The world is afraid of a repeat of the deflation of the Great Depression. Deflation is a negative drop in prices caused by the contraction of money supply, the opposite of inflation. In 1932, US consumer prices fell 10 percent and between 1929 and 1933 fell 27 percent in total. Today despite inflation at 40 year lows, prices are still going up, not down. In the 12 months ended in August, prices rose 1.1 percent.
Amid this fear of deflation, economists forget that deflation does not happen when there is an abundance of money. In fact the economy is not even suffering from a shortage of liquidity, but a shortage of confidence. Part of the reason is that the looming red ink and liquidity is unlike anything seen in US peacetime history. Banks today have plenty of reserves, but they are hoarding rather than lending. US corporations have repaired their balance sheets but are sitting with trillions of cash. Consumers are paying down their debts and savings are increasing. And nobody wants to borrow or use money despite zero interest rates.
Obama Becomes the Biggest Spender
This crisis started two decades ago when America pursued a policy of consumption and deficit spending amassing a horrendous debt load. The United States expanded government spending and influence incurring massive deficits running to hundreds of billions and now trillions a year. And trillions of government subsidies, guarantees and credits created an artificial GDP driver of home ownership that perpetuated the myth that every American had a right of homeownership or a chicken in every pot. To pay for this spending, monetary policy was based on unlimited money printing. In 2002, Ben Bernanke, a Fed governor then, delivered a speech saying the government had a technology called the “printing press”, that “allows it to produce as many US dollars as it wishes at essentially no cost”. Combined debt (government, business and consumer) has exploded to 360 percent of debt to GDP ratio surpassing the peak debt of 250 percent in 1933. Today, America has become the world’s biggest debtor amassing trillion of debt, more than four times its trillion economy. And that doesn’t count Fannie or Freddie’s liabilities and of course the entitlement liabilities. The next couple of generations are doomed to repay this debt.
President Obama has become the biggest spender in America’s peacetime history. Clearly, the private sector can no longer support the weight of government. And no one is focusing on America’s liabilities, except for its creditors. The budget deficit exceeds trillion, or 10 percent of GDP and government debt is approaching 100 percent of GDP which is dependent on foreign financing. As recently as 2005, total federal spending was .47 trillion. In only two years, Obamanomics has cost almost trillion of debt. The US dollar has given up almost eight percent in two months, dropping more than one percent in a week amid growing concerns the last stimulus package is waning in influence. A year into the recovery and twenty months of cheap money later, there are new calls for yet another round of stimulus, reminding investors that the US will again resort to the printing press. The problem of Mr. Obama’s bailouts and stimulus programs is that most went to Wall Street and the transfer payments had little growth or investment payback.
For some time we have felt that America’s preoccupation with deflation and recession was misguided. Americans continue to supply their economy with too much liquidity, financing their government deficit with other people’s money. US banks have invested some trillion of their largesse to finance America’s deficits as their holdings have doubled in the past two years, in a “quid pro quo” transaction with the US Treasury. Rates on US debt remain the lowest in decades. And to pay for the never ending deficits, the Federal Reserve, conducted rounds of quantitative easing (QE), printing more money to purchase its own debt pushing more liquidity into the system. Stricken with attention deficit disorder (ADD) syndrome, Obama’s White House, the serial bailout king, recently passed a billion state aid package with some billion passed through to the Teacher’s union payroll. And just ahead of the midterm elections, Obama’s ADD ways continues by doling out another billion in infrastructure bailouts and now there is talk of tax cuts. What is really happening here is a wealth transfer; from responsible creditors to irresponsible debtors.
Was it All Worth It?
Why the push for another round of stimulus? Most economists and policymakers continue to believe in that outdated Keynesian multiplier of a dollar in spending creates .50 in gross domestic product. Wrong. President Obama’s credibility was squandered over his government’s expenditures from “cash for clunker” schemes to the trillion dollar Obamacare to an expansionist government that has crowded out the private sector. Federal expenditures continue to outpace economic growth, climbing to over 35 percent, up from 23.5 percent in 1985. Unemployment remains stubbornly high, in fact, higher than the White House’s projections which said that without government support, unemployment would reach 9 percent, but with government support it would remain under 8 percent. Today, it is almost 10 percent.
