. “He’s been a valued member of our faculty and we appreciate his 14 years at Princeton.”

Shortly after Krugman’s departure was announced no less than the revered Paul Volcker, himself a Princeton alum, made a comment — subject unnamed — sounding as if directed at Prof. Krugman.   It sounded like “Don’t let the saloon doors hit you on the way out.  Bub.”

To the Daily Princetonian (later reprised by the Wall Street Journal, Volcker stated with refreshing bluntness:

The responsibility of any central bank is price stability. … They ought to make sure that they are making policies that are convincing to the public and to the markets that they’re not going to tolerate inflation.

This was followed by a show-stopping statement:  “This kind of stuff that you’re being taught at Princeton disturbs me.”

Taught at Princeton by … whom?

Paul Krugman, perhaps?  Krugman, last year, wrote an op-ed for the New York Times entitled  Not Enough Inflation.  It betrayed an extremely louche, at best, attitude toward inflation’s insidious dangers. Smoking gun?

Volcker’s comment, in full context:

The responsibility of the government is to have a stable currency. This kind of stuff that you’re being taught at Princeton disturbs me. Your teachers must be telling you that if you’ve got expected inflation, then everybody adjusts and then it’s OK. Is that what they’re telling you? Where did the question come from?

Is Krugman leaving in disgrace? Krugman really is a disgrace … both to Princeton and to the principle of monetary integrity. Eighteenth century Princeton (then called the College of New Jersey)president John Witherspoon, wrote, in his Essay on Money:

Let us next consider the evil that is done by paper. This is what I would particularly request the reader to pay attention to, as it was what this essay was chiefly intended to show, and what the public seems but little aware of. The evil is this: All paper introduced into circulation, and obtaining credit as gold and silver, adds to the quantity of the medium, and thereby, as has been shown above, increases the price of industry and its fruits.

“Increases the price of industry and its fruits?”  That’s what today is called “inflation.”

Inflation is a bad thing.  Period.  Most of all it cheats working people and those on fixed incomes who Krugman pretends to champion.  Volcker comes down squarely, with Witherspoon, on the side of monetary integrity. Krugman, cloaked in undignified sanctimony, comes down, again and again, on the side of … monetary finagling.

Krugman consistently misrepresents his opponents’ positions, constructs fictive straw men, addresses marginal figures, and ignores inconvenient truths set forward by figures of probity such as the Bank of England and theBundesbankthoughtful work such as that by Member of Parliament (with a Cambridge Ph.D. in economic history) Kwasi Kwarteng, and, right here at home, respected thought leaders such as Steve Forbes and Lewis E. Lehrman (with whose Institute this writer has a professional affiliation).

Professor Krugman, on July 7, 2014, undertook to issue yet another of his fatwas on proponents of the classical gold standard.  His New York Times op-ed, Beliefs, Facts and Money, Conservative Delusions About Inflation, was brim full of outright falsehoods and misleading statements. Krugman:

In 2010 a virtual Who’s Who of conservative economists and pundits sent an open letter to Ben Bernanke warning that his policies risked “currency debasement and inflation.”  Prominent politicians like Representative Paul Ryan joined the chorus.

Reality, however, declined to cooperate. Although the Fed continued on its expansionary course — its balance sheet has grown to more than $4 trillion, up fivefold since the start of the crisis — inflation stayed low.

Many on the right are hostile to any kind of government activism, seeing it as the thin edge of the wedge — if you concede that the Fed can sometimes help the economy by creating “fiat money,” the next thing you know liberals will confiscate your wealth and give it to the 47 percent. Also, let’s not forget that quite a few influential conservatives, including Mr. Ryan, draw their inspiration from Ayn Rand novels in which the gold standard takes on essentially sacred status.

And if you look at the internal dynamics of the Republican Party, it’s obvious that the currency-debasement, return-to-gold faction has been gaining strength even as its predictions keep failing.

Krugman is, of course, quite correct that the “return-to-gold faction has been gaining strength.” Speculating beyond the data thereafter Krugman goes beyond studied ignorance.  He traffics in shamefully deceptive statements.

Lewis E. Lehrman, protege of French monetary policy giant Jacques Rueff, Reagan Gold Commissioner, and founder and chairman of the Lehrman Institute, arguably is the most prominent contemporary advocate for the classical gold standard.  Lehrman never rendered a prediction of imminent “runaway inflation.”  Only a minority of classical gold standard proponents are on record with “dire” warnings, certainly not this columnist.  So… who is Krugman talking about?

Of the nearly two-dozen signers of (a fairly mildly stated concern) open letter to Bernanke which Krugman cites as prime evidence, only one or two are really notable members of the “return-to-gold faction.” Perhaps a few other signers might have shown some themselves in sympathy the gold prescription. Most, however, were, and are, agnostic about, or even opposed to, the gold standard.

Indicting gold standard proponents for a claim made by gold’s agnostics and opponents is a wrong, cheap, bad faith, argument.  More bad faith followed immediately.   Whatever inspiration Rep. Paul Ryan draws from novelist Ayn Rand, Ryan is by no means a gold standard advocate.  And very few “influential conservatives” (unnamed) “draw their inspiration” from Ayn Rand.

Nor are most proponents of the classical gold standard motivated by a fear that paper money is an entering wedge for liberals to “confiscate your wealth and give it to the 47 percent.”  A commitment to gold is rooted, for most, in the correlation between the gold standard and equitable prosperity.  Income inequality demonstrably has grown far more virulent under the fiduciary Federal Reserve Note regime — put in place by President Nixon — than it was, for instance, under the Bretton Woods gold+gold-convertible-dollar system.

