The true role of gold

Submitted by Alasdair Macleod – FinanceAndEconomics.org

At a time of growing concern about the global financial system, it is time to remind ourselves why physical gold is so important for the benefit of the nearly three quarters of a million BitGold and GoldMoney customers, as well as those who might be considering what the benefits are of opening a gold deposit account.

This article explains the role of gold as money, and the dangers of leaving money on deposit in the banking system. In the interests of informing and educating a wider audience about the potential benefit of using gold for day-to-day payments, I would be grateful for readers to share this article with their friends and family as widely as possible.

We all know that for thousands of years, gold has been used as money. It qualified for this role because of its rarity and its ornamental utility: in other words, it will always have a value, come what may. This contrasts with unbacked paper money issued by governments, which has no such fundamental value. It is no accident that all collapses in money’s purchasing power have involved either debasing gold and silver coinage, or far more often the over-issuance of government paper currency. To these two versions of fraud on ordinary people, we must add a third, and that is by banks licenced by governments to create credit out of thin air.

How banking works

Let us look at bank credit for a moment, because that is the source of most money in circulation today. If a bank agrees to lend you money so you can pay your creditors or buy new equipment, you pay these obligations by transferring money from your loan into their banks. Meanwhile your bank does not need to have the money to lend to you. It balances its books by borrowing the funds from other banks with surplus funds to lend.

To illustrate the point as simply as possible, imagine there is only one bank. The bank lends you money, and you spend it. And as you spend it, the people and businesses who sell you stuff see their bank balances rise as they are paid. The bank created the loan for you, which was then covered by the deposits created by your spending, as you draw down funds from the loan. This works for multiple banks as well. All they need is a mechanism to ensure deposits are efficiently allocated between them, so that all the banks end up with balanced books. That is the function of the money market.

So by this magic, the money originally lent to you was created out of thin air by your bank, and then covered by deposits taken from the other banks where necessary. Banking is in effect a closed money-creation system. Note that your bank has not had to use its own money to create the loan to you. So a simple banking balance sheet consists of its own money (its capital, or shareholders’ funds), money owed to it by borrowers, such as you in the example here, and owed by it to depositors, such as the people you have paid.

If you borrow money from the bank, they will charge you a rate of interest, which if you are an ordinary person, can be anything perhaps between five and twenty per cent. With interest rates close to zero, the bank can fund this loan to you at about half of one per cent. That is nice business, particularly when it doesn’t have to put up its own money. Obviously the bank faces a risk which it it has to cover out of its own capital if necessary, and that is if you default on the loan. Continue reading

Gold outlook improves

Submitted by Alasdair Macleod – FinanceAndEconomics.org

There is a conflation of three related events that materially alter the prospects in favour of a higher gold price.

The change in the outlook for US interest rates has probably put an end to the dollar’s four-year bull run, it is clear that there is a growing likelihood of negative interest rates in the future, and the global banking system is no fit state to manage the potential challenges of 2016. This article walks the reader through the likely economic effects relevant to the future purchasing power of the dollar, and therefore prospects for the gold price.

On the 5th February, the price action in gold was significant. At about 9.40AM New York time, a seller dumped 10,000 contracts on the Comex market, worth about $1.2bn. The price fell from $1162 to $1145, a fall of $17. Having risen over the course of the week, it was vulnerable to profit-taking, so in principal it was a good time to take the price down in order to take the steam out of the market. However, from that $1145 level, gold quickly and unexpectedly rose strongly, gaining nearly $30 into the close. Furthermore, the gold price has continued to rise this week.

Of course, we don’t know who the seller was, but he will be nursing some serious losses. If it was the US Government’s Exchange Stabilisation Fund, the cost won’t matter; what would matter is that an attempt to put a cap on the gold price was a dismal failure, and merely exposed a major change in market sentiment, from extremely bearish to growing bullishness. This is backed up by increasing open interest on the Comex market, a clear indication that a rising gold price is no longer driven solely by the closing of short positions, but new buying is now driving the market.

The change in sentiment is notable, and coincided with the Bank of Japan reducing its deposit rate to minus 0.1%. There is a growing realisation that negative interest rate policy (NIRP) could also be on its way for the United States, so we must digress from considering the gold price to explore the potential effects of NIRP. Continue reading

Shorting the yuan is dangerous

Submitted by Alasdair Macleod – FinanceAndEconomics.org

Last Sunday (31 January) Zero Hedge ran an article drawing attention to the big names in the hedge fund community who are betting heavily that the yuan will suffer a major devaluation any time between the next few months and perhaps the next three years. The impression given is that this view is universal, almost to the exclusion of any other.

