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A crude awakening
2011-NOV-26
 One
of the joys of interviewing some of the best brains in
the world of finance and economics is that they alert
you to important factors that perhaps you haven’t fully
considered. This was my experience with Chris Martenson
in Madrid last week (the interview will be posted on the
GoldMoney website in the coming weeks). He reminds us
that the availability and price of oil are central to
our economic future.
The basic argument is this: very little can happen in
our lives without oil. It is required for mining,
agriculture, manufacturing, transport and distribution.
Global consumption is rising, and extraction has
levelled off. Oil-exporting nations are consuming more,
leaving smaller balances for those with oil deficits.
The cost of extraction is rising sharply: whereas fifty
years ago it cost one barrel of energy to extract a
hundred, we are moving towards new fields where the rule
is one barrel for three. We face a train-wreck between
the increasing rates of global consumption and the
declining rates of net exportable production.
We are familiar with this story, but most of us
underestimate its importance, so it is worth repeating.
The chart below (which is based on statistics from BP’s Statistical
Review of World Energy 2011) sums up the
problem.
The black line is the five-year moving average of the
balance between annual production and consumption,
represented by the black columns. The last year of
production surplus was 1981, thirty years ago, and since
then the world has drawn down on strategic stockpiles
and inventory to meet consumption demand, at a trend
rate that is now accelerating. The blue columns
represent the European balance, which has benefited from
North Sea oil and which is now running out. The red
columns represent North America and Mexico, whose
production has been deteriorating since 1984. But most
frightening is the Asia/Pacific deficit, the yellow
columns, which has soared over the last twenty years.
The chart clearly shows a picture of an imbalance
between production and consumption that cannot continue
much longer. The world is now caught between inflexible
demand – because oil is vital to our very existence –
and declining net production. This explains the oil
price, which is the blue line in the second chart (I
shall comment on gold in a moment).
There have been three phases: the first, when OPEC
jacked up the price of oil; the second when more
expensive non-OPEC fields came on stream putting a cap
on prices, and finally the third, where prices have
increased seven times so far. It is this third trend,
from which there is no apparent escape. The chart is on
a logarithmic scale, which means that prices have been
rising at an exponential rate since 1998.
With the production/consumption imbalance set to
deteriorate further, there can be only one result, and
that is considerably higher prices. Based on BP’s
statistics, which show that the world’s most vital
commodity has been in a supply deficit for the last
thirty years, the logical outcome is a price explosion.
And with quantitative easing in the markets there will
be extra money to pay higher prices, the consequences
for global price inflation do not bear thinking about.
On this evidence we can therefore confirm Chris
Martenson’s analysis.
Living with an energy supply crisis will require a
radical change in our lifestyles – downwards. The best
financial protection from this event appears to be
physical gold, which has tracked the price of oil
reasonably well over the years as shown in the second
chart, and can be expected to continue to do so. After
all, the combination of the most rapid global monetary
expansion in peace-time history and soaring oil prices
is an inflationary disaster in the making.
An Austrian economic view
2011-NOV-12
 In
the last two weeks the headlines have switched from
Greece to Italy. Financial and economic commentators who
dismissed Greece as a small cog in the Euroland machine
are now seriously alarmed and see no solution to
Europe’s sovereign debt crisis other than the short-term
expedient of getting the European Central Bank to print
lots of money. They castigate Germany’s sound money
approach, ignoring the fact that it has been central to
Germany’s economic success, preferring to commend the
loose-money economics of the unsuccessful “PIIGS”
(Portugal, Ireland, Italy, Greece and Spain). And when
listening to them, just remember that none of them
foresaw this crisis, when it was obvious to Austrian
economists in the early days of the banking crisis.
Keynesian and monetarists believed that the problems
surfacing in the PIIGS would be resolved by economic
growth, which would follow so long as governments
maintained their deficit spending. As events are now
proving, this analysis was flawed, which is why
Keynesians are now confused. They should open their
minds and absorb Austrian economic theory to gain a
proper understanding of human actions and how people are
affected by money and credit.
The first thing they will learn is that the economic
benefits of credit expansion are a myth. All it does, by
a process of capital redistribution – from savers to
those who are first in line to receive the new money –
is distort the economy and restrict its long-term
potential. By lowering interest rates and diverting
private sector resources from genuine production to
government spending, the economy becomes less efficient
and malinvestments occur. The mistake has been to only
consider the visible benefits, such as short-term job
creation, while ignoring the destructive effects of
deficit financing.
The distortions created by easy money and deficit
spending will naturally try to reverse themselves as
surely as night follows day. The recession that follows
the temporary boom is the way an economy cures itself
from unsound money and government intervention. This is
hard for interventionist governments to accept because
it strikes at the heart of their existence. And while
printing money and credit is always popular with an
electorate that does not understand what is happening to
their money, reversing the process is readily noticed
and immensely unpopular.
This brings us back to Euroland’s problems. The creation
of the euro twelve years ago allowed banks to expand
credit massively in the mistaken belief that sovereign
risk had been eliminated. The result was that
spendthrift governments availed themselves of cheap
credit. Eurozone governments, particularly the PIIGS but
also France and Belgium, have squandered huge sums to
prevent the unwinding of malinvestments and other
economic distortions, preferring to perpetuate existing
malinvestments. The only solution is for them to let the
unwinding happen, which is what the financial markets
(for which read reality) are now forcing them to do.
What we are seeing, the markets unwinding economic
distortions from the past, is a necessary process and
therefore beneficial, a point which goes completely
unrecognised. If only governments had the sense to
understand this, it is not too late to plan wisely for
regenerated economies and a sounder Europe.
Unfortunately, the gut reaction of the political class
and its advisors is to continue as before at all costs,
deferring this necessary adjustment and increasing its
eventual severity.
There is no joy for the informed spectator in seeing
continuing economic destruction. However harsh it may be
in the short-term, the EU elite needs to start paying
attention to Austrian School remedies to Europe’s
financial woes – and fast.
The Chinese and the eurozone
2011-NOV-05
 The
basic market problem is there is too much sovereign
borrowing for the money available, which would normally
drive interest rates sharply higher. Some countries have
got round this by printing money while pretending they
are issuing bonds. A few countries are unable to do
this, because they lack their own printable currencies.
And that is the root of the problem faced by the weaker
eurozone members.
