In this essay, Gary discusses how the European elite are under (economic) attack. Some points are:
Today, the entire banking system of Europe is at risk.
The PIIGS governments that wrote the IOUs to the banks in northern Europe are technically insolvent.
When Spain … [and] Italy default … the entire banking system of Europe will be busted.
In this daisy chain of fiat money, credit, and debt, the European Central Bank is the lender of last resort.
First, there is a day of reckoning in the PIIGS countries, when depositors withdraw funds. The second day of reckoning is going to be imposed by the insolvent governments who have been borrowing hundreds of billions of euros from the banks.
The politicians seem blind to the real reason for the existence of central banking, namely, to bail out the largest commercial banks under its jurisdiction.
Bank runs are the most dangerous threat to the European banking system and they have begun or are well under way in Greece and Spain.
Issue 1180 June 22, 2012
For the first time in my career, I see the
international establishment, sometimes called the New World
Order, facing a crisis so large that its very survival is
at stake. For the first time, these people are scared.
There are not many of them. In his book, “Superclass,”
author David Rothkopf estimates that there are only about
6000 people at the top of the pyramid of world power and
influence. They are mostly males, and at least a third of
them have attended America’s most prestigious universities.
Most of the others have attended comparable universities in
The crisis in Europe is clearly beyond anything that
this generation of establishment leaders has ever seen. The
last time that anything like this faced the European
establishment, it led to World War II.
During the entire postwar period, the United States
has been the dominant force in the West. The United States
government through the Marshall Plan wrote the checks to
keep the European governments afloat, and it funded most
of NATO, the mutual defense system that was set up to
constrain the expansion of the Soviet Union.
The United States is no longer in a position to bail
out anybody. It is running a massive trade deficit, and is
running a massive federal deficit. Europe realizes now
that, from an economic standpoint, it is on its own. If
there are solutions to the European economic crisis, these
solutions are going to have to be generated inside the
BANKS AT RISK
Today, the entire banking system of Europe is at risk.
The banks are highly leveraged, and they have made enormous investments at low-interest rates in bonds issued by
governments that are technically insolvent. There is no
possibility that any of these bonds will ever be repaid.
They were never designed to be repaid. They were designed
to keep the taxpayers of all European countries in
permanent bondage to the banking system.
Now, in a complete reversal of fortune, the banks are
increasingly dependent on the governments. The governments
are now the lenders of next-to-last resort to the commercial banks. The central bank, of course, is the lender of last resort. But today, the European Central Bank has moved into neutral. It does not want to take action to bail out Greece, Spain, or Italy.
The PIIGS governments that wrote the IOUs to the banks
in northern Europe are technically insolvent. When Greece
defaults, which it will, there will be enormous losses
sustained by some northern European banks. When Spain
defaults, which it will, these losses will get far worse.
When Italy defaults, which it will, the entire banking
system of Europe will be busted.
The only things that can save the European banking system
today are the European Central Bank, which has the power to
create money out of nothing, and the taxpayers of Germany,
whose national leaders are relentless in their desire to
expand the power of the eurozone over all of Europe. These
politicians are willing to write IOUs on behalf of German
taxpayers in order to extend this consolidation.
A DAISY CHAIN OF DEBT
The problem is, the Northern European governments do
not have any money to serve as lenders to Greece, Spain, or
Italy. They are borrowing money at rates not seen before in
peacetime Europe. These governments are expected to
intervene and lend money to the Greek government. But every
northern European government is now faced with the
additional responsibility of being the lender of next-to-last resort to the large commercial banks inside its own borders.
Who is going to lend northern European governments
enough money to bail out southern European governments?
Which lenders think this is a good idea today? At today’s
rate of interest, not that many. That is why interest rates
are going to rise. But when long-term interest rates rise,
that will lower the present market value of all of the
bonds in the portfolios of the lenders.
So, on the one hand, investors have to pony up the
money to lend to the governments, and the governments need
the money to recapitalize the banks in their own borders.
This leads to the next problem: in order for the lenders to
lend money to a government, they have to write checks on
their bank accounts. What happens if their banks should go
under? Who will lend money to the governments?
In this daisy chain of fiat money, credit, and debt,
the European Central Bank is the lender of last resort. It
is the lender of last resort because it has the legal
authority to create money out of nothing. It can buy IOUs
issued by governments, and it can lend money to banks, so
that the banks can buy the IOUs of governments.
DAYS OF RECKONING
The entire political system that we know as the
European Union is dependent upon a system of fractional
reserve banking which has overextended itself, and now
faces a day of reckoning. Actually, it faces two days of
First, there is a day of reckoning in the PIIGS countries, when depositors withdraw funds. The second day of reckoning is going to be imposed by the insolvent governments who have been borrowing hundreds of billions of euros from the banks.
The arrival of a bank run threatens the ability of the
Greek government to borrow money from anybody. The Greek
government is dependent upon the Greek banking system to
collect taxes. If the Greek banking system goes belly-up,
the Greek government goes belly-up.
In this system, only the European Central Bank has the
authority to bail out the system. Every other potential
source of euros is dependent on the solvency of the
European banking system. But that is exactly what is at
This is why all fractional reserve banking must ultimately rest on the monopoly granted by government to a central bank. The central bank, above all, is the guarantor of the solvency of the largest banks. The central bank is the economic agent of the owners of the largest commercial banks. These owners are now facing bankruptcy. They hold shares in multinational banks whose lending officers had no understanding of basic economics. They wrote checks to the PIIGS.
In this scenario, the only way to save the system is
to risk destroying it. The only way to save the euro is to
risk destroying it. This is because there are only two ways
to save the largest commercial banks. The first way is by
hyperinflation. This will enable the banks to keep their
doors open, but the borrowers will be able to pay off their
loans by selling a handful of hard assets, which will raise
enough money to pay off the loans with worthless euros.
The second way to save the banks, which is what the
European Central Bank is attempting to do, is to avoid
hyperinflation, and to inflate the money supply only to the
degree that the largest banks can be bailed out by making
low-interest loans available to them. They in turn must
lend out the money, if they can find solvent borrowers, and
if those borrowers are willing to borrow.
If the European Central Bank adopts the second
approach, this is going to lead to a depression. The bank
has inflated. The commercial banks have lent money to
insolvent governments. These governments are going to
default if there is a recession, but by refusing to expand
the money supply, the European Central Bank will produce a
recession. The boom that it fostered in the Greenspan years
has blown up on European banks, in the same way that the
boom in the United States has blown up on America’s banks.
There is no equivalent of the FDIC in the European
banking system. There is no single government that has the
assets or the legal authority to lend to any and all of the
other governments. There is no common fiscal system, which
means that all the governments can run massive deficits.
This means that the governments are in constant competition
with each other to borrow enough money to fund their deficits.
So, the system is stretched to the limits. The few
remaining lenders with capital who have enough money in
their banks to write checks to insolvent governments are
now refusing to write the checks. This is why Spain is
paying over 7% to get lenders to fork over their money.
Lenders who do this are going to wind up like the saps who
loaned money to the Greek government prior to 2010. They
are going to see the value of their investments collapse as
interest rates go to double digits in Spain, which they are
going to do unless the European Central Bank intervenes and
makes fiat money loans to Spain’s government.
There is now at least one monthly emergency weekend
meeting of the political authorities, accompanied by their
bureaucrats from the ministries of finance. They come
together on a Saturday to talk about how they can save the
system. They issue a press release on Sunday. The press
release is always short on specifics. Within a month, the
crisis has escalated again, and there is another weekend
Every time there is a summit meeting, the investing
public that has sufficient money to invest waits with bated
breath to see if there is some solution offered on Sunday
afternoon. There never is a solution offered, so the stock
market drops for the first day or two after the meeting.
It is clear by now to everybody that there is no solution forthcoming. There is no agreement politically, especially between Germany and France, as to who is going to write the checks to bail out the next PIIGS government to hit the brick wall.
I can remember almost 40 years ago listening to a
speech by a young hotshot economist at Yale, who informed
us that there would be a new currency system established in
Europe by the year 2000. This was an accurate forecast. It
was established in 1999. The hotshot later moved to
Harvard. He has generally disappeared from public view. But
it was clear from his enthusiastic speech that he was
convinced that this new currency system would create a
completely new economic order in Europe. Boy, was he right!
The new economic order in Europe is now disintegrating. The establishment politicians, bureaucrats, and spokesman are looking in horror as the system which their predecessors designed to work permanently is disintegrating. Not to put too fine a point to it, but this is reminiscent of Adolf Hitler’s promise about the thousand-year Reich. It lasted 13 years.
This year, the euro had its 13th birthday. So far, it has not had a happy birthday.
The leaders of European establishment have never had
to deal with any crisis on a scale like this one. They keep
talking of the need for firewalls. Until they have firewalls, nobody is willing to yell “Fire!” Yet the fire is now raging.
What kind of firewall can be created that keeps a
default by one government from becoming a default by
another government? What firewall is there for a large
multinational bank that has just lost half of the value of
the bonds that it purchased at a rate of 3%, now that the
interest rate is 7%? Every time the interest rate doubles,
the market value of the bonds decreases by 50%, minimum.
There is no firewall. The financial system of Europe
is interrelated by way of the euro. Everybody uses the same
currency in 17 countries. Everybody is dependent upon the
same central bank, and that bank is not exercising
leadership. The head of the bank keeps saying that the
governments have to step up to the plate and take
responsibility. Every time he says this, I am reminded of
what Ben Bernanke keeps telling Congress.
The heads of the two largest central banks in the
world keep complaining that the politicians have got to
take responsibility for solving the crisis. But this is
exactly what the politicians do not want to do. The
politicians have always understood that the central bank
would bail them out of their crisis, merely by creating new
money and buying the IOUs of the government. This has
always been the public justification of central banking.
The politicians seem blind to the real reason for the
existence of central banking, namely, to bail out the
largest commercial banks under its jurisdiction. The
European Central Bank faces an enormous problem: it has
under its jurisdiction the largest banks in every country
in the eurozone, other than Great Britain. It has to
intervene to save any large bank that is under its
jurisdiction, because if it does not, there will be bank
runs in that nation.
A BANK RUN
Depositors can go down to their banks and have money
transferred to a bank outside the country. Usually, this is
going to be a German bank. Legally, the recipient bank can
refuse to take a deposit, but what bank would dare not to
take deposits? Any bank that would say that it was not
taking deposits from any other bank would be sending a
signal to the media that the other bank is bordering on
insolvency. That is the last thing that any bank in
northern Europe wants to do with respect to any bank in
Greece, Spain, or Italy.
The European Central Bank is sitting on a powder keg.
The fuse has already been lit. That fuse is connected to
the Greek banking system. If the Greek banking system blows
up, by which I mean implodes, that will light another fuse.
The other fuse leads to Spain. I could be wrong. There may
be two fuses, one leading to Spain, and the other leading
There is no firewall. The only firewall would be for
banks in northern Europe to refuse to take new accounts
from people who were closing out there accounts in southern
Europe. But if they do not stop the bank runs from taking
place in Greece, the Greek government is going to default
on its debt and pull out of the eurozone. It will have no
choice. If its banks are collapsing, how will it be able to
fund its debt? How will it be able to collect taxes?
You can see what is at stake here. A small-scale bank
run has been going on for at least a year in Greece, and it
is now threatening to escalate into a full-scale run.
Northern European banks could refuse to take new deposits
in euros from existing depositors in Greece. But they would
all have to do this at once. If only one or two major banks
in northern Europe refuse to accept new accounts from
Greeks, this will send a message to all the other Greeks:
“You had better get your money out of your bank, fast, and
get it into a northern European bank that has not yet
closed off new deposits.” The bank run escalates.
Because not all of the banks are under the same
banking laws, and because no regulatory agency can tell
them what to do, Europe has a system in which depositors in
PIIGS nations can create massive bank runs against the
banks in their own nations.
There is no firewall against this. The bank runs have
begun in Greece. Banks outside of the eurozone can refuse
to take on new deposits, but banks inside the eurozone
cannot do this without threatening the survival of the
entire banking system. Furthermore, if they do not create a
firewall, the collapsed banks of Greece, Spain, and Italy
will lead to the bankruptcy of their respective governments, and that in turn will lead to massive losses in northern European banks.
You do not see a detailed discussion of this in the
mainstream press, for very good reason: the mainstream
press is afraid of being blamed for triggering a bank run
out of Greek banks. Everybody in authority knows a Greek
bank run has begun, but this is not front page news. It is
certainly not a story on the evening television news shows.
Maybe “The PBS News Hour” will bring in two or three
experts to discuss it, who will offer rival views, but the
network news will not talk about the Greek bank run until
it is in its terminal stage.
So, the people who run the new European order sit
there, helpless, completely dependent upon decisions made
by depositors in Greek banks. At any time, a wave of fear
could spread through Greece, and a majority of depositors
will start lining up to get their money.
If they take out their money in currency, this collapses the local bank, which has to sell assets to buy the currency from the European Central Bank in order to hand the currency to the depositor. That kind of bank run is bad for a single bank, but usually depositors spend the money. When a depositor spends the money, the business that receives the money redeposits the money in its bank. So, a bank run into currency is not a huge threat to the Greek banking system as a whole.
In contrast, however, is a bank run in the form of the
transfer of digital money out of the country. All of the
Greek banks are facing this threat today. Once the euros
leave the Greek banking system, they are not redeposited in
the Greek banking system.
What we are seeing is the collapse of the Greek banking system. Unless the European Central Bank intervenes
again, by the end of the year, there is not going to be a
Greek banking system. All of the banks will be busted.
There is nothing that the Eurocrats can do about this.
The only agency that has the power to stop this is the
European Central Bank, which can do whatever it wants to
do, ultimately, which means lending money to Greek banks
based on any collateral they want to put up, especially
IOUs issued by the Greek government.
Angela Merkel can scream, yell, and hold her breath
until she turns blue, but ultimately she has no power over
the European Central Bank. Ultimately, no politician has
any power over it. No politician really wants power over
it. Why not? Because that politician would then be
responsible for coming up with the money that the European
Central Bank was about to come up with, but which was
stymied by the politician.
