Although this is the first time in the Fed’s 100 year history to use Quantitative Easing (QE), it is not the first time the Fed used the printing presses as fiscal policy. Money printing was attempted in the seventies, thirties and even during the Civil War (although the Fed was not in existence then) with inflationary consequences after each episode. Still, while the Fed’s balance sheet has quadrupled, nothing has been done to address the underlying causes of the disease. America has not addressed a tax system that hobbles businesses. They’ve done little to address dysfunctional Washington. Little has been done to rein in entitlements. And even less was done to address government spending. Instead, policymakers pushed for more spending, and of course more taxes to pay for that spending. They’ve wasted trillions on Wall Street making its members too big to fail and yet most are holding a paltry percentage of less than 10 percent of their capital against total assets.
Despite the fact that they now have a debt to GDP ratio of over 100 percent, the solution de jour is more inflation, at least a little. But as the last inflation fighter, former Fed Chairman Paul Volcker once said, “All experience demonstrates that inflation, when fairly and deliberately started, is hard to control and reverse.” As with Mr. Volcker who was forced to raise interest rates to almost 20 percent to clean up the inflationary mess caused by excess money printing under his predecessor Arthur Burns, the next Chairman will be asked to clean up an even bigger mess.
For too long, the Fed’s experimental policy has been a source of distortion of risk, capital flows, credit and currency values. The problem as Volcker warns is that it’s very difficult to stop easy money, once started. The threat of Fed tapering has sparked divisions in the US Congress and even the selection of the next Fed Chairman is being fought openly with name calling rather than in the conclaves of the White House. Today’s debts and deficits have accumulated as the Fed bought trillions of dollars of government bonds in order to keep interest rates low. The debt overhang plaguing the economy since the financial crisis has been a major drag on the economic revival. The Fed’s balance sheet is topping trillion of debt with over trillion of government debt making it vulnerable to the inevitable interest rate swings. Unwinding this portfolio will be left for the next Fed chairman and neither Yellen nor Summers are a match for Paul Volcker. Both candidates are considered “insiders” when an “outsider” is needed to take the unpopular steps to clean up Bernanke’s mess.
Then there is the continuation of the Eurozone’s problems with their splintered banking system, rising debt loads and tendency to postpone needed reforms. Germany is balking at loosening the purse strings any further to bailout the debt-laden sovereigns like Greece again. The underlying problem is that central banks have printed trillions to buy time but problems remain and the crisis of 2007-2008 was only postponed. Overnight the twenty biggest emerging market currencies tumbled against the greenback on fears that the effects of the Fed’s “tapering” plans will tighten credit and crimp growth. India’s rupee slumped to an all-time low.
Finally, there is the looming third round of the debt ceiling debacle. In the first round, the Republicans demanded one dollar of spending cuts for every dollar of new borrowing. Obama refused and we ended with the so-called sequestration. During the second round of debt ceiling negotiations, the Democrats passed a budget but the Republicans balked and sequestration was invoked. Now the third round of the debt ceiling discussion looms this fall with the Republicans calling for a repeal of Mr. Obama’s healthcare legislation. The federal debt limit must be raised, but this time it raises the threat again of a government shutdown or worse, default. Even after raiding the government’s piggybank, the debt ceiling will be reached and the government faces a partial or complete shutdown if there is no agreement, sequestration: part deux? The US dollar has already lost 5 percent. Gold will be a good thing to have.
Conflicts of Interest
Quantitative easing and the trillions of dollars have benefited the financial players who leveraged their own operations into monsters of mass destruction. The revelations that the banks control everything from Libor interest rates to the London gold fix to commodity prices is not surprising but that regulators are only now focusing on them is a surprise. The holding companies of the banks used their excess capital to leverage the derivative products of their customers, the miners, oil producers and farmers who have discovered that the banks helped drive up their costs. Indeed those inventories were the basis for which the banks or financial players leveraged or used as collateral for the multitude of structured derivative products which have become the main profit centers for these financial players.
As a result, regulators are focusing on the banks and other financial players for their investments in commodities and related markets. The ownership of the commodity warehouses and also the infrastructure such as oil tankers and pipelines are being scrutinized in response to a barrage of criticism over the banks’ activities. Not only are there obvious conflicts of interest but consumers are complaining about the lengthy delays to get their commodities from the warehouses. In fact, the gold mining industry has seen a dramatic draw-down in physical gold stored in vaults and Comex warehouses such that there are fears there is insufficient physical metal to back demand should a small percentage of those outstanding futures ask for immediate delivery.
Last year the 10 largest banks generated about billion from commodity-backed derivatives. Banks today control most commodities, and also store, transport and trade materials. Goldman Sachs, JP Morgan, Chase, and Morgan Stanley held .2 billion in physical commodities at year-end according to Fed data. In 2003, regulators opened the door allowing the deposit-taking banks to trade physical commodities. Five years ago they were given a grace period that expires September 2014. The looming deadline and increased scrutiny comes at a time when regulators are considering bringing back the Depression era Glass-Steagall Act which split the banks into banking and commercial activities. The Act was scrapped in 1999 and the merger of the two led to big profits, an explosion of derivatives and a phenomenal increase in systemic risk. Regulators are concerned that the inherent conflicts and growing financial volatility could endanger the financial system – you think?