This problem for some of them has become so acute that
they cannot now fund their deficits. What is less
obvious is that these highly-indebted states also have
to roll over existing debt as it matures. Traditionally
this debt has been absorbed on a replacement-basis in
the markets, but that only works as long as the markets
are fundamentally confident, which they are no longer:
the inability of the political classes to resolve their
difficulties has seen to that. Therefore, as bonds
mature, investors and banks are unlikely to re-invest,
preferring cash. Even if the weaker states are able to
fund redemptions, from an expanded European Financial
Stability Facility (EFSF) for example, this will be used
to reduce euro-denominated bank credit and improve
capital ratios.
This need not be a bad outcome, because the economic
effect is to simply transfer the funding of sovereign
debt to the EFSF. The question is who is going to fund
the EFSF, which with its gearing is a risky proposition?
There are only two possibilities: the ECB (which should
not be assumed at this stage) and those with trade
surpluses to recycle, particularly China. And since she
is the only major source of this potential funding in
the running, she is in a position of enormous
negotiating power.
Looking at the proposition from China’s viewpoint is
instructive. She is being asked to bail out profligate
nations, who have run out of credit and whose citizens
enjoy a far higher standard of living than their own. It
amounts to a position of power ahead of her economic
development. Furthermore, China’s economists were
brought up with the Marxist dictum, that capitalism
ultimately destroys itself, so they are being invited to
merely delay something that is inevitable. Will they
fund the EFSF? Beyond perhaps a token amount, it seems
unlikely. But will they stand back and let Europe sink?
That would be a missed opportunity to wield her enormous
power, and we need to give this thought some historical
context.
The one thing the Chinese have learned is that they
cannot guarantee their own security through military
means alone, they also require economic strength. This
was the reason old-style communism failed. It has taken
them only thirty years to acquire that strength. To
consolidate it, they now seek to eliminate their
dependency on the US dollar. Therefore, the price
Euroland will have to pay for funding is that either the
Chinese are given some control over the euro, perhaps by
having permanent representation at the ECB, and/or there
must be a material advancement for the yuan in trade
settlements. And it is unlikely loans will go through
the EFSF, because China will want to set her own terms.
This describes the strength of her position. It remains
to be seen how China uses this longed-for escape route
from dollar domination, and how she plays a winning
hand. Initially, she may wisely play for time, letting
the Euroland situation deteriorate further, to get the
terms she requires.
Inflation and German sensibilities
2011-OCT-29
 Angela
Merkel told the German Bundestag last Wednesday that in
the absence of a deal on the eurozone debt crisis,
“Nobody should take for granted another fifty years of
peace and prosperity in Europe: if the euro fails,
Europe fails”.
This perhaps encapsulates Germany’s fears, born out of
experience, and it would be wrong to dismiss her
statement, as many commentators have, as mere rhetoric.
The whole concept of the European Coal and Steel
Community, the original forerunner of the European
Union, was to tie Germany and her neighbours together in
a trade and political union to prevent future wars
between them.
The EU has delivered peace and prosperity for Germany.
It is reasonable to conclude, as Merkel does, that the
destruction of the euro will reverse the political
process. Post-war European politics has been largely
based on these two premises. But there is a deeper point
to Merkel’s statement, which has been forgotten in our
modern world of fiat currencies: in history the greatest
threats to peace and social stability have usually been
associated with currency debasement. And here, Germany’s
unhappy experience has become rooted in its people’s
psyche.
Germany’s spending in the build-up and early years of
the First World War was financed purely by monetary
inflation, and even by 1917, 85% of the cost was paid
for by new paper money. This came about as a result of
the economic advice at the time, principally from Georg
Knapp, who believed that money is a government product
and should be free of other constraints. For the Kaiser,
it was like having a modern Keynesian economist advising
a government today that it has a right to finance itself
through monetary inflation. It was therefore hardly
surprising that an ambitious Kaiser, having been shown
how to finance the expansion of Germany by attacking its
neighbours, actually did so.
The social consequences of printing money are entirely
supported by economic theory of the Austrian School of
economists and the lessons of history. It boils down to
a simple fact: any electorate can be patriotically
roused for war, so long as it doesn’t have to pay for
it. And that is the lie behind monetary inflation. If
you print money to finance a war instead of raising
taxes, for a time, no one notices the cost.
Germany has been through this lesson twice in the last
century, so her people instinctively understand the
chaos that results. It is the rest of Europe, with the
exception perhaps of Austria, which has forgotten it. So
let us state it loud and clear: sound money is the best
guarantee of peace, while fiat money is a precondition
for chaos.
So Angela Merkel is right, but the pressure from other
euroland and G20 states will be difficult to resist.
They have placed their trust in an expanded bailout fund
to be supported partly by the EU’s Asian trading
partners, which if it gets off the ground will do so at
the expense of the dollar. The trouble will come if the
European Central Bank is also expected to fund it, which
so far is assumed by many but not discussed. Any major
injection of ECB money into the fund will be extremely
controversial in Germany, and therefore should not be
taken as read.
US money supply growing fast
2011-OCT-22
 With
all the troubles of Europe hogging the headlines,
commentators are ignoring money supply in the US, which
is growing strongly, with the broad measure of M2
growing by over 10% for the last 12 months. Furthermore,
the annualised growth rate over the last six months has
been above 15%. The story told by the True Money Supply,
otherwise known as Austrian Money Supply, confirms this.
The reason for using TMS is simple. According
to the Ludwig von Mises Institute, it represents the
amount of money in the economy available for exchange.
Furthermore, it is designed to clearly show any
expansion that results solely from central bank
injections of cash and commercial banks’ credit
creation, by excluding anything that has to be converted
into cash first, such as credit and money market funds.
It is therefore a pure measure of money in the economy
available to be used for transactions, more pure than
official MZM, M0 or any other central bank "M" measures.
In economic theory this is important, because money is
simply a commodity that happens to be used exclusively
as a medium of exchange. And as a commodity, its value
ultimately depends on its supply and the demand for it.
By using TMS we keep the relationship between actual
money and prices pure from other arguable factors.
The growth in US dollar TMS over the long-term is shown
in the chart below. From this chart it can be seen that
following a pause in its long-term trend at the time of
the 2007-08 financial crisis, TMS has been growing
strongly ever since.