Krugman goes wrong through and through.  No wonder Ferguson wrote: “I agree with Raghuram Rajan, one of the few economists who authentically anticipated the financial crisis: Krugman’s is “the paranoid style in economics.” Krugman, perversely standing with Nixon, takes a reactionary, not progressive, position. The readers of the New York Times really deserve better.

Volcker is right. “The responsibility of any central bank is price stability.” Krugman is wrong.

Prof. Krugman was indicted and flogged publicly by Niall Ferguson. Krugman thereafter announced his departure from Princeton.  On his way out Krugman, it appears, was reprimanded by Paul Volcker.  Krugman has been a disgrace to Princeton.  Is he leaving Princeton in quiet disgrace?

Originating at


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.



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.
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.
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?


Today’s wealth destruction is hidden by government debt

Still unnoticed by a large part of the population is that we have been living through a period of relative impoverishment. Money has been squandered in welfare spending, bailing out banks or even — as in Europe — of fellow governments. But many people still do not feel the pain.

However, malinvestments have destroyed an immense amount of real wealth. Government spending for welfare programs and military ventures has caused increasing public debts and deficits in the Western world. These debts will never be paid back in real terms.

The welfare-warfare state is the biggest malinvestment today. It does not satisfy the preferences of freely interacting individuals and would be liquidated immediately if it were not continuously propped up by taxpayer money collected under the threat of violence.

Another source of malinvestment has been the business cycle triggered by the credit expansion of the semi-public fractional reserve banking system. After the financial crisis of 2008, malinvestments were only partially liquidated. The investors that had financed the malinvestments such as overextended car producers and mortgage lenders were bailed out by governments; be it directly through capital infusions or indirectly through subsidies and public works. The bursting of the housing bubble caused losses for the banking system, but the banking system did not assume these losses in full because it was bailed out by governments worldwide. Consequently, bad debts were shifted from the private to the public sector, but they did not disappear. In time, new bad debts were created through an increase in public welfare spending such as unemployment benefits and a myriad of “stimulus” programs. Government debt exploded.

In other words, the losses resulting from the malinvestments of the past cycle have been shifted to an important degree onto the balance sheets of governments and their central banks. Neither the original investors, nor bank shareholders, nor bank creditors, nor holders of public debt have assumed these losses. Shifting bad debts around cannot recreate the lost wealth, however, and the debt remains.

To illustrate, let us consider Robinson Crusoe and the younger Friday on their island. Robinson works hard for decades and saves for retirement. He invests in bonds issued by Friday. Friday invests in a project. He starts constructing a fishing boat that will produce enough fish to feed both of them when Robinson retires and stops working.

At retirement Robinson wants to start consuming his capital. He wants to sell his bonds and buy goods (the fish) that Friday produces. But the plan will not work if the capital has been squandered in malinvestments. Friday may be unable to pay back the bonds in real terms, because he simply has consumed Robinson’s savings without working or because the investment project financed with Robinson’s savings has failed.

For instance, imagine that the boat is constructed badly and sinks; or that Friday never builds the boat because he prefers partying. The wealth that Robinson thought to own is simply not there. Of course, for some time Robinson may maintain the illusion that he is wealthy. In fact, he still owns the bonds.

Let us imagine that there is a government with its central bank on the island. To “fix” the situation, the island’s government buys and nationalizes Friday’s failed company (and the sunken boat). Or the government could bail Friday out by transferring money to him through the issuance of new government debt that is bought by the central bank. Friday may then pay back Robinson with newly printed money. Alternatively the central banks may also just print paper money to buy the bonds directly from Robinson. The bad assets (represented by the bonds) are shifted onto the balance sheet of the central bank or the government.

As a consequence, Robinson Crusoe may have the illusion that he is still rich because he owns government bonds, paper money, or the bonds issued by a nationalized or subsidized company. In a similar way, people feel rich today because they own savings accounts, government bonds, mutual funds, or a life insurance policy (with the banks, the funds, and the life insurance companies being heavily invested in government bonds). However, the wealth destruction (the sinking of the boat) cannot be undone. At the end of the day, Robinson cannot eat the bonds, paper, or other entitlements he owns. There is simply no real wealth backing them. No one is actually catching fish, so there will simply not be enough fishes to feed both Robinson and Friday.

Something similar is true today. Many people believe they own real wealth that does not exist. Their capital has been squandered by government malinvestments directly and indirectly. Governments have spent resources in welfare programs and have issued promises for public pension schemes; they have bailed out companies by creating artificial markets, through subsidies or capital injections. Government debt has exploded.

Many people believe the paper wealth they own in the form of government bonds, investment funds, insurance policies, bank deposits, and entitlements will provide them with nice sunset years. However, at retirement they will only be able to consume what is produced by the real economy. But the economy’s real production capacity has been severely distorted and reduced by government intervention. The paper wealth is backed to a great extent by hot air. The ongoing transfer of bad debts onto the balance sheets of governments and central banks cannot undo the destruction of wealth. Savers and pensioners will at some point find out that the real value of their wealth is much less than they expected. In which way, exactly, the illusion will be destroyed remains to be seen.

This article was previously published at


No tapering, no surprise

It was not too surprising that there is going to be no tapering for some very good reasons. The commencement of tapering would have led deliberately to bond yields rising, triggered by an increase in sales of government bonds to the public and at the same time escalating sales by foreign governments as they attempt to retain control over their own currencies and interest rates. This was the important lesson from floating the rumour of tapering in recent months.