This is why the European Central Bank is going to
inflate, inflate, and inflate. The head of the bank can
make all the comments he wants about the responsibility of
politicians to intervene to keep the structure going, but
he is ultimately the bagman of the system. He is the guy
who has control over the printing press. He is the only
person, along with his colleagues, who is in a position to
keep the system afloat.
There is no firewall. There is only the ability of the
European Central Bank to create money, and to do so by
lending it to commercial banks or directly to governments.
It does not matter what kind of rules and regulations are
in place that were supposed to prohibit this back in 1999.
In the midst of a conflagration, nobody in power is
going to point a finger at the European Central Bank when
the bank intervenes to bail out a government that is about
to default on its debt. The reason is clear, or at least is
clear to me: no politician wants to be responsible for
coming up with the money to bail out the largest banks in
his country, all of which will be threatened with insolvency because of the default of Greece and Spain, because that will produce a domino effect by all of the PIIGS governments.
The global economy is now addicted to debt. Once debt stops expanding, the economy shrivels. But expanding dent forever is unsustainable. Welcome to the endgame.
Regardless of whether you call it debt saturation or diminishing return on new debt, the notion that taking on more debt will magically enable us to "grow our way out of debt" is not supported by data. Correspondent David P. recently shared this chart of Total Credit Market Debt Owed and GDP and this explanation:
The purpose of this chart is to examine the relationship of total debt to GDP. Since Debt is not factored into GDP, just exactly how much debt is being used to create growth, and over what time periods. But absolute numbers don't work so well, since they don't let you examine particular years, seeing what the 1950s look like vs the 2000s, for example.
Red Line: Annual Change in TCMDO (Total Credit Market Debt Owed) * 100/ That year's total GDP, showing that year's % increase in TCMDO/GDP.
Blue line: % change in GDP over last year.
Any gap between the red line and the blue line is what I would call the creation of debt in excess of income. And that gap is the ANNUAL gap, not a cumulative gap. As an example, in 2008 TCMDO grew by an average of 30% of that year's GDP, while GDP itself grew by around 5%. Ouch.
So projecting forward, how much debt growth do you think we'd need to get back to business as usual? 50s was 8%, 60s about 12%, 70s 15%, 80s maybe 20%, 90s back down to 15%, and 00s probably 25-30% per year. We'd probably need a surge of 35% or more, per year, to bring back those exciting bubble years. But who could possibly have the income to support that? To quote the parable of the Little Red Hen: "Not I", said the goose.
Thank you, David. Note what happened to GDP the moment debt ceased expanding in 2008: it tanked. This is the chart of debt addiction: the moment the expansion of debt is withdrawn, the economy implodes.
Here is a chart which shows debt has outrun income for decades:
Debt can be expanded at a rate that exceeds the rise in real income in only one way: by lowering interest rates so the same income can support a larger debt.
This is of course the reason the Federal Reserve has lowered interest rates to near-zero with the ZIRP (zero-interest rate policy).
Eventually the buyers of newly issued debt at near-zero (or even negative) yields start to fear they will never get their capital back or they will be paid back in depreciated currency, and so they demand a higher yield. Since income has already been stretched to the limit to support a towering mountain of debt, this rise in yield catapults the borrower into insolvency.
That is Greece, Spain, Italy, and eventually, the entire debt-dependent global Status Quo.
A sound system of credit is built on collateral. A doomed system of debt sits precariously on phantom collateral.
The global "recovery" is based not on reducing debt but on increasing it. Nice, but where's the collateral? The basic idea of debt is that credit is extended based on collateral, i.e. something of enduring, tradable value, or an income stream that isn't reduced to zero by non-discretionary spending and taxes.
Despite the stock market doubling since 2009 and a healthy run-up in the value of bonds, financial assets shrank by $2 trillion as well.
These are non-trivial sums when we consider that collateral is generally leveraged. If a home buyer puts down 20% cash, then that cash collateral is leveraged 4-to-1 in an 80% mortgage. If the buyer puts down 3% (as in an FHA loan), then the leverage is over 30-to-1.
Collateral matters when it comes to assessing the value of the debt. If a bank lists the mortgages in its "assets" column at full value even though the underlying collateral (the houses) has lost much of their value, then the bank is grossly over-estimating the value and security of the mortgage. The bank's "assets" are based on phantom collateral.
Take away $1 in collateral and you impair $4, $10, $20 or even $30 of debt.
Recall that the vast majority of real estate equity and financial wealth is owned by the top 20%, with the majority of that concentrated in the top 5%. That means the bottom 80% own little collateral to leverage into debt.
How about leveraging income into more debt? Since the top 10% receive almost 50% of the income, and most of the bottom 90%'s income goes to non-discretionary spending and taxes, then only the top 10% have discretionary income that can be leveraged into more debt.
Interestingly, The Wedge between Productivity and Wages by economist Mark Thoma reports that the enormous advances in productivity over the past few decades did not translate into higher wages for the bottom 90%.
I have often addressed income disparity and the evaporation of collateral, for example, Two Americas: The Gap Between the Top 5% and the Bottom 95% Widens (August 18, 2010) and The Housing Bubble Broke the Middle Class (April 27, 2011).
Regardless of the various causal factors, the fact remains that 90% of American households have limited collateral or discretionary income to leverage into more debt. That leaves around 10 million households (the top 10%) with the means to take on more debt--if they want to. Can 10% of the households prop up the entire economy with more debt and consumption? What if the wealthy decline the opportunity to leverage more debt?
We can also ask "where's the collateral?" of the banking sector. As frequent contributor Harun I. observed about the European banking sector's phantom collateral:
European banks do not have enough money for deposit redemptions (people withdrawing their cash from the banks) and the only way to get it is to have the European Central Bank (ECB) print money out of thin air thereby devaluing every euro, thereby destroying purchasing power (you get your money but it buys less).
And what collateral are the banks providing for these loans? The sovereign debt of countries that are insolvent. Why not sell the bonds to raise the capital that is rightfully owed to depositors so that they could receive their money at par? Why then bond prices would tumble and governments would be forced to borrow at much higher interest rates. But borrow from whom? Insolvent banks that must have money printed to give depositors their money back at a fraction of its worth from when they deposited it. Not due to market forces which indicate their labor is worth less but because everybody just wants what's rightfully theirs.
So to summarize this, the ECB prints money to buy the bonds of insolvent banks which are backed by the bonds of insolvent nations. The result of which is insolvent nations or in reality the people thereof are not only poorer, they are now responsible for paying back money that was their property to begin with... at interest.
Put these two factors together and you get a global economy dependent on debt borrowed against phantom collateral and an American economy in which only the top 10% have credible collateral and income to leverage into more debt.
In a sane system, when the collateral vanishes, so too does the debt (writedowns, write-offs, bankruptcy, take your pick). In an insane system, then phantom collateral supports ever greater mountains of debt.
How long do you reckon the insane system we have now will last? The collateral is phantom, but the interest payments are very, very real.
And now a little something for everyone who consistently has a nagging feeling that at any second the world is one short flap of a butterfly's wings away from complete systemic disintegration: according to David Korowicz of FEASTA, and his most recent paper: 'Trade-Off: Financial System Supply-Chain Cross-Contagion: a study in global systemic collapse." that just may be the case.
Without further ado, we hand over the mic to the author:
This study considers the relationship between a global systemic banking, monetary and solvency crisis and its implications for the real-time flow of goods and services in the globalized economy. It outlines how contagion in the financial system could set off semi-autonomous contagion in supplychains globally, even where buyers and sellers are linked by solvency, sound money and bank intermediation. The cross-contagion between the financial system and trade/production networks is mutually reinforcing.
It is argued that in order to understand systemic risk in the globalized economy, account must be taken of how growing complexity (interconnectedness, interdependence and the speed of processes), the de-localization of production and concentration within key pillars of the globalized economy have magnified global vulnerability and opened up the possibility of a rapid and large-scale collapse. ‘Collapse’ in this sense means the irreversible loss of socio-economic complexity which fundamentally transforms the nature of the economy. These crucial issues have not been recognized by policy-makers nor are they reflected in economic thinking or modelling.
As the globalized economy has become more complex and ever faster (for example, Just-in-Time logistics), the ability of the real economy to pick up and globally transmit supply-chain failure, and then contagion, has become greater and potentially more devastating in its impacts. In a more complex and interdependent economy, fewer failures are required to transmit cascading failure through socio-economic systems. In addition, we have normalised massive increases in the complex conditionality that underpins modern societies and our welfare. Thus we have problems seeing, never mind planning for such eventualities, while the risk of them occurring has increased significantly. The most powerful primary cause of such an event would be a large-scale financial shock initially centering on some of the most complex and trade central parts of the globalised economy.
The argument that a large-scale and globalised financial-banking-monetary crisis is likely arises from two sources. Firstly, from the outcome and management of credit over-expansion and global imbalances and the growing stresses in the Eurozone and global banking system. Secondly, from the manifest risk that we are at a peak in global oil production, and that affordable, real-time production will begin to decline in the next few years. In the latter case, the credit backing of fractional reserve banks, monetary systems and financial assets are fundamentally incompatible with energy constraints. It is argued that in the coming years there are multiple routes to a large scale breakdown in the global financial system, comprising systemic banking collapses, monetary system failure, credit and financial asset vaporization. This breakdown, however and whenever it comes, is likely to be fast and disorderly and could overwhelm society’s ability to respond.
We consider one scenario to give a practical dimension to understanding supply-chain contagion: a break-up of the Euro and an intertwined systemic banking crisis. Simple argument and modelling will point to the likelihood of a food security crisis within days in the directly affected countries and an initially exponential spread of production failures across the world beginning within a week. This will reinforce and spread financial system contagion. It is also argued that the longer the crisis goes on, the greater the likelihood of its irreversibility. This could be in as little as three weeks. This study draws upon simple ideas drawn from ecology, systems dynamics, and the study of complex networks to frame the discussion of the globalised economy. Real-life events such as United Kingdom fuel blockades (2000) and the Japanese Tsunami (2011) are used to shed light on modern trade vulnerability.
Think of the attached 78-page paper as Nassim Taleb meets Edward Lorenz meets Malcom Gladwell meets Arthur Tansley meets Herman Muller meets Werner Heisenberg meets Hyman Minsky meets William Butler Yeats, and the resultant group spends all night drinking absinthe and smoking opium, while engaging in illegal debauchery in the 5th sub-basement of the Moulin Rouge circa 1890.
The final product is frightfully spot on and should be read by every person even remotely close to setting policy (which is why it won't be).
Another rather notable excerpt dealing with financial system supply-chain cross contagion:
Something sets off an interrelated Eurozone crisis and banking crisis, a Spanish default say, which spreads panic and fear across other vulnerable Eurozone countries. This sets off a Minsky moment when overleveraged speculators in the banking and shadow banking system are forced to unwind positions into a one-sided (sellers only) market. The financial system contagion passes a tipping point where governments and central banks start to lose control and panic drives a (positive feedback) deepening and widening of the impact globally. In our tropic model of the globalised economy, the banking and monetary system keystone hub comes out of its equilibrium range, crosses a tipping point, and is driven away by positive feedbacks to some new state.
This directly links to another keystone-hub, production flows. Failing banks, fears of currency re-issue, fears of further default, collapse in Letters of Credit, and growing panic directly quickly shut down trade in the most affected countries. As the week progresses factories close, communications are impaired, social stress and government panic increases. After a week almost all businesses are closed, there is a rising risk to critical infrastructure.
Almost immediately internal trade and imports stops in the most affected countries, and there is impairment in a growing number of other countries. Trade is impaired globally via a credit crunch. This undermines exports from some of the most trade-central countries, with some of the most efficient JIT dependencies in the world. This cuts inputs into the production and trade into countries that were initially weakly affected by direct financial contagion. Globally, the spread of trade contagion depends on complexity, centrality, and inventory times and once a critical threshold is passed spreads exponentially until the effect is damped by a large-scale global production collapse (implying another keystone-hub, economies of scale is driven out of equilibrium).
Trade contagion and its implications feed back into financial system contagion, helping drive further disintegration. The interacting and mutually destabilising effects of keystone-hubs coming out of equilibrium destroy the equilibrium of the globalised economy initiating a systemic collapse.
Growing risk displacement in an increasingly vulnerable system is increasing the risk of system failure. Once the financial system contagion crosses a particular threshold the de-stabilisation of the globalised economy will be exceedingly difficult to arrest; this point may be in as little as ten days. Once a major system collapse occurs, scale, hysteresis, entropy, loss of critical functions, recursion failure, and resource diversion is likely to ensure that the features associated with the previous dynamic state of the globalised economy can never be recovered.
The above explains why the central planners of this world, all of them well-aware of the implications of what has just been said, will literally fight to the death to prevent the global system from reacquire its balanced natural state, which for 30 years they have been pushing further and further away from in other to perpetuate as long as possible, an unstable status quo, which has benefited a disproprtionately smaller number of systemic participants, and has lead the system far beyond its tipping point level. Sadly, the system will eventually regain balance: that is what nature dictates. When it does, a politically correct way of saying what happens it that "the previous dynamic state of the globalised economy can never be recovered" while a less PC framing would be "all hell will break loose."
The author continues:
We have outlined how the risk of a major shock arising from decades of credit expansion and imbalances is growing. We have also seen that we could expect a similar shock from the effects of peak oil on the economy. What unifies both is a catastrophic collapse arising from a loss of confidence in debt, and the solvency of banks and governments. What would be unique is the scale of the shock and its ability to strike at the heart of the world’s financial system. But the implications are not just within the financial and monetary system. They would immediately affect the trade in real goods and services. As our economies have become more complex, de-localised and high speed, the implications on supply-chains could be rapid and devastating.
There are three general points that are worth noting. Together they point to the likelihood that the crisis whenever it comes can be expected to be very large and society unprepared.