The bulk of the growth has been in check deposits
(customer current accounts) and savings deposits
(instant access accounts) at the banks. Some
commentators point out that this reflects cash not being
spent and cash representing risk-averse hoarding. But
this opinion ignores the fact that the cash is being
used, because the banks have lent it to the government,
and the government is distributing it into the economy.
So this cash does amount to extra supply of money, which
will be gradually reflected in a fall in its purchasing
power. Given that the acceleration in TMS dates back to
2009, we are already seeing this, with ShadowStats.com,
which applies an unbiased statistical rigour to key
statistics, estimating actual inflation to be running
considerably higher than official estimates.
The other aspects (other than of money that is) of the
pricing effects of supply-and-demand is the variability
of demand for individual goods. And here, the picture –
as always – is uneven. Welfare, defence and healthcare
spending by government maintain demand for energy, food,
defence and healthcare-related items. Banking and
related financial services are also doing well, despite
balance sheet problems, as they are closest to the
source of the new money (in this case, the Federal
Reserve). Much of the rest, as business surveys and
unemployment statistics confirm, is patchy at best. So
there are identifiable winners and losers in pricing,
and the expansion of TMS is feeding through to those
goods, demand for which is supported by government
spending.
With this monetary background, it is likely that the big
headache for 2012 will be persistent and rising price
inflation for the US and other economies tied to the
dollar. So we can expect stagflation to be in everyone’s
vocabulary in the New Year, which will inevitably lead
to pressure for interest rates to rise sooner rather
than later.
Quantitative easing, or when there's nowhere left to run
2011-OCT-08
 Over
the last few weeks there has been a growing realisation
that the weaker members of the eurozone are caught in
debt traps. When the “PIIGS” (Portugal, Ireland, Italy,
Greece and Spain) signed up to the eurozone they gave up
the right to devalue, which is the traditional and
delusionary escape route for sovereign debtors. But when
you come up against the realities of hard money, this
route is blocked. A temporary solution has been to gets
banks to buy government bonds, but the banks can take no
more. This leaves us with a banking problem, but
fortunately their solvency is being underwritten by the
European Central Bank, without which the eurozone would
have ground to a financial halt.
The ECB, together with the national central banks, can
only support these banks by writing a blank cheque on
itself, while using all means possible to conceal and
play down the losses in the system. This essentially is
what happens with the good-bank/bad-bank solution: if
the bad stuff is carted away to be dealt with out of the
public gaze leaving the good stuff behind, what is there
to worry about?
We have to keep our fingers crossed that the ECB
continues to succeed in co-coordinating this vital task,
and indeed, its strongest suit is that we all want it to
succeed. But this still leaves us with the unanswered
question of how to resolve the sovereign debt traps.
The problem is global. The eurozone’s debt problems,
which also extend to France and Belgium, have only
become obvious because of the inflexibility of the euro.
But debt traps have also closed on the US and the UK,
who can try to print their way out of trouble. Both
these governments are fully committed to monetary
inflation as the means to conceal and defer their own
financial difficulties. This is what quantitative easing
is actually about: it is the way a government funds
itself when markets are unable or unwilling to come up
with the money required. You bypass markets by printing
it for your own banks to lend to you.
The idea that QE is primarily to help the economy
recover is Keynesian guff, a cover for the true reason.
Without it, the US and UK would have to compete for
global savings at far higher interest rates. What price
$2 trillion in new Treasuries with no QE? What price
£175 billion in new gilts? The debt trap has already
sprung. And few investors yet seem aware of the irony
that loading up banks with Treasuries and gilts is
exactly what the eurozone banks have already done for
the PIIGS. Whatever the current difficulties faced by
European banks and the US and UK governments and their
banking systems, there is only one option for all of
them: buy time by printing yet more money. This is why
the banking system in the eurozone and elsewhere will
survive. Banks need governments as much as governments
need them. The cost of this survival will be borne by
the unwitting saver, who has been frightened into cash
only to find it being debased more rapidly than before.
This makes the recent fall in gold and silver prices
nonsensical. But then just as the investment community
walked blindly into stock market losses, they are just
as clueless about the inflationary implications of
rescuing sovereign debt.
EU elite lost at sea
2011-OCT-01
 Since
I last wrote about the euro crisis, events have taken a
predictable turn for the worse. In my GoldMoney
article dated September 17 I argued that
eurozone governments should cut their own spending
substantially, while the European Central Bank should
restrict itself to working with national central banks
to keep the banking system functioning, and that a sound
euro is better for private sector recovery than a weak
alternative. I also argued that there was a benefit in
allowing Greece to default, pour encourager les autres.
Keynesians argue that the worst thing to do is to slash
public spending. I would argue that the worst thing you
can do is to not cut public spending, because public
spending, which dominates most European economies, is a
misallocation of economic resources, stifling their
private sectors. A public sector is an economic burden,
not a benefit, and the strangulation of private sectors
in the eurozone is the fundamental economic problem.
Over the years the European Union and its members have
become increasingly dominated by central planners and
regulators, and the governmental solution to today’s
crisis is for more of the same. Already no one in the EU
can sell any product without conforming to myriad
regulations, and employment laws and taxes on employment
are strong disincentives for the expansion of small and
medium-size businesses that make up the bulk of any
domestic economy.
The deterioration in the underlying quality of private
sector business, the result of central planning and
needless regulation, has been concealed by the expansion
of bank credit, which has fuelled both private and
public sector debt. According to the International
Monetary Fund, at the end of 2010 gross government
debt-to-GDP for the Euro area was 87%, and household
debt 72%, giving a total of 159%. Germany itself was
running a combined total of 142%, which is often
overlooked. On these figures alone, it is clear that the
Keynesian solution of more government spending as the
route to salvation is unaffordable, whatever the
economic arguments.
It is difficult to know if anyone in the EU elite fully
understands the problem. Noises emanating from them are
extremely discouraging, from their resentment at being
pressured at the recent G20/IMF meeting to deal with a
rapidly deteriorating situation of which they seemed to
be insufficiently aware, to the President of the
European Commission’s analysis, which is that the
problem can only be solved by closer political
integration and new taxes. Their dilemma is not helped
by their advisors, who are all highly qualified central
planners who have no empathy with private sector
business, beyond what they are told by monopolists. They
are genuinely upset at and confused by the intrusions of
market reality into their plans.
