FinanceAndEconomics

Latest GoldMoney article

2012-02-19T19:28:00.001Z

The following article is posted at GoldMoney, here.

The destruction of savings by inflation

2012-FEB-18

In the past, insurance companies and pension funds have been keen to advertise the benefit of compounding arithmetic for savings. Over the last 30 or 40 years the rate has been lifted by inflation, but to understand the cost inflation brings you have to consider the whole savings cycle: not just the accumulation stage, but also annuity values in retirement. Furthermore, the historical experience of a typical working life should be compared with a theoretical sound-money alternative.

Let us assume a man works for 40 years, during which time he invests a fixed amount annually. This is invested mostly in bonds for a return that gives him a lump sum on retirement. The marketing folk stop at that point, but we shall go on. This lump sum is applied to an annuity to give a fixed income for the retiree’s life expectancy. Let us also assume that $1,000 is invested annually, and we shall use the average return on the 10-year US Treasury bond as our yardstick. The result is shown in the table below under the heading of Paper Money.

The nominal value of our pension-pot on retirement is an attractive $224,150, but during its accumulation price inflation has averaged 4.44%, so its inflation-adjusted value is only $74,056, implying that the difference ($150,094) is a hidden inflation tax, leaving our saver with only one-third of his savings in real terms.

Assuming the lump sum is then turned into an annuity at a continuing bond yield of 7.18% for a retirement of 25 years, this inflation-adjusted figure gives an annual income of $6,458, and if inflation continues to average the historic rate, the final payment will only be worth $2,075 in inflation-adjusted terms. Note how the purchasing power of the annuity falls over time while our retiree’s health and care expenses can be expected to increase when he can least afford them.

The reason for taking inflation out of the equation is so we can compare the inflationary past with a sound-money alternative. This calculation is dramatically different under the reasonable assumptions in the table’s last column: an average bond yield of 2.5% and price deflation of 1% annually. The deflation-adjusted outcome is significantly better than the paper-money example. Furthermore, the purchasing power of the annuity increases, in tune with the health and care needs of an aging retiree.

Our example is simplistic: bond yields have varied hugely since 1971, and we have ignored management fees and taxes. We have not considered bond yields that are exceptionally low today, so annuities taken out now will yield considerably less than our example shows.

The bottom line is the saver is impoverished by inflation to a greater extent than generally realised. The state has benefited from the transfer of wealth from its citizens’ savings, the result of monetary inflation, but at considerable future cost. The state is left with the welfare, health and care costs for an aging population unable to support itself and with an increasing life expectancy.

The cost of looking after growing numbers of impoverished retirees will become apparent in coming years, increasing government deficits more rapidly than expected. What we don’t know is when the markets will reflect the enormity of these future obligations.

Tags: fiat currency, government bonds, inflation, sound money

Alasdair Macleod

Latest article posted at GoldMoney

2012-02-12T13:06:00.001Z

This article is posted at GoldMoney, here.

Katastrophenhausse

2012-FEB-11

Mainstream economists seem to have a problem understanding prices. They might draw supply and demand curves and talk about elasticity. They are sure to have been taught the quantity theory of money. These are merely concepts, debating points in a classroom, with limited practical value. The consequence of replacing price concepts for price reality is that modern economists do not appreciate the consequences of monetary policy.

The most common error is to associate rising prices only with an increase in demand for goods and services, making it hard to imagine price inflation without economic growth. Stagflation, or inflation in a stagnating economy, becomes an unwelcome surprise, but is easily explained at the transactional level. In the pricing of anything, both the supply of the goods in question and the quantity of money available will have a fundamental bearing in setting the price. However, these factors are not necessarily considered when goods are sold and are often ignored.

Crucially, consumers assume that a dollar is a dollar and they never, for the purpose of day-to-day spending, question the value of paper money. People will say they are aware that the purchasing power of paper money declines over time, but they still expect the prices of everyday goods to be the same tomorrow as they are today. If they rise, they normally blame the retailer or perhaps some specific shortage, never realising that they are the victims of what they are otherwise aware of, the declining purchasing power of money. As monetary inflations progress there comes a point where this understanding changes. Increasing numbers of consumers will become aware that fiat money is losing purchasing power rather than the prices of goods rising. Trust in paper money begins to evaporate and the move into physical goods commences, gradually at first but then at an increasing pace. This is what the Austrian economist von Mises called “Katastrophenhausse” – the crack-up boom. Today, with paper money unbacked by anything other than public confidence in it, we are logically exposed to a new katastrophenhausse at any time, if that confidence is challenged.

Besides confidence, the interest that fiat money earns is the only true support it has. Unfortunately, the remedy of deliberately raising interest rates is impractical, because of the very high levels of public and private sector debt. Jacking up interest rates will only bankrupt insolvent governments and other borrowers, and the interest costs would end up being covered by the creation of yet more fiat money.

At some stage, the excesses of monetary inflation will undermine prices, irrespective of economic conditions, raising fundamental questions about purchasing power and confidence in fiat currency. So what does a central banker do? If he keeps a lid on interest rates a crack-up boom results. And if he raises interest rates, monetary inflation accelerates even faster, leading again to a crack-up boom.

It is a classic debt trap: you are damned if you do and damned if you don’t. The important point for owners of gold and silver is that rising interest rates should drive prices higher, and not suppress them as commentators might expect.

Tags: central banks, debt crisis, dollar, inflation, interest rates

Alasdair Macleod

The fallacy of economic growth

2012-02-06T15:56:00.001Z

This article is posted at Financeandeconomics.org

The fallacy of economic growth

The most important objective for any government is to achieve economic growth. Out of this growth develops employment and taxes to fund government itself. It is in other words the primary focus of all economic planning. Much effort is also spent perfecting the statistics deemed vital to quantifying everything that might contribute to the attainment of this end. Furthermore, “independent” monetary policy long ago migrated from the principal objective of controlling inflation to stimulating the economy into more growth. Almost everyone in developed economies knows and supports this objective, even if they argue over the means. However, not only have governments consistently failed to achieve this fundamental objective, they are now increasingly worried that government spending cuts will propel us all into a deep economic contraction.

But are we right to think in terms of economic growth or contraction? The concept is essentially Keynesian and stems from mainstream economic analysis. It presupposes that governments actually have a positive interventionist role and can improve economic outcomes, a supposition that is on examination completely flawed. Instead, an economy that successfully delivers the products and services people actually want does so in an unplanned, random fashion. It is the sum of all activity, which organises the production of goods and services by entrepreneurs and business proprietors in the considered belief they will be wanted.

The strength behind a free-market economy is the randomness of productive actions, and progress of mankind’s condition is the result. It only expands if the factors of production expand; otherwise the distribution of available resources depends on entrepreneurial anticipation of people’s needs and wants. When government intervenes in this unplanned but productive chaos it destroys this random quality, harnessing economic actions into in a common direction.

Destructive cycles of boom and bust have always been the result. Governments seek to co-ordinate randomness for an outcome they commonly call growth, and for a short time they might appear to succeed. But it is not long before these co-ordinated economic actions inevitably drive up prices, because extra factors of production (raw materials, labour and capital goods) only become available at higher price levels. Higher prices inevitably lead to higher interest rates, to the point where those who have fallen for the bait of artificially cheapened credit have to cut and take their losses. Capital theory predicts this outcome, events always confirm it, yet mainstream economists continually ignore it[i].

Intervention is as likely to succeed as water is to run uphill. Economic growth or the lack of it, the success or failure by which it is measured, is its child. The question then arises as to whether or not we can have economic growth without intervention.

The logical answer is no. A free-market economy in the absence of external factors does not grow: it progresses, which is a very different thing. It discards those things consumers do not want and produces things they are likely to want. It adjusts the price of products to a level which satisfies the consumer and is at the same time profitable. Overproduction is punished and underproduction invites competition. No one knows what the consumers will buy tomorrow or how much they are prepared to pay, but randomly-acting entrepreneurs are generally pretty good at guessing, because they put their own time and money on the line. They have to anticipate levels of demand and also prices for their output for at least as far in advance as it takes to plan, produce and market any product. This is progress, not growth. Progress is about better products and services tomorrow than today, using the resources actually available. Progress is about better value for money tomorrow, which means that prices tend to fall. And as prices tend to fall, more things can be bought for the same money. What governments do instead is destroy this process of progression in an attempt to replace it with statistical growth.

The statistics devised to measure it, principally gross domestic product, cannot measure anything other than the money in the productive economy, which it does imperfectly. Government spending, which is an economic cost, is included pari-passu with valued production. Efficient producers such as the manufacturers and suppliers of electronic goods and services, who reduce their prices over time, see their output diminished as a proportion of the statistical whole, while those that maintain their prices by monopolistic or subsidised means keep and even increase their weightings. This is simply the result of the indiscriminate use of a money-aggregate to measure the fallacious concept of economic growth. So GDP and related statistics do not measure progress: if anything they promote economic regression.

Instead, we must conclude that GDP is an approximation of the amount of money deployed in an economy. It is equal to a combination of measured production, government spending and price changes. Let us assume for a moment that extra factors of production at a given price level are not available, so production only progresses depending on how existing factors of production are redeployed. Let us further assume government spending and regulation of the private sector is also unchanged. These two conditions being the case, economic growth must be a reflection of price changes, which in turn is the result of changes in the quantity of money deployed in the economy. And in recording “real” economic growth, that is economic growth adjusted by a price-inflation index, statisticians avoid recording most of the effects of monetary inflation. Therefore, economic growth is not growth at all: it is just an alternative and flawed measure of unreported monetary inflation.

We would not take the central planners’ flawed attempts to manipulate an economy and the statistical outcomes seriously were it not for the ultimate consequences. Not only have they completely deceived the public over economic growth, but they deceive themselves. For this reason they are unequipped to deal with the developing crises, which are the result of earlier interventions. They now claim that economic growth, the ultimate source of tax revenue and government solvency is jeopardised by spending cuts. Statistically, this is obviously true, because if you take away government costs and support for unwanted economic activities, GDP will fall. But the important point that is commonly missed is that a government which stops draining an economy of its private sector resources actually releases them to be deployed more effectively for the common benefit by those randomly-acting entrepreneurs.

And that, ultimately, is the way out of all economic difficulties.

6 February 2012

Alasdair Macleod

[i] There are some excellent analyses of Capital Theory, but the error of converting random actions into common objectives, central to understanding the destructive effects of central planning, gets little attention. This is a mistake.

Gold and silver shakeout

2012-02-04T18:30:00.001Z

The following article was posted at GoldMoney, here.

Gold and silver price shakeout

2012-FEB-04

The consolidation of gold’s bull phase from October 2008 to the peak last September was a classic three-leg correction: an initial slide, rally, and final sell-off. Silver followed a similar but more violent pattern. The psychology was there too, with the final sell-off convincing many investors the game was finally over.

Those who sold will most probably be kicking themselves. Consolidations that break established trends, such as 200-day moving averages, shake out weak holders who will buy again higher up when they are more confident. The big traders in the futures market know this: your losses are simply their gains. And as a result both gold and silver are on a far sounder footing with these weak holders out of the way. It is lethal for your savings to play this game. Instead it is more sensible to understand what is happening in simple economic terms. To do this you must turn your normal thinking upside down, and realise that what is happening to precious metals prices is only a reflection of what is actually happening to paper money.

Put simply, governments all over the world are debasing their paper monies at an accelerating rate. Printing euros to rescue the banks has been in the headlines, but this process has only just begun. America, which has to be the focus of monetary attention, is committed to zero interest rates for the next three years, which is unprecedented. The result is that the price of gold has been left behind by exceptional monetary events. You can see this clearly in the chart below.

This chart shows US dollar True Money Supply (cash, instant deposits and checking accounts plus a few other minor cash balances) expressed in official gold reserves held at the US Treasury. This has soared over the years, and we can expect it to accelerate further from December’s figure of $31,600 per ounce of gold. Meanwhile, the percentage of TMS actually backed by gold stood at 4.8% at the year-end, and this is shown by the blue line.

The chart clearly shows that while gold has risen dramatically over the last decade in nominal dollar terms, adjusted for the extra money in the system it has only risen 150%. Amazingly, the price of gold measured in these TMS terms has only risen to where it was in late 1991, when the nominal price was $360. Gold’s valuation is therefore still at exceptionally low levels.

The sense of perspective charts like this imparts is vital for understanding the dangers from the tsunami of paper money and debt. Conventional portfolio managers have missed this point entirely, being hampered by the legacies of portfolio management theory and Keynesian economics. But there is a growing band of private individuals around the world who do get it and are accumulating physical gold and silver. They are beginning to understand that paper money is falling rather than gold and silver rising.

The message is if you think like an investor, you will probably lose your investment. Be aware of what is happening to paper money and you probably won’t.

Tags: central banks, Fed, gold price, silver price, USA

Alasdair Macleod

Latest article for GoldMoney

2012-01-28T10:08:00.001Z

The following article has been posted at GoldMoney, here.

FEDging the figures

2012-JAN-28

Both the US Federal Reserve and the European Central Bank are now offering limitless quantities of new money – the ECB to support the banks, and the Fed for reasons (despite explanations) that are not entirely clear. The Fed in its press release announced that it expected interest rates to “warrant exceptionally low levels for the Federal Funds Rate at least through late 2014.” The fact that the central banks governing the two most important currencies in the world are issuing money to all-comers at very little interest cost for up three years has not been lost on gold and silver, whose prices shot up in response to the Fed’s announcement.

The Fed has effectively extended its zero interest rate policy (ZIRP) for another 18 months. The reason stated is “low rates of resource utilisation and a subdued outlook for inflation in the medium run”. More important perhaps and unsaid is the presidential election due later this year and the need to finance a deficit that seems impossible to cut.

The Fed is running huge risks with its extended ZIRP, principally with monetary inflation morphing into price inflation. To help achieve its low inflation target the Fed uses the Personal Consumption Expenditures Price Index (PCEPI), which assumes that consumers switch spending from higher priced goods to those that are stable or falling. The result is that this index rises at about one-third less than the Consumer Price Index, which itself rises at less than half the CPI calculated on the more honest methodology used before 1980. The upshot is that the Fed uses inflation targets that are so heavily adjusted that they are effectively meaningless.

To the Keynesians at the Fed, subdued inflation is linked with a sluggish economy, and here the Fed is very selective in its approach. It admits that employment is picking up, and household spending “continues to advance”; but instead chooses to worry over slowing fixed investment and a depressed housing sector. Surely, whatever your views, there are enough signs of economic stabilisation to justify sitting on the fence, instead of committing to ZIRP for an extra 18 months.

I take the view that Gross Domestic Product is likely to surprise on the upside, as I wrote in an article for GoldMoney on 10 January. In that article I gave concrete reasons why, and suggested that money will begin to flow from capital markets into the economy. This is important, because GDP is only a money quantity and can rise without any underlying economic progression – the difference being reflected in the prices of goods and services. So GDP can actually rise with no underlying improvement in economic activity, it merely reflecting higher prices.

Changes in the prices of goods and services are actually impossible to measure and so cannot be quantified. Under-reporting price increases by using an index approximation such as the GDP deflator, which represents price inflation similarly to the PCEPI, artificially inflates real GDP. It will be interesting to hear what excuse the Fed comes up with then for the continuing for even longer with ZIRP. The reality is that the Fed and other central bankers are cornered and have only one tool left: issue as much paper money as it takes to prevent systemic financial calamity. This realisation is only just dawning on individuals with savings to protect, which is why precious metals were right to rise so sharply.

Tags: central banks, ECB, Fed, inflation, USA

Alasdair Macleod

Interview with Pedro Schwartz

2012-01-26T09:11:00.001Z

Just before the Spanish general election last November I interviewed Pedro Schwartz, who is Professor of Economics at San Pablo University in Madrid. Whilst there have been some developments in Europe since the interview, I still think Pedro’s take on developments in Spain, Greece and Italy remain relevant.

Pedro is both well-connected and wise so is worth listening to. The interview can be found on the GoldMoney site, here: http://www.goldmoney.com/video/schwartz-macleod-interview.html

Alasdair Macleod

Latest article posted at GoldMoney

2012-01-10T21:50:00.001Z

The following article has been posted tonight at GoldMoney, here.

Morning in America?

2012-JAN-10

US unemployment figures came in better than expected last week at 8.5%. While noting that the figures underrepresent actual unemployment, does this improvement mark the beginning of an American economic recovery? If so, it is the last thing the consensus expects.

Let us assume for a moment that Europe’s banks are rescued from the crisis. This being the case, there is every possibility a US recovery will take place for two basic reasons: businesses are always keen to invest as soon as market conditions stop deteriorating, and secondly GDP should begin to reflect increased quantities of money flowing into the economy. I shall comment on each in turn.

Businesses in the US have been accumulating cash in these uncertain times, and it is generally assumed, incorrectly, that managers are happy to just sit on this accumulating cash. It is not in the nature of business to sit idly waiting for the tide to turn: businessmen are entrepreneurs who continually seek profitable opportunities, recognising that wasting time is itself an expense.

This is why the capitalist system survives despite and not because of the attempts of central bankers and governments to assist the entrepreneurial function. And once capital investment begins to recover, competition ensures it spreads. The conditions now exist for this recovery to take place, if only because the bad news is elsewhere and interest rates are extremely low. We can therefore assume (Europe and other systemic disasters permitting) that a business recovery should take place. How far this goes before rising commodity and energy prices derail it is another matter.

Meanwhile the expansion of raw money since 2008 has been remarkable, but so far the bulk of this money has either gone back on deposit at the Fed, is being deployed for speculation in capital markets, or is funding the government. Very little of this money has actually added to the GDP statistic by being deployed in the economy, which will change when businesses go further than just reinvesting cash balances, and actually borrow to build capacity.

Putting this together, in the earliest stages of economic recovery companies reinvest their own money. The benefit to the GDP statistic is marginal to begin with, but as economic recovery gains momentum and businesses begin to borrow, money will flow into the economy from capital markets, inflating the GDP money-value. So by the time it is confirmed at the GDP level, the recovery will actually be well under way.

The political consequences in an election year of such a development are beyond the scope of this article. Rising interest rates will begin to be discounted, giving support to the dollar; but before that happens a bear squeeze should develop in energy and commodity futures, partly because markets are wrong-footed for economic recovery, partly because market liquidity has been reduced as a result of the MF Global scandal, and partly because the outlook for price inflation will change radically.

Precious metals should fare well. Industry will want to build silver stocks to lock in low prices, conflicting with physical demand from investors, and gold should get a significant boost from the change in the inflationary outlook.

Tags: commodities, economics, Fed, inflation, USA

Alasdair Macleod

Latest article for GoldMoney

2012-01-08T17:51:00.001Z

This article has been posted at GoldMoney, here.

Financial repression

2012-JAN-07

This phrase has suddenly started appearing in economic research, and will probably do so more frequently in the coming months. Its origin is a Bank for International Settlements working paper co-authored by Carmen Reinhart and Belen Sbrancia, economists well enough known to merit attention. So what is it all about?

Financial repression includes directed lending to governments by captive funds such as pension and insurance funds, artificial caps on interest rates, restrictions on capital flows and a generally tighter connection between government and banks. Some or all of these devices have been used in the past to reduce the level of government debt to GDP, particularly in the two decades after the Second World War. Many countries reduced the level of their outstanding debt by a significant amount over a 10 to 20 year timeframe through these techniques, assisted by moderate levels of inflation.

Two of the alternatives to financial repression listed in the paper are clearly unpalatable: default, and “a burst of high inflation”. Two further alternatives are either impractical or politically unattractive: economic growth, which is slipping away further into the future, and austerity plans involving years of unpopular policies with the risk of a deflationary depression. For these reasons, financial repression seems the default option to Reinhart and Sbrancia.

Some of its elements are already being implemented. eurozone bail-outs involve contributions from government-controlled pension funds. Bank and financial regulation allocates lower risk weightings to government debt, giving it a systemic subsidy despite current events. Interest rates are being held below the rate of inflation by central banks, lowering the cost of borrowing for most governments to artificially cheap levels.

But will it work this time? To do so will require private individuals to continue with an unquestioning belief in the soundness of their paper currencies. In the wake of Bretton Woods, when there was a gold exchange standard underpinning the dollar, together with higher levels of national patriotism, the might of the dollar was never questioned. Instead, we now have a US dollar-standard with substantial levels of foreign ownership of government debt and an increasingly sceptical public. This suggests that financial repression would probably bring on a currency crisis.

Reinhart and Sbrancia are not recommending financial repression, but they are right to point out its attractions to governments in financial difficulties. It is, in the cliché often used today, a description of the various means of kicking the can down the road. This is something governments have been doing for a long time: it has generally worked in the past, so they are almost certain to assume it will work again now.

However, economic and financial problems are rapidly mounting. Today’s situation is very different from the end of WW2 with all that destructive spending replaced by people rebuilding for the future, as they did in the 1950s and 1960s. Instead, our systemic and economic problems are leading to yet more deterioration in government finances. No amount of financial repression can fix that.

Tags: central banks, debt crisis, dollar, USA

Alasdair Macleod

Interview by Alternative Investors Hangout

2011-12-27T17:50:00.001Z

You may be interested in an interview I gave to Alternative Investors Hangout before Christmas.

The link is: http://www.altinvestors.com/2011/12/alt-investors-hangout-interviews.html

Alasdair Macleod

Latest posting at GoldMoney

2011-12-24T22:30:00.001Z

The article below was posted today at Goldmoney, here.

Gold price set for hyperbolic increase

2011-DEC-24

I recently posted an article for GoldMoney showing how US True Money Supply (TMS) appeared to be growing at a hyperbolic rate, and that gold was also on a hyperbolic course. The difference between hyperbolic and exponential is a hyperbola’s rate of growth increases with time, while exponential growth does not. Hyperbolic growth in the quantity of money ends with hyperinflation, while exponential growth can go on for ever. Both TMS and the dollar price of gold are pointing to a hyperinflationary outcome. This article explains why this might be so.

