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…
To read this article in pdf format, click here: May 5 2013
With equity valuations no longer levitating but in a different, 4th 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 24th 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 15th, 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 21st century, we no longer have time to worry about these superfluous things. Balance of trade deficits? Current account deficits? Fiscal deficits? In the 21st 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).
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.
In the past months and right after implementing Quantitative Easing Unlimited Edition, the Fed began surfacing the idea that an exit strategy is at the door. With the latest releases of weak activity data worldwide, the idea was put back in the closet. However, a few analysts have already discussed the implications of the smoothest of all exit strategies: An exit without asset sales; a buy & hold exit. I have no doubt that as soon as allowed, the idea will resurface again.
Underlying all official discussions is the notion that an exit strategy is a “stock”, rather than a flow problem, that the Fed can make decisions independently of the fiscal situation of the US and that international coordination can be ignored. This is logically inconsistent and today’s letter will address these inconsistencies. Let’s see…
Monetary expansions are treated as a flow process
Conventional PhD wisdom on monetary things tells us that government deficits represent net credits to the system via reserves, as well as to non-government deposits at banks.
When it comes to bond purchases by the Fed, such wisdom implies that the US Treasury is assisting markets with liquidity. This is not new. As a student, I once heard that “governments must run deficits, so that markets can have a benchmark rate”. My professor meant that “thanks” to fiscal deficits, bonds are issued and markets can proceed with the price discovering process. Today of course, we don’t even have that luxury, courtesy of Quantitative Easing (Not happy with the lesson, I asked Dr. Julio H. Olivera his thoughts on this statement. He chuckled (although Dr. Olivera never really chuckled) and recalled a similar exchange with John Hicks. According to Dr. Olivera, when Hicks was faced with the same proposition, he replied: “The merchant makes the market”. Unfortunately, I cannot prove this exchange, but thought I would share it with you).
But monetary contractions are treated as a stock problem
Why do I bring this up? Because if deficits are welcome by the PhD standard when it comes to monetary expansions, surpluses should not be ignored, when dealing with monetary exit strategies. It’s only fair…Yet, in the past months there has been a timid incursion into the upcoming debate on exit strategies available to the Fed, but without a single comment on fiscal policies. By now, I have become used to typing CTRL+F “fiscal” (i.e. find “fiscal”), whenever I come across any research note on potential exit strategies. If nothing comes up, it looks suspicious to me.
Once such example was Bank of America’s April 10th note titled “The consequences of a “no sales” Fed exit strategy”, from the Global Economics Rates & FX team. This paper has not a single sentence or thought on the fiscal situation and Treasury issuance forecasts of the United States (the word “fiscal” only shows up once). They are not alone. How can mainstream economics afford to ignore the fiscal side of the problem when facing an exit strategy? They simply treat it as a “stock”, rather than a flow problem.
Terms of the “stock” perspective
As a stock problem, mainstream economists look at a “no sales” exit strategy by the Fed, in these terms:
1.-Not to sell means to hold, while principal and interest payments are reinvested.
2.-The target of a 6.5% unemployment rate is reached and there are signs of a firm recovery underway
3.-Losses on their US Treasuries portfolio are manageable, particularly since the Fed announced its accounting policy change on January 6th 2011, where capital losses may be treated as negative liabilities (Truly, you can’t make this stuff up). Even putting this fiction away, mainstream analysis is comfortable with a negative impact on the asset side of the Fed’s balance sheet. To assess that impact, reference is made in terms of 10-yr equivalent duration exposure held outside of the Fed. Growth of 10-yr equivalents is expected to stabilize. As I mentioned in the last letter on the Bank of Japan, I side with Shuichi Ohsaki and Shogo Fujita, from Bank of America’s Pac Rim Rates Research team, who argue that volatility in the Japanese bond market could be diminished if the BOJ announced a schedule for buying operations, with the amounts that would be purchased in each maturity sector. In other words, the market does not look at the stock of government debt as a block of exposure that is sizable in equivalent duration terms.
4.-Reserves management, via interest on reserves, can be used to send short-term signals to the market.
