Conspiracy, complacency and the death spiral phase

Some thoughts on gold's failure to respond to Greece - is the answer only central bank manipulation? I think you can't ignore the complacency of professional money managers http://research.perthmint.com.au/2015/07/07/conspiracy-complacency-and-the-death-spiral-phase/

$4 billion of "fear" cash still out there

In late 2008 Australia nearly had a full blown bank run. The Australian newspaper's edited extract from the book "Shitstorm" details the run and is well worth a read:

"It was a silent run, unnoticed by the media. Across the country, at least tens and possibly hundreds of thousands of depositors were withdrawing their funds. Left unchecked, there would soon be queues in the street with police managing crowd control ... It's a long time since Australia has had a serious run on a financial institution, but it's all about confidence, and you cannot allow an impression to develop generally in the public that there is any risk."

The article states that there are "60 storerooms across the country with an average of about $35 million in each" plus "the Reserve Bank has its own cash stash ... understood to be in the region of $4 billion to $5 bn". This gives us a total of say $7b. Over an estimated adult (15y+) population of 17.8m that works out at only $400 per person.

The article also notes that "households pulled about $5.5bn out of their banks in the 10 weeks between US financial house Lehman Brothers going broke ... and the beginning of December ... a year later, only $1.5bn had been put back."

So there is still $4b of what I would call "fear" money out there. Now guess how long people will continue to hold this cash if faced with increased inflation while observing a strong AUD gold price? Would they not consider gold a better store of wealth in such circumstances?

Putting the $4b in perspective, it equals 87 tonnes of gold. Perth Mint refines on average say 6t per week. Now as the article says, the cash was withdrawn over 10 weeks, so you would not see instant conversion into gold. But then consider you would have at that time additional people who weren't freaked out last time starting to withdraw cash out of the banks.

Faced with that sort of local demand, the Perth Mint would be able to draw additional metal out of London, but either way in such a high/hyper inflationary environment I can see Australia's gold production being locked out of international markets for at least 3-4 months. Sorry India, sorry COMEX, we are all out.

Niall Ferguson on gold

Sharelynx drew my attention to this 13 May 2010 lecture by Niall Ferguson at the Peterson Institute for International Economics titled Fiscal Crises and Imperial Collapses: Historical Perspective on Current Predicaments. The following is on the last page of the transcript:

Finally, I guess one just has to ask oneself what’s going to happen in the world of dodgy paper currencies, of fiat monies, because you could quite easily get burned if ultimately we do get a crisis not just of the euro but of fiat currencies generally. And I keep thinking that maybe I should be valuing my portfolio not in terms of this or that currency but in terms of the barrel or the ounce—in terms of commodities like oil and gold.

Maybe one of the lessons of history is that periodically paper currency loses credibility so much that we have to revert to commodity standards, and I think that may well be happening. When you look at what’s happening in the gold market, it’s not so much fundamentals that are driving gold up from a $1,000 towards $2,000. It’s a fact that more and more people feel that they should hold gold as perhaps 10 percent of their portfolios. If everybody thinks that, if that becomes a standard investment strategy, then gold is going to go a lot further than its present price. So I’ve really re-thought my attitude towards gold almost on that momentum basis.

Note that this is a presentation made to the "elites", mentioning ideas that were once considered crazy goldbug talk.

All Ordinaries Fair Value 1,700 to 2,300

From the latest Leithner Letter:

Given how we came to this pass, where Australia now stands, what the government is doing to us and what may lie before us, it’s difficult to conclude that stocks are cheap and easy to believe that they remain dear. True, the AOI is less overvalued now than it was, but “less overvalued” is not the same as “undervalued.” Accordingly, Leithner & Co.’s plans include the possibility that an environment marked by recession and stagflation (like the one that plagued the early 1970s to the mid-1980s) prevails during the next several years. In such a climate, the fair value of the All Ordinaries Index would be ca. 1,700-2,300. That implies a fall of ca. 70% from the Great Bubble’s maximum and the harshest bear market in Australian history. Furthermore, taking 2,000 as the AOI’s “bottom” and assuming a long-run growth rate of 7.5% per annum, ca. 17.5 years will pass before the Index returns to its Bubble maximum of ca. 6,850. If so, this will be the most fraught recovery in Australian history.