But while economists quarrel over their models whether or not his stimulus programs are working, deficit spending remains a drag on the economy. Mr. Obama has already gone through trillions and yet he continues to throw good money after bad. Governments these days are good at spending but not unfortunately putting the economy to work. They are all Keynesians today. The problem with the debate between austerity versus stimulus is that governments are behaving like teenagers, who always have the propensity to spend. In conventional times, the time for austerity was during the boom times and the time to spread the wealth was during the bad times. However, the last two decades have seen policymakers pursue the reverse with a propensity to spend in both bad and good times. Keynesian demand management did not work then or now. And now Ben Bernanke, Fed Chairman, before the Senate Banking Committee, warned that fiscal policy has reached its limits. The US has reached a deadend for stimulus programmes.
Debt Has Become Money
At the end of the day, it is not even important whether we opt for austerity, tax cuts or throw more stimulus money at the problem. The reality is that we are mired in a debt based monetary system. Money today is created by the Federal Reserve as debt. In other words, debt has become money. In inflating our way out of this debt, Washington just issues more debt since the global appetite for its debt seems undiminished. However, the monetization of this debt only postpones the day of reckoning and as other deficit economies discovered, paves the way for hyperinflation. And that money must go somewhere.
Commodities are a leading indicator of inflation. We believe that much of the excess global liquidity flowed into oil last year and then currency markets early this year and now agricultural.
Rising wheat prices in the wake of Russia’s embargo, reminds us of the time when in 1972 the anchovies went missing off the coast of Peru which helped cause a dramatic surge in commodity prices as the Japanese switched to soy as a protein replacement. News of the “missing anchovies” were thought to be a benign event but later impacted the economy through rampant inflation. A spike in commodity prices also sparked the food crisis of 2007-08 when prices from corn to rice shot up to record levels, triggering food riots from India to Haiti. Today, cattle futures have soared to their highest levels in nearly two years. Cocoa prices have soared, with hedge funds becoming big buyers. Coffee and sugar prices spiked to fresh highs. Global meat prices have hit a 20 year high. Should we be concerned about another benign event? Unlike financial markets which are closely regulated, the commodity markets are mostly unregulated, affected more by liquidity. It is our view that inflation has worked itself into the commodity markets raising the price of food which will reduce spending power and savings. Inflation is a dynamic animal, and this time bomb is ready to explode. Gold will be a good thing to have.
Refinancing Yesterday’s Problems
Amid meagre times for the economy, America’s banks have emerged from stress tests, Basel III and a sharp drop in loans but still enjoyed their best years. And despite the Dodd-Frank Act, the banks are left to continue their financial engineering ways, and for many, to continue their leverage. Shunned only two years ago, the big institutions have become bigger, sitting with some trillion of surplus capital. US banks have largely refinanced this year’s obligations already. Yet the Fed continues to expand bank reserves by taking on and guaranteeing their obligations despite the banks’ largesse. Banks remain major players in the commodity, currency and debt markets. Another area where banks have been allowed to prosper is their “high frequency” trading operations which make up about 70 percent of the market’s volume. High frequency trades are simple computerized algorithms that often front run trades. In providing so-called liquidity to the marketplace, the big investment banks have found yet another way to scalp their clients. These black boxes have replaced the market makers and as the last “flash crash” showed, it was not fat fingers that should concern us, but the fact that those high speed trades can move markets significantly, intentionally or otherwise in their quest for profit. We believe that the emphasis on speed, volume, technology at the expense of liquidity, exacerbates market volatility which increases systemic risk putting some investors at a disadvantage by distorting stock prices. High-frequency trading should be slowed down.
