To read the June 9, 2013 letter, please click here.

Republished from Popular Macro. To read this article in pdf format, click here: June 2 2013

As we are in the final stage of the global bubble, I realize that we often fail to ask the most obvious questions. In this case, as every central banker tells us that his policies are directed to obtain growth, the obvious question is…how do we define economic growth? What is economic growth? Yes, yes, I know that what they do is simply monetize deficits and enable the transfer of wealth between sectors and generations, but there is also an intellectual battlefield, which we should be aware of.

In the next sections, I will (extremely) briefly walk through the history of the idea of economic growth to this day. Obviously, I cannot be exhaustive and I encourage you to do further research on the works mentioned below. At the end, I examine what view policy makers have on economic growth, if any…

When did the idea of economic growth first appear? Up to the 18^th century, economic thinking was predominantly concerned with comparative statics, intellectual exercises designed to establish causes and consequences of policy making.

I dare to suggest that the concern on economic growth grew before the French Revolution, when the distribution of income was first examined. My suggestion contradicts Nicholas Kaldor, who finds David Ricardo pioneering the theory of distribution. Although David Ricardo explicitly says in the preface to his “Principles of Political Economy and Taxation” that: “…To determine the laws which regulate this distribution, is the principal problem in Political Economy…”, my view is that this perspective had already been adopted by Francois Quesnay, in 1759, and was the foundation of the Physiocracy. If agriculture was the basis of economic growth, a distribution of income favouring this sector was thought to be advisable. I copied below the very same Tableau Economique, probably the first economic model (designed by Quesnay):

 

The idea that there was an “optimal” distribution of income triggered the investigation of what determines the same. Simultaneously and brewed by Malthus, there was another idea: Full employment requires a growing income. Perhaps this idea, which we are reminded of every two months by the minutes of the Federal Open Market Committee meeting at 2:15pm, goes all the way back to Karl Marx.

It was on these two pillars (i.e. distribution of income and the relation between employment and output) that the modern theory of economic growth was born, with the additional analysis of how capital is created.

The first “modern” discussion on economic growth is probably that of R. F. Harrod, titled “An Essay in Dynamic Theory”, published in 1939.

Harrod’ work has historical relevance although it is not original and merely seeks to give Keynes’ thought a dynamic dimension. His main assumptions are that the supply of savings is determined by income (i.e. interest rates play no role, which would have probably made him a good FOMC member). For Harrod, investment responds to income growth and there is always equilibrium in the savings market.

Just like in the rest of the modern discussions on economic growth, monetary aspects are completely ignored. There is a constant concern –sometimes turned into an obsession- to address equilibrium conditions.  These analytic frameworks are Walrasian in structure (I also discussed Walras here) and ignore the impact of aggregate leverage in a credit-based monetary system. I think there is no excuse for such omission, for it is clear that already in the 1930s the Austrian school was very much aware of such impact.

Harrod worked within a single commodity and production factor model, and held that a departure from equilibrium would activate a self-fulfilling, spiraling instability.

He anticipates Ben Bernanke and followers, when he asserts that to address such instability, policy is required: “…The ideal policy would be to manipulate the proper warranted rate, so that it should be equal to the natural rate…” Sounds familiar?

After World War II, Evsey Domar presented his work “Capital expansion, rate of growth and employment”, in January 1946.

Domar incorporated prices into his model, but assumed no fluctuations. Unlike Harrod, he was not obsessed with equilibrium in the savings market, but discussed the generation of capital in an economic system. He brought attention to the issue of full employment: “…Our first task is to discover…the rate of growth at which the economy must expand in order to remain in a continuous state of full employment…”

He was not just referring to the employment of labour, but of capital too.  In this regard, he precedes John B. Taylor’s famous “rule”, because he examines the dynamics of the gap between potential and actual output (he actually focused on the relation between change in output and investment, which he called potential social average investment productivity).

Almost a decade later, economists were still working with the assumptions that the factors of production were fixed and that the monetary context had no impact on economic growth. James Tobin was to challenge the status quo in a paper titled “A Dynamic Aggregative Model” published in April of 1955, by the Journal of Political Economy.

For Tobin, economies have constant returns to scale (“…if labor and capital expand over time in proportion, then output will expand in the same proportion…”). His innovation is the introduction of “asset preferences”, as one more variable affecting economic growth.

Tobin assumes that we either hold currency (zero interest) or real assets. There are no financial assets (i.e. paper that pays a rent). Inflation or deflation is therefore the product of shifts in our aggregate allocation, between currency and real assets, driven by preferences. For instance, if we decide to hold less currency (i.e. we bid for real assets), there will be inflationary pressures.

Interestingly, he realized that technological progress is deflationary, and recommended monetary expansion to offset deflation. His merit was in understanding the implication of said expansion. Tobin tells us that the same “…cannot be accomplished by monetary policy in the conventional sense but must be the result of deficit financing… (…)…clearly, such a discussion requires the introduction of additional types of assets, including bank deposits and private debts…” In other words, he anticipated our current “problem”: Lack of collateral, in a credit-based system with shadow banking. For a good discussion of this system, read here, from Zerohedge.com. Tobin concludes that under such expansion”…the normal result is that consumption will be a larger and investment a smaller share of a given level of real income…”

Mr. Solow is “the” name in the theory of economic growth. His work on this field eventually earned him the Nobel Prize in Economics, in 1987. His ground-breaking work appeared one year later than Tobin’s, in February 1956, published at the Quarterly Journal of Economics and titled “A contribution to the Theory of Economic Growth”.