The first is temporal paralysis:
As financial and monetary systems become more unstable, the risks associated with doing anything significant to change or alter the course increase (see also the discussion of lock-in in the final section). In addition, the diversity of national actors, public opinion, institutional players and perceptions works against a coherent consensus on action. Therefore the temptation is to displace immediate risk by taking the minimal action to avert an imminent crisis. This increases systemic risk. Some steps in the evolving crisis might be handled, for example, a Greek default. However, each new iteration of the crisis is likely to be bigger and more complex than the one before, while the system is becomes ever less resilient.
A second issue is what might be called the reflexivity trap:
The actions taken to prevent a crisis, or preparations for dealing with the aftermath of a crisis, may help precipitate the crisis. Therefore to avoid precipitation, the preparation has to be low key and below the radar of the public and markets. This limits the extent and scope of preparation, increasing the risk of a chaotic and slow response.
The final point is about black swans & brittle systems:
The growing stress in our very complex globalised economy means it is much less resilient, see the discussion in section 3.1 and figure 2. Thus a small shock or an unpredictable event could set in train a chain of events that could push the globalised economy over a tipping point, and into a process of negative feedback and collapse.
One cannot predict how such a financial and monetary collapse will occur, or when. However, in this section we are considering a scenario, ideally one that in the light of what we know of the economic conditions sketched earlier seems at least reasonable. This scenario should be considered a warning, but also a more general guide to how supply-chain cross contagion might operate in any financial/ monetary collapse.
Everyone who is curious how the European endgame will (not may) plays out (especially all the bureaucrats at the ECB and the Bundesbank) should read what ensues. Because it is not pretty. Here is a snapshot:
Globally, monetary systems would become increasingly opaque. A lack of money, operational banks, currency re-issue, inflation and hyper-inflation expectations would become a reality in many advanced economies in and outside the Eurozone. Debt deflation would in its formal sense start to die-nobody would (even if they could) pay down debt, nor would there be any credit. Production would be increasingly shut down, while complex societies got a rapid lesson on the extent of system dependency.
The perception of continued socio-economic disintegration would alter behavioural responses such as trust radii and social discount rate.
Finally, financial system supply-chain cross-contagion is a re-enforcing negative feedback driving the globalised economy away from its stable state and into a new collapse one.
Granted the above is dubbed a worst-case outcome, but one which is inevitable unless authorities admit that it is a distinct possibility and actively prepare a contingency plan, which however in itself is somewhat self-defeating because as the Eurozone crisis has demonstrated the mere admission of reality is enough to propagate the system into a whole new level of unsustainability, and so on until the system crosses a final threshold beyond which there is no salvageability. The author himself acknowledges this:
We do not like to think of ourselves as potentially irrational herd animals (that will be the Jones’s). We seek narrative frameworks that purport to explain our good fortune, ideally in ways that flatter. Reinhardt and Rogoff called it the This Time It's Different syndrome as each age sought to deflect warnings by arguing we're smarter now, better organised, or living in a different world. Just as the sellers of an overpriced home will convince themselves that it was their interior decorating skills not an inflating bubble that got them the good deal.
Of course warnings may keep coming, and almost by definition, from the fringes. When assessing risks that challenge consensus, people are more likely to defer to authority, which generally sees itself as the representative of the consensus. Furthermore, as a species with strong attachments to group affirmation, being wrong in a consensus is often a safer option than being right but facing social shaming, or especially if found to be wrong later.
Far better to say: “Look, don't blame me, nobody saw this coming, even the experts got it wrong!”
But even if we can appreciate a warning, the inertia of the status quo generally ensures acting on such warnings is difficult. In general we chose the easiest path in the short-term, and the easiest path is the one we are familiar and adaptive with. We would rather put off a hard and high consequence decision now, even if it meant much higher consequences some time in the future. However, if each step on the path of least resistance is a step further from where we ideally should be, the risks associated with doing anything rise as the divergence is so much wider. Eventually one's bluff may be called, but not yet, and hopefully on somebody else’s watch.
The consensus can often be correct and the marginal voices may be deluded. The point for the risk manager is to try and step through cognitive and social blind-spots by first recognising them. This is particularly true if the risks (probability times impact) considered are very high.
Unfortunately, it is very clear that we have learned almost nothing general about risk management as a societal practice arising from the financial crisis. We have merely adopted a new consensus, with a questionable acknowledgement that we will not let this type of crisis happen again. However, the argument in this following report is that we are facing growing real-time, severe, civilisation transforming risks without any risk management.
Which brings us to the conclusion:
We are locked into an unimaginably complex predicament and a system of dependency whose future seems at growing risk. To avoid catastrophe we must prepare for failure.
We are entering a time of great challenge and uncertainty, when the systems, ideas and stories that framed our lives in one world are torn apart, but before new stories and dependencies have had time to evolve. Our challenge is to let go, and go forth.
Our immediate concern is crisis and shock planning. It should now be clear that this is far more extensive than merely focussing on the financial system. It includes how we might move forward if a reversion to current conditions proves impossible. That is we also need transition planning and preparation. Even while subject to lock-in and the reflexivity trap, this will be most effective if it works from bottom-up as well as top-down.
Finally, neither wealth nor geography is a protection. Our evolved co-dependencies mean that we are all in this together.
Everyone who wishes to know what will happen unless everyone is aware of what may happen, should read the attached paper.
Trade-Off: Financial System Supply-Chain Cross-Contagion: a study in global systemic collapse (pdf)
Macroeconomic issues currently playing out in Europe, Asia and the United Sates may be linked by the same dynamic: over-leveraged banking systems concerned about repayment from public- and private- sector borrowers, and the implication curtailment or non-payment would have on their balance sheets. Global banks are linked or segregated by the currencies in which they lend. Given the currencies in which their loan assets are denominated, market handicapping of the timing of relative bank vulnerability is directly impacting the relative value of currencies in the foreign exchange market, which makes it appear that the US dollar (and economy?) is, as Pimco notes, “the cleanest dirty shirt”. Is there a clean shirt anywhere – creased, pressed and folded? We think so, but first some preliminary points:
• The current macroeconomic landscape presents strong evidence of a global balance sheet-centric malaise brought about by the end of an almost 40-year global credit cycle. Both creditors and debtors are starved of base money (currency in circulation and bank reserves held at central banks) with which to service debt. The end of this cycle is characterized by issues not present within more typical “economic cycles” that commonly define recessions.
• Conventional monetary and fiscal policy responses seeking higher growth and more efficient spending cannot work. The current perceived “debt crisis” across developed economies is by extension a global currency crisis for which there are two potential policy responses:
1) debt monetization – more currency is created by monetary authorities to purchase outstanding debt, and
2) asset monetization – monetary authorities create new currency to buy assets instead. Both debt and asset monetization requires currency creation (inflation), which leads to rising prices.
• The modern process of creating currency is to lend it into existence by issuing debt. First, global treasury ministries increase their borrowings. Second, primary dealer banks or central banks buy their debt directly and pay for it with newly-created electronic “credit credit” or “base money” respectively. Base money is currency in circulation plus bank reserves held at the central bank. In a fiat currency system, base money may be created only by central banks. It serves as “reserves” against which credit money is issued by private banks.
• “Credit money” is created in the banking system and is all money in existence that is not base money. It is unreserved electronic accounting entries used by the public in exchange for labor, goods, services, and assets. Credit money is conjured through the process of fractional reserve banking wherein banks issue loans that are literally unreserved by base money. Banks do this by simultaneously making loans (treated as assets on their balance sheets) and deposits (treated as liabilities). As it works through the system, credit money funds commerce, wages, consumption, investment and, circuitously, the majority of bank deposits. So, credit money is unreserved currency ultimately dependent upon the central bank to literally monetize it as base money so that it may settle – not just roll – actual debts. (The central bank must also provide the interest/rent that debtors owe the banks for the “service” of creating the credit money.)
• The difference between “credit money” and “credit” is that credit money is commonly yet erroneously perceived by the public as fully-reserved money that can be used in commercial exchange without cost. Credit, per se, can either be reserved (non-bank to non-bank) or unreserved (bank to non-bank borrower). It is explicit lending at a higher rate of interest than available to bank depositors with the explicit agreement that the obligation will be repaid. While credit money earns interest when lent, including to banks that borrow it (deposits), explicit users of credit (debtors) must pay higher rates, thereby giving banks a positive net interest margin.
(Banks literally create the credit money collateralizing the credit they extend.)
The ultimate obligation for all debt repayments within the current global monetary system, whether conjured initially through credit money or outright credit creation, falls to central banks that enjoy monopoly franchises to issue base money. Base money comprises only about 13.5% of total bank deposits (about 8.5% in bank reserves and about 5% in circulated currency). So, the vast majority of global bank deposits are comprised of credit money, meaning the current global monetary system is unreserved by a factor of over seven times. (For example, US bank deposits held domestically and abroad total almost $20 trillion while base money is about $2.7 trillion.) The gap separating credit money deposits from base money defines systemic leverage. Outright credit held by the public is fully-collateralized by private sector assets or future wages.
The global commercial marketplace, comprised of significantly leveraged banking systems and an indebted (but not necessarily over-leveraged) public, is currently pressuring monetary authorities to de-leverage credit money by creating more base money.
Systemic deleveraging can occur either through:
1) credit deterioration and debt write-downs, or
2) base money creation. Base money creation is far less socially disruptive and more politically expedient, and thus we believe base money inflation is highly likely to continue.
And to set up the blockbuster movie about to hit theaters near you...
• As we are seeing, the dominant determinant of economic and asset performance at the end of a long credit cycle is the nature, speed and extent of necessary systemic deleveraging. Within this context, the pursuit of risk-adjusted relative performance of financial assets no longer seems a credible (certainly not complete) investment objective. Rather, we believe investors should explore the pursuit of properly defined real (inflation-adjusted) returns.
• Contrary to popular perception, over the last forty years financial asset returns have not kept pace with the general price level or have only marginally exceeded price inflation. The likely need for even more money stock inflation, including base money and credit money (unreserved electronic deposits posing as base money), suggests significant future price inflation.
• We believe the purchasing power of currency in which financial assets are denominated will continue to decline more than most nominal financial asset prices will increase (certainly the case for fixed-rate bonds). In a highly inflationary or hyper-inflationary environment, simply maintaining purchasing power would appear as substantial nominal investment performance.
• Zero-bound sovereign interest rates suggest that the generally accepted perceptions of safety and risk are currently diametrically reversed when considered in real terms. We believe prudent asset allocators today should consider increased allocations in:
a. “treasure” (unlevered non-financial investments and irreplaceable property)
b. unlevered and/or term-funded scarce resources with inelastic demand properties
c. unlevered and/or term-funded productive businesses providing goods or services with inelastic demand properties (pricing power regardless of nominal prices)
The following movie trailer focuses on treasure – the most optimal risk-adjusted allocation in the pursuit of positive real returns. Warning: the following trailer is rated “GIV” for graphic inflationary violence.
Time for Treasure (The Trailer)
Dramatic Voice Over:
In a world where time series stand still...and real purchasing power value has no meaning...a few monetary bodies stand between you and economic death and destruction...between commercial hope and financial despair...between risk-free returns and return-free risk.
Concept: Like a Hollywood fantasy, confidence in the integrity of Treasury yields – the benchmark annual return against which the value of all global assets is ultimately judged – relies on the suspension of disbelief. As we have argued, significant past and current systemic credit issuance must be followed by significant monetary base inflation, which in turn must lead to significant goods and services price inflation. Why then do ten-year US Treasury notes currently offer negative real (inflation-adjusted) yields, calculated using either official CPI data (-.11%) or CPI data many would argue is more consistent with experience (-7.71%)? (The red real yield line on the graph deflates nominal yields by the BLS CPI-U, which is continually adjusted by the Bureau of Labor Statistics. The green line uses the SGS 1980 Alternative CPI-U, which reflects the BLS methodology used prior to 1980 and unadjusted since then.2)
Negative real sovereign yields prevail in the US and across the world because central banks are acting as buyers (or funders of buyers) of last resort of sovereign debt. (See sovereign yield table at the end of this note.) Central banks are synthesizing demand for the highest quality sovereign debt by:
1) outright purchases;
2) giving leveraged banks and hedge funds incentive to own it as one leg of an arbitrage; and
3) withholding credit to competing sovereigns in distress, in turn forcing dedicated sovereign allocators into the highest quality debt. Capital Asset Pricing Models (CAPMs) cannot be accurate in such an environment.
Further, the market signal that low or negative real sovereign yields would ordinarily send is deflation (i.e. the increasing purchasing power of money); however, central bank maneuverings are greatly distorting default-free rates and sending a false signal. Thus, unleveraged investors seeking true preservation of purchasing power are being fooled as to what constitutes safety and risk.
On a Meta plane where Heisenberg uncertainty is vanquished and where time is stopped by proclamation...huff and puff financial men of uncommon intelligence and unclear motives...prophets with bold and indefatigable resolve whispering get-rich-forever secrets to the bottom 99% of the top 1% who think the cost of free cable is a fair price to pay for privileged investment insights.
Have equities delivered positive real returns? Well, as the graph above implies, timing is everything. (We will show this in more detail later.) It shows the compound monthly returns of the US S&P 500 Total Return Index (includes dividends) in both nominal and real terms, and indicates consistent positive nominal and real returns were generated until 2000. Returns since then have been negative and quite volatile. It seems clear that US equities over time have been a more dubious store of purchasing power than most acknowledge.
We believe the average level of broad equity indexes is biased to climb in nominal terms over time, but it seems unlikely they will be positive in real terms. The basis of this assertion is that base money inflation will continue to outpace credit growth while the total money stock, (base money plus unreserved credit-money that comprises the balance of broader monetary aggregates), will in aggregate inflate more than the supply of goods, services and real assets.
There is a very close relationship linking credit growth and equity returns. Without total money stock growth there would be natural de-leveraging from credit and debt deterioration, which, in turn, implies no systemic re-leveraging and declining equity market sponsorship from explicitly or implicitly leveraged market participants. Further, Western equity investors are likely to be net withdrawers of capital from the markets to fund consumption in retirement, making credit-money growth even more critical.
