Duration Mismatch

In all the hoopla over Japan's stock market crash and China's PMI miss last night, the biggest news of the day was largely ignored: copper, and the fact that copper's ubiquitous arbitrage and rehypothecation role in China's economy through the use of Chinese Copper Financing Deals (CCFD) is coming to an end.

Do you think that depositors in Cyprus are being taxed? That their money is being taken from them to go to the government in Cyprus or to Europe? Most analysis of the Cyprus bailout is wrong...

The Real Bill is quite different from the bond. It isn’t lending at all. It is a clearing instrument that allows the goods to move to the gold-paying consumer before said consumer pays with gold.

From a valuation perspective, Chinese equities do not, at first glance, look to be a likely candidate for trouble. The PE ratios are either 12 or 15 times on MSCI China, depending on whether you include financials or not, and do not scream 'bubble'. And yet, China has been a source of worry for GMO over the past three years and continues to be one. China scares them because it looks like a bubble economy. Understanding these kinds of bubbles is important because they represent a situation in which standard valuation methodologies may fail. Just as financial stocks gave a false signal of cheapness before the GFC because the credit bubble pushed their earnings well above sustainable levels and masked the risks they were taking, so some valuation models may fail in the face of the credit, real estate, and general fixed asset investment boom in China, since it has gone on long enough to warp the models' estimation of what "normal" is. Of course, every credit bubble involves a widening divergence between perception and reality. China's case is not fundamentally different. In GMO's extensive discussion below, they have documented rapid credit growth against the background of a nationwide property bubble, the worst of Asian crony lending practices, and the appearance of a voracious and unstable shadow banking system. "Bad" credit booms generally end in banking crises and are followed by periods of lackluster economic growth. China appears to be heading in this direction.

Following Part 1 (History), and Part 2 (Interventionism), Part 3 provides a more technical look at the key features of the unadulterated gold standard.  It could be briefly stated as a free market in money, credit, interest, discount, and banking.  Another way of saying it is that there would be no confusion of money (i.e. gold) and credit (i.e. paper).  Both play their role, and neither is banished from the monetary system. There would be no central bank with its “experts” to dictate the rate of interest and no “lender of last resort”.  There would be no Securities Act, no deposit insurance, no armies of banking regulators, and definitely no bailouts or “too big to fail banks”.  The government would have little role in the monetary system, save to catch criminals and enforce contracts.

The choice of the word “unadulterated” is not accidental.  There were many different kinds of gold standard, including what we now call the Classical Gold Standard, the Gold Bullion Standard, and the Gold Exchange Standard.  Each contained flaws; each was adulterated.

John Tamny of Forbes is one of the more informed contributors in the increasingly dismal state of economic commentating.  Tamny readily admits he is on the libertarian side of things and doesn’t give into the money-making game of carrying the flag for a favored political party under the guise of a neutral observer.  He condemns the whole of the Washington establishment for our current economic woes and realizes that government spending is wasteful in the sense that it is outside the sphere of profit and loss consideration.  In short, Tamny’s column for both Forbes and RealClearMarkets.com are a breath of fresh air in the stale rottenness of mainstream economic analysis. Much to this author’s dismay however, Tamny has written a piece that denies one of the key functions through which central banks facilitate the creation of money.  In doing so, he lets banks off the hook for what really can be classified as counterfeiting.  In a recent Forbes column entitled “Ron Paul, Fractional Reserve Banking, and the Money Multiplier Myth,” Tamny attempts to bust what he calls the myth that fractional reserve banking allows for the creation of money through credit lending.  According to him, it is an extreme exaggeration to say money is created “out of thin air” by fractional reserve banks as Murray Rothbard alleged.  This is a truly outrageous claim that finds itself wrong not just in theory but also in plain evidence.  Not only does fractional reserve banking play a crucial role in inflationary credit expansion, it borders on being outright fraudulent.