Solow takes Harrod’s and Domar’s research but abandons the assumption that production takes place under conditions of fixed proportions (between labour and capital), allows for a rate of technological change, and incorporates an interest rate-sensitive savings function.

Solow’s conclusions are powerful and based on the axiom that in the long-run, our economic system has constant returns to scale. The main conclusion is that full employment (or perhaps I should say, an optimal ratio between labor and capital) is not (as suggested by his predecessors and Ben Bernanke) obtained from a key level of output/income, but from a key marginal productivity of capital, which in turn determines the real wage rate. How do we get to that key marginal productivity of capital? Thanks to perfect price flexibility, within a stable monetary system (implied; for those interested, refer equations 10-12 of his model). Lastly, Solow incorporates technological progress as an exogenous (i.e. arbitrary, not determined by his model) and neutral variable.

It’s a pity –in my opinion- that Solow did not explore the monetary aspects implied in his work. His idea of economic growth makes sense under commodity-based money (i.e. no central banking), because one can reasonably agree with him on the elasticity of supply of factors (capital and labour, he excludes land) to their respective prices (interest rate and wages). But I guess that if he had done that, he would have been an Austrian by now, and possibly less popular… Robert Solow is currently Institute Professor of Economics emeritus at MIT and recently wrote (here) on the ongoing financial crisis.

The Austrian School

I do not think that one can point to a unique author within the Austrian school, on the theory of economic growth. In fact, the Austrian school rightly denies a special spot to economic growth and focuses instead on what Jesús Huerta de Soto calls “dynamic efficiency”. If humans act purposefully and the price system works freely, all it takes to improve our standard of living is to allow markets to allocate resources where consumers want them to be. The market is a cooperation and coordination process.

With regards to income distribution, Von Mises made the case that it is a flawed concept. We do not produce something and then distribute the income generated by it. The distribution of that income is already decided, agreed and precedes production. And that product gets made precisely because of and not in spite of, that agreed income distribution.

With regards to the full employment of resources, under a transparent market, with prices signalling where resources are needed and were they are not, unemployment is simply at a natural and low rate, the result of constant change/creative destruction.

Equilibrium is a ridiculous concept, because under it, no change would occur. It is exactly that constant reallocation of resources, carried out by the entrepreneur (an absent figure under all other economic schools) the factor that increases our efficiency, our productivity. Hence there is no need for an optimal savings rate or an optimal stock of capital.

Money and financial assets are relevant, because as medium of indirect exchange and store of value, respectively, they enable the necessary coordination among humans to satisfy their needs. This coordination leads to specialization and improvement of production methods. When money dies under inflation, specialization dies with it too. Risk-taking is acknowledged and not exogenous. It is the blood of entrepreneurship.

If I still have to name economists within the school that focused on the idea of growth, I come up with three: Roger Garrison (Auburn University and adjunct scholar of the Mises Institute), Israel M. Kirzner and Frederick Von Hayek.

Having very succinctly mentioned the topics, axioms and conclusions around economic growth, we can legitimately ask ourselves what position policy makers of the 21^st century have on the same.

Let’s start by acknowledging who the policy makers are: The global cartel of central banking. Fiscal policy is non-existent or even subdued, repressed, as members of the European Monetary Union are witnessing. All members of this cartel are highly educated and many of them even have an academic background, I would expect from them to have a view on each of the topics mentioned above. Let’s see…

Income Distribution

Apart from the explicit wealth transfer from taxpayers to the banking and government sectors, and the implicit ones (a) from wage earners to stock holders and (b) from future generations to the present one, I am afraid that there is no clear, laid-out view with respect to an optimal distribution between labour and capital. Not that I endorse one, as I agree with the Austrian perspective, but I would assume central bankers have an opinion on this point.

Proportion of production factors

The current zero-interest rate policy has completely inverted the risk-return relationship in the capital structure of the centrally planned economies. For instance, banks act like private equity firms. It is now the new normal to see a bank extend a loan at below market prices to win a debt or equity mandate. Once that loan has given the financial support to proceed with public capital raising, it is also normal to see the same companies implementing share buybacks or dividend payment increases, either with bank debt or public capital. There is also no concern about the distortions generated in the labour market by the ultra-low interest rates or the labour legislation itself.

Output growth

Growth in output is the target of economic policy in any mainstream discussion. The approaches differ not in how to get there (all opinions agree in that the stock of capital has to grow) but in how the stock of capital can best increase.

What is the view of the central banking cartel on how to grow output? Surprisingly, not via an increase in the marginal productivity of capital, but via the so called wealth effect: As interest rates fall, asset prices increase (it doesn’t matter which assets see their prices rise) and the assets can be used as collateral to leverage a higher than previously possible consumption level. This consumption level will drive output growth, and this increase in output –they believe- will bring about full employment.

The wealth effect is mistakenly attributed to Keynes, who actually argued against it:

“…For whilst an increase in the quantity of money may be expected, cet. par., to reduce the rate of interest, this will not happen if the liquidity-preferences of the public are increasing more than the quantity of money; and whilst a decline in the rate of interest may be expected, cet. par., to increase the volume of investment, this will not happen if the schedule of the marginal efficiency of capital is falling more rapidly than the rate of interest; and whilst an increase in the volume of investment may be expected, cet. par., to increase employment, this may not happen if the propensity to consume is falling off.…”Chapter 13, , The General Theory of Employment, Interest and Money

Thus, the central banking cartel has its own interpretation of economic growth and it does not fit any of the perspectives presented above.

This was a very, very brief discussion on economic growth. I understand it may have been too abstract and I tried to make it as easy to understand as possible, because I firmly believe that there is value in a historical perspective on economic thought, vis-à-vis current policy.