In the next sections, I will seek to demonstrate that it is a huge mistake to ignore the fiscal side of this dynamic picture, and that a smooth, no sales exit strategy is fiction. Moreover, I will show that this is a flow, rather than a stock problem. Before I proceed, let me offer you this interesting exchange between Stanley Druckenmiller and Kevin Warsh, which took place on March 5th (Druckenmiller’s intervention starts on minute 5:41)
The flow perspective of the “no sales” exit strategy
To simplify the exposition, let’s look at the cash flow situation of the US government. Like any of us, the government has to collect taxes and pay for expenses. For this particular discussion, it will not matter if the same are ordinary, extraordinary, operating, capital expenditures etc. All I want to do here is to separate this collection of taxes net of expenses –which I will call Primary Cash flow- from the cash flow that has to be used to service debt obligations. In other words, like any of us, the US government will have, after collecting taxes and paying expenses, a primary cash flow with which to service debt obligations:
If the Primary Cash flow (PCF) is not enough to service the debt, unlike us, the government can issue more debt (at least the US government; at least for now). Additionally, the government can liquidate assets. Therefore:
Let’s now look at the demand for the gross issuance and simplify it, saying that the same is purchased either by the Fed, by the rest of the central banks in the world, and by the rest of the world (ROW, i.e. anyone else in this planet who is not a central bank, either in the public or private sector). Under these terms:
Let’s assume that the government sells no assets. If the Fed stopped purchasing US sovereign debt but did not sell any holdings and kept reinvesting the interest and principal payments it received, re-arranging the terms, we obtain:
Let’s further call a Net Demand of one of the agents (i.e. central banks, rest of the world) the difference between its purchases and the collected interest and debt repayments. We can then say that under a “no sales” exit strategy of the Fed and without asset sales, the primary cash flow of the US government equals the sum of the net demands of the central banks and the rest of the world. This is valid at one point in time as well as when we consider the comparative statics of the issue (the term “D” below denotes temporal change in a variable, between t and t+1):
Having arrived to the identity above (the above notations are identities, not equations), let’s look at the context under which the “no sales” strategy would take place. It is a context of a firm recovery, as the Fed has told us and we have every grounds to believe that for this reason, interest rates would tend to rise, as capital moves out of fixed income and credit, into equities. This means that the Net Demand of US Treasuries by the Rest of the World will likely be negative (i.e. Drucknemiller’s observation) or zero, at best:
Let’s take the optimistic view that the Net Demand of the Rest of the World is zero (Clearly, Mr. Druckenmiller does not share this view…and he has every reason not to be). This means that if neither the Fed nor the Rest of the World add US Treasuries to their balance sheets, the primary cash flow of the US government has to be addressed by the Net Demand of central banks, exclusively.
We can think of three different scenarios for the primary cash flow of the US government: A scenario of surpluses (PCF >0), deficits (PCF <0) or balance (PCF = 0).
If the primary cash flow is negative
This is the toughest scenario. It implies that the negative primary cash flow of the US government will be financed by the central banks of the rest of the world. The question here is: Why would these central banks keep accumulating US Treasuries when the Fed itself does not? From here, it is very clear to me that in the presence of continuing fiscal deficits, regardless of where the unemployment rate is, the Fed has no alternative but to continue monetizing the deficits.
But let’s examine this case further. Let’s suppose that by some miraculous intervention, the central banks of the rest of the world would in fact resolve to continue purchasing US sovereign debt, even if the Fed itself wouldn’t. How would this process take place?
There are two ways. Either the currency zones these central banks operate in generate balance of trade surpluses or their respective nations incur into fiscal deficits.
In my last letter, I explained how the latter way worked in Japan under Shirakawa. With regards to the former, to expect a sustainable recovery in the United States (which is the a priori condition for an exit) within a context of fiscal deficits, increasing sovereign debt and balance of trade deficits is a contradiction. Yet some mainstream economists see this as something very feasible, whereby the Debt/GDP ratio falls because the denominator rises faster than the numerator. If this is true, then I am completely wrong and I have nothing else to say. If you believe in the sustainability of this context, please accept my apologies for having taken your time. If you don’t, please proceed to the next scenario analysis.
If the primary cash flow is positive
If the primary cash flow was positive, the Net Demand of the rest of the central banks would be negative. This would imply a strong and positive savings rate in the United States. The problem is to figure out how the United States can get to achieve a savings rate strong enough to get to this point, in a context of negative to zero interest rates, where nobody has any incentive to save and where the same Fed wants to boost consumption. I asked about this problem (i.e. how the savings rate will improve) to a very well-known economist who gave a presentation this past Wednesday April 24th, at the Oakville Community Foundation. His answer was that the stronger savings rate would come from the public sector. But this explanation seems to me a tautology (i.e. The US government will be cash flow positive because it will save)
The real question in the face of this problem is “What will push the US government and the US to save, when all its deficits are monetized and interest rates are negative?” This is not a new question. In fact, it occupied the mind of Jacques Rueff for decades. Perhaps the first time M. Rueff made public this concern was during an exchange with no other than the same John Maynard Keynes in 1929, during a conference at the Assembly of the League of Nations, in Geneva. M. Rueff suggested that there was indeed an adjustment mechanism for the balance of trade and Keynes asked how such an adjustment could be brought about.
Rueff explained that inflation is nothing else but the creation of purchasing power in a country without a counterpart increase in production. For that reason, it is only possible to run balance of trade deficitsindefinitely –like the US has done over the 20th and 21st centuries- if there is inflation. The opposite should also be true: In the absence of inflation, there would be a balance of trade surplus, until all debts are paid (as in this scenario, where the Net Demand of the rest of the central banks is negative).
In summary, to effect a negative Net Demand of the rest of the central banks in US Treasuries, the purchasing power of Americans should be decreased. But how will the United States ever achieve such a state of affairs, when the Fed targets a 6.5% unemployment rate precisely by inflating the purchasing power of Americans? If the Fed is successful, the opposite will have occurred and the nominal purchasing power of Americans will have increased. Therefore, a positive primary cash flow is not possible, as long as the Fed continues boosting asset prices.
