Friday, 4 December 2009
Gold in Terms of the S+P
The chart[1] shows the value of Gold in terms of the S+P index (Gold / S+P) and the long term perspective shows clearly that Gold was at its most valuable(relative to the stock market) both in the deflationary 1930s and inflationary 1970s . Gold is not just a hedge against inflation; it’s a store of value in many difficult periods. Looking at Gold versus the dollar is only part of the story. If the dollar is weak then a strong Gold may simply represent that phenomenon and so comparing Gold to a basket of currencies is more illuminating. Gold relative to the S+P is a way of judging how well Gold compares to other paper assets (It would be better to look at Gold versus a world stock market index , denominated in a basket of currencies, and that may be studied later.)
When Gold was at its strongest , it was roughly 4-6 xs greater than the S+P.
1932 S+P 4.5 Gold 20.67
1938 S+P 8.5 Gold 35
1980 S+P 110 Gold 800
When Gold was at its weakest, it was 1/3 or 1/6 of Gold
1966 S+P 110 Gold 35
2000 S+P 1500 Gold 250
We are at the half way point, roughly at 1:1 i.e. Gold 1200 S+P 1100
If you believe that the crisis has further to go, irrespective of it being a deflationary or inflationary environment, Gold does have the potential to climb considerably higher relative to stocks. Whether that means Gold at 3000 and Stocks at 700 or Gold at 700 and S+P at 175 I have no idea, but in historical terms Gold is merely at an average valuation.
Deflationary Scenario
This is not so problematic. You simply hold gold and cash pay down debt and wait it out .Jonathan[2] Wilmot has written an excellent piece arguing that the fears of a large monetary overhang are greatly exaggerated. It can take many years for this to play out but the motto is simply stay out of the market
Inflationary Scenario
In principal this is much tougher for several reasons. Everything is going up and Gold will outperform stocks but of course the gains will be subject to taxation. It will be hard to have an after- tax real gain. More importantly, if we were to move into hyper inflation then the exit strategy from holding gold is far more complicated. The hyper inflation in Germany ended in 1925 when Germany rejoined the Gold Standard with a new currency of 4.2 Reichsmarks to the dollar. It had left the Gold Standard in 1914 with the same exchange rate of 4.2 Deutschmarks. If you had held gold, you would have had huge profits in local currency but if you hadn’t exchanged the gold for hard assets before the new currency, all you would have been left with is a lump of gold. This is the key point. In the unlikely, but still frightening scenario, of wild money-printing , Gold only acts as a stepping-stone. At some point it will be necessary to sell the Gold and buy property or land, otherwise when a new currency is introduced all you will be left with is Gold valued at an exchange rate commensurate with several years earlier. In that environment, as in Germany 1925, there was a great shortage of the new currency and so Gold was not nearly as valuable as rent – producing assets. It was the industrialists and “insiders” who survived the inflation, because they owned land , property and factories and borrowed at artificially low interest rates from the central bank.
Simon GILLIS 4 xii 2009
Other references.
T.J. Sargent, The end of four big inflations’, 1986
C.P.Kindleberger, A financial History of Western Europe 1993
[1] Bloomberg
[2] CSFB Market Focus-Long Shadows ; The Sequel Nov 30, 2009
The chart[1] shows the value of Gold in terms of the S+P index (Gold / S+P) and the long term perspective shows clearly that Gold was at its most valuable(relative to the stock market) both in the deflationary 1930s and inflationary 1970s . Gold is not just a hedge against inflation; it’s a store of value in many difficult periods. Looking at Gold versus the dollar is only part of the story. If the dollar is weak then a strong Gold may simply represent that phenomenon and so comparing Gold to a basket of currencies is more illuminating. Gold relative to the S+P is a way of judging how well Gold compares to other paper assets (It would be better to look at Gold versus a world stock market index , denominated in a basket of currencies, and that may be studied later.)
When Gold was at its strongest , it was roughly 4-6 xs greater than the S+P.