There are five apocalyptic engines pushing the growth in US money supply: they are the government’s budget deficit, its debt trap, the financial condition of the banks, the delusion of Keynesian solutions, and lastly simple compounding arithmetic.

1. The US government collects only 55c in taxes for every dollar spent. It is relying on economic recovery to reduce welfare payments and increase tax revenue to close the gap. This prospect is receding and establishment economists advise against cutting government spending.

2. The US government’s debt trap is concealed by the exceptionally low interest cost of funding. The only reason this cost is not higher is the Fed maintains a zero interest rate policy. However, as surely as night follows day, price inflation will start rising as monetary inflation feeds through, forcing the Fed to allow interest rates to rise long before any economic recovery occurs. The rise in interest costs will escalate the budget deficit, which will be financed, directly or indirectly by further monetary expansion.

3. The banks’ balance sheets are considerably weaker than stated, because of unrealised losses on assets, loan collateral and write-downs on their own debt. Real estate collateral write-downs alone probably exceed bank equity of $1,400bn. On an honest analysis the US commercial banks are collectively bankrupt. To simply survive the banks have no alternative other than to reduce loan exposure while requiring continuing monetary support from the Fed.

4. Keynesian economists, aware of the banks’ difficulties are terrified of bank credit contraction. For this reason, the macroeconomic establishment strongly promotes the expansion of narrow money to buy off a deflationary depression.

5. As the purchasing power of the dollar falls, the result of past monetary expansion, yet more dollars have to be issued to cover increased government costs. Past inflation becomes a compounding factor behind price rises.

Essentially, money will be printed at an accelerating rate to buy time rather than face the three realities of government default, an over-indebted private sector, and a bankrupt banking system. The Keynesians are belatedly aware of the dangers and see no alternative to printing as much money as is required to defer these problems. The monetarists in the central banks are hesitant, torn between Keynesian fears of outright deflation and worries about the rate of monetary expansion so far.

However, the history of monetary inflation confirms that once it enters a hyperbolic phase, it is almost impossible to stop. Armchair critics have derided the stupidity of central banks and economists in past hyperinflations, such as in Weimar Germany, Argentina and Zimbabwe. The truth is that when hyperinflation has become visible at the price level, it has already gone past the point of no return at the monetary level.

Tags: dollar, gold price, inflation, Keynesianism, USA

Alasdair Macleod

http://www.goldmoney.com/video/bagus-macleod-interview.html

Conversation with Philipp Bagus

2011-12-21T23:12:00.001Z

The GoldMoney Foundation has just posted my interview with Phillip Bagus, author of The Tragedy of the Euro. The interview can be found here:

Alasdair Macleod

Video discussion with Juan Castaneda.

2011-12-20T11:31:00.001Z

On behalf of the GoldMoney Foundation I recently discussed sound money and the monetary policies of the Fed and the ECB with Juan, who is a senior lecturer in economics at Universidad Nacional de Education a Distancia, which is based in Madrid. The video is here.

Alasdair Macleod

Accelerating money supply

2011-12-17T20:18:00.001Z

This article has been posted at GoldMoney, here.

Money supply explosion will lead to accelerating inflation

2011-DEC-17

This is the time of year when City pundits produce their forecasts for the forthcoming year. Historically there has been little point to this exercise. Instead, here is the one chart which defines the background to all events in the coming years. It is the Mises Institute's True Money Supply (TMS) for the US dollar. TMS consists of cash, checking accounts and no-notice deposit accounts, as well as a few other minor cash balances. It represents the actual cash and electronic cash in the system that is instantly available for purchases of goods and services, and the chart goes back to 1959.

The dotted line is the exponential growth trend, in other words the maximum rate of growth that can continue for ever. This trend was valid until mid-2002, since when TMS has accelerated at a faster rate, telling us that TMS growth entered a hyperbolic phase when the Fed eased rates in the wake of the dot-com collapse. Put another way TMS is already hyperinflationary.

Bear in mind that economists are now telling central banks to accelerate monetary growth even faster to offset the tendency for bank credit to contract. They see no other way to avoid a bank balance sheet implosion with all the deflationary consequences that implies. So the prospects for 2012 and thereafter are for TMS to continue its hyperbolic trend, and incidentally supply funds for a government deficit completely out of control. Also bear in mind that when such a trend becomes established it becomes almost impossible to stop, since the whole debt-based economy and the banking system would collapse.

The second chart shows gold’s established hyperbolic course. This chart was put together by Armand Koolen, a Dutch physicist, after reading James Turk’s and my writings on gold and economics. In Koolen’s words, the hyperbola fits in with the official gold price in the early 1900s, the revaluation to $35 in 1934, the onset of the secular bull market in 2001, the bottom in October 2008 and its approximate track since then.

His discovery is interesting. Singularity for this curve, or the point where the gold price goes to theoretical infinity, is in February 2014, only 26 months away. Unless this long-term trend is somehow broken, gold is also telling us the dollar is heading for hyperinflation.

It would be a mistake to vest magical powers in such an extraordinary discovery, but given TMS itself is showing signs of going hyperbolic we must sit up and take notice. And we know how difficult it is to stop printing money at an accelerating rate: after all, the ECB’s reluctance to do so is threatening to collapse the eurozone. Will the Fed pull the trigger on the US economy or chicken out? The answer is clear.

So in 2012 we can expect a further escalation of money-printing. This being so, it will be followed by unexpected and accelerating price inflation. Nominal interest rates will then rise at the market’s behest, bringing a sovereign debt crisis for the dollar with it as the cost of borrowing for the government escalates.

And the world is on a dollar standard, which is why the chart of TMS tells us all we need to know about 2012.

Tags: debt crisis, dollar, ECB, Fed, inflation

Alasdair Macleod

Eurozone defaults on their way

2011-12-15T14:34:00.001Z

The following article is posted at GoldMoney, here.

Eurozone government defaults looking certain

2011-DEC-15

For some time I have taken the view that rescuing eurozone governments from their financial crises was too big a job for the European Central Bank, which should stick to keeping the banking system going. The only hope was that individual governments would be forced to face up to the reality of cutting government spending hard and quickly. They have failed to even begin to address this fundamental problem. As a consequence, it is now impossible for them to roll over their maturing debt, let alone raise new money. Instead there is now a scramble into cash as banks and hedge funds prepare themselves for sovereign defaults.

Posturing over geared stability funds, financial transaction taxes, installing unelected governments, putative treaty changes and finally enhanced fiscal supervision proposals have finally convinced markets that the only outcome is widespread government defaults. There is now no alternative and the fallout will have to be managed.

The inept handling of this crisis has weakened the eurozone’s banks to the point that they are unable to subscribe for more debt. Furthermore, the ECB cannot afford to see the liquidity it provides to European banks disappear into new government bonds that will default anyway. Therefore, it is now in the ECB’s interest to see sovereign defaults occur as soon as possible, unless the International Monetary Fund can come to the rescue, which is looking less likely by the day.

There is growing evidence that there is insufficient support for an IMF bailout from its member governments. The IMF’s charter is as an intergovernmental lender of last resort, not a supporter of government profligacy. Following the failure of the G20 meeting in mid-October there has been no substantive attempt to rescue the eurozone. The telephones might be buzzing, but there is no urgent meeting, suggesting that events must take their course.

So the quicker these defaults happen, the sooner the ECB can work with the national central banks to bail out the major Eurozone commercial banks. Once we accept this line of reasoning, we must think about the likely candidates. In no particular order they are France, Italy and Greece: France and Italy because they have to roll enormous amounts of debt in the coming months and Greece for obvious reasons. Less pressing perhaps but also likely default candidates are Belgium, Spain, Portugal and Ireland: Belgium might fall with France and the others have the potential to struggle through but might chose to wipe the slate clean. And when the first goes, the rest will surely follow rapidly.

The sequence of events is now under way. This will be followed by the defaults themselves, and the likely trigger will be escalating French government bond yields.

In summary, we have reached the point where the ECB’s vested interest requires eurozone governments to default because further delay will make the rescue of the currency and banking system more difficult. Expect co-ordination between the Bank for International Settlements, The Fed, Bank of England and Bank of Japan to smooth markets through the turmoil and to back up the ECB.

Tags: debt crisis, ECB, euro crisis, Europe, IMF

Alasdair Macleod

The end of the EU

2011-12-13T16:43:00.001Z

The following article has been posted at GoldMoney, here.

The end of the EU

2011-DEC-13

Last Friday, David Cameron came back from Brussels having rejected proposals to draft a new European Union treaty, having failed to get promises of adequate safeguards to protect Britain’s financial sector. But given that the UK has no veto over Brussels’ power to regulate anyway, the prima facie reasons presented to Parliament were therefore not crystal clear. However, Cameron must have been aware that ratifying a new treaty without safeguards was a non-starter, and the fact that the dominant mainland powers were not even prepared to consider them is a reflection of their lack of rational thinking rather than his. After all, they should have been briefed that any treaty changes now require a referendum under UK law, and given the EU’s self-aggrandising tendencies, any treaty changes would be a tough sell to Parliament – let alone the electorate.

What was proposed in Brussels was a typically dirigiste response to unwelcome economic reality. Perhaps the script intended was as follows: we go through the motions of imposing fiscal controls and responsibility, and that should be enough to get the European Central Bank – working with the International Monetary Fund if necessary – to release the money to continue to finance our political ambitions. This is not the direction of travel for the UK.

In political terms we are probably witnessing the end of an empire, and when such an event occurs it can be swift. Forward-thinkers need to look beyond the EU as an institution, and in this respect an alternative and as yet unrecognised future for Germany is evolving. She faces stagnant markets in Europe, declining markets in the US, but booming markets for her products in China, South East Asia and other emerging economies. Even if the eurozone does not break up, her economic motivations will lie increasingly elsewhere and the weaker EU members will remain an unwelcome burden.

Her biggest problem is France, a point not yet recognised by commentators and as yet untested in the markets. In the short-term, Sarkozy faces an election next May, which explains why he must stick like glue to Angela Merkel rather than cut government spending. But France also has to refinance the same amount of debt as the Italians before May: about €180bn, and half in the next two months. This is an impossible task without external help, because the major French banks which have always been coerced into buying French government bonds in the past are themselves in a critical condition. A short-term fix is urgently needed of which there is no sign as yet.

We have to trust that there will be a solution, but talk of treaty-change does not represent urgent action. Anyway, the French socialists, who look like winning May’s election, have said they will not ratify any new treaty – creating more doubt and uncertainty for markets. It does not take much imagination to see French bond yields rising to over 7%.

This is the mess that Cameron has disassociated himself from. It will not be long before this becomes more widely appreciated.

Tags: ECB, euro crisis, Europe, France, Germany, UK

Alasdair Macleod

Deflating the derivatives balloon

2011-12-10T17:23:00.001Z

The following article has been posted at GoldMoney, here.

Deflating the derivatives balloon

2011-DEC-10

Derivatives have a bad name for many commentators, with some describing them variously as dangerous or even weapons of mass destruction. The sheer size of over-the-counter derivative markets is staggering. According to the Bank for International Settlements, OTC derivatives stood at $707 trillion at the end of June, nearly fourteen times global GDP and forty seven times that of the United States. This is not as alarming as it seems, since over 87% of this is interest-rate swaps and foreign exchange contracts, business that has a solid commercial foundation. However, with forces like these at work it is easy to understand why people think they would be de-risked if they were regulated.

Such a simplistic view ignores the linkages between a firm’s activities in unrelated markets. This seems to have led to the downfall of MF Global, the eighth-largest bankruptcy in US history. It appears that they were scuppered by perfectly legal off-balance sheet repos-to-maturity in European government debt. It also appears that segregated customer funds were used for this purpose, and not co-mingled with the firm’s funds as first supposed. While final redemption of the sovereign debt was guaranteed by both the individual sovereigns and the European Financial Stability Fund and matched to its funding, MF Global was tripped up by margin calls it was unable to meet. The use of client funds in this manner may turn out to have been perfectly legal and so they are completely lost.

As the story unfolds the result is bound to lead to increased questions about Comex operations, where MF Global was a clearing member; and when confidence is lost turnover is almost certain to decline as users of the markets make hedging and trading arrangements elsewhere. This is already happening. Barnhardt Capital, a small agency broker, was closed by its owner who stated, “I could no longer tell my clients that their monies and positions were safe in the futures and options markets – because they are not”. Last Monday Commodity Online ran a story about how “silver positions are being liquidated by Comex traders after the MF Global fiasco uncovered the fragility of paper assets.” This is very bad news for small traders, but it is also bad news for the large traders who require market liquidity to maintain their short positions.

You simply cannot run a position many times larger than normal dealing size when turnover is contracting, and thanks to a disaster beyond Comex’s control, liquidity is drying up. For the large commercial traders who are short of gold and silver futures this could turn out to be a very serious problem.

The good news is that we are finally witnessing the transfer of pricing-power from futures to physical markets, which at least is a vote for honesty and a step in the right direction.

Tags: Comex, commodities, debt crisis, USA

Author: Alasdair Macleod

Alasdair Macleod

Recent interview with Chris Martenson

2011-12-08T16:49:00.001Z

I recently interviewed Chris Martenson (of Chrismartenson.com) for the GoldMoney Foundation. We talked about the economy, oil prices and their knock-on effect on food and other commodity prices, as well as the outlook for gold. The interview can be found here.

Alasdair Macleod

Latest article for GoldMoney

2011-12-03T17:59:00.001Z

This article is posted at GoldMoney, here.

Currency swaps – the beginning of a 'solution'?

2011-DEC-03

By far the most important event of the week was the joint announcement by the world’s leading central banks that they were extending existing US dollar swap agreements and lowering the swap rate. Furthermore, these dollar swaps will be extended to secondary swaps between individual central banks in non-dollar currencies as required.

The stated purpose of this action, according to the Bank of England, is to ease strains in financial markets to ensure credit continues to be available to households and businesses, and so foster economic activity. Forget the PR spin, it is simply about saving the banks and that is why markets jumped, fuelled by a massive bear squeeze ahead of and after the announcement.

Market reactions aside, the plans for resolving the West’s financial and economic difficulties are becoming clear. There are two different elements to this crisis, which should not be confused: the problems faced by the banks as their balance sheets continue to contract, and Euroland sovereign debt. The agreement to extend currency swaps is designed to help the banks, and measures to address sovereign debt will probably be announced shortly.

The obvious way to deal with sovereign debt will be through the International Monetary Fund, perhaps issuing SDRs (Special Drawing Rights). The SDR was created by the IMF in 1969 to support the Bretton Woods system of fixed exchange rates, a function that was swept away by events. According to the IMF, the SDR is not a currency, but a claim on “the freely used currencies of IMF members”. So if an SDR facility is extended to Italy, for example, the SDR can be cashed in for the underlying currencies and converted into euros. The facility is sitting there unused.

If the SDR route is taken, governments such as Italy would become net buyers of euros, generating a bear-squeeze in both the euro and government bonds bringing yields down smartly. Market-aware central planners love this sort of thing, because they can force the switch in market sentiment from extreme pessimism to do much of their work for them.

So far, so good; but to anyone with a grasp of the economics of sound money, the encashment of SDRs is raw monetary inflation. But with the economic establishment and the general public happy to accept quantitative easing as a responsible economic policy, despite its ultra-thin cover for monetary inflation, it is unlikely the inflationary aspects of SDRs will be understood. Instead, the media will praise the benefits of international co-operation to resolve the sovereign debt problem, selling the concept as a way to counteract contracting bank credit to prevent deflation.

Whether or not the short-term fix for the sovereign debt problem is by activating SDRs, the underlying truth is that a way will be found and it will involve monetary inflation. The alternative is a transfer of real wealth to governments in trouble through taxation of one form or another, and that is not going to happen. So we will end up with two solutions to the current crisis, both of which will accelerate the expansion of money supply everywhere. This is confirmation of a trend firmly established and from which there is no politically acceptable escape.

Money-creation that cannot be stopped has only one logical outcome: the complete debasement of the currency. This is good for gold and silver. Furthermore the first two days’ delivery notices on Comex for the December gold contract total a massive 50 tonnes, indicating the futures market is also set up for a bear squeeze from lack of physical.

Tags: buy gold, central banks, dollar, IMF, inflation, SDR

Author: Alasdair Macleod

Alasdair Macleod

The UK Chancellor's Autumn Statement

2011-12-02T14:20:00.001Z

This article is posted at FinanceandEconomics.org

The Autumn Statement

The UK’s Chancellor of the Exchequer presented his Autumn Statement last Tuesday. His independent Office for Budget Responsibility (OBR) downgraded economic growth prospects, partly due to higher than expected energy prices and their effect on the GDP deflator. He made much play about why his sensible approach ensured interest rates remained low, unlike those in most European countries.

Interest rates are a wild-card, and in this respect the Chancellor is surely tempting providence. For the fact is that interest rates are only as low as they are because the Bank of England is funding the Government’s borrowing more cheaply than the free market would on its own, given the size of the borrowing requirement. That is the difference between Italy and Britain, not as the Treasury tells us. But then the Treasury has a long history of not understanding markets, as those of us who were around in the 1970s will remember.

In that socialist era the government of the day frequently maxed-out its credit with the markets. This would encourage sharp slides in sterling which would disrupt the sales of gilts. The result was that money supply, without the sterilisation of bond sales, would take off, driving sterling yet lower and making it harder for the government to borrow. The Bank of England, which in those days was under direct Treasury control, would respond with interest rate rises, which were always too little too late. Eventually, the Treasury would give in and sanction a rise in interest rates high enough to satisfy the most bearish expectations. That is how we ended up with 12%, 13½% and 15¼% coupons on twenty year gilts and a poorly performing economy which staggered from crisis to crisis.

The solution was only resolved by gilt yields rocketing to sufficiently high real rates adjusted for inflation. How different it is today! The market turns a blind eye to negative real yields for gilts against a background of record debt issuance, but this will not continue for ever. The budget deficit is forecast to be 8.4% of GDP in the current year, and outstanding government debt will be at 67.5% and rising. Compared with European states and with a reasonable debt maturity profile it perhaps doesn’t look so bad. But as Italy found out, the fact that there are countries in a worse position does not guarantee you will escape the market’s attention for long.

Tucked away in the Statement was an extraordinary bit of wishful thinking, which perhaps explains the Treasury’s optimism about interest rates: the rate of CPI-measured inflation is forecast to fall from 4.6% in the current fiscal year to 2.4% next, and 2% thereafter. These estimates are central to everything, but so far the forecasting record for price inflation has been very poor. If inflation turns out higher than forecast, the GDP deflator will again be higher than expected, to the detriment of real GDP. And if real GDP undershoots, the budget deficit will not fall as forecast.

The set-up for a repeat of the funding crises of thirty years ago is in place, and it is only a matter of time before markets understand this. The OBR’s inflation forecasts are exposed to further rises in energy and food prices, and sterling weakness. All we need is for Europe to slip out of the headlines, which it eventually will, for the focus to swing to Britain.

Alasdair Macleod

2 December 2011

http://www.goldmoney.com/video/thomas-rustici-macleod.html

Oil, inflation and gold

2011-11-26T21:27:00.003Z

The following article is posted at GoldMoney, here.

A crude awakening

2011-NOV-26

One of the joys of interviewing some of the best brains in the world of finance and economics is that they alert you to important factors that perhaps you haven’t fully considered. This was my experience with Chris Martenson in Madrid last week (the interview will be posted on the GoldMoney website in the coming weeks). He reminds us that the availability and price of oil are central to our economic future.
The basic argument is this: very little can happen in our lives without oil. It is required for mining, agriculture, manufacturing, transport and distribution. Global consumption is rising, and extraction has levelled off. Oil-exporting nations are consuming more, leaving smaller balances for those with oil deficits. The cost of extraction is rising sharply: whereas fifty years ago it cost one barrel of energy to extract a hundred, we are moving towards new fields where the rule is one barrel for three. We face a train-wreck between the increasing rates of global consumption and the declining rates of net exportable production.
We are familiar with this story, but most of us underestimate its importance, so it is worth repeating. The chart below (which is based on statistics from BP’s Statistical Review of World Energy 2011) sums up the problem.

The black line is the five-year moving average of the balance between annual production and consumption, represented by the black columns. The last year of production surplus was 1981, thirty years ago, and since then the world has drawn down on strategic stockpiles and inventory to meet consumption demand, at a trend rate that is now accelerating. The blue columns represent the European balance, which has benefited from North Sea oil and which is now running out. The red columns represent North America and Mexico, whose production has been deteriorating since 1984. But most frightening is the Asia/Pacific deficit, the yellow columns, which has soared over the last twenty years.
The chart clearly shows a picture of an imbalance between production and consumption that cannot continue much longer. The world is now caught between inflexible demand – because oil is vital to our very existence – and declining net production. This explains the oil price, which is the blue line in the second chart (I shall comment on gold in a moment).

There have been three phases: the first, when OPEC jacked up the price of oil; the second when more expensive non-OPEC fields came on stream putting a cap on prices, and finally the third, where prices have increased seven times so far. It is this third trend, from which there is no apparent escape. The chart is on a logarithmic scale, which means that prices have been rising at an exponential rate since 1998.
With the production/consumption imbalance set to deteriorate further, there can be only one result, and that is considerably higher prices. Based on BP’s statistics, which show that the world’s most vital commodity has been in a supply deficit for the last thirty years, the logical outcome is a price explosion. And with quantitative easing in the markets there will be extra money to pay higher prices, the consequences for global price inflation do not bear thinking about. On this evidence we can therefore confirm Chris Martenson’s analysis.
Living with an energy supply crisis will require a radical change in our lifestyles – downwards. The best financial protection from this event appears to be physical gold, which has tracked the price of oil reasonably well over the years as shown in the second chart, and can be expected to continue to do so. After all, the combination of the most rapid global monetary expansion in peace-time history and soaring oil prices is an inflationary disaster in the making.

