The Financial Markets , Gold and Good Wine

LAST CHANCE

2011-11-17T00:04:00.000-08:00

For several years this blog has warned of inadequate policy formation, the necessity of owning gold as a hedge against financial default and the length of the crisis. This is a last warning.

Governments wont pay. Bonds will default and pensions will be decimated.

By 2020 Health Care services will be a fraction of what they are now.

Owning Gold is an insurance. Do not regard it as an investment.

Civil unrest will be become more violent.

Democracy will be undermined.

There is a sound principle that doctors are not allowed to cure themselves. The equivalent should be true today with politicians. Politicians are the root of the crisis (although they have ably helped by bankers) and yet they are charged with curing the crisis. A cure will not be found

Swiss fix Franc vs Euro

2011-09-06T01:55:00.000-07:00

This is a very poor decision by the SNB. They will now find depositors from all over Europe choosing the Swiss Franc. Marginally solvent European banks will also choose the Franc as a haven. We are now in a new stage of Currency Wars and uncooperative economic decision making. That is dangerous.

Heading into the Storm

2011-09-05T00:59:00.000-07:00

The markets are set for achieving the minimum objective of Dow : Gold of 5:1 On both sides of the Atlantic puerile posturing, ignorance and complacency by politicians only worsens the environment. The European banking system is close to insolvency ( liberal marking of debt and derivatives masks the danger) which has obviously wider ramifications. Bernanke's pledge to keep a quasi-zero rate policy for 2 years is not only unprecedented but is even more dramatic than QE3. Expect further dramatic liquidity injections (QE9, one day?) not because it works, but its the only tool that policy makers can think of as they are caught "in the headlights". If Gold reaches 2.800 this autumn, it might be worth considering taking a partial profit

2011-08-18T22:41:00.000-07:00

What now?

2011-08-18T22:33:00.000-07:00

Above you will see an update of a chart posted before (see blog 21 September 2010). It is a semi-logarithmic chart of the Dow priced in Gold, since 1921. Support is coming at 5 (Dow 10.000 / Gold 2.000 ?) This has been the minimum objective commensurate with the 1932-1935 basing in the stock-market. Its possible that in this Global Government Debt crisis the ratio falls even lower.

Politicians still do not appreciate the size of the problem. Markel and Sarkozy appear naive and Congress's teenage posturing lamentable.There are many years of debt-delevaraging ahead and the continual issuence of debt simply enslaves our children's generation to pay interest to emerging Asia.

STERLING VS EURO

2011-05-03T07:42:00.000-07:00

The long term chart of Sterling vs. Euro confirms the budget proposal that the Government and Bank of England will sell Sterling to build up reserves of currency. Tight fiscal policy will be counterbalanced by weak monetary policy; QE keeping longer term rates artificially low and a weakening exchange rate to boost the export sector.

Unfortunately this policy is typical of a "race to the bottom" where countries try and weaken exchange rates (UK, USA) or impose capital controls (Brazil) to gain competitive advantage. It might be the case that countries that act in this manner quickly will get an advantage over countries that do not, but the sum total of such mercantilist behaviour is usually zero at best. A competitive battle between Coke and Pepsi where bottom line is paramount is quite different to a win-lose battle between countries. Mercantilism does not succeed now and Ricardo's view of comparative advantage means that free trade and cooperation always wins over a nationalistic competitive ethos. We are back to the 1930s.

On top of this, the UK policy of zero rates is understandable in terms of preventing a deflationary nightmare but zero rates distort capital formation. Investment is eschewed for speculation (commodities) hoarding (gold) or simply flees to other currencies that do pay interest.

We live in a world where there is little cooperation between the main players (G20) and if the UK and USA really think they can outwit China they are niave as well as isolationist.

Unfortunately (for students) this is the exception.

2011-04-16T22:53:00.000-07:00

Texas University Endowment Storing About $1 Billion in Gold Bars

By David Mildenberg and Pham-Duy Nguyen – Apr 15, 2011 6:13 PM ET

The University of Texas Investment Management Co., the second-largest U.S. academic endowment, took delivery of almost $1 billion in gold bullion as the metal reaches a record, according to the fund’s board.

he fund, whose $19.9 billion in assets ranked it behind Harvard University’s endowment as of August, according to the National Association of College and University Business Officers, last year added about $500 million in gold investments to an existing stake, said Bruce Zimmerman, the endowment’s chief executive officer. The holdings reached about $987 million yesterday, as Comex futures closed at $1,486 an ounce.

The UK Budget 2011

2011-03-25T00:16:00.000-07:00

Having promised a budget for growth, Mr. Osbourne gave the country an indication that his stewardship of the economy will lack innovative thinking. Taking from Oil Companies will give concern to other industries that future profits may be expropriated and then giving to the consumer via lowering petrol duty is shamefully populist. Mr. Snow on Channel 4 news skilfully questioned Danny Alexander and pointed out that higher petrol prices would have forced the population to adapt to higher energy prices; a market mechanism for perhaps considering ways to embrace new sources of energy. Unfortunately the coalition are interventionist at heart despite the rhetoric.