1932 S+P 4.5 Gold 20.67
1938 S+P 8.5 Gold 35
1980 S+P 110 Gold 800
When Gold was at its weakest, it was 1/3 or 1/6 of Gold
1966 S+P 110 Gold 35
2000 S+P 1500 Gold 250
We are at the half way point, roughly at 1:1 i.e. Gold 1200 S+P 1100
If you believe that the crisis has further to go, irrespective of it being a deflationary or inflationary environment, Gold does have the potential to climb considerably higher relative to stocks. Whether that means Gold at 3000 and Stocks at 700 or Gold at 700 and S+P at 175 I have no idea, but in historical terms Gold is merely at an average valuation.
Deflationary Scenario
This is not so problematic. You simply hold gold and cash pay down debt and wait it out .Jonathan[2] Wilmot has written an excellent piece arguing that the fears of a large monetary overhang are greatly exaggerated. It can take many years for this to play out but the motto is simply stay out of the market
Inflationary Scenario
In principal this is much tougher for several reasons. Everything is going up and Gold will outperform stocks but of course the gains will be subject to taxation. It will be hard to have an after- tax real gain. More importantly, if we were to move into hyper inflation then the exit strategy from holding gold is far more complicated. The hyper inflation in Germany ended in 1925 when Germany rejoined the Gold Standard with a new currency of 4.2 Reichsmarks to the dollar. It had left the Gold Standard in 1914 with the same exchange rate of 4.2 Deutschmarks. If you had held gold, you would have had huge profits in local currency but if you hadn’t exchanged the gold for hard assets before the new currency, all you would have been left with is a lump of gold. This is the key point. In the unlikely, but still frightening scenario, of wild money-printing , Gold only acts as a stepping-stone. At some point it will be necessary to sell the Gold and buy property or land, otherwise when a new currency is introduced all you will be left with is Gold valued at an exchange rate commensurate with several years earlier. In that environment, as in Germany 1925, there was a great shortage of the new currency and so Gold was not nearly as valuable as rent – producing assets. It was the industrialists and “insiders” who survived the inflation, because they owned land , property and factories and borrowed at artificially low interest rates from the central bank.
Simon GILLIS 4 xii 2009
Other references.
T.J. Sargent, The end of four big inflations’, 1986
C.P.Kindleberger, A financial History of Western Europe 1993
[1] Bloomberg
[2] CSFB Market Focus-Long Shadows ; The Sequel Nov 30, 2009
Wednesday, 2 December 2009
The Problem of buying Gold
The Problem of buying Gold
As many friends and colleagues know , I have been interested in Gold as an investment for some time. Gold double- bottomed in US dollars in August 1999 and then again in February 2001 at around $252.I expect it will go considerably higher (currently $1210)
The problem about buying Gold is that individuals and traders often make the mistake of viewing it as a trade. “Making money in Gold is a good thing”; don’t be so sure. A rise in gold usually accompanies either much higher inflation or a deflationary bust as under the Gold Standard in the 1930s. In today’s environment a much higher gold price may even reflect the possibility of governments defaulting on their bonds. It is perhaps better to regard Gold as an insurance policy.
Imagine a friend boasting that they just received a payout of $100.000 on their health insurance. Is that a good thing? Of course not, their health must have been seriously in danger for such an award. Equally house insurance for fire or car insurance. You don’t want the pay-out. If Gold rises to $5.000 the profit itself will be a good thing but most investors will have more serious problems to worry about like social unrest, banking failures, the safety of their families, fuel shortages etc.
This would suggest that Gold is best held as a hedge against crisis. Jim Sinclair[1] is clear about this. The leveraged trader will be lucky to make money in the bull market because the volatility will be so huge that just one mistake could wipe out years of gains. The day after Gold peaked in New York at over $850 in Jan 1980, it opened in Hong Kong at $750 and kept falling That was a remarkable $100 “gap down “.