So we suggest that while equity indexes may be pulled higher over time by monetary and price inflation, the gap separating nominal from real returns is very likely to widen. In fact, we assert broad equity markets will produce negative real returns (equity indexes will not increase as much as the general price level). We further think equities would generally decline in the event interest rates were to rise to levels that provide investors with positive real returns (via contracting P/E multiples as rates rise). Thus, we believe the risk-adjusted case for broad equity indexes is poor in real terms.
For over forty long years a Trojan horse called “wealth” was delivered to the masses... exorbitantly privileged financial societies enjoying a permanently high plateau...wisely taking on unsupportable debt together...so that its ultimate destruction would be in real terms, and would also have to be borne by their lenders...
Storyboard: What about housing, the American (and Spanish and Irish) dream? Considerable bank credit creation was channeled to the housing market from 1994 to 2006. The extraordinary quantity of credit issued by banks and by buyers of mortgage-backed securities over this time served the interests of credit issuers and home buyers alike. For banks, earnings continually rose from lending transactions and the apparent health and value of their loan books increased as home prices rose. For MBS buyers, relatively wide yield spreads on perceived high quality cash flows and a calm interest rate environment provided attractive and stable yields. For mortgagees, term funding ultimately derived from overnight repurchase agreements (from bank loans) or from stable pension capital (from MBS buyers), provided easy access to levered asset speculation and granite counter tops.
The graph above does not show the exorbitant amount of bank credit extended and pension money lent, both of which were necessary to drive home prices higher. (We and many others have shown countless graphs indicating consistently rising systemic debt levels.) When one considers the credit/debt funding boom behind the housing boom, it becomes clear that:
a) all homes effectively became financial assets – more akin to corporate equity shares than real estate, and
b) the embedded risk of future losses would ultimately be borne by both borrowers and lenders.
As with equities, declining nominal home price performance could certainly be reversed through money creation, sufficient enough to de-leverage homeowner balance sheets so that systemic credit could be re-ignited. Again, this would imply significant asset value losses in real terms. And, just like equities, rising interest rates would likely generate further housing losses in both real and nominal terms. So, we think mismatched-funded real estate also seems to be a poor risk-adjusted bet in real terms – even despite the painful correction to date. (Yes, the graph shows that homeowners over the last forty years have either gained 2% or lost 72% in real terms, depending upon which CPI figure one chooses to use.)
Dramatic VO: Never before in our short memories have societies been wrested from their financial dreams. Never before in our short memories have powerful human forces had to unite to fight the dark forces of overwhelming economic leverage. Never before in our short memories have global icons had to face-down the curious relationship between political imperatives and compounding interest.
Investor allocations to commodities over the last forty years has been comparatively slight, most reasonably because physical delivery involves significant transaction costs and requires more complex infrastructure capabilities than simply rolling derivative contracts. Derivative products further demand that investors accept holding leveraged, potentially volatile contracts. (The price volatility of commodity futures contracts would be quite tame were they not implicitly leveraged.) Further still, steep contango curves, unjustified by the time value of money, tend to eat away returns over time for longer-term investors seeking exposure to commodities. As a result, commodity derivative products understandably tend to be limited to hands-on professionals executing short–term trades or arbitrage positions. They exert enormous influence over physical commodity pricing.
Physical commodity prices tend to represent input costs for manufactured goods and services that impact consumer behavior. Thus, speculation in economically critical commodities such as oil – whether based on valid macroeconomic projections or financial speculation – invites political and regulatory scrutiny. Speculations in futures or fundamental supply/demand dynamics that drive spot prices down tend to be socially acceptable. Higher consumable commodity prices; however, place an economic burden on consumers with relatively static wages. In financially-dominated economies politically structured to rely on perpetual nominal growth, rather than allowing market forces to work towards economizing (increasing affordability), political energy is geared towards perpetuating increasing demand. Higher commodity prices work against this objective.
So it is easy to understand why investors of all sizes and at every level of sophistication have not wholeheartedly embraced consumable commodities. Relative to unleveraged financial asset capital structures in the West commodities are difficult to own and disown and are generally biased to be fraught with social and political angst. As a result, natural resources as a store of purchasing power have been trivialized over the last generation and not fully embraced by Western capital asset pricing models.
Dramatic VO: In a world where hyperventilating gold bugs frantically extinguish their burning hair with tin foil hats...willing the sky to fall while warning of impending doom and gloom...only an elite monetary fighting force stands between financial chaos and the menacing threat of barbarous austerians...
Using the US as a proxy in the graphs and discussion above, we can see that the past real returns of stocks, housing and commodities have been less-than stellar over time. Wealth, in the form of sustainable purchasing power, has had to rely on timing investment allocations correctly and indeed shifting them quite aggressively. As for sovereign bonds, whatever positive real returns may have been generated since 1981, double-digit yields cannot be repeated from zero-bound interest rates.
In order to form a reasoned opinion about potential future performance of investment assets in real terms, we must provide a framework that further defines the basis for purchasing power parity (PPP). It is time financial asset investors consider gold as a proxy for ongoing PPP that transcends credit cycles. (No, seriously.)
Imagine gold as a money-form not currently used as legal-tender currency (i.e. not currently used as a medium of exchange or unit of account). Indeed, gold remains on the balance sheets of most treasury ministries and central banks as an asset, (not so the BOE and BOJ), and as such it may be monetized if necessary. Its only current use (and intrinsic value) therefore, is as a relatively scarce item that potentially may be called upon by monetary authorities to be a currency, or, more likely, the basis of value for sovereign-issued (fiat) currencies.
The Fed continues to hold gold certificates in the event that US dollars, as the current basis of value for all global currencies, are not perceived to provide the global marketplace with a store of purchasing power, and gold remains on the balance sheets of most developed treasury ministries and central banks for the sole purpose of allowing them to devalue their currencies against it if need be.
Physically-held gold is not an obligation of its possessor (unless specifically pledged as collateral, and to do so would defeat the purpose of holding it). As such, gold is 'treasure' – an unlevered monetary asset that negative real interest rates make cheap to own. There is very little cost currently associated with holding gold relative to holding cash balances or investment instruments denominated in major sovereign fiat currencies.
Indeed gold’s increasing exchange rate vis-à-vis other currencies (i.e. its rising price in terms of all currencies) has become very well-established since 2000. This rationally suggests there is a link connecting increasing gold prices with the trend towards negative real interest rates in major currencies and low or negative real returns in financial assets denominated in them.
The graph on the following page is a time series showing the price of gold in US dollar terms and our Shadow Gold Price, which is calculated by dividing the US Monetary Base (i.e. currency in circulation plus bank reserves held at the Fed) by US official gold holdings (in troy ounces). (The SGP formula was used to define the gold/USD exchange rate under the Bretton Woods global monetary system from 1945 to 1971.) The Shadow Gold Price is the intrinsic value of gold given past monetary inflation. In short, it is the credit-adjusted purchasing power parity of gold to US dollars.
The widening spread of the two lines from 1981 to 2008 implies a stable stock of official US gold, (about 8,300 metric tons), and an increasing stock of base money (about $2.7 trillion presently). The sudden spike of the SGP in 2008 and continued increase in the spot gold/SGP gap ever since indicates the dramatic Fed-administered increase in USD base money (in the form of bank reserves) through quantitative easing.
The takeaway of the graph above is that US dollars, as the benchmark reserve currency in a global monetary system where all currencies are un-anchored, have been diluted far more than the gold/USD exchange rate has increased. In other words, even though nominal gold prices have risen consistently since 2000, gold’s implied future purchasing power has actually increased far more than the prospect for US dollar purchasing power. Why? Because interest rates are already zero-bound, credit money is tougher to perpetuate, and only base money creation can ease credit conditions. The more base money the Fed manufactures, the higher the Shadow Gold Price rises. The higher the SGP rises, the cheaper gold becomes to its “intrinsic fair value”. (This relationship would reverse if either a large sum of USD base money is destroyed or a large sum of US official gold is added).
Past and potential future real performance in financial assets is startling when deflated for the SGP – the intrinsic value of gold (and by implication the intrinsic value of US dollar purchasing power). The graph on the following page shows past compounded returns of US stocks, housing and commodities in terms of the intrinsic value of gold. We believe it indicates accurately the purchasing power loss experienced by investors over the last credit cycle when adjusted for currency dilution.
The point of the graph below is not that stocks, housing and commodities are rich or cheap relative to each other, but that their performance in real terms can be quite negative at times. (More on this later.) It shows that when we consider implicit purchasing power loss of the currencies in which they are denominated, equities were quite rich in real terms in 2000 and housing and commodities were quite rich in 2008. Looking forward, either these markets must increase enough to overcome past currency dilution that leads to price inflation (the tacit goal of global policy makers), or else they will continue to provide negative real rates of return for investors.
Dramatic VO: This mighty band of monetary brothers valiantly launches an epic battle against nature...fighting arm in arm to hold back commercial and trade incentives...until suddenly, out of nowhere...a flash of clarity “no one could have foreseen”...the silent bell of human cognition.
Climax: For savers, the ultimate question is (or should be): “where should one place current purchasing power with the objective of maintaining it without risk?”
For investors: “where should one allocate current purchasing with the objective of increasing it commensurate with prudent risk?” We believe the greatly overleveraged nature of global public and private sector balance sheets currently suggests the acknowledgement of substantial ongoing currency dilution (base money inflation-induced deleveraging) as the driver of future asset valuation. In such an environment we believe the optimal risk-adjusted play is to allocate capital towards treasure.
Treasure comes in many forms including fine art, rare property and, of course, gold. (We understand some enterprising wine marketers promote a return to “SWAG” – silver, wine, art and gold – though we would categorize wine more as a consumable commodity.) Treasure does not need to have any functional utility. The all-important common characteristics of treasure are scarcity and ongoing demand. It is simply, quite simply really, a sanctuary for purchasing power during a period of currency dilution. The more currency in existence, the more currency chases scarce items.
Whether he knows it or not, (and we would bet he most definitely knows it), Leon Black just personally exchanged US dollars for treasure by paying almost $120 million for the original pastel of Edvard Munch’s The Scream. Though Leon may like the piece because it matches his sofa, there should be no doubt that its value is in its scarcity. It is treasure and it is highly likely (to use a phrase Black made famous funding takeovers with junk bonds at Drexel) to maintain its purchasing power upon liquidation – no matter how much the general price level rises. The same would be true for signed first edition Edith Wharton books, original Chippendale chests, Honus Wagner baseball cards, and Wyatt Earp pistols. They are all scarce, easily verifiable and portable (just like gold).
Beachfront homes and midtown Manhattan properties are scarce but not portable. The value of natural and human resources rely on perpetual marginal global demand that may come and go with innovation and political shifts. Taxing powers and control over shipping lanes ensure great wealth for nations but also come with great carrying costs and risks. We believe it is time to hold treasure, because it is the very definition of unadulterated, undiluted, unlevered wealth (just like we learned as small children).
Treasure is quite literally priceless because price is derivative of value. Price is just a number but there are only four original versions of The Scream. They may be exchanged currently for about $120 million or about 75,000 gold ounces. Were central bank-issued currency to increase in quantity by 10 times, Mr. Black should theoretically be able to exchange his picture for $1.2 billion or, well, 75,000 gold ounces.
Owning the picture for $120 million today allows Mr. Black to
maintain his purchasing power tomorrow relative to a society currently over its head in unreserved credit posing as currency and financial assets. Did he pay too much? We don’t think so. Given past and likely future base and credit money creation, we think treasure represents the best store of purchasing power – and the best risk- adjusted investment class – because most investors still do not realize its current intrinsic value in real terms.
So we think precious metals should be taken very seriously by financial asset investors because of the potential (likelihood?) for recognized systemic monetary inflation leading to manifest price inflation. Whether physical possession is taken above-ground or below ground (via shares in precious metal miners), gold is the only treasure that is fungible, liquid, held by public and private sectors across the world, and has a long history of being recognized as money.
It is the official asset to which today’s baseless currencies may be devalued, and we think this likely explains central bank hoarding presently (see table at the end of this note).
Let’s look further at gold’s value as a discrete investment in the current environment. Please recall that the Shadow Gold Price (SGP) divides US base money by US official gold holdings, the value of which was almost $10,000/oz at the end of June (see graph on page 8). The graph below further divides the spot gold price by the SGP. At a ratio of 1.00, the stock of US dollars and the stock of official gold would be at theoretical equilibrium (i.e. the stock of base money would be fully-reserved by gold). Above 1.00, a holder of gold would have incentive to exchange gold for dollars. Alternatively, below 1.00 a holder of dollars would have incentive to exchange them for gold. As the graph below shows, gold has been theoretically cheap vis-à-vis US dollars since shortly after the parabolic blow-off peak in 1980.
So why would this relative gold cheapness be reversed anytime soon (and with a vengeance, as we think it will)? The answer: it has been rational for savers and investors to ignore gold’s cheapness for most of the last generation because positive real returns were available in various financial assets over that time. This is no longer true. US dollars no longer provide sanctuary to savers in real terms and so global financial markets no longer provide investors with positive currency-adjusted, risk-adjusted real returns.
We reprise the graph below from page 9 and add circles to stress the periodic availability of positive real returns in liquid equity markets, housing market and commodity markets. The obvious and precipitous fall in the SGP-adjusted real returns of stocks, housing and commodities in 2008, and continued decline since then, comes directly from the first and second rounds of quantitative easing.
We think the gig is up on levered financial asset markets until baseless currencies are made sound again. If one believes there will be further quantitative easing, then one may easily envision further purchasing power loss in the currencies supporting the indexes on the graph above. The point here is not to arrive at a quantitative terminal projection for negative real returns in popular investments, but to show their implied past performance in PPP terms, to justify the bullish trend in gold since 2000 (and in fine art and trophy properties since 2008), and to raise the prospect of an extension of this well defined trend.