Of note was the reference to currencies. Mr. Osbourne made clear that the Bank would be building reserves; a clear statement that Sterling will be sold to complement the low interest rates.

The comment that it was important that G7 buys yen to support the Japanese economy was the highlight of a dull budget. Was that a faux pas or a Freudian Slip?

Upcoming 2011 UK Budget.

2011-03-07T10:42:00.000-08:00

Mr. Cameron is trying to prepare the country for a budget that will be the most pro-growth in a generation and one which will encourage the entrepreneur. At the same time there is an emphasis on getting banks to lend to small business.

Mr. Cameron might find British Economic History from the early 1970s interesting. Ted Heath pressed cabinet and the chancellor, Tony Barber, into an expansionary budget; a dash for growth. At the same time the Bank of England had liberalised the high street banks to lend money without credit constraint and the World was embarking on a commodity boom fueled by the break down of the dollar peg.

The result was a classic Keynesian expansion, UK style. Investment into industry actually fell as the banks chose property as the sector to invest in. ( British banks have always favored property with its natural collateral, rather than small business). Billions went into property and when interest rates rose in November 1973 and a rent freeze was imposed, the whole house of cards collapsed. The Bank of England was forced to rescue the secondary banks and property companies collapsed alongside the banks.

In other words, the combination of pushing banks to lend, a reflationary budget with ever increasing commodity prices and low interest rates produced a classic boom and bust. Sounds familiar?

Proposed Pension Reform will encourage Government to inflate the economy

2011-03-06T00:15:00.000-08:00

The Pension reform being proposed by Lord Hutton may have dangerous consequences. It is clear that the public sector will have to see a cut in their final salary schemes, but a more transparent solution must be preferable to one which may have dangerous consequences.

What is being proposed is that workers receive a pension in line with their average life-time earnings. What is not being disclosed is that wage inflation will seriously erode that average. If compounded interest is a marvel for savers, it is a nightmare for pension beneficiaries.

Suppose wage inflation is 5% compounded over 40 years. A person starting on £30.000 p.a will receive £201,000 after 40 years with an average salary of £90,600.

If wage inflation is 8% compounded, that same person will receive £603,000 with an average salary of £194,300

In the 1st scenario, the pension will be 45% of leaving salary and in the second just 32%

Once again government is changing to policy that undermines the population through inflation.

The Bank of England is both candid and economic with the truth

2011-02-19T08:49:00.000-08:00

Mr. King was one of the few leaders in 2008 to be candid about our economic future. He said that standards of living would fall; i.e. wages would not increase as much as prices. However, his recent comments might suggest that he might raise rates to curb inflation. True, but it is a little economic with the truth. The market's assessment through short sterling futures suggest rates at 1.5% by the end of the year. That is hardly enough to deal with CPI above 4% and RPI above 5%. (RPI is conveniently being dropped by government). Both the Government and the Bank want inflation. It is the only palatable way to reduce our debt in real terms. Don't be fooled.

2010-12-14T00:58:00.000-08:00

With all the Economic Doom and Gloom around in the West, it was a real pleasure to become British Gold Cup Bridge Champions in 2010. The team of Zia, Gunnar Hallberg, Robert Sheehan, David Burn, Fredrick Bjornlund all played magnificently for team Gillis. It's also ironic that the Cup is made of the Yellow Metal.

39.25 Year Cycle Kicking In.

2010-11-30T02:24:00.000-08:00

The first chart is Gold in terms of the Euro. The 2nd chart is a 30 year Spanish Government Bond.

The 39.25 year cycle (November 2010) mentioned 2 blogs ago is really kicking in. Irish, Italian and Spanish Bonds are collapsing and Gold is making new highs against the Euro. This is a debt crisis first and foremost. Restructuring will inevitably mean that many governments will not pay the full amount of their debt back.Protect yourself.

The discord among G20 is of greater concern than fears of capital controls and protectionism

2010-11-23T08:02:00.000-08:00

Manchester Liberalism was an early 19^th century school of thought that combined belief in free-trade and consensual politics. Rooted in the work of Hume and Smith , and championed by Cobden it lead to the repeal of the corn laws in 1846 and the Cobden-Chevalier treaty for free-trade in 1860.It opposed mercantilism .The Washington Consensusarising from the economic leanings of Thatcher and Reagan advocated free trade, liberalising markets and capital flows, privatisation and falling barriers; however, America’s determination to effect open trade and promote the world economy had been evident since the late 1940s.This paper will argue that the effectiveness and willingness of both Britain and America to influence other countries with free-trade policies (namely the Manchester school and Washington Consensus) was conditional not just on their hegemon status but also when they acted in a cooperative manner with trading partners. In other words, when Britain and America were not cooperative, world trade and business would suffer from protectionism, myopia and lack of leadership.

The 1^st era of Globalisation from 1870 to 1914 was championed by Britain as the Hegemon. Britain’s ability to have minimal tariffs when the international average was 15%demonstrated her being a “strong state”. Government had overcome landed-interests to reduce tariffs, promote free-trade and raise revenue with more equitable higher income- taxes. America in this period had tariffs set considerably above the 15% average. America’s share of Customs revenue to total revenue was 51% from 1870-1910 compared to Britain’s 22%. America was not anti-free-trade per se but in a labour scarce economy preferred openness in immigration to the removal of trade barriers. As Irwindemonstrates, customs revenue was an efficient way of collecting taxes in a country (like America) which had a low population density. Her influential land-owners were able to pressure the taxation of imports over the direct taxation of their land.