The most important aspect of holding gold is knowing why you hold it. This might seem a ridiculous comment but as this bull market accelerates many people seem to be buying because “its going up “ . Are you buying it on inflationary fears or general fears? Gold has done well in both environments and Martin Armstrong[2] shrewdly points out that a rising gold price under the gold standard reflected a deflationary crisis but after Bretton Woods collapsed , a rising gold price was symptomatic of ensuing inflation. I don’t want to enter the inflation / deflation debate on this blog, however it is clear that in a certain way it’s irrelevant. Mervyn King was extremely candid when he simply said to the British public in 2008.”Your standard of living will drop”. That’s the point. Inflation-deflation is an argument worth discussing but secondary to whether you view the world as safe enough not to own gold. The inflation / deflation debate is less important than the hard-to-accept fact that either way your standard of living is going to drop to pay for the current mess. Like Fascism and Communism in extremis, the spectrum bends round and inflation and deflation become extremely close in practical terms. You are probably going to get poorer.
Simon GILLIS 1 xii 2009
[1] Jim Sinclair’s Mineset
[2] MartinArmstrong.org
As many friends and colleagues know , I have been interested in Gold as an investment for some time. Gold double- bottomed in US dollars in August 1999 and then again in February 2001 at around $252.I expect it will go considerably higher (currently $1210)
The problem about buying Gold is that individuals and traders often make the mistake of viewing it as a trade. “Making money in Gold is a good thing”; don’t be so sure. A rise in gold usually accompanies either much higher inflation or a deflationary bust as under the Gold Standard in the 1930s. In today’s environment a much higher gold price may even reflect the possibility of governments defaulting on their bonds. It is perhaps better to regard Gold as an insurance policy.
Imagine a friend boasting that they just received a payout of $100.000 on their health insurance. Is that a good thing? Of course not, their health must have been seriously in danger for such an award. Equally house insurance for fire or car insurance. You don’t want the pay-out. If Gold rises to $5.000 the profit itself will be a good thing but most investors will have more serious problems to worry about like social unrest, banking failures, the safety of their families, fuel shortages etc.
This would suggest that Gold is best held as a hedge against crisis. Jim Sinclair[1] is clear about this. The leveraged trader will be lucky to make money in the bull market because the volatility will be so huge that just one mistake could wipe out years of gains. The day after Gold peaked in New York at over $850 in Jan 1980, it opened in Hong Kong at $750 and kept falling That was a remarkable $100 “gap down “.
The most important aspect of holding gold is knowing why you hold it. This might seem a ridiculous comment but as this bull market accelerates many people seem to be buying because “its going up “ . Are you buying it on inflationary fears or general fears? Gold has done well in both environments and Martin Armstrong[2] shrewdly points out that a rising gold price under the gold standard reflected a deflationary crisis but after Bretton Woods collapsed , a rising gold price was symptomatic of ensuing inflation. I don’t want to enter the inflation / deflation debate on this blog, however it is clear that in a certain way it’s irrelevant. Mervyn King was extremely candid when he simply said to the British public in 2008.”Your standard of living will drop”. That’s the point. Inflation-deflation is an argument worth discussing but secondary to whether you view the world as safe enough not to own gold. The inflation / deflation debate is less important than the hard-to-accept fact that either way your standard of living is going to drop to pay for the current mess. Like Fascism and Communism in extremis, the spectrum bends round and inflation and deflation become extremely close in practical terms. You are probably going to get poorer.
Simon GILLIS 1 xii 2009
[1] Jim Sinclair’s Mineset
[2] MartinArmstrong.org
Saturday, 28 November 2009
Comparing The Great Depression with The Current Crisis
The two major financial crises that can be considered “world wide” in magnitude are the Great Depression of 1929-1939 and the current one, which became clearly recognisable when Bear Stearns had to be rescued in March 2008. In between, there have been many other shocks , including the 1920-1922 German hyperinflation and the late 1990s Asian collapse .All these events highlight missed opportunities to learn from the past but hopefully suggest new clues on how to anticipate and dampen the effects of future crises.