We believe the graph illustrates the great disconnection between the spot gold price and real interest rates. Either real rates must climb measurably to justify the current spot gold price or the spot gold price must rise measurably to justify the current level of real interest rates. The fundamental macroeconomic arbitrage is this: interest rates are negative in real terms, perhaps at record negative yields, so spot gold should logically trade at a premium to the SGP (as it did briefly in 1980), not at a huge discount. Collecting interest on a 10-year Treasury while holding the SGS 1980 Alternative CPI-U constant over a ten year period implies one would lose about 80% of purchasing power by maturity. Alternatively, holding gold for those ten years – without collecting interest and even assuming no further base money printing – implies at least a 6x nominal return upon a reversion of spot gold to the SGP. (It is further rational to assume that the base money stock will be far bigger in ten years than today, which implies an even higher SGP and most likely a much higher CPI, all else equal.)
Thus, we believe treasure, and for most investors, gold (properly purchased), offers the most fundamentally cheap risk-adjusted way to protect and enhance purchasing power.
Consumable resources with relatively inelastic demand properties should also re-price well in a base money inflationary environment regardless of an increasing general price level. As for productive businesses with pricing power, we cite the masters at Berkshire Hathaway who methodically built enormous wealth through a one-way secular inflation bet over the entire credit cycle by effectively borrowing to own consumer franchises with bulletproof branding. Obviously one should be more cautious borrowing to own assets today with interest rates zero-bound and with consumers already highly leveraged. We should also note that businesses with pricing power – and even consumable resources – would likely lag treasure if inflation is accompanied by a decline in economic activity. Treasure actually benefits from having no functional utility beyond being a store of value. It is held in physical possession of its owners unlevered and therefore is impervious to shifting rate markets and popular liquidity.
Dramatic VO: The reviews are in! The New York Mimes calls Time for Treasure “ ”. E. L. James gushes; “It’s a macroeconomic bodice ripper!” The El Paso Intelligencer raves “a damn near perfect little golden nugget of Yee Ha“! El Diario Miami warns, “¡Corer, no caminar! James Carville wants to come back in another life as Treasure. Get “Treasure” at an investment board near you!
Denouement: Now that we are at zero-bound rates, either there will be significant further base money inflation and rising prices or there will be irreconcilable debts, asset deterioration and a decline in economic activity. Investing in advance of significant inflation should not be considered a rogue position.
CPI, regardless of how it is calculated or who calculates it, is a contemporaneous indicator of consumer prices that lags past money stock inflation. It has not yet flared because the value of systemic credit has been deflating. The longer this trend lasts, the deeper the value of assets sink, the lower credit demand and economic production drops, the sooner intense base money inflation will be administered by central banks to reverse it, and the sooner and higher the general price level will rise. Economic activity and the general price level can travel in opposite directions, as they did in the 1970s stagflation.
Contemporary Western financial asset investors are struggling to make sense of an investment environment offering negative real returns because analyzing assets in absolute currency terms is not commonly practiced. There was no reason to do so prior to 1971 when currencies were ostensibly disciplined by gold’s scarcity, and since then positive real returns have been sporadically available in fiat currency-denominated financial assets. This is no longer the case.
We have become conditioned over the last forty years to invest in relative terms, with the underlying presumption that the mostly unreserved currencies in which assets are denominated will be relatively stable to other fiat currencies, without regard for potential step-shift inflation in the general price level of goods, services and resources. Thus, Western investors have not invested in treasure in any meaningful way. (Total precious metal investment among global pension funds amounts to 0.15% and total investment in precious metal ETFs and precious metal miners is less than the market cap of AAPL.)
The current set of circumstances underlying the global economy and the financial assets tied to them remains very unstable, and for good reason. Monetary and fiscal authorities seeking to execute market- expectations management and seeking to maintain bank system solvency through monetary inflation provide little defense against the potential for a rational and widespread loss of investor confidence in fiat currencies, and little defense for savers and holders of financial assets denominated in those currencies. Indeed, central banks are the cause of the dilution.
Coordinated Whack-A-Mole currency debasement cannot mask forever the loss of absolute purchasing power. It seems likely monetary authorities will save their banking systems by destroying the purchasing power of their currencies. The catalyst for broad recognition of such conditions will likely be the global commercial marketplace, not the capital markets.
Commercial counterparties – manufacturers, exporters, vendors and laborers – will eventually opt out of accepting “a reasonable quantity of currency” in exchange for their goods and services. This naturally comports with reduced incentives among consumers and purchasing managers to borrow further to consume or to increase capital expenditures, regardless of the nominal level of borrowing rates.
We have repeatedly argued about the fundamental relationship linking the quantity of base money to the gold price. Over the last fifteen years market trends have driven real rates into negative territory while aggressively suppressing the spot gold price in SGP terms. More recently, the overall money stock, (loosely defined as the sum of the base money stock and the prevailing quantity of credit money), has ceased to grow and has even contracted because unreserved bank credit growth (deposit growth) has fallen or gone negative. The stagnation/contraction of bank deposits thus leaves only base money growth in the form of bank reserves to fill the void. This process has already begun.
Central banks may follow the markets and provide reserves as nominal bank credit expands. That has been the Fed’s modus operandi for 25 years. On occasion the Fed has also led the markets by targeting sequentially lower Fed Fund rates, thereby increasing reserves. (Such maneuvers prompted the mortgage and corporate refinancing waves.) However, the policy of expanding nominal output growth by expanding credit is likely finished because private markets are now in a well-established deleveraging phase. Escalating public market borrowing filled this gap to some extent recently, yet even this is quickly becoming a source of strain as the events enveloping the PIIGS are proving.
If neither the private sector nor the public markets demand incrementally more credit, central banks would be left with only one policy option: asset purchases to expand base money. Gold is the monetary asset owned by monetary and fiscal authorities and the asset against which they would devalue their currencies (by inflating the base money stock to purchase gold). Central bank gold monetization would achieve two goals:
1. Bank system deleveraging would expand the leverage denominator (base money) and sustain (or even goose) the nominal pricing of assets underpinning the numerator (bank credit).
2. Maintain (or even goose) the nominal quantity of the money stock available to service and retire existing nominal debts.
For now, it would be imprudent to expect central banks to stop inflating their base money stocks. There is no direct marginal cost of producing fiat base money. In the current regime, the traditional supply/demand curve relationship (downward sloping demand curve, upward sloping supply curve) does not exist. So, central banks can shape sovereign yield curves any way they wish (e.g. Operation Twist). Contrary to basic microeconomic principles then, one may be prone to argue that the slope of the base money supply curve has been and continues to be negative rather than positively-sloped, as most supply curves are conventionally thought to be (i.e. the Fed has been supplying more reserves at ever lower rates).
However, one could also argue, perhaps more rationally, that the supply curve at any point is perfectly flat and that central banks have been shifting the curve lower. (The latter is probably the better representation of what happens under a Fed Funds targeting policy regime.)
So, on one hand central banks may supply infinite reserves at a given interest rate but this does not mean they will always be able to control the demand for goods and services, which are also underpinned by the prevailing stock of bank deposits – even at zero-bound interest rates. On the other hand, the demand curve for bank credit is traditionally downward sloping to a point, but seemingly becomes vertical as credit loses its propensity to expand – even at a 0% cost of money. Central bankers are well-versed in such matters.
The point here is that if the monetary base is theoretically infinite with zero marginal cost of production and, ironically, base money is very much in demand to alleviate systemic credit pressures (as our banking systems are prone to deleveraging), then it seems base money has little potential value on one hand and very dear value on the other. Such is the current paradox. Amid this set of conditions it seems entirely prudent to position purchasing power in vehicles that would benefit as the nominal stock of base money grows at a rate far in excess of the gold stock growth rate. Logic certainly bears this contention out and historical data confirm it.
We believe “the market” has it wrong, but not in a way that should invite suspicion. “The market” to which we refer is not the smattering of real-return investors currently sponsoring treasure so they can maintain purchasing power. It is the great majority of institutionalized investors dedicated by mandate or inertia to highly-mismatched financial asset markets producing negative real returns and the likely prospect for more. The collective market value of treasure will continue to be dwarfed by the market value of financial assets, until suddenly economic conditions force reconciliation. (Perhaps it is time to tweak the Capital Asset Pricing Model?) We think early investors in treasure will be well rewarded.
Lee Quaintance & Paul Brodsky QB Asset Management Company, LLC
Forget decoupling from Europe--we've been decoupled from reality since 2008.
Have we decoupled from the global slowdown? Doubtful. Have we decoupled from reality? Undoubtedly--and have been since 2008. One key attribute of reality is feedback: actions have consequences, and various forces reinforce or resist each other in a dynamic interplay of positive and negative feedback.
Another key attribute of reality is risk. Risk is as ever-present as gravity, and it cannot be eliminated; it can only be shared or transferred.
When you overwhelm feedback with massive interventions that mask risk, you decouple from reality. With feedback suppressed and risk hidden, the system's resilience and resourcefulness both atrophy. Participants start making decisions not on risk assessment and feedback from reality but on the results of the intervention.
Pharmaceutical intervention offers an apt medical analogy. Various risk factors such as high blood pressure and high levels of LDL cholesterol have been correlated with increased risk of heart disease. Medications can lower these metrics, and so these interventions are now ubiquitous.
Sometimes these result from genetic propensities, but other times they are consequences (feedback) of an unhealthy lifestyle: obesity, poor diet, lack of fitness, etc. If we suppress a single feedback from a spectrum of health-related feedbacks and consequences, have we restored health or simply masked the risk of an unhealthy lifestyle?
Clearly, complex systems do respond to critical thresholds or "pivot points" that trigger cascading responses. It is wise to identify key metrics and manage the risks they present or elevate. But it is unwise to assume that manipulating one metric will necessarily restore a system that is wobbling out of equilibrium to a dynamic equilibrium.
Slamming down one metric or another does not necessarily reduce the systemic risk. Just as someone who eats junk food, smokes cigarettes and drinks sodas all day while slumped on a sofa will not become "healthy" just because statins have slammed down his LDL cholesterol levels, an unhealthy economy cannot be restored to health by manipulating a handful of inputs such as money supply or key metrics such as unemployment.
All these interventions accomplish is to mask risk by transferring it to the system itself, where it builds up behind the apparent "fix" and eventually explodes.
All sustainable systems must be resilient and transparent. Intervening to suppress key inputs and manipulating data points makes the system appear less at risk, but reducing apparent risk is not the same as encouraging resourcefulness and resiliency.
What we have as a consequence of four years of intervention, suppression and manipulation of data is a stock market that is now totally dependent on one input: quantitative easing intervention by the Federal Reserve. An unmanipulated market is based on multiple transparent inputs, including corporate earnings, revenues, currency valuations and so on.
Once inputs are gamed or manipulated, transparency is lost and feedback is distorted or suppressed.
Four years of intervention, suppression and manipulation of data have left the U.S. economy dependent on monetary interventions and massive fiscal deficit spending. Imagine a sickly patient in bed who has become totally dependent on several driplines (interventions). To keep the patient alive, the meds are steadily increased.
Are these interventions restoring health, or simply keeping the patient going until some unknown magic restores health?
In the U.S. economy, the driplines are debt-based spending and leverage. Thanks to endless intervention and manipulation, the economy is now totally dependent on massive debt-based spending and increased leverage for its "growth."
The person or business that becomes dependent on welfare loses resiliency and resourcefulness. To the degree that economies become dependent on debt and leverage just like individuals and companies become dependent on welfare, entire economies lose their resilience and resourcefulness.
A healthy forest offers another apt analogy. A healthy temperate-region forest depends on occasional forest fires to clear out deadwood and refertilize the depleted soil with ashes. In suppressing all fires--what we might call "stress" and feedback-- management virtually guaranteed that when the forest was eventually set ablaze by a random lightning strike, the resulting fire would be catastrophic because the deadwood had been allowed to pile far higher than Nature would have allowed.
The "managers" of the economy have let a couple hundred billion dollars in bad debt burn, and they think the $15 trillion economy is now restored to health. Writing off a couple hundred billion is like letting a few acres of grassland around the parking lot burn and reckoning you've cleared the entire forest of deadwood.
The buildup of deadwood--fraud, impaired debt, leverage, bogus accounting, malinvestments, promises that cannot possibly be met and the multiple pathologies of crony capitalism--continues apace, untouched by Federal Reserve intervention.
Masking risk and suppressing feedback do not restore resiliency or vitality; they cripple the system's ability to respond to reality.
The greater the system's dependence on intervention for its stability, the greater the probability of instability and systemic collapse.
The astounding hubris of central bankers is comical, but the consequences of their actions are playing out as needless tragedy.
Central bankers present themselves as Masters of the Universe. They are, but only in their own little Theater of the Absurd. In the real world, they are as clueless as any other mortals about the unintended consequences of their actions and the speed with which the corrupted, unsustainable financial Status Quo will decay and die.
The only attribute they possess in abundance is hubris. Their claims to godhood are comical when viewed in their little Theater of the Absurd, but they become tragic when the consequences of their actions play out in the real world.
Their job, such as it is, is to deflate a tottering system based on phantom assets slowly enough that it doesn't implode. Stripped of mumbo-jumbo, their strategy to accomplish this is to inflate other phantom assets to replace the phantom assets that are falling to zero.
All their promises, preening and posturing boil down to patting their breast pocket and speaking vaguely about a "secret plan" to end the crisis without bringing down the system that spawned the crisis as a consequence of its very nature.
There is no secret plan, of course, and no secret financial weapons; all they really have is artifice and the hubris to present artifice as reality.
To admit the usustainable is not sustainable would bring the entire rotten edifice crashing down, so the central bankers invite us into their little Theater of the Absurd and evince a phantom confidence in their phantom solutions that depend on phantom assets.
A swollen cloud of doom hangs over the central banker's little Theater of the Absurd; all their chest-pounding hubris and empty confidence is artifice, as phantom as the assets they claim will replace the phantom assets that have been destroyed by exposure to reality.
On their absurd little stage, they claim the Emperor's robes are thick and fine; and we laugh, bitterly, for these threadbare lies are all they have to "save" a parasitic, predatory, anti-democratic financial Status Quo.
