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

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

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

Overview

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

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

The latest move: Tax moratorium to repatriate capital

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

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

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

How it works

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

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

 

 

Final Observations

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

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

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

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

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

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

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

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

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

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

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

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

What makes the gold market of 2013 different?

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

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

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

Martin Sibileau

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

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

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

How it all began

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

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

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

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

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

How adjustments worked under the Gold Standard

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

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

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

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

How adjustments worked under the Gold Exchange Standard

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

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

 

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

How the perspective changed as the US became a debtor nation

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

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

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

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

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

My graph below should help visualize the mechanism:

 

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

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

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

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

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

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

How adjustments work today, without currency swaps

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

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

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

 

 

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

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

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

How adjustments work today, with currency swaps

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

Final words

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

 

Martin Sibileau

(To read this article in pdf format, click here: April 14 2013)

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…)

Brief introduction to Modern Monetary Theory

I suggest you do your own research on this topic, because what I will say here is by no means exhaustive. But it is important to be aware of a new reality. I, for one, found a fair summary of it here. Below is a list of some theses held by this school, from L. Randall Wray’s “Modern Monetary Theory: A Primer on Macroeconomics for Sovereign Monetary Systems”(From chapter 18, edited by me):

“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 21^st 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 17^th 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).

On April 4^th, we had a strong indication that the raison d’etat was becoming increasingly relevant. During a press conference, Mr. Draghi, answering a question from Zerohedge.com, stated that “… people(…)  vastly underestimate what the Euro means for the Europeans (…); they vastly underestimate the amount of political capital that has been invested in the Euro...”  I thought he was very wrong. I don’t think anyone actually underestimates them, which is why I so fear that this game will end in a war, as unseen unemployment rates are coerced upon millions of innocent families.

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 12^th). 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 21^st. In no particular order, these are the challenges:

-Annihilating the last bastion of redeemable, alternative marketable value:

After April 13^th, 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 exponentially securitized. 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 38^th 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.

Conclusion

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.

Martin Sibileau

(Click here to read this article in pdf format: April 8 2013)

It is hard to make sense of the markets these days. For instance, gold showed no support while the geopolitical situation in Asia deteriorated, Japan embarked in the mother of all monetization programs, and a member nation of what is supposed to be a monetary union was imposed controls on the movement of capital. Or take the case of the Euro, which jumped from $1.2750 to $1.2950 on the day of one of the most confusing and embarrassing press conferences the president of its central bank ever gave.

However, in a faraway land, where there is no shadow banking, leverage or even capital markets, economic fundamentals still hold, which and can help us, inhabitants of the developed world, visualize a dynamics lost in the shelves of our collective memory. The land I am referring to is Argentina, but not Argentina of 2001. Today, I want to write about Argentina of 2013, and no, I will not discuss their legal battles with Mr. Singer.

Introduction

The topic I want to bring your attention to refers to an earlier article titled “What causes hyperinflations and why we have not seen one yet” (December 18^th, 2012). In it, I drew a few conclusions; the most relevant of which was that high inflation and high nominal interest rates are not incompatible, but on the contrary…they go together: There cannot be hyperinflation without high nominal interest rates. The article suggested that high interest rates are the product of a collapse in confidence, represented by a serious shrinkage of the deposit base in a currency jurisdiction. But the article was not exhaustive. It was limited to pointing out fear of confiscation, as the driver behind the collapse in confidence. This will be the driver behind the Euro zone break up. But there is another driver and Argentina of 2013 may be a template for the US. Bear with me…

Fear and greed

When human beings act/decide/choose, they face a risk/return trade off. When choosing whether or not to leave their savings deposited in a bank, indeed their decision can be driven by fears of confiscation. In other words, at a given return (almost 0% nominally and negative in real terms these days), if risk is perceived as too high, deposits will decrease or at best and at the margin, not increase. That was the scenario contemplated in my earlier article.