The reason tapering was not going to happen is summarised as follows:

1.       Monetarists and therefore central bankers believe that rising bond yields and interest rates will strangle economic recovery. They want to see more robust evidence of recovery before permitting that to happen.

2.       Rising bond yields would have required the Fed to raise interest rates sooner rather than later to stem the flight of bank deposits from the Fed’s own balance sheet held as excess reserves, which only earn 0.25%.

3.       Importantly, the global banking system has too much of its collective balance sheet invested in fixed-interest bonds, and is also exposed to rising interest rates through interest rate swap derivatives. Tapering would almost certainly have precipitated a second bank crisis starting at the system’s weakest point.

4.       The cost of funding the US Government’s deficit would have risen, difficult when the debt ceiling has to be renegotiated yet again.

5.       Rising US interest rates will most probably destabilise emerging market currencies, risking a new Asian crisis.

6.       It is a bad time to shift the burden of government funding back into the markets, because foreign holders have shown they will sell into rising yields.

The Fed has reaffirmed that zero interest rates will be with us for some time to come. It simply has no choice: it has to play down the risk of inflation. The result will be more price inflation, which is bad for the dollar and good for gold.  This was reflected in the US Treasury yield curve, where prices of long maturities fell yesterday relative to the short end.

The markets had wrongly talked themselves into believing that tapering was going to happen, when the rumour was no more than an experiment. In the process precious metals were sold, driven by increasingly bearish technical talk every time a support level was breached. It is hardly surprising therefore that the recovery in gold and silver prices last night was dramatic, with gold moving up $70 and silver by $2 from intra-day lows. It looks like a significant second bottom is now in place above the June lows and the bear position, coupled with the shortage of physical metal will drive prices in the coming weeks.

The implications of the Fed not going ahead with tapering are bad for the dollar and won’t stop bond yields at the long end from rising. It shows that the whole US economy is in a massive debt trap that cannot be addressed for powerful reasons. The reality is the expansion of cash and deposits in the US banking system is tending towards hyperinflation and is proving impossible to stop. That is the message from this week’s FOMC meeting, and I expect it to gradually dawn on investors world-wide in the coming weeks.


Debt addiction, USA: how much debt reduction has the crisis caused?

The purpose of this essay is to put the latest crisis in the context of longer-term debt trends in the US and to attempt some predictions in respect to the US economy and financial markets.

Statistics are records of past events. Analyzing statistics means interpreting history, and this can only be done on the basis of theory. We must first have some theoretical notions to be able to render past events intelligible. Of course, historic data cannot be in conflict with the theory used, as that would put the validity of the latter in doubt. But we can neither use statistics to prove the correctness of a theory nor directly discover new theories (although history may give us ideas about potential theories). Before we look at the data I should give a brief outline of my theory, which readers of my book Paper Money Collapse will be familiar with.

The theory – short version

Paper Money Collapse challenges the prevailing consensus on money. This consensus holds that it is good to have something called ‘monetary policy’. Most mainstream economists today, while accepting the superiority of markets when it comes to allocating scarce resources to their most urgent uses, also maintain that in the field of money state involvement is desirable, and that a smoothly functioning economy requires a constantly expanding supply of state paper money and the guidance (manipulation) of certain market prices (interest rates) by a central bureaucracy, i.e. the central bank. More precisely, this bureaucracy should keep expanding the supply of money in such a way that money’s purchasing power declines continuously (moderate, controlled inflation) and that, whenever the economy is weak, it should use its powers to ‘stimulate’ the economy towards faster growth, usually through accelerated base money production and administratively lowered interest rates.

Paper Money Collapse argues that all these notions are erroneous and dangerous. Constant monetary expansion is not needed (not even in a growing economy) and is always highly disruptive. The continuous expansion of fiat money, naturally via financial markets, systematically distorts interest rates, which must lead to capital misallocations and other economic imbalances that will make recessionary corrections at a later stage inevitable. The recessions that ‘easy’ monetary policy is then supposed to shorten or ease are thus nothing but the result of previous monetary expansion.

Recessions can only be avoided by avoiding artificial booms through credit expansion. Once monetary expansion has led to sizable economic distortions the recession becomes unavoidable – and even necessary to cleanse the economy of dislocations. But to make matters worse, in our present system of unconstrained fiat money creation, recessions are – whenever they occur – countered by accelerated money creation (usually via new bank reserves from the central bank) and further cuts in interest rates. Imbalances are thus not being purged from the economy. Instead they accumulate over time making the financial system and the economy overall progressively more unstable. The system is moving towards a point of catharsis: either a complete purge is finally allowed to unfold (painful) or ever more fiat money is created until the public loses confidence in fiat money itself and a hyperinflationary currency collapse occurs (more painful).

I maintain that this theory is logically consistent and not in conflict with past events.

The data

Clearly identifying, let alone quantifying, imbalances is exceedingly difficult if not impossible. It is usually during crises that imbalances become visible as such. Consequently, analyzing data requires a considerable degree of judgement. In the following I look at ‘excessive indebtedness’ as a major dislocation caused by fiat money expansion.

The present monetary system naturally encourages the excessive accumulation of debt, and discourages deleveraging and disinflation, although at certain points in time these may be difficult to avoid altogether. During the financial crisis deflationary and recessionary forces briefly gained the upper hand. To what extent have they purged the system of money-induced imbalances? Has a meaningful ‘cleansing’ of imbalances taken place? If so, has the economy ‘healed’?