Falling interest rates are a feature of our current monetary regime, so central that any look at a graph of 10-year Treasury yields shows that it is a ratchet (and a racket, but that is a topic for another day!).  There are corrections, but over 31 years the rate of interest has been falling too steadily and for too long to be the product of random chance.  It is a salient, if not the central fact, of life in the irredeemable US dollar system. Irving Fisher, writing about falling prices (I shall address the connection between falling prices and falling interest rates in a forthcoming paper) proposed a paradox: “The more the debtors pay, the more they owe.” Debtors slowly pay down their debts and reduce the principle owed.  This would reduce the NPV of their debts in a normal environment.  But in a falling-interest-rate environment, the NPV of outstanding debt is rising due to the falling interest rate at a pace much faster than it is falling due to debtors’ payments.  The debtors are on a treadmill and they are going backwards at an accelerating rate. How apropos is Fisher’s eloquent sentence summarizing the problem!

Duration mismatch is when a bank (or anyone else) borrows short to lend long.  It is fraud, it is unfair to depositors (much less shareholders) and it is certain to collapse sooner or later. This discussion is of paramount importance if we are to move to a monetary system that actually works. By taking demand deposits and buying long bonds, the banks distort the cost of money.  They send a false signal to entrepreneurs that higher-order projects are viable, while in reality they are not.  The capital is not really there to complete the project, though it is temporarily there to begin it. Capital is not fungible; one cannot repurpose a partially completed desalination plant that isn’t needed into a car manufacturing plant that is.  The bond on the plant cannot be repaid.  The plant construction project was aborted prior to the plant producing anything of value.  The bond will be defaulted.  Real wealth was destroyed, and this is experienced by those who malinvested their gold as total losses. Note that this is not a matter of probability.  Non-viable ventures will default, as unsupported projects will collapse. Unfortunately, someone must take the losses as real capital is consumed and destroyed - and these losses are caused by government’s attempts at central planning, and also by duration mismatch.

If we understand the difference between parasitic wealth and real value/wealth creation, we can properly align the tax structure to reality: the tax on authentic wealth creation should be low, to encourage wealth creation and the employment (broad-based wealth creation) generated by legitimate value creation. We must also understand that the Central State now protects and enables parasitic skimming as the primary function of the nation's financial system. Thus the entire financial system is parasitic on the wealth of the nation. Financial parasitic incomes should be taxed at 99%. If Mitt Romney reshuffles assets created by others and skims $100 million, 99% of that parasitic wealth should be returned to the nation via taxes. The parasite still gets to keep $1 million, more than enough to live well but not enough to buy the presidency, the Congress and the regulatory machinery of the Central State.

While events over the weekend have had a dramatic impact on the political landscape of Europe, that's just what they are: political events. Yet for all the rhetoric, promises, and bluster, only one thing matters in the end: cold, hard math. The same math which last weekend indicated that Europe is still facing trillions and trillions in bank deleveraging. That has not changed one cents between then and now, regardless who is the puppet (muppet?) head of this country or that. But since that won't become evident for at least a few more years, it can be safely forgotten, until the time comes to recall it that is, at which point there will be a full blown crisis even though there were years of advance warning to prepare for the crunch. So here is some more math: in a downside case forecast looking at funding capacity of Spanish and Italian banks - the same banks that would have been long insolvent had it not been for a $1.3 trillion injection by the ECB - Deutsche Bank predicts that the two groups may have as vast a funding shortfall as €210 billion in 2012 (€114.4 billion in Spain, €96.1 billion in Italy). Which to DB means one thing of course: more LTROs coming because once the market has habituated to the now periodic infusion of monetary heroin it will not let go until it is convulsing in its death rattle, something the status quo will never allow, or until it gets just one more hit.