We will not change these people’s views, but their
attempts to cross-subsidise their public sectors must be
thwarted. This will not be done by the IMF, which is
institutionally sympathetic to governments over free
markets. The task must fall on the shoulders of the ECB,
which is why it is so important that the ECB limits its
activities to keeping the banking system solvent and not
funding insolvent governments.
It must also resist calls for a weaker monetary stance,
beyond what is necessary to keep the banking system
functioning. Contrary to every bystander’s advice, you
need certainty of monetary values to allow the
regeneration of savings and business investment to
develop, which is the precondition for economic
progress. Let’s hope the ECB is strong enough to stand
firm.
Gold, the euro and Operation Twist
2011-SEP-23
 At
first sight it is puzzling that systemic uncertainties
are escalating rapidly in the eurozone and that the gold
price is subdued. And if the press is to be believed,
the euro might even disintegrate.
There is no doubt that Europe’s difficulties are a good
reason to take out some insurance, but to argue that the
fall-out from the euro crisis should increase demand for
gold much beyond that is to misunderstand what gold is
about. Yes, it is an effective temporary refuge from
paper money in uncertain times, but the real reason for
the price to rise is to be found in monetary inflation.
In managing the euro, the European Central Bank has done
well to resist calls for substantial monetary easing,
and by standing firm politicians have generally stopped
badgering the ECB to do so. This has given some support
to the euro and restricted flight from it to manageable
quantities. True, the euro has fallen about 6% against
the dollar, but then the dollar was overdue for a
bounce. There is on-going panic in the eurozone, but all
things considered there has not been much of a panic
over the euro itself.
All this suggests that the fringe money that has gone
out of the euro and into gold is for the central banks a
containable problem. And if anyone has a deposit at say,
a French bank, and is worried about it, it is far easier
to move it to another too-big-to-fail bank elsewhere
than to take a more difficult decision, such as “Do I
buy some gold, even though the euro price has risen
five-fold in the last eleven years?”
Meanwhile, there are far better reasons to sell the
dollar and buy gold, even though the market’s initial
response to the Federal Open Market Committee statement
on Wednesday was to mark down precious metals along with
everything else. Operation Twist disappointed those that
were hoping for QE3, but realistically the headline
focus was always going to shift to bank credit. Few
commentators have picked up on this, but they should do
in the coming weeks.
Put simply, the Fed is going to sell short-dated US
Treasury stock and buy maturities of 6-30 years. The
short-dated stock will most probably be bought by funds
gearing up through the repo market, which will shift
excess bank credit from the Fed balance-sheet into the
banking system. This is consistent with the announcement
last month, that funding rates will be held at current
rates for the next two years.
While the Fed claims this will benefit the economy by
lowering long-term rates, the true beneficiary is the
Treasury, which gains an improved maturity profile at a
ridiculously low cost. This is actually highly
inflationary, as bank credit will expand to finance
government borrowing through the repo market, and room
will be created on the Fed’s balance sheet for up to
$400bn of new money to be issued.
So not only do we have QE3 of $400bn, but we have an
expansion of bank credit to match: now that is monetary
inflation. What price gold when people actually wake up
to what is going on?
23 September 2011
Rocky Banks
2011-SEP-03
 The
banking crisis of 2008 alerted us to the risk of a
systemic collapse of the banking system. Today these
fears again seem very real, with concerns over the
European banks and the share prices of banks everywhere
having taken a big hit recently. Splitting the banks
into domestic lending and investment banking has also
returned to the top of the political agenda in Britain
this week.
There is a contrarian adage that when no one expects an
event, it might happen, and when an event is commonly
expected it might not happen. This could apply to the
much-heralded banking collapse. But since the Bear
Sterns and Lehman crisis the banks themselves have been
busy rebuilding their core capital and adjusting their
business activities in line with the new Basle III
regulations and the Dodd-Frank Act in the US. In
Britain, regulation of the banks has moved back from the
FSA to the Bank of England, where it belongs. Both the
banks and their regulators, having had a very nasty
shock three years ago, have taken big steps to avoid a
second crisis.
It is not as difficult for central banks to prevent a
collapse of the banking system as many observers
believe. The key to it is to buy time, which the Bank of
Japan did in the 1990s when it faced a collapse of the
major Japanese banks. Banks are also major beneficiaries
of monetary inflation, which partially justifies the
quantitative easing policies of the Fed and Bank of
England. Furthermore, financing governments has always
been a lucrative activity, contributing to gross returns
on capital of as much as 20% for the investment banks.
It only requires a few years in this monetary
environment to rebuild healthy capital ratios.
Today, the European banks pose the biggest risk to the
global financial system, as the sovereign debts of the
weaker nations edge towards default. But even here, the
ECB is not toothless, and can do much to prevent a
Europe-wide banking crisis, working with national
central banks to ensure liquidity is always available
for the banks that need it. This is already happening
with Greece’s banks, which have seen a steady withdrawal
of deposits since Greece’s first bail-out.
The real test will be an actual sovereign default, which
is a genuine concern. But here again, money that is
withdrawn from one bank perceived to be in trouble and
deposited in a stronger competitor merely gets recycled
to back to the first bank, if not through the
money-markets, through the central bank. The ECB may
have to copy the Bank of Japan twenty years ago, by
pretending that banks’ individual problems don’t matter,
because they are back-stopped by the central bank. After
a while, depositors, bond-holders and investors might
stop worrying, if only because nothing happens and the
crisis is no longer news.
However, it would be wrong to be complacent about the
substantial risks facing the global banking system, and
there is still the possibility of a second systemic
crisis. But the bigger crisis by far, which is beyond
anyone’s control is in government finances, which
ironically, should continue to be a source of
substantial profits for the banks – so long as they
survive.
Tags: Bank
of England, ECB, euro
crisis, Greece
Keynes versus Hayek (Posted at GoldMoney
here)
2011-AUG-07
 While
the whole world seems to be collapsing into a financial
black hole, I came across a glimmer of hope in the
unlikely form of a BBC radio broadcast last Wednesday.
The programme was a debate held at the London School of
Economics, the subject of which was the relative merits
of Keynes versus Hayek, or state intervention versus
free markets.