The 1980s Washington Consensus that suggested lower tariffs, and almost demanded capital account liberalisation, was seen as the policy mix to best promote world trade. This mix was not necessarily true 100 years earlier. Estevadeordal, Frantz and Taylor showed that the decline in transport costs alongside a well run monetary system were more trade-creating forces than lowering tariffs. They demonstrated that the correlation between high growth and high tariffs was misleading. Britain played a major part in both reducing transport costs and supporting the Gold Standard. Before the steam ship, Britain’s superior navy ensured safe-cargo and her mature insurance market kept insurance rates to a minimum. The steamship and the opening of the Suez Canal led to dramatically lower transport costs and quicker journeys. The pre-eminent position of the City of London to discount bills, transact in sterling (rather than bullion) and most importantly, to be fully committed to the Gold standard , was the 2^nd key to increased trade .Lopez-Cordova and Meissner showed that 2 countries on the Gold Standard were likely to trade 60% more than 2 countries who did not. Therefore the success of trade between 1870 and 1913 owes as much to the commitment that Britain gave to monitoring the Gold Standard and lowering transaction costs as to her actual trade policy. This cooperation was matched by other countries’ policies acceptable to their own political interests; America was open to immigration, Northern European countries joined the Gold Standard to standardise their currency regimes and Asian countries lowered tariffs on imported British textiles. Britain, in turn, recycled her Gold through the capital account investing in crucial infrastructure (particularly railroads and canals) in primary producing countries.

America’s U turn on tariff policy was evident soon after the 2^nd World War with the establishment of GATT and a desire to see some European trade barriers come down; however she did not advocate that total free trade be imposed everywhere. Her cooperative position was evident with the Marshall Plan and the creation of the EPU as the necessary institutional support to bring Europe out of its economic devastation. Ruggie showed that America was not so dogmatic that her free trade-policy should be replicated as a quid pro quo for aid. For example, France was allowed protection for agriculture, Britain a more interventionist government in building the welfare state. The growth of the European Union from a coal and steel alliance between Germany and Belgium to a fully integrated currency union was always endorsed by America, but at no time did America insist on laissez-faire free trade. America’s position was always pragmatic and respectful of the European desire for a larger welfare state. America used her dominant position not to eulogise free-trade but to run Bretton Woods (and overcome the problems of lack of convertible currency) help Europe and benefit her mass-producing home industries. The large plants which had helped the allies in the War still needed an export market when they switched from armaments in 1945.In the post war period the “Washington Consensus” was indeed consensual.

The interwar period was the opposite. Both Britain and America resorted to more insular policy and withdrew from the International Political economy. Although Britain imposed the deflationary policy of re-joining the Gold Standard supposedly to promote world trade, it has been argued by Baines and others that it was also trying to move resources and labour from the old and inefficient businesses of coal, ship building and textiles to the more modern sectors like power, motors and durable goods. This was called “Rationalisation”. In September 1931 when Britain withdrew from the gold standard, not only did she break with 200 years of Gold convertibility she also imposed higher tariffs at the same time.

After the First World War, America did not use her new premier economic position in a cooperative way. Firstly she withdrew from the political economy by neither attempting to rebuild a safer Germany nor by arguing against the dangerous level of reparations set at Versailles. From 1926, America and France chose to hoard their Gold rather than recycle it through the capital account. In 1929 USA and France had over 50% of the World Gold reserves and after the 1929 Crash, America imposed even higher tariffs (Smoot Hawley) and did not help the allies until Pearl Harbour.

The misleading correlation between higher growth and higher tariffs is also prevalent from the 1980s under the Washington Consensus. The USA did successfully persuade many western countries to join GATT as well as Bretton Woods. GATT an international institution aimed at the promotion of free trade did effect an impressive decrease in tariffs from 34% in 1980 to 12.6% in 2000 and world exports as a percentage of World GDP rose from 11% to 18.8%. However, the increase in trade had less to do with tariff reduction than assumed. Baier and Bergstrand demonstrated that 67-69% of Trade Growth in that period could be explained by GDP growth but only 23-26% by tariff reductions.

The growth in world income is the major part of America’s contribution to free-trade, not her supposed adherence to free trade per se. Since the 2^ND World War, America has contributed to world growth with Marshall Aid, the EPU (to overcome problems in currency convertibility) GATT, Bretton Woods and a strong military presence. She has been a large importer of world products and facilitated new countries which had been restricted under the iron curtain. During financial crises of 1987 and 2001/2 she added liquidity. In other words, unlike the 1914-1939 period, the USA since 1945 has largely tried to be cooperative as Britain was in the 19^th century. America tried to be the “Leader of the Orchestra”. However, since 2008 there have been less consensual policies .America is critical of Chinese currency manipulation and is retaliating with QE and the latest round of GATT, the Doha round, has broken down. If there is to be a continuation of the Manchester School and the Washington Consensus, a “Shanghai View” ,say, later this century, then the lesson for China is that simply advocating free-trade is not enough. China would need to use its Hegemon status to cooperate with the rest of the world and create new institutions to successfully manage the economic well- being of the world as well as her own primary economic position.