I had a look at the Federal Reserve’s Flow of Funds data and the following picture emerges.

Over the 31 years from 1981 to the end of 2012, total debt outstanding in the US economy grew from $5,255 billion to $56,280 billion. The debt load has increased continuously from year to year – with only one single exception: 2009, when total debt declined by just 0.2%. Debt has grown faster than nominal GDP in 27 out of 31 years. The average growth rate in total debt was 8% per annum, compared to 5.4% for nominal GDP. In 1981, total debt outstanding was 168% of GDP, today it is 359% of GDP.

In 1981, total debt broke down as follows: household debt was about 48% of GDP; business debt was about 53% of GDP; the public sector owed about 38% of GDP and the financial sector 29% of GDP. Note that of the four major sectors, the public sector and the financial sector were the two smaller ones. Debt of the financial sector was only slightly more than half of corporate debt.

Things looked very different by the end of 2012: Household debt had ballooned to 82% of GDP and corporate debt to 81%. Public sector debt now stood at 93% of GDP and financial sector debt at 103% of GDP. The public and financial sector had become the largest debtors.

While corporate debt was about 7.5 times larger in absolute terms at the end of 2012 than at the end of 1981, financial sector debt was 17 times larger. Over the 26 years from 1981 to the eve of the current financial crisis in 2007, financial sector debt grew at an average clip of more than 12% per annum compared to about 6% for nominal GDP over the same period. When we entered the present financial crisis in 2007, financial sector debt stood at an all-time high for any sector in US financial history, at 131% of GDP.

I maintain that such a dramatic growth in overall indebtedness, as well as the specific breakdown of that growth by sector, is symptomatic of our unconstrained fiat money system with its constant money growth and lender-of-last-resort central banks that encourage debt accumulation and promote high-leverage strategies in the financial sector. That this has led to substantial economic instability is now self-evident.

Has the US economy deleveraged since 2007?

The two sectors that were most exposed in 2007 were households (via the residential mortgage market) and the financial sector. Both sectors have shed debt since 2007. Both have deleveraged. Households reduced their debt from a record $13,712 billion in 2007 to $12,831 billion at the end of 2012. These $881 billion mean a reduction of 6.4%. The financial sector was forced to cut debt even more: From 2007 to 2012, total outstanding debt of the financial sector was reduced by more than $2,100 billion, a reduction of 12%.

Such reductions in debt were unprecedented in the 31-year history we are looking at here. At no point before had household debt and financial sector debt declined on a year-over-year basis. In this respect, the events of the recent crisis were indeed unique. ‘Cleansing’ has occurred. But how meaningful are these reductions? In absolute terms – total amounts of debt outstanding – both sectors are roughly back to where they were … Q3 of 2006, barely a year before the crisis started! Not much has happened in absolute terms. However, in recent years, the economy has continued to grow moderately, so as a percentage of GDP, household debt is today roughly where it was in 2002/3, and financial sector debt is about where it was in 2001/2. In relative terms, a decade of excess has thus been unwound.

Nevertheless, as mentioned above, the total debt load has continued to grow and stands at an all-time record today. The reason for this is mainly the explosion in public sector debt. While households and financial firms have cut debt by $3 trillion since 2007, the state has taken on an additional $6.6 trillion in new debt over the same period– almost all of it at the federal level! In fact, outstanding debt of the federal government has more than doubled since 2007!

The trend of ever-rising overall debt has thus continued. The deleveraging in the household and financial sector has, however, resulted in a reduced pace of debt accumulation overall, despite heavy borrowing from the federal government. In 2010, for the first time since 1992, the economy has grown faster than total debt, and this has continued in 2011 and in 2012, if at a slowing pace. Consequently, total debt stands at 359% of GDP today, slightly down from its peak of 381% in 2009. At 359% debt-to-GDP is back to where it was at in early 2007. Again, not much deleveraging has occurred in total.

Conclusion and outlook

I cannot see that the recent crisis has already brought about some kind of fundamental healing of the US economy, some much needed purge of monetary excesses. Yes, households and the financial industry have trimmed back and are now probably in better shape than a few years ago. Household debt numbers now seem to be stabilizing, meaning deleveraging could be coming to an end, while there is no sign yet that financial deleveraging has concluded. Of course, given the prevailing belief system, those who control the levers of the fiat money system are doing what they can to discourage further deleveraging. Zero interest rates and open-ended QE are hardly conducive to debt reduction.

Here are my present forecasts, and they are necessarily highly speculative:

  • Super-easy monetary policy will continue as far as I can see. The Fed has declared that it wants to use monetary policy to boost employment (the hubris of the bureaucrat!). But deleveraging in the financial sector, if it persists, would be a problem for the Fed’s strategy. The financial sector is crucial in transmitting easy policy. The Fed can thus reasonably be expected to continue leaning against deleveraging with all its might. And if and when deleveraging turns into re-leveraging, the Fed will probably nurture it for some time.
  • Public sector profligacy is not a crisis phenomenon but has been in full bloom since 2002 and is now in large part structural. A political solution looks unlikely any time soon. The state will thus continue to be the main driver behind the overall growth in debt. Funding this debt accumulation is not a problem with the Fed now the biggest marginal buyer of Treasury securities and the Fed unlikely to abandon super-easy policy anytime soon.
  • The corporate sector has not been a major driver in this story so far. Recently, corporate debt has begun to expand again. It is not unreasonable to assume that this will continue.
  • In aggregate, the picture could be the following: outstanding debt of the public sector will continue to grow rapidly, corporate debt mildly to maybe strongly; household indebtedness might stagnate. The wild card remains the financial sector. My guess is that what little overall deleveraging we experienced – measured as a modest decline in total debt in relation to the economy’s capacity for income-generation, i.e. GDP – is in the process of being reversed. The interventionists (i.e. the mainstream) will hail this as a success of policy. ‘Debt-deflation’ has been avoided – for now. A more realistic assessment is that the economy is as much on financial steroids as a few years ago, and – in aggregate – as fragile. Expanding debt levels further from here will require interest rates that are continuously depressed through policy and an even more activist and interventionist central bank. The Fed is fully on board with this.
  • Deflation is very unlikely from here. The debasement of paper money continues. Inflation rates should begin to move higher.

Debt-GDP-ratios of 359% (now) or 381% (2009) are unusual historically. The ratio was below 200% at the start of the Great Depression and it peaked at a touch above 300% in 1933, when nominal GDP collapsed. The current debt load is unprecedented. But then, countries such as Japan and the UK have total debt in excess of 500 percent of GDP. Disaster still looks inevitable but maybe not imminent.

…a final word on the bond market.

It so happens that the start year of the above analysis – 1981 – also marked the peak in bond yields in the US. 10-year Treasury notes reached 15% back in 1981 and went on a downward path from there that lasts to this day. We have had an almost uninterrupted, 31-year bull market in bonds. Not only Treasuries but also corporate and mortgage debt are presently trading at or near historic lows in yield. Although the US economy never had to carry more debt – certainly never more in absolute terms and almost never more relative to GDP – the compensation that investors get for holding all this debt has never been lower!

Sure, inflation was still high in the early 1980s but the structural drop in inflation was over by 1992. CPI inflation has broadly moved sideways in a stable range since the early 1990s without any additional disinflationary momentum.

It seems that over the past three decades the debtors were encouraged to take out ever more debt because the lenders – the bond buyers – were happy to hold ever more debt at ever lower yields. A market in which demand for assets keeps rising at persistently rising prices (persistently falling yields) has all the ingredients of a bubble. I think the US bond market – and by extension, international bond markets – could be the greatest bubble in history.

The big question is when will this bubble pop?

This article was previously published at


Easy, isn’t it?

With the halls no longer decked with boughs of holly and the wassailers at last stuffed full of figgy pudding, we have all reluctantly begun to struggle back to our desks, turn on our Bloomberg screens, and wearily face up to the long slog ahead towards the annual profit target.

Even though the New Year is still wrapped in its swaddling clothes, it is hard to avoid the jaded feeling that the market has already arrived at an all too cosy consensus about how events will unfold in 2013 and where the money is to be made as they do.

The Yen will continue to fall and fall under the maniacal compulsion of the new Japanese government; bond yields will finally cease their three-decade decline; and stocks will (of course) rally, probably dragging industrial commodities with them. In Europe, the worst is widely held to be behind us – even though nothing much has been done there beyond persuading traders that the line of least resistance lies in not calling Mario Draghi’s bluff when he insists that sovereign spreads must not widen. China’s typically sagacious new central planners will somehow ‘rebalance’ the ailing giant that is their fiefdom by pouring yet more concrete and digging yet more holes without this time stumbling into a further mindless duplication of capacity, sparking a divisive property rush, or re-igniting a socially disquieting round of consumer price rises. Perched high above, in the crow’s nest which sways alarmingly above this Ship of Fools, the Bernanke Fed will keep on buying however many of the obligations of an incurably profligate government it feels like monetizing, thereby hoping to prise the prudent out of their more passive habits of saving by means of the insidious, corrosive, time decay which negative real interest rates visit on the thrifty and, in doing so, it will seek to insure us against all possibility of renewed recession. 

Easy, isn’t it?

Well, perhaps. But before we start spending our bonuses before we have truly earned them, let us first pause to consider whether  any or all of these suppositions are really imbued with the full hue of inevitability or whether instead an all too typical mass disappointment will set in, either around the start of February (as has traditionally been the tendency when the last winning trade of the old year is carried too eagerly on into the new) or sometime in the Spring (as has been the case in the last three years of policy undulation and Risk-On/Off hysteresis).

Take the US, for example. Just like the Mayan fiasco of prophecy, the budgetary apocalypse of the so-called ‘fiscal cliff’ (a hackneyed phrase whose overuse grates on the ears almost as much as that damnable cliché relating to metallic containers, public highways, and coups de pieds) has been partly averted, even if we can all look forward, in the coming weeks, to another round of facile political posturing ahead of the near-inevitable debt ceiling extension.

Rather than cheer, however, any rational investor would find this procrastination a mater of deep anxiety for, as Laurence Kotlikoff points out, it is not so much the minor contour change of the ‘cliff’ which should be exercising our concerns, but the terrifying, Miltonian ‘abyss’ which lies beyond it in a country where the accelerated transmutation of ageing Baby Boom tax payers into voracious entitlement eating retirees is adding no less that $11 trillion a year to the unpayable $222 trillion NPV of the nation’s overall sum of actual and contingent liabilities.

For now, though, even if the recovery is a deal more anaemic than anyone seeking votes might hope, America has managed to avoid slipping back into the mire in the way so many of its peers have done, where, that is, these latter have been fortunate enough to free themselves from the choking quagmire of unresolved crisis in the first place.