I discussed only those works I was more familiar with and omitted other important economists, in no particular order, like Hicks, Swan, Robinson, Phelps, Malinvaud, Arrow, Kahn, Kaldor and Sidrauski .

 

 

M. Sibileau

To read this article in pdf format, click here: May 26 2013

A week later and everyone is a bit more nervous, with the speculation that US sovereign debt purchases by the Federal Reserve will wind down and with the Bank of Japan completely cornered.

In anticipation to the debate on the Fed’s bond purchase tapering, on April 28th (see here) I wrote why the Federal Reserve cannot exit Quantitative Easing: Any tightening must be preceded by a change in policy that addresses fiscal deficits. It has absolutely nothing to do with unemployment or activity levels. Furthermore, it will require international coordination. This is also not possible. The Bank of Japan is helplessly facing the collapse of the country’s sovereign debt, the European Monetary Union is anything but what its name indicates, with one of its members under capital controls, and China is improvising as its credit bubble bursts.

In light of this, we are now beginning to see research that incorporates the problem of future higher inflation to the valuation of different asset classes. One example of this, in the corporate credit space was Morgan Stanley’s “Credit Continuum: Debt Cost and the Real Deal” published on May 17^th, 2013. Upon reading it, I was uncomfortable with the notion that inflation is the simple reflection of the change in a price index, which implies the thesis of the neutrality of money. For instance, the said research note discusses how standard financial metrics compare vis-à-vis a rate of inflation.

Why is this relevant? The gap between current valuations in the capital markets (both debt and credit) and the weak activity data releases could mistakenly be interpreted as a reflection of the collective expectation of an imminent recovery. The question therefore is: Can inflation bring a recovery? Can inflation positively affect valuations?

I am not going to comment on others’ views or recommendations, but on the underlying method. A price index is a mental tool that has no relation to reality. In the real world, we trade driven by relative prices. To infer economic behaviour off changes in a price index is a mistake. The impact of inflation is more complex. For this reason and in anticipation of future debates on this topic, I offer you today a microeconomic analysis of such impact, on value.

Framework

I suggest that a good way (but certainly not the only one) to assess the impact of inflation on the valuation of a firm is to think of the same within the typical free-cash flow approach. After all, what matters is not how inflation can affect a certain component of its capital structure, but how the entire value of a firm is impacted, before the same can be shared among the different contributors to the said capital structure (i.e. equity, debt holders, etc.)

Simplifying, as far as I can recall from the times when I worked in the area of Private Equity,  the way to calculate the free cash flow of a firm for a determined period is to obtain its operating margin, add to it depreciation & amortization costs and subtract capital expenditures, changes in net working capital and taxes. I show the formula below:

Revenues

– Operating Costs

Operating margin

 

+ Depreciation & Amortization

- Capital Expenditures

- Change in net working capital

- Operating tax

Free Cash flow

What follows is a discussion on the impact of inflation on each of the components of the valuation formula above:

Revenues (= unit price x volume sold)

Under inflation, only those firms that have pricing power can defend the value of their production. At the same time and because inflation brings unemployment and the destruction of purchasing power, in general (not for all firms, of course), sales volume drops too. This backdrop encourages consolidation, where big players get bigger and small ones disappear. With it, the bigger firms obtain oligopolistic to monopolistic pricing power which assures two things: The currency zone where this development takes place loses in innovation and prices become less flexible. This inflexibility, when fully unfolded, directly leads to indexation, which is the stepping stone for any hyperinflationary process. If the consolidating firms are public, it is likely that during the consolidation process they become private via leveraged deals, as long as credit is still available.

Operating costs (=unit cost x volume bought + factors)

With regards to direct inputs, the same pricing problem described above arises. There are those firms that have leverage with their suppliers and can force these to delay price increases (i.e. margin contraction) and those that can’t. Consolidation therefore pays off on this front too, carrying the same consequences mentioned above. From an accounting perspective, when inflation is high, firms can’t even measure the cost of their inputs and are forced to take a Schrodinger approach, with either Last in-First Out (LIFO) or First in – First Out (FIFO) accounting.

With regards to indirect inputs, these can be segmented into labour and capital. Labour intensive firms will struggle with a unionizing work force and inflation always nourishes the growth of unions, to renegotiate labour contracts. All things equal, this context simultaneously encourages higher unemployment and illegal immigration, because while credit is available at negative real rates (i.e. the nominal interest rate is lower than the inflation rate), firms will find more convenient to replace labour with capital. This takes place during the lower stages of an inflationary process. In later stages, credit disappears and the higher interest rates make refinancing debts unfeasible, bankrupting those firms that dared to invest in capital expenditures.

Where the required labour is low skilled but expensive due to social security legislation, firms will also replace it with illegal immigration, whenever possible.

Conclusion

The impact of inflation on operating margins (i.e. revenues – operating costs) is to drive consolidation, the replacement of labour by capital, indexation, price rigidity and the loss of competitiveness. The loss of competitiveness is the natural result of an environment that favours oligopolistic/monopolistic structures and short-term investment opportunities. It is very common to blame entrepreneurs or management for this outcome. However, the conditions that drive firms to adopt these survival strategies are the exclusive responsibility of politicians.

Depreciation & Amortization

“…Both depreciation and amortization (as well as depletion) are methods used to prorate the cost of a specific type of asset to the asset’s life…these methods are calculated by subtracting the asset’s salvage value from its original cost…” (Investopedia)

It is clear that any attempt to accurately portray the value and life cycle of fixed or intangible assets under inflation becomes irrelevant. What if due to high inflation the salvage value of an asset is higher than its original cost?