The International economy during the two world wide crises is different in one essential way. In the 1930s, the world was on the gold standard but by 2008 a great part of the world had floating exchange rates and all countries use fiat currency. Ironically, the 2 crises were similarly magnified and diffused by the structure of their monetary systems.
Bernanke and James [1] suggest the Great Depression worsened and spread internationally because the gold standard acted as a transmission mechanism for deflation and banking- crisis contagion. The asymmetry of the Gold standard was that countries who experienced gold out-flows necessarily deflated but countries who enjoyed gold inflows (notably France and USA) could hoard the specie and avoid increasing their money supply. In other words, avoid the necessary reflation which was in every one’s interests.
Leading up to 1929 all 4 major economies had overly tight monetary policy. Britain needed to be tight as gold was flowing to France and Germany; France chose not to recycle its gold, Germany needed credibility after the 1920-23 inflation and America was worried by its stock market boom. Deflation was concurrent and spreading.
Equally, banking difficulties were contagious. A crisis in one country led to instability in another. For example, when Credit Anstalt collapsed in May 1931, and exchange controls were enforced to prevent capital flight, there was immediately pressure in Budapest because deposits had been frozen in Vienna creating currency shortages for her trading partners. Two months later, German banking came under pressure and British depositors rationally withdrew money from Germany for fear of having their money frozen or devalued. Banking fears became infectious. Raising rates to remain on the standard, would deflate an economy, make debt (particularly short term debt) harder to service, endanger the banks and create fear of devaluation and capital flight .As Harold James[2] suggests, the change in the debt structure of banks and governments to a large increase of short term debt relative to long term debt made it more difficult to accommodate capital movement. Curing deficits made up of large short-term debt required raising rates, which increased debt servicing and heightened fears of the banks’ very solvency.
The Financial crisis that enveloped the world in the 1930s was the sum and culmination of many different problems. The very nature of the Gold standard intensified price- deflation and banking weakness, but there were other destabilising events. Florida had enjoyed a real estate boom in the 1920s when credit was made too easy by unregulated banks and irresponsible intermediaries. Wall Street soared from 1926-1929 and the speculative element increased dramatically with “ bucket shops “ which allowed gambling on the price of securities with leverage of 10 to1.Speculative commodity funds had accumulated large stores of grains and metals. When the crisis broke after the Wall Street crash there was a simultaneous collapse of real estate, securities and commodities. Agricultural economies suffered particularly badly as did the American consumer. Debt deflation ensued and consumers delayed their purchasing. Adherence to the Gold Standard and ignorance of modern macro economic ideas prevailed and monetary policy remained too tight for too long. Eichengreen and Sachs [3] showed that it was only when countries abandoned the standard like GB in 1931 and USA in 1933 that industrial production picked up. Those who remained late, like France (until 1936) never fully recovered.
The irony is that the current 2000s contagion has dangerous similarities . The current fiat system has equally transmitted banking crises and capital flight , however fiat has also transferred unsound credit practices , money creation and speculative fever around the world.
The root of the crisis lies with the unnecessary easy monetary policy following the 2000-2002 recession and the subsequent proliferation of easy credit ( particularly for the housing market ), leading to an unsustainable housing boom, and a vast unregulated derivatives market [4] .The key problem was that the FED’s 1 pct interest rate policy was matched by inappropriately low rates by many countries who feared asset market declines. In particular, the Gulf States, Hong Kong , China and other Asian countries who linked themselves to the dollar either formally or informally were forced to have commensurately low rates. The real estate boom in the US was then spread through the unnecessarily easy monetary policy around the world. Many countries have had unsustainable real estate booms which bust. USA,UK Spain , Ireland , Dubai all have huge problems. This is the opposite side of the 1930s deflationary coin.