The debate was chaired by Paul Mason, BBC2’s economics
correspondent, and attended exclusively by LSE students,
about half of which were Hayek supporters. This was a
surprise to those of us not au fait with the LSE of
today, perhaps confounding out-dated prejudices that it
is a hot-bed of left-wing Keynesianism. It is quite
likely that the audience did not reflect the consensus
of all LSE students, but at least there were a
reasonable number of Hayekians willing to stand up and
be counted.
Heading the panel were eminent professors defending one
or the other. Much of the debate was entirely
predictable, with the Hayekians pointing to the failure
of Keynesianism, and the Keynesians accusing the
Hayekians of having no constructive solution to the
current economic difficulties that doesn’t involve
unacceptable pain and misery. Same old, same old: the
alcoholic wants more drink, and Mr Nasty says it won’t
cure his problem.
The debate was interesting, as Donald Rumsfeld might
say, for what was said was said, as well as for what
wasn’t said. The leading Keynesian panellist, who has
written a biography of the great man, knew in meticulous
detail his quotes and writings. He used this to nit-pick
the other side, rather than address actual economic
theory. The leading Hayekian panellist mostly pointed to
the Keynesian failures as evidence against a statist
approach. Neither panellist presented their favoured
economic theories really cogently. Of course, it is
difficult to do this in the confines of a radio debate
of 45 minutes, without the wider audience switching off,
and in the knowledge that the programme might be heavily
edited anyway before going on-air.
What was not mentioned, except in passing, is the role
of fiat currency and bank credit in fuelling increasing
economic instability. No mention was made of the
destruction of savings through monetary inflation and
discriminatory taxes, and why savings are so important;
a subject where there is sharp disagreement between
Keynes and Hayek, and ripe for debate. The simple
proposition, that individuals are better than the state
at spending their own money was not put forward either.
In many senses the debate was unsatisfactory, and I
couldn’t help thinking if Keynes and Hayek were alive
today that they would be disappointed at how their views
were represented. I have no doubt that Keynes’s views
would have altered significantly, because the world has
altered fundamentally since he was at the peak of his
powers. There is no longer a communist or fascist
threat, and much of what he thought appropriate 80 years
ago is clearly no longer appropriate – but it doesn’t
stop his acolytes thinking so. Hayek would surely be
more confirmed in his views by recent events.
Unfortunately, they are both dead, so we will never
know. The result of the debate? It was judged a narrow
victory for Hayek. Now, that is a glimmer of hope!
ECB to say yes to QE?
2011-JUL-16
The surprise of the week has undoubtedly been panic over
Italy’s finances. Until this happened, it was commonly
assumed that the PIIGS would fall in strict order, with
Spain due to follow Portugal. The political response to
this development amounts to total confusion among the
Eurocrats. They recognise they must do something, but
they do not know what, so they have meetings.
It is hard to have sympathy with these, the most statist
of politicians, but there is in reality nothing they can
do. The underlying problem is that western governments
are nearly all running massive budget deficits, and the
savings simply do not exist to fund them all, not even
if interest rates doubled or tripled from current
levels. In the funding queue some governments have
precedence over others, either because they are seen as
low-risk, or in the case of the US, because the dollar
is the reserve currency. The propensity to save is
important, which gives Germany and China, for example, a
greater degree of funding security. This used to be true
of Japan. The competition for savings leaves Euroland’s
PIIGS shut out of capital markets.
Bond market analysts, the rating agencies, and
organisations such as the OECD and the IMF, all produce
optimistic forecasts of the funding requirements for
these countries in the coming years. They are optimistic
because economic recovery is assumed, when it is
actually becoming impossible. And as the prospects for
economic recovery are replaced by the near certainty of
slump, these nations become locked into a cycle of
raising taxes and cutting welfare, plunging them further
into depression.
This may be a fatal blow to the European Project. It
certainly puts the ECB in an impossible position. The
central bank has done little to help the PIIGS
governments with their financial difficulties, sticking
mainly to keeping the eurozone banking system solvent.
The ECB now faces the ultimate test: in the face of
these escalating sovereign difficulties, will it
continue to follow its relatively sound money policies?
(Relative, that is, compared with the brazen money
printers at the US Federal Reserve, Bank of England and
Bank of Japan.) Sound money is bankrupting the PIIGS and
will soon do the same for Belgium and France. Or will it
cooperate by buying newly-minted PIIGS debt in a
quantitative easing programme? If it does, the eurozone
will live to fight another day. Though the ECB’s charter
says no to QE, political reality says it is vital.
Any easing of the ECB’s stance against QE can be
expected to fuel European demand for precious metals,
and with gold hitting new highs this week, perhaps the
smart money is ahead of it. And if the ECB starts its
own QE programme, we can expect the Bank of England to
consider QE2, and thus the Fed will have an excuse for
QE3.
The reality is that the only way the large budget
deficits of many developed countries can all be funded
is by printing money to buy debt. The alternative is far
higher bond yields for all but the very best credit
ratings, yields that few governments can afford to pay.
No wonder gold is so strong. The penny is finally
dropping in the slot machine that passes for the
collective brains of the investment community.
Inflation is beyond the tipping-point
2011-JUL-09
 Forecasters
face a dilemma: is the outlook inflation, or deflation?
And given the recent signs of disappointing economic
growth, are we worrying too much about inflation?
Certainly, for the Keynesians, who are constantly on the
look-out for signs of deflation, and who believe that
governments must at all costs keep prices gently rising,
the alarm bells are ringing.
At the heart of their economic philosophy is the tired
old economic fallacy of under-consumption as the reason
for recession, and government deficit spending and
stimulation of consumption as the way to recovery. In
their desire to promote consumption at all costs, they
have destroyed savings, and encouraged consumers into
unsustainable debt. And despite the stimulation of 10%+
budget deficits, the vapour trail of recovery is fast
disappearing. The Keynesian solution has left us in a
worse position than we were in at the time of the
credit-crunch and the collapse of Bear Stearns and
Lehman Brothers.
That point in our economic history marked the end of the
era of ever-expanding credit, when banks competed to
lend. The paralysis in the money-markets changed that,
and ever since both the banks and highly-indebted
borrowers have become risk-averse. It also marked the
end of the post-war Keynesian experiment. The cycle of
monetary go-stop has been repeated too often, and now
fools no one.