By all accounts, the economy – and by extension, a stock market flattered by the artificially exiguous discount factors applied to its prospective earnings stream – has much going for it: corporate profits are elevated, cash flow is at record highs, wages are subdued, the buying-back of equities is proceeding apace, that last aided greatly by a booming market in corporate debt . Capital expenditures are on the rise (if not so impressive in inflation-adjusted, net – rather than nominal, gross – terms) and payrolls are indeed expanding if not as rapidly as some might wish.

Moreover, the broad brush of the overall jobs numbers has been obscuring the heartening detail that the country’s more productive sectors are making their contribution to re-employment (manufacturing and the extractive industries have, between them, added almost 600,000 to the roster since the trough), while the bulk of the retrenchments have come in the non-productive, if not parasitical, sectors of finance (mea culpa!) and government.

The main concern here is that, despite the Fed’s ongoing efforts to force everyone to swim by flooding the land in liquidity, overall business revenues have undergone something of a deceleration in recent months and regular surveys of small businesses are obstinately throwing off readings typical of a slump, while claims of rediscovered vigour in the enfeebled construction sector seem to be belied by the trifling gains in headcount and hours worked in the field, not to mention the refusal of mortgage purchase applications to shake off their post-crash sloth, or of office vacancy rates to decline in any meaningful manner.

In Europe, politics may yet play an unexpected part, not least in Italy where Il Caviliere seems to have found a way to manoeuvre himself back to the centre of things in the form of the partial self-denial of ambition encapsulated in his faction’s deal with its erstwhile allies of the Northern League, under the terms of which he would settle for the finance minister’s job. However that particular gambit pays out, it seems certain that the hustings everywhere will resound to cries of repudiation for anything associated with the slow grind of Orient Express Austerity (i.e., that pernicious assault on the commonwealth which seeks to keep an overgrown and intrusive state as large as possible, no matter what the cost to that enterprising and self-reliant middle which is otherwise most likely to spark a renaissance).

Even in Germany, the cracks have begun to appear as the Merkel coalition has already delivered a sackful of costly pre-election sweeteners to keep the electorate onside in this, the key year for the coalition. As one perceptive acquaintance put it, we should expect little else when the struggle for power will be conducted between what he sourly called the red socialists, the green socialists, the yellow socialists, and the black socialists.

For our part, it has always been the contention that the true test of Germany’s avowed resolve to insist upon budgetary discipline and at least the pretence of monetary rectitude would arrive if and when the country’s recent good fortune began to run out and its own mighty engines of growth were heard, at last, to sputter and cough.

With business revenues now falling in all sectors, except that of what are probably inflation-boosted consumer non-durables (making the MDAX, if not yet its larger sibling the DAX, seem historically expensive by comparison) and with industrial production and exports each having suffered a three-month retracement of a magnitude not seen outside either 2008’s global ‘sudden stop’ or the post-Reunification hangover, we’ll see the test of our thesis that the Bundesbank may soon pass from a show of Schlesinger-like sternness to its polar opposite of Welteke-like vacillation.

Curiously, this slowdown seems to be taking form despite an intensification of the Eurozone’s dysfunctional ‘biflation’, a sharp divergence in monetary trends between the core and the periphery which has seen the key aggregate grow at accelerating double digit rates in the Eastern Frankish Realm and barely growing (if not actively deflating) in the Western half of New Carolingia.

Some of this inconsistency is largely to be explained by the transfer of deposits from the PIIGS – where they run a risk, however vanishing one is meant to believe it is, of not only being lost in a local banking collapse, but of being summarily redenominated in a devalued numeraire – to the perceived safe havens of Germany, Luxembourg, Finland, and the Netherlands. When such monies come to rest in banks north and east of the Rhine, they are not immediately intended for spending on the output of the Mittelstand: their ‘velocity of circulation’ is preternaturally low, if you will.

However, that this is not the full story can be seen from the fact that, since Draghi quelled the incipient panic last summer when he issued his resounding boast to ‘do whatever it takes’, the tell-tale TARGET2 balances which reflect this twin-sided process of credit withdrawal and flight-to-quality have undergone a partial decline which we can quantify roughly either by way of the shrinkage of the joint Spanish-Italian total (or of that of its De-Fin-Nl-Lux counterpart) of some €110 billion seen between August and November. Alongside this, non-currency portion of the money supply in the former has shrunk by €6.2 billion (-1.8% annualized), while that in the latter has shot up by €77 billion (a massive 19.4% annualized which stretches to 26.0% in Germany alone).

If these funds, too, are not  being spent with quite the abandon they were a few short months ago, it might be taken to indicate that conditions are worsening and sentiment darkening more drastically than the superficial optimism of the securities markets would have us infer.

The one place where things do seem to have taken a decided downward lurch is in France. After coming back broadly into balance, its T2 debits jumped back up to €43 billion in October (the last period for which the BdF has seen fit to publish its balance sheet). Alongside this, there has been a sharp, €15 billion, -10.5% annualized decline in non-currency money supply which has served to take the annual rate of change close to zero in real terms and hence very much back into the danger zone.

It can hardly be a coincidence that this mini-run occurred in the context of the spat over the possible nationalization of Arcelor Mittal’s steel works; the implosion into internecine strife of the UMP opposition; and the disarray so evident at the heart of Hollande’s administration – not least regarding the status of the soak-the-rich tax – which led to the international embarrassment of Gerard Depardieu’s very public defection to the Russians.