How did Keynes react to this view? We have only the testimony of Jacques Rueff on this, which I reproduce below:
“…Et Keynes, qui marchait de long en large –c’était sur la scène d’un théâtre- s’est arrêté brusquement et a dit: “Tiens, mais, cela c’est une idée intéressante, il faudra que j’y réflechisse.”
Je dis cela à mon ami Largentaye, parce que c’est très important pour l’historie de la pensée keynesienne. Cela prouve qu’en 1929 la théorie de la dépense global n’était pas encore au point dans son (i.e. Keynes’) esprit et que c’est plus tard, dans l’ouvrage que M. de Largentaye a traduit, qu’elle s’est élaborée, d’abord dans le Traité sur la monnaie et, ensuite, dans la Théorie générale. Et cela indique, d’ailleurs, le caractère mouvant de sa pensée; ce n’est pas une critique que je lui adresse, c’est plutôt un éloge; c’était un des esprits les plus actifs qui fût…” (J. Rueff, Le système monétaire international”, presentation given at the Conseil Economique et Social, May 18th, 1965).
Finally, if the nominal purchasing power of Americans will not be decreased by the Fed, the real purchasing power will have to fall, with the devaluation of the US dollar. This is a logical conclusion. In a context of global monetary easing, this can only be achieved against gold and…. why not, commodities in general.
If the primary cash flow is zero
This is a simple theoretical conjecture, just like the existence of general equilibrium in the fractionary reserve system and shadow banking we live in. To discuss it is an intellectual exercise of dubious utility.
In this discussion, I sought to show that:
-The exit strategy of the Fed is not a stock, but a flow problem.
-Just like expansionary monetary policy must address fiscal policy, contractionary monetary policy cannot ignore fiscal deficits.
-The fiscal issue PRECEDES the monetary issue. Without first addressing fiscal policy, it is irrelevant whether or not a labour market objective is achieved (i.e. unemployment rate of 6.5%).
-Any analysis of a potential exit by the Fed that dismisses fiscal deficits and focuses on the management of the balance sheet of the Fed only is surreal. It is not enough to claim that buy & hold is better than selling.
-In the case of the Fed, international coordination is required for an exit strategy to succeed.
Bonus: Was Mr. Druckenmiller correct?
As you may have noticed, I was optimistic and assumed that the Net Demand of US Treasuries by central banks would increase (i.e. international coordination) and that the Net Demand of the Rest of the World would remain unchanged.
What I believe Mr. Druckenmiller had in mind is a more realistic picture, where the Net Demand of the central banks would remain unchanged, while that of the Rest of the World becomes increasingly negative. In this context, with the US government continuing to run negative primary cash flows and the Fed shifting from quantitative easing to a buy & hold stance, the supply of US Treasuries would increase and interest rates would rise exponentially. Mr. Druckenmiller was correct.
“…MMT is to me the 21st century re-incarnation, in monetary policy, of Cardinal Richelieu’s raison d’état concept. If I am correct, it will bring the same serious consequences it brought in the 17th century…”
If I have to summarily describe the events of the past week, I will say that it was the week Modern Monetary Theory won over any other school of thought…(I promise you this: Today’s letter will not be a rant…)
“Statements that do NOT apply to a currency-issuer:
-Governments have a budget constraint (like households and firms) and have to raise funds through taxing or borrowing
-Government deficits drive interest rates up, crowd out the private sector…and necessarily lead to inflation
-Government deficits leave debt for future generations: government needs to cut spending or tax more today to diminish this burden
-Government deficits take away savings that could be used for investment
-We need savings to finance investment and the government’s deficit
While these statements are consistent with the conventional wisdom, and while they are more-or-less accurate if applied to the case of a government that does not issue its own currency, they do not apply to a currency issuer…”
“…Principles that DO apply to a currency issuer. Let us replace these false statements with propositions that are true of any currency issuing government, even one that operates with a fixed exchange rate regime:
-The government names a unit of account and issues a currency denominated in that unit;
-The government ensures a demand for its currency by imposing a tax liability that can be fulfilled by payment of its currency;
-Government spends by crediting bank reserves and taxes by debiting bank reserves; in this manner, banks act as intermediaries between government and the non government sector, crediting depositor’s accounts as government spends and debiting them when taxes are paid;
-Government deficits mean net credits to banking system reserves and also to non government deposits at banks;
-Central banks set the overnight interest rate target; it adds/drains reserves as needed to hit its target rate;
-The overnight interest rate target is “exogenous”, set by the central bank; the quantity of reserves is “endogenous” determined by the needs and desires of private banks; and the “deposit multiplier” is simply an ex post ratio of reserves to deposits—it is best to think of deposits as expanding endogenously as they “leverage” reserves, but with no predetermined leverage ratio;
-The treasury cooperates with the central bank, providing new bond issues to drain excess reserves, or retiring bonds when banks are short of reserves; for this reason, bond sales are not a borrowing operation used by the sovereign government, instead they are a “reserve maintenance” tool that helps the central bank to hit interest rate targets;
-The treasury can always “afford” anything for sale in its own currency, although government always imposes constraints on its spending; and lending by the central bank is not constrained except through constraints imposed by government (including operational constraints adopted by the central bank itself).