Real estate derivatives have been used by banks and other financial companies (notably AIG) for highly leveraged trading .These complex instruments were often mispriced .Regulators and auditors missed the danger. In the 30s it was the extent of short-term debt that caused the problems. This time it’s the unregulated nature of debt in the derivatives market and the nature and size of consumer debt; for example 50 year mortgages, interest –only mortgages, teaser rates, sub prime lending etc..
When the USA housing boom turned sour, there followed a reinforcing cycle down. As real estate values fell, the value of mortgage backed securities in turn fell which put pressure on banks (which owned them ) to foreclose and withdraw credit to new real estate purchasers. This in turn pressured the property market and forced down the banks’ credit -backed securities. As one bank came under pressure , or one country witnessed capital flight, the globalization of this capital structure set off fears that trading partners , financial intermediaries and other banks would also be in danger of insolvency.
Why the similarity? The similarity lies because the fiat system has allowed a build up of credit and leverage around the world of unprecedented proportion. This time, unlike the 1930s, the problem was rooted in too easy monetary policy. A small fall in the value of the underlying assets is magnified by leverage and threatens the institutions and banks that own these assets. The very nature of a world real estate boom coupled with a proliferation of mortgage-backed securities has meant that assets are owned all over the world and a crisis in one bank or one country will set off dangers in all her trading partners. The Royal Bank of Scotland and AIG are both worthy of note. RBS in essence became a holding company of UK and US real estate assets and has a toxic asset book (guaranteed by the public sector) of over 50 pct of the government’s expenditure. This is a similar proportion as Credit Anstalt which had in effect been a holding company for the securities and assets of the Hapsburg Empire[5]. AIG had to be supported otherwise many Wall Street firms would have failed creating a systemic breakdown. The fiat system now acts as a transmission for banking problems and unsound reflation. Government deficits have exploded due to collapsing tax revenues and the injection of public money to support the monetary system. The US and UK in particular have monetised over 50 pct of their government debt and there is a possibility of a buyers strike. China may equally monetise if the dollar weakens enough to threaten her quasi-fixed exchange rate. The consequence is clear. The credibility of the fiat system , like the gold standard , is in question. In the last few days India , Russia , China and Vietnam have all bought gold and announced intentions to buy more. China has made clear the need for a new reserve currency; a basket of currencies including perhaps gold. Dubai has defaulted, Vietnam has devalued.
From the 1930s we learnt that our banking system had to be separated from securities trading to prevent a systemic crisis .Real estate credit had to be regulated and stock trading derivatives had to be exchange-based. It was learnt that deflation was hard to reverse and most importantly, government cooperation was key. We have not learnt; Glass-Steagall was disbanded and real estate credit became even laxer; the credit market in general became a source of monetary pilfering. The corporate world issued themselves stock options, raised money through the bond market and with that money bought back its own shares to enhance the value of their stock holdings and options. Fannie Mae and Freddie Mac have been nationalised.
The need for reform is clear. It is not the monetary system at fault but the way it is administered. The Fiat system needs governance and sound institutional support. Governments must understand moral hazard and cannot keep interfering with central bank policy to prevent necessary hard recessions as in 2000-2002. Fiscal deficits have to be kept within reason to prevent debt crises; perhaps there should be 2 government houses .The first one is elected to raise taxes and the 2nd house elected to allocate those taxes with a strict Chinese wall between the two. All derivatives must be on an exchange to allow losses to be settled continuously and immediately[6]. This will act as a necessary transparency to prevent companies like AIG misreporting losses. Most of all, the experience of Germany and the other belligerents in the 1920s and 1940s should be used in assessing debt. The size of the allies debt after both wars is comparable to the current debt, but the public were prepared to pay those losses through rationing and austerity because the wars seemed justifiable. The current crisis rooted in easy money, unsound banking and naïve regulation might not appear worth paying for. German hyperinflation was inevitable due to the inability to fund colossal short term debt , bloated by reparation. The UK and USA in particular ,and other countries too ,should face up to the current debt to GDP ratio quickly before the fiat system breaks down. They cannot just print themselves out of the problem. To quote Von Mises[7] on the demise of the Deutschmark ,the Continental and other debased currencies:
"'This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people in the country who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services. These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings. As long as such ideas are still held by public opinion, it is not yet too late for the government to abandon its inflationary policy.'