A sacred cow is usually defined as that which is regarded as far too valuable or prestigious to even think about altering. Any proposition that comes close to complete abolition is met with astounding ridicule. In the realm of legalized harlotry (politics), careers are made out of defending sacred cows no matter how expensive, socially corroding, or intentionally dishonest they are. Compulsory public education is one of the first to come to mind. The various vote buying schemes that masquerade as a welfare safety net are another. Whenever the political class or its apologists in the media find themselves in a bind trying to validate the government’s latest plot to fill its coffers or grind already-undermined liberties further into the curb, they often resort to evoking the greatest sacred cow of all: democracy.
Starting from the earliest years of basic comprehension, children in the Western world are propagandized into believing that without democracy, society would descend into unlivable chaos. Schools, both public and private, perpetuate the fantasy to millions of forced attendees every year. They are told that the government which has a hand in practically anything they encounter was formed with only the best intentions. In America especially, the representative democracy constructed out of the collective genius of the country’s founding fathers is lauded as a gift to humanity. And though its influence is waning in recent years, the Constitution served as a model for developing nation-states around the globe. Back in 1987, Time magazine estimated that of the 170 countries that existed at the time, “more than 160 have written charters modeled directly or indirectly on the U.S. version.”
The Constitution is presented as the miraculous creation of divine individuals when, in fact, it was nothing of the sort. Like any attempt to centralize state power, the Constitution was formed out of the economic desires of its framers. Thomas Jefferson, John Adams, Thomas Paine, and Henry Adams weren’t even present at the Philadelphia Convention as it was drafted. Many Americans at the time were suspicious at what ended up being a coup to toss out the decentralized Articles of Confederation in return for an institution powerful enough to be co-opted for the purposes of rent seeking. As Albert Jay Nock noted:
The Constitution had been laid down under unacceptable auspices; its history had been that of a coup d’état.
It had been drafted, in the first place, by men representing special economic interests. Four-fifths of them were public creditors, one-third were land speculators, and one-fifth represented interests in shipping, manufacturing, and merchandising. Most of them were lawyers. Not one of them represented the interest of production when the Constitution was promulgated, similar economic interests in the several states had laid hold of it and pushed it through to ratification in the state conventions as a minority measure, often — indeed, in the majority of cases — by methods that had obvious intent to defeat the popular will.
Moreover, and most disturbing fact of all, the administration of government under the Constitution remained wholly in the hands of the men who had devised the document, or who had been leaders in the movement for ratification in the several states.
Unvarnished history like this is never taught in public schools and is hardly known by the public at large. There is a reason for this of course. When the rose tinted glasses are removed, the state appears as the organized criminal racket it really is. Those entrusted as “representatives of the people” are really looking out for themselves and their financial well-being. As government grows and regulatory bureaucracies flourish in size and scope, law formation becomes not just a job for the elected legislature but also of the executive enforcers. In other words, the same people tasked with enforcing the law are also given discretion over what rules they wish to impose. These unelected bureaucrats, in a constant effort to validate their positions of authority, will never seek to cut the tax money that is their lifeblood. Instead, they will spend the whole of their budget every year as they live out their desire to have meaningful employment through crushing freedom. The people’s will is sold off to ensure a new bloc of state-privileged voters.
Leviathan’s growth by bureaucracy has been occurring all over the Western world but it is accelerating at a worrisome rate in the United States and Europe. In the 2012 edition of the Competitive Enterprise Institute’s 10,000 Commandmentswhich provides a type of snapshot of the American regulatory state, it is documented that federal agencies were responsible for the implementation of 3,807 rules. These economically destructive regulations were set in stone despite only 81 bills passing Congress and being signed by the President. Representative democracy has been replaced by the rule of the unaccountable. In an environment where the power players are shielded from public backlash, the opportunity for cronyism, corruption, and back room deals increases tenfold. Revolving door politics becomes the norm as the regulators who write the laws end up being employed at the same firms that avoid their punitive nature.
Across the pond in Europe, unelected technocrats continue to try and save the floundering currency union.
Austerity measures, which amount to more tax increases than cuts in government spending, have been imposed by bureaucrats who have little to no identification with the people they are levied against. It is centralized planning on continent-wide scale. The person with the most sway in the crisis has been European Central Bank President Mario Draghi. Though Draghi only has one vote in the body that controls the printing press, he is seen as its mouthpiece. Last week as the Olympic Games kicked off, he infamously made the off-the-cuff remark on doing “whatever it takes to preserve the euro”. The remark, whether Draghi admits it or not, carried with it the bought-and-sold notion that the printing presses would soon be put on overdrive in an effort to quell the crisis by buying sovereign debt. Stocks in both the U.S. and Europe rallied on the news but sunk soon after the plan was revealed as a farce. There was no trick up his sleeve; Draghi’s remark was pure posturing.
However the event was highly revealing of the reliance the global economy has on a constant injection of cheap, fiduciary currency. Under central banking, consumer preferences which normally guide the free market’s structure of production take a backseat to the whims of the operators of the printing press. Financial markets begin centering their operations around fresh batches of newly created digital currency. Fractional reserve banking becomes even more emboldened. Because money isn’t neutral and always enters the economy at specific points, the first receivers are able to spend and invest before overall prices are affected. The last receivers must deal with prices rising prices as their wages stagnate; thus lowering their real income.
The free market economy is analogous to democracy because consumers vote with their wallets on who produces the best product. Under central banking, a few individuals are granted the monopolistic license to produce that which facilitates all transactions. There is nothing democratic about central banking in practice; it is a system of top-down governance based on the fantastical idea that there exists an ideal amount of money that only a few intellectually gifted economists can determine. With one hundred years of operation under its belt, all the central banker profession has learned through the various recessions which plagued the 20th century is that money printing appears to solve everything.
From the beginning of the Eurozone crisis, anyone not quenching their thirst with the Kool-Aid of good, honest government recognized that the large banks were the true beneficiaries of the various bailout schemes. Because commercial banks in Northern Europe are exposed to sovereign debt, it is in their best interest for default to be avoided even if it means receiving interest payments in a devaluing currency. The people of the PIIGS (Portugal, Italy, Ireland, Greece, and Spain) are told their governments are being bailed out as a benefit to them. What’s really happening is the bankers are pulling the reigns of an unscrupulous political class looking to ultimately cash out by helping their friends in high places. The rhetoric of preserving democracy by EU officials amounts to nothing but a childish ploy when contrasted with the brazen, systematic exploitation the state embodies.
To the ruling establishment, the approval of “we the people” matters insomuch that they don’t recognize their oppressors. Democracy is a charade to convince the masses that they are in charge of their future when actually they are servants to authoritarianism. Economist and philosopher Hans-Herman Hoppe was spot on when he recognized that;
"Democracy has nothing to do with freedom. Democracy is a soft variant of communism, and rarely in the history of ideas has it been taken for anything else."
Rather than give the people a voice, democracy allows for the choking of life by men and women of state authority. When Occupy protestors were chanting “this is what democracy looks like” last fall, they wrongly saw the power of government as the best means to alleviate poverty. What modern day democracy really looks like is endless bailouts, special privileges, and imperial warfare all paid for on the back of the common man.
None of this is to suggest that a transition to real democracy is the answer. The popular adage of democracy being “two wolves and lamb voting on what’s for lunch” is undeniably accurate. A system where one group of people can vote its hands into another’s pockets is not economically sustainable. Democracy’s pitting of individuals against each other leads to moral degeneration and impairs capital accumulation. It is no panacea for the rottenness that follows from centers of power.
True human liberty with respect to property rights is the only foundation from which civilization can grow and thrive.
Eliminating Elites won't eliminate our structural problems or the reduction in phantom wealth we've all been relying on.
Many finance-oriented critiques start from the position that our problems largely stem from the financial/political dominance of Elitist cartels and cabals. Clearly, the malinvestment, exploitation, predation and disregard for the law that characterizes the rule of political-financial Elites in both developed and developing nations have wreaked havoc on societies and economies around the globe.
Implicit in this critique is a dangerously naive assumption: if all our problems can be traced back to Elitist cabals such as the Federal Reserve and the European Central Bank, then it follows that the subjugation or eradication of these concentrations of self-serving power would remove the cause of our problems.
Alas, that would be a welcome step in the right direction, but that alone would not resolve the structural causes of our devolution. Freeing ourselves of self-serving Elites would certainly create an opening for structural transformation that is currently impossible, but the transformation will require changing much of what the average citizen takes for granted as a "given" or even "right."
For a little perspective on what lies ahead, let's consider the structural problems that remain even if we were fortunate enough to throw off the yoke of the Fed, the corporate cartels, and the entire system of Elitist dominance.
1. We would still have mountains of debt that will never be paid and enormous losses to write off. It would be nice is we could place all the inevitable losses as phantom assets are exposed to price discovery on bankers and Elites, but the reality is that these assets are distributed throughout the economy: as these phantom assets vanish, pension funds, insurance companies and other bulwarks of non-Elite wealth/security will have to write off significant portions of their assets.
Citizens will ultimately find their wealth/financial security has been degraded, perhaps severely. It's tempting to think that a "debt jubiliee" on (for example) student loans would "solve the problem," but this is not a pain-free solution: the $1 trillion in student loans are someone's assets, and the "someone" is not necessarily a banker or billionaire: it might be the pension fund that is paying Mom or Dad's pension.
The unpayable debts are only symptoms of a deeply flawed system. To see the debt as the problem is to ignore the system which created the "need" for that debt: in the education cartel, that is the entire system of "higher education," which is fundamentally a "skimming operation" not unlike its partner in crime, the financial industry and central State that creates and enforces the debt.
In other words, simply writing off debt does not address the structural causes of the debt. That will require a massive revolution in our understanding and delivery of education, and a wholesale elimination of tens of thousands of "skimming" positions within the education complex.
That means tens of thousands of people will lose their high-paying jobs.
You see the point being made here: living within our means requires a massive structural downsizing of assets, employment and expectations. An economy that has lived on the creation of debt (phantom assets) cannot be transformed by the mere writedown of debt: the entire structure that created and enforced that debt must be torn down, and everyone who skimmed off a profit or livelihood from that reliance on the machinery of debt will experience a decline in their standard of living.
2. We would still have a global economy facing the constraints of higher-cost energy and commodities. As we all know, it's easier to create phantom wealth than it is to create real goods such as grain, energy, gold, etc. Phantom assets are ultimately claims on A) income streams or B) real-world assets, and so all phantom assets are ultimately claims on a limited resource, either a commodity or an enterprise.
You can "grow" phantom assets to near-infinity, but that near-infinite sum of money will still distill down to a claim on limited resources and income streams.
As I have often noted here (thanks to correspondents Bart D. and Harun I.), energy may well be abundant at a certain price; what will be scarce is the cash/income to pay for that "abundant" energy. Abundance of a commodity that has a high cost-basis due to real-world constraints does not lead to lower prices: if it takes one barrel of oil to extract and refine three barrels of shale oil, the cost of those barrels cannot drop below the cost of extraction, refining, return on the capital invested, labor costs, etc.
Sellers of oil below cost will rapidly deplete their capital and go bust.
Eliminating Elites is a first good step, but it does not magically eliminate the constraints imposed on a phantom-asset based system.
Living within our means will require a massive reduction not just in phantom assets but in the income that has been generated by those phantom assets. It won't just be bankers and billionaires who will be poorer; everyone with exposure to the financial system and the real-world costs of the FEW essentials (food, energy, water) will be poorer in terms of purchasing power.
3. As Status Quo policies fail, replacement policies will become less predictable in their implementation and unintended consequences. Recognizing that a policy has failed is only a first step; understanding the structural causes and designing a policy that won't alienate all the vested interests while addressing the problem is politically impossible until the crisis has left the Status Quo no other choice.
But there is very little history that informs the confluence of crises we now face; the more replacement policies diverge from the mainstream, the more unpredictable their comsequences become. As the saying has it, the road to Heck is paved with good intentions, and policy choices that seem common-sense in crisis could issue disastrous results.
Political expediency is a powerful force for unintended consequences. Even if we got rid of the Fed and various financial Elites, the losses trickling down to the Main Street economy would still be large enough to cause powerful vested interests (union and municipal pension plans, for example) to support Status Quo "saves" of phantom assets and the machinery of debt-creation.
Political expediency will not vanish along with the Fed; vested interests will still seek to impose self-serving policies that have not been thought out or tested in the real world on smaller scales. they will attempt to conserve their own wealth and power at the expense of the general citizenry or politically weaker rivals.
But there is another dynamic at play: a self-destruct sequence triggered by central bank and Central State efforts to reflate asset and credit/leverage bubbles. All central bank and State policies aimed at driving capital into risk assets boil down to reflating phantom assets purchased with debt by issuing more debt that is based on newly issued phantom assets.
Phantom assets purchased with debt cannot be reflated by issuing more debt that is based on newly issued phantom assets . Piling more debt/leverage on a sandpile of phantom assets (CDS, bonds that cannot possibly be paid back, empty condos in the middle of nowhere, etc.) only heightens the probability that the unstable pile will collapse.
The implicit Central Planning campaign to trigger "mild" inflation is part of the self-destruct sequence . Central planners metaphorically fight the last war, or at best the last two wars, and so they remain blind to any dynamics that did not exist in their case studies.
In the 1970s, central bank easing and Central State stimulus sparked a nasty bout of accelerating inflation. This reduced the weight of debt because wages inflated along with goods and services.
Now that labor is in surplus globally, wages are not keeping pace with inflation . This completely changes the dynamic of "mild" (3%) inflation: as the purchasing power of earned income declines, servicing debt becomes more burdensome. Inflation only renders debt less burdensome if wages rise at the same rate as the cost of goods and services.
In a decade of "mild" inflation and stagnant wages, households will experience a very real-world 30+% decline in their income. Meanwhile, their debt payments remain unchanged.
"Mild" inflation in an era of stagnant earned income will crush households, forcing liquidation or renunciation of debt. What happens as debt service costs rise as a percentage of real net income? There is less cash for consumption, and so the consumer-dependent economy spirals down. Credit is poured into the banking sector, but little trickles down to high-debt, stagnant-income households. This is deleveraging writ large.