I could discuss at length (and likely shall have to in the future) how I disagree with the statements above, but today it is not relevant. Today, that school of thought won the day and rather than criticism, I believe it merits that we acknowledge its existence and understand its implications.
Historical context of Modern Monetary Theory (MMT)
MMT is to me the 21st century re-incarnation, in monetary policy, of Cardinal Richelieu’s raison d’étatconcept. If I am correct, it will bring the same serious consequences it brought in the 17th century (In his book “Diplomacy”, Henry Kissinger gives Cardinal Richelieu all the credit for this political concept. It is very unfair. About a century earlier, Niccolò Machiavelli dedicated his book “The Prince” precisely to encourage the Medici family to undertake his dream of national unification in Italy. Yet, Kissinger did not devote one single sentence of his book to Machiavelli).
When Cardinal Richelieu thought of état, he thought along the terms most of us can relate to. When Modern Monetary Theory discusses sovereignty, the borders change: We can no longer speak of states, but of fiat currency jurisdictions; and there are only two: The one corresponding to the global reserve fiat currency and the one corresponding to the rest of fiat currencies, which are benchmarked to the global reserve.
Why Modern Monetary Theory won last week
Perhaps to MMT, its raison d’état is its very same existence. When Richelieu (but not Machiavelli) thought about état, he did not think in état as “the” entity in itself. He thought of France, as a particular case. MMT however is universal; its raison d’etat is the survival of fiat currencies, which forces policy makers to cooperate globally in order to destroy any other alternative currencies. In the case of gold, precisely, I methodically proved it in an earlier letter (here).
Then, last week we saw the evidence of MMT realpolitik at work: First with Bitcoins and then with gold. Both destroyed on no fundamentals. In the case of gold, it even occurred at precisely predicted timing. Because even if Draghi openly did (although in a more subtle way) what Gordon Brown did in May of 1999, the prospect of Cyprus selling its gold had already been made public two days before last Friday (April 12th). Therefore, this was not a new fundamental. Hence, having not been enough, the typical take down on gold first at 4:00am ET, then at 8:20am and 10:30am ensued (see chart below).
Free, open, markets cannot be anticipated in such way. Yet I can remember pointing out to you the precise timing of these moves in earlier letters (i.e.”… I am tired of seeing endless proof of suppression (i.e. the typical take downs in the price at either 8:20am ET or at 10am-11am ET, with impressive predictability) …February 21, 2013”). Nothing else to add here. If a schmuck like me can tell you months in advance that a market price will fall at 8:20am and 10am and you see that price falling at 8:20am and 10am, then….
Why did bitcoin and gold collapse? (And make no mistake, because gold did collapse). Because they are not redeemable. In the first case, it is easier to accept this. In the second, most will disagree with me. To those, I answer that as long as the US government can refuse (or get away with refusing) to deliver the physical gold to a central bank the sorts of the Bundesbank, one can safely say that regardless of the marginal bullion held by retail in safety boxes or bullion banks in vaults, for all practical purposes, gold shall be negated. I am deeply disappointed with myself, for not having understood this fact earlier, of course.
There are those who still think China will reveal its true holdings of gold. Personally, I think it is very unlikely. They would be acting against their own interest.
What next? Upcoming challenges to Modern Monetary Theory
As at April 2013, I can see three main challenges to MMT. If they are overcome by MMT, freedom as we know it, will be a thing of the past. They can be temporarily overcome, with coercion, and the words of Mr. Draghi at his last press conference are more than ominous in this regard. Times like these have taken place in every century of the history of civilization, and I see no reason to deny the probability of them occurring once again in the 21st. In no particular order, these are the challenges:
-Annihilating the last bastion of redeemable, alternative marketable value:
After April 13th, the last bastion of redeemable and alternative market value is in agricultural commodities. Because these are perishable, they cannot be stored away and refused to deliver, like precious metals. Because they cannot be stored away, they cannot be exponentiallysecuritized. And because they cannot be exponentially securitized, their price cannot be sustainably manipulated.
Furthermore, if redeemability was affected, these markets would segment, into one with capped prices (where nobody sells), and an underground one, where inflation expectations inevitably will be shaped. In addition, their production is not the monopoly of any particular country and the rise in its prices, always ends in social conflict (as my uncle Alberto Mario once told me: “Every revolution begins with a baker being hanged by the mob”).
This will be a challenge, although not new. In the past, it has always been addressed with price controls, from the times of the grain trade between Egypt and Rome, to the 1930s with the creation of grain/meat Boards, which were monopolies that failed miserably at containing inflation. Canada and Argentina, for instance, are an example of the latter. I have to give the intellectual credit to Albert Friedberg, founder of the Friedberg Mercantile Group, for bringing this challenge to light and remembering the Russian wheat deal of July-August 1972 (Mr. Friedberg’s quarterly conference calls are invaluable. This topic was discussed on January 31st here, after the 38th minute)
There is no doubt in my mind that MMT will address with this challenge with repression too. In the process, food prices will rise but as I wrote before (here), this will not mean that Jim Rogers will be proved right. Farmers will not drive Lamborghinis. Prices will rise precisely because the opposite will occur and scarcity of production will be the norm.