A market cynic would point out that when everyone is short, there is no one left to sell, so it is a good time to buy. This may indeed be true, and gives the Chinese authorities the opportunity to squeeze the bears mercilessly should they so choose. However, as Zero Hedge points out, some bear positions are in the form of put options rather than naked shorts, so hedge fund losses in this case would be limited to option money if the trade goes wrong. Instead, whoever sold the options to them will ultimately absorb the losses to the extent they have not hedged their corresponding positions in turn.

The advantage of buying long-dated OTC put options is that you can wait for a financial strategy to come right. The motivation for buying them is therefore less to do with market timing, and more to do with economic expectations.

At its simplest, the common view appears to be that China is suffering from the debt problems that follow an excessive expansion of bank credit, the unwinding of which is expected to lead to crippling deflation. This view is variously informed by the findings of Irving Fisher in his analysis of the 1930s depression, and perhaps the Austrian school’s description of credit-driven business cycles thrown in. To these can be added the experience of modern credit bubbles, particularly the aftermath of the sub-prime crisis of 2007/08, which remains fresh in hedge-fund managers’ minds. It amounts to a rag-bag of impulsive thought, and consequently it is assumed a large devaluation will be required to reduce the prices of China’s exports, so that China’s labour force will remain competitive and employed.

There are many empirical examples that disprove the idea that devaluation is the route to export success, so it is something of a mystery why it should be seen as a certain outcome for the yuan. The root of the idea that devaluation for China is an economic cure-all is the supposed improvement it gives to the balance of trade. And here the mystery deepens, because the fall in prices for imported commodities has actually increased China’s trade surplus, so much so that the trade surplus for all of 2014, which was $382bn equivalent, was exceeded by just the last seven months of 2015, while at the same time the economy was supposed to be collapsing. The total trade surplus for 2015 at $613bn was a record by a very large margin. A devaluation is definitely not required on trade grounds. Continue reading

Surprises in store

Submitted by Alasdair Macleod – FinanceAndEconomics.org

The month of January has been a wake-up call for complacent equity investors.

From the peaks of last year stock indices in the major markets have fallen 10-20%, give or take. On their own, these falls could be read as healthy corrections in an ongoing bull market, and doubtless there are investors hanging on to their investments in the hope that this is true.

The conditions that have led to the fall in equities are tied up in the realization that global economic activity has contracted sharply. This is now reflected in the performance of medium and long-dated US Treasury bonds, where yields have declined, despite a rise in the Fed Funds Rate. The problem equity markets face is not just a reaction to growing evidence of recession, it is that the normal Fed solution, lower interest rates, is exhausted. The Fed’s put option is now being questioned.

Far from this being an equity correction in the early stages of a credit cycle, which is what the small step towards normalization of US interest rates would have had us believe, the evidence points to a developing debt crisis, whose future course we can now tentatively map, though there are important differences to observe compared with a normal credit cycle.

In a normal credit cycle, bank credit stimulated by artificially low interest rates leads to rising consumer prices and rising bond yields. The recovery in nominal GDP growth supports equity prices, which will have already anticipated recovery, and benefited from the lower interest rates set earlier by the central bank. Eventually the equity bull market starts to lose momentum, when it becomes apparent that monetary policy favours tightening. Interest rates are then increased by the central bank to the point where demand for money is curtailed and the economy stops growing due to debt liquidation.

The dynamic that is missing from this simplistic description of an orthodox credit cycle is the level of outstanding debt. The higher it is, the less of a rise in interest rates is required to trigger a downturn in economic activity. So over a long period of increasing accumulations of outstanding debt, the levels of interest rate peaks on successive credit cycles will decline. This is clearly evident in the chart below of the yield on 13-week US Treasury bills.

Chart 1 28012016

The pecked line shows these declining peaks, and that a short-term interest rate of less than 3% today would now appear to be enough to trigger a downturn. With such a small margin for error, it is clear that any increase in the yield spread between this, the highest quality debt, and corporate debt yields could trigger a cyclical debt liquidation. Bear in mind that this credit cycle has seen an acceleration of corporate debt issuance, in order to enhance earnings to stockholders without requiring an underlying improvement in operating profits. The result of this financial engineering has been to increase the growth rate of corporate debt and significantly reduce the interest-rate level that will result in widespread corporate debt defaults. Continue reading

Out of the mouths of babes….

