Please, click here to read this article in pdf format:may-30-2011

At the beginning of May, we thought we were facing a textbook run for liquidity triggered fundamentally by the sovereign crisis in the European Union and the higher than expected unemployment rate in the US (besides low activity and housing data). Technically, of course, the run started with M. Trichet’s dovish announcement on EU rates, combined with an oversold position in the US dollar.

In the past two weeks however, since our last letter, we notice that that run for liquidity has not materialized yet. The fundamentals described above have not only been confirmed, but also proved to be worse than most of us thought. Is there anything wrong with this picture? Not if you think that easy monetary conditions will remain untouched, unlike what many analysts believe.

In our past letter, we wrote that it was not unthinkable to see US sovereign debt being monetized while the Fed at the same time raises rates. The trick, we wrote, would be done like most nations who are in trouble do: Infecting their financial system with sovereign risk. The push by new regulations (see our last letter) to hold Treasuries as collateral is one way.

Ironically, the world may now see certainty in the collapse of sovereign debt from peripheral countries in the EU and uncertainty around the future of US risk. This, added to the general rise in interest rates by emerging markets (= repudiation of QE2), might trigger another round of weakness for the US dollar. That would be evidenced by the sudden strength of gold, now in USD terms. If this thesis is correct, our thought of May 9th, should still be valid: We must see further deleveraging, before any serious inflationary threat becomes a reality. This means to us that volatility should not decrease.

Personally, in volatile times, we search for classics. We seek in the pages of economic history the clues that will make that volatility look like what it is: Only one more period in a bigger chart. We think we have found that in Jesús Huerta de Soto’s “Money, Bank, Credit and Economic Cycles”, 2nd edition, 2009. Huerta de Soto starts this opus magnus with a legal, moral and historical review of the fractional reserve system. In chapter II, there’s a section titled “ Banking in Greece and Rome”, where we learn that the same concerns we have today on risk management by banks were documented no less than twenty four centuries ago; that back then bank debt holders were as uncertain about their privileges as Euro senior financial bondholders are today and that just like governments today, Ptolemaic Egypt, in Alexandria, sought to control banking to the point where the crowding out was total, through government-owned institutions. In light of all this, how could we now be surprised when Basel III is indefinitely postponed or evaded? How can we doubt that the end game here is global monetization of sovereign liabilities? Indeed, we cannot.

Martin Sibileau