The idea behind monetary stimulus is to get businesses
investing in new production and creating jobs in the
process. But any industrial investment requires
long-term stability in the factors of production, which
include labour costs, the cost of money, and raw
material prices. The Keynesians have unfortunately
achieved short-term instability in all of them by
monetary manipulation.
If, instead of the systematic destruction of savings
through taxation and inflation, savings had been
encouraged, the US and UK would have a healthier balance
between manufacturing and consumption, and their trade
would be more balanced. This is the lesson we have
failed to learn from observing the post-war economies of
Germany and Japan, both of which were driven by a strong
savings ethos.
Both the mark and the yen were exceptionally strong
currencies against sterling and the dollar, which
according to our Keynesian experts should have restored
trade balances. At first sight, this static analysis
appears logical, but it ignores the far greater benefit
to German and Japanese industry of stability in the
source (savings) and cost of money. It ignores the
stability of labour and raw material costs that comes
naturally with savings, and which do not suffer
disruption from unstable money supply and bank credit.
The evidence from savings-driven and consumption-driven
economic models clearly disproves the Keynesian fallacy
of under-consumption, and its correction by monetary
manipulation. But anyone with knowledge of economic
history, and of the clear evidence that free markets
cannot be bettered for allocating resources between
consumption and savings, knows this. Relearning the
lesson has destroyed our economies, and made us even
more dependent on monetary inflation to buy off the
consequences of debt-deflation.
We passed the tipping point when banks stopped becoming
aggressive lenders. Now we will print money to save our
skins.
The limitations of technical analysis
2011-JUN-25
 It
is generally encouraging for precious metals bulls when
technical analysts are cautious or suggest that a
correction is not yet over, because they have a knack of
advising caution just before prices rise. Silver is
particularly difficult for technical analysts who apply
Elliott Wave theory: today, they see the possibility of
an A-B-C correction, in which case a downward C-leg
would take the price down to the $25–$30 level.
Technical analysis is for those who are unprepared to
properly consider the true factors that drive a market.
The laws of chance suggest that an unemotional technical
analyst might be right 50% of the time. This is not to
say that applied technical analysis is little better
than tossing a coin, because some technical analysts do
get reasonable results and some of their tools are
worthwhile. Good technical analysis gives us a better
understanding of the balance between greed and fear in
the markets.
The people who really know where this balance lies are
the market makers, or in the case of the futures market,
the commercials. They learn with great rapidity the
quality of business a floor broker has, and how
successful that broker and his clients are in their
trading activities. This is important knowledge that is
denied to the rest of us, which is why the commercials
were so successful in precipitating the severe shake-out
in silver in late-April.
But if you are a technical analyst, all you see is a
bullish trend that has been severely broken, raising the
real possibility of a new bear phase, with an Elliott
Wave C-leg to come. You think you are reading in graphic
form the tussle between greed and fear. This is
certainly valid in the narrow context of the Comex
futures market, into which is corralled all the
speculative interest from American punters. But it does
not capture the emotion behind the physical market: the
concealed activities of central bankers, the demand from
Chinese and Indian investors and the developing panic in
Europe. The central banks are secretive, the ordinary
people are countless and uncounted. They were never
greedy, only fearful that paper money might lose its
value. In the overwhelming absence of greed, there can
be no balance with fear, negating the very basis of
technical analysis.
Perhaps the best lesson to learn from the recent
shake-out in prices is that it has provided an
opportunity for everyone around the world, fearful of
the precariousness of paper money, to buy more physical.
We have no definitive statistics on this, but you cannot
ignore the recorded demand for gold and silver from
China and India – the two most populous nations on earth
– the announcement that the Mexican central bank has
bought 100 tonnes this year, and that the Russians
continue to accumulate gold. Nor can you ignore the
draining of silver from the Comex warehouses. Nor can
you ignore the fact that the investment management
industry has virtually no client exposure to the sector,
and that the general public in Europe and America is
totally ignorant about what is happening to their paper
currencies.
The way mistakes are made is by following advice based
on the wrong information. That is the danger of
technical analysis forecasts for gold and silver prices.
They often become a reflection of analysts’ own emotions
rather than of the market itself.
Splitting the banks
2011-JUN-18
This
week George Osborne, the British Chancellor, announced
that UK banks would ring-fence their domestic banking
operations from wider banking activities. It is
presented as a protection from the riskier activities
inherent in international and investment banking.
But is this where the greatest risks lie? These plans
have been fomenting for many months against a general
assumption that the UK economy would recover on a
medium-term view. It is only in recent weeks that this
assumption has been turned upside down, in which case
domestic banking is significantly more risky than
previously assumed. Of course, risk assessments of
banking business are produced by the Bank of England as
regulator, whose track record in this respect is far
from encouraging.
An alternative way of looking at it is to understand
that international and investment banking activities
have high margins and that these diversified banks use
sophisticated markets to cover changes in risk
perceptions at a moment’s notice. A
borrowing-and-lending bank restricted to real customers
has considerably less flexibility, and given the high
level of capital gearing permitted, it has significant
risks without the offset of diversification enjoyed by
modern integrated banks. It is a return to the old from
the new.
The models are entirely different. For the last 30 years
banking has moved away from interest income towards
fees. The advantage of fee income is that it is earned
without encumbering the balance sheet, so requires
minimal regulatory capital: this is what has driven
banks into capital markets. A ring-fenced domestic
banking business which loses these benefits becomes less
profitable and their customers will probably face rising
costs as a result. And so long as domestic banks rely on
money markets as part of their business there will still
be counterparty risk with the wider banking community.
Of course, it is easy to share the regulator’s concerns
about investment banking and cross-border business: the
collapse of Lehman is fresh in our minds. Putting aside
the question as to whether Lehman collapsed because it
was badly managed or whether it was simply the victim of
systemic failure, there have to be valid concerns about
activities beyond national control, such the chains of
counter-party risk in off-market derivatives. But it
would be wrong to assume that managements in the banking
community are unaware of these risks and have not
already taken practical steps to protect themselves.
But perhaps the most worrying aspect of ring-fencing
domestic banking is the implication that if there is a
global banking problem, the British government will have
the option to walk away from it. Logically, there can be
no other interpretation. And given the Government is
advised by the Bank of England as regulator, the bank
itself must not be entirely confident that an
international systemic event can actually be prevented.