Submitted by Alasdair Macleod – FinanceAndEconomics.org

Parents will tell you the most difficult questions to answer sometimes come from their children. Here are some apparently innocent questions to ask of economists, journalists, financial commentators and central bankers, which are designed to expose the contradictions in their economic beliefs. They are at their most effective using a combination of empirical evidence and simple, unarguable logic. References to economic theory are minimal, but in all cases, the respondent is invited to present a valid theoretical justification for what invariably are little more than baseless assumptions.

A pretense of economic ignorance by the questioner is best, because it is most disarming. Avoid asking questions couched in anything but the simplest logical terms. You will probably only get two or three questions in before the respondent sees you as a trouble-maker and refuses to cooperate further.

The nine questions that follow are best asked so that they are answered in front of witnesses, adding to the respondent’s discomfort. Equally, journalists and financial commentators, who make a living from mindlessly recycling others’ beliefs, can be great sport for an interrogator. The game is simple: we know that macroeconomics is a fiction from top to bottom: the challenge is to expose it as such. If appropriate, preface the question with an earlier statement by the respondent, which he cannot deny; i.e. “Last week you said that…”

Commentary follows each question, which is in bold.

  1. How do you improve economic prospects when monetary policy destroys wealth by devaluing earnings and savings?

Central bankers and financial commentators are always ready to point out the supposed merits of monetary expansion, but are never willing to admit to the true cost. You can add that Lenin, Keynes and Friedman agreed that debasing money destroyed wealth for the masses, if the respondent prevaricates. Often politicians will duck the question with the excuse that monetary policy is delegated to the central bank.

The argument in favour of devaluation relies on fooling all of the people some of the time by encouraging them through lower interest rates to spend instead of save. However, monetary debasement has become a permanent and continuing fixture today, instead of a short-term fix. Continue reading

Austrians get some mainstream credibility

Submitted by Alasdair Macleod – FinanceAndEconomics.org

Well, well: who would have believed it. First the Bank for International Settlements comes out with a paper that links credit booms to the boom-bust business cycle[1], then Britain’s Adam Smith Institute publishes a paper by Anthony Evans that recommends the Bank of England should ditch its powers over monetary policy and move towards free banking[2]. Admittedly, the BIS paper hides its argument behind a mixture of statistical and mathematical analysis, and seems unaware of Austrian Business Cycle Theory, there being no mention of it, or even of Hayek. Is this ignorance, or a reluctance to be associated with loony free-marketeers? Not being a conspiracy theorist, I suspect ignorance.

The Adam Smith Institute’s paper is not so shy, and includes both “sound money” and “Austrian” in the title, though the first comment on the web version of the press release says talking about “Austrian” proposals is unhelpful. So prejudice against Austrian economics is still unfortunately alive and well, even though its conclusions are becoming less so. The Adam Smith Institute actually does some very good work debunking the mainstream neo-classical economics prevalent today, and is to be congratulated for publishing Evans’s paper.

The BIS paper will be the more influential of the two in policy circles, and this is not the first time the BIS has questioned the macroeconomic assumptions behind the actions of the major central banks. The BIS is regarded as the central bankers’ central bank, so just as we lesser mortals look up to the Fed, ECB, BoE or BoJ in the hope they know what they are doing, they presumably take note of the BIS. One wonders if the Fed’s new policy of raising interest rates was influenced by the BIS’s view that zero rates are not delivering a Keynesian recovery, and might only intensify the boom-bust syndrome. Continue reading

Why the Fed will never succeed

Submitted by Alasdair Macleod – FinanceAndEconomics.org

The Fed will never succeed in its attempt to manage inflation and unemployment by varying interest rates, because it and its economists do not accept the relationship between, on one side, the money it creates and the bank credit its commercial banks issue out of thin air, and on the other the disruption unsound money causes in the economy. This has been going on since the Fed was created, which makes the question as to whether the Fed was right to raise interest rates recently irrelevant.

Furthermore, it’s not just the American people who are affected the Fed’s monetary management, because the Fed’s actions affect nearly everyone on the planet. The Fed does not even admit to having this wider responsibility, except to the extent that it might have an impact on the US economy.

That the Fed thinks it is only responsible to the American people for its actions when they affect all nations is an abrogation of its duty as issuer of the reserve currency to the rest of the world, and it is therefore not surprising that the new kids on the block, such as China, Russia and their Asian friends, are laying plans to gain independence from the dollar-dominated system. The absence of comment from other central banks in the advanced nations on this important subject should also worry us, because they appear to be acting as mute supporters for the Fed’s group-think.

This is the context in which we need to clarify the effects of the Fed’s monetary policy. The fundamental question is actually far broader than whether or not the Fed should be raising rates: rather, should the Fed be managing interest rates at all? Before we can answer this question, we have to understand the relationship between credit and the business cycle.