Simon GILLIS 4 XI 2010

Baier and Bergstrand: The Growth of World Trade; tariffs, transport costs and income similarity.

Baines. The 1920s P Johnson (ed.) Twentieth Century Britain; Economic, Social and Political Change

Estevadeordal, Frantz, and Taylor: The Rise and fall of world Trade 1870-1939

Hatton and Williamson (2005).A dual policy paradox: Why have trade and immigration policies always differed in labour-scarce economies?

Irwin (2002): Interpreting the Tariff –Growth Correlation of the late 19^th century.

Irwin (draft 2010) “Did France Cause the Great Depression”?

Lopez-Cordova and Meissner: Exchange Rate regimes and International Trade.

Maddison (1995): Monitoring the World Economy

Matoo and Subramanian: Currency undervaluation and Sovereign Wealth Funds.

Overy (2005): Why the Allies Won.

Ruggie 1994: Trade, Protectionism and the Future of Welfare Capitalism

Williamson (2000): What should the World Bank think about the Washington Consensus?

Hatton and Williamson (2005).A dual policy paradox: Why have trade and immigration policies always differed in labour-scarce economies?

Hobson. The Wealth of States.

Hatton and Williamson. ibid

Irwin (2002): Interpreting the Tariff –Growth Correlation of the late 19^th century.

Estevadeordal, Frantz, and Taylor: The Rise and Fall of world Trade 1870-1939

Lloyds had specialised in maritime insurance since the late 1600s.

Lopez-Cordova and Meissner: Exchange Rate regimes and International Trade.

EPU. An institution that overcame the problem of a shortage of hard currency in post-war Europe. Countries settled their trade monthly at the BIS allowing multilateral trade and with the aid of US credit.

Ruggie 1994: Trade, Protectionism and the Future of Welfare Capitalism.

US mass production of arms was partly sent to GB and Russia. 1/6 of Russian arms were American under the Land-lease scheme. Refer R. Overy (2005) : Why the Allies Won.

Baines. The 1920s P Johnson (ed.) Twentieth Century Britain; Economic, Social and Political Change (1994)

Britain did withdraw convertibility during times of War. This was an acceptable contingency of the Gold Standard. (1814 Napoleonic War, 1914 WW1) but always intended to re-join after hostilities ended.

Irwin (draft 2010) “Did France Cause the Great Depression”?

Maddison (1995): Monitoring the World Economy

Baier and Bergstrand: The Growth of World Trade; tariffs ,transport costs and income similarity.

39.25 Year Bond and Gold Cycle

2010-11-02T09:32:00.000-07:00

May 1775

August 1814

Late 1853

February 1893

June 1932

August 1971

November 2010 ?

These dates are all 39.25 years apart and are all starting points for rising bond yields ( falling bond prices ) and rising gold prices. In some cases the moves were quick and sudden in others, the dates were starting points for long trends.

May 1775.Boston occupied by British Troops.Start of the revolutionary War.Continental currency introduced.(which would become worthless) British Bond yields climb from 1775 to 1780 by over 2%. i.e. 3% to 5.3%

August 1814. Napoleonic War. Bullion convertibility is suspended. From that point the Rothschilds accumulate Gold and nearly corner the market and Consols collapse until Waterloo.

Late 1853. The low deflationary point in the depression leading up to civil war. Gold convertibility is suspended in 1857. By 1869 Gold has climbed from $19.37 to $162.4.

Feb 1893. Philadelphia and Reading Rail Road company collapses; start of the 1893-1897 depression. Gold leaves the USA and in order to buy it back the government issues high coupon bonds

June 1932. the low point in the Dow and the market starts "pricing in" the devaluation of the dollar against Gold. 1933 Gold revalued by 70 pct from $20.67 to $35.00 Government bonds start declining in mid 1932

August 1971. Breakdown of Bretton Woods. Gold soars from $35 to $873 in January 1980. Bonds decline for longer, not bottoming until 1981

November 2010. QE2 marks the point that printing money is not just to save the system but is an active central bank policy. Government bonds start declining,particularly in countries without a printing-press(but it may be a slow process in the US). Gold moves to $4.000 per ounce?

GOLD vs STOCKS

2010-09-21T03:39:00.000-07:00

If you refer to the chart below, it is time to look again at the stock market in terms of gold. This time it is the Dow since 1925 rather than the S+P.

As the market goes down, that means that the stock market is declining relative to Gold. The trend line is just below 5. The interesting question is ( if we get there and I believe we will ) does that mean 10.000 Dow and 2.000 Gold or perhaps 7.500 Dow and 1.500 Gold.

It’s possible that later in the decade, the trend-line is broken and the Dow falls (or gold goes ballistic) to very long-term support at 2.

Both the 1929-1932 and 1966-1982 bear markets were 86 pct in real terms.

The Great depression saw stocks fall by 89 pct but deflation reduced the real loss to 86 pct. The fall in the late 60s and 70s was only 50 pct but inflation added the real loss to 86 pct.

