In 2012, Greece and increasingly other peripheral EU countries owe to other governments, the IMF and the European Central Bank. Private investors have been wiped out and will not return any moment soon. We fear that just like in 1931, when the next bailout is due either for Greece again or Portugal or Spain, political conditions will be demanded that no private investor in his/her right mind would ever have demanded.
Please, click here to read this article in pdf format: March 18 2012
We are back from Washington DC and realize that we could choose different titles for today’s letter. Let’s try a few…
Title No.1: “The market proved us wrong”
Indeed, we have been, and continue to be, long term gold bulls. We have been buying dips in gold and find ourselves having averaged down on our holdings, as gold did not find a floor in the low $1,700/oz, nor $1,695/oz or even $1,660/oz. Averaging down is the sure way to ruin and wisdom calls for trimming rather than increasing one’s exposure to a falling asset. And we trimmed only a bit and stopped buying, with the belief that it will prove a wrong decision, but with the unemotional duty to survive. As we write, we learn that there’s an article on the Financial Times telling us that central banks (not the Fed, of course) have been doing the same, only better than us: They really added!
We have no doubts that the plunge in gold on February 29th was simple manipulation and it is only this reason that encourages us to hold on to what we have. With respect to stocks, we continue to remain neutral of them, not willing to buy but also, not willing to short them. From conversations with friends and readers, we noticed that we have not explained ourselves appropriately. Therefore, we want to briefly stop here to provide these short comments:
The popular view on inflation is that which sees it coming from a steady increase in the supply of money spilled over onto assets, lifting investments, increasing employment, wages and later the price of every consumption good. If the price of assets and the employment rate rise, it is understood that the original goal by the central banker, that of lifting the level of activity with monetary easing, is working and that soon, that easing will disappear, followed by an increase in interest rates.
The problem we have with this view is personal. Unfortunately, we lived through inflation and remember it differently. Inflation is a steal. It is a tax charged by the government. And they charge this tax because they run a deficit. No government would nor will ever target inflation under surplus or balanced fiscal conditions. Inflation is the distortion of relative prices, and it always starts with that of the cost of capital. It is a manipulation first of the cost of capital, then of commodities and followed by price controls: First on goods and later on salaries. It entails control on capital flows (which we are currently seeing everywhere in the world), currencies, and financial repression. Therefore, our view is different: Inflation does not bring full employment. That’s a myth. Inflation creates unemployment. Under inflation, production does not rise lifting prices. That’s another myth. Under inflation, production falls, creating shortages of goods, which is what further shifts the inflationary process to hyperinflation. If a country like the US manages to have the rest of the world finance that shortage of goods, that’s another story and it will last as long as the rest of the world wants it to last. But we should be clear on the underlying process. If you have any doubts, just drive around the former industrial areas in the outskirts of Buffalo, Detroit, Boston, Pittsburgh, Philadelphia, etc. and you will picture what we’re talking about here.
As we explained at the beginning of the year, the rally in stocks and in gold was expected. It was only three weeks ago that the world was injected with more than half a trillion Euros in 3-yr liquidity lines!!! But gold was manipulated and stocks were not. And we have gold at below its 200-day moving average and the capitalization of Apple Inc. at higher than half a trillion US dollars, without Steve Jobs as CEO. Take this as you wish. In the meantime, on Friday we saw a violent increase in US yields, followed by demand, that kept the 30-yr Treasury yield below 3.5%, which is what brings us to the next possible title, for today’s letter…
Title No. 2: “Financial repression, Stage 1”
Perhaps the most clear exposition of financial repression occurred this week, when President Obama and Prime Minister Cameron openly threatened to manipulate crude reserves to lower the price of oil. The sense of embarrassment is gone. The leaders of two world powers meet and tell us in our faces that they contemplate manipulating the reserves of a commodity? What is going on? We, at “A View from the Trenches” take signals of repression like this one seriously. It was only a few years ago that governments started running after people’s assets in other jurisdictions. They followed with open repression in the foreign exchange markets (Switzerland pegging the Franc, Brazil controlling capital flows). They kept on directing the lending activities of banks. They manipulate the reserves in gold. They wiped out investors in sovereign debt and this is a trend that will not weaken but strengthen. Perhaps our readers don’t, but we do see union strikes more often these days vs. in past years. How can any entrepreneur in these conditions feel encouraged to invest in increasing the productivity of his/her business? They cannot and all they are doing and will be doing is maintain what they have, refinance their liabilities longer term for cheaper rates and use every excess cash they count on to increase their dividends, as a way to cash out in a world where the price of equity, the price of risk, is anything but clear. We remember those times in Argentina when suddenly, bankrupt companies were owned by rich businessmen. One thing is to invest in dividend producing companies, with dividends driven by stable and healthy cash flows. Another thing is to invest under the illusion that those exist, when in fact the dividends are the only outlet entrepreneurs have to cash out with bank debt. We think we are witnessing the latter case but, as followers of Von Hayek, we can understand the confusion, because the price system is broken and the signals sent by prices are misleading. We need to quote the great Friederich A. Von Hayek here, on the price system:
“…The price system is just one of those formations which man has learned to use (though he is still very far from having learned to make the best use of it) after he had stumbled upon it without understanding it. Through it not only a division of labor but also a coordinated utilization of resources based upon an equally divided knowledge has become possible. Its misfortune is the double one that it is not the product of human design and that the people guided by it usually do not know why they are made to do what they do…(…)… I am convinced that if it were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind…” F.A. Von Hayek, “The Use of Knowledge in Society”, American Economic Review. XXXV, No. 4., September 1945
The actions of central banks have totally annihilated the price system, in relation to both the inter-temporal allocation of resources and the capitalization structure of economic systems. This brings us to our last title…
Title No. 3: “Remember the KreditAnstalt”
Since the debt swap of Greece’s sovereign debt, in terms of the capitalization structure of this sovereign, we understand that more than two thirds of it is in the hands of the public sector (European Central Bank, IMF, other governments) and highly collateralized. This is a point we have been thinking during last week because it painfully reminds us of the KreditAnstalt crisis of 1931. We highly recommend readers to do their own research on this topic and to reach their own conclusions. On our part, we are interested in one angle of it.