The most catastrophic example of the fear scenario is the monetary developments at the fall of the Roman Empire, when depositors took their monies and dug holes in the backyards of abbeys to hide them from either the tax man or barbarian hordes. However, the earliest documented example (by Isocrates; discussed by Prof. J. Huerta de Soto in his great book “Money, Bank Credit and Economic Cycles”) of this scenario dates back to 393BC and took place in Athens, triggered by the war with Sparta and the victory at Thebes, when Passio, an Athenian banker could no longer hide the insolvency of his bank (Demosthenes seems to indicate that Passio had a leverage ratio of approx. 5 to 1). He was not alone. A general run also against the banks of Timodemus, Sosynomus and Aristolochus ensued and it resulted in a deposit freeze that lasted 10 years (ref. Bogaert, Banques et banquiers dans les cités grecques). Those who feared first, feared best.

Fast forwarding some 2,406 years to 2013, what I missed in my earlier article (although it was implied in subsequent ones: i.e. on gold manipulation) is the “return” or greed component of the decision to shrink deposits. By this I mean that, for a given, known and manageable risk, if the return is perceived as too low, the deposit base can also shrink.

The perception of a low return will be shaped in relative terms. If there is an alternative to placing savings in a chequing account, for same or lower risk, the deposit base will shrink. In the developed world, courtesy of the creation of fiat gold and the volatility it generated around the price of the metal, such alternative is still non-existent. This was the smartest move of central bankers. But with the Cyprus event and others to come, without a Plan B, even this volatility can be ignored in favour of a longer term view on gold.

Argentina 2013

An example of falling deposits driven by greed rather than fear is Argentina in 2013. Depositors there learned the “fear lesson” already 12 years ago and for that reason, today a US dollar under the mattress is always worth more than a US dollar deposited in a bank. But the story didn’t stop there. Later on, as it became increasingly evident that the confiscation by the government had not ended with the default of 2002, the US dollar market saw another segmentation.  As the government competed with the public to source US dollars (to repay whatever was still left outstanding on their debt) and those dollars were out of the system, it decided to prohibit access to them in open markets. The repression began in earnest about a year and a half ago. For that “national and strategic” cause, even US dollar sniffing dogs were recruited to search for any US dollar bills, out of the system (watch here and here)

Since then, the market broke and there’s the official US dollar price, where of course you find no sellers, and the market price (for an unknown reason, called the “blue” market).  The graph below (source: Reuters/La Nación) does not need additional comments; it is self-explanatory. Today, while an official US dollar is worth about 5,15 pesos, the market demands about 8,50 pesos, or a 2/3rds premium.

 

So far, you will be asking yourselves how this can be a template for the US. And you would be right: The gold market is still one and the US government will never have to compete with the public to source physical gold to repay its debt, which is denominated in US dollars. But there’s more to it..

Why it can be a template

But let me get back to my initial point: Deposits can also fall driven by greed, rather than fear. In Argentina of 2013, deposits in pesos are now starting to contract exponentially, not driven by fear but by greed. Why? Argentines observe the escalation in the price of the US dollar bill outside the system (+25% YTD) vs. the interest paid on peso denominated deposits (-10% in real terms) or stocks (+18.5% nominally), and correctly figure out that they are better off with a king-size mattress than a bank account. Now, that to me is likely to be a template of what may happen in the US, once the market for fiat gold collapses. Here’s why: If the fiat gold market broke in a run for physical gold, the credit multiplier on paper gold would be crushed and from that moment onward  depositors in US dollars all over the world would see the performance of gold as a benchmark against US dollar deposits, just like Argentines today regard US dollar bills as a benchmark against their peso deposits. This is every central banker’s biggest nightmare: An asset whose price shapes inflation expectations.

The likely outcome of this would be an initial fall in USD deposits and a rise in interest rates, as the USD unsecured funding market would dry. Following this, the Fed, just like I am expecting the central bank of Argentina to do, would be dragged into a deficit (I am not going to explain here the mechanics of the deficit of a central bank. The reader may want to see my last article on hyperinflation, mentioned above).