The newsletter is worth reading for the detailed analysis behind that conclusion - it is not just some number picked out of the air or drawing some trend line on a graph. It is not coincidental that the Directors of Leithner & Co are Austrians (as in economics).

Restart the bubble

An interesting statement buried in the comments to Steve Keen's latest blog entry (which itself is worth reading as it discusses how neoclassical economics got us into this mess and how [if] it can be changed - as usual with the Keen blog, the comments are just as illuminating):

I have spoken to many whom I thought educated and found a pattern. Those in debt or those that stand to lose from asset deflation wants the bubble restarted.

... and those who didn't get into debt, saved prudently and/or bought some gold, don't want it restarted, I'd add. The observation is that the former are in the majority, but this doesn't mean they will "win". I think they are all waiting for someone else to start buying so they can offload their assets and get rid of their debt.

All this Government "help" going on at the moment is about restarting the bubble, which is another way of saying restoring consumer confidence, which is another way of saying let suck some other idiots in to boost up asset prices. The question is will it work, are people so desperate for the bubble to restart that they will believe and thus act, or is there just too much debt?

Before you answer that it is comeuppance time, consider this from February 1991 in "The case for gold in the 1990s" (see my blog of 7 Sep 2008):

The old remedy of inflating out of this predicament by issuing cheaper and cheaper money into the banking system simply will not work this time. The reason is simple – the country is already awash with too many debtors.

Well they got away with it then, maybe they will do it again. But maybe this time people are bit less trusting and a bit more exposed to alternative views via the internet.

Credit ratings agencies

In this article, Standard & Poor's answers a number of questions posed by gtnews.com. This one caught my eye:

Q: Why haven't the CRAs downgraded the US AAA rating?

A: We have affirmed the ratings on the US despite our judgment that fiscal risk has noticeably increased because we expect that the fiscal deterioration will be temporary and that the country's other credit strengths will withstand current pressures.

The ratings on the US primarily reflect our opinion of the sovereign's high-income, highly diversified, and exceptionally flexible economy. The ratings also reflect our view of its strong track record in terms of growth-enhancing policies, as well as the unique advantages coming from the US dollar's role as the key international currency. In our opinion, these strengths continue to outweigh the US's weakening current-year fiscal performance, growing risks in its financial sector, longer-term challenges associated with its entitlement programs, and the nation's weak external position.

If you read it quickly it sounds OK. Lets list the negatives:

* weakening current-year fiscal performance - they think it is only "temporary"
* growing risks in its financial sector - I'd say "exceptionally" growing
* longer-term challenges with entitlement programs - they spend more than they earn, isn't that bad noncurrent-year fiscal performance?
* weak external position - isn't that another way of saying they spend more than they earn?

Outweighed by:

* high-income economy - what does that mean?
* highly diversified economy - any contraction in spending will also be highly diversified
* exceptionally flexible economy - yes, with high unemployment people will be exceptionally flexible about what jobs they will do
* growth-enhancing policies - euphemistic phrase for easy credit - debt, debt, debt
* key international currency - that is, foreign investors give them money that allow the growth-enhancing policies.

Have S&P considered that the key international currency is not something that mitigates against the negatives, but that the negative can affect the USD status as a key international currency, that people will not want to hold it debts because of the negatives, that this will undercut growth-enhancing policies, in which case you only have the diversified and flexible economy left as positives?

The great penance

When the economic crisis becomes acute, when the rate of profit sinks towards zero, the bourgeoisie can see only one way to restore its profits: it empties the pockets of the people down to the last centime. It resorts to what M. Caillaux, once finance minister of France, expressively calls "the great penance": brutal slashing of wages and social expenditures, raising of tariff duties at the expense of the consumer, etc. The state, furthermore, rescues business enterprises on the brink of bankruptcy, forcing the masses to foot the bill. Such enterprises are kept alive with subsidies, tax exemptions, orders for public works and armaments. In short, the state thrusts itself into the breach left by the vanishing private customers. ...

