It is a beautiful autumn day in London, unseasonably warm and sunny, the city looking its very best, and I am trying to find a hook for this blog. I should write about the European debt crisis, the sharp drop in equity markets last week after “Operation Twist” was announced, and the washout in commodity markets, not least in gold. I will cover all these topics but what should my hook be?
A good place to start is always the mainstream media, first and foremost the Financial Times, that most mainstream of mainstream organs, reliable purveyor of common wisdom, a paper written by the establishment for the establishment in the unshakable belief that for every problem there is a political solution. If this won’t shake me out of my jetlag and stomach-bug induced stupor, nothing will.
In today’s FT Martin Wolf writes again about the European debt crisis, a problem for which, so he believes, there is a political solution.
“The emergence of doubt”
Before we go to the solution, let’s specify the problem first. After the usual references to the great and powerful who met in Washington last week, the “clear, compelling, courageous” analysis by the great IMF, and quotes from Mr. Wolf’s favourite celebrity bureaucrats, Mr. Geithner and Mme Lagarde, he correctly identifies the problem: Most sovereign states are bust and so are the banks, which are today a protectorate of the state and have repaid the generosity of their protectors by lending excessively to them. Mr. Wolf is too skilled and sophisticated a writer to put it this bluntly but if you read his article that is what it boils down to:
“The emergence of doubt about the ability of sovereigns to manage their debt undermines the perceived soundness of the banks, both directly, because the latter hold much of the debt of the former, and indirectly, via the dwindling value of the sovereign insurance.”
And why are we in this mess? Because some time ago we adopted a system of limitless and constantly expanding fiat money. In such a system, the privileged money producers – no prize for guessing who they are, correct, the state and the banks – apparently never have to shrink and can conduct their financial affairs in the comforting knowledge of unlimited access to the printing press. No credit contraction, no bank failures, no sovereign defaults. Whenever the money runs out we simply lower interest rates, create more bank reserves out of nothing, and off we go again. This has worked for 40 years. Alas, no more.
The present problems, the unsustainable bank balance sheets, the out-of-control budget deficits, and the mindboggling levels of public debt, are inconceivable without a system of constant fiat money creation and extended periods of artificially low interest rates courtesy of the central banks. Or, to put it the other way round, a monetary system like ours, in which interest rates can be set administratively to encourage bank lending and to underwrite the constant growth of state and banks, must ultimately lead to a bloated public sector and a bloated banking industry. The fiat money system is feeding its own disintegration.
Bail me out again, Sam.
Mr. Wolf offers two solutions. Both are dangerously misguided, which means that both stand an excellent chance of becoming policy.
Apparently, Mr. Wolf does not want to deprive the banks and the states of their special status. They lent too much and they borrowed too much but the laws of economics, the laws of gravity and the laws of logic are still not supposed to apply to them. They should be saved again.
Wolf says the banks should be “recapitalized”.
Wait a minute. These are failed corporations. They lent billions to corrupt Greek politicians. They put their chips on red and black came. They lost.
For capitalism to work it requires that the market be cleansed of failed corporations, not that these corporations get “recapitalized”. We are simply perpetuating the bad habits of our fundamentally flawed and anti-capitalist monetary system by shielding the banking industry from its mistakes and never allowing market forces to shrink it. This is not only a mistake for reasons of “moral hazard”. That is the least of it. It is simply a fact that after a forty-year fiat money binge the banking industry is too big, it is now sized for a never-ending credit boom when we just entered the credit bust. We should not be relying for our economic future on an ever more bizarrely propped-up banking sector.
But this “solution” begs another question: who is going to pay for this? We just learnt that the state is bust, too.
Well, while he is at it, Mr. Wolf also wants to save the state. How? Via a super-sized EFSF (European Financial Stability Facility) – a mega bailout fund. Mr. Wolf joins his buddy, Tim Geithner, in recommending “shock and awe” – not that this term conjures many positive memories.
In short, more money is needed. Much more.
“Given the funding needs of banks and sovereigns, this translates into well more than EUR1,000bn, and, quite plausibly, several times that number.”
Bring your bazooka
Several trillion? – Me thinks that Mr. Wolf has been hanging out it in Washington too much. I am convinced that in the macho atmosphere of IMF and World Bank power banquets you are now looked down upon as a policy-making lightweight if you are still content with assigning only billion dollar price tags to your pathetic policy initiatives. ‘Trillion’ is the new denomination for the grown-ups in the policy elite. Hey, Europeans, if you want to be players you better add a few zeros!
But again, where does the money come from?
Want to guess?
Here is Wolf again, warming to the military theme:
“The eurozone needs a much bigger bazooka. Apparently, five different plans are under discussion. These involve leveraging up the EFSF’s money, by issuing guarantees rather than loans, or borrowing from the European Central Bank, or by borrowing in the markets. But if action needs to be immediate, as it does, the only entity able to supply the needed funds is the central bank.”
Ah, here we are. The central bank. Finally. After all the elegant prose, the bureaucracy worship and the habitual name-dropping, the bottom-line is this: turn on the printing press! Print more money! Print! Print!
This is madness, so I do think it is precisely what will happen. Mr. Wolf will get his way. Because the policy elite thinks just like he does. Default is not an option. Banks cannot be allowed to fail. States – at least if they are not called Greece for which this comes too late – cannot be allowed to fail either. We rather try and print our way out of this. Everybody gets bailed out – via the printing press.