It will be interesting to see the reactions of other
countries, and whether or not they also seek to
ring-fence domestic from international banking. If they
do so, it will signify a worrying shift away from global
central banking co-operation in favour of domestic
financial protectionism.
Catch-22 for the Fed
2011-JUN-04
 In
the last week there have been a raft of statistics
showing that the US economy is weakening. The
implications for other western economies are hardly
bullish. They also strengthen arguments in favour of
more reflation for fear of something worse. This is
despite further increases in the US monetary base to a
record $2.5 trillion. It is easy to forget that less
than three years ago, when the economy was surfing on a
fading credit bubble, the monetary base stood at a
record $820 billion, so it has increased by over 300%
since then. Compare this with the 44% rise over the
preceding seven years. With such a substantial
debasement of money it must be worrying to the
authorities that there has been little discernible
economic benefit.
The simple reason is that the banks have increased their
reserves at the Fed, rather than lending them out to the
private sector. This is reflected in non-borrowed
reserves, which have increased from virtually nothing to
nearly $2.5 trillion. It is because the money is sitting
in the Fed that price inflation is not yet totally out
of control, but inflation has the potential to become a
very serious problem.
Putting this issue to one side for a moment, the Fed has
to consider its actions in the coming months, taking
into account the end of the stimulus from QE2 and the
political deadlock over raising the debt limit. As
regards the latter, the federal government is now
running on empty, and its central bank is severely
restricted in what it can do to help.
We will never know for certain if the Mexican central
bank anticipated the Fed’s problem before deciding to
buy 100 tonnes of gold, but for a NAFTA member to
publicly break ranks and buy gold is quite a step. And
for it to do this in a rising market is doubly
interesting, because the vast bulk of the purchase was
done before the April correction. It is also a clear
signal that the cartel controlling the Bank for
International Settlements is losing influence.
It is the Fed’s problem, rather than Greece’s impending
financial collapse, that should be closely monitored by
gold bugs. This is not to belittle European difficulties
and those of the European Central Bank. But in a strict
monetary sense, the ECB is not so far down the monetary
inflation route as the Fed – yet. It is the Fed which
has already expanded its money-quantity explosively, and
is struggling to find further monetary fuel to lift the
economy. It is the Fed that is locked on a course of
accelerating monetary inflation, as those monetary base
statistics show.
There is little doubt that the Fed will try to find some
way to create more money while funding the deficit; we
don’t yet know how. Even if this is achieved without all
those non-borrowed reserves flooding into the economy,
the risk escalates of a sudden loss of confidence in
paper dollars. Both Keynesians and monetarists forming
policy seem oblivious to the increasing possibility of a
tipping-point being reached, where the dollar’s fall
suddenly accelerates.
So whatever the true reason for the Mexican purchases of
gold, it is an eminently sensible risk diversification
out of dollars. Other central banks will surely have
taken note.
Silver corrects
2011-MAY-07
 Over
the last two weeks silver has fallen from just under $50
to under $40, following a meteoric rise. Much of the
fall has been engineered by the big commercial dealers
triggering stop-losses, giving them easy profits. They
have been extremely effective in achieving this
objective, picking times when mainstream markets were
shut for public holidays. The result is that bullish
speculators are now full of doubt having learned an
expensive lesson about price manipulation.
Of course, powerful groups conspire to manipulate
prices. It is usually profitable to do so, and
incidentally, conspiring with powerful financial agents
is the way government routinely conducts its business.
The speculators have been further disadvantaged by
escalating margin calls. Yet again, these are factors
other than bullion’s fundamentals that determine who
wins and who loses. Business in the futures markets is
almost entirely speculative in nature, the real business
being in the physical; and over time, speculative
business has grown to be far larger than the cash
market. The futures markets are little more than
casinos.
The establishment has had two basic reasons to
manipulate precious metals markets: to remove all
monetary credibility from precious metals, and to
protect the short positions of the central and bullion
banks, both of which run large fractional reserve
systems with their customers’ metal. But instead of
hedging these liabilities as logic dictates, the
financial establishment increases them by short-selling
futures and options.
This dangerous strategy can only be managed so long as
there are no price shocks to the upside. After all, the
price of gold has increased fairly consistently over the
last eleven years without any noticeable market failure.
The reason for this is that the bullion banks and
commercials in the futures markets naturally run short
positions, making their money in bull markets by selling
dear and buying cheaply. They have the best market
intelligence and with the deepest pockets they control
the rise in prices, and the mug-punters are an easy,
profitable target.
Now that the futures business is considerably larger
than the physical, the futures market is the tail that
wags the dog. Anecdotal evidence tells us there are
severe shortages of physical metal, which suggests that
both gold and silver are significantly under-priced as a
result of futures manipulation. But so long as the
adjustment to higher prices is gradual, there is no
reason why they cannot rise to a more realistic level
without market dislocation. The pace of adjustment must
allow the commercials and LBMA members to trade
profitably, to allow them to offset losses on their
short positions with trading profits.
This status quo was upset when silver rose rapidly to
nearly $50 recently, and this is why the commercials had
to get the price back down. Among the speculators, the
talk is now of backing red, because that is the new
lucky colour, so their new price targets are all lower.
But for those who have good reason to be frightened of
fiat money, what an opportunity it all presents!
7 May 2011
Bernanke boxed in
http://www.goldmoney.com/gold-research/bernanke-boxed-in.html
2011-APR-30
 After
the first-ever Fed press conference, gold and silver
rose sharply. This was hardly a vote of confidence in
paper money.
Perhaps the event and the Federal Open Market Committee
statement that preceded it were over-hyped, but both
events were disappointing – ducking as they did the
important issue of what happens after QE2 is completed.
The statements on inflation did little more than
recognise a temporary and small – or “transitory” –
pick-up in prices. By revising downwards estimates for
economic growth over the next few years, the Committee
claims that inflation will probably subside. In any
event, the Fed is more concerned with the risk of
inflation being closer to zero, given the risk that the
economy might then tip into deflation.
All in all, the statement and the press conference
exposed the weakness of the Fed’s position. We are left
with the thought that if a Paul Volcker were in charge,
things would be very different. A return to sound money
and a stabilised dollar would be a pre-emptive strike
against both global and US inflation, and the experience
from the Volcker era is that economic growth was much
better than might have been expected following interest
rates of 20%.