"But then, finally, the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against 'real' goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.
If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds. Inflation is a policy that cannot last forever.
China in particular realizes the danger of fiat creation and has started reallocating its dollar assets , buying gold and investing in mining companies and commodity assets. It is important that many indebted governments act decisively before everyone else participates in the crack-up boom.
Simon GILLIS 27 xi 2009
Other references
Bernanke . The Macroeconomics of the Great Depression 1995.
Schubert. The Credit-Anstalt crisis of 1931. 1992
Eichengreen. The origins and nature of the Great Slump revisited 1985
North and Weingast. Constitutions and commitment. The Evolution of Institutions Governing Public Choice in Seventeenth Century England. 1989
Miskin.Global Financial Instability ;Framework,Events,Iissues. 1999
Galbraith. The Great Crash 1929. 1954
Bernanke. Essays on the Great Depression.2004
[1] Ben Bernanke and Harold James .The Gold Standard , Deflation, and Financial Crisis in the Great Depression: An International Comparison 1995
[2] Harold James. Financial Flows across Frontiers during the Interwar Depression 1992
[3] Exchange Rates and Economic Recovery in the 1930s. Barry Eichengreen and Jeffrey Sachs 1984
[4] 605 Trillion dollars as of Jun 2009. BIS report 11 November 2009
[5] RBS toxic asset book approximately £340 Billion vs. UK Government Expenditure of £540 Billion
Austrian State loss on Credit Anstalt Schilling 700 Million vs. Federal Budget of 1.800 Million Schilling
Credit-Anstalt Crisis of 1931 Schubert 1991
[6] On a futures exchange, the aggregate of all a company’s trades are collated. If the net total is a loss a commensurate margin needs to be posted by the start of business the next day or otherwise all trades will be closed.
[7] Von Mises . Human Action
The International economy during the two world wide crises is different in one essential way. In the 1930s, the world was on the gold standard but by 2008 a great part of the world had floating exchange rates and all countries use fiat currency. Ironically, the 2 crises were similarly magnified and diffused by the structure of their monetary systems.
Bernanke and James [1] suggest the Great Depression worsened and spread internationally because the gold standard acted as a transmission mechanism for deflation and banking- crisis contagion. The asymmetry of the Gold standard was that countries who experienced gold out-flows necessarily deflated but countries who enjoyed gold inflows (notably France and USA) could hoard the specie and avoid increasing their money supply. In other words, avoid the necessary reflation which was in every one’s interests.
Leading up to 1929 all 4 major economies had overly tight monetary policy. Britain needed to be tight as gold was flowing to France and Germany; France chose not to recycle its gold, Germany needed credibility after the 1920-23 inflation and America was worried by its stock market boom. Deflation was concurrent and spreading.
Equally, banking difficulties were contagious. A crisis in one country led to instability in another. For example, when Credit Anstalt collapsed in May 1931, and exchange controls were enforced to prevent capital flight, there was immediately pressure in Budapest because deposits had been frozen in Vienna creating currency shortages for her trading partners. Two months later, German banking came under pressure and British depositors rationally withdrew money from Germany for fear of having their money frozen or devalued. Banking fears became infectious. Raising rates to remain on the standard, would deflate an economy, make debt (particularly short term debt) harder to service, endanger the banks and create fear of devaluation and capital flight .As Harold James[2] suggests, the change in the debt structure of banks and governments to a large increase of short term debt relative to long term debt made it more difficult to accommodate capital movement. Curing deficits made up of large short-term debt required raising rates, which increased debt servicing and heightened fears of the banks’ very solvency.