For perspective, if this bear market started in 2000 and we have seen the S+P fall by 28 pct with inflation of 30 pct, then the net real loss has only been 50 pct. (.7*.72)

In other words, for a comparable loss to the 1920s and 1970s , there needs to be a further 72 pct loss. (.72*.7*.28 = .14)

It is my opinion that the lessons of the 1930s are clear. Deflation is the worse outcome. Central Banks will try to reflate enough to keep the market at least steady ( although that might ultimately require 20-40 trillion of QE as total US Dollar debt alone is $58 Trillion).

Therefore if 72 pct of inflation can be engendered and the stock-market remains at around 10.000 ,the real price of Gold in comparison to the 1980 high of 873 will increase from 2.300 USD per ounce to 4.000 USD per ounce.

This strikes me as plausible, although such ideas rarely come true.

DOW JONES priced in GOLD

2010-09-21T03:04:00.000-07:00

Is the Bank of England being disingenuous?

2010-09-19T12:59:00.000-07:00

In the UK CPI has been considerably higher than the allowed 2 pct. In fact its over 3 pct at the moment with RPI close to 5 pct.And yet time and time again, Mervyn King has suggested that due to the weak recovery, inflation will fall below target and there is no need for interest rate hikes.It is probably correct to keep rates at 0.5 pct but its not necessarily true that CPI will fall below 2 pct. Simply put, The Bank doesn't care about inflation any more. QE2 in USA, B of J Yen intervention, and the Bank not being tough are all strong clues that the world is changing from Central Bank Inflation targeting.Maybe they will start targeting property prices if the real estate market starts a bear trend again. The one thing the Central Bank can't say is that it doesn't care about inflation.Don't sell your Gold.You might need it one day

Deflation first, then possibly inflation

2010-06-01T03:16:00.000-07:00

The deflationary pressure in Europe and the USA is clearly increasing. Banks in Europe are becoming more reluctant to lend and $ libor is edging up too. The fear of inflation is still prevalent despite contrary evidence; why is this?

There is an assumption that monetising debt is de facto a route to inflation, but that is not necessarily the case. Referring to government orchestrated debt buying, Von Mises wrote in Human Action “The first stage of the Inflationary process may last for many years…..it is not too late for the government to abandon its inflationary policy”.

Monetising debt (or QE) is not an automatic route to the (hyper) inflation that many people fear. Firstly the banks need to use this new cash and be prepared to lend it out within the fractional banking system. They are not doing that. They prefer to hoard the money as reserve requirements are being raised and they are fearful of the current economic conditions (with good reason). Secondly, even if banks were prepared to lend the money, consumers must be prepared to borrow more and leverage their own balance sheets. That is equally not happening. In fact the saving rate in the US is increasing as people pay down their mortgages.
In short, the velocity of money has collapsed and money available for exchange is contracting (M3). The money created by recent QE is merely plugging holes in the banking system. This is unlikely to change until Real Estate starts increasing, consumers chose to leverage themselves and quickly increase borrowings.

In the medium term, debt pay- down will drive assets lower and the dollar higher. It may also even drag gold down, but gold will not fall nearly as hard as Real Estate or the Stock market. Interest rates are set to stay low as there is a drive to cash. The reason the dollar stays strong is because it’s the reserve currency. Borrowers who cannot raise money in their own currency usually chose the dollar instead. As assets decline quickly in a disinflationary environment, the need for cash increases and de facto the need for dollars to pay down debt.

The end game of this crisis may well be a reflationary nightmare. Don’t worry about that now. In fact when it comes, it will be so horrendous that central banks may be forced to expand their balance-sheets by 50 x not the current 3 x.

With over USD 500 trillion of outstanding derivatives a breakdown in the banking system in a few years might precipitate the need for a new currency but in the meantime deal with a declining real estate, declining wages and a declining stock market

2010-04-28T23:56:00.000-07:00

Brown’s Gaffe; British Politicians underestimate the UK public

There is an interesting phenomenon in the UK that the public do have an excellent grasp of how serious our fiscal deficit is. In fact since 2008 they have been several steps ahead of what the politicians have been trying to paint over. Last night Mrs. Duffy made possibly the correct observation that taxes will rise and stay high for 20 years. 20 years; quite.

Unfortunately others like Mr. Mandelson warn us that comparisons with Greece are merely attempts to engender fear. I don’t think so. Unlike 1945-1951 where War debt was seen as worth paying for, the public might not accept the mismanagement of the Economy and incompetence of the banking sector.

Stay with Gold.

2010-03-16T15:17:00.000-07:00

I'm reluctant to call the market, but I think that Gold is a clear cut buy.

The market is not paying enough attention to the IMF's volte face. For 30 years since Reagan and Thatcher the IMF have slavishly followed the Washinton Consensus; namely that the pursuit of growth is best achieved through deficit cutting and trade liberalization. The IMF now advocate the delay of deficit cutting. Give politicians a chance to resist a hard choice and they will take it gladly. Every year , slow growth will be used as the excuse to avoid the painful medicine.

Similarly , inflation targeting, the mainstay of central bank policy since the 1990s.It is being questioned. We are in a period where deficits won't be addressed and inflation will be encouraged.