But there is a crucial difference today compared with 30
years ago. The level of private sector debt is
substantially higher, and shows a strong tendency
towards contraction. High interest rates are not
actually needed to reduce demand, because bank credit,
which is the counterpart of private sector debt, has
been contracting of its own accord. It is this that
frightens the Fed most, because contracting bank balance
sheets are very difficult to manage without risking a
full-blown banking crisis.
So it is the difficulty of keeping the banking system
running while there is credit deflation in the air that
actually pre-occupies the Fed. This is more important
than the official mandate of maintaining a low rate of
inflation consistent with high employment. But by
focusing on keeping the banking system solvent, the Fed
is taking enormous risks with monetary inflation. The
unprecedented growth in raw money, reflected in the
increase of the monetary base since the Lehman Bros
crisis, has been designed to offset the contraction of
broader credit, and is deemed by the Fed to be
non-inflationary overall.
Economists generally support this view, taking comfort
from the build-up of bank deposits on the Fed’s balance
sheet in the form of non-borrowed reserves. They argue
that only when the banks draw down on these reserves to
use as a base for further bank lending will the
inflation risk escalate. But this argument ignores the
fact that this money is already in circulation through
government spending.
There may have been nothing new from the FOMC statement,
and nothing about QE3, but in the absence of more
positive measures the markets have the confirmation they
need that the dollar is headed lower. The Fed is boxed
in. No wonder gold and silver rose so sharply.
Will governments confiscate gold?
2011-APR-23
 As
concerns mount that there is another financial crisis in
the offing and the gold price rises, American investors
worry increasingly about whether the US government will
confiscate their gold. The precedent was set by
President Franklin Delano Roosevelt, who in 1933 forced
all of America’s gold owners to sell their bullion to
the Federal government at the official price.
However, the situation today is very different from that
of 78 years ago. At that time, gold was the primary
currency, the dollar being tied to it at $20.67 per
ounce. But today, the Fed and European central banks
strongly deny that gold has any monetary role at all,
and argue instead that it’s just a hangover from the
past: “that barbarous relic” as Keynes called it. Its
confiscation would be an embarrassing admission that
gold, after all, is money.
Nevertheless, as paper currencies continue to lose
credibility, the temptation for any government to seize
its citizens’ gold to enhance official holdings must be
growing. Americans today, however, are unlikely to
meekly accept confiscation the way they did under
Roosevelt. And nowadays, you may be American, but your
gold is not necessarily held at an American bank: it is
just as likely to be in London, Zurich or Hong Kong.
The wording of a compulsory order is all-important.
Confiscation requires the gold itself to be surrendered,
which presumably would be the objective if a government
is to add to official holdings. If gold ownership is
merely banned, it is a different matter. A bullion bank
holding gold in an unallocated account would almost
certainly be unable to deliver physical gold if required
to do so by the American government, but it would be
able to close out the account for cash. And there is the
thorny question of derivatives, which hardly existed in
the 1930s. All futures and options trading would cease,
and contracts for forward delivery would be cancelled,
possibly with serious financial consequences.
The international nature of gold would probably require
all G10 or even G20 members to agree to similar actions
against their own citizens. It seems unlikely that all
governments would agree to this, unless they all had
their backs hard against the wall. Switzerland, an
associate member of the G10, would almost certainly face
a referendum and be unable to comply. The G20 also
includes China, India, Saudi Arabia and Russia. It is
extremely unlikely that these countries will be prepared
to confiscate their citizens’ gold to appease the
Americans.
Just the mention of these names alerts us to the dangers
of a confiscatory move by the US. It would make the
Chinese and Indian middle classes instantly wealthier
than the average American, measured by gold ownership –
an interesting thought when paper currencies are losing
credibility. On balance, a repeat of the Roosevelt
confiscation seems unlikely. But there is one thing we
can be certain of, and that is that the risk of silver
confiscation is more remote, so perhaps that is the
safer metal to own.
Anatomy of a short squeeze
2011-APR-16
 The
shortage of gold and silver is the driving force behind
the bull markets in these metals. Quite simply, the
outstanding obligations in these commodities exceed the
stock available. I vividly recall a rare example of a
similar situation during my stockbroking days, which
will serve to illustrate this point.
In the UK’s property crash of 1974, the shares of
property companies fell by as much as 90%, but one share
that resisted this trend was London Bridge Securities.
LBS shares remained stubbornly high, because as it
turned out, the directors and their cronies were buying
them. Eventually, however, they were swamped by
short-sellers, and the share price fell heavily. The
directors of London Bridge Securities then realised that
they and their friends owned more than 100% of the
company. This state of affairs arose because the
short-sellers were unable to deliver any scrip, and none
of the existing shareholders were prepared to lend them
any. The result was a buying-in procedure involving an
auction on the floor of the stock exchange, where the
price was bid up to a level where holders of the shares
were prepared to sell.
The short was closed out at about three times the share
price of earlier that morning. The squeeze on the bear
position had nothing to do with the company’s underlying
value: it occurred because one big speculator got into
an impossible position that had to be resolved. And that
more or less is where gold and silver appear to be
today.
Silver offers the closer parallel with the London Bridge
example. There are a few banks with large short
positions in silver on the US futures market in
quantities that simply cannot be covered by physical
stock. The outstanding obligations are far larger than
the stock available. The lesson from the London Bridge
example is that prices in a bear squeeze can go far
higher than anyone reasonably thinks possible. The short
position in gold is less visible, being mainly in the
unallocated accounts of the bullion banks operating in
the LBMA market. But it is there nonetheless, and the
bullion banks’ obligations to their bullion-unallocated
account holders are far greater than the bullion they
actually hold.
But there is one vital difference between my example
from the property market of 1974 and gold and silver
today. The bear who got caught short of London Bridge
Securities was right in principal, because LBS went bust
shortly afterwards; but in the case of gold and silver,
the acceleration of monetary inflation is underwriting
rising prices for both metals, making the position of
the bears increasingly exposed as time marches on.
Perhaps the most important lesson we can learn from the
LBS situation – and highly applicable to the situation
today in precious metals, which could be developing into
the largest short squeeze in history – is that very few
other people in the investment community actually
understand what is happening. This is something to bear
in mind when taking investment advice.
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