Under inflation there is uncertainty on the true cost of maintaining the fixed resources involved in the operation of a business. This uncertainty forces firms to cut back on capital expenditures. Investment demand and economic growth therefore collapse

Capital expenditures

Because nothing can be reasonably forecasted under inflation and growth and efficiencies are better served via consolidation and without innovation, capital expenditures can only be of a very short nature, if any.

Change in net working capital

This item is perhaps the most neglected and yet, most relevant, in my view. For valuation purposes, an increase in net working capital means that a higher amount of capital is tied to the operations of a firm. Therefore, a lower amount of cash is available to the contributors of capital to the firm (i.e. debt and equity holders). For this reason, the change in net working capital is subtracted in the valuation formula above.

What is net working capital? In simple terms:

Accounts receivable

+ Inventory

-  Accounts payable

Net working capital

If from one period to another the time necessary to collect on accounts receivable increase and/or the inventory turnover necessary to run an operation decreases, the value of the firm falls, as less cash is available to the contributors of capital. Alternatively, if the firm manages to increase the time necessary to honor accounts payable –all things equal- more cash is available.

What is the impact of inflation on net working capital? Complete! Under inflation, firms seek to delay any cash outflow. The higher their accounts payable, the more debt they dilute. At the same time, bank lending quickly shrinks. At high inflation levels, even working capital lending disappears. At this stage, vendor financing is key and only those companies that demonstrate a steady commitment to their suppliers can obtain credit from them. Suppliers, on the other side, often go bankrupt precisely because they cannot collect on their receivables. One of the painful ironies of inflation is that under it, liquidity evaporates!

With regards to inventory, this is counter intuitive, but firms will try to maximize its amount, as long as they can get vendor financing. The accumulation of inventory allows firms to lock in a cost of production that would otherwise be uncertain. This is very inefficient. Just-in-time production models become totally unfeasible. The accumulation of 

inventory is more understandable when one realizes that inflation is the destruction of the medium of indirect exchange, which forces us to barter. Under barter, inventory is not a burden.

Just as much as firms seek to delay cash outflows, they will want to collect as quickly as possible. Those firms that operate at the end of the distribution chain and can sell to a granular, cash-paying public will be at an advantage over those that operate at earlier links of the chain (and have a concentrated customer base which demands vendor financing). Inflation therefore leads to consolidation on this basis too, towards the end of a distribution chain.

An example of a firm that would fit this profile, benefitting from an inflationary context would be Costco Wholesale Corp. (and no, this is not an investment recommendation, but a hypothetical example). As Costco sells in bulk, its customer base would grow, since the public that seeks to escape from a devaluing currency and lock the price of necessary staples would see an advantage in purchasing the same in quantities, at a discount. Simultaneously, the company would be in a privileged position to exert pricing power over its suppliers and grow via acquisitions. As an extreme (but illustrative) example, I recall that during the ‘80s in Argentina, when employees were paid their salaries, many took the day off (and parents left their kids with nannies) to go shopping. They were simply ensuring that not one day would pass with them holding depreciating currency, which had to be exchanged as fast as possible for all the goods that were going to be consumed until the next wage payment. They set off in a hurry and bought, when possible, in bulk!

 

Operating tax

Tax payments are simply one more cash outflow. Even without inflation, one tries to minimize and delay this outflow. Under high inflation, delaying its payment is a matter of survival and represents and additional source of

financing. Because all hyperinflations took place before the internet era, we don’t know how easy it will be to delay tax payments when the next hyperinflation arrives. I imagine it will be much harder in the digital era.

The inflationary policies carried out globally today, if successful will have a considerably negative impact on economic growth. The microeconomic impact described above brings the following unintended and unnecessary macroeconomic consequences:

-Oligopolistic/ Monopolistic structures

-Loss of innovation, competitiveness

-Indexation, price rigidities

-Unionization of labour force and higher unemployment

-Illegal migratory flows

-Destruction of public capital markets

-Higher fiscal deficits

If this analysis is correct, the record asset values we see today cannot be interpreted as the omen of an imminent recovery. I am not saying that these nominal values are not justified. What I am saying is that they should not be interpreted as an indication that economic growth is on the way □

Martin Sibileau

To read this article in pdf format, click here:May 20 2013

I am back from a brief trip to Argentina’s Patagonia, where I could confirm first-hand the irreversible damage caused by interventionist policies: Widespread poverty, abandoned infrastructure, scarcity of consumer goods, unseen unemployment and criminality, etc. I could also see for myself the madness of hedging against inflation with the purchase of new cars. The streets of any forgotten small town in Patagonia are filled with brand new 4×4 vehicles that would be the envy of many in North America.

While visiting too, the Argentine government made a new move to suppress the price of the physical US dollar. In previous articles (here and here), I made the case that the broken US dollar market in Argentina would provide insights into what we may eventually expect from the gold market, if it broke in the same fashion. However, I had underestimated the magnitude of the USD physical market. Zerohedge brought attention to this point a few days ago (here).

Overview

In August of 2011, Argentina’s government slowly began to implement a series of actions destined to curtail the right of citizens to access US dollars (foreign exchange in general). The goal was and is to force savings into pesos, as pesos are after the taxable asset in a country that cannot access capital markets and fully monetizes its deficits.

