(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

Last week we had suggested that the strength of the Euro (by strength, we mean a Euro above $1,30) could be based on the fact that the liquidity lines extended by the European Central Bank were collateralized. As the sovereign risk of Spain,Italy and Portugal had deteriorated, so had the value of their sovereign debt diminished and, as this debt had been used as collateral by the banks of the Eurozone, these banks would be forced to sell assets and buy Euros to post on margin. It was simple and beautiful logic. However, we were wrong and the reason for that left us even more concerned. Someone better informed than us, who shall remain anonymous, wrote us the following (the highlighting is ours):

“…Hi Martin,

I just wanted to chime in on the issue of ECB (European Central Bank) margin calls. I completely agree that in theory the collateralized lending that now dominates can develop into a vicious cycle (as well as a virtuous one of course). However, in practice, a lot of the collateral that is pledged at the ECB is marked to model rather than marked to market. At least that’s what I am inferring from the ECB margin calls. The spikes that you saw relate to Greek collateral coming in and out of the ECB refi ops. Abstracting from those the margin calls themselves tend to be too small in my view to have an impact on the Euro…”

Having proved our axiom wrong (i.e. margin calls triggered by market volatility), our thesis is proved wrong. We had at the beginning of 2012 however warned that: “…in the short-term, the demand for Euros does not wane, because sovereign debt is denominated in that currency and the refinancing operations of the European Central Bank facilitate the purchase of that debt. This suggests to us that shorting the Euro will be a painful trade, with very high volatility…” (“Walking the fine line”, Feb 6^th, 2012).

It is time now for us to write a few lines today about Canada and India. Over the past months, we have seen crude oil appreciate. Simultaneously, the Canadian dollar did not (the Canadian dollar is positively correlated with crude oil) and the data coming from activity in Canadahas been disappointing. What makes matters worse is that in light of this, the price of housing has remained strong and even slowly increasing. In discussions with those following this market we noticed that in general, investors tend to see the Canadian context with the same lens used to see that of the USand the UK: They see a bubble in the housing market that would eventually be harmful to the financial system, and which would end in systemic weakness for Canada. This is, after all, what occurred in the USand the UK(We remind readers that at “A View from the Trenches”, we have never seen the EU crisis based on anything else but an institutional problem, rather than a liquidity or solvency problem. Refer: http://sibileau.com/martin/2010/02/10/)

We see the Canadian context differently. We think that it is likely that the barbarians will use the back, rather than the front door. Because Canadians have on average tended to put significant down payments on their houses, only a fraction of the outstanding mortgages have required insurance from the Canadian Housing Mortgage Corp. That fraction can be (but is not necessarily) securitized. The rest remains warehoused by Canadian banks, which unlike US banks, have recourse on their borrowers (if these default on their homes). Our fear then is of a potential contagion from the government. Indeed, rather than expect contagion from the banking system to the government, inCanada, we expect contagion from the government to the banking system. If the fiscal situation deteriorated (led by Ontario), the guarantee of the Canadian Housing Mortgage Corp. and the implicit comfort based on the country’s sovereign AAA rating would immediately affect the banks.

Do we expect this deterioration to be triggered by an endogenous dynamic? No. We fear that Canada may be affected by a foreign development and we can think of many, from the Euro-zone,China, or theUS…which takes us to India.

India has and is embarked in an inflationary process and, like in any other inflationary process, the outstanding amount of money is the taxing base. Following the example set by the Mahatma Gandhi, Indians peacefully protest this taxation by leaving the taxing base, the rupee, in exchange of gold. This has angered the government there which has taken a few repressive measures. It has taxed gold (a tax currently under review), set import duties and even barred gold loan companies (that lend on gold as collateral) from lending against gold bars, coins and bullion. These companies can now only lend against gold jewellery, with a cap on the loan-to value asset ratio and maintaining a minimum Tier 1 capital of 12 per cent. Does anyone think that these measures will favour the development of capital markets in India? Does anyone actually believe that because the competition from the gold loan market falls, savings in rupees will grow and investors will accept the government’s strong hand and lend in rupees? This is another example of the idiocy of bureaucrats that is destroying capital markets across the globe. Not only will savings in rupees not grow, but the overall savings rate will tend to fall, because on the margin, if savings have nowhere to go…why save?