As Argentina is at the gates of a new hyperinflationary process, it would be wise to follow it closely. It is a template. There are two conclusions that come to mind:

Conclusion No.1 : The Fed/US government would be better off not confiscating gold

Counter intuitively and contrary to the belief of the gold bug community, the US government would have every motive NOT to confiscate gold, for in so doing, they would trigger a run for physical gold and lose every leverage they have to suppress its price. This conclusion should hold even if a run for physical gold took place for other reasons. Their best move is to keep the suppression of the price of gold via fiat gold as long as possible.

Conclusion No. 2: The Fed would be more pressed than Argentina’s central bank to run a deficit

With the peso as a local currency, the pension funds nationalized, the absence of shadow banking and capital markets, if deposits in pesos drop, the central bank of Argentina does not worry about systemic contagion. As nobody there relies on the banking system to fund their businesses, the drop in deposits would likely end up affecting the profitability of the banks, with a high probability of seeing a complete nationalization of deposits.

The Fed however would be multiple times more pressed to intervene. Its liabilities affect credit and commodity markets worldwide, the pension and money market funds would be at the risk of collapsing. The high leverage of the shadow system would be too much. Therefore, the Fed would have to subsidize not just the US but the global banking system, to maintain US dollar deposits as a competitive alternative to gold worldwide. (Once more, to see how this would take place, please see this link)

Why I disagree with Martin Feldstein

Continuing with the topic of rising interest rate, in this recent article (link), Martin Feldstein expressed his concerns on the subject. Unfortunately, he does not explain how he sees that rise being triggered. He simply begins with “When interest rates rise…”. Unlike him, I have been explicit at least since December 2011: To me, the most likely driver is a wave of corporate defaults coming from the Euro zone, forcing the Fed to become the lender of last resort (in fact, they already are) and triggering a repudiation in US Treasuries. As a consequence, the repudiation of US Treasuries would further spark the fall of the money market and probably that of a commodity market clearinghouse.  In this context, the price of gold would not fall as Mr. Feldstein predicts.

In my scenario, before (i.e. independently of) the rise in rates,  credit spreads would rise as defaults increase. Markets would realize that the Fed is no longer in control and that the transfer of losses to the public sector are no longer bearable and the Fed would be forced to buy any US Treasury the market sells.

Martin Feldstein’s story has the opposite narrative thread. According to him, rates will rise and defaults will follow. In his words: “…Long-term interest rates are now unsustainably low, implying bubbles in the prices of bonds and other securities. When interest rates rise, as they surely will, the bubbles will burst, the prices of those securities will fall…”

How does Mr. Feldstein expect that rates to rise? Not because the Fed raises them, but because inflation expectations would drive nominal rates higher: “…If inflation turns out to be higher (a very likely outcome of the Fed’s recent policy), the interest rate on long-term bonds could be correspondingly higher…”

Mr. Feldstein omits to tell us what he thinks would cause inflation to be higher than the 2% targeted by the Fed, but my guess is that he has the mainstream economics model in his mind, whereby as the output gap decreases, prices increase. I will have more to say about such models in subsequent letters, but for today, let me end with this: There is no such a thing as an output gap. The notion of its existence is an ad-hoc mental tool, which dismisses the role of the price system in allocating resources.

Martin Sibileau

Please, see important disclaimer/ note at the end of this article:

To read this article in pdf format, click on the following link: March 16 2013

This is the third and last of three articles I am posting on the price 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.  Mainstream economics, framed by the Walras’ Law, believes in global monetary coordination which, to be achieved, necessitates that gold, if considered money, be oversupplied. The second article showed, at a very high (not exhaustive) level, how that suppression takes place and how to hedge it (if my thesis is correct, of course). Today’s article will examine the systemic impact of this suppression and test the claim of the gold bugs, namely that physical gold will trade at a premium over fiat/paper gold, commensurate with the credit multiplier created by the bullion banks.