From that moment onward  physical US dollars started to trade at a premium. Last week, with the paper US dollar value at 5.11 pesos, that premium was over 100%. Physical US dollars, i.e. dollars outside the system, reached a bid/ask of 10.30/10.45 pesos. The chart below should help visualize this dynamic (source: Reuters/La Nación)

The latest move: Tax moratorium to repatriate capital

With a 100% premium over the “official” price of the US dollar, on May 7th, the federal government announced a moratorium for off-shore capital (see here, in Spanish). A simple reading of this measure would reveal a government encouraging capital inflows to an investments-starving nation. The moratorium, after all, is for capital directed to the real estate and energy sectors. The real intention behind it is, however, to narrow the gap between the official and black market price of the US dollar, via manipulation of the “official” price, as I will show further below. At the official price, of course, one finds no sellers.

The moratorium is a tax pardon, no questions asked, for all Argentines who decide to bring onshore their undeclared US dollars deposited offshore. Although it is not clear yet whether the declared funds can be freely disposed of, the government seeks that they be applied to the purchase 2016 4% bonds issued by the federal government or USD certificates, issued by the central bank. These USD denominated certificates (see image below, source: La Nacion) are to be used to clear transactions in the real estate sector, are fully endorsable and have no maturity. In other words, the government wants to further segment the US dollar market.

I can’t help speculating that years into the future, one would see a developed country implementing a similar measure to repatriate undeclared gold.

How it works

The tax moratorium is a simple transaction. Let’s forget about the USD certificates issued by the central bank that pay no interest and assume that the public will accept them like US dollars. We are talking about a public that already holds 1 every 15 US dollar bills in the world. My view is that these will not prosper, because I doubt that anyone selling real estate would be willing to take them at face value.

We are left with the 4% coupon bonds issued by the federal government, maturing in 2016, which are bought by offshore depositors. The figure below shows the accounting:

 

 

Final Observations

By now it should be clear that if the Argentine government had only wanted to attract offshore capital to fund investments, there would have been no need to have the Government Issue interest paying certificates.

It is also obvious that for this policy to be successful, offshore depositors must believe that declared, taxable, interest paying USD certificates are better than holding US dollars off-shore. But if these certificates are to be liquid, the discount in the secondary market should be lower than 12% approximately, in the absence of counterparty risk (4% x 3 years). And with the Federal Government of Argentina as the issuer, there is no doubt that counterparty risk is real and present. Preliminarily the government expects $4 billion to be declared.

One would find this measure laughable, as it is absolutely evident that one is better off holding undeclared funds offshore than facing scrutiny to earn a 4% interest on a certificate issued by the government of a country that defaulted on its debt and has no access to the capital markets.  Yet, in this new normal world we live in, with the announcement, the price of the US dollar fell to 8.87 pesos, which represents a considerable 13.9% drop. To put the reaction in perspective, the Argentine government jawboned the foreign exchange market more efficiently than Draghi did with the gold market upon the insinuation that Cyprus would sell its gold.

It is also a known fact that financial repression in Argentina is a publicly disclosed policy, and some may attribute the drop to the same. But I cannot deny that the reaction surprised me. If the measure is successful, would the success indicate that monies currently offshore are perceived to be in far greater danger than in a country where they can be laundered into the energy sector? To finance a company that was confiscated in 2012 to the Spanish crown?

Regardless of the initial drop (the closing price on Friday May 17^th was 8.95 pesos, while the official price was 5.25 pesos), one wonders if the Argentine government can sustainably manipulate the price of the US dollar, assuming the certificates are accepted in the market, and if there are lessons to be learned here.

Without changing the terms of the tax moratorium, Argentina’s government could replicate the tactics of the gold cartel to suppress the price of the US dollar. The way to achieve this is by expanding the credit multiplier, as shown below:

The figure above shows that with the US Dollars repatriated and in the balance sheet of the Federal Government (assets), it could be possible, assuming that the certificates are accepted, to generate a credit pyramid in the system. If the certificates are accepted in deposit by banks (step 2 above), these can use them to expand their USD loan base (just like bullion banks use the gold ETFs to expand their gold loans).

This scheme would suppress the price of the US dollar (just like gold loans suppress the price of gold), in a country where depositors have not lost their deposits to their banks (i.e. in a country where people trust their banks). But we all know this is not the case with Argentina. However, I can imagine that the 4% coupon of the certificates will not carved in stone. Would a 20% interest on USD certificates encourage certificate holders to leave them in deposit? It did in 2001, and with Argentina’s holdouts still alive and fighting, this alternative scheme would allow the government to source US dollars and keep kicking the can until the next election.

Nevertheless, with an ever increasing fiscal deficit, it would take an equally growing amount of leverage (on the bonds) to keep the party going. But remember: This whole intellectual exercise is based on the assumption that the bonds trade in the secondary market and that one can only produce a tax moratorium every few years….

If the “bancos” had to offer a high interest rate to use the bonds as collateral (say, above 20% or most likely above the actual inflation rate), the Banco Central (i.e. not the Federal Government that issues the 4% bonds) would feel tempted to directly subsidize the banks, while earning a laughable amount, from its US dollar bills. This subsidy would be required to maintain a positive net interest margin, because I doubt that the bancos would be able to make any significant USD loans at such rates. There is a precedent to this in the Cuenta de Regulación Monetaria, established in 1977.

We can now see that the sustainability of the manipulation in a segmented/broken foreign exchange market causes a negative carry, which would create a quasi-fiscal deficit in Argentina (i.e. the deficit of the Banco Central), fully opening the gates to hyperinflation. I have made the point in earlier letters (here) that the same could be conceived to happen with the manipulation in the price of gold. This latest example from Argentina serves therefore as another experiment in the history of failed manipulations.

One last comment: Because the scheme is so visibly unsustainable, the temporary drop in the price of US dollar bills (i.e. physical US dollars) will attract a higher demand of said US dollar bills, forcing the leverage provided by the certificates to grow exponentially. In the week of the announcement, USD deposits fell another 96 million. This is the same behaviour seen in physical gold.