-Overcoming the lack of a price system to allocate resources:
When prices are suppressed, markets cannot efficiently allocate resources. When this happens, defaults eventually follow. And as they take place and production falls, the difference between the former and actual output is seen as something negative. Of course, in a world with fiat currency and leverage, this gap is brutal. In a world without leverage, this would be mere evidence of creative destruction.
One of the most (if not the most) flawed concepts in non-Austrian economics is that of the existence of an output gap, which has to be closed by economic policy. The concept is so deeply embedded and so little challenged that it is assumed right away without further ado. It was in Martin Feldstein’s article (“When interest rates rise”) two weeks ago and it is in the famous Taylor’s policy rule.
The idea of an output gap denies the role played by the price system in allocating resources. In other words, it would be very wrong to think that because I could work until 10pm but leave my work regularly at 6pm, my output gap is 4 hours worth of my productivity. Why? Because I consciously decide to leave at 6pm, since I am not paid enough to stay at the office until 10pm. Vice versa, my employer does not see any marginal value that would be compelling enough to pay me for those additional hours. Therefore, even though the capacity/ infrastructure is there for me to stay at the office until 10pm, it is simply mistaken to infer that there is an output gap. It is even more idiotic to believe that by lowering interest rates, my employer would be willing to invest more, to fill that hypothetical gap.
There is one more angle to this. If there is a gap, it is understood that at some point in the past, I used to work until 10pm and now that I no longer do, it would be desirable that I go back to work until 10pm everyday. Why? Nobody wonders why I decided not to work until 10pm. Nobody asks why resources are no longer allocated to work from 6pm to 10pm. The reallocation of resources (of my time) is completely ignored. In the same fashion, when governments seek to close that gap manipulating the inter-temporal rate of exchange (i.e. interest rates), rather than facilitate a natural reallocation of resources, they insist with sustaining the old state of affairs, which was not desired, in the first place.
The idea of an output gap is Aristotelian in nature, and had Galileo been an economist in 2013, he would have invited Mr. Feldstein, Krugman or Bernanke to see for themselves that there has never been high inflation with full employment of resources; that high inflation is never triggered by an increase in demand, but by a lack of supply, when production collapses destroyed by fiscal and financial repression. The scene of high inflation is a scene of empty shelves at supermarkets while goods are transacted at higher prices in underground markets; enforced high minimum wages under which nobody gets employed; banks that post negative lending interest rates but lend to no one (except their governments); entrepreneurs who borrow outside the system or vendor financing replacing working capital lines from banks.
With the steadily increasing level of financial repression, how will this challenge present itself to MMT? Via defaults. Until last week, I was convinced that these defaults would come first from the European Union. Now, I am inclined to accept the possibility that they originate in Japan. How will MMT deal with them? By creating more liquidity, of course. By further suppressing any possible signal.
-Suppressing a spiraling of inflation expectations in Japan:
The recent change in regime at the Bank of Japan merits a lot more than this final comment. When I have a moment, I will address it. Meanwhile, it is becoming clear to me that Japan is close to entering a Latin American-style spiraling cycle, where inflation expectations take the lead and the central bank can only follow.
As the Yen is devalued, capital in Yen-denominated fixed income and credit flees and is reallocated in the same, but USD denominated, asset classes. This simple movement increases interest rates in Yen, which is counterproductive to the initial efforts by the Bank of Japan. The Bank has to therefore purchase even more Yen-denominated debt, which triggers a further devaluation. As the devaluation makes imported commodities/food more expensive, the rate of devaluation channeled through to consumer prices can shape inflation expectations and the market may incorporate the expected rate of devaluation to Yen nominal yields.
Indexation is MMT’s worst nightmare. They were able to postpone it destroying the gold market, but this may prove a more formidable challenge. The unintended consequence of the Yen intervention is that the Bank of Japan ends up indirectly effecting quantitative easing on USD debt; both sovereign and private. This was in my view another bearish driver for gold, as the need for direct Fed intervention in the US Treasury market, on the margin, decreases.
As capital out of Japan floods the USD corporate debt market, credit spreads compress even further, weakening correlations among asset classes and making eventual defaults, of global consequence, more likely and dangerous. In summary, MMT is faced here with perhaps its biggest challenge, because the spiraling process just described sets the stage for an uncooperative Japanese central bank, which will be terribly busy trying to fix the unfixable. In Latin America, MMT often crystallizes in a controlled and segmented foreign exchange market. But this is unconceivable in a G-7 country like Japan and if any hint of it was even suggested, chaos of an unseen scale would fall upon the Asia Pacific region, dragging the rest of the world with it.
Last week, without any doubt, Modern Monetary Theory had a great victory. We are not in Kansas any more. From now on, without any price signals left, we will only be guided by volume, particularly in the labour market. This situation will persist until finally a new signal emerges. Whether it will come from the agricultural commodity market, the European Union or the Japanese fixed income market, remains to be seen.