What happens when central bank financial repression--lowering the yield on cash to near-zero--causes pension plans to fail and savings to earn negative real returns? Households must save more income to compensate for the destruction of yield by Central Planners.
These mutually reinforcing dynamics feed the self-destruct sequence's inevitability . Add up the self-destructive forces: declining purchasing power, negative real returns on savings, rising debt based on newly issued phantom assets, and promises unbacked by real assets or based on declining national surpluses.
In the euphoric blow-off top phase of financialization, expectations of security and wealth were raised by political Elites anxious to mask the systemic looting of national wealth by financial/political Elites. Promises were even easier to issue than paper money.
But issuing promises, credit and leverage did nothing to expand the national surplus or the resources that ultimately back the promises and credit.
We can characterize the sudden, explosive convergence of fantasy (phantom assets and promises) and reality as Snapback! (October 9, 2008 ). The entire project of Central Planning (central banks and States) is to "extend and pretend" the Status Quo in the hopes that the gargantuan divergence between fantasy and reality will magically close as the result of "aggregate demand" or a new business cycle, or some other version of renewed "animal spirits."
But "animal spirits" require trust in the transparency and fairness of markets and Status Quo institutions . As markets are rigged and manipulated to manage perceptions and enable vast skimming operations to continue, the credibility of the markets, politicos, State oversight agencies and the financial sector is eroded.
As central bank/State reflation of phantom assets fail, the credibility of the entire political/financial Elite and the institutions they control will be irrevocably lost.
Financialization's self-destruct sequence has been triggered, and there is nothing anyone can do to stop it. The workings of the machine are opaque, and the interactions complex. We cannot know when the sandpile will collapse, or what the proximate cause of the collapse will be, but we can know that the unstable pile will collapse under the weight of the system's illusory assets, fraud, collusion, embezzlement, corruption and corrosive dependence on artifice and lies.
We also know that self-serving vested interests will continue their pillaging until the destruct sequence's final implosion brings the entire rotten edifice down in heap of empty promises.
As the world collectively muddles through 2012, it is has become increasingly apparent that we still don’t get it. Even after the collapse of 2008 and the completely fabricated and bogus ‘recovery’ that the lapdog press corps still insists is ongoing, plus the various financial and economic ‘accidents’ that have happened along the way since, such as MFGlobal and PFGBest, plus the annexing of entire countries by the banking syndicate (Greece and Italy for starters), we still don’t get it. We are Rome. Obsessed with bread and circuses such as government handout programs and the Olympics and NASCAR, we’ve taken all that is abhorred by productive societies and made a center stage spectacle of it.
Many readers and clients have commented to me that this is the strangest recession they’ve ever seen and they are right. America is hurtling in multiple directions simultaneously, at least from a socioeconomic perspective. In the same country where you have families living in cars and tent cities because of job losses, foreclosures, and other manifestations of a system gone awry, you’ve got areas where people are living the good life and spending money like there is no tomorrow. Much of it is borrowed, but that is of little significance to a generation that has been schooled and brainwashed into believing that debt doesn’t matter. Utopia is available for easy monthly payments. Paying back the loans is never really an issue or even something to be contemplated. If the government can do it so can we, right? We still don’t get it.
Not Just an American Problem
We’re not alone in our near complete lack of understanding either. Europe, the poster child for greed and avarice, is further along in the game. Their currency has, for all intents and purposes, collapsed. As one country after another succumbs to consequences of its misunderstanding, the global banking syndicate stands ready with open arms to offer the bailout money in exchange for what amounts to indentured servitude. On a global scale, we are returning to Feudalism, and anyone who actually takes the time to do a little research will quickly conclude that Feudalism and the concept of the American circumstance as was envisioned by our founding fathers are incompatible.
And the Feudalism is becoming built into the American psyche at younger and younger ages. The biggest crisis in this country right now in my opinion is the student loan crisis and nobody is talking about it. Making monthly payments has become a part of the formative years for most of our young people these days and if you think that is an accident, I’ve got some great oceanfront property in South Dakota that I’ll sell very cheap. Kids learn their habits from their parents and as a group we’ve set a terrible example. Hey parents, knock it off. Start living responsibly and within your means. Model wise financial behavior for your kids so they don’t end up in debt up to their eyeballs like you. You’re doing your kids a huge disservice. And if you think you’re going to be loaded enough to care for them their entire lives for the most part you are grossly mistaken. We still don’t get it.
Sure Bernanke went on television and ensured us that all is well and that our kids owing over a trillion bucks to banks is quite all right even though beyond waiting tables there are precious few opportunities for many of them. And we know how accurate Ben was on the housing and mortgage mess. About the only thing he’s been right about has been the ‘jobless recovery’ he promised back in 2009. Still think he’s incompetent? I contend he knows exactly what he’s doing as do the rest that actually set global financial and economic policy. The Congress is nothing more than a conduit for carrying out the policy directives of the global banking syndicate. You don’t believe me? What about Hank Paulson going around threatening Representatives with martial law in America if the TARP bailout wasn’t passed?
Sadly, America will fall just as Europe is falling. In many ways we’ve already fallen. Our sovereignty has been ceded to a banking cartel that creates its bingo chips from nothing, charges us to use them, and requires us to expend land, labor, capital, and scarce resources in order to make our monthly payments as a nation. Yet we sleep, totally unaware of the pillaging of the past 100 years. There is not a better example of the frog and the hot water analogy made so popular by those who have attempted to wake people up from this fatal slumber. We still don’t get it.
Signposts for the Future
Ask 10 people you know about MFGlobal and see if anyone can give you the bottom line. It was labeled by the media as an accident and an aberration, but it is much more than that. It is a blueprint. It was a trial balloon designed to see how much outrage would flow over the fact that over a billion dollars in client funds was stolen and not one single arrest has been made.
An appeals court in the US has already ruled that clients in these types of situations have no recourse; that the actions of Jon Corzine and his good buddies on Wall Street are not only acceptable, they’re legal as well. And the outrage? Nonexistent. Given the fact that the average 55 year old has roughly $26,000 saved for retirement, a billion dollars makes up the retirement accounts of over 38,400 such individuals. And there is no outrage. Then there was another failure, this time ‘only’ $220 million disappears. That failure barely generated any attention whatsoever from the media and negligible outrage outside the circle of folks who really pay attention to such matters.
Let’s take this a step further. Just in 2008 alone, we had the Fannie/Freddie mess, AIG, Lehman, Wamu, Wachovia, Bear Stearns and several other notable failures. To date there has not been a single arrest made, yet Bernie Madoff and John Sanford went down for kiddie-sized Ponzi schemes by comparison while the real felons continue to do business as usual, even stooping to rubbing our faces in it much in the way Jamie Dimon smirked his way through JP Morgan’s PR stunt when he went on ‘Meet the Press’ and talked about how the bank would still make a pile of money despite its ‘mistake’ that cost untold billions. These are bank robberies perpetrated by bankers. They make Butch Cassidy and John Dillinger look like amateur petty thieves. Pure and simple. There is a clear blueprint right here for stealing every single fiat dollar from every single American. And when you think of the nearly 1,000 trillion in notional value of cancerous OTC derivatives, which is enough to wipe out every IRA and pension in this country roughly 120 times. We can all remember back in the days of the cold war hearing about how both the US and USSR had enough nukes to wipe out the globe several dozen times. We’re dealing with this identical situation with derivatives. They aren’t even weapons of mass financial destruction; they’re weapons of total financial and economic disintegration. They’re global game changers and wealth redistributors that stretch across numerous areas of financial impact. And another reminder, this doesn’t stem from incompetence, but rather from the darkest parts of the human soul; those given over to the idea that the world is not enough. To call these people megalomaniacs would be a compliment.
If this resonates with the reader then it should become readily apparent why the banking syndicate is waging an all-out war on precious metals. They cannot be controlled in the long run, are not easily confiscated, and unlike the paper FRN, are real money and an honest measure. An honest measure to today’s banker is like sunlight to a vampire. Jimmy Stewart is clearly dead. Today’s bankers are little more than casino operators and loan sharks. But the funny thing is that while the bankers wage a public relations war on precious metals and call them barbaric relics, they themselves are accumulating them like crazy. Again, are we dealing with incompetence or psychopathic behavior?
The Eurozone Crisis – Proven as a Coup d’ Etat
I got into quite a bit of trouble with many readers several months ago when I called the Eurozone crisis a series of financial and economic coups. Now it has become clear that is precisely what they were and are. They’re takeovers. Not in the traditional sense, which are generally military in style, although we’ve seen a raft of those in the Middle East lately, but rather these are economic and financial takeovers. Allow me the latitude of an example. Let’s say Person A purchases a home from Person B and pays cash for the home. Putting aside the lack of allodial title in the US, we can assume that Person A now owns the property. However, over time, the ability of Person A to continue on its current financial and economic course is hindered by the fact that Person A’s five children all live at home and for lack of a better term, mooch off their parents. The situation deteriorates over time to the point where Person A now needs a loan or a bailout of sorts to keep things going in the right direction. In steps Bank C, who is willing to give a massive loan even though it knows Person A will never be able to evict its five mooches, nor significantly change its financial picture. Yet Bank C doesn’t really care because its loans are made from money which is created out of thin air. So it writes the loan, even though common sense dictates otherwise, and Person A signs on and now there is a lien on the house (mortgage). Person A is now an indentured servant to the bank. Six months later, the economic and financial situation hasn’t changed because no meaningful reforms have been made (remember, the entitlement situation is a mentality and a moral issue) and so Person A goes back to Bank C for another ‘bailout’. Now there is a second mortgage on the home and another lien and so forth.
The end result of this scenario is that Person A ends up dedicating more and more of his productive energies and labor towards paying off the bailouts. In America we call this situation prosperity because the party can go on, but thinking people call this indentured servitude. I call it a takeover by the banks. They know full well that the Eurozone situation is not fixable. They know that meaningful reforms will be met with strikes, riots, and a general lack of economic momentum because, after all, the entitlement mentality is fully ingrained in the population. Yet the syndicate makes the loans anyway. Why? There is zero risk to the syndicate because it creates its ‘money’ from nothing. If the countries don’t pay, however, there are steep penalties. And even if they do pay, the fruits of the labor go right back to the syndicate. Heads the syndicate wins, tails the Eurozone loses.
This is an identical replica of the situation that now faces America. The Treasury is broke, yet the fed is more than happy to buy bonds. Why? Is the fed that concerned with the welfare of the American people? Is the fed really interested in clipping coupons on its plethora of Treasury bills, notes, and bonds? Or is it more about power and control? Again, the fed creates the money it lends to the people (with the government acting as a conduit) from nothing. However, We the People have to expend scarce land, labor, and capital in order to repay all this debt that the government has assumed on our behalf.
Reversing the transaction, the government again acts as a conduit. The various new taxes that have now been deemed ‘legal’ by the supreme court (an institution that ignores its mandates does not deserve proper noun status) are a way for the fed to be repaid with the government collecting the payment as ‘taxes’ and ‘penalties’. Distilling this, what is really happening is that more and more of our productive capacity is going to need to be dedicated to paying off the bankers. Just like Europe. You can certainly bet that when the next banking crisis hits that our government, which is nothing more than a collection agency for the bankers, will be more than happy to commit We the People to another generation of indentured servitude to the bankers. Just like Europe.
When the Euro is ‘officially’ pronounced dead, the countdown clock on the USDollar will begin and the next domino will fall.
Grant’s Rules have never been more important than they are now. There is Rule #1 that is cast in stone and reiterated nine times to form the bulwark of my thinking which is “Preservation of Capital.” You may do what you like and there is certainly a place for some speculation at the edges but you do not, ever, put the core of your capital at risk. It is on this corner stone where I stand and hold court and have done so for the ten years that my commentary has been in existence. Not only is my viewpoint valid in all markets but the point is now of particular importance in a time of such low interest rates where it takes so long to make lost money back. Hedge fund, money manager, bank or insurance company there is never a time and now is certainly not the time where any risk should be taken that will diminish the bulk of your capital.
Besides the issue with minimal yields there is a second consideration which is the incredible amount of risk that is currently on the table. You may believe what you like about Europe. You may be wildly optimistic or incredibly pessimistic but what cannot be denied is that tremendous risk is currently present and that things could go wildly erratic in one direction or another. Economics, outside of the classroom, never exists without its cousin politics but the political considerations are now so huge and the money at stake is now so large that the sheer size of the capital on the table should and ultimately will give everyone pause. We are about to arrive at moments where the notion of “muddling through” will no longer be possible and where real decisions, tough decisions, are going to come into play. Predicting coming events is never an easy task but it is made easier if you can determine the limits past which boundaries cannot be stretched.
There are many events that could go either way such as the German Constitutional Court’s ruling on the ESM and I think the vast majority of market participants think that the court will allow the Stabilization Fund’s existence in one form or the other and I am not speaking today about these kinds of events. Today I want to pinpoint specifically the 90% events. I want to shift your focus to the boundaries of the playing field so that the consideration of everything else properly lies within the out of bounds lines that I will try to define. Today I mark the perimeter.
Odds at 90%
Germany with a GDP of $3.5 trillion does not have the capital or the resources or the assets to support the rest of Europe. You may think of a wooden cross bar and the Brooklyn Bridge and the absolute inability of some piece of wood to support the trucks that roll across the bridge. It is just not possible and the same can be said with exactly the same amount of certainty for Germany’s position with all of Europe; they cannot support the European Union alone which is exactly what some ill informed people think. Therefore given Germany’s realistic position and not some fantasy notion, it is possible to project the limits of what can be done and what they will allow to be done to preserve their own country and their national interests. I would put forth the point that no country in Europe will bankrupt itself to save its neighbors and work backwards from this proposition.
It may be in September or a few months later or even six months from now but Germany will not keep handing Greece money ad infinitum; it is not happening. Greece, on the other hand, is not capable of paying its debts; sovereign, bank or private obligations, they cannot pay them. They also know they cannot pay them which is why they beg for money using the strategy of a European Union which is all for one and one for all and the common good and all manner of schemes appended to this basic concept but the money they owe cannot be paid back and so they make this and those kinds of noises and plead to put off the final act for as long as they can. There are only three choices here which are growth which is economically impossible or debt forgiveness which is politically impossible or the refusal to fund which is the 90% odds play that I see coming soon. In one sense Greece played the game well and got way more money than they should have ever been given and Germany played the game badly and allowed themselves to be suckered into a corner where they should have never gone but now with the stakes so high it will end soon and you can bet on it; a 90% you have it right bet.