Tags: commodities, dollar, gold price, oil prices, quantitative easing

Author: Alasdair Macleod

Alasdair Macleod
macleod@financeandeconomics.org
www.financeandeconomics.org

GoldMoney Foundation interview with Tom Rustici

2011-11-24T11:31:00.001Z

The GoldMoney Foundation has just posted a video of my interview of Tom Rustici, professor of economics at George Mason University. This took place in New York City on 27^th October.

The interview can be found here:

Kind regards

Alasdair

Alasdair Macleod

Latest GoldMoney article

2011-11-19T18:29:00.001Z

This article is posted at GoldMoney, here.

Watch out for maturing debt

2011-NOV-19

It was hoped that the appointment of Mario Monti to head a new Italian government would stabilise Italian and European bond markets. Instead, after a brief pause, bond yields on Italian debt rose back above the seven per cent level, leading the yields of other euro-denominated sovereign bonds upwards. It is not just that markets have been unimpressed about the prospects for the new Italian government, but even maturing debt will be hard to refinance.

To understand why, assume you are an executive director of an average Euro-zone bank. You have loans to the private sector, the bulk of which gives you exposure to large and medium size businesses, with some smaller businesses thrown in through your branch network. You have exposure to residential and commercial real estate. Your in-house economist tells you that the wave of public spending cuts in the weaker Euro-zone states is going to have a negative effect on your borrowers doing business in those regions, and that the prospects for Germany, which exports to these markets, are also deteriorating. Your branch managers all tell you that smaller companies are struggling and with the prospect of deteriorating economic conditions you can expect a rise in bad debts.

Meanwhile, your large depositors are becoming aware of risks in the banking system, and are beginning to seek reassurance that their money is safe. Your branch managers also report that even small depositors are getting edgy. And in the interbank market, other banks are reducing the amounts they will lend to you.

You should be worried. As recently as three months ago your in-house economist had forecast reasonable German growth led by exports, and he expected the problems of Greece et al to be contained, if only because it was in everyone’s interest to do so. In less than three months the situation had deteriorated rapidly. And then there is all that sovereign debt you took on in happier times, when by borrowing euros in the interbank market, you could buy Greek, Portuguese, Spanish and Italian sovereign debt and turn five basis points on what seemed a risk-free deal. You remember the strategy: balance your private sector risk with risk-free sovereign debt.

You now have substantial losses on sovereign debt, and your private sector loans are exposed to economic weakness. You see risk everywhere, not reward. You have hidden sovereign losses by transferring the positions from trading accounts, where they were marked-to-market, to “investments”, which are marked-to-maturity. This is done on your auditor’s recommendation and with the central bank’s blessing.

What do you do? You know your financial position is considerably worse than stated, and sources of funding are becoming very difficult. You need more information. You ask your bond dealers to run off a list of government and corporate bonds held by the bank to enable you to estimate the money coming in from maturing redemptions. You need the cash.

Welcome to the world of European banking. As yet, few people understand the fundamental pressures driving bank balance sheets to contract, and while that remains the case, it is not enough for Euroland states to just balance their budgets: they will need to cut enough to pay back much of the maturing debt as well. Unless, that is, the ECB relents and steps in to cover the deficits.

Tags: buy gold, euro crisis, fiat currency, sovereign debt

Author: Alasdair Macleod

Alasdair Macleod

Latest article at GoldMoney

2011-11-12T09:32:00.001Z

This article is posted at Goldmoney, here.

An Austrian economic view

2011-NOV-12

In the last two weeks the headlines have switched from Greece to Italy. Financial and economic commentators who dismissed Greece as a small cog in the Euroland machine are now seriously alarmed and see no solution to Europe’s sovereign debt crisis other than the short-term expedient of getting the European Central Bank to print lots of money. They castigate Germany’s sound money approach, ignoring the fact that it has been central to Germany’s economic success, preferring to commend the loose-money economics of the unsuccessful “PIIGS” (Portugal, Ireland, Italy, Greece and Spain). And when listening to them, just remember that none of them foresaw this crisis, when it was obvious to Austrian economists in the early days of the banking crisis.

Keynesian and monetarists believed that the problems surfacing in the PIIGS would be resolved by economic growth, which would follow so long as governments maintained their deficit spending. As events are now proving, this analysis was flawed, which is why Keynesians are now confused. They should open their minds and absorb Austrian economic theory to gain a proper understanding of human actions and how people are affected by money and credit.

The first thing they will learn is that the economic benefits of credit expansion are a myth. All it does, by a process of capital redistribution – from savers to those who are first in line to receive the new money – is distort the economy and restrict its long-term potential. By lowering interest rates and diverting private sector resources from genuine production to government spending, the economy becomes less efficient and malinvestments occur. The mistake has been to only consider the visible benefits, such as short-term job creation, while ignoring the destructive effects of deficit financing.

The distortions created by easy money and deficit spending will naturally try to reverse themselves as surely as night follows day. The recession that follows the temporary boom is the way an economy cures itself from unsound money and government intervention. This is hard for interventionist governments to accept because it strikes at the heart of their existence. And while printing money and credit is always popular with an electorate that does not understand what is happening to their money, reversing the process is readily noticed and immensely unpopular.

This brings us back to Euroland’s problems. The creation of the euro twelve years ago allowed banks to expand credit massively in the mistaken belief that sovereign risk had been eliminated. The result was that spendthrift governments availed themselves of cheap credit. Eurozone governments, particularly the PIIGS but also France and Belgium, have squandered huge sums to prevent the unwinding of malinvestments and other economic distortions, preferring to perpetuate existing malinvestments. The only solution is for them to let the unwinding happen, which is what the financial markets (for which read reality) are now forcing them to do.

What we are seeing, the markets unwinding economic distortions from the past, is a necessary process and therefore beneficial, a point which goes completely unrecognised. If only governments had the sense to understand this, it is not too late to plan wisely for regenerated economies and a sounder Europe. Unfortunately, the gut reaction of the political class and its advisors is to continue as before at all costs, deferring this necessary adjustment and increasing its eventual severity.

There is no joy for the informed spectator in seeing continuing economic destruction. However harsh it may be in the short-term, the EU elite needs to start paying attention to Austrian School remedies to Europe’s financial woes – and fast.

Tags: ECB, euro crisis, Germany, PIIGS, sovereign debt

Author: Alasdair Macleod

Alasdair Macleod

Speech given at the CMRE fall meeting in New York

2011-10-25T13:01:00.001+01:00

On 20 October I was sponsored by the GoldMoney Foundation to speak at the Committee for Monetary Research and Education fall meeting in New York City.

At this meeting I spoke on the subject of the benefits of sound money relative to fiat money and credit, with emphasis on the destructive effects of the credit cycle and the mistake of regarding GDP as an important economic indicator. My conclusion is the US is ensnared in a debt trap from which there is no escape.

The link to my speech is here

Alasdair Macleod

US money supply

2011-10-23T04:30:00.002+01:00

The following article is posted at GoldMoney, here

US money supply growing fast

2011-OCT-22

With all the troubles of Europe hogging the headlines, commentators are ignoring money supply in the US, which is growing strongly, with the broad measure of M2 growing by over 10% for the last 12 months. Furthermore, the annualised growth rate over the last six months has been above 15%. The story told by the True Money Supply, otherwise known as Austrian Money Supply, confirms this.

The reason for using TMS is simple. According to the Ludwig von Mises Institute, it represents the amount of money in the economy available for exchange. Furthermore, it is designed to clearly show any expansion that results solely from central bank injections of cash and commercial banks’ credit creation, by excluding anything that has to be converted into cash first, such as credit and money market funds. It is therefore a pure measure of money in the economy available to be used for transactions, more pure than official MZM, M0 or any other central bank "M" measures.

In economic theory this is important, because money is simply a commodity that happens to be used exclusively as a medium of exchange. And as a commodity, its value ultimately depends on its supply and the demand for it. By using TMS we keep the relationship between actual money and prices pure from other arguable factors.

The growth in US dollar TMS over the long-term is shown in the chart below. From this chart it can be seen that following a pause in its long-term trend at the time of the 2007-08 financial crisis, TMS has been growing strongly ever since.

The bulk of the growth has been in check deposits (customer current accounts) and savings deposits (instant access accounts) at the banks. Some commentators point out that this reflects cash not being spent and cash representing risk-averse hoarding. But this opinion ignores the fact that the cash is being used, because the banks have lent it to the government, and the government is distributing it into the economy.

So this cash does amount to extra supply of money, which will be gradually reflected in a fall in its purchasing power. Given that the acceleration in TMS dates back to 2009, we are already seeing this, with ShadowStats.com, which applies an unbiased statistical rigour to key statistics, estimating actual inflation to be running considerably higher than official estimates.

The other aspects (other than of money that is) of the pricing effects of supply-and-demand is the variability of demand for individual goods. And here, the picture – as always – is uneven. Welfare, defence and healthcare spending by government maintain demand for energy, food, defence and healthcare-related items. Banking and related financial services are also doing well, despite balance sheet problems, as they are closest to the source of the new money (in this case, the Federal Reserve). Much of the rest, as business surveys and unemployment statistics confirm, is patchy at best. So there are identifiable winners and losers in pricing, and the expansion of TMS is feeding through to those goods, demand for which is supported by government spending.

With this monetary background, it is likely that the big headache for 2012 will be persistent and rising price inflation for the US and other economies tied to the dollar. So we can expect stagflation to be in everyone’s vocabulary in the New Year, which will inevitably lead to pressure for interest rates to rise sooner rather than later.

Tags: central banks, dollar, Fed, inflation, USA
23 October 2011
Alasdair Macleod
macleod@financeandeconomics.org
www.financeandeconomics.org

Monetary fallacies

2011-10-16T12:32:00.001+01:00

This article is posted at GoldMoney Foundation, here.

Monetary fallacies

2011-OCT-15

One rationale for quantitative easing is that it encourages economic growth. This must be based on the belief that monetary inflation is good for the economy. But as the great economist Ludwig von Mises points out in The Theory of Money and Credit(1912) this is a misconception. In his words: “it is a mistake to think that the depreciation of money stimulates production”. Instead, the economy is distorted, with those closest to the QE engine benefiting most, while those furthest away lose out.

We see this today, with the finance industry doing very well despite on-going problems in many other sectors of developed economies. This spreads out to all the service industries within commuting distance for bankers. In London and New York everything is busy and prices are high, and lucky is the tradesman servicing the wealthy in the suburbs. At the other end of the scale are humble workers and farmers in the provinces, and pensioners whose meagre savings are being depreciated by rapidly rising costs in food, heating and other basics. When Mervyn King, the Governor of the Bank of England, was asked about the plight of savers (mainly pensioners), he expressed sympathy for them but insisted he would not “push Britain into a recession” just to help them.

So let them eat cake. The truth is that monetary inflation distorts markets into winners and losers, and unfortunately pensioners are stuck in their voting habits so are not worth wooing: they lose.

The other Keynesian fallacy is that deficit spending can get economic recovery going by appealing to the private sector’s “animal spirits”. This is true in the sense that false credit, by replacing genuine savings, can get businesses and consumers to accelerate their purchases; but that is a short-lived credit-driven cycle that merely reverses later, and has been tried so often that animal spirits have pretty much evaporated.

The inflationary consequences of these macro-economic experiments will be far more disruptive in the coming months than appears likely today. We are now entering winter for the Northern Hemisphere and energy demand will pick up; and with production constraints (notably Peak Oil) there is only one way for energy prices to go. Furthermore, food is energy-intensive to produce and deliver, requiring considerably more oil-based energy to produce than the calorific output of the food itself.

Higher energy costs will affect other aspects of our lives, and nowhere is this more important than in the production of raw materials, particularly those that are mined. A paper published on ZeroHedge last Monday analyses the impact of energy costs on silver mining. The message is clear: Peak Oil also means Peak Silver, and Peak lots-of-other-things as well.

It is against this background of a growing imbalance between falling supply and static demand for energy and raw materials that central banks are injecting large quantities of new money. It matters not whether the process is done formally through QE, or informally through an open cheque book; the effect on prices for basics from this winter onwards is potentially explosive.

But as von Mises pointed out, it is a mistake to think that the depreciation of money stimulates production. So it will not be demand that chases these prices higher, but expanding quantities of money that have already occurred and are yet to occur.

Alasdair Macleod

Quantitative easing, or when there's nowhere left to run

2011-10-09T21:41:00.001+01:00

This article is posted at http://www.goldmoney.com/gold-research/quantitative-easing-or-when-theres-nowhere-left-to-run.html

Quantitative easing, or when there's nowhere left to run

2011-OCT-08

Over the last few weeks there has been a growing realisation that the weaker members of the eurozone are caught in debt traps. When the “PIIGS” (Portugal, Ireland, Italy, Greece and Spain) signed up to the eurozone they gave up the right to devalue, which is the traditional and delusionary escape route for sovereign debtors. But when you come up against the realities of hard money, this route is blocked. A temporary solution has been to gets banks to buy government bonds, but the banks can take no more. This leaves us with a banking problem, but fortunately their solvency is being underwritten by the European Central Bank, without which the eurozone would have ground to a financial halt.

The ECB, together with the national central banks, can only support these banks by writing a blank cheque on itself, while using all means possible to conceal and play down the losses in the system. This essentially is what happens with the good-bank/bad-bank solution: if the bad stuff is carted away to be dealt with out of the public gaze leaving the good stuff behind, what is there to worry about?

We have to keep our fingers crossed that the ECB continues to succeed in co-coordinating this vital task, and indeed, its strongest suit is that we all want it to succeed. But this still leaves us with the unanswered question of how to resolve the sovereign debt traps.

The problem is global. The eurozone’s debt problems, which also extend to France and Belgium, have only become obvious because of the inflexibility of the euro. But debt traps have also closed on the US and the UK, who can try to print their way out of trouble. Both these governments are fully committed to monetary inflation as the means to conceal and defer their own financial difficulties. This is what quantitative easing is actually about: it is the way a government funds itself when markets are unable or unwilling to come up with the money required. You bypass markets by printing it for your own banks to lend to you.

The idea that QE is primarily to help the economy recover is Keynesian guff, a cover for the true reason. Without it, the US and UK would have to compete for global savings at far higher interest rates. What price $2 trillion in new Treasuries with no QE? What price £175 billion in new gilts? The debt trap has already sprung. And few investors yet seem aware of the irony that loading up banks with Treasuries and gilts is exactly what the eurozone banks have already done for the PIIGS. Whatever the current difficulties faced by European banks and the US and UK governments and their banking systems, there is only one option for all of them: buy time by printing yet more money. This is why the banking system in the eurozone and elsewhere will survive. Banks need governments as much as governments need them. The cost of this survival will be borne by the unwitting saver, who has been frightened into cash only to find it being debased more rapidly than before.

This makes the recent fall in gold and silver prices nonsensical. But then just as the investment community walked blindly into stock market losses, they are just as clueless about the inflationary implications of rescuing sovereign debt.

Tags: euro crisis, gold price, inflation, PIIGS, quantitative easing

Alasdair Macleod

An extraordinary tale of a false statistic

2011-10-08T22:29:00.001+01:00

This article is posted at http://financeandeconomics.org/Articles%20archive/2011.10.08%20GDP.htm

An American economist and econometrician, Simon Kuznets, was awarded a Nobel Prize in 1971 for “his empirically founded interpretation of economic growth which has led to new and deepened insight into the economic and social structure and process of development”. It was Kuznets who is credited with the invention of Gross Domestic Product, which he worked on in the late 1930s.

Before his work on GDP there was no statistical measurement of the size of an economy. The problem was to reduce the diverse production of goods and services to a single measurement, so that apples and pears could be lumped in with motor cars and trucks. GDP is the value of all goods and services in an economy measured in the currency of the country, in this case US dollars because Kuznets worked for the US Government. Allowance was also to be made for government provisions of goods and services, many of which were provided to end-users for free. The solution was to include these at cost.

GDP might be useful when quantifying the size of one economy compared with another, and it allows us to construct a table showing their relative importance to each other. But GDP was taken further in its use by Keynesian economists to become an important, and now the most important statistic, for assessing the effectiveness of macro-economic policy. And because it does not differentiate between the value of consumer-driven GDP and government-driven GDP, it has been easy for politicians and their economic advisers to slip into the habit of assuming they have similar economic values. This allows a politician to spend money and know that that spending contributes to “economic growth” as reported in the GDP statistic, to the same degree as does an increase in private sector output.

This lack of value-judgement in the GDP number is analogous to valuing a company on its balance sheet alone. The balance sheet might say the company has productive assets at a figure in the books, but no serious investor is going to take the accounting information as read: he will go and look at the trucks, the factories, and the equipment therein and then form a judgement on their condition and value to the enterprise. The numbers in the balance sheet are no more than an accounting identity of the factors of production. In the same way, a GDP figure will be comprised of the output of some businesses that are dynamic, inventive and have a commanding global product. There will be other businesses that rely on government subsidies to remain in business: the value of their product is less valuable perhaps to the economy, except in the eyes of the politicians who have authorised the subsidy. In that case, it cannot be said that the product of these subsidised businesses are wanted by the consumer in the quantity produced or at a profitable price. There are also those businesses whose output is dependent on government contracts; contracts that may or not add true value to an economy. And then there is the cost of government services, which are forced upon people whether they want them or not, which diverts through taxes financial resources that would otherwise be applied to products and services that people actually do want.

This much the Austrian School of economists agree with. Von Mises himself wrote that “the attempt to determine in money the wealth of a nation or the whole of mankind is as childish as the mystic efforts to solve the riddles of the Universe by worrying about the dimensions of the pyramids of Cheops”.[i] But we can advance criticism one step further to demolish any pretence the GDP statistic has to represent the values of production, and therefore be a valid measure of economic output.

To do so, we need to consider an economy with sound money, with no change in the quantity of money and bank credit, and a balance in trade and cross-border capital flows. If, on the last day of the previous year, GDP is one billion monetary units, what will it be on the last day of the current year? It has to be the same one billion units. Production activity can change, the ratio between consumption and savings can change, the ratio of private sector to public sector in the economy can change, but if there is no change in the quantity of money, GDP must be the same. The adjustment is on prices, so a rise in overall production leads to lower prices, and lower production to higher prices.

Having established that in a sound money regime there can be no change in GDP, it becomes clear that in a fiat money regime, GDP will change only to reflect monetary inflation, independently of production activity. In this case the stock of money is simply being increased, and the effect on the prices of final goods is a secondary consideration, just as it is in the sound-money example.

But there is a further difference between the two conditions. In the sound money example, prices can be expected to fall over time, making the application of savings to business investment an attractive proposition for savers. Not only does the saver get a modest interest return, but the purchasing power of his capital increases over the years. For this reason surplus capital tends to be productively invested as savings rather than speculated with, positive returns being certain except for individual entrepreneurial risk.

In a fiat-money regime, this relationship between savers and productive investment is interfered with by the consumption of capital that results from inflation, and by the destabilising effect of credit-driven boom-and-bust cycles. As savers become aware of the loss of their capital they seek other ways to protect it. And because they, or financial intermediaries acting on their behalf, increasingly seek to protect their savings from inflation, money-savings shift away from productive investment. Instead they are reapplied to more speculative activities, such as gambling in stock markets and other asset classes thought to benefit from monetary inflation.

The long-run effects are demonstrated in the contrast between economies primarily driven by savings and those driven by consumption. In the post-war years, Germany and Japan developed a strong savings culture that flourished under successive governments, which pursued an anti-inflation bias in monetary policy. The consequence was interest rate stability at levels that were more influenced by supply and demand for savings than by the central banks’ monetary expansion. The benefits enjoyed by these savings-driven economies are in accordance with the Capital Theory developed by adherents to the Austrian School of economists. Stability in the cost of money and other factors of production allowed intermediate manufacturing processes to thrive, and both Germany and Japan developed into economic power-houses as a result.[ii]

The position of consumption-driven economies has been entirely different. In the post-war years the governments of the US and UK (taken as an example) have relied on monetary expansion as the driver of economic growth as they followed Keynesian and Monetarist macro-economic policies. Inevitably, the ethos whereby savings are applied to industrial investment has suffered considerable and increasing disruption. The decline in the savings ethos in both these Anglo-Saxon economies has been driven by monetary inflation and the unstable economic conditions for productive investment that results from monetary expansion. Again, this is easily deduced from Capital Theory. The consequence is that manufacturing, with unstable costs of both money and the other factors of production declined, leaving these economies increasingly dependent on consumption.

The growing pool of speculative capital

Attempts to manage the GDP statistic through injections of fiat money have not only distorted the relationship between genuine savings and productive investment, they have also led to a growing accumulation of speculative capital, as mentioned above. For this reason, monetary expansion does not automatically feed into GDP. To the extent that this leakage occurs, monetary expansion has to be pursued more aggressively to bolster this number. And here a self-defeating mechanism becomes evident. The more monetary inflation is injected into the economy, the more capital owned by the private sector is consumed, and therefore the more monetary expansion favours financial speculation over productive investment. Further injections of fiat money are simply ceasing to bolster the GDP statistic.

Not that this will stop economic policy from continuing to try to grow the GDP accounting identity: Keynesianism and Monetarism is based in large measure on the delusion that the GDP statistic is actually economic growth and not just growth in the money in the economy. The only way this process will cease is when all confidence is lost in the purchasing-power of fiat money. Only then, in the post mortem, might the mistake of confusing an accounting identity for the real thing become clear to the economic establishment and the wider population at large.