..Far from being a unique situation, the fragile exposure of unsecured depositors across the Euro zone is the norm…
Please, click here to read this article in pdf format: March 29 2013
At the end of my last letter, I anticipated I would devote the next one to explain why, in my view, the European Central Bank is hypocritical on the Cyprus situation and why the rest of the periphery has to expect the same fate than Cyprus. Fortunately for me, Mr. Joeren Dijsselbloem who is both Dutch Finance Minister as well as the leader of the Eurogroup of Finance Ministers, confirmed my second point in a press conference 24 hours later, making my work easier…
A quick view of a bank’s capital structure
There are multiple issues on the Cyprus event. Perhaps the most relevant is the fact that unsecured depositors were sacrificed because their banks did not have enough subordinated debt to bail in.For this reason, the official story goes, Cyprus is a special case. Let me explain this point. In the figure below, I show the stylized version of the capital structure of a bank. From top to bottom, every portion of it is subordinated to the one immediately above it. It is clear that the least subordinated should be the deposits that finance a bank.
What is clear to us was not clear to leaders of the European Union. At closed doors, they first decided that deposits above EUR100M would arbitrarily lose 9% (in spite of existing subordinated debt to bail in) and put the matter to vote….only to revise this figure a week later up to 40% and without voting. It was hardly an ordinary bankruptcy proceeding; banks did not go through an ordinary liquidation and nobody could see an actual market appraisal of recovery values across the capital structure. The portion of such structure, which was supposed to be the most protected, saw its recovery value fluctuate between 9% and 40% within days because folks who live far away from this drama decided so over a weekend. On the other hand, those who held deposits of amounts below EUR100M are only entitled to them nominally. Effectively, they cannot withdraw their monies, let alone send them outside Cyprus. If they hold demand deposits believing that they can serve as medium of indirect exchange and they cannot use them precisely for that function, their property was affected, regardless of what the official story says.
Let’s return then to the thesis that Cyprus is a special case because the subordinated debt of its banks did not provide with enough cushion in the liquidation. As you can see from the figure above, the thicker the subordinated debt tranche is they lower the likelihood that unsecured senior debt and depositors will be affected. If Cyprus is a special case and it is not a template for the rest of the Euro zone banks, then it must be true that the rest of the Euro zone banks have stronger tranches below that of depositors. The sections below will show that during the last year (since March 2012):
a) The same Euro zone authorities that imposed the loss on unsecured depositors were the ones who enabled a cash-out of subordinated debt holders, leaving depositors exposed to the firing squad,
b) The Fed has been the ultimate enabler of this situation, and
c) The fate of the US dollar is indirectly coupled with the fate of the Euro zone = There is no place to hide.
How the ECB financed the exit of subordinated debt holders
In December of 2011 and February 2012, the European Central Bank (ECB) extended longer-term refinancing operations to provide liquidity to euro zone banks. The liquidity, in euros and at a below market price, was against sovereign debt held by the banks, as collateral. Part of this liquidity was used for what is called “liability management” exercises, where the banks changed the composition of their liabilities: They borrowed from the ECB to repay their subordinated debt holders. This is the reason why Cyprus should actually be a template for the rest of the Euro zone. Because across the Euro zone, subordinated debt was reduced, leaving unsecured depositors exposed….again, across the Euro zone. The figure below, with the aggregate balance sheets of the main players, should help visualize what happened during the last twelve months:
In step 1, we see the focused balance sheet of the Euro zone banks and their subordinated investors (i.e. holders of subordinated debt), with regards to the subordinated debt. The same is a liability to the banks and an asset to the investors.
In step 2, we see the aggregate change caused by the extension of the LTRO Loans (i.e. loans issued under longer-term refinancing operations, by the ECB). These loans are an asset of the ECB and a liability to the banks.
Against these loans, the ECB issued Euros, which are an asset of the banks and a liability to the ECB.
In step 3, we see the transaction that I hold responsible for allowing unsecured depositors to be fair game across the Euro zone. With the Euros loaned by the ECB, banks bought out subordinated investors. Unfortunately, I have not had the time to quantify the exact impact of this transfer to date. However, reviewing past research notes released at that time (March 2012), my point will be clarified. (ADDENDUM: I HAVE BEEN GENEROUSLY FORWARDED TO THIS LINK, WHERE ZEROHEDGE.COM DID THE MATH ON THIS POINT, PROVIDING AN UPDATED STATUS ON THE ISSUE)
On March 28th, 2012, Barclays’ Credit Research team had published a report titled “European Banks: Liability management shrinks the bank capital market”. In it, it was estimated that at the end of March (only one month after the second LTRO), about 20% of the subordinated debt (equivalent to EUR97BN) had been targeted for exchange. The average exchange ratio of the transactions had been calculated at 82% of par (74% for Tier 1 and 89% for Lower Tier 2). The reductions were split as follows: Close to 35% of cash out in the Tier 1 market (EUR54BN), 12% reduction of the Lower-Tier 2 (EUR37BN), and 18% reduction in Upper-Tier 2 (EUR6BN).