It may be Merkel and her allies or it may be the opposition but I project that the citizens of Germany have just about had it with tossing their hard earned money into the olive tree groves in Greece and that it will soon stop. Germany is being dragged into a recession along with her neighbors and I predict soon that the productions numbers, not quite accurate for their automobile industry among others and the real costs of their Traget2 funding and the cash that is pouring into their ownership of the ECB and of the EU will not only come to light but will glisten with the resonance of a loud “Auchtung” and then a screamed “Verbotin” which will thunder down the Autobahn between Frankfurt and Berlin. As we have seen with the idiocy of the IMF projections and the 120% debt to GDP ratio for Greece that was trotted out and flaunted by the wish-it-would-be’s of Washington; the real numbers a few quarters out eventually show up to embarrass those that created the fairy tale.
Then there is the Draghi Hail Mary pass. He has made a promise that cannot be kept because there is no possible way to keep it. The ECB on its own cannot rescue Europe and his muttered under the breath “whatever it takes” flashing neon billboard proclamation is stopped in its tracks by the realizations that someone has to pay for all of this, that there are economic consequences of printing money and that the ECB is only as sound as the financial health of the nations in the EU which fund it and so with Spain and Italy slipping into the Mediterranean along with Greece there may be the will at present but there are not the resources to do it. In my mind this is another 90% bet because the ECB does not exist in a vacuum and does not stand on its own and people would be better served using their hopes and prayers in other areas of concern rather than wasting them on fantasies of Camelot and on Lancelot riding out of the castle gates to save the day. Don’t bet your money on make believe fables; that is my opinion.
The next 90% bet is Spain; they are going down. For years they have provided inaccurate Real Estate valuations, inaccurate bank numbers, inaccurate regional debt figures and the manure has hit the fan and is splattering. The country can no longer afford itself, cannot afford their obligations for the European Union and I predict a very hard landing. The hogwash about the money being only for some banks that most of us never heard of until recently is a lie compounded by Mr. Rajoy’s desire to remain in power which is also something that I see soon coming to an end one way or the other. Perhaps somewhere in some unknown universe governments can live in castles in the air but not on this world and not in our universe and the rock is going to hit the hard place and the make believe is going to collapse.
The final comment I will make today is about the ECB. It is a 90% bet that the ECB cannot do anything of gravity without the tacit support of Ms. Merkel and of the Bundesbank. There will be no grand scheme without their approval because if there is then I think that Germany will refuse to fund it and so end any fantasy. It can certainly be said that Germany has now found herself in a corner of her own making. Germany has played the Great Game badly and allowed country after country in Europe to get in financial trouble and so the majority of nations in Europe are now up against it and pleading for funds, mercy and alms all under the banner of the motto of the three musketeers but what could be done has been done and now the intrusion of reality is making itself known to one and all. Soon, I think, Italy will be joining the chorus and the tumult will be loud and noisy but the road is already marked by the brambles that have been put in place and so the course is set.
The Days of Muddling are now behind us and the Days of Reckoning are to the fore!
Alright, OK, so we have new sorts of relative highs in European and US stock markets, even as we keep a w(e)ary eye on Shanghai's new lows. The western highs seem to have a lot to do with all kinds of expectations of ECB sovereign bond purchases and/or cooling German resistance against them.
All this is accompanied by a rising Euro, and that little detail is far more puzzling than is generally acknowledged. Because there is only one reason for the ECB, with perhaps Angela Merkel and the Bundesbank chiming in, to even consider such measures as more - PIIGS - bond buying, that are tremendously unpopular among a broad swath of Europeans. That reason is that the PIIGS countries, and Greece, Spain and Italy in particular, are doing much worse than anyone wishes to admit in public.
Thus, we have a substantial part of the Eurozone sinking deeper fast than anyone will tell you, while at the same time the currency they use is rising. A rise based on expectations of other Eurozone nations, notably Germany, basically putting up the health of their own economies as collateral to inspire confidence in ECB sovereign bond purchases. Now, you can play this game for a while, no reason to doubt that. But I would personally think we've finished playing out that particular "while" a long time ago and running. Whatever remains now is but a wager. As in: the entire Eurozone has turned into a casino.
If we, and they, the ECB, Germany, Holland, Finland on the one hand, and Monti, Rajoy and Samaras on the other, want to play these moves AND have a shred of credibility left once they're done (and I know what you're saying: will they ever be done?), we and they will need in the end to be able to answer this one simple question. Which they will never ask, we will have to do that for them.
That question is: Where's The Debt? Or maybe more accurately: What Happened To The Debt?.
If a party, be they an individual, a company or a sovereign nation, carries so much debt that it is vulnerable to attacks by the likes of bond markets (or bailiffs in the case of individuals), a handout or bailout will never suffice to abolish the threat for very long, unless it is provided on the condition that the debt that led to the threat in the first place is restructured. That is to say, creditors take a haircut on what is owed to them.
Handing over money to these creditors without that haircut doesn't even begin to solve the issue. It just - hopefully - keeps them quiet for a little while, but then they'll be back, because they're still owed money. Yeah, think Tony Soprano.
In the case of Europe, the EU's national governments, Germany's first of all, refuse to tackle the debt issue, when it comes to Italy and Spain, because it would threaten their own respective banks. And probably their pension funds too. The highly needed haircuts that would come with the highly needed debt restructuring, would threaten to expose the very real very dire situation that these banks are in. And that in turn would risk setting off a domino avalanche that would risk bringing down international - including American - banks as well.
And so the one question that makes any true sense to ask, is never asked.
In the case of Spain, it has become abundantly clear lately that there is no clear distinction to be made between bank debt and sovereign debt. Hence, an ECB bond buying program would be beneficial to Spanish banks too. If only because they own so much of the stuff, something they were coaxed into doing by the ECB schemes that allowed, nay pressed, them to borrow on the cheap to buy their own sovereign debt. Rajoy even suggested using the remainder of the €100 billion bank bailout for sovereign debt. Which is quite plainly illegal, but who's counting?
If you would add Spanish sovereign debt to Spanish bank debt, you would come up with a number that nobody in the whole wide world wishes to address (and so they don't).
Which is why we see Mario Draghi et al "invent" clever schemes to buy Spanish bonds even though that's not the ECB's mandate at all.
The latest line is that they do it to "stabilize the currency". Which is fine in itself, or so I guess, only we would like to know how long they would plan to stabilize it for (two weeks doesn't seem to cut it). And that issue is not addressed. Ever.
Hence, we are left to conclude that there is no effort to deal with the debt, there's not even an attempt to do it. Mario Draghi is merely trying to lift a corner of the magic flying finance carpet, so Spain can be allowed to sweep its true debt burden under it, out of our sight.
And a carpet can hide quite a bit of dead dust for quite some time, as you know if you've ever tried the approach. The thing about debt, though, is that it's not dead dust.
Debt lives. It's alive. It's almost organic. Debt festers and ferments under that carpet, it requires interest and principal payments, and it grows if these payments are not made.
Well, if you look at the real numbers, Spain can't even meet the interest payments anymore. And whether that's 6% or 7%+ is immaterial really. That's why it's in such a mess that Draghi feels he needs to come up with these rule and law bending and stretching schemes to begin with. If Spain had any chance at all of getting out from under its debt load on its own anytime soon, we wouldn't be talking about these ECB measures today at all.
But we are talking about them. And they lift financial markets. And as the Eurozone deteriorates, the euro - ironically - goes up.
Why? ¿Por qué? Because the markets think Germany et al will agree to join Mario Draghi's mind games and pay up to lower Spain's debt. As simple as that.
But Draghi has no solution for the Spanish debt, be it sovereign or bank debt. He just has that carpet to sweep the debt under.
Well, he perhaps has other options, like debt restructurings, defaults etc., but he's not addressing those. Mario is a servant of the banking industry. Just like any other central banker and government official in the western world.
There's no-one in sight who tries to balance the reality of the sovereign and financial sector debt with the ability of the people, the taxpayers, to pay for it. Which is why the Euro can be a hot item even as the countries that presently use it as their currency go down in flames. And their people go down with it.
Yes, there's money to be made in the markets. That's obvious when you look the numbers. But what would have to be at least as obvious is that none of it is based on anything fundamental.
This rally will implode upon itself.
Some of the big boys will have left in time, and made a killing. From the point of view of the people on the ground and in the street, however, it's not going to look all that great. They're mere pawns in a game that seeks to maximize profits off their backs.
And that will continue whatever Mario Draghi or Angela Merkel present in the way of grand plans. They may all look great, and the markets may react with yet another high of one kind or the other, but down the line there's still that one and only question that needs to be answered:
What Happened To The Debt?
Any plan that doesn't address that question directly is worth less than the digital paper it's written on. Any such plan won't solve a thing.
And that magic carpet that the likes of Mario Draghi are trying to sweep reality under? You know what? It's gruesomely expensive, but that's not all, the cost is not even the most important part. Here's what is: that carpet was bought on credit. And the collateral for that credit is the future of Europe's younger, even its unborn, generations. That's right, the generations that presently face 50% or so unemployment numbers.
Enjoy your rally. But do realize that you're trying to outsmart reality. It's hiding under a carpet, but it's no less real.
Easy, cheap credit has created a fantasy world where everyone "deserves" everything right now, and trade-offs and sacrifice have been banished as unnecessary.
Debt offers a compelling fantasy: there is no need for difficult trade-offs or sacrifices, everything can be bought and enjoyed now. In the old days when credit was scarce and dear, buying a better auto required substituting 1,000 brown-bag lunches for restaurant meals: yes, four years of daily sacrifice.
Sending a child to college meant no meals out (or perhaps once or twice a year), driving an old car, no vacations other than camping, working overtime to make a few extra dollars, summer jobs for every teen in the family and a hundred other sacrifices and trade-offs. All too often, only the oldest got to go away to university; younger siblings had to sacrifice their education for the greater good of the family.
If the oldest sibling was fortunate enough to earn a decent salary after graduation, he or she sacrificed to pay for the education of younger siblings.
Trade-offs and sacrifices were the core of household finances for those families that sought to "get ahead" or purchase things that required substantial cash.
Abundant, cheap credit upended the incentives to make adult trade-offs and sacrifice consumption for future benefits. Why eat 1,000 brown-bag lunches when you can buy a new car for $500 down and "easy" monthly payments? Heck, you don't even need to pay for the lunches with cash; just charge them.
Want to go to college? Just borrow the money via student loans. Why scrimp and save when Uncle Sam will guarantee $100,000 in student loans?
Why choose between a lavish vacation, a year of college or a boat? Buy all three on credit.
This mentality has infected the entire nation and culture. Why should we have to choose between $600 billion military spending and $600 billion Medicare spending? Let's just borrow the $1.2 trillion every year to pay for both.
I personally know families that have no savings or assets to speak of, but every summer the parent(s) and kids travel overseas with little effort made to budget-travel. These families earn good incomes but the income is all blown in current consumption: the teens get daily Starbucks and a cafe-bought lunch, dinner is often a sit-down restaurant meal, and all the computer/gadgetry in the household is the latest and greatest: iPhones, iMacs, iPods, etc.
I also know young families who are "working poor," where the father earns less than $20,000 a year and Mom stays home with the two young kids--yet they own a much nicer and newer car than I do, and the Federal government gives them over $2,000 a month in cash benefits: $500 Section 8 rent subsidy, $600 in food stamps and $1,000 in free medical care.
As a self-employed person, I have to earn $3,000 a month to net the $2,100 this family receives every month, so it's like a magic full-time wage earner slaves away and gives this family his entire earnings.
Only there is no "magic worker:" the $3.8 trillion the Federal government distributes every year is two-thirds tax revenues and one-third borrowed.
To the degree that our government distributes $1.3 trillion in borrowed money every year, everyone receiving money from the Federal government is living off debt that draws interest and will never be paid.
Thus it is an artifice to say that a person collecting money from the Federal government is "debt-free": the debt they are incurring is simply once removed.
Credit leverages income. If $10 per month in disposable income can leverage $100 in debt, then if disposable income rises to $20 per month, debt can be doubled to $200.
Lowering interest rates increases leverage. If the interest rate is cut in half, $10/month can leverage $200 in debt.
We are now at the end-game of these two expansions of leverage: incomes are no longer rising, and interest rates have been cut to near-zero when adjusted for inflation (a.k.a. loss of purchasing power).
Relying on credit to fuel "growth" in everything only worked when incomes were rising and interest rates could be cut. Now that incomes are stagnant for 90% of the populace and interest rates have been slashed, there is no way to increase leverage.
Here is a chart of adjusted real income. Note that it has been stagnant for the "bottom 90%" for the past 40 years.
The savings rate has plummeted; the brief spike up in savings triggered by the global financial meltdown has already faded. U.S. households save a mere third of what they once put aside. Note that the savings rate is not broken out by income; the bottom 90% probably save very little, and the top 10% is probably responsible for most of the savings. So the "real" savings rate of the bottom 90% households is likely much lower.
Here is "total credit owed" in the U.S. If income is flat and interest rates already near zero, then where is the leverage for additional debt going to come from?
The answer is the game of relying on ever-expanding debt is over. You can claim phantom assets and income streams as collateral for a while, but eventually the market sniffs out reality, and the phantom assets settle at their real value near zero. Once the collateral is gone, the debt is also revalued at zero, and the debtor is unable to borrow more.
This is the position Greece finds itself in; the collateral and income steams have been discounted, the credit lines have been pulled, and so the reality of living within one's means is reasserting itself. Living within one's income (household or national income) requires making difficult trade-offs and sacrfices: either current consumption is sacrificed for future benefits, or the future benefits are sacrificed for current consumption. You can't have it both ways once the collateral and credit both vanish.