In richer, more fortunate countries, the bourgeoisie seems to have succeeded, not in escaping the crisis permanently, but at least in extricating itself for the time being from its difficulties. They have been able to start up again, after a fashion, the mechanism of profit, resorting to expedients which at least have not required the substitution of dictatorship for democracy. But they used basically the same methods in both cases: the state refloated private capitalism, revived it with great public works and huge "defense contracts."

Guerin, Daniel. Fascism and big business. 2nd ed. 1973.

Originally published in 1939 by a French journalist and scholar. I found this in a used bookshop many years ago and had never got around to reading it (there are a number of books in a similar state of limbo in my library). It title on its spine caught my eye tonight and I thought the chapter titled "Big business finances fascism" might yield something relevant to our current situation. Didn't take long to find the paragraphs above. History repeating? Question is: if the "bourgeoisie" can't start capitalism back up, are we headed for fascism? Some may say that the fact that the President/Prime Minister changes every now and then just distracts us from the fact that we are already there!

Flawed Economics

Two interesting articles on the failure of convention economics.

Wanted: A new economic theory discusses real estate cycles as a the cause of recessions and concludes "that until radical economists learn to focus on practical outcomes instead of trying to change human nature, and traditional economists fully accept and develop theories around the work of regulatory economists, and we learn that we can't all quit our day jobs to become property developers, it will all be forgotten as before, until next time."

Economists are the forgotten guilty men claims that bankers and regulators ("practical men") were "blinded with science” by academic economists' theories but didn't realise that these theories were flawed: "the risk management consultants who told them their banks would face no solvency problems and the economists who advised them that financial markets were always right were basing their analyses on two theories that were catastrophically wrong. These two theories - called “rational expectations” and “the efficient market hypothesis” - essentially assume that the economy is a predictable, comprehensible machine with a defined set of instructions."

For me Steve Keen makes a lot more sense.

The roving cavaliers of credit

The latest Steve Keen post is essential reading. Some quotes:

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The standard money multiplier model’s assumption that banks wait passively for deposits before starting to lend is false. Rather than bankers sitting back passively, waiting for depositors to give them excess reserves that they can then on-lend in the real world, banks extend credit, creating deposits in the process, and look for reserves later.

---

The point made by endogenous money theorists is that we don’t live in a fiat-money system, but in a credit-money system which has had a relatively small and subservient fiat money system tacked onto it.

We are therefore not in a “fractional reserve banking system”, but in a credit-money one, where the dynamics of money and debt are vastly different to those assumed by Bernanke and neoclassical economics in general.

---

The money multiplier model implies that, whatever banks might want to do, they are constrained from so doing by a money creation process that they do not control.

However, in the real world, they do control the creation of credit. Given their proclivity to lend as much as is possible, the only real constraint on bank lending is the public’s willingness to go into debt ... that willingness directly relates to the perceived possibilities for profitable investment—and since these are limited, so also is the uptake of debt.

But in the real world—and in my models of Minsky’s Financial Instability Hypothesis—there is an additional reason why the public will take on debt: the perception of possibilities for private gain from leveraged speculation on asset prices.

Bank Runs

I find the recent Australian Government guarantee of banking deposits (and the Treasury briefing of the leader of the opposition) very interesting. Briefing opposition leaders does not occur very often and I would assume was done because they wanted the opposition leader to know that the problem was serious and not to be used for political point scoring. The problem, then, must have been the real chance of a bank run developing.

Speaking to the Perth Mint's Depository and Shop staff about the reasons why people were buying gold and silver and how they were doing it leads me to believe that Australian banks were seeing the beginnings of a bank run developing. Stories of people not wanting to wait for cheques to clear and going to the bank to withdraw cash so they can get immediate delivery of metal may be reflective of wider cash withdrawals from Australian banks.