I see two complementary ways to approach the systemic impact of gold manipulation. The first one would be to examine how the same affects the relevant prices. The second one would be to analyze the flows involved in the manipulation. With both ways, we should be able to reach a final conclusion on the sustainability of the manipulation. I will not keep the suspense: It is not sustainable. But if it isn’t, what is the end game? Without further ado…

Relevant prices involved in the manipulation

From the second article, we know that 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…”  The graph is reproduced below:

 

Note: Since my last article, Zerohedge raised the possibility that a bullion bank may have its vault adjacent to another one owned by a central bank. In such particular case, the graph above should be revised as follows:

Humor aside and returning to our first graph, we can see that the swap obtains liquidity in exchange of collateral. Any profit maximizing agent would weigh placing gold as collateral for cash versus the cost of raising funds in the unsecured market. After all, anyone long gold could sell it, obtain the cash and buy it later, with a gold forward contract. Therefore, the liquidity cost facing (in this example) a central bank seeking to monetize its gold holdings, without selling, is expressed:

Cost of liquidity to a central bank = Min (gold swap rate, gold forward rate)

The gold forward rate is published by the London Bullion Market Association as the Gold Forward Offered Rate (GOFO). This rate represents the difference, in annual percentage terms, between the cash price and forward price of gold. Of course, the expression above implies that the central bank maximizes profit (i.e. minimizes cost). Just like a central bank does when it purchases bankrupt sovereign debt, to stabilize the liquidity in the system… (Temporarily, obviously).

On the other side of the swap, the Bullion Bank that receives gold as collateral must consider the transaction vis-à-vis providing liquidity in the unsecured US dollar market. The price for the latter market is Libor (London Inter-bank Offered rate), which is not really a price (because it doesn’t in itself clear anything), but a benchmark (The proof of this statement is simple: If Libor was indeed a price, the aggregate sum of the credit risk –as quoted in the credit default swaps market- of the panel banks that determine Libor should approximate zero. However, this sum is a positive number and far from zero). Indeed, the collateralized (with gold) lending should not be compared with lending in the unsecured US dollar market. Here, we have gold as collateral, which at the same time has storage and insurance costs. The benefit for a Bullion Bank for entering a gold swap is therefore expressed:

Benefit of gold swap = Max (gold swap rate, Libor)

When the swap occurs, both the central bank and the Bullion Bank agree on a price, the gold swap rate. Therefore:

Min (gold swap rate, gold forward rate) = gold swap rate = Max (gold swap rate, Libor)

Therefore, for the transaction to take place:    Gold forward rate > gold swap rate > Libor

This implies that the GOFO should approximate Libor. Unlike what mainstream economics tells us, exchange does not take place at indifference points along so-called utility curves. The Bullion Bank will either lend in the unsecured US dollar market or through a swap. Choice will happen and will have a cost. Therefore, if it lends via swaps, it has to be more profitable than earning Libor. The question is….what makes collateralized lending more profitable?

The answer is simple: the Bullion Bank not only earns the gold swap rate, but also a gold interest rate, as it uses the gold it receives to make gold loans. Hence, there is an extra benefit in swapping cash for gold, as the gold is loaned and earns a spread. As in the case of fiat money, where cash held by banks is used to expand credit, gold held by bullion banks is used to expand fiat gold:

The gold interest rate earned on fiat gold is commonly referred as the gold “lease” rate. This implies that the gold loan is not a loan, but a lease. The terminology is not coincidental. It allows the “leased” gold to be carried on the central banks’ books, as if the bullion was still in the vault. But this may certainly not be the case, because while I show gold in the asset side of the aggregate balance sheet of bullion bankS , this will not necessarily be the case at an individual level. For instance, let’s assume that the gold is loaned by what I will call Western bullion banks, but it ends up deposited in Eastern bullion banks. The aggregate position of the Bullion banks can be now shown as below:

At this time, it is important to understand the difference between gold swaps and gold loans. The graph below should help visualize it:

 

As can be seen, in a swap, the party that facilitates the bullion receives cash upfront. That cash is absent in a loan. This may be a reason for central banks to prefer swaps over loans: The swaps can become a liquidity management tool. They can be used for sterilization. As long as the gold swapped does not end up being sold in the spot market, gold swaps should be neutral to the price of gold.