The Financial crisis that enveloped the world in the 1930s was the sum and culmination of many different problems. The very nature of the Gold standard intensified price- deflation and banking weakness, but there were other destabilising events. Florida had enjoyed a real estate boom in the 1920s when credit was made too easy by unregulated banks and irresponsible intermediaries. Wall Street soared from 1926-1929 and the speculative element increased dramatically with “ bucket shops “ which allowed gambling on the price of securities with leverage of 10 to1.Speculative commodity funds had accumulated large stores of grains and metals. When the crisis broke after the Wall Street crash there was a simultaneous collapse of real estate, securities and commodities. Agricultural economies suffered particularly badly as did the American consumer. Debt deflation ensued and consumers delayed their purchasing. Adherence to the Gold Standard and ignorance of modern macro economic ideas prevailed and monetary policy remained too tight for too long. Eichengreen and Sachs [3] showed that it was only when countries abandoned the standard like GB in 1931 and USA in 1933 that industrial production picked up. Those who remained late, like France (until 1936) never fully recovered.
The irony is that the current 2000s contagion has dangerous similarities . The current fiat system has equally transmitted banking crises and capital flight , however fiat has also transferred unsound credit practices , money creation and speculative fever around the world.
The root of the crisis lies with the unnecessary easy monetary policy following the 2000-2002 recession and the subsequent proliferation of easy credit ( particularly for the housing market ), leading to an unsustainable housing boom, and a vast unregulated derivatives market [4] .The key problem was that the FED’s 1 pct interest rate policy was matched by inappropriately low rates by many countries who feared asset market declines. In particular, the Gulf States, Hong Kong , China and other Asian countries who linked themselves to the dollar either formally or informally were forced to have commensurately low rates. The real estate boom in the US was then spread through the unnecessarily easy monetary policy around the world. Many countries have had unsustainable real estate booms which bust. USA,UK Spain , Ireland , Dubai all have huge problems. This is the opposite side of the 1930s deflationary coin.
Real estate derivatives have been used by banks and other financial companies (notably AIG) for highly leveraged trading .These complex instruments were often mispriced .Regulators and auditors missed the danger. In the 30s it was the extent of short-term debt that caused the problems. This time it’s the unregulated nature of debt in the derivatives market and the nature and size of consumer debt; for example 50 year mortgages, interest –only mortgages, teaser rates, sub prime lending etc..
When the USA housing boom turned sour, there followed a reinforcing cycle down. As real estate values fell, the value of mortgage backed securities in turn fell which put pressure on banks (which owned them ) to foreclose and withdraw credit to new real estate purchasers. This in turn pressured the property market and forced down the banks’ credit -backed securities. As one bank came under pressure , or one country witnessed capital flight, the globalization of this capital structure set off fears that trading partners , financial intermediaries and other banks would also be in danger of insolvency.
Why the similarity? The similarity lies because the fiat system has allowed a build up of credit and leverage around the world of unprecedented proportion. This time, unlike the 1930s, the problem was rooted in too easy monetary policy. A small fall in the value of the underlying assets is magnified by leverage and threatens the institutions and banks that own these assets. The very nature of a world real estate boom coupled with a proliferation of mortgage-backed securities has meant that assets are owned all over the world and a crisis in one bank or one country will set off dangers in all her trading partners. The Royal Bank of Scotland and AIG are both worthy of note. RBS in essence became a holding company of UK and US real estate assets and has a toxic asset book (guaranteed by the public sector) of over 50 pct of the government’s expenditure. This is a similar proportion as Credit Anstalt which had in effect been a holding company for the securities and assets of the Hapsburg Empire[5]. AIG had to be supported otherwise many Wall Street firms would have failed creating a systemic breakdown. The fiat system now acts as a transmission for banking problems and unsound reflation. Government deficits have exploded due to collapsing tax revenues and the injection of public money to support the monetary system. The US and UK in particular have monetised over 50 pct of their government debt and there is a possibility of a buyers strike. China may equally monetise if the dollar weakens enough to threaten her quasi-fixed exchange rate. The consequence is clear. The credibility of the fiat system , like the gold standard , is in question. In the last few days India , Russia , China and Vietnam have all bought gold and announced intentions to buy more. China has made clear the need for a new reserve currency; a basket of currencies including perhaps gold. Dubai has defaulted, Vietnam has devalued.