This report on ninemsn.com.au certainly would scare your average central banker: "according to Officeworks, the retailer has noticed a 'significant' increase in the sale of personal safes in recent times ... a number of people who feel nervous and consequently are pulling their money out" (see also this report from The Times)

I doubt the cash withdrawals would have posed a significant risk at this time, but I suspect that the banks were seeing abnormally high cash withdrawals and/or a trend developing and wanted the Government to stop it. It is interesting that this was necessary considering that "depositors in authorised deposit‑taking institutions (ADIs) already receive preference in any liquidation" (2 June 2008 press release by Treasurer).

Maturity Crisis in Gold

Excellent blog at Unqualified Reservations about the lease rate.

It should be noted that the primary driver of lease rates has been miner hedging. Have a look at the chart at this blog and then compare to chart of lease rates.

You will see that as miner hedging increased from 1994, lease rates moved from average 0.75% during early 90s to 1.5% during mid 90s to early 00s. They then drop to historically low levels when miners started to de-hedge, all wanting to meet investor calls for full exposure to the gold price.

Doubtful this time miners will be hedging again so this lease spike totally dependent on when central banks regain confidence in bullion banks. Funny how they are prepared to throw fiat money around to any bank that needs it, but not so keen to do the same with gold.

Steve Keen's Oz Debtwatch

http://www.debtdeflation.com/blogs/ subtitled: Analysing Australia’s 45 Year Obsession with Debt, a new addition to blogs I'm following after seeing him on the 7:30 report. Choice quotes:

"As the experience and the memory of the Great Depression receded, academic economics produced a hybrid of Keynes’s macroeconomic ideas grafted on top of Neoclassical microeconomics that they called “the Keynesian-Neoclassical Synthesis”.

Unfortunately, the ideas were incompatible–and over time, wherever there was a conflict, academic economics rejected the Keynesian graft, rather than the underlying Neoclassical microeconomics. After fifty years of this, Keynes’s ideas were completely ejected from the economic mainstream, the Neoclassical belief that the economy is self-correcting became dominant once more, and economists trained in this belief came to dominate Treasuries and Central Banks around the world. They ignored levels of private debt, championed deregulation of finance, and virtually encouraged asset price speculation.

Now we have twice as much debt as caused the Great Depression, and inflation so low that, were it not for unprecented factors (the rise of China, global warming and peak oil), deflation would almost be a certainty.

Having thus unlearnt the real lessons of the Great Depression, the economics profession may yet make us relive it."

"I can be pro-inflation and anti-gold at the same time because I have supreme confidence in the ability of our economic managers to FAIL to cause inflation. So I actually expect deflation in the future, in which case the money price of gold may well fall (though it will surely fall less than other commodities).

However, I could be gazumped by global warming and peak oil, which could cause the inflationary surge that our economic managers will finally realise is needed, but not know how to consciously cause. There is also the slim possibility that truly over the top increases in fiat money could trigger a hyperinflation.

So given those two possibilities, I’m not anti-gold; it depresses me to say that I have actually started considering whether I might put some of my money into gold. But I would still prefer to remain in both bank deposits and my super fund’s so-called cash accounts."

Public interest in private actions

In the complexity of modern commerce it should be recognised that there is no such thing as a "self-regarding" or a private action. ... Every industrial action, however detailed in character, however secretly conducted, has a public import, and necessarily affects the actions and interests of innumerable persons. Indeed it is often precisely in the knowledge of those matters regarded as most private, and most carefully secreted, that the public interest chiefly lies. Yet so firmly rooted in the business mind is the individualistic conception of industry, that any idea of a public development of those important private facts upon which the credit of a particular firm is based, would appear to destroy the very foundation of the commercial fabric.

But, although in the game of commerce a single firm which played its hand openly while others kept theirs well concealed might suffer failure, it is quite evident that the whole community interested in the game would gain immensely if all the hands were on the table. Many, if not most, of the great disasters of modern commercial societies are attributable precisely to the fact that the credit of great business firms, which is pre-eminently an affair of public interest, is regarded as purely private before the crash.

The Evolution of Modern Capitalism: A Study of Machine Production by John A Hobson, published 1906

Deflation or Inflation?