The KreditAnstalt of 1931 had been created in October of 1929, as the merger between the bankrupt Bodenkreditanstalt and the Öesterreichischekreditanstalt. However, the distressed assets of the Bodenkreditanstalt’s were too distressed to deal with. Given the Austrian regulations on capital requirements, when on May 11th, 1931 the KreditAnstalt disclosed a 140MM Schilling loss, it immediately suffered a run on deposits. The Österreichische Nationalbank intervened, loaning 152.5MM Schillings. The Bank of International Settlements loaned an additional 100MM Schillings three days later. But by June, more funds were needed and this time….this time the Bank of International Settlements, under a request from the French, would only provide them if the Austrian government aborted a customs union with Germany, which was underway. The Austrian government did not accept the political condition and instead only received a third of the funds needed, from the Bank of England, on June 16th.
In the meantime, the Austrian government had been forced to guarantee the bank’s foreign deposits and imposed exchange controls to sustain the convertibility of the Schilling to gold. But the violence of the capital outflows was so strong that Austrialeft the gold standard on June 17th. Unlike Greece, Austrians in 1931 did not have the 3-yr liquidity lines from Mario Draghi at the European Central Bank. These events triggered a wave of bank defaults in Eastern Europe and Germany. Gold eventually also was withdrawn from London. In July, the Federal Reserve Banks and the Bank of France saved the Bank of England with currency swaps of US$650 million and £eq.25 million, respectively. But this was not enough and Great Britain had to leave the gold standard on September 21st. The countries that held sterling pounds as foreign reserves suffered heavy losses.
Fiat currencies were no longer to be trusted and the run on deposits was now taking place in the United States. Think of this: As Europe owed the US payment in specie and Europe had gone off the gold standard…who was the Fed going to recover the loaned money (approx. the equivalent of 465 metric tonnes of gold) back from??? We have written about this before too, in relation to the swaps extended by the Fed to the European Central Bank. If the Eurozone breaks up, who is the Fed going to recover the money from? They will not. But unlike back in 1931, the US dollar is not backed by gold and depositors are not going to run for their funds to exchange them into gold. However the Fed will need to undoubtedly print more US dollars and the devaluation, eventually, will happen anyway. The year 1931 was the year of bank failures in America. In 1932, after a bank holiday that lasted a week, the US government confiscated gold from its citizens.
The question you may have in mind now is what similarity do we see with the current situation? Well, this whole series of events was triggered because France, a public sector creditor, introduced a political condition to Austria, in exchange for a bailout of the KreditAnstalt. Today, like in 1931, in the Eurozone, the public sector is increasingly the creditor of the public sector. In 1931,England andFrance were creditors of Austria and demanded conditions that no private investor would have demanded.
Private investors live and die by their profits and losses. Politicians live and die by the votes they get. Private investors worry about the sustainability and capital structure of the borrower, the collateralization and the funding profile of their credits. Politicians worry about the sustainability of their power. It’s a fact and we must learn to live with it.
In 2012, Greece and increasingly other peripheral EU countries owe to other governments, the IMF and the European Central Bank. Private investors have been wiped out and will not return any moment soon. We fear that just like in 1931, when the next bailout is due either for Greece again or Portugal or Spain, political conditions will be demanded that no private investor in his/her right mind would ever have demanded. Think of it…What in the world had the customs union between Austria and Germany in 1931 had to do with the capitalization ratio of the KreditAnstalt??? Nothing! Yet, millions and millions of people worldwide were condemned to misery in only a matter of days as their savings evaporated! Ladies and gentlemen, welcome to the world of fiat currencies! You have been warned! If months from now you read in the papers that the EU Council irresponsibly demands strange things from a peripheral country in need of a bailout, remember the KreditAnstalt. Remember 1931…
Please, understand that this is not a tail risk. The tail risk is precisely the opposite. The real tail risk here is that when the next bailout comes due, politicians think like private investors and give priority to economic rather than political considerations. That’s the tail risk! If such a crisis occurred, the media will speak of increased correlations and tell you that everything is actually fine on this side of the Atlantic. But if you read us, you will know that all that led to such a situation was perfectly foreseeable and nothing is really fine on this side of the Atlantic either. You will have remembered 1931…