From the perspective of a bullion bank, the gold loan leaves it “short bullion” vis-à-vis the gold swap obligation entered into with central banks. To hedge this risk, the bullion bank can use the gold swap rate received from the central bank to buy gold on a forward basis:

For the bullion bank to profit from a gold loan without the risk of being short bullion:

 (Gold swap rate – Gold forward rate) + Gold loan spread  > 0

In practice, Bullion banks quote these loans as: Cost of funds + x bps, where the cost of funds is defined as (Libor – Gold forward rate), for the applicable tenor (i.e. 3 months). This cost of funds is what is popularly called the Gold lease rate.

As bullion banks seek to hedge their gold loan counterparty risk, their demand for gold on a forward basis should raise the gold forward rate to the point where it is no longer profitable to expand the credit multiplier on fiat gold. That point can be expressed below as:

(Gold loan spread + Gold swap rate) < Gold forward rate

The pressure on the futures market for gold should therefore be the stabilizing mechanism that limits the expansion of fiat gold. However, this is only so under a static perspective. The dynamics of the process also involves gold miners. If, for instance, due to the expansion of fiat gold, the spot price of gold fell significantly, affecting the margins of miners, we could see consolidation in the industry via leveraged mergers in the current context of ultra-low interest rates. In this case, the same banks that led junior miners to become insolvent as they drove the price of gold down could be now selling their investment banking services to merge them with bigger players. In the process, the banks would demand that the new companies hedge their production, against further future gold price declines. This supply of future gold could offset the initial demand of the bullion banks, leaving room for a further expansion of gold loans…longer than most would believe.

As I wrote above, the collateralized lending rate (gold swap rate) should not be directly compared with the unsecured lending Libo rate. However, if a bullion bank loans gold and at the same time hedges with a gold forward contract, the resulting position can be comparable with unsecured lending.

If the gold lease rate is negative, it is expensive -ceteris paribus- to hedge the short bullion position, and the incentive to expand fiat gold decreases. This is supportive of the spot price of gold. If the gold lease rate is positive, it is relatively cheap to hedge the short bullion position and to continue expanding fiat gold. This is negative for gold. When fiat gold expands, we are likely to see a simultaneous bid for gold on a forward basis, to hedge. This should steepen the gold term curve, raising the gold forward rate.  When fiat gold contracts relative to bullion, the gold forward rate should fall, flattening the term curve. If spot gold is more expensive than forward gold, in other words, if there is a bid for storage of gold: Gold enters backwardation. In backwardation, the term structure is that of money. There is an inter-temporal rate that discounts future vs. present purchasing power.

Why we can say that this is manipulation

At this point, we must ask ourselves what is wrong with all this. After all, why should the morphing of gold reserves into fiat gold (via gold loans) be called a manipulation? There is nothing different between the creation of fiat gold out of bullion and the creation of US dollars out US Treasuries.

The answer is simple: There should be nothing wrong with it, if it was not hidden. Let me explain myself: If the central banks did not show the bullion swapped as gold in their possession and if the bullion banks showed the reserve ratio of fiat gold-to-bullion, just like banks do with fiat money, this could not be called a manipulation. Even with consistent sell offs at 8:20am ET or 4am ET, we would still not be able to call this a manipulation (I challenge readers to do their own research and find out what the credit multiplier of fiat gold and the equity ratio of the bullion banks are).

How would the market react therefore if there was full disclosure? Physical gold would trade at a premium. As an example, at the verge of the collapse of the currency board in Argentina, the premium for holding USD bills under the mattress vs. USD in the bank (i.e. paper USD), was expressed in terms of an opportunity cost: Banks were offering 20% per annum to retain USD deposits in savings accounts! In other words, those holding to their USD under the mattress, were foregoing a 20% return rate, for not taking risks….Now, let me ask you this: Do you see gold ETFs paying a dividend? There you go!