This destruction of capital markets, as we noted, is not only taking place in India. The same is carried away slowly, by breaking the price system, whose signals no longer seem to work. Compared to July 2011, we have more than a trillion of new Euros, we have had Operation Twist, the banks of England and Japan weaken their currencies, sovereign downgrades worldwide, Ben Bernanke announcing low rates until 2014 and yet, gold is below $1,700/oz, courtesy of the interventions (see: http://www.zerohedge.com/news/paul-mylchreest-presents-various-visual-case-studies-gold-price-manipulation) . Even worse, although gold is below $1,700/oz, it is obviously higher than a year ago…but the capitalization of the gold mining sector is lower.

Repression, repression, repression…Interest rates don’t reflect anything these days. If you ask us, we don’t even know what to call capital. The price of crude oil touched $110/bl and yet the capitalization of energy sector in Canada slipped. Only a few dare to short the Euro, in the face of the massive destruction of the financial system in the Euro-zone. How can this be possible?

People wonder and at the same time praise the fact that companies nowadays hoard record amounts of cash, as a sign of strength. We think this is actually a disgrace and it shows how central banks managed to distort the relative prices of the different components of the economy’s capital structure. These companies are not investing that cash but as we mentioned a month ago, they have started to return it via dividends or share buybacks.

The final outcome of these repressive policies can only be a reduction in the savings rate and investments, a fall in productivity, an increase in consumption, if the supply of money continues and the inevitable stagflation.

 

Martin Sibileau

Please, click here to read this article in pdf format: March 18 2012

We are back from Washington DC and realize that we could choose different titles for today’s letter. Let’s try a few…

Title No.1: “The market proved us wrong”

Indeed, we have been, and continue to be, long term gold bulls. We have been buying dips in gold and find ourselves having averaged down on our holdings, as gold did not find a floor in the low $1,700/oz, nor $1,695/oz or even $1,660/oz. Averaging down is the sure way to ruin and wisdom calls for trimming rather than increasing one’s exposure to a falling asset. And we trimmed only a bit and stopped buying, with the belief that it will prove a wrong decision, but with the unemotional duty to survive. As we write, we learn that there’s an article on the Financial Times telling us that central banks (not the Fed, of course) have been doing the same, only better than us: They really added!

We have no doubts that the plunge in gold on February 29^th was simple manipulation and it is only this reason that encourages us to hold on to what we have. With respect to stocks, we continue to remain neutral of them, not willing to buy but also, not willing to short them. From conversations with friends and readers, we noticed that we have not explained ourselves appropriately. Therefore, we want to briefly stop here to provide these short comments:

The popular view on inflation is that which sees it coming from a steady increase in the supply of money spilled over onto assets, lifting investments, increasing employment, wages and later the price of every consumption good. If the price of assets and the employment rate rise, it is understood that the original goal by the central banker, that of lifting the level of activity with monetary easing, is working and that soon, that easing will disappear, followed by an increase in interest rates.

The problem we have with this view is personal. Unfortunately, we lived through inflation and remember it differently. Inflation is a steal. It is a tax charged by the government. And they charge this tax because they run a deficit. No government would nor will ever target inflation under surplus or balanced fiscal conditions. Inflation is the distortion of relative prices, and it always starts with that of the cost of capital. It is a manipulation first of the cost of capital, then of commodities and followed by price controls: First on goods and later on salaries. It entails control on capital flows (which we are currently seeing everywhere in the world), currencies, and financial repression. Therefore, our view is different: Inflation does not bring full employment. That’s a myth. Inflation creates unemployment. Under inflation, production does not rise lifting prices. That’s another myth. Under inflation, production falls, creating shortages of goods, which is what further shifts the inflationary process to hyperinflation. If a country like the US manages to have the rest of the world finance that shortage of goods, that’s another story and it will last as long as the rest of the world wants it to last. But we should be clear on the underlying process. If you have any doubts, just drive around the former industrial areas in the outskirts of Buffalo, Detroit, Boston, Pittsburgh, Philadelphia, etc. and you will picture what we’re talking about here.