7 October 2011

Alasdair Macleod

[ii] See http://financeandeconomics.org/Articles%20archive/2010.07.01%20Capital%20Theory.htm

[i] Human Action as quoted in an article by Dr Frank Shostak published by BrookesNews.com 3 Sept 2007.

Article written for GoldMoney

2011-10-02T08:13:00.001+01:00

This article is published at http://www.goldmoney.com/gold-research/eu-elite-lost-at-sea.html

EU elite lost at sea

2011-OCT-01

Since I last wrote about the euro crisis, events have taken a predictable turn for the worse. In my GoldMoney article dated September 17 I argued that eurozone governments should cut their own spending substantially, while the European Central Bank should restrict itself to working with national central banks to keep the banking system functioning, and that a sound euro is better for private sector recovery than a weak alternative. I also argued that there was a benefit in allowing Greece to default, pour encourager les autres.

Keynesians argue that the worst thing to do is to slash public spending. I would argue that the worst thing you can do is to not cut public spending, because public spending, which dominates most European economies, is a misallocation of economic resources, stifling their private sectors. A public sector is an economic burden, not a benefit, and the strangulation of private sectors in the eurozone is the fundamental economic problem.

Over the years the European Union and its members have become increasingly dominated by central planners and regulators, and the governmental solution to today’s crisis is for more of the same. Already no one in the EU can sell any product without conforming to myriad regulations, and employment laws and taxes on employment are strong disincentives for the expansion of small and medium-size businesses that make up the bulk of any domestic economy.

The deterioration in the underlying quality of private sector business, the result of central planning and needless regulation, has been concealed by the expansion of bank credit, which has fuelled both private and public sector debt. According to the International Monetary Fund, at the end of 2010 gross government debt-to-GDP for the Euro area was 87%, and household debt 72%, giving a total of 159%. Germany itself was running a combined total of 142%, which is often overlooked. On these figures alone, it is clear that the Keynesian solution of more government spending as the route to salvation is impractical, whatever the economic arguments.

It is difficult to know if anyone in the EU elite fully understands the problem. Noises emanating from them are extremely discouraging, from their resentment at being pressured at the recent G20/IMF meeting to deal with a rapidly deteriorating situation of which they seemed to be insufficiently aware, to the President of the European Commission’s analysis, which is that the problem can only be solved by closer political integration and new taxes. Their dilemma is not helped by their advisors, who are all highly qualified central planners who have no empathy with private sector business, beyond what they are told by monopolists. They are genuinely upset at and confused by the intrusions of market reality into their plans.

We will not change these people’s views, but their attempts to cross-subsidise their public sectors must be thwarted. This will not be done by the IMF, which is institutionally sympathetic to governments over free markets. The task must fall on the shoulders of the ECB, which is why it is so important that the ECB limits its activities to keeping the banking system solvent and not funding insolvent governments.

It must also resist calls for a weaker monetary stance, beyond what is necessary to keep the banking system functioning. Contrary to every bystander’s advice, you need certainty of monetary values to allow the regeneration of savings and business investment to develop, which is the precondition for economic progress. Let’s hope the ECB is strong enough to stand firm.

2 October 2011

Alasdair Macleod

Gold, the euro and Operation Twist

2011-09-23T14:24:00.001+01:00

This article is posted at GoldMoney, here.

Gold, the euro and Operation Twist

2011-SEP-23

At first sight it is puzzling that systemic uncertainties are escalating rapidly in the eurozone and that the gold price is subdued. And if the press is to be believed, the euro might even disintegrate.

There is no doubt that Europe’s difficulties are a good reason to take out some insurance, but to argue that the fall-out from the euro crisis should increase demand for gold much beyond that is to misunderstand what gold is about. Yes, it is an effective temporary refuge from paper money in uncertain times, but the real reason for the price to rise is to be found in monetary inflation.

In managing the euro, the European Central Bank has done well to resist calls for substantial monetary easing, and by standing firm politicians have generally stopped badgering the ECB to do so. This has given some support to the euro and restricted flight from it to manageable quantities. True, the euro has fallen about 6% against the dollar, but then the dollar was overdue for a bounce. There is on-going panic in the eurozone, but all things considered there has not been much of a panic over the euro itself.

All this suggests that the fringe money that has gone out of the euro and into gold is for the central banks a containable problem. And if anyone has a deposit at say, a French bank, and is worried about it, it is far easier to move it to another too-big-to-fail bank elsewhere than to take a more difficult decision, such as “Do I buy some gold, even though the euro price has risen five-fold in the last eleven years?”

Meanwhile, there are far better reasons to sell the dollar and buy gold, even though the market’s initial response to the Federal Open Market Committee statement on Wednesday was to mark down precious metals along with everything else. Operation Twist disappointed those that were hoping for QE3, but realistically the headline focus was always going to shift to bank credit. Few commentators have picked up on this, but they should do in the coming weeks.

Put simply, the Fed is going to sell short-dated US Treasury stock and buy maturities of 6-30 years. The short-dated stock will most probably be bought by funds gearing up through the repo market, which will shift excess bank credit from the Fed balance-sheet into the banking system. This is consistent with the announcement last month, that funding rates will be held at current rates for the next two years.

While the Fed claims this will benefit the economy by lowering long-term rates, the true beneficiary is the Treasury, which gains an improved maturity profile at a ridiculously low cost. This is actually highly inflationary, as bank credit will expand to finance government borrowing through the repo market, and room will be created on the Fed’s balance sheet for up to $400bn of new money to be issued.

So not only do we have QE3 of $400bn, but we have an expansion of bank credit to match: now that is monetary inflation. What price gold when people actually wake up to what is going on?

23 Sept 2011

Alasdair Macleod

Greece's economic crisis should be a warning to others

2011-09-18T17:56:00.001+01:00

This article is posted at Goldmoney.com

2011-SEP-17

Greece is probably going to default soon, which is hardly a surprise. That was the message we got from Wednesday’s telephone call between Angela Merkel, Nicolas Sarkozy and George Papandreou, who after 25 minutes merely issued a statement saying that Greece is determined to meet its commitments to its partners and will stay in the eurozone. In other words, there is nothing more anyone can do, so Greece will default, most likely within days.

We need to move on from Greece, in order to understand how to deal with the wider crisis. There are three separate problems that must be resolved: the poor state of eurozone nations’ finances, the eurozone banking system, and the euro itself.

The collective borrowing requirements of Greece, Portugal, Spain, Ireland and Italy – to which must be added Belgium and almost certainly France – are simply too big to fund. It is possible that the International Monetary Fund working with the G20 might come up with a package, perhaps funded by the creation of more Special Drawing Rights (SDRs), but that is not being discussed at the moment. So in the absence of such a package and if Greece is somehow bought more time, the markets will almost certainly focus on any of the remaining “PIIGS” (Portugal, Ireland, Italy and Spain). So the rescue of one debtor will encourage a run on the others.

The only way these countries’ public finances can be restored is by substantial cuts in public spending. Greece’s descent into public sector chaos will be a sharp and valuable lesson to politicians and electorates elsewhere. For this reason, there is a benefit to be had from allowing Greece to go to the wall.

The European Central Bank’s task in this is clear: it should concentrate all its efforts together with the national central banks in ensuring the banking system remains intact. This brings us to the third problem: the euro.

The euro is a paper currency with some of the attributes of sound money. It is that soundness that is creating much of the pain, which is why Keynesians have turned against it. Now that they see Greece’s default as inevitable, these Keynesians think Greece should leave the euro, or perhaps Germany and a few others should leave so that stricken economies can arrange for themselves the “benefits” of a weaker currency.

Like most Keynesian ideas, their solutions are not thought out. Breaking up the euro would be chaotic, throwing all debts and contracts into doubt, triggering needless bankruptcies in the private sectors throughout Europe, and destroying credit ratings. It would also hinder and not help the private sectors in all the PIIGS, which is the only place where a genuine economic recovery can come from. The private sector needs sound money if it is to regenerate itself, and that is what the euro can provide.

It will be hard to abandon Greece as a hopeless case, but this must be done in the interests of the whole, and eventually for Greece itself. Rather than thinking about bailing out Greece, the eurozone and the IMF should be working on an emergency funding package designed to fund law and order and other vital services only, conditional on Greece remaining in the eurozone.

Any other approach to dealing with these three problems is likely to come unstuck very rapidly.

Alasdair Macleod

Central banks and the gold price

2011-09-11T17:43:00.001+01:00

This article is published on GoldMoney’s website, here

Central banks and the gold price

2011-SEP-11

Last week the Swiss National Bank suddenly announced that it was “no longer going to tolerate a EUR/CHF exchange rate below the minimum rate of CHF1.20”. Just before the announcement the franc had been trading at CHF1.10, so it represented a devaluation of about 9%. The Swiss Franc had been as strong as parity about a month before the move, so the decision appears to have been based on more than simple currency over-valuation.

The SNB definitely has a problem. Switzerland is a successful economy surrounded by nations in a currency union that threatens to disintegrate. Essentially, Switzerland’s success is out of step with the rest of Europe. This is obvious, but the motivations for central banks are rarely stated plainly, and there is usually more to an action such as this than meets the eye.

It was gold’s reaction to the news that surprised everyone, because gold fell $60 from its high at the time of the announcement, when the SNB’s action was expected to be good for gold. Half the fall in the gold price occurred in the few minutes ahead of the SNB’s announcement at 10.00am European time, so it appears that the gold price was getting some guidance from the central banks. Furthermore, very late that evening US time, when trade is thin and Europe was asleep someone dumped 4,000 futures contracts, driving the price down over $50 to $1,816. The first trade was on privileged information, while the second was clearly timed for maximum effect.

Rarely do we see such a public determination to hit the gold price. Indeed, the promptness of the action suggests that the move on the Swiss franc was designed to get the gold price down as much as it was the franc itself. If this is the case, then there must be a good reason, and we should bear in mind that the central banks have it in their interest to reduce volatility in bullion markets as well as currencies.

In common with dealers and market makers in all markets, bullion traders run short positions in bull markets. The turnover on the bullion markets is massive, and a dealer active on behalf of its customers and its own trading book can make substantial dealing profits. So long as those profits exceed the losses on their short positions, all is well. This is why the greatest threat to the bullion market is not the bull market itself, but prices rising too rapidly.

In the last two months, the market for gold has been particularly strong, erasing trading profits for many bullion dealers. Central bankers see this as the result of financial flows building due to the difficulties in the euro area. The targets for these flows out of the euro are the Swiss franc and gold, so the SNB’s move is designed to take the heat out of both of them.

Attempts to keep the price of gold down are unlikely to succeed for long. Westerners who buy gold may be unhelpful to the central banks, but you cannot stop a few hundred million Chinese and Indians from protecting their hard-earned savings. And the Chinese are busy developing their own bullion markets, taking control away from the Western central banking cartel.

Alasdair Macleod

Why GDP is complete nonsense

2011-09-04T07:33:00.001+01:00

This article is posted in PDF form here.

Why GDP is complete nonsense

GDP is an economic planners’ concept, and is the yardstick by which their success or failure is judged. As the definition used by Wikipedia puts it: “GDP refers to the market value of all final goods and services produced in a country in a given period”. Only refers. This article questions the validity of GDP as a meaningful statistic, and finds it to be valueless and even worse, misleading, with profound implications for mainstream Keynesian economics.

If you really want to know how an economy is growing, you must take every item of manufactured product and every service sold, and estimate the change in their individual quantities and qualities over time. You should only include products and services freely exchanged for value, otherwise there is no sound transactional basis for their existence. You must somehow capture technological improvements in each product, and changes to benefits in each service. It amounts to an impossible task, given its complexity and the degree of subjectivity involved: this is why it is far simpler to use money values instead for central planning purposes. And therein lies the trap, which is readily exposed by considering the application of money GDP in a sound money environment.

If a nation has completely sound money, there is no expansion or contraction in its quantity, or of bank credit. Let us also assume that there are no net cross-border flows. This being the case, GDP in Year 1 obviously will be exactly the same as in Year n, irrespective of the actual economic activities in those years. This makes it obvious that GDP is a measurement of total money deployed in an economy, and not of the goods and services themselves, which are free to vary within the confines of the money total. The only money variances that can occur are from changes in cash levels (hoarding and liquidity) and exclusion of activities from the statistics (black markets). It is the nature of sound money that these errors will be very small, reflecting public and business confidence in the medium of exchange. And with sound money, there is no statistical error to consider since there is no change in its quantity.

History has shown that in a sound-money economy, the prices of goods fall over time, reflecting increased production efficiencies and technological advancements. So, in real terms, this impossible-to-measure annual economic growth probably works out at a few per cent annually, and the purchasing power of money can be said to have risen to reflect that improvement. And it is the certainty of this return on savings from the gradual increase in their purchasing power that helps keep nominal interest rates low.

In practice, economic performance is always a combination of private and public sector activities. As any thinking economist with experience in the commercial world should know, the difference between the two is that the private sector, left to its own free choices, uses the available resources of consumption and savings to maximum efficiency because waste is abhorred; while the public sector, which deploys economic resources primarily for social and bureaucratic purposes is considerably less efficient in its use of them. There is no way of measuring the loss of economic resource from its redeployment to the public sector, and it will be greater or lesser across different government functions. In all instances of government-provided goods and services, there is no independent pricing mechanism to establish their true value. To the loss of economic resources from government transactions must be added the loss of the economic production that the private sector would otherwise have enjoyed if its economic resources had not been redeployed to finance government spending. These two losses together can be considerable.

We can begin to see the differences emerging between the changes that can occur in an economy despite a fixed monetary value for total market transactions. Furthermore the cost of government in a sound money environment becomes immediately obvious to the public, because the government cannot use the hidden tax of inflation as a source of revenue, or as an economic management tool. In a sound money environment, when a government borrows to finance its spending, it drives up interest rates against both itself and against the productive private sector, because it is unable to increase money in circulation to compensate. Because all government intervention is immediately noticed for what it costs, democracy in a sound money economy can be expected to elect small efficient governments. Consequently, the drag on an economy from government spending and intervention should be minimised in a sound money environment.

Now let us consider the conditions we have today, whereby governments manage the quantity of money at will, and banks are licensed by the authorities to vary credit supply. Our task is to identify the factors that enable nominal GDP, as reported by statisticians, to grow over time. The information that makes up GDP is based on domestic product, so trade imbalances are already compensated for, and capital transactions are not included.

The first factor is the addition into the economy of fiat money itself. This additional money and bank credit must be reversed out, because it is solely extra money and does not represent an increase in the market value of goods and services, which became clear when we considered the sound money example. Secondly, government spending is also an additional statistical distortion, because it is included as if it were a normal productive activity, but again we know from our sound-money example that it is actually a net economic cost; so here again, an increase in government spending artificially increases GDP above its true worth and should also be removed. And finally, the change in the general price level which accompanies monetary and credit expansion further boosts nominal GDP, rather than the other way round as is commonly supposed: this is a misleading impression caused by the use of a GDP deflator to compensate for price inflation.

Accordingly, the increase in GDP in a fiat currency over a period of time is the simple monetary result of these three distortions. If they are removed from official GDP figures, there should be no growth in an adjusted GDP statistic at all. The chart below, which is of US GDP from 1960 to 2010 showing the relevant adjustments, supports this conclusion.

The chart reflects the removal of the three distortions we have identified that make up nominal GDP (the red line) in individual steps to arrive at a sound money equivalent (the black line). Nominal GDP grew from $526.4bn in 1960 to $14,849bn in 2010. The fully compensated figure fell marginally from $439.7bn in 1960 to $436.3bn in 2010,

So our theoretical proposition, that all the growth in GDP is entirely due to the growth in government spending, domestic monetary and credit inflation, and the falling purchasing power of the currency, is confirmed by the adjusted statistics. However, the compensated figures do have some volatility, though this is small compared to the adjustments made. The variables not taken into account, that might have some effect, are changes in levels of money-hoarding, changes in the level of black-market activity, and changes in the composition and methodology of calculating the consumer price index. Over the period there have been improvements in data collection and there is the changing relationship between M2 and other monetary factors, such as money in the shadow banking system, which are bound to affect any estimates. But taking these variations into account the relative constancy of the fully adjusted number over the last forty years is impressive. Our conclusion therefore stands as valid on this evidence.

So it turns out that GDP, this emperor among central planners' statistics, has no clothes. It is just a meaningless money quantity. It started as an invention of a US economist and Nobel laureate, Simon Kuznets, who was working for the National Bureau of Economic Research in the 1930s, and GDP was first applied in 1942 to complement estimates of national income and to facilitate war-time planning. Any caveats he might have put on its application have been ignored. The result was as if Congress had asked him to come up with a new statistic that would justify the future growth of government, making sure the losses to the economy were concealed[i]. And the fundamental basis of this statistic does not seem to have been seriously questioned since: after all, the ground-breaking work of a Nobel laureate, and all the statistical methodology of the best brains government can employ is regarded as authoritative.

Therefore the majority of published material on economics over the last seventy years is itself based on complete bunkum. Modern statistics are selected to support bad economic theories that seek to justify government intervention rather than the truth; and the further theories derived from the fundamental building-blocks of modern economics are themselves built on sand. According to the GDP statistic government spending does boost the economy, which is why Keynesians are convinced that government intervention is beneficial. But economists of the Austrian school know that government spending is detrimental to the economy. It is reliance on false statistics, such as GDP, that go a long way to explaining how the two camps can radically differ in their opinions. So familiar are we to the concept that GDP actually reflects economic activity that it is hard to accept that it is no more than a meaningless money number, but that is precisely what it is.

We shall now briefly look at the implications of this conclusion.

There are the obvious ones. For example, the more monetary inflation there is, the better GDP statistics will appear: this is an incitement for central banks to continue to expand money supply and encourage the growth of bank credit. No wonder we have ended up with a progression of higher and higher debt, the counterpart of bank credit, to the point where the debt bubble has finally become unstable. Secondly, the more government taxes and spends in an economy, the more it artificially inflates the GDP numbers: this gives socialism its veneer of success. No wonder government is encouraged to grow itself at the expense of the private sector, when this growth has statistical benefits, even though it is economically destructive. And finally, the more a government can manipulate CPI calculations to keep them artificially low, the more GDP appears to grow, reflecting actual changes in price levels: this is precisely what the US government has been doing in recent years, as recalculated inflation statistics from Shadowstats.com clearly demonstrate.

Governments use all these tricks, and have been successfully fooling themselves in the process since the GDP concept was invented and developed at their behest. So long as GDP is growing, we have tolerated the increasing burden of government and its management of our affairs. And the public now firmly believes from GDP statistics that increases in government spending, management and control over the economy are the road to salvation from the uncertainties of economic life.

Less obviously, at least to governments, we are now at the end of this social fallacy, with all the signs that the central planners have led us into a dead-end. Government debts in nearly all developed nations have now spiralled out of control, with even greater welfare costs in the pipeline. Governments are now no longer just fooling themselves with false statistics; they are fighting for their own economic survival, ensnared in a debt trap.

The fight will be lost, because governments are victims of their own statistical propaganda, wrongly believing that anything can be fixed with enough intervention, and not understanding why their flawed schemes are falling apart. Instead they blame the private sector for the economic ills that are actually the consequence of their own interventions. Their gut reaction is to inflate the components of GDP identified in this article even further: banks must lend more, governments must spend more, and the recent growth in the CPI must be ignored because a little inflation is good for GDP growth.

While these quack remedies are pursued in the vain hope that modern economies will recover given enough time, they are killing the prospects for any lasting recovery. The right balance of consumption and savings is needed, which can only be decided in the free market, and not by economic planners. Instead of permitting this to happen, accelerating levels of money and credit creation will take place, destroying savings entirely. And monetary inflation is no longer just puffing up GDP; it is being used to buy time to defer government bankruptcy and the unwinding of the associated malinvestments in the private sector.

For further proof that the GDP statistic is as far removed from actual measures of economic performance as stellar objects are from each other, consider this: if GDP had been calculated in the early 1920s, Germany would have been shown to be enjoying an unprecedented post-war boom, when the reality was hyper-inflation. And if you still cannot accept the proposition that GDP has no statistical value, come up with a convincing argument how the total money-value of all goods and services can actually change in a sound money environment.

Alasdair Macleod

4 September 2011

Alasdair Macleod

[i] See The Bureau of Economic Analysis 2000 survey of current business, “GDP: One of the Great Inventions of the 20^th Century”. The BEA is very proud of their role in the creation of GDP and its role in the US’s national accounts.

Latest GoldMoney article - Rocky Banks.

2011-09-03T21:20:00.001+01:00

This article is posted at GoldMoney.com

Rocky Banks

2011-SEP-03

The banking crisis of 2008 alerted us to the risk of a systemic collapse of the banking system. Today these fears again seem very real, with concerns over the European banks and the share prices of banks everywhere having taken a big hit recently. Splitting the banks into domestic lending and investment banking has also returned to the top of the political agenda in Britain this week.

There is a contrarian adage that when no one expects an event, it might happen, and when an event is commonly expected it might not happen. This could apply to the much-heralded banking collapse. But since the Bear Sterns and Lehman crisis the banks themselves have been busy rebuilding their core capital and adjusting their business activities in line with the new Basle III regulations and the Dodd-Frank Act in the US. In Britain, regulation of the banks has moved back from the FSA to the Bank of England, where it belongs. Both the banks and their regulators, having had a very nasty shock three years ago, have taken big steps to avoid a second crisis.

It is not as difficult for central banks to prevent a collapse of the banking system as many observers believe. The key to it is to buy time, which the Bank of Japan did in the 1990s when it faced a collapse of the major Japanese banks. Banks are also major beneficiaries of monetary inflation, which partially justifies the quantitative easing policies of the Fed and Bank of England. Furthermore, financing governments has always been a lucrative activity, contributing to gross returns on capital of as much as 20% for the investment banks. It only requires a few years in this monetary environment to rebuild healthy capital ratios.