What makes the gold market of 2013 different?

As gold is a commodity, there is no counterparty risk: Either the gold is or isn’t where it is supposed to be. This makes the gold market less flexible than, say the foreign exchange market just described above. Why? There cannot be an interest rate in gold paper that will keep investors in the Ponzi scheme, just like there is one for US dollar bonds in Argentina.

For instance, if a gold ETF (or any commodity ETF for this purpose) offered a coupon, it would raise all kinds of suspicions, unless we are in a system where gold is allowed to compete with legal tender, in which case too, there would not be a need for gold ETFs. This means that in order to keep its price suppressed, the gold market requires outright fraud. It also means that the only way that such fraud can be resolved is with plain and swift confiscation, because once revealed, no interest rate will clear the market.

If it is correct, as reported, that 1 out of every 15 US dollar bills is held by an Argentine, it is easy to see why the retail US dollar investor in Argentina managed to break the market and keep the official manipulation at bay. This is not the case with the global gold market today, but it was certainly not the case in Argentina of the ‘70s either, when the decline of its economy began to show itself as evident.

Martin Sibileau

To read this article in pdf format, click here: May 5 2013

With equity valuations no longer levitating but in a different, 4^th dimension altogether, and credit spreads compressing… Which fiduciary portfolio manager can still afford to hedge? Any price to hedge seems expensive and with no demand, the price of protection falls almost daily. The CDX NA IG20 index (i.e. the investment grade credit default swap index series 20, tracking the credit risk of 125 North American investment grade companies in the credit default swap market) closed the week at 70-71bps. The index was at this level back in the spring of 2005. By the summer of 2007, any credit portfolio manager that would have wanted to cautiously hedge with this index would have seen a further compression of 75% in spreads, completely wiping him/her out.

It is in situations like these, when the crash comes, that the proverbial run for liquidity forces central banks to coordinate liquidity injections. However, something tells me that this time, the trick won’t work. In anticipation to the next and perhaps final attempt, I want to offer today an historical perspective on the favorite liquidity injection tool:  Currency swaps. These coordinated interventions are not a solution to the crashes, but their cause, within a game of chicken and egg. But I’ve just given you the conclusion. I need to back it now…

How it all began

Let me clarify: By currency swaps, I refer to a transaction carried out between two central banks. This means that currency swaps cannot be older than the central banks that extend them. On the other hand, foreign exchange swaps between corporations may date back to the late Middle Ages, when trade began to resurface in the Italian cities and the Hansastädte. Having said this, I believe that currency swaps were born in 1922, during the International Monetary Conference that took place in Geneva. This conference marked the beginning of the Gold Exchange Standard, with the goal of stabilizing exchange rates (in terms of gold) back to the pre-World War I.

According to Prof. Giovanni B. Pittaluga (Univ. di Genova), there were two key resolutions from the conference, which opened the door to currency swaps. Resolution No. 9 proposed that central banks “…centralise and coordinate the demand for gold, and so avoid those wide fluctuations in the purchasing power of gold which might otherwise result from the simultaneous and competitive efforts of a number of countries to secure metallic reserves…”

Resolution No. 9 also spelled how the cooperation among central banks would work, which “…should embody some means of economizing the use of gold maintaining reserves in the form of foreign balance, such, for example, as the gold exchange standard or an international clearing system…”

In Resolution No. 11, we learn that: “…The convention will thus be based on a gold exchange standard.” (…) “…A participating country, in addition to any gold reserve held at home, may maintain in any other participating country reserves of approved assets in the form of bank balances, bills, short-term Securities, or other suitable liquid assets…. when progress permits, certain of the participating countries will establish a free market in gold and thus become gold centers”.

Lastly, gold or foreign exchange would back no less than 40% of the monetary base of central banks. With this agreement, the stage was set to manipulate liquidity in a coordinated way to a degree the world had never witnessed before. The reserve multiplier, composed by gold and foreign exchange could be “managed” and through an international clearing system, it could be managed globally.

How adjustments worked under the Gold Standard

Before 1922, adjustments within the Gold Standard involved the free movement of gold. In the figure below, I show what an adjustment would have looked like, as the United States underwent a balance of trade deficit, for instance:

Gold would have left the United States, reducing the asset side of the balance sheet of the Federal Reserve. Matching this movement, the monetary base (i.e. US dollars) would have fallen too. The gold would have eventually entered the balance sheet of the Banque of France, which would have issue a corresponding marginal amount of French Francs.

It is worth noting that the interest rate, in gold, would have increased in the United States, providing a stabilizing/balancing mechanism, to repatriate the gold that originally left, thanks to arbitraging opportunities. As Brendan Brown (Head of Economic Research at Mitsubishi UFJ Securities International) explained (here), with free determination of interest rates and even considerable price fluctuations, agents in this system had the legitimate expectation that key relative prices would return to a “perpetual” level. This expectation provided “…the negative real interest rate which Bernanke so desperately tries to create today with hyped inflation expectations…”

There is an excellent work on the mechanics of this adjustment published by Mary Tone Rodgers and Berry K. Wilson, with regards to the Panic of 1907 (see here). The authors sustain that the gold flows that ensued from Europe into the United States provided the liquidity necessary to mitigate the panic, without the need of intervention.  This success in reducing systemic risk was due to the existence of US corporate bonds (mainly from railroads) with coupon and principal payable in gold, in bearer or registered form (at the option of the holder) that facilitated transferability, tradable jointly in the US and European exchanges, and within a payment system operating largely out of reach from banksters outside of the bank clearinghouse systems. The official story is that the system was saved by a $25MM JPM-led pool of liquidity injected to the call loan market.