Finally, if there was full disclosure, gold would have to enter into backwardation, which is exactly what mainstream economics seeks to discourage, because the backwardation would once and for all bring to light the fact that gold is money.

 

The systemic risk of the manipulation: A flow analysis

The manipulation is also not without risk. The graphs below should illustrate this point:

The graphs above show the flows involved in the manipulation and the positions taken by the players. At inception of the conversion of bullion into fiat gold, the central bank assumes a short bullion/long cash position. The Bullion bank enters into a short bullion/long gold futures position, partly or fully financed via Treasuries repoed with money market funds, to cover the swap with the central bank as well as the margin for its long futures position. The gold borrower that sells the gold in the spot market to fund the purchase of asset y is therefore short bullion/long asset y. There are three main risks to this scheme that give the manipulation a systemic dimension. The systemic implication is tangible and should not be ignored, because we have proof of its actual costs. A clear example was the loss that UK taxpayers suffered when Mr. Gordon Brown, as Chancellor of the Exchequer, sold 400 metric tons belonging to the UK government. The sale was on purpose pre-announced, driving the price of gold down, to bail out those who had been profiting from the manipulation. Member of Parliament Nigel Farage had something to say about this:

Is this ever going to end?

The first graph above shows three events/risks that would crush the manipulation, possibly unleashing a systemic crisis, which should be enough ground to forbid the manipulation altogether. I will then proceed to elaborate on them and seek to reach a conclusion as to which one of them is the most likely to occur.

Event 1: Repudiation of US Treasuries

Description: This is a risk to the money market funds that are long US Treasuries through repurchase agreements. The repurchase agreements provide cash to the bullion banks who use it to either swap for gold or establish margins for their long gold futures position. In our example above and to keep things simple, I assumed that the gold borrower does not use leverage. This would be unusual and it is to be expected that the counterparties to the bullion banks also use leverage from repoeing US Treasuries. If there was a sell off, a repudiation of US Treasuries, bullion banks and their counterparties would have to unwind their positions and rush to purchase back the bullion they sold multiple times.

What could trigger it?: The repudiation of US Treasuries could be triggered by a ratings downgrade, or an outright sell off by the market, forcing the Fed to acknowledge their role as the only buyer regardless of the unemployment rate, caused by political instability in the US.

Mitigants: The current degree of financial repression would rise exponentially. Already Standard & Poors is under pressure and Egan Jones was banned from rating US Treasuries. Margin requirements could be lowered, shorting of US Treasuries could be forbidden and ultimately, the Fed could intervene bailing out the money market funds, as I explained before.

Likelihood: This event is unlikely to be triggered in the near term.

Event 2: Rush for delivery of physical gold

Description: This is a risk to all those who are short bullion. As the expansion of fiat vs. physical gold grows, the risk to a rush for delivery rises. In this case, gold futures would trade at a discount vs. bullion. Those short bullion could quickly face insolvency causing an exponential rise in counterparty risk within the market and eventually the crash of the clearinghouse. The clearinghouse would then have to be bailed out by a central bank(s) and bullion could be outlawed and confiscated.

What could trigger it?: As I write, there is already a rotation going on, from paper gold to bullion. I may even venture to suggest that stop losses are increasingly absent, as the manipulation renders price signals irrelevant. During the first week of March, the $1,570/oz level was broken twice on bearish news, only to find  minimal sensitivity, forcing the shorts to cover. This behaviour is typical from segmented, broken markets, where price is no longer the relevant signal and volume becomes the guideline. Having said this, an event that could trigger the rush for delivery could be an “accident”, just like the one the world witnessed in 1972, when Russia announced it had purchased 440 million bushels of wheat. The purchase surpassed the total U.S. commercial wheat exports for that year. In similar fashion, we could see the disclosure of an upwards revision in the gold reserves held by a central bank in the East that would seriously challenge the integrity of the reports issued by central banks in the West with respect to their bullion holdings.