Today, the European banks pose the biggest risk to the global financial system, as the sovereign debts of the weaker nations edge towards default. But even here, the ECB is not toothless, and can do much to prevent a Europe-wide banking crisis, working with national central banks to ensure liquidity is always available for the banks that need it. This is already happening with Greece’s banks, which have seen a steady withdrawal of deposits since Greece’s first bail-out.

The real test will be an actual sovereign default, which is a genuine concern. But here again, money that is withdrawn from one bank perceived to be in trouble and deposited in a stronger competitor merely gets recycled to back to the first bank, if not through the money-markets, through the central bank. The ECB may have to copy the Bank of Japan twenty years ago, by pretending that banks’ individual problems don’t matter, because they are back-stopped by the central bank. After a while, depositors, bond-holders and investors might stop worrying, if only because nothing happens and the crisis is no longer news.

However, it would be wrong to be complacent about the substantial risks facing the global banking system, and there is still the possibility of a second systemic crisis. But the bigger crisis by far, which is beyond anyone’s control is in government finances, which ironically, should continue to be a source of substantial profits for the banks – so long as they survive.

3 September 2011

Alasdair Macleod

http://www.goldmoney.com/video/macleod-turk-interview.html

GoldMoney interview

2011-09-02T09:38:00.001+01:00

You may be interested in an interview of me by James Turk of GoldMoney, at the recent GATA conference in London. The link is here:

Regards

Alasdair Macleod

Gold, politics and Venezuela

2011-08-28T22:49:00.001+01:00

This article is posted at Goldmoney.com.

Gold, politics, and Venezuela

2011-AUG-27

Markets were abuzz last week with Chavez’s recall of Venezuela’s gold reserves not currently held in Caracas. Bulls are excited by the thought that withdrawing some 150-200 tonnes from the Bank of England and the bullion banks will force a bear squeeze on the LBMA, where gearing between the physical and paper markets are assumed to be 100 to 1. This stretches the relationship between paper gold and physical gold even further. They are also excited by the possibility that others might follow Venezuela’s example.

These concerns are real and should not be dismissed lightly, and the announcement could not have come at a worse time for LBMA members, who also face being caught up in a European banking crisis. Fear dominates, but the real trigger for this market emotion, and therefore its outcome, is global politics. Chavez is not just recalling his country’s gold to protect its integrity, he is waging an idealist’s war against the capitalist system and the US in particular. This is why he has threatened to move gold and foreign reserves to the countries he says he trusts, principally Russia and China, and why he is proposing to nationalise Venezuela’s gold mines.

He has picked the capitalist system’s weakest point. He has been told by his central bank that the Fed, the BoE and the Bank for International Settlements hold gold for the whole central banking community in the main trading centres, and that much of this gold exists only as a ledger entry and is not backed by physical metal. Whether or not Venezuela’s gold is held in these fractionally-backed sight accounts, or in earmarked accounts where the gold is held separately, we do not actually know; but there is little doubt that this move is designed to encourage other central banks to demand that their gold is also repatriated.

Chavez has a point. It is a fair bet that the International Monetary Fund’s 2009 sales of 212 tonnes of gold to other central banks are held in sight accounts as a condition of sale. India, Mauritius and Sri Lanka, who bought this gold, must be very nervous. Interestingly, India and Sri Lanka are also associated with the Shanghai Cooperation Organisation, which was set up by China and Russia with the eventual goal of establishing an Asian supranational state.

This little-known connection is extremely important. The SCO even has a website. The central banks of its member states, observer states and dialogue partners are nearly all buying gold, overtly or covertly. This is more likely to be a co-ordinated economic attack on the West than just a purely random event.

Until Chavez’s intervention, China and Russia – who run the SCO – were gently turning the screws on the gold market: Russia by announcing regular purchases and China by encouraging its citizens to buy. They appear to have put the word about through the SCO that gold will have an important role in the SCO’s future, and those involved should have some. This is a world Chavez wants to be part of, and by removing his country’s gold from capitalist markets he is declaring his credentials.

Underlying this extreme socialist action is the Marxist belief that capitalism will destroy itself. Chavez believes it is his duty to give it a helping hand.

Alasdair Macleod

Europe

2011-08-20T12:48:00.001+01:00

(This article is posted at GoldMoney)

Merkel and Sarkozy impotent in the face of debt crisis

2011-AUG-20

Mrs Merkel and Mr Sarkozy achieved nothing last Tuesday by holding, at short notice, a meeting to sort out the eurozone sovereign debt crisis. They only succeeded in exposing their political impotence. They came up with four proposals – none of which stand a chance of being implemented – having dropped one of Sarkozy’s, the issuance of a “eurobond”, after the Germans refused to lend their name and credit to it. This charade has more to do with French presidential elections next year than anything else, and Sarkozy’s diminishing re-election prospects. Mrs Merkel must regret being dragged into it.

They have no answers for the sovereign debt crisis, which now extends beyond the PIIGS to Belgium and France as well. According to the CIA database, the only eurozone countries with budget surpluses last year were Finland and Malta; the rest have a combined budget deficit of $760bn. Germany, who everyone is relying on, accounted for $120bn of the total deficit and has a government debt-to-GDP ratio of 80%. The most solvent are Estonia, Luxembourg, Slovenia and Slovakia, three of which have not had the chance to rack up much debt having been shackled behind the Iron Curtain for much of the last century.

The reality is that the member states of the eurozone face a political crisis. The politicians refuse to address their insolvencies and slash government spending. The alternative is for the European Central Bank to start printing money to cover budget deficits, which thus far it is refusing to do. The ECB does not want the political crisis to become a euro crisis. It is one thing to anticipate a crisis by announcing such a measure, another to respond to it. Having nailed its colours to the sound-money mast (relatively speaking), the ECB can hardly change course now, even if its constitution allowed it. The politicians will have to find their own solution.

The whole European Project is now at a dead-end, and there is a loss of political momentum. It was this momentum and the vision of the European leaders that kept the project going, because the little desire there was for it from their electorates is now evaporating. The original reason for the EU’s existence, to secure peace and trade between the European nations, is no longer relevant. The political establishment is now highly vulnerable to attack from dissenters and many of them know it.

It is the nature of politics that when a political ideal loses credibility and when it lacks fundamental democratic support, it crashes. The irony is that the only bedrock under these shifting sands is the euro itself. Very few commentators seem able to grasp this, regarding the euro as symbolic of the eurozone mess and therefore most vulnerable. But as the political situation deteriorates, the ECB will have less monetary room for manoeuver, because it will be seen as the last outpost of stability. For this reason the euro is likely to strengthen further despite the continent’s sovereign debt problems.

Angela Merkel faces great difficulties with domestic politics. In order to survive, she is already wisely turning her back on the European Project. In contrast, Sarkozy has tied himself irrevocably to France’s place in the grand European ideal. We await his electorate’s verdict next year.

Alasdair Macleod

The upcoming expansion of US bank credit

QE to be replaced by bank credit expansion

2011-08-17T12:43:00.001+01:00

This article has been posted at Financeandeconomics

Since the FOMC meeting, there has been a noticeable silence over the Fed’s monetary policy following QE2. But there is some evidence that the funding of government debt at low interest rates will shift to the repo market, rather than a new round of quantitative easing.

The silence on this subject may be partly explained by the monetary focus shifting to Europe. However, it is likely that the Fed has no intention of introducing QE3, given that the expansion of narrow money so far has led only to a degree of price inflation, without much benefit to asset prices. And with the ECB still reluctant to print euros, QE3 would probably collapse the dollar/euro rate and propel gold considerably higher, putting unwelcome strains on the financial system. The Fed also finds itself having dramatically expanded the monetary base for little economic benefit: against all its expectations, the economy is sliding into recession again. Perhaps it is a case of all the people being no longer fooled all of the time with respect to what QE actually is. No, another approach is called for.

To the Keynesian mind the obvious alternative must be to expand bank credit, particularly when there is an accumulation of non-borrowed reserves sitting on the Fed’s balance sheet. The NBRs represent the excess capital owned by the commercial banks, which have not been drawn down for use as the capital base for the expansion of bank credit. They currently stand at about $1.76 trillion while in normal circumstances NBRs would be no more than a few tens of billions. High levels of NBRs reflect the reluctance of banks to lend and bankable borrowers to borrow: they are symptomatic of an economy that refuses to expand.

It is against this background that Ben Bernanke announced at the recent post-FOMC meeting press conference that interest rates would be held at current levels (close to zero) for the next two years. This could be the basis for shifting the funding of government debt from printing raw money to expanding bank credit. The public do not understand the inflationary implications of expanding bank credit as easily as they do that of printing money: switching to bank credit as a funding route for government debt allows the Fed to fool all of us a while longer.

The logical way to do this is by developing the repo market, where the buyer of government securities conducts a reverse repurchase agreement, or a reverse repo. In a reverse repo an investor buys securities with an agreement to sell them back to the seller at a fixed price at a future date. For the seller of the securities, the deal is defined as a simple repurchase agreement and is the mirror-image of the reverse repo. If the cost of financing a reverse repo is profitable then the transaction can be highly geared to give a substantial return on the underlying capital. By encouraging this market for short-term government debt, the Fed can exercise tight control over short-maturity government bond yields with benefits extending to medium maturities, irrespective of the quantity issued. The key to it is to get the banks to lend to the institutions on the Fed’s Reverse Repo Counterparty List, and the key to that is reducing the interest rate paid on non-borrowed reserves to slightly below the targeted government bond yield rate.

The development of the repo market is the way to getting the NBRs put to constructive government use. Given that short-term US government paper is seen as the lowest investment risk and the highest quality collateral, gearing up a reverse repo fifty or even a hundred times is a no-brainer. Theoretically, that $1.76 trillion of NBRs could fund nine times that amount of government debt, or more than doubling it to $30 trillion. The point is that the successful development of the repo market in this way is an obvious and more powerful solution than extending quantitative easing.

We know from FOMC minutes last year that the Fed has been assessing the repo market, so it is a definite possibility. All that is required is interest rate certainty, and that is what the Fed gave the market in its announcement that it would peg rates at close to zero for the next two years. The probability that the repo market will be developed in this way has been increased by the inclusion on the 27^th July of both Fanny Mae and Freddy Mac on the Fed’s Reverse Repo Counterparty List. We should be interested in this development, because it allows these government-owned entities to gear up their fast-accumulating cash for certain returns, and using government entities allows the Fed to exercise further controls on the development of the repo market.

The apparent disadvantage is that reliance on the repo market will shorten the overall debt maturity profile. But successful funding at the short end of the yield curve will have the effect of keeping yields down for longer maturities, and the Fed can also use derivatives to extend its control to the longer end. Correctly managed, the Fed will believe that it can keep the cost of government borrowing low and at the same time manage the overall debt maturity profile.

We cannot be certain the Fed will use the repo market in this way, but the problems with a new round of quantitative easing, the studies of the repo market admitted in FOMC minutes, and the recent entry of Fannie Mae and Freddie Mac to the Reverse Repo Counterparty List are strong evidence they will. Furthermore, the establishment Keynesians and monetarists will be unconcerned by inflationary consequences. To them, the greater danger is still a 1930’s style deflationary depression, the result of not enough government economic stimuli. Unlocking the NBRs and gearing them up through the repo market gives them all the room for manoeuvre they could wish for.

If the Fed unlocks bank credit in this way, other central banks will want to follow. This will not be so simple, since most banks in other jurisdictions operate under Basle rules, which require them to maintain a minimum level of risk-adjusted capital, instead of keeping reserves at the central bank. Basle rules are being tightened, forcing most banks to increase core capital as a percentage of loans, so there is less capital available to back a dramatic expansion of repo markets for government debt. Other central banks will have to use more imagination to expand bank credit to finance government deficits.

In the short run, this may not matter too much. All currencies are on a de facto dollar standard, so they will benefit from the dollar’s extended low interest rates. Furthermore the expansion of bank credit as a means of government funding in the US will reduce demands on the global savings pool, easing the imbalance between government deficits and funding availability.

So we have a workable monetary solution for all the world’s ills. There are market benefits, too. Extended low interest rates should help place a floor under asset prices, and the resolution of the immediate uncertainties over US sovereign debt and less pressure for government spending cuts will be seen as a confidence restorative. But expanding bank credit to finance increasing government spending merely allows that spending is no solution to the underlying causes of the real economic difficulties.

Importantly, it guarantees yet more price inflation down the road: bank credit expansion always has in the past, and it always will in the future. Above all, it guarantees the next leg upwards in the precious metals bull market.

17 August 2011

Alasdair Macleod

The ECB's only choice is to protect the banks

2011-08-10T21:19:00.001+01:00

(This article can be found on the FinanceAndEconomics website here)

The ECB is under great pressure from all sides to rescue Euroland’s sovereign debtors with a round of quantitative easing. Such a solution is totally against the principals and charter of the central bank, and has so far been resisted, the ECB only buying debt in the secondary market to lower the apparent cost of funding for stricken governments. This is little more than a sop, because no investor in their right mind would buy government debt at a price artificially inflated by ECB purchases. And nor should the ECB encourage banks that continue to buy bonds issued by insolvent governments.

The clamour for QE is entirely Keynesian. The simple answer is that indebted governments must cut their spending, and hard. By doing so, much needed economic resources will stay in their private sectors, which can lead to a surprisingly rapid recovery: look at Iceland, which was forced by reality to bite the bullet and whose economy is already recovering. But this simple answer does not fit into Keynesian ideals, which merely dismiss the private sector as having lost its animal spirits, and therefore, they argue, it is the duty of the public sector to take charge.

It was hair-brained Keynesian economics and socialism that got Europe into this mess in the first place, and this should weigh on the realists at the ECB in their deliberations. They now have the practical task of keeping the banking system intact. They cannot finance, or even part-finance, Euroland’s government deficits as well. Just underwriting Euroland’s banks might require up to a trillion euros, which is inflationary enough; pumping money into insolvent governments ad infinitum will involve considerably more.

These governments are looking for a soft touch: they have found it in the European Financial Stability Fund, but that is too small for their continuing negative cash-flow. The Chinese, after expressing initial interest just to annoy the Americans, have backed off. The PIIGS are now offering their begging-bowls to the ECB. However, printing money for governments to spend is the high road to hyperinflation. The ECB are therefore likely to say no, to the disappointment of Keynesians and socialists alike.

If the ECB does refuse to subscribe for new government paper, the PIIGS governments will at last be forced to face up to the reality of their financial position. And who knows, if one of them gets real, the others might follow. Keynesians everywhere will probably advise them to leave the euro in favour of their old softer money. This is like advice to a chess player from someone who can barely think one move ahead, because it would leave liabilities in hard euros, and future funding in a collapsing drachma, punt, lira, peseta or whatever. While exiting the euro would rapidly force a default on any of the PIIGS ejected from the sty, it would also offer the prospect of hyperinflation for the ejected, and the position of Euroland’s banks would probably be worse than if they stayed.

By dealing with the European banking crisis in this way, the ECB will then be able to tackle the separate issue of exchange rate policy, which is another problem lurking in the background. With the world on a dollar-standard and the Fed printing money with gay abandon, the euro will continue to be strong. This will intensify political pressures on the ECB from all Euroland governments, worried about terms of trade. That is a totally separate issue and should not be confused with the immediate problem.

The ECB’s decision in this matter will be for the markets a decisive indication of the course of future euro inflation.

10 August 2011

Alasdair Macleod

Speech given at the GATA Gold Rush 2011 London conference

2011-08-08T17:56:00.001+01:00

Some of you will be aware that the Gold Anti-Trust Action Committee (www.gata.org) hosted a very successful two-day conference at the Savoy Hotel in London last weekend, attended by about 400 delegates from 38 different countries.

At the conference, I addressed the delegates on the economic factors driving precious metal prices, and my speech, entitled “Beyond the tipping point” can be found on my website, here.

I hope it is of interest to you.

Regards

Alasdair Macleod

Latest article posted at GoldMoney

2011-07-31T21:13:00.001+01:00

This article is posted at GoldMoney

Lies, damn lies and GDP statistics

2011-JUL-30

Earlier this week preliminary figures for the UK’s second quarter GDP were released, showing that the economy grew at an annualised rate of 0.2%. Both politicians and markets have become slaves to these statistics, the former prepared to alter economic policy to bolster them and the latter attaching significant importance to them. But how important are they actually?

GDP numbers reflect the final consumption of both private and public sectors, to which are added the trade balance and business investment for a given period. This is then deflated to reflect price inflation of all goods and services, and seasonally adjusted. However, there are several problems with this approach.

Firstly, the economic activity associated with the intermediate stages of production is not adequately reflected in GDP, which imparts a statistical bias in favour of consumption, and against production. Over time, this has the effect of driving production abroad, to where the factors of production are more readily available, skewing the economy towards consumption and a dependency on service activities.

Secondly, an increase in government spending financed by deficits raises GDP: socialist governments have used this fact to engineer headline growth. By this trick, Gordon Brown, as Chancellor from 1997 to 2007, was able to make it appear as if the economy was growing at a faster rate than his critics expected. But this “growth” came at a long-term cost to Britain’s economic health.

And thirdly, the easiest short-term fixes for adverse trade balances and business investment are a “competitive” currency and freely available bank credit. The effect of these inflationary policies has been to destroy savings, which are the bedrock of a stable economy.

As if this wasn’t bad enough, the GDP deflator further conceals the gap between statistics and reality. Put simply, so long as money and bank credit expand at a faster rate than the deflator, GDP will grow purely from the extra cash in the economy. For governments, this is an incitement to monetary inflation: never mind the reality that Weimar Germany, for example, was collapsing in the early 1920s – statistically it would have been growing strongly until money itself finally “died”.

The least we can do is adjust GDP to better reflect the economic reality of our situation. In the UK’s case, nominal GDP is shown as growing 49% between 2000 and 2010, but if you strip out the increase in central government, that falls to 41%. But the real shocker comes from deflating the private sector by the increase in M1, which represents cash in circulation and sight deposits. Instead of growing at a price-deflated annual average of 1.3%, GDP actually falls by an annual average of 3%.

This result arises from looking at economic performance in strictly sound money terms. We can only conclude that monetary inflation is very effective at concealing hard economic truths, and that the UK has actually been in a slump for some time. And the UK is not alone, because the USA’s GDP numbers are similarly inflated.

No wonder unemployment is so high; no wonder the economic miracle we were all promised has been a mirage. And any recovery will only be a statistical aberration resulting from the difference between monetary and price inflation. No wonder the sterling price of gold is knocking on the door of £1,000 per ounce: it’s a wake-up call that things are not as good as they seem.

Alasdair Macleod

31 July 2011

Latest GoldMoney article

2011-07-16T22:17:00.001+01:00

This article is posted at GoldMoney, and copied at FinanceandEconomics.

ECB to say yes to QE?

2011-JUL-16

The surprise of the week has undoubtedly been panic over Italy’s finances. Until this happened, it was commonly assumed that the PIIGS would fall in strict order, with Spain due to follow Portugal. The political response to this development amounts to total confusion among the Eurocrats. They recognise they must do something, but they do not know what, so they have meetings.

It is hard to have sympathy with these, the most statist of politicians, but there is in reality nothing they can do. The underlying problem is that western governments are nearly all running massive budget deficits, and the savings simply do not exist to fund them all, not even if interest rates doubled or tripled from current levels. In the funding queue some governments have precedence over others, either because they are seen as low-risk, or in the case of the US, because the dollar is the reserve currency. The propensity to save is important, which gives Germany and China, for example, a greater degree of funding security. This used to be true of Japan. The competition for savings leaves Euroland’s PIIGS shut out of capital markets.

Bond market analysts, the rating agencies, and organisations such as the OECD and the IMF, all produce optimistic forecasts of the funding requirements for these countries in the coming years. They are optimistic because economic recovery is assumed, when it is actually becoming impossible. And as the prospects for economic recovery are replaced by the near certainty of slump, these nations become locked into a cycle of raising taxes and cutting welfare, plunging them further into depression.

This may be a fatal blow to the European Project. It certainly puts the ECB in an impossible position. The central bank has done little to help the PIIGS governments with their financial difficulties, sticking mainly to keeping the eurozone banking system solvent. The ECB now faces the ultimate test: in the face of these escalating sovereign difficulties, will it continue to follow its relatively sound money policies? (Relative, that is, compared with the brazen money printers at the US Federal Reserve, Bank of England and Bank of Japan.) Sound money is bankrupting the PIIGS and will soon do the same for Belgium and France. Or will it cooperate by buying newly-minted PIIGS debt in a quantitative easing programme? If it does, the eurozone will live to fight another day. Though the ECB’s charter says no to QE, political reality says it is vital.

Any easing of the ECB’s stance against QE can be expected to fuel European demand for precious metals, and with gold hitting new highs this week, perhaps the smart money is ahead of it. And if the ECB starts its own QE programme, we can expect the Bank of England to consider QE2, and thus the Fed will have an excuse for QE3.

The reality is that the only way the large budget deficits of many developed countries can all be funded is by printing money to buy debt. The alternative is far higher bond yields for all but the very best credit ratings, yields that few governments can afford to pay.

No wonder gold is so strong. The penny is finally dropping in the slot machine that passes for the collective brains of the investment community.

Alasdair Macleod

Latest article for GoldMoney

2011-07-09T22:07:00.001+01:00

This article is posted at GoldMoney and copied at FinanceandEconomics

Inflation is beyond the tipping-point

2011-JUL-09

Forecasters face a dilemma: is the outlook inflation, or deflation? And given the recent signs of disappointing economic growth, are we worrying too much about inflation? Certainly, for the Keynesians, who are constantly on the look-out for signs of deflation, and who believe that governments must at all costs keep prices gently rising, the alarm bells are ringing.