Despite the trillions of excess reserves, the doubling of capital ratios under a Basel III will not address the “too big to fail” systemic risk. The refinancing of maturing debt is a major problem for the global banks. The Bank of England warned in its semi-annual financial report, that banks worldwide have a whopping $5 trillion of funding due to mature in the next three years. Even today, the big European banks are still dependant on unlimited European Central Bank support and must look for new sources of funds given the euro’s problems as well as their refinancing obligations. EU banks are believed to hold more than $3 trillion of public debt from Greece, Spain and Portugal alone. The International Monetary Fund (IMF) has estimated almost $900 billion euro zone bank debt matures this year. The banking system is still in big trouble.
Derivatives Déjà Vu
Under the new financial reform bill there is the need to draft some 500 odd rules leaving the Securities Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC) to rewrite more than 300 rules to cover derivatives, asset-backed securities, credit default swaps, etc. Derivatives have grown to over $614 trillion or ten times the global economy. Derivatives are a product of the modern financial system that sank Long Term Capital Management, Enron, Lehman Brothers and of course the US mortgage market. We now know US homeowners borrowed a trillion dollars from the banks, securitised their homes allowing Wall Street to create trillions of mortgage backed securities. Now that money is gone with the system is left with paper losses and defunct lenders. Indeed most of the debt is still on the books of the big banks.
The collapse exposed a dangerously interconnected financial system but amazingly less than four percent of these derivatives trade on any stock exchange. The first task of the financial bill was to push these derivatives into the daylight of clearing houses or exchanges which would reduce counterparty risk, but that would require a pool of capital, collateral, and most importantly enhance transparency of counterparty risk. Second, derivatives should be priced by the markets and not in some shadowy corner between two parties. But that would require fewer financial players, less secrecy and of course more capital. And third, the non-financial players including the big hedge funds, private equity players and institutional investors which buy and sell these kinds of financial instrument should also come under the new wave of reform and regulation. That did not happen.
Fourth, there should be reform of Fannie Mae and Freddie Mac which has so far cost the taxpayer over $145 billion in bailouts as well as to address their trillions of obligations. So far, derivatives have been a big money maker for the big investment banks. With the new rules, that pie will be split. The outcome is still uncertain as the big investment banks are fighting today to keep their turf. And so the main beneficiaries are the lawyers and lobbyists. Déjà vu, nothing seems to change. Just what was this 2,300 page Dodd-Frank bill to reform then?
China the World’s Banker
China was the first to use paper money, tying the yuan to land or silver. However, China experienced a horrible hyperinflation from 1935-1947 which saw its paper currency lose value when it removed the silver backing. China has since developed into a superpower in economic terms and currency, surpassing Japan as the world’s second largest economy in the last quarter. After a three decade rise from isolation to superpower, there are concerns that China will soon overtake the United States. Already China is the world’s biggest exporter, consumer of energy, and maker of goods. China too has become the world’s banker.
Yet China realizes that its economic gains could be lost without reforms to its currency system. China has relaxed restrictions on the circulation of its currency, allowing settlements in the Hong Kong interbank market, an offshore first. China is slowly making the yuan an international currency. China now has taken an important second step in the internationalization by allowing offshore banks to invest in its bond market. China is also pushing more companies to denominate their exports and imports in yuan instead of dollars. The first of course was the much ballyhooed removal of the peg to the US dollar. To fund its operations on the Chinese mainland, McDonald’s recently floated a reminibi-denominated bond in Hong Kong, paying 3 percent, which is a another step in the liberalization of their currency. Rather than acquiesce to the US, China is pursuing a more independent path, not wanting to participate in the US scheme that inflates away their debt and devalues their dollar-denominated obligations. Tellingly, China has scaled back its purchases of US Treasuries offloading $100 billion in the past year, the first year over year decline since 2001, moved some of the proceeds into euros and of course, gold.
Financial strength will become a decisive factor in determining the new landscape of international relations. The importance of creditor status or potential banker to the world means China will be able to expand the scope of their domestic and foreign policies. Inversely America will find themselves declining in importance. Finally, at a time when there are doubts over the credit worthiness of major countries, or the threat of a euro zone default, we believe a reminibi indexed to a basket of currencies including gold might not be such a bad thing.
If Debt is not Money, What is Gold?