As we explained at the beginning of the year, the rally in stocks and in gold was expected. It was only three weeks ago that the world was injected with more than half a trillion Euros in 3-yr liquidity lines!!! But gold was manipulated and stocks were not. And we have gold at below its 200-day moving average and the capitalization of Apple Inc. at higher than half a trillion US dollars, without Steve Jobs as CEO. Take this as you wish. In the meantime, on Friday we saw a violent increase in US yields, followed by demand, that kept the 30-yr Treasury yield below 3.5%, which is what brings us to the next possible title, for today’s letter…

Title No. 2: “Financial repression, Stage 1”

Perhaps the most clear exposition of financial repression occurred this week, when President Obama and Prime Minister Cameron openly threatened to manipulate crude reserves to lower the price of oil. The sense of embarrassment is gone. The leaders of two world powers meet and tell us in our faces that they contemplate manipulating the reserves of a commodity? What is going on? We, at “A View from the Trenches” take signals of repression like this one seriously.  It was only a few years ago that governments started running after people’s assets in other jurisdictions. They followed with open repression in the foreign exchange markets (Switzerland pegging the Franc, Brazil controlling capital flows). They kept on directing the lending activities of banks. They manipulate the reserves in gold. They wiped out investors in sovereign debt and this is a trend that will not weaken but strengthen. Perhaps our readers don’t, but we do see union strikes more often these days vs. in past years. How can any entrepreneur in these conditions feel encouraged to invest in increasing the productivity of his/her business? They cannot and all they are doing and will be doing is maintain what they have, refinance their liabilities longer term for cheaper rates and use every excess cash they count on to increase their dividends, as a way to cash out in a world where the price of equity, the price of risk, is anything but clear. We remember those times in Argentina when suddenly, bankrupt companies were owned by rich businessmen. One thing is to invest in dividend producing companies, with dividends driven by stable and healthy cash flows. Another thing is to invest under the illusion that those exist, when in fact the dividends are the only outlet entrepreneurs have to cash out with bank debt. We think we are witnessing the latter case but, as followers of Von Hayek, we can understand the confusion, because the price system is broken and the signals sent by prices are misleading. We need to quote the great Friederich A. Von Hayek here, on the price system:

“…The price system is just one of those formations which man has learned to use (though he is still very far from having learned to make the best use of it) after he had stumbled upon it without understanding it. Through it not only a division of labor but also a coordinated utilization of resources based upon an equally divided knowledge has become possible. Its misfortune is the double one that it is not the product of human design and that the people guided by it usually do not know why they are made to do what they do…(…)… I am convinced that if it were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind…” F.A. Von Hayek, “The Use of Knowledge in Society”, American Economic Review. XXXV, No. 4., September 1945

The actions of central banks have totally annihilated the price system, in relation to both the inter-temporal allocation of resources and the capitalization structure of economic systems. This brings us to our last title…

Title No. 3: “Remember the KreditAnstalt”

Since the debt swap of Greece’s sovereign debt, in terms of the capitalization structure of this sovereign, we understand that more than two thirds of it is in the hands of the public sector (European Central Bank, IMF, other governments) and highly collateralized. This is a point we have been thinking during last week because it painfully reminds us of the KreditAnstalt crisis of 1931. We highly recommend readers to do their own research on this topic and to reach their own conclusions. On our part, we are interested in one angle of it.