There are two types of economic activity, one that correctly anticipates consumer demand and is successful, and one that fails to do so. In free markets the failures are closed down quickly, and the scarce economic resources tied up in them are redeployed towards more successful activities. A sound-money economy quickly eliminates business errors, so this self-cleansing action ensures there is no build-up of malinvestments and the associated debt that goes with it. Continue reading

Commodity losses

Submitted by Alasdair Macleod – FinanceAndEconomics.org

Markets have been extraordinarily complacent about the bad debts building up in the financial system. In the wake of the Fed’s decision to raise interest rates this week, the effect on debt was barely mentioned in the subsequent analysis by any of the mainstream media’s talking heads. Establishment economists are even claiming that in 2016 we can now gradually get back to more normal interest rates of three or four percent as the US economy continues its recovery. This simply cannot happen when one considers the effect on outstanding debt.

In considering the debt position, one should start by asking a very basic question: of total global debt, which currently exceeds $200 trillion equivalent, how much has been taken out without any intention of repaying it? We know that nearly all governments never intend to repay debt, instead looking to roll it, add to it, and inflate it away. Household debt continues to build in aggregate, and we know that the easiest way to make money is to take out a mortgage and buy a home. And how many company treasurers think about actually reducing debt, as opposed to refinancing it? One could go on, but the point is that monetary inflation has turned us all into habitual borrowers and debt continues to compound.

Complacency and markets are a dangerous combination. So far, there have been some rumblings about the position of lower quality borrowers with junk status. But even here, no one worries much, dismissing it as a liquidity problem. Note the evasion: the problem is not regarded to be the borrowers so much as market liquidity. Well, there is now a real issue that challenges this complacency, and that is commodity-related debt.

Energy-related liabilities are where most of the trouble lies. The annualised gross value of oil sales has fallen during 2015 by about $2 trillion. The effect on oil company profits and the decline in tax revenue for oil exporting countries is obvious. The effect on suppliers, ancillary businesses and retailers in the vicinity of oil production is perhaps less so. But the biggest problem for the oil industry is the loss of cash-flow to support the debt that has financed the investment and working capital involved. And because oil is priced in dollars, most of this debt is also denominated in dollars, not in local currencies that can be devalued to depreciate the debt. Continue reading

India and gold

Submitted by Alasdair Macleod – FinanceAndEconomics.org

The Indian government made headlines recently with its attempts to obtain possession of the gold held by its citizens. It claims it is in the national interest to restrict gold imports, which would reduce India’s trade deficit. Accordingly, Indians are being asked to deposit their physical gold in the banks for a promised yield of 2½%.

The government said the gold will be used to supply jewellers and other domestic users, replacing imports. Furthermore, the government announced the launch of a gold-backed bond, which in the words of Prime Minister Modi, and I quote, “People will not get any gold bar but a piece of paper that will have the same value as gold. When you return that piece of paper you will get money as per the value of gold at that time. You will not need to buy gold and worry about where to keep it.”

The World Gold Council is lending its name to the coin issue, which is part of what the government is calling, with disarming honesty, its gold monetisation scheme. However, only 4 kilos will be minted initially in 5 gram and 10 gram coins, so it looks like little more than a PR stunt for the wider scheme drawing in the authenticity of the WGC.

Wisely the public, both as individuals and also as representatives of religious communities, are having none of it. They are obviously not interested in sharing possession with the government, and the response to the deposit scheme attracted a paltry 400 grammes in the first two weeks. The media speculates this is due to the reluctance of people to declare their assets because of tax implications. While there may be some truth in this, the real reason may be far simpler but unquotable: people do not trust the government with their gold. Continue reading

The Fed’s in a bind

Submitted by Alasdair Macleod – FinanceAndEconomics.org

One can understand the Fed’s frustration over the failure of its interest rate policy, and its desire to escape the zero bound.

However, since the FOMC has all but said it will increase rates at its December meeting, events have turned against this course of action. The other major central banks are in easing mode, and the slowdown in China has further undermined both world trade flows and commodity prices. The result has been a strong dollar, which has effectively eliminated any perceived need for higher dollar interest rates. Meanwhile, the US’s non-financial economy remains subdued.

Last August, a similar situation existed, when the FOMC signalled that a rise in the Fed Funds Rate might be announced at its September meeting. Ahead of it, China revalued the dollar by announcing a small devaluation of its own currency, taking the wind out of the Fed’s sails. While the talking heads saw this as a failure of Chinese financial policy, it was nothing of the sort. Given the US was dragging its feet over the yuan’s inclusion in the SDR, it was a salvo in the financial war between the two states, and the Fed found itself in the firing line.