It seems self-evident. The government can debase the currency and thereby be able to pay off its astronomical debt in cheaper dollars. But as I will explain below, things don’t work that way. In order to use the debasement of paper currencies to repay the debt more easily, governments will need to issue and use the gold bond. The paper currencies will not survive too much longer. Most governments now owe as much or more than the annual GDPs of their nations (typically far more, under GAAP accounting). But the total liabilities in the system are much larger. The US dollar game is a check-kiting scheme. The Fed issues the dollar, which is its liability. The Fed buys the US Treasury bond, which is the asset to balance the liability. The only problem is that the bonds are payable only in the central bank’s paper scrip! Meanwhile, per Bretton Woods, the rest of the world’s central banks use the dollar as if it were gold. It is their reserve asset, and they pyramid credit in their local currencies on top of it. It is not a bug, but a feature, that debt in this system must grow exponentially. There is no ultimate extinguisher of debt. In reality, stripped of the fancy nomenclature and the abstraction of a monetary system, the picture is as simple as it is bleak. Normally, people produce more than they consume. They save. A frontier farmer in the 19th century, for example, would dedicate some work to clearing a new field, or building a smokehouse, or putting a wall around a pasture so he could add to his herd. But for the past several decades, people have been tricked by distorted price signals (including bond prices, i.e. interest rates) into consuming more than they produce. In any case, it is not possible to save in an irredeemable paper currency.  Depositing money in a bank will just result in more buying of government bonds.  Capital accumulation has long since turned to capital decumulation... I propose a simple step. The government should sell gold bonds. By this, I do not mean gold “backed” paper bonds. I mean bonds denominated in ounces of gold, which pay their coupon in ounces of gold and pay the principal amount in ounces of gold. Below, I explain how this will solve the three problems I described above.

As the title of this essay suggests, a loan is an exchange of wealth for income.  Like everything else in a free market (imagine happier days of yore), it is a voluntary trade.  Contrary to the endemic language of victimization, both parties regard themselves as gaining thereby, or else they would not enter into the transaction. In a loan, one party is the borrower and the other is the lender.  Mechanically, it is very simple.  The lender gives the borrower money and the borrower agrees to pay interest on the outstanding balance and to repay the principle. As with many principles in economics, one can shed light on a trade by looking back in history to a time before the trade existed and considering how the trade developed. It is part of the nature of being a human that one is born unable to work, living on the surplus produced by one’s parents.  One grows up and then one can work for a time.  And then one becomes old and infirm, living but not able to work.  If one wishes not to starve to death in old age, one can have lots of children and hope that they will care for their parents in their old age.  Or, one can produce more than one consumes and hoard the difference.

The Keynesians and Monetarists have fooled people with a clever sleight of hand. They have convinced people to look at prices (especially consumer prices) to understand what’s happening in the monetary system. Anyone who has ever been at a magic act performance is familiar with how sleight of hand often works. With a huge flourish of the cape, often accompanied by a loud sound, the right hand attracts all eyes in the audience. The left hand of the illusionist then quickly and subtly takes a rabbit out of a hat, or a dove out of someone’s pocket. Watching a performer is just harmless entertainment, and everyone knows that it’s just a series of clever tricks. In contrast, the monetary illusions created by central banks, and the evil acts they conceal, can cause serious pain and suffering. This is a topic that needs more exposure.

As first reported here, two weeks ago European banks saw the amount of USD-loans from the Fed, via the ECB's revised swap line, surge to over $50 billion - a total first hit in the aftermath of the Bear Stearns failure prompting us to ask "When is Lehman coming?" However, according to little noted prepared remarks by Anthony Sanders in his Friday testimony to the Congress Oversight Committee, "What the Euro Crisis Means for Taxpayers and the U.S. Economy, Pt. 1", we may have been optimistic, because the end result will be not when is Lehman coming, but when are the next two Lehmans coming, as according to Sanders, the relaunch of the Fed's swaps program may "get to the $1 trillion level, or perhaps even higher." As a reference, FX swap line usage peaked at $583 billion in the Lehman aftermath (see chart). Needless to say, this estimate is rather ironic because as Bloomberg's Bradely Keoun reports, "Fed Chairman Ben S. Bernanke yesterday told a closed-door gathering of Republican senators that the Fed won’t provide more aid to European banks beyond the swap lines and the discount window -- another Fed program that provides emergency funds to U.S. banks, including U.S. branches of foreign banks." Well, between a trillion plus in FX swap lines, and a surge in discount window usage which only Zero Hedge has noted so far, there really is nothing else that the Fed can possibly do, as these actions along amount to a QE equivalent liquidity injection, only denominated in US Dollars. Aside of course to shower Europe with dollars from the ChairsatanCopter. Then again, before this is all over, we are certain that paradollardop will be part of the vernacular.