Gold, Gold Stocks, commodity stocks are all a clear cut buy

2010-03-14T03:52:00.000-07:00

Did Globalization lead to the end of government control of the economy?

At the end of the 20th Century there were approximately 400 million[1] workers in the leading 25 Industrial countries. If the proportion working in farming and services had been the same as 100 years earlier, rather than the current 20 million in agriculture and 270 million in services, there would instead be 190 million in agriculture and only 100 million in services. (The Manufacturing proportion has remained the same at 27 pct of the workforce). This dramatic shift exemplifies globalization. The rapid spread of technology, foreign direct investment and trade combined with the opening up of capital markets has changed the nature of labour to a more urban and skilled work force. Assets, particularly financial assets, are owned by different corporations all over the world. Globalization has perhaps moved faster than changes in government policy and the institutions that monitor, influence and regulate these markets. As the current world economy suffers under a weight of debt and unfunded liabilities, it is possible that the consequences of globalization may have been too rapid for governments to adequately negotiate the current economic difficulties.

The last period of Globalization between 1870 and 1914 saw a brisk increase in trade and migration. Britain was both the industrial and financial leader. Most of the trading nations operated under the Gold Standard and the core countries of Britain, France and Germany cooperated to ensure that the system worked efficiently. World exports[2], as a percentage of GDP, almost doubled from 1870 to 1913 and foreign assets more than doubled. Transportation costs fell dramatically and migration to the new world was an economic consequence of the shortage of labour and high wages outside Europe. The inter war period reversed many of these gains. The economic devastation of the Great Depression and 2 World Wars was accompanied by 2 breakdowns in the Gold Standard both in the post war period and then again between 1931 and 1936. Most significantly ,World Trade[3] collapsed and the ratio of exports, as a percentage of GDP, was only marginally higher in 1950 than it had been in 1870. In this light, the Globalising period from 1950 until now seems even more remarkable. It started with scarce capital and a new monetary system based on semi - fixed exchange rates. Over 60 years World Exports[4] have more than tripled and real GDP per person has grown by over 3.25 pct among globalising countries. HDI[5], perhaps a better measure of living standards, has jumped by 20 pct to 0.95. And yet, despite these gains, globalisation is questioned and governments in the western world seem unsure how to deal with the current problems. Government deficits , unfunded pension liabilities , popular disquiet with immigration and a world-wide weakness in real estate and mortgages appear to have left governments little room for manoeuvre. After so much success, why such pessimism?

The new monetary system of Bretton Woods had to cope with both the economic collapse of the period and the social implications of a world war that had left even the victors demanding change. Britain had lost her industrial and financial pre-eminence and Europe as a whole was short of capital. The Marshall Plan, with surprisingly little aid, kick - started the European economy. This was facilitated by the EPU in dealing with credit in a world short of foreign exchange.

The new monetary order required and allowed compromise. Ruggie[6] described it as “Embedded Liberalism”. It would contrast the nationalistic tendencies of the 30s with a multilateral character but it would not embrace the laissez-faire liberalism of the 1st Gold Standard. There would be compromise. The USA allowed Europe her choice of greater social welfare and strong protection of agriculture. Domestic policy that granted safety nets for the disenfranchised, greatly increased spending on health and benefits and capitalist cooperation with the unions was the new pragmatic backdrop of the period. The Golden age that followed until 1973 witnessed average European growth[7] of over 4 pct. The social contract that workers would forego excessive wage increases in order that capital could be reinvested was the mainstay of a virtuous economic circle. The workers believed the promise of delayed economic benefits. Both capitalists and workers trusted each other. Government spending[8] rose as her part of the contract, by an average of over 5 pct of GDP from 1937-1960 in the 5 countries France, Germany, Sweden, UK and USA . Despite the economic problems that followed the Golden Age (inflation, high unemployment, strikes and wage disputes), the Globalising countries still kept a steady pace up until 2007.

Standards of Living were rising for the majority but it is only since the downturn in 2008, and the subsequent deterioration in government finances, that there has been universal recognition that policy might be ineffectual or out dated. Ruggie had suggested that concerns of trade wars and protectionism, particularly in the 1980s, were misplaced. He feared that it would be government’s inability to maintain her share of the social contract that would be the greatest threat to prosperity and open trade. Krugman[9] validated this view . He observed that continuous reference to “poor competiveness” , whether in terms of exchange rate policy or trade openness , was either a means of deflecting from the real problem of poor productivity growth or perhaps an ignorance of it. His conclusion is that “national living standards are overwhelmingly determined by domestic productivity”.

Poor productivity is at the heart of policy inaction. As “migrating” agriculture and manufacturing labourers move to the service sector, living standards are in jeopardy of falling because services have the worst sector- productivity rate. It is here that Government policy faces a dilemma. In order to increase the productivity rate of the service sector , the workforce needs to be re-skilled to a higher level. The comparative advantage of the Globalising countries lies in design and highly skilled work. However , in order to pay for this advanced education , it will require cuts in health care and perhaps pensions. That is unlikely be endorsed by the electorate. It’s a timing dilemma. Short term losses to living standards are required for longer-term economic gains, but voters will choose shorter term benefits.

