Please, click here to read this article in pdf format: june-06-2011

Almost two months ago, we went on record stating that stagflation was here to stay. On April 11th, we wrote:

“…If we had to define in one sentence the action last week and that which is to develop in the future, we would say it in actually one word, not even a sentence. That word is “stagflation”.  We truly believed stagflation would present itself to us later this year or even next year. However, we think it is here now.  This leaves us on the contrarian side, because almost everyone we read, hear or watch is telling us that “growth” (a misnomer used by mainstream economists, including those at the helm of the Fed, to refer to a higher GDP) will be high in 2011 and that the Fed will be forced to raise rates in 2012…”

The latest activity data seem to be supporting our call but we now fear a worldwide desperate reaction by all governments in general. Possibly, you may have heard a recently popular definition of such reaction: “Financial repression”. What does it mean? We will offer our explanation…

Since 2009, with the start of quantitative easing by the Fed, the expansion in the money stock has produced excess reserves in the financial system in the US. In the Euro zone, something technically similar has occurred with the monetization of the sovereign debt of peripherals: The ECB has issued short-term debt to sterilize the purchases. This is a liability to the central bank, just like excess reserves. But we are now reaching a point where the stagflation we identified in April is becoming self evident, challenging the wisdom of monetizing fiscal deficits. What can governments do about it? The usual: Deny the problem and blame speculators. However, the monetization of fiscal deficits must go on, to keep the circus playing. The way to achieve this is by forcing financial institutions and pension funds to buy sovereign debt while at the same time, the credit multiplier of the fractional reserve system is pressed down.

This is not new at all (Prof. Huerta de Soto in his great work “Money, Bank Credit and Economic Cycles”, 2009, tells us there was financial repression as far back as under the Ptolemaic rule in Alexandria, citing Michael Rostovtzeff’s “The Social and Economic History of the Hellenistic World”, 1957). But for what matters to us today, the first country to start with financial repression since the start of this last recession was China. We called collective attention to it when it picked up, back on January 21st, 2010. Back then, we warned that the People’s Bank, by making it harder to bring US dollars to China, was going to segment the funding market into a mainland China and a Hong Kong funding platform. The restriction of capital inflows is a “classic” form of financial repression within those countries that don’t face trade deficits and which seek to delay or even prevent the appreciation of their currencies. Sadly, we fear that Canada will be the latest to join this club. During last week, it was reported that the Office of the Superintendent of Financial Institutions was researching into how big a factor foreign investment in Canada’s housing market is. To blame capital inflows is ridiculous. If foreign demand generates a bubble it is because the Bank of Canada is not allowing the Canadian dollar to appreciate enough to restrict foreigners’ purchasing power in a “natural” way. And we think this answer is obvious, for the Bank of Canada has postponed raising rates in the face of clearly bullish activity data. In summary, as this crisis reaches its next stage, in trade surplus nations, citizens will see credit restrictions either because capital inflows are taxed or regulated or because reserve requirement ratios increase.

In trade deficit nations, financial repression will be more perverse. The increase in money stock in these nations does not stem from capital inflows or trade surpluses, but from governments whose deficits are monetized. That monetization needs to find a place. When it was not so obvious, it could end in the hand of retail or institutional investors. But as it gets more obvious the propensity of these investors to buy fiscal deficits disappears. Therefore, governments will have to force institutional investors and banks to acquire the debt. In other words, the asset side of pension funds and banks’ balance sheets will deteriorate, making them more dependent of their respective central banks. At the same time, once the monetized debt reaches the system, governments will blame speculators for the resulting increase in asset prices, forcing also the increase in reserve ratios.

In conclusion, in trade deficit nations, financial repression consists of two acts: In the first one, governments force the deterioration in the quality of assets carried by pension funds and banks. In the second one, governments increase the reserve requirements of banks. This last act has a negative impact on the profitability of banks. Right now, defaults are at record lows, but as the proverbial wall of maturities is hit in say, two years, and interest rates can not be lowered further, the impact will be really felt. The realization of this scenario, down the road, will call for demanding physical gold, rather than gold ETFs.

Martin Sibileau