The country, which has seen debt/GDP jump 20 points since the crisis (and with ongoing deficits of ~€2 billion a day do add to the tally) and which has a €40-45 billion structural–looking current account gap to fill, is not entirely securely placed in the affection of the world’s investing public even if the implicit support of the rest of the European mechanism makes a full-blown flight an unlikely prospect just yet.  Nonetheless, all this bears watching.

Just across the channel, the fall of the services sector PMI to a 3 1/2 –year low, coupled with a dip in the construction analogue the bottom reaches of its last two years’ range, has raised the spectre of a ‘triple dip’ recession. Notwithstanding this, the UK manages to run a record trade gap in goods, clearly in excess of £100 billion a year, leaving the overall trade deficit of £36 billion a bare £3.8 billion less deep than it was at the peak of the boom and a current account which is beginning to push into a zone which heralded the last two sterling crisis – in the mid-1970s and during the first ERM break-up.

Ironically, this has come about as the BOE’s latest efforts at QE have finally had some purchase on the nation’s stock of usable money. Between February and November last year, the Old Lady’s balance sheet expanded by £90-odd billion and money supply rebounded from its post-Crisis lows, climbing £70.6 billion at an annualized rate of no less than 10%.

Loose money, loose fiscal policy (the shortfall is still running at some £10 billion a month), low competitiveness, and a weak leadership unable to steel itself to do anything to address the issue. This all sounds horribly familiar to this particular seed of Albion.

All of which brings us to China (sigh!).

No-one can surely need to be told that the last few months have seen a modest improvement in the Middle Kingdom’s fortunes which has auspiciously coincided with the induction of the new leadership. In part, this was grounded on the usual year-end orgy of spending undisbursed government budgets, in part on the typical fourth quarter acceleration which took place in the money supply. This last quickened to a 34% annualized rate from the third quarter’s unchanged pace – impressive enough, perhaps, but still the slowest closing burst in four years. Furthermore, the volume of new loans granted – seemingly hamstrung by lacklustre deposit formation – touched a 3-year low, with the important medium-long term sub-category dipping to a 4-year nadir.

But if the banks were not officially in the game, the ‘shadow system’- including Xiao Gang’s Ponzi component – certainly came up trumps!

‘Total Social Financing’, as it is called (and less equity issuance), outstripped boring old bank loans by a factor or 1.7:1 in the final quarter of the year and constituted no less than 72% of all new credit extended in December. Compared with the same month in 2011, new, official, on-balance sheet bank loans declined 38% from CNY733 billion to CNY453 billion, while all other forms of credit rose 112% from CNY538 billion to CNY1, 139 billion.

Now some of this shift is probably not entirely a retrograde step, at least not to the extent that it represents a genuine entrepreneurial attempt to circumvent China’s antediluvian, financially-repressed, SOE-favouring, bank-coddling regulatory framework and instead tries to put people’s savings to work at a suitable rate of interest, funding genuine productive undertakings.

The problem is that some sizeable – if necessarily unquantifiable – fraction also comprises local government boondoggling, loan sharking, and outright fraud.  No wonder the central authorities moved last week to clamp down on the activities of the lower tiers of government in this regard.

To put all of this in come kind of context, it looks as though every extra renminbi of incremental GDP in 2011 was ‘bought’ with around CNY1.76 in new credit: last year the ratio was 3:1. Capital efficiency, anyone?

Moreover, when we look at liquidity, matters become even more pressing. In 2011, the system was already pyramiding Y5.50 on top of every new Y1 of actual new money created (2.54:1 for the shadow component). Last year the overall ratio was 8.22:1 and the shadow one stretched to 3.87:1.

And what is all this moolah being used for? For moving away from a malinvestment-led graveyard of capital such as has been constructed over the past decade of SOE princeling dominance? It certainly doesn’t look like it. 

‘Urbanization’ may be the new buzz word (and one about whose exact meaning we still maintain certain caveats), but this just means that instead of crushing returns at home and abroad (and piling up zombie loans on the books of the pliant state-owned banks) in such sectors as aluminium, steel, ship-building, photo-voltaic, etc., China now seems to wish to emulate post-bubble 1990s Japan with a whole host of non-paying propositions aimed at the domestic, rather than the international, market.

Take commercial real estate. Forced to cut back on their residential excesses, developers have been parlaying a good part of those new funds into building shopping malls wherever they can cut a deal with those paragons of municipal virtue, their buddies at the local land office. And, typically, they have not done things by halves for, as a recent press report made known, between now and 2015, if all goes according to schedule, China will add no less than 600 million square metres of mall floor space (around 120,000 football pitches’ worth). For comparison the ICSC estimate of the existing stock of US shopping malls comes in at around 650 million, around half the nations’ overall retail area. 

Then there are the subways. All well and good in principle to reduce congestion, increase safety and convenience and lower logistic costs, but they are hardly going to pay even their maintenance charges, much less their construction costs if the present economics are anything to go by.

As the China Daily reported in what was – for the sensitive tenor of the times – an unusually critical article, doubts are already surfacing about the sustainability of the current programme. 

Keen to spare the new bosses the loss of face of a soggy end to a soft year, in September, the NDRC suddenly approved 25 subway projects in 18 cities, for a total investment of more than CNY800 billion. Still furiously pump-priming, by November they had authorised four more cities — Beijing, Nanchang, Fuzhou, and Urumqi — to commit to plans requiring another CNY135 billion even though 35 cities had already broken ground on such projects in 2012, for an estimated ante of CNY260 billion, said the paper, citing a report of the Comprehensive Transport Research Institute of the commission.