How adjustments worked under the Gold Exchange Standard

During the 1920s and particularly with the stock imbalances resulting from World War I, the search for sustainable financing of reparation payments began. Complicating things, the beginning of this decade saw the hyper inflationary processes in Germany and Hungary. By 1924, England and the United States rolled out the Dawes Plan and between 1926 and 1928, the so called Poincaré Stabilization Plan in France. The former got Charles G. Dawes the Nobel Prize Peace, in 1925.

As the figure below shows, against a stable stock of gold, fiat currency would be loaned between central banks. In the case of a swap for the Banque de France, US dollars would be available/loaned, which were supposedly backed by gold. The reserve multiplier vs. gold expanded, of course:

 

With these transactions central banks would now be able to influence monetary (i.e. paper) interest rates. The balancing mechanism provided by gold interest rate differentials had been lost. As we saw under the Gold Standard before, an outflow of US dollars would have caused US dollar rates to rise, impacting on the purchasing power of Americans. Now, the reserve multiplier versus gold expanded and the purchasing power of the nation that provided the financing was left untouched. The US dollar would depreciate (on the margin and ceteris paribus) against the countries benefiting from these swaps. Inflation was exported therefore from the issuing nation (USA) to the receiving nations (Europe). The party lasted until 1931, when the collapse of the KreditAnstalt triggered a unanimous wave of deflation.

How the perspective changed as the US became a debtor nation

Fast forward to 1965, two decades after World War II, and currency swaps are no longer seen as a tool to temporarily “stabilize” the financing of flows, like balance of trade deficits or war reparation payments, but stocks of debt. By 1965, central bankers are already worried with the creation of reserve assets, just like they are today; with the creation of collateral (see this great post by Zerohedge on the latter).

Indeed, 48 years ago, the Group of Ten presented what was called the Ossola Report, after Rinaldo Ossola, chairman of the study group involved in its preparation and also vice-chairman of the Bank of Italy. This report was specifically concerned with the creation of reserve assets. At least back then, gold was still considered to be one of them. In an amazing confession (although the document was initially restricted), the Ossola Group explicitly declared that the problem “…arises from the considered expectation that the future flow of gold into reserves cannot be prudently relied upon to meet all needs for an expansion of reserves associated with a growing volume of world trade and payments and that the contribution of dollar holdings to the growth of reserves seems unlikely to continue as in the past…”

Currency swaps were once again considered part of the solution. Under the so called “currency assets”, the swaps were included by the Ossola Group, as a useful tool for the creation of alternative reserves. Three months, during a Hearing before the Subcommittee on National Security and International Operations, William McChesney Martin, Jr., at that time Chairman of the Board of Governors of the Federal Reserve System, acknowledged a much greater role to currency swaps, in maintaining the role of the US dollar as the global reserve currency.

In McChesney Martin’s words: “…Under the swap agreements, both the System (i.e. Federal Reserve System) and its partners make drawings only for the purpose of counteracting the effects on exchange markets and reserve positions of temporary or transitional fluctuations in payments flows. About half of the drawings ever made by the System, and most of the drawings made by foreign central banks, have been repaid within three months; nearly 90 per cent of the recent drawings made by the System and 100 per cent of the drawings made by foreign central banks have been repaid within six months. In any event, no drawing is permitted to remain outstanding for more than twelve months. This policy ensures that drawings will be made, either by the System or by a foreign central, bank, only for temporary purposes and not for the purpose of financing a persistent payments deficit. In all swap arrangements both parties are fully protected from the danger of exchange-rate fluctuations. If a foreign central bank draws dollars, its obligation to repay dollars would not be altered if in the meantime its currency were devalued. Moreover, the drawings are exchanges of currencies rather than credits. For instance, if, say, the National Bank of Belgium draws dollars, the System receives the equivalent in Belgian francs; and since the National Bank of Belgium has to make repayment in dollars, the System is at all times protected from any possibility of loss. Obviously, the same protection is given to foreign central banks whenever the System draws a foreign currency.

The interest rates for drawings are identical for both parties. Hence, until one party disburses the currency drawn, there is no net interest burden for either party. Amounts drawn and actually disbursed incur an interest cost, needless to say; the interest charge is generally close to the U.S. Treasury bill rate…”

My graph below should help visualize the mechanism:

 

Essentially, with these currency swaps, foreign central banks that during the war had shifted their gold to the USA, became middlemen of a product that was a first-degree derivative of the US dollar, and a second-degree derivative of gold.

On September 24^th 1965, someone called this Ponzi scheme out. In an article published by Le Monde, Jacques Rueff publicly responded to this nonsense, under the hilarious title “Des plans d’irrigation pendant le déluge” (i.e. Irrigation plans during the flood). He minced no words and wrote:

“…C’est un euphénisme inacceptable et une scandaleuse hyprocrisie que de qualifier de création de “liquidités internationales” les multiples operations, tells que (currency) swaps…” “C’est commetre une fraude de meme nature que de présenter comme la consequence d’une insuffiscance générale de liquidités l’insufficance des moyens dont disposent les Etats-Unis et l’Anglaterre pour le réglement de leur déficit exterieur”

My translation: “…It is an unacceptable euphemism and an outrageous hypocrisy to qualify as creation of “international liquidity” multiple transactions, like (currency) swaps…”…“…In the same fashion, it is a fraud to present as the consequence of a general lack of liquidity, the lack of means available to the USA and England to settle their external deficits…”

Comparing the USA and England to underdeveloped countries, Rueff added that these also lack external resources, but those that are needed cannot be provided to them but by credit operations, rather than the superstition of a monetary invention disguised as necessary and in the general interest of the public (i.e. rest of the world).