At the heart of their economic philosophy is the tired old economic fallacy of under-consumption as the reason for recession, and government deficit spending and stimulation of consumption as the way to recovery. In their desire to promote consumption at all costs, they have destroyed savings, and encouraged consumers into unsustainable debt. And despite the stimulation of 10%+ budget deficits, the vapour trail of recovery is fast disappearing. The Keynesian solution has left us in a worse position than we were in at the time of the credit-crunch and the collapse of Bear Stearns and Lehman Brothers.

That point in our economic history marked the end of the era of ever-expanding credit, when banks competed to lend. The paralysis in the money-markets changed that, and ever since both the banks and highly-indebted borrowers have become risk-averse. It also marked the end of the post-war Keynesian experiment. The cycle of monetary go-stop has been repeated too often, and now fools no one.

The idea behind monetary stimulus is to get businesses investing in new production and creating jobs in the process. But any industrial investment requires long-term stability in the factors of production, which include labour costs, the cost of money, and raw material prices. The Keynesians have unfortunately achieved short-term instability in all of them by monetary manipulation.

If, instead of the systematic destruction of savings through taxation and inflation, savings had been encouraged, the US and UK would have a healthier balance between manufacturing and consumption, and their trade would be more balanced. This is the lesson we have failed to learn from observing the post-war economies of Germany and Japan, both of which were driven by a strong savings ethos.

Both the mark and the yen were exceptionally strong currencies against sterling and the dollar, which according to our Keynesian experts should have restored trade balances. At first sight, this static analysis appears logical, but it ignores the far greater benefit to German and Japanese industry of stability in the source (savings) and cost of money. It ignores the stability of labour and raw material costs that comes naturally with savings, and which do not suffer disruption from unstable money supply and bank credit.

The evidence from savings-driven and consumption-driven economic models clearly disproves the Keynesian fallacy of under-consumption, and its correction by monetary manipulation. But anyone with knowledge of economic history, and of the clear evidence that free markets cannot be bettered for allocating resources between consumption and savings, knows this. Relearning the lesson has destroyed our economies, and made us even more dependent on monetary inflation to buy off the consequences of debt-deflation.

We passed the tipping point when banks stopped becoming aggressive lenders. Now we will print money to save our skins.

Alasdair Macleod

Weekly note posted at Goldmoney

2011-06-26T19:03:00.001+01:00

This note is posted at Goldmoney and copied at Financeandeconomics

The limitations of technical analysis

2011-JUN-25

It is generally encouraging for precious metals bulls when technical analysts are cautious or suggest that a correction is not yet over, because they have a knack of advising caution just before prices rise. Silver is particularly difficult for technical analysts who apply Elliott Wave theory: today, they see the possibility of an A-B-C correction, in which case a downward C-leg would take the price down to the $25–$30 level.

Technical analysis is for those who are unprepared to properly consider the true factors that drive a market. The laws of chance suggest that an unemotional technical analyst might be right 50% of the time. This is not to say that applied technical analysis is little better than tossing a coin, because some technical analysts do get reasonable results and some of their tools are worthwhile. Good technical analysis gives us a better understanding of the balance between greed and fear in the markets.

The people who really know where this balance lies are the market makers, or in the case of the futures market, the commercials. They learn with great rapidity the quality of business a floor broker has, and how successful that broker and his clients are in their trading activities. This is important knowledge that is denied to the rest of us, which is why the commercials were so successful in precipitating the severe shake-out in silver in late-April.

But if you are a technical analyst, all you see is a bullish trend that has been severely broken, raising the real possibility of a new bear phase, with an Elliott Wave C-leg to come. You think you are reading in graphic form the tussle between greed and fear. This is certainly valid in the narrow context of the Comex futures market, into which is corralled all the speculative interest from American punters. But it does not capture the emotion behind the physical market: the concealed activities of central bankers, the demand from Chinese and Indian investors and the developing panic in Europe. The central banks are secretive, the ordinary people are countless and uncounted. They were never greedy, only fearful that paper money might lose its value. In the overwhelming absence of greed, there can be no balance with fear, negating the very basis of technical analysis.

Perhaps the best lesson to learn from the recent shake-out in prices is that it has provided an opportunity for everyone around the world, fearful of the precariousness of paper money, to buy more physical. We have no definitive statistics on this, but you cannot ignore the recorded demand for gold and silver from China and India – the two most populous nations on earth – the announcement that the Mexican central bank has bought 100 tonnes this year, and that the Russians continue to accumulate gold. Nor can you ignore the draining of silver from the Comex warehouses. Nor can you ignore the fact that the investment management industry has virtually no client exposure to the sector, and that the general public in Europe and America is totally ignorant about what is happening to their paper currencies.

The way mistakes are made is by following advice based on the wrong information. That is the danger of technical analysis forecasts for gold and silver prices. They often become a reflection of analysts’ own emotions rather than of the market itself.

Alasdair Macleod

26 June 2011

Weekly note posted at Goldmoney

2011-06-19T21:09:00.001+01:00

This note is posted at Goldmoney and copied at Financeandeconomics

Splitting the banks

2011-JUN-18

This week George Osborne, the British Chancellor, announced that UK banks would ring-fence their domestic banking operations from wider banking activities. It is presented as a protection from the riskier activities inherent in international and investment banking.

But is this where the greatest risks lie? These plans have been fomenting for many months against a general assumption that the UK economy would recover on a medium-term view. It is only in recent weeks that this assumption has been turned upside down, in which case domestic banking is significantly more risky than previously assumed. Of course, risk assessments of banking business are produced by the Bank of England as regulator, whose track record in this respect is far from encouraging.

An alternative way of looking at it is to understand that international and investment banking activities have high margins and that these diversified banks use sophisticated markets to cover changes in risk perceptions at a moment’s notice. A borrowing-and-lending bank restricted to real customers has considerably less flexibility, and given the high level of capital gearing permitted, it has significant risks without the offset of diversification enjoyed by modern integrated banks. It is a return to the old from the new.

The models are entirely different. For the last 30 years banking has moved away from interest income towards fees. The advantage of fee income is that it is earned without encumbering the balance sheet, so requires minimal regulatory capital: this is what has driven banks into capital markets. A ring-fenced domestic banking business which loses these benefits becomes less profitable and their customers will probably face rising costs as a result. And so long as domestic banks rely on money markets as part of their business there will still be counterparty risk with the wider banking community.

Of course, it is easy to share the regulator’s concerns about investment banking and cross-border business: the collapse of Lehman is fresh in our minds. Putting aside the question as to whether Lehman collapsed because it was badly managed or whether it was simply the victim of systemic failure, there have to be valid concerns about activities beyond national control, such the chains of counter-party risk in off-market derivatives. But it would be wrong to assume that managements in the banking community are unaware of these risks and have not already taken practical steps to protect themselves.

But perhaps the most worrying aspect of ring-fencing domestic banking is the implication that if there is a global banking problem, the British government will have the option to walk away from it. Logically, there can be no other interpretation. And given the Government is advised by the Bank of England as regulator, the bank itself must not be entirely confident that an international systemic event can actually be prevented.

It will be interesting to see the reactions of other countries, and whether or not they also seek to ring-fence domestic from international banking. If they do so, it will signify a worrying shift away from global central banking co-operation in favour of domestic financial protectionism.

Alasdair Macleod

The destructive power of weak money

2011-06-09T10:34:00.002+01:00

The online version can be found here

The rate at which money is being manufactured out of thin air has accelerated in recent times, as shown by the chart of the US Monetary base, which is shown below:

The exponential rise in the monetary base from the post-war years was enough on its own perhaps to eventually guarantee a hyper-inflationary outcome for the dollar, even before the credit bubble suddenly burst in 2007. The Federal Reserve Board then responded to contracting bank credit by increasing the quantity of money threefold in less than four years. This raises the question of inflationary implications for prices, given the Quantity Theory of Money as understood by mainstream economists.

Milton Friedman, who is associated with monetarism, summed it up by repeating Hazlitt’s earlier assertion: inflation is always and everywhere a monetary phenomenon.[1] Indeed, it is generally forgotten that there cannot be an increase in the general level of prices without an increase in the quantity of money. This is too imprecise for modern economists who theorise over what measure of money to use. Today, the economists at the Fed lead us to assume that the link between monetary inflation and prices applies to the broadest measure, which includes bank credit. This is suspiciously convenient, given the deflationary implications of a contraction of bank credit, which left unchecked would threaten the end of the fractional-reserve banking system. Using the broadest measure allows the Fed to argue that deflation arising from contracting bank credit must be balanced by the expansion of raw money, when their true concern is the prevention of a banking collapse.

Indeed, this unprecedented expansion in the monetary base has not yet been reflected in a substantial rise in consumer prices. Monetarists point out that the bulk of this expansion is due to an accumulation of non-borrowed reserves, or money left on deposit at the Fed owned by commercial banks, and so not in general circulation. This increase is shown in Chart 2. In the neat world of the mathematical economist, price inflation will only take place when the banks draw down on these reserves to expand bank credit, presumably to lend to the private sector when the economy recovers. But the point that our neat mathematical economists miss is that the money is already in circulation, having been lent by the Fed to the Government through its purchases of Treasury bonds and T-bills.

The replacement of bank credit by expanding non-borrowed reserves amounts to a gift given by the Fed to the banks. Without it, the American banking system would simply be insolvent. The hope was that the banks’ future solvency would be guaranteed by the economic recovery, eliminating the need for the Fed’s continuing support.

In the last few weeks it has become apparent that the US economy is not recovering as forecast, and the decision has to be taken as to whether or not more monetary expansion is appropriate. While more quantitative easing may be required to keep the banks afloat, as a means of stimulating the economy, monetary expansion has not worked. The Fed will remain focused on keeping the Wall Street banks solvent, which is after all its primary function. It is therefore very likely that QE3 will happen in one form or another. To allay fears of price inflation, QE3 will probably be explained as necessary to stop an ailing economy from sliding into deep recession, so it will be introduced when this new trend is confirmed in the coming weeks. And it is interesting to note that Mr Bernanke in his speech at Atlanta this week has prepared the ground: “The economy is still producing at levels well below its potential; consequently, accommodative monetary policies are still needed.”

But this represents the triumph of hope over experience. There has been no net benefit to the economy from zero interest rates and an unprecedented expansion of the monetary base. In the face of a deteriorating economic outlook, the banks will continue to deposit the bulk of any new money at the Fed in the form of excess deposits, as they have been doing for the last three years. This might matter less if there is little practical difference between the monetary base and bank credit, but they are two very different things. To understand the different effects of the expansion of one relative to the other, we must differentiate between the drivers for changes in the general price level of goods and services, compared with those of assets typically used as collateral at the banks.

An increase in the quantity of money tends to be spent on goods and services, pushing up prices, as we have recently seen. The effect on capital goods is similar, though bank finance can play a role in overall demand, depending on the capital good. The effect of an expansion of money quantity on bank collateral is more complex: the lower interest rates that usually accompany monetary expansion tend to underwrite collateral values; however, in most cases buyers require bank credit to facilitate actual market transactions, and if this credit is not available prices will trend lower as forced sellers find no buyers.

Put more simply, narrow money tends to fuel purchases of everyday items, while bank credit is required to sustain asset prices. Consequently, a rapid expansion of the monetary base results in a fall in the currency’s purchasing power, or a rise in the general price level, while contracting bank credit can, at the same time, lead to lower asset prices. We see this in the US today with price inflation rising and house prices continuing to fall.

In the absence of growing demand for goods and services, the rise in prices is classic stagflation. Stagflation seems to be poorly understood by mainstream economists, who habitually associate price inflation with excess demand, not understanding that over-supply of paper money produces the same price effect.

The Fed appears to have fallen into this same trap, but being closer to the markets than theoretical economists it almost certainly understands better what is happening to prices. It is aware of the slide in the dollar against other currencies, and against commodities and raw materials generally. It also sees that despite expanding the monetary base in dramatic fashion the value of bank-held collateral is not improving. However, it cannot admit to stagflation and it continues to conceal its true motives of keeping the banking system solvent. The moment the Fed tells the truth, the markets would anticipate more inflation by devaluing the dollar and the big banks would suffer a run on deposits: the spell would be broken.

Instead markets prefer not question the Fed’s strategy too closely. Economists and market analysts, who rarely concern themselves with purely financial matters, discuss further quantitative easing only in an economic context. They are confused that monetary stimulation and the lower dollar have not led to a stronger economy. However, the failure of monetary stimulation to spark economic recovery was entirely predictable. It fails to address the underlying problem of excessive levels of debt; instead, monetary policy is intended to grow that debt even further.

At some stage, these inconsistences will be revealed for what they are. The markets’ ability to ignore the gathering clouds of stagflation, coupled with a banking system moving back into crisis, will be tested. The financing of a rising budget deficit at negative real interest rates, as the economy slides and revenues collapse, is unlikely to continue for long. The scene is set for both a lower dollar and rising bond yields. The distortions have been wound up so much that a return to normality will be a violent, disorderly event.

This is the eventual cost of expanding the monetary base so dramatically. And the option of abandoning weak monetary policies is not available, because a move towards sound monetary policies would break the banks, the stock market and the Government. The banking system, which is central to it all, has to be kept going at all costs.

Gold has only just started to anticipate this risk with its rise from severely depressed levels. The Western financial system, which has been in thrall to Keynes, is short of gold, and this folly is about to become more widely understood. Those central banks not sitting at the Bank for International Settlement’s high table see the danger, and are accumulating gold. Into this mix is thrown the West’s cold-war enemies, who have broken its monopoly of economic sophistication, replacing it with a newer, better model. Both China and Russia now have sounder monetary bases than America, Europe and Japan, because their banks are less geared and they recognise paper money for what it is. They have cleaned the market out of physical gold, and are certain to hold considerably more than they officially admit, while the US is suspected of exaggerating her holdings. Here again, the distortions are simply incredible, with over $50,000 of bank liabilities and monetary base in the US for every ounce of gold officially held by the US Treasury.

Those economists who think that any transition from today’s problems into tomorrow’s can be managed as an orderly event are simply naïve. But then they didn’t see the financial crisis of 2007/08 coming either. Ever greater manipulation of markets has developed distortions so large that a return to reality will almost certainly be sudden and violent. And then the Fed really will start creating money in earnest, to save the world. That’s when it all begins to fall apart.

9 June 2011

Alasdair Macleod

Financeandeconomics.org

macleod@financeandeconomics.org

[1] "The basic cause of inflation, always and everywhere, lies in the field of money and credit." Hazlitt in Newsweek, December 22, 1947, p. 68

Catch-22 for the Fed

2011-06-05T17:50:00.001+01:00

This article was written for GoldMoney and has been posted here

Catch-22 for the Fed

2011-JUN-04

In the last week there have been a raft of statistics showing that the US economy is weakening. The implications for other western economies are hardly bullish. They also strengthen arguments in favour of more reflation for fear of something worse. This is despite further increases in the US monetary base to a record $2.5 trillion. It is easy to forget that less than three years ago, when the economy was surfing on a fading credit bubble, the monetary base stood at a record $820 billion, so it has increased by over 300% since then. Compare this with the 44% rise over the preceding seven years. With such a substantial debasement of money it must be worrying to the authorities that there has been little discernible economic benefit.

The simple reason is that the banks have increased their reserves at the Fed, rather than lending them out to the private sector. This is reflected in non-borrowed reserves, which have increased from virtually nothing to nearly $2.5 trillion. It is because the money is sitting in the Fed that price inflation is not yet totally out of control, but inflation has the potential to become a very serious problem.

Putting this issue to one side for a moment, the Fed has to consider its actions in the coming months, taking into account the end of the stimulus from QE2 and the political deadlock over raising the debt limit. As regards the latter, the federal government is now running on empty, and its central bank is severely restricted in what it can do to help.

We will never know for certain if the Mexican central bank anticipated the Fed’s problem before deciding to buy 100 tonnes of gold, but for a NAFTA member to publicly break ranks and buy gold is quite a step. And for it to do this in a rising market is doubly interesting, because the vast bulk of the purchase was done before the April correction. It is also a clear signal that the cartel controlling the Bank for International Settlements is losing influence.

It is the Fed’s problem, rather than Greece’s impending financial collapse, that should be closely monitored by gold bugs. This is not to belittle European difficulties and those of the European Central Bank. But in a strict monetary sense, the ECB is not so far down the monetary inflation route as the Fed – yet. It is the Fed which has already expanded its money-quantity explosively, and is struggling to find further monetary fuel to lift the economy. It is the Fed that is locked on a course of accelerating monetary inflation, as those monetary base statistics show.

There is little doubt that the Fed will try to find some way to create more money while funding the deficit; we don’t yet know how. Even if this is achieved without all those non-borrowed reserves flooding into the economy, the risk escalates of a sudden loss of confidence in paper dollars. Both Keynesians and monetarists forming policy seem oblivious to the increasing possibility of a tipping-point being reached, where the dollar’s fall suddenly accelerates.

So whatever the true reason for the Mexican purchases of gold, it is an eminently sensible risk diversification out of dollars. Other central banks will surely have taken note.

Tags: central banks, dollar, gold investment, Mexico

Author: Alasdair Macleod

Commodities and a stalling economy

2011-05-16T10:28:00.002+01:00

This article has been posted at http://www.goldmoney.com/gold-research/commodities-and-a-stalling-economy.html

The sharp fall in prices over the last few weeks was not confined to precious metals, but affected a wide range of other commodities. Their prices have been rising for some time, reflecting dollar weakness, and there is little doubt that the whole complex had become over-bought.

The sell-off coincided with growing evidence of a slowing American economy. It is becoming clear that the Fed’s monetary stimulus has had little economic benefit and analysts are revising their GDP forecasts downwards. Simplistically, this lowers potential demand for all commodities, including energy, so on the face of it prices must be too high. But this simple argument ignores the fact that the price of any commodity also reflects the value of the currency in which it is priced. So in dollar terms, commodity prices have risen strongly, but in real terms many of them have hardly risen at all.

Not that it is easy to separate out currency weakness from increasing commodity demand, but we can easily understand the principle. It allows us to sensibly dismiss arguments that commodity prices have been in some sort of bubble and instead accept that high rates of monetary inflation are undermining the purchasing power of paper currencies.

And now that America faces a disappointing economy, we must think about the Fed’s next monetary response, rather than just the effect on commodity demand. A weakening economy must surely encourage the Fed to continue with monetary easing when QE2 ends next month. The Fed is paranoid about the risk of sliding into deflation, and will do anything to stop it. This is generally bullish for gold and silver, so we can conclude that the events that triggered a decline in commodities should also be positive for precious metals. However, other commodities are unlikely to fall much, because their prices should reflect continuing dollar weakness. The mini-crash of the last few weeks may be a buying opportunity for the whole asset class, particularly when countries like China continue to dump dollars for raw materials.

But there is also a big change in pricing dynamics for gold and silver, which everyone in the blog-o-sphere has missed, and it is simply this: the underlying reason behind the take-down in gold and silver is that the commercial shorts know the fundamentals have turned against them, and they also know they are wrong-footed. They are not blind to a further extension of zero interest rates and the inflation risk from that. Nor are they blind to the turnaround in central bank demand for gold. Nor are they blind to rising demand for gold and silver from the newly-affluent in Asia.

This knowledge summarises a few of the changes in financial markets since the collapse of Bear Stearns and Lehman Bros. Because of these changes the commercial shorts desperately needed a get-out-of-jail card, and that was the logic behind the manipulation of gold and silver prices. They have reduced their shorts and have probably acquired stakes in the big ETFs, which they can redeem for physical metal to meet demands for physical delivery. They are now set up as much as they can be for the new realities in precious metal pricing.

Understand this and you understand the fundamental shift that will drive gold and silver prices in the coming years.

15 May 2011
Alasdair Macleod
macleod@financeandeconomics.org
www.financeandeconomics.org

Bernanke boxed in

2011-05-01T08:54:00.001+01:00

The following article has just been posted at GoldMoney, here.

After the first-ever Fed press conference, gold and silver rose sharply. This was hardly a vote of confidence in paper money.

Perhaps the event and the Federal Open Market Committee statement that preceded it were over-hyped, but both events were disappointing – ducking as they did the important issue of what happens after QE2 is completed. The statements on inflation did little more than recognise a temporary and small – or “transitory” – pick-up in prices. By revising downwards estimates for economic growth over the next few years, the Committee claims that inflation will probably subside. In any event, the Fed is more concerned with the risk of inflation being closer to zero, given the risk that the economy might then tip into deflation.

All in all, the statement and the press conference exposed the weakness of the Fed’s position. We are left with the thought that if a Paul Volcker were in charge, things would be very different. A return to sound money and a stabilised dollar would be a pre-emptive strike against both global and US inflation, and the experience from the Volcker era is that economic growth was much better than might have been expected following interest rates of 20%.

But there is a crucial difference today compared with 30 years ago. The level of private sector debt is substantially higher, and shows a strong tendency towards contraction. High interest rates are not actually needed to reduce demand, because bank credit, which is the counterpart of private sector debt, has been contracting of its own accord. It is this that frightens the Fed most, because contracting bank balance sheets are very difficult to manage without risking a full-blown banking crisis.

So it is the difficulty of keeping the banking system running while there is credit deflation in the air that actually pre-occupies the Fed. This is more important than the official mandate of maintaining a low rate of inflation consistent with high employment. But by focusing on keeping the banking system solvent, the Fed is taking enormous risks with monetary inflation. The unprecedented growth in raw money, reflected in the increase of the monetary base since the Lehman Bros crisis, has been designed to offset the contraction of broader credit, and is deemed by the Fed to be non-inflationary overall.

Economists generally support this view, taking comfort from the build-up of bank deposits on the Fed’s balance sheet in the form of non-borrowed reserves. They argue that only when the banks draw down on these reserves to use as a base for further bank lending will the inflation risk escalate. But this argument ignores the fact that this money is already in circulation through government spending.