Among the doubters, was one Wang Mengshu of the Chinese Academy of Engineering who told the interviewer that:- 

A city is eligible to build subways only if it has an urban population of more than 3 million, an annual GDP that exceeds 100 billion yuan, and a local government budget higher than 10 billion yuan. In addition, the one-way traffic flow must reach 38,000 people at peak time, according to the National Development and Reform Commission…

“However, some less developed cities in inland China have manipulated the figures to meet the requirement,” he concluded.

Quelle surprise!

One other thing to note is that, despite running a trade surplus of $235 billion and attracting FDI inflows of what will turn out to be around $95 billion over the 10 months since the last lunar holiday, the official count of foreign exchange reserve holdings shows zero net gain for the period. Subtracting outward FDI of an estimated $70 billion (and noting that euro and sterling parities versus the US did not undergo any significant changes in the interim), that leaves a cool $260 billion unaccounted for.

No wonder the North American and Australasian press is rife with tales of Chinese visitors getting stopped at customs for not declaring $10s of 1000s of bills stuffed into their luggage, or of their less than discreet presence at housing auctions in their destination countries. All well and good, you may say, if the external surpluses are being recycled into the hands of private individuals, rather than being directed, via purchases of government securities, to the dead hand of the state, but it nonetheless speaks volumes about how the insiders view the prospects for wealth preservation, much less further capital gain, at home.

It is presumably on such grounds as these that Bernard Connolly recently compared present day China to 1830s America – an era your author dealt with in the fifth chapter of ‘Santayana’s Revenge’. Glancing back at this today, we can see where the similarities lie: a vast orgy of infrastructure spending taking place in a wildly uncontrolled manner by eager local governments; a febrile property market in denationalized land, rampant speculation in commodities – all financed by pliable, politically-controlled banks and their shadow market counterparts. 

Tick…tock… tick… tock!

So, as we started by saying, we are uneasy regarding the consensus, but, for all the whispers that the Fed is about to become a deal less accommodative—and frankly, we’ll believe it when we see it—it doesn’t look as though anyone is short of anything out at the back end, even if that bear market dog-with-fleas, the 5-year, has seen specs switch to the other side of the trade in the past few weeks That said, a number of the key interest rate charts are showing some signs of stress, with a number of trend breaks to be found here and there, not least in the US. 

Hardly the calamity of 1994 as yet then, though the one area which does bear watching is the Japanese bond market.

It may be too much to hope that Abe and his coterie of economic illiterates can grasp the fact that by trying to favour his export lobby, he is raising Japanese input prices across the whole economy, and so not only potentially eroding margins but reducing real incomes and hence possibly hurting both the supply and the demand side of a system which hardly needs to be inflicted with any further disadvantages. But what he might take cognisance of is that any lack of trust he engenders in the value of both the currency and the mountain of government debt which, in the main, provides its backing—not least on the balance sheets of the banking system—might begin to cost him more than he can possibly hope to gain by stimulating ’consumption’ like the good little Keynesian he is.

Yes, the country needs, once again to re-orient itself, as it did in the wake of each of the major busts of the past 20 years. Further, it can probably not rely so heavily from here on upon supplying China’s vast, subsidized processing trade with high value-added inputs for incorporation into mass consumer products and transhipment to a West not so willing or able to indenture itself so as to buy them. This would have been the case even before the casus belli of the Diaoyu/Senkaku island dispute put business relations between the two prickly neighbours into the deep freeze. No one suggests that this will be swift or simple to effect, but given that the country has done it several times before, there is no prima facie case to suggest it will prove unable to do so again.

If Abe really wants to help, he should get someone to pull up a chart of what happened during the term of office of his predecessor Koizumi. Government shrank and a re-invigorated private sector expanded into the gap. Even if the aggregate GDP numbers recorded this as at best a minor victory, the quality of the whole was improved and hope of something greater briefly flickered into life before the experiment was prematurely abandoned.

The state and its pampered banks have everywhere reduced private initiative to near impotence, if not to outright Randian insurrection. It’s about time it quit its infernal meddling and let the wealth creators at the problem once again.

I suspect they’d be more than happy to have the opportunity to show what they can do, if asked.


Steve Baker on Russia Today

A must-watch interview: RT’s Laura Smith talks with Steve Baker MP:


Godfrey Bloom MEP on Germany’s “golden opportunity”

Episode 73: GoldMoney’s Andy Duncan talks to Godfrey Bloom, who represents Yorkshire and North Lincolnshire in the European Parliament, and who is a member of the parliament’s Committee on Economic and Monetary Affairs. They talk about the possibility of Germany instituting a gold-backed Deutschmark, and broader issues to do with European monetary and fiscal policy.

In a recent daily article co-authored with Patrick Barron, Mr Bloom states that Germany now has a “Golden Opportunity” to get back to sound money by pulling out of the euro and introducing a gold-backed Deutschmark. However, given the lack of a comprehensive audit, suspicions about the integrity of the German gold reserves remain. Bloom therefore advocates that Germany should repatriate its physical gold from the storage locations abroad.

They also talk about monetary policies of the European Union, the errors of European politicians and whether or not the eurozone can be sustained. In addition, they also discuss Britain’s relationship with the EU and Britain’s own precarious financial position, particularly in relation to its welfare state and deficit spending.

This podcast was recorded on 21 November 2012 and previously published at