Two scenarios are receiving increasing attention in assessments of the US economic outlook – inflation and deflation. Some assessments favour a combination of both – such as a severe deflation followed by inflation, or hyperinflation. Others feel that successive development of alternating deflationary and inflationary periods of increasing intensity is more likely, leading ultimately to a collapse of confidence in the US economy.

With the inflationary scenario, the rise in total US debt becomes so extreme that the level of interest rate required to attract ever higher international capital inflows seriously damages GNP growth. Faced with this dilemma, the Federal Reserve will have no choice but to relax its policies (as it is currently doing), and expand money supply with ultimately inflationary consequences. The interest rate reductions will debase the currency by allowing the real value of debt to be inflated away, a collapse in support for the USD abroad, and together with a retreat into gold by many USD holders.

With the deflationary scenario, proponents see similarities between the 1930s and the current situation. In their scenario, the debt explosion becomes too large to be serviced in many parts of the economy. Asset liquidation becomes endemic, forcing prices down, creating debt deflation in a vicious downward spiral with continuing attrition of debt collateral. Personal incomes and consumer confidence plunge, causing a contraction in spending. As faith in the USD evaporates, there is a flight into gold and other safe haven currencies.

The position of the USD as the major international reserve currency is pivotal to the unfolding of either scenario. The prospect of currency debasement through a monetary reflation by the Federal Reserve would undoubtedly provoke a flight from the dollar by foreign investors. Such a flight would cause a quick reversal of Federal Reserve policy and a surge in domestic interest rates, in an attempt to maintain investor confidence. This move would eventually undermine the corporate sector by raising debt servicing costs in an economy in recession, thereby ultimately triggering a credit collapse with consequent deflationary effects.

It is not possible to prove or disprove these theories and scenarios. Nonetheless, it is sufficient to note that the US has been on a track of increasing financial instability for 40 years and that inflation has been checked only by periodic credit crunches which have triggered debt crises, followed by another round of monetary stimulus.

Nevertheless, the evidence now accumulating in the financial and banking sectors suggests that the outcome is more likely to be a deflationary depression. There is no evidence of new developments in the US economy at this time that might transform international disinterest in the USD. Consequently, the US deficit will have to be internally funded in the future – unless the authorities choose some unforeseen strategy such a mobilising US gold reserves into gold swaps. The question is, however, whether internal funding is a practical option under the circumstances?

The old remedy of inflating out of this predicament by issuing cheaper and cheaper money into the banking system simply will not work this time. The reason is simple – the country is already awash with too many debtors.

Corporations, individual, and the Federal government are already suffering from a gigantic surfeit of debt, from the highest debt total to GNP levels in recent US history. The Federal Reserve can no longer make the inverted debt pyramid grow because the debtors in it are too illiquid – they are unable to go further into debt – no matter how attractive the authorities make interest rates. The lever of expansionary money has been pulled once too often. The next phase will be the rapid descent of investors down the inverted debt pyramid from illiquid assets such as property into quality money – including gold – at the inverted apex. This phase will be prompted by a collapse in confidence in the dollar – triggered possibly by the collapse of a major bank, the stock market, and/or the bond market.

In any case, as it is made clear above, the situation now emerging has all the hallmarks of an insoluble dilemma for the US authorities. Against the background of the global capital crunch, the decline of foreign savings to fund the increasing deficit, the growing global economic contraction, the deflationary or inflationary scenarios are both insoluble. There are no solutions that do not involve a dramatic transformation of the USD in international financial markets, and its role as the reserve currency. Both scenarios ultimately lead to a flight to quality money and liquidity, out of the USD and into gold and other currencies.

------

Unfortunately I cannot take credit for the insightful words above. They were written by my former boss - Michael Kile. What is shocking is that they were written in February 1991, one chapter in a 40 page document titled "The case for gold in the 1990s", published by the Perth Mint.

Consider that I had only to remove a few sentences (which included giveaway dates and figures) for it to read as if it was written in 2008. It is worth re-reading it with the understanding that the analysis is 17 years old and realise that during those 17 years the US got away with "the old remedy of inflating out of this predicament by issuing cheaper and cheaper money".

The question is: will the US get away with it this time, or will Mr Kile be finally correct that the old remedy "simply will not work this time"?