Mitigant: In 1972, the world was divided. Today, all central banks are on the same expansionary program and the systemic impact of a rush for delivery in gold would likely affect all currency zones. I would therefore not expect emerging central banks to report their actual gold purchases and holdings. They have more to benefit from keeping these in secret, profiting from the cheap prices the manipulation causes.

Likelihood: This event is unlikely to be triggered in the near term.

Event 3: Liquidity crunch

Description: This is a widespread, macro risk. Its scope surpasses that of the gold market. For this reason, mitigating it is impossible, when all central banks are engaged in the monetization of sovereign debts. This is the risk of having malinvestments surface their ugly heads and causing a wave of defaults. Central banks would once more, but with a very publicly low marginal efficiency, flood markets with liquidity. And this liquidity would quickly find its way into bullion, triggering the events no.1 and 2 above.

What could trigger it?: In my view, political and social unrest in Europe would cause a selloff in European risk, compromising the balance sheet of the Fed, which is coupled indirectly via USD swaps and directly via funding of European banks. These banks also raise funds from US money market funds.

Mitigant: The mitigant here is only political. It depends on how longer the status quo can force the Euro zone to live under high unemployment, taxes and austerity.

Likelihood: I see this event as the most likely to put an end to the manipulation, although I do not see it occurring in the near term.

Is Eric Sprott’s prophecy valid?

In recent interviews, Mr. Sprott has made the point that as the manipulation comes to end, the premium on physical precious metals vs. fiat precious metals will be as high as the leverage (i.e. credit multiplier) that suppressed it.

The manipulation just described somehow resembles the suppression of the value of the US dollar in Argentina during the convertibility of the peso, after the 1994 Mexican peso crisis. Officially, the Argentine peso was convertible to US dollars at a 1:1 ratio. But the credit multiplier for US dollar deposits was legally capped at 3x in March 1995 (this was a simple calculation, because Argentina lacks any sophisticated shadow banking system). As it became evident that this situation was unsustainable and the public began a run on US dollar deposits, US dollar bills (under the mattress) began to trade at a premium against US dollars in bank accounts, as I explained above. First, limits on withdrawals were established at the end of 2001 and eventually a bank holiday was declared. When the holiday was lifted and the system imploded, the US dollar overshot to 3.80 pesos, but after a few months, it settled back to around $3.00…exactly the ratio implied by the credit multiplier that caused the crash. This simple and real example tells me that Eric Sprott’s claim is spot on. The chart below (source: Bloomberg) on the USD in terms of ARG peso, makes my point very clear:

However, I expect a financial repression like never seen before unleashed before the prophecy finally becomes reality. Something to keep in mind: The repression of the price of the USD in Argentina lasted seven years in a context with (a) no shadow banking system, (b) full disclosure of the credit multiplier and (c) a market price for the opportunity cost of holding USD bills under the mattress. Seven years, folks! This suggests two things: (1) It will take a period far longer than most are willing to accept until the day of reckoning comes, and (2) when that day comes, the crash will be far more formidable than anyone can imagine.

Conclusions

This extensive letter was the third of a series on the manipulation of the price of gold. I am confident that through them, I established the following conclusions:

-According to mainstream economics, the manipulation is a necessary policy tool, to achieve the global monetization of sovereign deficits. Without manipulation, inflation expectations would be shaped by the gold market, causing the fall of fiat money.

-The manipulation consists in inventing a new fiat currency, fiat gold, with a credit multiplier.

-To hedge the manipulation, one can trade the expansion or contraction of the credit multiplier in gold

-The creation of fiat gold, per se, is not manipulation. The manipulation consists in keeping the credit multiplier undisclosed and misrepresenting reserves of bullion.

-The manipulation of gold engenders serious systemic risks that could eventually lead to the crash of a clearinghouse. The costs are tangible.

-The most likely event to put an end to the manipulation is a wave of corporate defaults.

-When the manipulation ends, the premium in physical gold vs. fiat gold will approximate the credit multiplier.

Martin Sibileau

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 in 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 post 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.

Martin Sibileau