In our view, the scrutiny is coming at a time when the leverage of the bullion banks is being tested by the markets. Too many paper derivatives have been created and at long last, the derivative swamp is being drained. Only the problems remain. To be sure, counter-party risk which surfaced in the Lehman bankruptcy in 2008 has not been resolved by Dodd-Frank (the SEC still has not enacted major amendments). Some initiatives at Wall Street reform recently received a Presidential nudge but the major bills remain untouched, including the Volcker Rule.
But it is not only over commodities that the big US banks are facing problems. The Basel Committee has proposed boosting the capital behind the huge trillion REPO market where financial institutions borrow against government bonds. JP Morgan alone has said that such a change would cost the banks at least 0 billion of additional regulatory capital. That the bank recently put their physical commodity business up for sale, signals a retreat after paying a whopping 0 million to settle a dispute with US power regulators over alleged market manipulation. The same regulators cast a wider net asking for records and emails of the big European banks raising a regulatory turf war with the EU. US regulators have been clamping down on everything from laundering to privacy laws on both sides of the ocean, and the Europeans have not sorted out who’s in charge.
The common denominator however is the powerful US banks, the linchpin of the global monetary system, have lobbied hard pushing the regulators to soften their stance. We believe the industry is poorly capitalized notwithstanding their protestations and leverage remains problematic. The industry to date has resisted shoring their balance sheets and since governments depend on them to finance their debt problems, lawmakers are stymied on how to put the genie back into the bottle. Gold will be a good thing to have.
The Piper Must Be Paid
Detroit’s bankruptcy is symptomatic of America’s fiscal prolifically. While everyone focuses on Detroit’s billion debt and declining population, few recall that Detroit’s problems was due simply because it was spending more than it was bringing in. Spending was fueled by giving its workers and paid pensioners big healthcare benefits and annual increases to buy labour peace but now the pensioners find themselves in the same position as Cyprus’ bank depositors with only claims. Detroit is proposing to treat pensioners and bondholders alike which will be a test of America’s bankruptcy laws. But in truth, Detroit’s bankruptcy symbolizes America’s problem today, in that they continue to believe that they could spend more than they earn and promise more than they can keep. And issues such as the “debt ceiling”, “fiscal cliff” or “grand bargains” can just be set aside until the future. But, as Detroit has found, like Cyprus’s depositors, the piper must eventually be paid. In Cyprus, the depositors bailed out the banks. However with pensioners’ liabilities so large on both the federal and municipal level, are pensioners’ savings and their obligations from the state to be used to bailout America’s profligacy? They already do, the Federal Reserve has purchased 40 percent of government issuances.
Ironically Detroit’s bankruptcy follows that of General Motors which recently emerged from Chapter 11. Of interest, is that derivatives played a major role in the demise of Detroit. The amounts involved are hundreds of millions of dollars or maybe billions. For example at the end June, Ernst & Young calculated that the value of Detroit’s derivatives was a negative 0 million. By the time the city pays off the .4 billion of borrowings, the total bill from 2013 and onwards, will have been more than .7 billion, almost double the original debt of which 0 million are derivatives. (Detroit took this step in order to avoid 2 million in interest payments). The question arises however, who owns the derivatives. Dexia Group, the big Franco-Belgium bank recently took a million euro charge to cover potential losses on 5 million of Detroit’s debt. Now that Detroit has gone bankrupt there is a little left but those big unfunded liabilities. In fact the fight over Detroit is likely to be a prelude to the unfunded liabilities showdown over the social security liabilities of the Federal government. Like the Cyprus bail-in, innocent parties are being dragged down by the fiscal ineptness that has allowed this financial crisis to grow.
China Redux
In the wake of a slowing economy and Beijing’s crackdown on corruption, China’s central bank (PBOC). briefly sent interest rates surging to 30 percent in order to exert more control over the economy and the shadow banking system. Until now local government financing entities were given free rein to finance growth but now those debts are coming home to roost. China’s National Office conducted research on 15 provincial capitals incorporating 36 municipalities found that 14 cities were found to have debt ratios higher than 100 percent. To be sure China’s gross debt is somewhat higher than the estimated 22 percent of GDP but no one knows.
[Hear more: Grant Williams: China Slowdown Affecting Commodity Prices]
The PBOC move caused the Shanghai Stock Index to lose 15 percent in a month which was a warning shot to wrest more control over the shadow banking world comprising of local government entities, guarantee companies and trust entities. The shadow banking world complemented the financing of the banking system but was left largely unregulated, financing many dubious projects raising the risk of contagion. The PBOC liberalized interest rates and removed the floor on bank rates which allocated credit more freely as they got more control over the shadow banking system. In addition the PBOC was concerned over the explosion in lending which went to prop up property projects and other local government pet projects outside the influence of the central bank’s purview and thus regulation. In taking control, the PBOC is ensuring no bank will go under and that the state supported system is as good as gold, something the Americans can’t claim. Beijing in contrast is making the hard decisions, confident in their growth outlook. Gold will be a good thing to have.