The difficulty in accommodating sectoral change in the workforce is only one area of policy inaction. Coincidentally, governments need to fund themselves as well as their citizens’ retirements. Are they capable of it? At the end of previous long waves of economic growth, there have been market crashes that have required major policy adjustments to rectify the market failure. As Eichengreen , Bordo and Irwin[10] show, the Canal and Railroad investment manias of 1825 and 1873 required new accounting rules and greater contractual transparency .The agriculture depression of the 1870s resulted in tariff increases and generalised protectionism. After the 1929 Crash, Glass –Steagall was introduced to prevent commercial banks dealing in securities and both GATT and the IMF were institutions devised to implement the new monetary system. The collapse of the Gold Standard and the Great Depression needed a complete change, not just an overhaul. Martin Woolf[11] suggests that although Globalization in the long term may be inexorable, over the short term, corrections and pauses are inevitable. The contemporary market crash in US real estate and its mortgage market is a crash with a global complexion. Unlike the 1870s era, capital markets are open, countries use fiat currency and credit is plentiful within a lightly regulated system. US mortgages are split up, and repackaged , and owned all over the world. Low interest rates following the 2001-2002 recession led to Real Estate speculation. The monetary policy of the 2000s is suggestive of government losing control. In the USA, the administration applied pressure to the FED to accommodate the busting of the technology bubble with an inappropriately low interest rate. It would appear that fear of popular disapproval prevented the much needed deleveraging that should have occurred after the bubble. In Europe, monetary policy is applied singularly by the European Central Bank. Interest rates that might have been appropriate for Germany and France , were not for Ireland and Spain who were experiencing real estate and construction booms. In the current reversal, interest rates are now too high for these countries. Their governments have both lost the ability to lower rates and ease policy through the exchange rate.

Government borrowing is also unusually high. The Western governments have found that the drop in tax revenues since 2008, combined with the monetary injections into the banking system, have left them competing with each other for domestic and international funding .Greece[12], for example, despite rigorous deficit criteria codified in the Maastricht Treaty, has overextended herself and now needs to borrow at 2.8 pct higher than Germany. It is interesting to note that the IMF[13] has warned countries of cutting spending too early. The Washington Consensus of trade liberalization and fiscal reform has been expounded since the early 1980s as necessary requisites for growth and higher living standards. Is procrastination on deficit- cutting a clue that the IMF recognises Government inertia and inability to implement the necessary policies to ease the debt burden. Only in 2009, the IMF forced Hungary to retrench and cuts its deficit and such an abrupt change in policy reflects the bewildering complexities that the IMF and governments face in choosing what to cut and where to invest in order to attract capital and win votes.

Aging population is a demographic phenomenon which can partially be explained by the benefits of globalization, but it also threatens to undermine government policy. Rising living standards , the breakdown of the nuclear family and a long spell of economic prosperity has been reflected in fertility rates in Europe dropping well below the replacement level of 2. The ratio of persons[14] aged 15-64 to those aged over 65 is projected to drop from over 4.3 in 2000 to under 3.0 by 2025 and threaten the ability of government to provide pensions and health provision. During the Golden Age there were two coincident misunderstandings. a. Fertility rates would stay above the replacement level of 2 and consequently population ageing would not be an issue and b. The failure to recognise that improvement in health would greatly increase life expectancy. In Britain the Labour Party reneged on its commitment to increase the retirement age of certain workers in the public sector. Continental Europe is in a more serious position as private pensions are quite rare unlike Britain. It is clear , that at some point, retirement ages will need to rise dramatically and/ or pension benefits be cut in real terms. However, the inability to take any decisive action thus far reflects how governments have been unable to undo the policy mistakes and misunderstandings of several decades ago.

The Losers of Globalization

Low productivity in the service sector, high government debt , unfunded liabilities ( particularly in pensions) , an ageing population requiring health care and ,not least, the bursting of a real estate bubble have left government with complex problems. However, central to these 5 issues lies perhaps the core dilemma. How can these problems be solved equitably? Or, put another way, how are the losers compensated so that they do not bear an overwhelming burden? The losers , inter alia, are low- skilled workers, the elderly who do not have private pension provision and property owners who entered the market late, particularly in the USA. Perhaps in the future, the greatest losers will tragically be the younger generation if these problems are merely ignored.

Two of the greatest periods of Globalization, 1870 -1914 and 1950 - 1973 had one noticeable similarity; they were periods of cooperation. In the first period Britain ,in particular, acted benignly as the hegemon and facilitated the monetary system and trading environment to work efficiently. Equally the “Golden Age” was cemented by the trust between capitalists and workers in ensuring the best allocation of capital. Unfortunately, in today’s climate, we see the reverse. World Trade liberalization has stalled in the Doha round and discriminatory[15] free-trade areas (FTAs) have replaced the brief period of “Open Regionalization”[16]. The Copenhagen conference was not just marred in terms of lack of progress on climate change , but was damaged by the conclusion that USA and China had little to discuss in terms of economic cooperation. As in Davos and G20 meetings, their antipathy is clear and disquietening. Japan’s own Golden Age has been halted by a 20 year period of infighting between rival factions, notably the Central Bank and the Finance Ministry. An unfortunate example of the(multi) prisoner’s dilemma; the government lacking ability to enhance cooperation.