Since then the pressure has been mounting from the IMF for the US to back down over the SDR issue. The result was announced only this week, with the dollar content hardly changing and the yuan being accommodated mostly at the expense of the euro from September next year. However, despite the SDR issue having been dealt with for now, the Fed appears to have very little room for manoeuver before higher interest rates will give rise to a new financial crisis.

The chart below illustrates the problem. It is of the Fed Funds Rate since 1980 and the Fiat Money Quantity, which simply put is the sum of the commercial banks’ reserves at the Fed, plus cash and sight deposits held at the banks.

Interest Rate Cycle

Continue reading

Advice to the Prime Minister/President

Submitted by Alasdair Macleod – FinanceAndEconomics.org

Your country faces a stagnating economy. Let us assume your Prime Minister (or President if that is who holds the executive power) seeks advice from two imaginary economists.

PM: You two economists have different views on what our economic policy should be. What is your advice?

FIRST ECONOMIST (Austrian school): Prime Minister, the reason we face a stagnant economy is your central bank perpetuated the credit cycle by suppressing interest rates when the economy turned down after the banking crisis and lending risk escalated. That has left us with a legacy of under-performing businesses, which should have been left to go bankrupt. Instead they are struggling under a burden of unrepayable debt. Capital is not being reallocated to the new enterprises of the future. The dynamism of free markets has been throttled.

The extra money and credit created by the banking system has not been applied to the real economy. Instead they are fuelling a financial boom in asset prices, which have become dangerously separated from production values.

Eventually, current monetary policy will lead to a fall in the purchasing power of the currency, and the central bank will be forced to raise interest rates to a level that will precipitate the next financial crisis, if the crisis has not already occurred by then. Overvalued assets become exposed to debt liquidation. It happens every time, and if you think the last crisis, which led to the Lehman collapse was bad, on current monetary policies the next one will be much worse, just as Lehman was much worse than the aftermath of the dot-com boom.

A monetary policy that relies on the transfer of wealth from savers to debtors always fails in the end, as certainly as death and taxes exist. It is also the real reason the bankers are getting wealthy while ordinary people become poorer. The time has come to recognise that your central bank, by licencing and encouraging the banks to create credit out of thin air, is the source of the problem.

Sadly, your central bank seems blissfully unaware of the debilitating effect of monetary inflation on your voters’ wages and savings, and if I may say so Prime Minister, your administration pays little regard to the natural injustice of rewarding profligate borrowing and penalising thrift.

I advise you to stop your central bank from manipulating interest rates and to let the markets sort themselves out. Furthermore your central bank must stop debasing the currency as a cure-all. So this is what I suggest. Continue reading

The truth about GDP

Submitted by Alasdair Macleod – FinanceAndEconomics.org

“I can prove anything by statistics except the truth” – George Canning

Canning’s aphorism is as valid today as when he was Britain’s Prime Minister in 1817. Unfortunately, his wisdom is ignored completely by mainstream economists. Nowhere is this error more important than in defining economic activity, where the abuse of statistics is taken to levels that would have even surprised Canning.

Today we describe the economy as being in one of two states, growth or recession. We arrive at a judgment of its condition by taking the sum total of the transactions selected by statisticians and then deflating this total by a rate of inflation devised by them under direct or indirect political direction. Nominal gross domestic product is created and thereby adjusted and termed real GDP.

The errors in the method encourage a bias towards a general increase in the GDP trend by under-recording the rate of price inflation. From here it is a short step to associate rising prices only with an increase in economic activity. It also follows, based on these assumptions, that falling prices are to be avoided at all costs.

Assumptions, assumptions, all are assumptions. They lead to a ridiculous conclusion, that falling prices are evidence of falling demand, recession or even depression. Another of Canning’s aphorisms was that there is nothing so sublime as the truth. There’s no sublimity here. If there was, the improvement in everyone’s standard of living through falling prices for communications, access to data, and the technology in our homes and everyday life could not possibly have happened.

Well, they have happened, and the falling prices of the products of the greatest private sector corporations on earth are proof that they are both popular and good for business. Furthermore, the either/or condition of inflation/deflation firmly believed by macroeconomists would logically rule out the impoverishment of people in hyperinflations. If rising prices are good for the economy, how come everyone was so unhappy in Germany’s Weimar Republic in 1923, or in Zimbabwe fifteen years ago? Surely, as inflation accelerates the happiness level should rise…… Continue reading