There may have been nothing new from the FOMC statement, and nothing about QE3, but in the absence of more positive measures the markets have the confirmation they need that the dollar is headed lower. The Fed is boxed in. No wonder gold and silver rose so sharply.

I May 2011

Alasdair Macleod

www. Financeandeconomics.org

New article for GoldMoney

2011-04-24T08:36:00.001+01:00

GoldMoney has posted my new article entitled “Will governments confiscate gold?” here.

Regards

Alasdair Macleod

Articles for GoldMoney

2011-04-17T19:52:00.002+01:00

I am now writing a weekly column for GoldMoney, and the first article was posted last Saturday, here:

http://www.goldmoney.com/gold-research/anatomy-of-a-short-squeeze.html

These articles will have a precious metals or sound money theme, and be approximately 500 words. My regular articles will continue, but possibly every two weeks rather than weekly.

If you have an interest in precious metals I urge you to take time to look at their website.

I shall send a link to the GoldMoney articles as and when they are posted.

Regards

Alasdair Macleod

FinanceAndEconomics.Org

Interest rates and Plan B

2011-04-11T09:36:00.003+01:00

The online version is here

The ECB's interest rate increase last week has been heavily criticised because it makes the rescue of the PIIGS more difficult. It might however turn out to be a sensible move: the rate increase and the one or two that will surely follow should actually have a restricted impact on the funding problems round Euroland, while the ECB bolsters its anti-inflation reputation. Furthermore, this and further small rises over the course of the year give cover for the ECB to do things that don't make headlines, particularly with respect to extending credit to insolvent banks to keep them from going under.

The Fed can now be expected to follow suit, to steady the dollar, and because a middle way between simplistic alternatives has to be found now that zero interest rate policy (ZIRP) has more or less run its course. One of the stark alternatives is to end quantitative easing and permit far higher interest rates, plunging the Obama administration into bankruptcy and the US economy into deep economic cleansing. The other is more ZIRP plus QE3 resulting in accelerating stagflation, made worse by a rapidly depreciating dollar. So a middle course between these two has to be chosen very carefully.

The debate over this looming crisis is deeply unsympathetic to the real issues facing the Fed. Commentators seem unwilling to appreciate there is much going on behind the scenes that drives actual policy, and that Bernanke, Trichet and King are in constant communication in these difficult times. Critics seem unable to understand the central banks' primary concern, which is not inflation: it is keeping over-leveraged insolvent banks afloat through a period of private sector credit deflation.

The problems facing the fractional-reserve banking system have worsened since the Lehman crisis, but bank solvency is rarely the headline story. In the US, nearly 25% of households have zero or negative net worth, compared with 18.6% in 2007. Home values have fallen by $6.3 trillion since 2005. Last year, 12.5% of households had at least one member unemployed, and household debt has reached 136% of average household income[i]. These statistics warn us that if the American economy doesn't recover, there will be a home-grown banking crisis. Furthermore, the banks themselves are becoming complacent, having tucked away losses with the connivance of the Federal Accounting Standards Board. Out of sight has become out of mind, and as long as the Fed can produce the cash flow by buying debt at artificial prices, why worry?

It is however naïve to think that the Fed is unaware of the fragility of the domestic banking system, and it is also naïve to think that central banks have no co-ordinated plan to deal with a major banking crisis. They will have examined any amount of what-if scenarios, from a derivatives melt-down to an old fashioned bank run spreading throughout the system. They will have worked out plans together to respond to a full-blown crisis. And you can bet short odds that the major central banks are being very careful with interest rate policy while the system is so fragile, which is why it is unlikely that the ECB's increase last week was enacted without careful consideration.

Obviously, this has increased the pressure on the Fed and the BoE to raise interest rates sooner rather than later. Furthermore, the Fed and the BoE are having their hands forced by the unstoppable rise in gold and silver prices. This is a suppression scheme the central banks have finally and demonstrably lost, and in doing so the mounting costs of the short positions on Comex and in the unallocated accounts of LBMA members have become a serious systemic risk. And rising commodity and energy prices show the Fed's ZIRP to be inflationary and no longer appropriate. The Fed would have preferred to wait for more evidence of economic recovery before raising rates, but it no longer has that luxury.

The reality is that the Fed is fighting a losing battle, but it must continue the fight. The Fed has delayed the end of ZIRP as much as possible by spinning the myth that core inflation is still low. The point has arrived when the Fed should take the initiative and increase interest rates by a first small step. This would be designed to take the steam out of gold and to help stabilise the dollar, thereby reducing inflation concerns. At the same time, it will make little difference to both banking and government funding costs.

Doubtless, the Fed will be accused of having to raise rates because of the ECB's rate increase. The reality is that the Fed will have known about the ECB's rate increase well in advance and has been prepared to abandon ZIRP at the appropriate time. A virtue can be made from a necessity: the end of ZIRP will act as a passport for the Fed to continue with quantitative easing programmes, because even with a rise in Treasury yields, no one else is going to fund Obama's deficit. The Fed's monetary policy will come into line with the ECB's: raise interest rates as little as possible, while bailing out both government and the banks through the banking system. And above all, pray.

With the end of ZIRP the over-riding economic objective has to be to stop the US from sliding into depression. It is still the economic locomotive pulling the western train: if the locomotive fails the train stops. Any time purchased by money-printing allows us to continue to travel in the hope that recovery is round the corner, otherwise the banks' balance sheets will start to contract in earnest. The share prices for Bank of America and Citigroup, for example, indicate that these banks, which are both major components of America's financial system, are unable to take much more financial stress. And if you discount the puffed-up statistics on unemployment, inflation and GDP, the US private sector is actually sinking. But US interest rates can probably be raised by a few small steps without too much damage, so long as QE programmes continue to fund the deficit.

This time-purchase scheme is bound to fail eventually, if the system is not undermined by a black swan event first. But again, we can be reasonably sure that the ECB, Fed, BoE, BoJ and other important central banks will have developed contingency plans for this event. Indeed, only today the UK's Independent Commission on Banking has proposed that the banks ring-fence domestic banking from non-domestic banking. This will ensure that lines of credit, deposit accounts and the cash machine network will continue to operate in a systemic crisis. It is the only practical strategy for keeping money circulating in the domestic economy in a banking crisis, and you can be reasonably sure it has been pre-agreed with the Bank of England.

This strategy makes sense, but the implications should be thought through. The plan implies that in a financial storm domestic banking activities would automatically pass into public control. This would be politically popular; the unpopular bit would be to preserve the fat-cat end of the business. However, the strictly financial activities of banks are also necessary for the survival and operation of high-street banking, so they have to continue uninterrupted as well. This can be achieved both practically and politically by giving the task of rescuing international and investment banking activities to the central banks.

Thus we have the makings of a global Plan B, to be implemented if a black swan arrives or the US economy fails to recover. Will it save the banks? Possibly, but the price will be an acceleration of money-printing to save the system and then pay for it if the plan fails. Above all, Plan B will prevent an economic collapse occurring through a lack of paper money. And because economists like Dr Bernanke have dedicated their working lives to preventing the deflationary alternative, it is time for him to go for Plan B and raise rates by one quarter of one per cent.

11 April 2011

[i] See http://www.lewrockwell.com/rep2/depressing-stats-us-economy.html

Alasdair Macleod

FinanceAndEconomics.Org

Bank regulation

2011-03-30T14:00:00.002+01:00

The online version is here

The regulation of banks simply does not work and has led to a serious loss of public credibility in them and of confidence in their true motives. Almost all of the problems arise from their activities in securities markets, rather than traditional banking. The conflicts of interest and profitability of these fee-earning and trading activities have been growing, dwarfing the importance of normal banking income. These factors are irreconcilable, and a sensible unregulated business would have decided long ago where its true priorities lie, so that they may focus on them by ceasing any conflicting activities.

Government-sponsored regulation therefore fundamentally alters the competitive picture by legitimising the natural desire of banks to maximise their financial power, rather than compete in a free market for customer business. In this sense, the regulator has become the tool of the monopolistic banks, because the regulator is the path to that power.

The relationship is always presented the other way round. A good example of this occurred last year, when JP Morgan Securities Ltd in London was fined $33.32m by the Financial Services Authority for co-mingling segregated client funds with the parent bank's assets.

This is extremely easy for a bank to do, deliberately or unwittingly. The JPMSL case involved client money held in connection with futures and options business over a seven year period, and the balances fluctuated between $1.9bn and $23bn. These balances were deposited with JPMSL's parent, JPMorgan Chase Bank, so in the event of JPMCB going bust, segregated client funds would become the property of the liquidator. According to the FSA statement this "error" was not deliberate, and was "self-reported". The implication is that regulation works so well that even a major banking organisation confesses to regulatory breaches that might otherwise have gone undetected.

If the law had not been changed in the first place to accommodate the role of the FSA and the legal status of its regulations, the error would arguably have been criminal. The confusion initially arises from the benefits conferred on a bank by its license, which allows a bank to take someone else's property onto its own books and use it for its own benefit. Anyone who does this without a banking licence clearly commits fraud, and this must also apply when a bank offers non-banking services, because its customers by definition are not in a banking relationship. JPMCB's compliance department should have been alive to this possibility when JPM merged with Chase Bank, which is when the problem first arose. And the management of JPMSL's futures and options business should have thought through the implications for their customers, rather than not thinking at all.

But the question that jumps out from this episode is why did the FSA itself not detect this gross breach in any of its routine and ad-hoc inspections from December 2002 onwards, when the breach first occurred? The first thought in an inspector's mind should be to examine all possible conflicts of interest arising between a subsidiary and its parent. Furthermore, all regulated entities make periodic returns, so any deposits from separately licensed subsidiaries should be apparent and therefore questioned. And while failing in their stated duties the FSA employs 4,000 full-time staff on an annual budget of £500m.

The answer is that the regulator is primarily a government bureaucracy, and only secondly a watch-dog for the protection of market participants: the priorities are firmly in that order. There is no mechanism for placing a value on the FSA's role, so it cannot be otherwise. As such, the FSA can never do its job satisfactorily, and it will always manage itself in order to satisfy its own priorities ahead of those of the public. To demonstrate that it is actually doing the opposite, the FSA relies on an enormous and complex rule book, with the result that regulated businesses are required only to comply with it. Any other business considerations, such as a primary duty to the customer, come a poor second. Thus, the creation of a regulatory bureaucracy, responsible primarily to the political elite and the powerful banks rather than the markets, has played a large part in the destruction of traditional business ethics in the UK's financial sector.

It is perhaps ironic that the FSA is unable to understand its own limitations, but joins in attempts to limit super-regulation from Europe. The FSA can grasp the political intent from Berlin and Paris to limit London's role as a competitive financial centre, but fails to see the damage it has wreaked itself at the behest of British politicians. However, the inability of regulators to discharge their allotted functions is also evident in America.

The US Commodity Futures and Trading Commission was established to regulate futures and options markets. But the same rules apply: the CTFC's primary responsibility is to the political elite that created it and its own organisation rather than to the market itself, which is a secondary consideration in common with all government-sponsored regulators.

The result is the CTFC does not have a free hand in policing the market and controlling systemic risks, which, if the role of the CTFC could be valued, is what the users of the market would probably require. Even though the CTFC has just closed a public consultation period where it has sought the views of all market participants, it will only enact those changes that do not conflict with the interests of the powerful vested interests that govern it. So the wider users of the market who expect unbiased results will again be most probably disappointed.

The relationship between regulators and the powerful monopolist banks has become one of servants and masters respectively. The CTFC has recently rubber-stamped an application by JPMorgan to operate a Comex/Nymex precious metals storage vault, in a fraction of the time usually taken for such an authorisation. One is left wondering whether the speed of processing the application reflects the desires of the CTFC's true masters. But, as Mark Anthony said of Brutus & Co., "They are all, all honourable men." The power of JPMorgan and its long-running short position in silver make us vulgar mortals intensely suspicious of their motives. Can we really assume that they will use the facility honestly for their customers, and never for their own ends?

The granting of this precious metals depository licence follows the opening of JPM's precious metal storage facility in Singapore and its announcement that that it is prepared to accept gold as loan collateral. On the face of it, JPM's management have decided that precious metals will continue to be a growing business for JPM's customers for years to come. But anyone depositing gold with JPM as collateral should be careful that the loan agreement stipulates it is held separately by JPM as custodian, and the same identified bars are to be returned at the end of the loan.

But hey, friends, Romans and countrymen, perhaps this caution is undue, because JPM's management are all, all honourable men. And remember, while you may end up out of pocket, those regulatory boxes will have been well and truly ticked.

30 March 2011

Alasdair Macleod

FinanceAndEconomics.Org

Inflation and equities

2011-03-25T08:30:00.001Z

This is the third article in a series describing the disadvantages of inflationary policies. The online version is here.

There is a general belief that equities offer the best protection from increasing inflation. This over-simplifies the relationship between share prices and inflation and is only true in certain circumstances. Gold and silver mining enterprises however are the true beneficiaries of inflation, but for investors in bog-standard equities there will be substantial losses before the final inflation protection kicks in.

The perception of the benefits of inflation to share prices often arises from a comparison to bonds. But on a total return basis, assuming reinvestment of income, the returns are actually not much different. The annual return on the ten-year US Treasury bond over the last forty years was 7.18%. A lump sum invested in this instrument in 1971 with income re-invested would be worth nearly fifteen times as much today, while an investment in the S&P would have grown only thirteen times, to which one must admittedly add re-invested dividends.

A greater influence by far is changes in interest rates. Over the credit cycle, interest rates are initially depressed by the central bank to encourage business investment and economic growth. It is at this point that equities are usually in well-established bull markets. The pundits will tell you that equities are discounting improving profits; while there is some truth in this the realty is that equity prices are benefiting mostly from the expansion of money and credit and low interest rates. But the longer that interest rates are held artificially low, the greater the expansion of money and credit and the greater the inflationary pressures that result. Eventually interest rates have to be raised, to the detriment of both bond and equity prices.

The credit cycle in this simple theoretical example should perhaps be completed by the excesses of money and credit being withdrawn: in other words the mistake of an expansionary monetary policy is realised and corrected. In reality, there is a ratchet effect, because the credit created in the previous cycle is allowed to stand, and the general price level is not permitted to fall. Consequently, the cumulative effects of these credit cycles are reflected in the long-term trend for inflation. Share prices reflect this trend through progressively rising cyclical highs and lows, supporting the contention that equities offer a hedge against inflation, while conveniently overlooking the bear markets at the end of each credit cycle.

The situation today is radically different in an important respect. Interest rates are at record lows and have fuelled share price rises, conforming to the first phase of our credit cycle model. But instead of inflation arising from excess demand, we have stagflation, the result of excess money in circulation. Consequently, the prospect is for increasing interest rates without the usual economic recovery.

This statement needs further amplification: the tentative signs of recovery are misleading in the US, the UK and much of Europe. The unprecedented quantities of raw money injected into these economies have been about as effective as trying to kick life into a dead body. Meanwhile, the emerging market economies, which have fuelled export demand for the West, are over-heating; credit is tightening and these countries are in the later stages of a conventional credit cycle. The potential for emerging markets to create a tide of rising employment in the mature economies is not there, because this tide has turned and is now on the ebb.

So corporations in the Western economies now face a future of rising interest rates and deteriorating earnings. Not only will this make their share prices vulnerable to rising interest rates, but it will radically reduce hoped-for earnings. Therefore, stagflation has the potential to undermine equity markets with a bear market of greater than normal magnitude, destroying any link that protects investors in equities from inflation. There is a good historical precedent: the 1972-74 bear market in London reflected the last severe bout of stagflation, when similar economic dynamics were in play, and when the All Share Index fell over 70%.

To relate inflation prospects to equity prices in all their totalities we must broaden our debate. In the current economic context, excessively high levels of monetary inflation from the US are beginning to be reflected in growing price inflation in nearly all fiat currencies. Keynesian economists and other wishful thinkers in the West continue to attribute rising price inflation to external factors, dismissing the monetary link. They say the demand for food and raw materials in emerging economies is driving up the prices of essentials, and political disruption in the Middle East is blamed for rising energy prices. Those in charge dare not admit the obvious link between excessive growth in raw money and inflation. Some, like the Governor of the Bank of England, believe there is insufficient demand in the economy for prices to continue to rise at current rates. Others claim that higher energy prices will reduce demand from cash-strapped households for other goods, concluding that these higher energy costs are actually deflationary for other prices, and implying that the wrong thing to do is to raise interest rates. These are simply arguments by the authorities and their economic advisors who are in denial, and they are consistent with the uninformed level of debate usual in the early stages of stagflation.

Even though it is slowly becoming clear to governments around the world that the rise in the general level of prices is actually a real problem, policy responses will inevitably be too little, too late. This is partly due to confusion among government economists and central bankers, but also fears of the deflationary alternative. Furthermore all central banks tie their currencies to the dollar in the belief this is necessary to protect trade balances, so where the Fed’s monetary policy goes, the others have to follow. For this reason the inflationary effects of the Fed’s unprecedented levels of money creation are being transmitted into all fiat currencies.

This is the principal danger to international stability currently posed by the world’s reserve currency, and government finances in the US today are so bad that it has no political option but to continue with monetary inflation in accelerating quantities. Furthermore, the Keynesian mindset justifies this flood of money as the only appropriate response to a stalling economy. These circumstances lead us to conclude that the current emerging period of stagflation can only be followed by hyperinflation, not just for the US dollar, but for all paper currencies. And when inflation rises to, say, thirty per cent, interest rates will be at least in the upper teens or twenties.

It is this background that investors have to consider. Those seeking protection in equities from this deteriorating outlook will have to allow for more interest rate rises, escalating raw material costs for companies and collapsing consumption. Essentially, the companies that survive a hyperinflation will do so by winding down their operations. There will be little or no escape for investors in companies with foreign earnings, because today’s inflationary problem is global, thanks to the Fed’s money-printing. The eventual rise in equity prices at a time of hyperinflation will therefore reflect the flight out of paper money more than anything else, and in this respect will behave like any other physical asset in a currency’s dying moments. It is Ludwig von Mises’s crack-up boom, and there is no point in investing today in any assets based on this eventuality.

The only sector that truly benefits from the death of paper currencies is precious metals. The miners will enjoy rising prices for their output, and dramatically falling costs of production, measured in gold or silver. Net income, measured in paper money, expands exponentially, even without any increase in production. The costs of raw materials and equipment will rise in paper currency terms, but will be falling heavily priced in gold and silver, reflecting the general collapse in economic demand. The cost of labour will also fall in real terms, and the cost of capital will becomes immaterial, as legacy debt is inflated away and operations are funded entirely out of escalating profits.

So investors who think that investment in equities offers the benefits of inflation protection in this uncertain economic environment will be in for a rude shock, unless they restrict their interest to gold and silver mines.

25 March 2011

Alasdair Macleod

FinanceAndEconomics.Org

The online version is here

How precious metals will replace fiat money

2011-03-17T09:07:00.002Z

The online version is here

How precious metals will replace fiat money

It is only a matter of time before the global banking system unravels. For those of us planning for life after such an event, it is time to think what might replace fractional reserve banks and the paper money that is their stock in trade, but first we must understand why modern banking is certain to fail.

The seeds of the banks’ destruction lie in the fractional reserve system, whereby banks lend out many times their capital. The problem with fractional reserve banking is that if a number of a bank’s depositors decide to withdraw their money at the same time, the bank might only be able to satisfy a fraction of the demands. This is the permanent state of modern banking.

In our hearts we know this, but we have confidence that bank runs will not happen. In the current financial climate this view is dangerously complacent. The five to ten per cent of core capital in each of the large international banks is badly impaired, with these impairments swept under the carpet by accounting standards designed to conceal the true position instead of inform creditors. Again, we all know this.

However, it is increasingly clear there will be a global slump in business activity, as higher inflation kicks in and interest rates inevitably rise. Banks will face an escalation of bad debts as a result of higher interest rates that will eliminate much, if not all, of their remaining capital. Unfortunately, the abilities of governments to back-stop the banks are now very limited, because of the unprecedented deterioration in government finances since the first banking crisis.

The international nature of modern banking exposes even relatively sound banks to risks from bad debt contagion, if not at first hand, then through interbank relationships that were previously sound. The collapse of Irish, Portuguese or Spanish banks has the potential to undermine British, French or German banks, and therefore all their counterparties elsewhere. There are many chains of risk like this, respecting no borders. While there is much that can be done out of the public’s sight, it will be very difficult for governments to foist a second banking rescue on their electorates, because they have unwisely encouraged everyone to believe banks and bankers are evil and do not deserve public support. For this reason the only option central banks have is to continue to flood the financial system with new money to compensate for the deflationary effects of contracting bank credit. This new money in the central banker’s mind can be directed to supporting the weaker members of the banking system, and in the Keynesian mind, provide vital economic stimulus. But since successive tranches of new money are having less effect, the amount required continues to escalate.

This is why central banks are unable to stop issuing paper money, because to turn off or even to restrict the flow of the money-tap would fatally undermine the commercial banking sector. For this reason central banks have no option but to deny that inflation is a growing problem, otherwise they have to stop printing money and let interest rates rise.

So put simply, the future we face is that the entire banking system will sink, along with the purchasing power of paper money. Fractional reserve banking has been with us too long, so we have to consider what will replace it, having no working knowledge of any alternative. In doing so, we also have to consider what we want the bank of the future to do.

The original function of a bank was to hold deposits safely, and facilitate customers’ payments. If a bank lent money to a borrower, it had to be the bank’s own money and not taken from deposits entrusted to them by depositors for safe-keeping. It was clearly set out in Roman law that to take a deposit and then use it for your own purposes is theft, and that is still true for all of us today, unless you have a banking licence. However, a loan to a bank is an entirely different thing, because the relationship between the parties is clearly established. Like any business, a bank can use a loan for its own benefit, and in the event of the borrower’s bankruptcy the lender is simply a creditor. It is these two basic relationships, depositor and lender, that get rolled up into one by fractional reserve banking.