With impressive prediction, Rueff warned that the problem would present itself in all its greatness, the day these two countries decide to recover their financial independence by reimbursing with their dangerous liabilities (i.e. currencies). That day, said Rueff, international coordination would be necessary and legitimate. But such coordination would not revolve around the creation of alternative instruments of reserve, demanded by a starving-for-liquidity world.  That day would be a day of liquidation, where debtors and creditors would be equally interested and would share the common responsibility of the lightness with which they jointly accepted the monetary difficulties that are present….Sadly, Rueff’s call could not sound more familiar to the observer in 2013…

How adjustments work today, without currency swaps

Until the end of the Gold Exchange Standard, even if the reserve multiplier suppressed the value of gold (like today), gold was still the ultimate reserve and had in itself no counterparty risk. After August 15^th, 1971, when Nixon issued the Executive Order 11615 (watch announcement here), the ultimate reserve was simply cash (i.e. US dollars) or its counterpart, US Treasuries. And unlike gold, these reserve assets could be created or destroyed ex-nihilo. When they are re-hypothecated, leverage grows unlimited and when their value falls, valuations dive unstoppable. Because (and unlike in 1907) the transmission channel for these reserves today is the banking system, when they become scarce, counterparty risk morphs into systemic risk.

When Rueff discussed currency swaps, he had imbalances in mind. In the 21^st century, we no longer have time to worry about these superfluous things. Balance of trade deficits? Current account deficits? Fiscal deficits? In the 21^st century, we cannot afford to see the big picture. We can only see the “here and now”. Therefore, when we talk about currency swaps, the only thing we have in mind is counterparty risk within the financial system. The thermometer that measures such risk is the Eurodollar swap basis, shown below (source: Bloomberg). As the US dollar became the carry currency, the cost of accessing to it became the cornerstone of value for the rest of the asset spectrum, widely known as “risk”.

In the chat below, we can see two big gaps in the Eurodollar swap basis. The one in 2008 corresponds to the Lehman event. The one in 2011 corresponds to the banking crisis in the Eurozone that was contained with a reduction in the cost of USDEUR swaps and with the Long-Term Refinancing Operations done by the European Central Bank. In both events, the financial system was in danger and banks were forced to delever. How would the adjustment process have worked, had there not been currency swaps to extend?

 

 

In the figure below, I explain the adjustment process, in the absence of a currency swap. As we see in step 1, given the default risk of sovereign debt held by Eurozone banks, capital leaves the Eurozone, appreciating the US dollar. We see loan loss reserves increase (bringing the aggregate value of assets and equity down). As these banks have liabilities in US dollars and take deposits in Euros, this mismatch and the devaluation of the Euro deteriorates their risk profile

Eurozone banks are forced to sell US dollar loans, shown on step 2. As they sell them below par, the banks have to book losses. The non-Eurozone banks that purchase these loans cannot book immediate gains. We live in a fiat currency world, and banks simply let their loans amortize; there’s no mark to market. With these purchases, capital re-enters the Eurozone, depreciating the US dollar. In the end, there is no credit crunch. As long as this process is left to the market to work itself out smoothly, borrowers don’t suffer, because ownership of the loans is simply transferred. This is neutral to sovereign risk, but going forward, if the sovereigns don’t improve their risk profile, lending capacity will be constrained.

In the end, an adjustment takes place in (a) the foreign exchange market, (b) the value of the bank capital of Eurozone banks, and (c) the amount of capital being transferred from outside the Eurozone into the Eurozone.

How adjustments work today, with currency swaps

Let’s now proceed to examine the adjustment –or better said, lack thereof- in the presence of currency swaps. The adjustment is delayed. In the figure below, we can see that the Fed intervenes indirectly, lending to Eurozone banks through the ECB. Capital does not leave the US. Dollars are printed instead and the US dollar depreciates. On November 30th, of 2011, upon the Fed’s announcement at 8am, the Euro gained two cents vs. the US dollar. As no capital is transferred, no further savings are required to sustain the Eurozone and the misallocation of resources continues, because no loans are sold. This is bullish of sovereign risk. The Fed becomes a creditor of the Eurozone. If systemic risk deteriorates in the Eurozone, the Fed is forced to first keep reducing the cost of the swaps and later to roll them indefinitely, as long as there is a European Central Bank as a counterparty for the Fed, to avoid an increase in interest rates in the US dollar funding market. But if the Euro zone broke up, there would not be any “safe” counterparty –at least in the short term- for the Fed to lend US dollars to. In the presence of a European central bank, the swaps would be bullish for gold. In the absence of one, the difficulty in establishing swap lines would temporarily be very bearish for gold (and the rest of the asset spectrum).

Final words

Over almost a century, we have witnessed the slow and progressive destruction of the best global mechanism available to cooperate in the creation and allocation of resources. This process began with the loss of the ability to address flow imbalances (i.e. savings, trade). After the World Wars, it became clear that we had also lost the ability to address stock imbalances, and by 1971 we ensured that any price flexibility left to reset the system in the face of an adjustment would be wiped out too. This occurred in two steps: First at a global level, with the irredeemability of gold: The world could no longer devalue. Second, at a local and inter-temporal level, with zero interest rates: Countries can no longer produce consumption adjustments. From this moment, adjustments can only make way through a growing series of global systemic risk events with increasingly relevant consequences. Swaps, as a tool, will no longer be able to face the upcoming challenges. When this fact finally sets in, governments will be forced to resort directly to basic asset confiscation. 

 

Martin Sibileau