The KreditAnstalt of 1931 had been created in October of 1929, as the merger between the bankrupt Bodenkreditanstalt and the Öesterreichischekreditanstalt. However, the distressed assets of the Bodenkreditanstalt’s were too distressed to deal with. Given the Austrian regulations on capital requirements, when on May 11^th, 1931 the KreditAnstalt disclosed a 140MM Schilling loss, it immediately suffered a run on deposits. The Österreichische Nationalbank intervened, loaning 152.5MM Schillings. The Bank of International Settlements loaned an additional 100MM Schillings three days later. But by June, more funds were needed and this time….this time the Bank of International Settlements, under a request from the French, would only provide them if the Austrian government aborted a customs union with Germany, which was underway. The Austrian government did not accept the political condition and instead only received a third of the funds needed, from the Bank of England, on June 16th.

In the meantime, the Austrian government had been forced to guarantee the bank’s foreign deposits and imposed exchange controls to sustain the convertibility of the Schilling to gold. But the violence of the capital outflows was so strong that Austrialeft the gold standard on June 17^th. Unlike Greece, Austrians in 1931 did not have the 3-yr liquidity lines from Mario Draghi at the European Central Bank. These events triggered a wave of bank defaults in Eastern Europe and Germany. Gold eventually also was withdrawn from London. In July, the Federal Reserve Banks and the Bank of France saved the Bank of England with currency swaps of US$650 million and £eq.25 million, respectively. But this was not enough and Great Britain had to leave the gold standard on September 21^st. The countries that held sterling pounds as foreign reserves suffered heavy losses.

Fiat currencies were no longer to be trusted and the run on deposits was now taking place in the United States. Think of this: As Europe owed the US payment in specie and Europe had gone off the gold standard…who was the Fed going to recover the loaned money (approx. the equivalent of 465 metric tonnes of gold) back from??? We have written about this before too, in relation to the swaps extended by the Fed to the European Central Bank. If the Eurozone breaks up, who is the Fed going to recover the money from? They will not. But unlike back in 1931, the US dollar is not backed by gold and depositors are not going to run for their funds to exchange them into gold. However the Fed will need to undoubtedly print more US dollars and the devaluation, eventually, will happen anyway. The year 1931 was the year of bank failures in America. In 1932, after a bank holiday that lasted a week, the US government confiscated gold from its citizens.

The question you may have in mind now is what similarity do we see with the current situation? Well, this whole series of events was triggered because France, a public sector creditor, introduced a political condition to Austria, in exchange for a bailout of the KreditAnstalt. Today, like in 1931, in the Eurozone, the public sector is increasingly the creditor of the public sector. In 1931,England andFrance were creditors of Austria and demanded conditions that no private investor would have demanded.

Private investors live and die by their profits and losses. Politicians live and die by the votes they get. Private investors worry about the sustainability and capital structure of the borrower, the collateralization and the funding profile of their credits. Politicians worry about the sustainability of their power. It’s a fact and we must learn to live with it.

In 2012, Greece and increasingly other peripheral EU countries owe to other governments, the IMF and the European Central Bank. Private investors have been wiped out and will not return any moment soon. We fear that just like in 1931, when the next bailout is due either for Greece again or Portugal or Spain, political conditions will be demanded that no private investor in his/her right mind would ever have demanded. Think of it…What in the world had the customs union between Austria and Germany in 1931 had to do with the capitalization ratio of the KreditAnstalt??? Nothing! Yet, millions and millions of people worldwide were condemned to misery in only a matter of days as their savings evaporated! Ladies and gentlemen, welcome to the world of fiat currencies! You have been warned! If months from now you read in the papers that the EU Council irresponsibly demands strange things from a peripheral country in need of a bailout, remember the KreditAnstalt. Remember 1931…

Please, understand that this is not a tail risk. The tail risk is precisely the opposite. The real tail risk here is that when the next bailout comes due, politicians think like private investors and give priority to economic rather than political considerations. That’s the tail risk! If such a crisis occurred, the media will speak of increased correlations and tell you that everything is actually fine on this side of the Atlantic. But if you read us, you will know that all that led to such a situation was perfectly foreseeable and nothing is really fine on this side of the Atlantic either. You will have remembered 1931…

Martin Sibileau