Are we at the beginning of a new cycle of rising interest and rising prices? No, and here's why.
In 1933, FDR confiscated the gold of Americans. This common telling portrays it as a simple case of robbery. It makes people wonder if 1933 is a precedent. I don’t think it is so simple.
We have warned a number of times that China is a ticking time-bomb (and the PBoC finds itself between a housing-bubble rock and reflationary liquidity injection hard place) but the collapse of trust in the interbank funding markets suggests things are coming to a head quickly. The problem the administration has is re-surging house prices and a clear bubble in credit (as BofAML notes that they suspect that May housing numbers might have under-reported the true momentum in the market since local governments are pressured to control local prices) that they would like to control (as opposed to exaggerate with stimulus). As we noted here, while the PBOC may prefer to be more selective with their liquidity injections (read bank 'saves' like ICBC last night) due to the preference to control the housing bubble, when they finally fold and enter the liquidity market wholesale, the wave of reflation will rapidly follow (and so will the prices of precious metals and commodities).
A month ago, when stock markets around the globe were hitting all time highs, we wrote "The Bronze Swan Arrives: Is The End Of Copper Financing China's "Lehman Event"?" which as so often happens, many read, but few appreciated for what it truly was - the end of a major shadow leverage conduit (one involving unlimited rehypothecation at that),and the collapse of a core source of shadow liquidity. One month later, China's "Lehman event" is on the verge of appearing, and with Overnight repo rates hitting 25% last night, coupled with rumors of bank bailouts rampant, it very well already may have but don't expect the secretive Chinese politburo and PBOC to disclose it any time soon. So now that the market has finally once again caught up with reality, for the benefit of all those who missed it the first time, here is, once again, a look at the arrival of China's Bronze Swan.
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.