According to Barclays too, all the transactions had been bondholder-friendly, with an average 7pt (i.e. 7%) premium to secondary market across all issues (9pts for Tier 1, 5pts for Lower Tier 2). The main motivation behind all the transactions was capital optimization. They created capital gains to the banks. Except for two transactions in which the subordinated debt was exchanged for common stock or new Lower Tier 2, the rest were all tenders for cash. Greek banks in particular (i.e. National Bank of Greece, EFG Eurobank and Piraeus Bank) also participated in this liability management exercise; in some cases (i.e. Piraeus’s Prefs at 37 and LT2 floater at 50, announced on Mar 7/12) at premiums ranging 10 to 17pts.
In other words, both banks and subordinated debt holders enjoyed great capital gains, leaving unsecured depositors exposed to higher risk. This played out in the context of a virtuous cycle, where the cheaper funding improved the risk profile of the financial institutions and attracted capital back to the Euro zone. In the process, both the Euro appreciated and the EURUSD basis tightened, which further strengthened the equity of the financial system. The depositors of course, continued to receive mere basis points for their trust. On May 29th and later on June 25th, I had warned about the danger of this outcome.
But the story did not end here. In steps 4 and 5 of the figure above, I show the impact the Fed had in all this with its quantitative easing policy. By literally printing money in US Treasuries purchases, it added fuel to the fire, because Euro zone banks took advantage of the situation to borrow cheap US dollars, helping them repay their LTRO loans. Zerohedge.com has explained this with more detail than I can provide in this note, (in chronological order) here, here and here. I recommend that you read these articles in detail, if you want to understand how the game is going to end.
Step 6 seeks to show the status quo after the party. If the Cyprus situation is contained (which I doubt), going forward we should see the reduction in both assets (i.e. LTRO loans) and liabilities (i.e. Euros) at the balance sheet of the ECB and the banks, with banks replacing LTRO repaid loans with unsecured USD funding.
The Fed as the ultimate enabler tied the fate of the USD to the Euro
If you noticed, I circled the US Dollars held at the balance sheet of the Euro banks in step 6 of the figure above, as an asset. I did this because I want to emphasize a point I have been making for a long, long time: The collapse of the Yankee bond market (i.e. the market for bonds denominated in US dollars, where the borrowers are non-US resident corporations), caused by corporate defaults in the Euro zone will unmask the exposure that the Fed has to the fate of the Euro zone. The dollars that end up with the Euro zone banks get recycled in multiple ways and one of them is via the Yankee market (another one is of course the USD loan market).
It should be clear therefore that this whole transfer of wealth will ultimately (and irresponsibly by the Fed) end up exponentially (through leverage) affecting those holding their savings in US dollars.
I am confident that the story above shows that far from being a unique situation, the fragile exposure of unsecured depositors across the Euro zone is the norm; and that their fragility was further increased in the last twelve months thanks to policies created by the same authorities who now refuse to honor their promise of a banking union, and instead impose capital controls, which have effectively destroyed any credibility on the safety of capital in the Euro zone.
One last word of caution: I think it would be wrong to interpret from the process depicted above that there was a premeditated conspiracy on the part of policy makers to weaken the position of depositors. This outcome, I believe, was simply an unintended consequence in their efforts to sustain the Euro zone. However, even if one accepts my view, the unintended outcome begs the following question: Why was there cheap money available for subordinated debt holders to cash out, but there is none now to protect the savings of depositors? Nobody can answer that question but with speculation, and as such, intellectual honesty demands that I keep mine to myself, because as Mark Antony said in Shakespeare’s “Julius Caesar”: “…You are not wood, you are not stones, but men; and being men, it will inflame you, it will make you mad”.
This is the second of three articles I am posting on the suppression of gold. In the first article I showed that, under mainstream economic theory, the suppression of the gold market is not a conspiracy theory, but a logical necessity, a logical outcome. This second article will show how that suppression takes place. Those familiar with the gold market will likely find nothing new. The third article will examine the implications of this suppression and support the claim of the gold bugs, namely that physical gold will trade at a premium over fiat gold or gold paper is also not a conspiracy theory, but the logical outcome of the current paradigm.
How they do it: The concept
The popular notion, which central bankers would love to destroy, is that gold is a good hedge against inflation. In its simplest form, gold cannot be printed and, as its supply remains anchored, its price should spike if the supply of fiat money increases. The implicit math behind can be represented as follows:
Given a constant demand for money…
The equation above shows the price of gold, in terms of a fiat currency (in this case, the US dollar) as a function of the relative supplies of gold and the US dollar. In the case of a fiat currency, its supply is the product of two factors: the monetary base created by the respective central bank and the corresponding credit multiplier. This multiplier reflects every single mean by which the original base is expanded, through the banking system and the shadow banking system.
If the equation above was indeed representative of the state of affairs we’re in, there would be no room for manipulation. The supply of gold, in terms of ounces available, could be perhaps capped or confiscated, but not expanded. The price of gold, therefore, could not be suppressed.
Now that we know what cannot be, let’s understand what really is happening. To suppress the price of gold. central bankers, simply, have invented a new currency: Fiat gold. The math involved in it now is:
Given a constant demand for money…
As you can see from the second equation above, the genius of central bankers was not to forbid gold but to morph it into another fiat currency, by adding a credit multiplier to it. With this, it only takes to proportionally expand this credit multiplier faster than the numerator (of the equation) and the price of gold will fall regardless of fundamentals. If they want to go one step further and signal to the public that they can do this with complete impunity and for as long as they please, they then proceed to expand the credit multiplier predictably at specific times of the day (i.e. 8:20am ET).