Believe me it will not work. It will lead to complete disaster. But it will be tried.
Mr. Wolf looks at it in hope, I look at it in horror. Once this gets implemented and the market realizes what is going on, it will dump government bonds, real yields will shoot up, and confidence in state paper money will evaporate. What will the central banks do then? Print money faster as the overstretched system cannot cope with higher real yields.
So what should you do to protect yourself? – Well, I don’t want to give investment advice, so please treat this carefully – I could be wrong, so this may not work but I think it wouldn’t be unreasonable to ditch government bonds, and while you are at it, ALL bonds, and man the lifeboats, which consist of gold and silver.
But what did markets do last week? They trashed gold and silver and lifted government bonds to new heights. Does it make sense? No, it doesn’t. But here is why I think it happened.
The market was apparently disappointed with “Operation Twist”. This surprised me, and maybe surprised the Fed. I didn’t think that any more than a portfolio adjustment at the Fed was expected at this meeting. There was always a chance of QE3, or a lowering of the interest rate the Fed pays the banks on the gargantuan reserves they are presently keeping at the central bank, but in my view, most people had assigned small possibilities to these scenarios at this point in time. Maybe it was the combination of the bleak assessment of the economy by the Fed and the absence of any promise of future quantitative easing that disappointed the market so much.
Is the Fed done?
Could it be, as Russell Napier, one of the speakers at the conference I attended last week in Hong Kong, suggested, that the Fed was reaching the limits of balance sheet expansion and money printing? Had monetary policy reached the end of what could be expected of it? Would a deflationary correction, which the market had been craving for many years, a cleansing of its accumulated dislocations, finally be allowed to unfold, if not by political design, then by necessity?
The Fed’s balance sheet has reached a leverage ratio of more than 50-to-one, as Russell pointed out in Hong Kong. When Bear Stearns and Lehman Brothers went under they had ratios of 30-to-one and 40-to-one. Additionally, Bernanke is getting a lot of flak and may get tired of being called Helicopter Ben at those power banquets in Washington with Geithner, Lagarde and Martin Wolf. Could the prospect of no more cash from Ben even explain the drop in the gold price last week, and the rise of the dollar in fx markets? Does paper money get a lifeline?
No, I don’t think so. But let’s look at gold.
As my good friend, the Swiss-based bon vivant and intellectual, Tristan Geschex, said to me, there are a couple of explanations for the drop in gold:
First, while gold remains, first and foremost, eternal money and is always the monetary asset of choice when paper money dies, it is also still an industrial commodity. I suspect that only a small portion of its present market value reflects compensation for industrial use but when industrial commodities get hammered because of a weak economic outlook, that element of the gold price – even if it is a minor element – will get ‘adjusted’ as well.
Second, there are market dynamics. Gold is held alongside other assets in the diverse portfolios of hedge funds and other institutional investors. When those take a hit in some markets, they may also reduce positions in other markets, in particular those where they can still realize a profit, and investors most certainly could still take profits last week on their long gold positions. Sharp sell-offs in equity markets initiate balance-sheet reductions and traditional de-risking (i.e. returns to the paper-dollar base) at financial firms and leveraged funds. These also tend to affect gold, at least in the short term. In the second half of 2008, gold famously took a big dive, although it then rallied sharply when the market woke up to what the policy response would be.
Third, the rehabilitation of paper money as a result of the Fed’s reluctance to print more money.
This is the most serious threat to anybody who is holding gold as a monetary asset, as the ultimate self-defence in an economy characterized by weak banks, overburdened sovereigns and excessive debt loads, in which the printing press is already being used to postpone the inevitable. Is the Fed now finally becoming reluctant to print more money?
Sadly, I don’t think so. I think they should stop the printing press but I don’t think they will.
Gold wins – in inflation and deflation
There is no indication whatsoever that Bernanke and other central bankers have stopped believing in the power of monetary stimulus or in the need to avoid asset price corrections, slow-downs in money growth, or deflation. There is no sign whatsoever that they now believe that the market should finally be allowed to set interest rates, determine asset prices and cleanse the system of never-to-be-repaid debt. After all, they still consider themselves to be the Lords of Finance.
But even if that were to happen and the printing presses were finally turned off, I would still see no reason to ditch gold. Given the size of present imbalances, this would unleash a massive deflationary correction. As Mr. Wolf has so elegantly explained in his article today, this would mean banks and states would face default. The paper dollars and the paper euros in your pockets would then no longer be debased – their purchasing power would actually rise. But how much wealth can be stored in paper cash? And in such a scenario, bank deposits and government bonds would certainly become highly dangerous assets, indeed – and gold would again be an important self-defence asset, even in a deflation.
I do believe that in both an inflationary and a deflationary crisis, gold is a lifeboat. But I am not being facetious if I say that Mr. Wolf has his finger on the pulse of the establishment. What he suggests for the eurozone – saving it via the printing press – also applies to the U.S. It is the position that the global policy bureaucracy will most easily drift toward. The logic on display in that article is the logic of the policy elite.
As to Mr. Napier’s assertion that practical limits to money printing exist – I think he is wrong. For a ‘determined’ central bank, a leverage ratio of 50-to-one is no hindrance whatsoever. Look at the balance sheet of the People’s Bank of China. Its leverage ratio is 1,200-to-one, which makes it undoubtedly the most heavily geared institution on the planet. That is where we’ll be going.
That must be what Mr. Wolf calls a proper bazooka.
In the meantime, the debasement of paper money continues.