The 1974 Liquidity Squeeze in Australia

Googling for background on the Banking Act for a future blog, I found a paper titled "A History of Last-Resort Lending and Other Support for Troubled Financial Institutions in Australia" (http://www.rba.gov.au/rdp/RDP2001-07.pdf).

I had an unnerving déjà vu experience when reading Section 10 (except the bank run part, maybe that is next). Below are some extracts.

"Section 10 The 1970s

Following the comparative calm of the 1950s and 1960s, the growth of non-bank financial institutions fuelled a property boom in the early 1970s. The 1974 liquidity squeeze brought the boom to an abrupt end. The failure of a number of property financiers precipitated runs on building societies in several states, particularly South Australia and Queensland. Building societies in Queensland also experienced difficulties in 1976 and 1977. Weakness in the property market brought down the Bank of Adelaide later in the decade. The Reserve Bank provided some liquidity support in each of these cases, although it did not lend directly to non-banks.

10.1 The 1974 Liquidity Squeeze

Following a boom in lending by banks and non-bank financial institutions, the Reserve Bank tightened monetary policy in 1973. This was accompanied by a drain in liquidity resulting from a deterioration of the balance of payments and a government budget surplus. As interest rates soared, property prices began to collapse triggering the failure of several property development companies.

On 30 September 1974, the property financier Cambridge Credit went into liquidation. The failure of two other substantial property developers (Home Units Australia in July and Mainline Corporation in August) preceded Cambridge Credit’s closure. While those failures prompted sharp falls in the share prices of other property developers, finance companies and banks, Cambridge Credit’s failure saw public nervousness spread directly to other financial intermediaries. The following day, runs developed on building societies in NSW, Victoria, Queensland and South Australia. While the runs in NSW and Victoria were comparatively small, the runs in Queensland and South Australia were far more severe.

...

Although the Hindmarsh Building Society in South Australia was financially sound, it was subject to the most severe run. The run, based on rumours the society had lent to failed property companies, continued, little affected by the Acting Treasurer’s statement. The run exhausted the society’s cash reserves. The National Australia Bank lent the society cash until the National also ran low. On 3 October, the South Australian Premier, Don Dunstan, addressed customers queuing outside the Hindmarsh’s offices, assuring them that their funds were safe. The run subsided the next day."

For "youngsters" like me (I was only 5 years old when this liquidity squeeze occurred) I would also recommend reading "Appendix A: Financial Disturbances in Australia – A Chronology". Runs happen. Interesting question is whether the public these days would be comforted by a statement by a politician that all is OK. Maybe they will be, is there any proof that society has gotten any smarter? If anything one could argue they have gotten stupider and more greedy and are just as invested in keeping the system going so will want to believe there isn't any fundamental problem with the system. Coming soon to a theater near you: The F-Files: I Want to Believe in Fiat Currencies.

I also found some other interesting comments about legal tender gold backed notes in the paper:

“High-powered money consists of those forms of money that are directly exchangeable for real goods (i.e. commodity money, such as gold coin, and instruments declared to be legal tender). While, up until 1910 the notes issued by banks and backed by gold were also highly liquid, the fact that their widespread acceptance relied on public confidence in the banks that issued those notes indicated that they were one step removed from high-powered money.”

“In 1910, the Federal Government’s legal-tender note issue was introduced. Initially, it was required that the government’s gold reserve cover one-quarter of the value of notes issued up to £7 million. For any note issuance above £7 million, one-for-one backing was required. In 1914, however, the gold reserve provision was relaxed so that the required gold reserve was one-quarter of the value of notes on issue regardless of the size of the total note issue.”

“The bank [Commonwealth Bank] was required to maintain a minimum gold reserve of 25 per cent of the notes on issue (although the required gold reserve was reduced to 15 per cent in June 1931). Although Australia went off the gold standard at the end of 1929, it was not until the introduction of new banking legislation in 1945 that the gold reserve requirement was completely abandoned.”

I like the term "high-powered money". I wonder if this is some defined academic term or just made up by the authors? History lesson for today - get hold of some high-powered money!