How they do it: The details
Below, I will describe how the supply of this new currency, fiat gold, is expanded. The motivation for this expansion was already explained in the previous article. Below, I present the steps included in the expansion of the supply of fiat gold. In the next article, I will elaborate on the graph below, addressing its implications and consequences. But today, let’s just look at the mechanics:
The above graph shows the aggregate balance sheets of the central banks, bullion banks and the gold market. Bullion banks handle transactions in precious metals and, in this case, in gold. As you can see, central banks hold gold as part of their assets. However, they can swap their gold holdings for liquidity, for US dollars. This swap is a mere exchange and is shown as step 1, in the graph. The official explanation is that such swaps would have temporary liquidity management purposes, because they remove US dollars from the market (i.e. from the Bullion banks). At a later date, not shown in the graph, the Bullion banks should return the gold to the central banks, and receive US dollars back (including an interest). For this reason, because the swap contract implies the return of the gold at a later stage, central banks are allowed to continue showing the gold they swapped in their balance sheets, as an asset.
Once the physical gold is in the hands (i.e. balance sheet) of the Bullion banks, these banks can create loans against it, supplying the market with fiat gold. This is shown in step 2. Gold is debited and Gold loans are credited. The ultimate amount of gold loans outstanding is obviously a factor of the credit multiplier in fiat gold. The higher the multiplier, the higher the supply of fiat gold in the market and the pressure on the price to come down.
The anxiety around this issue is noticeable and the big questions are: How far can central banks go with this manipulation? How long can it last? Is there a mechanism by which the market should revert to fundamentals? I will devote the next letter to the last question. With respect to the first ones, all I can say is that central banks can go very, very far with the manipulation and can last longer than you or I are willing to believe. Why? Because unlike the case of other currencies and their respective credit multipliers, in fiat gold, the players that demand gold loans are also the ones who transact in gold (i.e. Bullion banks) and dominate the repo market to provide funding (to those ultimately speculating with gold). They are all the same and only a handful. They play a cooperative game among themselves and with the central banks. The public that holds physical gold or the central banks that accumulate physical gold but do not enter into swaps with the Bullion banks cannot force a contraction in the credit multiplier. By their actions (i.e. hoarding of physical gold), all they can do is to force the rest of the central banks and Bullion banks involved to take a higher risk in the expansion of the multiplier. But they cannot force a rush for delivery. They are, by definition, outside of the system.
How can we protect ourselves from the manipulation?
One way to protect ourselves from the manipulation described above is to simply trade the expansion of the credit multiplier for fiat gold. At this point, I remind the reader to read my disclaimer. (My comments are not intended to provide personal investment advice and they do not take into account the specific investment objectives, financial situation and the particular needs of any specific person).
If the supply of fiat gold is a factor of the monetary base in fiat gold and its credit multiplier, one can think of proxies for these factors. In my view, the monetary base is represented not only by the stock of physical gold outstanding, but also by the stock that is to be mined: By the gold miners, collectively. Fiat gold, on the other hand is represented by either futures or gold certificates.
When the manipulation succeeds, the credit multiplier expands. In this case, if I am correct, it should be profitable to be long the promise to deliver gold and short the monetary base of fiat gold. When the manipulation is not successful or a rush for delivery is triggered, the credit multiplier contracts. Here, if I am correct again, it should be profitable to be short the promise to deliver gold and to be long the monetary base of fiat gold. There are many ways to express this trading thesis, but I’d rather leave these speculations to the reader.
Note: In a recent post published by Mr. Chris Powell on Gata.org on March 22, 2013, a few inferences on me are published that are false. I have no control on such inferences and was not contacted by Mr. Powell nor GATA with regards to any of my posts on this blog. Had I been contacted, I would have strongly denied such inferences, which I completely disavow.
First, I am not a high executive in a big investment firm, as Mr. Powell has portrayed me. I am an employee with very limited responsibilities, completely outside the precious metals markets or mining.
Second, I do not work in investments nor invest for anyone or work in the area of investment banking or trading and, with respect to this particular article, I do not have any previous working experience or inside knowledge of the precious metals markets or mining. This should be clear from reading the “About the contributor” tab in this blog.
Third, as the disclaimer on this blog duly notes, the comments expressed in this website and daily letters are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer or its affiliates. I maintain this personal and independent blog outside my working hours and absolutely all of my posts are based on nothing else but public information and my own analysis/reading/interpretation of that information.
In particular, I completely disavow the inferences made by Mr. Powell’s post with respect to bullion banks and the mining industry. They are 100% his responsibility. The paragraph on the involvement of miners in the futures market of my (third) post on this topic is nothing else than my personal interpretation of articles in the public domain on the subject and only seeks to explain a certain dynamics affecting the gold forward rate. As my disclaimer also notes, the information contained herein is not necessarily complete and its accuracy is not guaranteed. In other words, I can be wrong.
Unfortunately, my name and comments have been subject to incorrect inferences. I am not responsible for them.
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