From the 1930s we learnt that our banking system had to be separated from securities trading to prevent a systemic crisis .Real estate credit had to be regulated and stock trading derivatives had to be exchange-based. It was learnt that deflation was hard to reverse and most importantly, government cooperation was key. We have not learnt; Glass-Steagall was disbanded and real estate credit became even laxer; the credit market in general became a source of monetary pilfering. The corporate world issued themselves stock options, raised money through the bond market and with that money bought back its own shares to enhance the value of their stock holdings and options. Fannie Mae and Freddie Mac have been nationalised.
The need for reform is clear. It is not the monetary system at fault but the way it is administered. The Fiat system needs governance and sound institutional support. Governments must understand moral hazard and cannot keep interfering with central bank policy to prevent necessary hard recessions as in 2000-2002. Fiscal deficits have to be kept within reason to prevent debt crises; perhaps there should be 2 government houses .The first one is elected to raise taxes and the 2nd house elected to allocate those taxes with a strict Chinese wall between the two. All derivatives must be on an exchange to allow losses to be settled continuously and immediately[6]. This will act as a necessary transparency to prevent companies like AIG misreporting losses. Most of all, the experience of Germany and the other belligerents in the 1920s and 1940s should be used in assessing debt. The size of the allies debt after both wars is comparable to the current debt, but the public were prepared to pay those losses through rationing and austerity because the wars seemed justifiable. The current crisis rooted in easy money, unsound banking and naïve regulation might not appear worth paying for. German hyperinflation was inevitable due to the inability to fund colossal short term debt , bloated by reparation. The UK and USA in particular ,and other countries too ,should face up to the current debt to GDP ratio quickly before the fiat system breaks down. They cannot just print themselves out of the problem. To quote Von Mises[7] on the demise of the Deutschmark ,the Continental and other debased currencies:
"'This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people in the country who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services. These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings. As long as such ideas are still held by public opinion, it is not yet too late for the government to abandon its inflationary policy.'
"But then, finally, the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against 'real' goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.
If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds. Inflation is a policy that cannot last forever.
China in particular realizes the danger of fiat creation and has started reallocating its dollar assets , buying gold and investing in mining companies and commodity assets. It is important that many indebted governments act decisively before everyone else participates in the crack-up boom.
Simon GILLIS 27 xi 2009
Other references
Bernanke . The Macroeconomics of the Great Depression 1995.
Schubert. The Credit-Anstalt crisis of 1931. 1992
Eichengreen. The origins and nature of the Great Slump revisited 1985
North and Weingast. Constitutions and commitment. The Evolution of Institutions Governing Public Choice in Seventeenth Century England. 1989
Miskin.Global Financial Instability ;Framework,Events,Iissues. 1999
Galbraith. The Great Crash 1929. 1954
Bernanke. Essays on the Great Depression.2004
[1] Ben Bernanke and Harold James .The Gold Standard , Deflation, and Financial Crisis in the Great Depression: An International Comparison 1995
[2] Harold James. Financial Flows across Frontiers during the Interwar Depression 1992
[3] Exchange Rates and Economic Recovery in the 1930s. Barry Eichengreen and Jeffrey Sachs 1984
[4] 605 Trillion dollars as of Jun 2009. BIS report 11 November 2009
[5] RBS toxic asset book approximately £340 Billion vs. UK Government Expenditure of £540 Billion
Austrian State loss on Credit Anstalt Schilling 700 Million vs. Federal Budget of 1.800 Million Schilling
Credit-Anstalt Crisis of 1931 Schubert 1991
[6] On a futures exchange, the aggregate of all a company’s trades are collated. If the net total is a loss a commensurate margin needs to be posted by the start of business the next day or otherwise all trades will be closed.
[7] Von Mises . Human Action
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