In a period of cooperation, losers have a better chance of being compensated . Between 1870 and 1914 , countries who would not have been able to access capital or would have had high transaction costs , were included in the “orchestra”. In the Golden Age, manual and semi skilled workers were promised a completely new level of welfare , education and health-provision. The working classes were so confident that they were not society’s losers that they were prepared to defer wage increases and abstain from disruptive bargaining.

Today’s losers are not so confident. The banking sector , which was the biggest player in the real estate boom through leveraging its balance sheet with direct property loans, mortgage-backed securities and real-estate derivatives , has required a bail-out of unprecedented proportion. Despite punishment taxes on banks, all workers will have higher fiscal demands to fund the bail-outs.The poorest paid will proportionally have the most to pay. The unskilled and the young are actually facing cuts in education at the time they most need an increase and a chance to re-train. The countries most in need of liberalization are watching the larger countries choose NTAs.

The 2nd half of the 20th century has seen an unparalleled increase in prosperity among western industrializing countries, East Asia and others but also a new and larger group of dispossessed; an underclass. Alongside the winners , there has been a growing group; the undereducated, sub Saharan countries and the Afro American community in the USA (who are the predominant losers in the sub-prime crisis.) In order to pay for higher education, lower worker retiree ratios and an ageing population governments will need to retrench and reallocate. Unfortunately those they wish to tax can change domicile (multi nationals) , or simply form a quorum large enough to vote against that change .Governments have run out of money. With over 50 pct of GDP allocated by European governments, there is not much scope for increase (Sweden went as high as 63 pct and since needed to retrench).

The necessary market mechanism to reallocate capital is several steps behind the pace of globalization. This in itself is a symptom of loss of control. In particular, Governments are unable to apply macro economic policy as many nations have unified monetary policy or fixed exchange rates. Equally, fiscal policy is constrained by the convergence of tax rates (which itself is a consequence of monetary harmonisation) and voter appeasement. It is also hampered by multi- nationals with their choice of domicile and voters reluctant to bail out the financial sector. (The regulators of the open capital-market system were unable to recognise the real estate bubble and were reluctant to restrict balance-sheet leverage).Immigration to overcome the age-imbalance of a population is unpopular and market liberalization has been reversed in favour of discriminatory blocs. If governments are unable to embrace the losers and overcome this current period of non-cooperation then it is possible that loss of control will lead to a reversal of the World Economy that may partially reflect the chaos of the 1930s.

Simon GILLIS 10 iii 2010

C.H.Feinstein. Structural change in developed countries during the twentieth century.

N.Crafts. Globalization and Growth in the Twentieth Century.

J.Ruggie. Trade, Protectionism and the Future of Welfare Capitalism.

P.Krugman . Competitiveness, a dangerous obsession .

M.Bordo B.Eichengreen and D.Irwin Is Globalization really different than Globalization a Hundred Years ago.

M.Wolf Is Globalization in danger?

R.Garnault and D.Vines. Regional free-trade areas: sorting out the tangled spaghetti

D.Baines N Cummins M Schulze Population and Living Standards

D.Baines European Demographic Change since 1945 in Schulze Western Europe.

M.Bordo H Rockoff The Gold standard as a “Good Housekeeping Seal of Approval”

J de Long B Eichengreen The Marshall Plan: History’s Most Successful Structural Adjustment Programme

N Crafts. The Great Boom 1950-1973 Schulze Western Europe

P Temin. The Golden Age of European Growth Reconsidered.

[1] C.H.Feinstein. Structural change in developed countries during the twentieth century
[2] D. Baines . Class Lecture Notes
[3] Ibid
[4] N.Crafts. Globalization and Growth in the Twentieth Century
[5] Ibid
[6] J. Ruggie. Trade, Protectionism and the Future of Welfare Capitalism.

[7] N.Crafts. Globalization and Growth in the Twentieth Century
[8] Ibid
[9] P.Krugman . Competitiveness, a dangerous obsession.
[10] M.Bordo B.Eichengreen and D.Irwin Is Globalization really different than Globalization a Hundred Years ago
[11] M.Wolf Is Globalization in danger?
[12] March 4, 2010 . Most recent Greek Government Bond issue
[13] IMF policy paper February 2010.Strategies for Fiscal Consolidation in the Post-Crisis World
[14] OECD, Employment Outlook 2007: Weighted average of France, Germany, Italy, Spain, Sweden and UK
[15] R.Garnault and D.Vines. Regional free-trade areas: sorting out the tangled spaghetti
[16] Ibid

Gold in Terms of the S+P Index 1927-2009

2009-12-04T02:56:00.000-08:00

2009-12-04T02:50:00.000-08:00

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 Problem of buying Gold

2009-12-02T11:35:00.001-08:00

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

Comparing The Great Depression with The Current Crisis

2009-11-28T10:22:00.000-08:00

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

Introduction.

2009-11-28T10:20:00.000-08:00

My aim is to post interesting ideas, essays and articles on Financial Markets , Gold and Wine