The problems of Greece and other sovereign nations have focused attention on the debt accumulation of the United States. Currencies are falling in value, particularly the greenback as investors worry about sovereign risks. In 2004, there was $3.7 trillion of Treasury debt outstanding and today there are $7.3 trillion of debt. As such the Treasury has held over 250 auctions or nearly one for every business day, an increase of almost ninety percent in six years. Moreover, today’s yields and prospects of higher food inflation provide little protection or cushion against a reversal in rates which would cause horrendous losses. Of course, the United States could always create more dollars at will to meet any obligation. Freed from the Bretton-Woods’ Agreement of fixed exchange rates, President Nixon severed the dollar’s linkage to gold in 1971 to boost their economy. The United States subsequently supplied the world with a faith based currency which became the cornerstone of the global financial system, allowing them to spend and pay bills with printed fiat money. America has been able to pile up its debt to record levels, bailout its institutions and finance day-to-day consumption with newly minted Treasury securities, and to date free from credit risk. Until now.
We believe that the dollar’s reserve role is threatened by America’s twin deficits and mountain of debt. Debt is not money. The current federal debt explosion is being driven by America’s penchant to spend, and since they cannot grow out of their fiscal problem, the Fed must monetize the debt leading eventually to higher inflation and hyperinflation. To be sure, confidence in our financial institutions and currencies have been deeply shaken by the financial crises two years ago and recently the festering and unresolved European crisis. Even the European Central Bank, a pillar of financial respectability has relaxed its standards to bail out its members. As such, there is a bear market in currencies and the mountain of sovereign debt is so huge that the prospect of making good has disappeared. There is ample historic evidence of the linkage between fiscal profligacy and hyperinflation. Needed then is an alternative and return to sound money.
And What Is Sound Money?
Sound money is not debt. Sound money is a linkage to a store of value, like gold. Gold historically has been a protection against overvalued currencies. Today while trust in the fiscal and monetary creditability of the global financial system is being questioned, gold reaches fresh highs. Also, the history of hyperinflation shows that as governments monetize their debts and print more money, hyperinflation is a natural consequence. In the last century, we reviewed 25 episodes of hyperinflation including China’s hyperinflation and noted that they all were preceded by at least a decade of excess government spending and monetization of debt. Indeed, all went off some monetary standard. One thing was clear then and now, when governments spend more than they bring in, monetize their debt with fiat money to fill that gap, great countries can go insolvent.
Today, America is the world’s biggest debtor and the dollar’s status as the sole reserve currency is on borrowed time. In the last century the dollar has lost almost 95% of its purchasing power and gold has appreciated 13 times. Today gold is telling us that the dollar is just not worth what it used to be. It is not that gold has done so well, it’s that the dollar has done so poorly. This is not lost on America’s creditors. America’s biggest creditor, the Chinese are looking for alternatives and even the beleaguered euro, which replaced the US dollar in some places has become the recipient of Chinese money. To be sure with an overvalued dollar, gold is the only alternative investment today.
Gold has recorded successive new highs with a short term target at $1,350 an ounce. Gold is up more than 15 percent for the year partly due to a falling US dollar, low interest rates and a hedge against financial uncertainty. Investors bought more than half of all gold in the second quarter – only the second time since 1979 when gold peaked at $850 per ounce. Retail demand continues to increase as ETFs are now among the sixth largest holder of gold, at over 2,000 tonnes. Jewellery has picked up in part because of the increase in demand, but also because of the holiday season.
Europe’s three big banks, were among more than ten based in Europe, that swapped 346 tonnes of gold with the Bank of International Settlements (BIS) in exchange for dollar loans. The commercial banks needed US dollar funding at a time when Europe was under stress. The gold swaps were in affect collateral. Gold is still used by the International banks and speaks to gold’s role as a universal store of value. The lack of confidence in currencies, in particular the greenback, is also causing central banks to increase their purchases. Central banks were net sellers of gold over the past decade adding a source of supply to the market but have since become net buyers. China, Russia and India have been buyers of gold as they diversify their reserves from dollars. China has also relaxed rules on gold investment providing a home for Chinese savings. Gold has become the default currency of the world. We continue to believe that gold will hit $2,000 an ounce this year.