There have been many instances of governments exempting banks from Roman legal principals over deposits, usually because it has allowed governments to borrow money in greater quantities. This is as true today as it was in ancient Greece and Rome, for the Florentine and the Catalonian banks in the fourteenth century, the Medici Bank in the fifteenth, the banks of Salamanca in the sixteenth, John Law in France in the eighteenth, and finally the fractional reserve system supervised and guaranteed by central banks since Peel’s Banking Act of 1844.

These are just some examples of banking systems which start off respecting the custodianship of deposits and then sequester them for their own use. The fact that all this has happened before with predictable outcomes nails the lie that this time is different, or that we are now more sophisticated in our financial knowledge. The co-mingling of deposits, loans and bank capital almost always ends with bank failures, which is the true precedent for today’s banking outcome. Our banks have highly-geared balance sheets in uncertain times: these are precisely the conditions that end with a run on deposits, and because the global banking system is already under great financial strain, it is hard to see how they will avoid the mass failure predicted by the history of human behaviour.

The failure of the banking system does not deny the usefulness of an institution whose function is to look after customer deposits, but the business model will have to be entirely different. Since these deposits cannot in future be loaned out, they gain no interest; so paper currencies that lose purchasing power are unsuitable as a store of value. The only secure bank deposit system that truly works has to be based on gold and silver.

This true depository service already exists in bullion dealing and depository facilities, the model for which is provided by GoldMoney, based in Jersey[i]. They store customers’ bullion in secure storage facilities with no bank involvement. And they offer the further advantage of storage in a choice of different jurisdictions. With little or no modification to their businesses, bullion-dealing depositories can provide this facility to a wider public, allowing customers to access their deposits and make payments without going through a fractional reserve bank.

For example, assume you employ a local tradesman. To pay his bill, you get him to open an account with your bullion-dealing depository, and transfer to him the gold or silver equivalent of what you owe him. His bill is settled without the involvement of the banking system, and he has the wherewithal to pay his bills in the same way. It is also possible to envisage a network of these bullion-dealing depositories settling transactions for each others’ depositors. This network could grow rapidly as the payment system spreads.

The advantages of such a system include self-regulation, because bullion-dealing depositories are not required to be licenced to misappropriate customers’ deposits. And in the event of a banking wipe-out, customers of these bullion-dealing depositories will be in a powerful position, because at the outset they will be the only people able to settle transactions without resorting to barter, physical metal or Weimar-style cash.

It seems ironic that the greatest danger posed to personal wealth, apart from inflation, is from respected, regulated banks. With their demise, and the end of fractional reserve banking, the need for bank regulation will entirely disappear. Since bank regulation is one of the two primary responsibilities of central banks, the collapse of paper currencies will leave them wholly redundant, and finished as institutions.

While advocates of sound money will welcome the end of central banks, it will nevertheless be important to protect oneself from the event. A store of value in precious metals held and accessed independently from the banking system appears to be the logical conclusion.

17 March 2011

[i]GoldMoney was set up by James Turk, who foresaw the need for a post-banking settlement and bullion storage facility. It is the only precious metals depository business of which the writer has first-hand experience. There are others, that may not share quite the same vision, and it goes without saying that the reader must make his own inquiries before opening an account with any of them.

Web www.financeandeconomics.org

Rising interest rates and precious metals

2011-03-10T16:12:00.002Z

Concerns are growing that dollar interest rates are due to rise in the coming months, which will obviously bring about fundamental changes to the valuations of all asset classes, including precious metals. However, precious metals should weather rising interest rates best. At the other end of the risk spectrum lies government bonds, and the most powerful endorsement of these concerns is the elimination of all US Treasuries from the PIMCO Total Return Fund. This fund is the largest bond fund in the world and is dollar-based, so this is a very, very important signal for both the Fed and other bond investors.

We do not know to what extent PIMCO’s investment committee shares the concerns expressed in my article of last week about governments losing control of the markets, but they obviously expect a significant rise in yields all along the curve. Higher yields will affect all conventional asset classes for obvious reasons, but the effect on precious metals is not so clear cut. There are two ways in which rising interest rates affect any asset class, including gold and silver: these are the higher risk-adjusted returns available on investment alternatives, and the financing cost of holding an investment position.

Physical gold and silver, except leasing and backwardation opportunities, offer no yield, so an increase in interest rates reduces their relative attraction to other asset classes. While this may deter investors from increasing their exposure to this asset class, their very limited exposure of less than one per cent, means they have little to actually sell. Public, as opposed to portfolio exposure is mostly through ETFs, which can sensibly be classified as hoarding, rather than investment; so many, if not most of ETF shareholdings are not subject to portfolio management considerations. Furthermore there is a tendency for investors to regard precious metals as an insurance policy, so higher returns on other asset classes is not in itself a reason to sell.

Greater selling pressure will be exerted on geared portfolios, and in this respect, ownership of physical metal is limited. The hedge fund industry does have some physical gold exposure, but this is generally ungeared and restricted to a small number of specialist funds. Almost all the geared activity by hedge funds and other speculators is in the paper markets, particularly futures and options. But margin requirements mean that both longs and shorts are equally affected by a rise in borrowing costs, so higher interest rates are basically an incentive to reduce positions overall.

However, the incentive is not even. The cost of finance for futures margins is both lower and its availability is greater for the large banks, which are almost all short. They can therefore be expected to use higher interest rates as an opportunity to increase their positions and force prices lower.

The foregoing gives us a brief technical summary of the precious metal markets in the event of rising interest rates. We can conclude that selling pressure on the physical will be generally limited, and selling is more likely to be seen in the futures markets. To assess the overall importance of these factors, we must broaden the debate to consider the impact of the wider financial and economic background. Of far greater relevance is the impact of rising rates on the dollar, and this is what we must next consider.

On the face of it, rising interest rates will attract investment flows into the currency, making it rise. Dollar bulls might also argue that significantly higher rates leading to asset liquidation would also be good for the dollar, since dollar cash represents the risk-free position for most international portfolios. There is some logic in this, but the UK’s experience in the 1970s strongly suggests this might not be the case.

The various UK governments of the time tended to run uncomfortably high budget deficits, funded by sales of gilts and an expansion of money supply. When there was insufficient demand for gilts at the prevailing yields, the Bank of England was faced with a choice: raise interest rates, or print money. Under political pressure not to raise rates, and being of Keynesian persuasion, they always chose the latter as a temporary measure, in the hope they could buy enough time to lean on the pension funds and insurance companies to buy more gilts with their accumulating cash.

Unfortunately, not selling gilts and printing money heightened inflation fears among fund managers, and crucially, foreign holders of sterling. This was the basis of a self-feeding cycle of currency weakness leading to higher raw material costs, rising stagflation fuelled by printed money, and to falling real interest rates due to increasing inflation. So yet higher gilt yields were required for successful funding.

The BoE was always behind this curve, raising interest rates insufficiently to break the funding log-jam. Eventually, they would be forced to raise interest rates suddenly and substantially to regain control of the gilt market. Gilts would then be sold in greater than needed quantities, sterling would recover strongly and interest rates would fall.

A repeat of this uncomfortable experience is now faced by the US today. PIMCO’s investment strategy is an advance warning of a buyers’ strike, whereby Treasury auctions will fail to attract real buyers. Their failure may well continue to be covered up for a time through QE2 to QEn, or by central banks buying each others’ issues and other such actions; but now that stagflation has become a real threat, we must consider the possibility that attempts to overprice Treasuries by these means will backfire badly on the currency.

We must consider the consequences of the Fed always being too slow to raise interest rates, just as the BoE was in the 1970s. We must also consider the consequences of money being deterred by a rising interest rate trend and its effect on bond and asset prices, rather than attracted by better nominal returns. The political and economic pressures not to raise interest rates sufficiently are greater on the Fed today than they were on the BoE in the 1970s. Furthermore, America has the added burden of being deeply ensnared in a debt trap, where higher interest rates increase the future borrowing requirement disproportionately.

The betting has to be that the Fed will try to keep real interest rates negative by any means. To fail to do would bring forward a national debt crisis that would most probably break the banks, whose loan collateral would then be collapsing in value. With or without a banking crisis, government revenue would collapse and its expenditure escalate. So long as this is the case, further inflation or stagflation is the most likely outcome, which is generally beneficial for precious metal prices in dollar terms.

America is not alone with this developing problem: the UK, despite her attempts to rein in public spending, faces the problem as well, and the EU is a smorgasbord of escalating funding requirements. For this reason, the hedge against a falling dollar cannot be to find refuge in these currencies. If anything, the US, UK and EU make the problem far worse for each other by having to compete for genuine funds. The only other large and liquid alternative, the Japanese yen, is not now seen as a lower-risk alternative and other currencies are too small to absorb the large money flows seeking protection from the collapsing purchasing power of the dollar, euro and pound.

It is against this background that precious metals will be valued. The markets for them are simply too small to absorb the trillions seeking to dodge the deteriorating fundamentals behind the major currencies. This does not mean they will be overlooked: rather, the potential for them to rise is greatly enhanced. Precious metals markets will not be too small for portfolios, whose exposure as a whole is estimated to be only 0.6%. They can readily increase their exposure through ETFs and mining shares at the expense of other asset allocations. Nor will the desire of Chinese and Indian hoarders diminish, instead it will accelerate.

The question remains, to what extent will the banks running short positions in precious metals on the futures markets manage to manipulate prices downwards, on the basis that rising interest rates should lead to lower prices? There is little doubt they will try it, but so long as real interest rates adjusted for both actual and prospective inflation remain negative, the strategy seems certain to backfire.

We can therefore conclude that rising dollar interest rates will be the result of a drop in the currency’s purchasing power, and not a tool used by the Fed to support the dollar by taking advance action. So long as this remains the case the bull market in precious metals will continue its powerful course.

11 March 2011

Alasdair Macleod

FinanceAndEconomics.Org

Governments are about to lose control of the markets

2011-03-07T10:02:00.002Z

The website version is here

The low interest rate honeymoon is coming to an end, and we can now expect rates to rise and continue to rise for the foreseeable future. For Western economies and their banking systems it is the worst possible time for this to happen. The reason interest rates will go up is because inflation, not deflation, now presents the greatest danger and a policy response is required.

Agricultural commodity prices have been rising for some time, and the central banks have dismissed them as being due to special factors and too small a part of the CPI to worry about. To this inconvenience can now be added the political revolutions in the Middle East and their effect on energy prices. It is perhaps this development that forced Jean-Claude Trichet to break ranks last week and admit that the ECB will have to consider an interest rate rise.

There is no such admission from Mr Bernanke and Mr King, the latter still denying that an official UK inflation rate of over 4% requires remedial action. And this high inflation rate was recorded before the current jump in energy costs. All three central bankers have been effectively caught on the hop by events. They have been ignoring inflation while wrestling with two immediate problems: financing government budget deficits and keeping the banking system alive. For these reasons the Fed and the BoE have been simply printing money by buying government debt. What made this strategy attractive is that it lowered the cost of government borrowing below that demanded by the free market, making government finances appear far better than they would be without this intervention, and at the same time it gives valuable breathing-space to the banking system.

Consequently, there is money in circulation that will have to be neutralised if inflation is to be controlled. It will require the central banks to sell back into the markets much of the government stock they have accumulated, at the same time as government borrowing continues at its high pace. This will force governments to bid up against their own central banks in the market for private sector savings. The increase in interest rates along the yield curve would therefore be sudden and brutal, and theoretically only stop when enough consumption is switched into savings, attracted by the high rates.

For this to happen when economies are fragile is the last thing the central banks need. Any hope of economic recovery will be quickly replaced by expectations of a slump, leading to deterioration in government finances everywhere, as tax revenue estimates are adjusted sharply downwards and welfare commitments sharply upwards. Add to that increases in the cost of government borrowing from higher interest rates, and the sudden collapse in government finances becomes truly alarming. The dramatic moves in the prices of precious metals are, perhaps, an early warning of this escalating risk.

The prospects for precious metals will ultimately depend on the central banks determination to control inflation. If only it was so simple; but a higher interest rate environment will break the banks, which are full of dodgy loans dating from credit-crunch days. So what does a central banker do? Does he squeeze inflation out of the system, while governments slash their spending, or does he find another way of rigging the markets, while governments dither over their deteriorating finances?

Paul Volker faced up to the problem and picked the former course thirty years ago, but this time the levels of private and public sector debt are a whole magnitude larger and government spending is a far greater problem. This time, embarking on austerity and interest rate plans sufficient to control inflation is simply too painful to contemplate in social democracies. The markets are beginning to understand this, having now been kicked awake by escalating energy prices.

History never repeats itself precisely, but there are similarities to late 1973, when inflation was on the rise and the Arab oil-producing nations imposed an oil embargo on Western nations, leading to considerably higher energy prices. This gives us perhaps a basis for divining today’s outcome, but there were notable differences.

US Inflation, on a comparable basis, is now running at about 5%[i] compared with 6% then, but interest rates are now close to zero compared with 7% in October 1973. An inflationary kick from higher oil prices could therefore lead to a much greater interest rate increase today. Government finances were far stronger then, reflecting economic growth, compared with the serious and deteriorating situation now. So rather than higher oil prices occurring at the top of the economic cycle, today it is happening when the world’s developed economies are struggling to recover.

The pick-up in inflation today is therefore more directly a function of monetary developments than excess demand. Arguably, this makes it more considerably serious than that faced in October 1973, which was easier to diagnose. It is a direct consequence of the monetary expansion that is the bedrock of economic policy. This is not welcomed by the establishment, which seems to think inflation can only occur as a result of excess demand. That is perhaps why the Mervyn Kings and Ben Bernankes of this world turn a blind eye to inflationary pressures, because so far as they are concerned it should not be happening until later in the cycle.

This unfortunate result of current monetary policy gives them an uncomfortable dilemma, because the consequences of stopping or even slowing the printing presses are too ghastly for them to contemplate. The truth is that there are not enough lenders, other than the central banks themselves, to finance government deficits at anything like current interest rates. To stop printing puts government finances in deep crisis and runs counter to cherished Keynesian and monetary theories, so it is hard to see how central bankers will take the initiative to jack up interest rates and bring inflation under control.

This phase of the inflation crisis has been brewing since the Lehman bankruptcy, when the Fed first dramatically expanded its balance sheet to rescue the American banking system. The policy since then has been to muddle along, printing more money to cover deficits and to get the economy recovering. But the crisis in the Middle East is putting an end to that approach and control of the markets is therefore shifting away from the authorities. The markets will raise interest rates against inflating governments whether they like it or not, and their currencies will suffer if central banks are slow to respond. At long last, markets will make governments face the reality they have been so keen to avoid.

The effect on asset prices will be dramatic, and share and bond markets, currently reflecting zero interest rates, are likely to be badly hit. Property is similarly vulnerable, with the end of any pretence that over-leveraged homeowners can afford their mortgages and commercial property tenants their rents. Values for collateral held by the banks against their loan books will therefore be further undermined, putting into doubt the banking system’s survival.

This new phase is stagflation, pure and simple. Asset prices fall, while the prices of goods rise. It is an outcome that has been obvious to some of us since the printing-presses were first cranked up after the credit-crunch. It will now become obvious to the wider public, because the authorities are finally losing control of the markets.

7 March 2011

[i] See www.Shadowstats.com, which removes most of the “adjustments” to the CPI that have been made over the last thirty years.

Alasdair Macleod

FinanceAndEconomics.Org

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The destruction of industry by fluctuating interest rates

2011-03-01T10:21:00.002Z

The destruction of industry by fluctuating interest rates

This is the second in a series describing the disadvantages of inflationary policies.

Keynesian and monetarist policies targeting price stability have indirectly contributed to the demise of industry in Western nations. This may be counter-intuitive, given that most economists routinely call for a weakening currency to give these same industries a trade advantage, and industry itself consistently supports these erroneous recommendations. Yet the two post-war economies that most successfully developed and retained capital goods manufacturing industries, Germany and Japan, did so against a background of strong currencies and a savings ethos. At the same time, economies that had a weak currency and declining savings saw the destruction of much of their manufacturing industries.

The world of manufacturing is competitive, with price and quality being the main determinants of sales. To achieve these objectives, a manufacturer has to seek economies of scale, to ensure unit costs are kept as low as possible, and to employ expensive machinery and good worker skills to ensure quality. To be successful, he has to invest and continually reinvest large amounts of capital for long periods of time. This means that to make profits over the lifetime of his investment he needs stability in his production costs, especially in the cost of capital employed. Without that stability, he will find that the assumptions behind his investment plans will be undermined. As he seeks to evolve his product into new and improved models, the financial returns may no longer be there.

The yardstick for measuring these returns is obviously interest rates; so low, stable interest rates are paramount for the long-term success of manufacturing businesses. Broadly, there are two ways interest rates can fall to attractive levels for industrial investment: either through an increase in savings at the expense of consumption, or through central bank manipulation of interest rates. The results are sharply different.

When there is a genuine increase in savings, it is at the expense of demand for consumer goods, leading to a relative fall in consumer goods values. Furthermore, economic resources are released through this fall in demand and so are available to be redeployed in any business seeking to increase investment in manufacturing. From the entrepreneur's point of view, lower interest rates, which are also proxy for the hurdle on investment returns, make new manufacturing processes profitable compared with an investment at the consumption end of the manufacturing chain where the returns have fallen, while at the same time the raw materials and labour become available to him at stable prices. In other words, the reduction in consumption that results from an increase in savings releases the capital, the labour and the raw materials required by the manufacturer.

But when interest rates are lowered by a central bank to stimulate demand for money, consumption is not reduced, but maintained or even increased. In this case, lower interest rates arise from monetary and credit stimulation, and not savings. The economic resources necessary for a new manufacturing enterprise are not released, and the entrepreneur finds he is in competition for them. So the entrepreneur who considers investing in production finds his cost of capital, and therefore his return hurdle, will have dropped, but his other costs have not.

The entrepreneur may decide to invest in manufacturing on the basis of lower interest rates, but to do so is a mistake. His raw material and commodity costs begin to increase as the inflationary effects of monetary and credit expansion work through the system, and before long the central bank is forced to raise interest rates to control inflation. This rise in interest rates inevitably kills the profitability and any remaining logic of his manufacturing investment.

This description is a simplification of the effects of monetary expansion on manufacturing, compared with manufacturing financed out of increased savings. But there are two principal points to appreciate. Firstly, the expansion of money and credit ends up punishing those that erroneously invest in production, because inflation is the result and interest rates have to subsequently rise. The second point is the timelines for manufacturing very long, and profitability can be disrupted by volatile interest rates many times over the life of the capital investment.

Compare, for example, the establishment of a factory designed to manufacture products for a minimum of twenty or thirty years, with a retail operation that can easily lay off staff and reduce stock levels as a response to difficult times, knowing it can restock and rehire at only a few weeks notice.

The lengthy life of a manufacturing process in a declining savings environment has to suffer many cycles of severe interest rate volatility as a result of monetary expansion. In the US, for the last forty years the interest rate score-card is as follows: from 3% to 9% to 4.5% to 16% to 6.5% to 17.1% to7% to 10.5% to 5% to 9% to 2.8% to 6.1% to 0.9% to 4.9% and to 0%[i]. In Britain, the swings have been generally greater. And when a new manufacturing enterprise draws on outside finance, its returns and losses, being geared, are magnified in terms of the return on equity employed.

It is therefore hardly surprising that over time businesses have learned not to invest in production in an economy plagued by credit-driven economic cycles. Instead, they have moved their operations abroad to emerging economies, where there is plentiful labour, and factories and equipment can be up and running relatively quickly. Labour there is eager to learn and work for the prospect of a substantial improvement in their lives, and the time-consuming government bureaucracy that is a feature of the advanced economies is avoided. These benefits taken all together can be more easily financed due to the shorter time-scale to profitability.

As if to prove the point, the exportation of manufacturing activities is particularly noticeable in countries with the weakest currencies, while manufacturing is retained in the strong, when there is a strong savings ethos. In Japan, the yen rose from ¥350 to the US dollar in 1971 to ¥128 in 1989, and in Germany, the mark rose from Dm3.60 to the dollar in 1971 to Dm1.5 in 1991, offering us strong evidence of the importance of a reliable flow of savings to back investment, compared with the supposed disadvantages of a strong currency.

Admittedly there were substantial swings in interest rates in both these countries over the period, but they were significantly less than those for the dollar and pound and they were not enough to undermine a strong savings ethos. Furthermore, both Japan and Germany were certainly not free from errors in macro-economic policy, but thanks to strong savings flows they did not destroy their manufacturing bases as effectively as the Americans and the British.

So we can now see why American and British businesses have had good reasons to relocate their manufacturing elsewhere, and that the experience of the post-war period confirms our reasoning. The increasing trend towards service industries is also consistent with our findings. Far from being symptomatic of an advanced economy as often claimed, it is purely a result of consumer focus and the destruction of manufacturing. Service industries require little long-term capital investment, in common with retailing consumer goods. So long as a service-industry business is careful to nurture its reputation, it easily hires and fires with the business cycle. They are ephemera compared with the heavy industries that depend on stable long-term savings flows for their finance.

There can only be one conclusion: that weak monetary policy, targeted at improving export competitiveness, economic recovery, or whatever the problem of the day, actually undermines the production structure of modern economies. Remove this source of interest rate volatility, encourage savings, and business can repair itself. The source of our troubles lies in the Keynesian mandates given to the central banks and in the central banks themselves. Instead of achieving price stability, their weak-money policies have managed to destroy manufacturing, which is life-blood of a healthy economy.

28 February 2011

[i] As measured by the US 13 week T-bill rate from 1971 to 2011.

Alasdair Macleod

FinanceAndEconomics.Org