Reserve Currency

• After the worst post-Christmas market performance since 1937, we had the largest surge to kick off any year in recorded history
• The myth is that we are now seeing the clouds part to the extent that cash will be put to work. Not so fast It is very likely that much of the market advance has been short-covering and some abatement in selling activity
• As equities now retest the cycle highs, it would be folly to believe that we will not experience recurring setbacks and heightened volatility along the way
• The reality is that the tough choices and the tough bargaining have been left to the next Congress and are about to be sworn in
• The myth is that the economy escaped a bullet here. The reality is that even with the proverbial "cliff" having been avoided, the impact of the legislation is going to extract at least a 11/2 percentage point bite out of GDP growth

The chart below illustrates why the U.S. economy is so dependent on the wealth effect generated by asset bubbles.   It’s stunning to think that average real earnings in the U.S. are almost 11 percent lower than where they were in 1973. Policymakers’ focus should be on increasing worker productivity through: 1) reforming the country’s education system;  2) unleashing entrepreneurship;  and 3) in the words of ECB chief, Mario Draghi, “doing whatever it takes” to empower small businesses. But, this is tough political business, however, so we take the easy way out.   The political pandering increases budget deficits, forcing the Fed to repress interest rates and print money to drive up asset prices.   The boom side of the cycle is sustained longer than most expect because of the reserve currency status of the dollar.  This temporarily generates artificially inflated demand (i.e, fake) through the wealth effect, which eventually collapses when asset markets crash. This is not a good long term economic strategy and sustainable path for permanent wealth creation

Time is running out. The cliff negotiations have devolved into two unpalatable options: (1) extend just the middle income tax cuts and extended unemployment benefits and allow about two-thirds of the cliff to happen, or (2) go over the cliff in the entirety. In BofAML's view, given the short time frame and legislative hurdles, the latter appears much more likely. Stock market vigilantes have replaced bond vigilantes as the potential good, bad, and ugly scenarios are devoured flashing red headline by flashing red headline. They, like us, believe that going over the cliff is not a benign “slope” as some suggest. Rather, it accelerates the already-building damage to the economy and markets. The latest evidence is the plunge in consumer confidence. Indeed, this could mark the beginning of the rotation in the uncertainty shock from businesses to consumers. Going over the cliff has many secondary, largely ignored, negative impacts, including tax changes that could damage the housing recovery, as well as negatively impact education and alternative energy, among many others.

We are happy to announce that starting today, and going forward every week, as part of a new feature dubbed, appropriately enough, FleeceBook, we will introduce our readers to one, previously largely unknown member of the ruling banker aristocracy: an individual who is as far from the glamor of the daily media headlines as possible: just the way they like it, and just the way the co-opted media will agree to have it. We hope that by the end of the series, these individuals - all of them perfectly law abiding citizens of their various jurisdictions, at least under conventional legal terms - will form a tapestry of what really happens behind the scenes, especially in a context such as that presented yesterday, where we found that no matter how guilty beyond a reasonable doubt a member of the political-financial elite is, hell would have to freeze before any legal action is taken (for reference, please see the very underrated movie The International). For our inaugural edition on FleeceBook, which will compile various public profiles already posted elsewhere, we present Benoît Gilson, Head of Foreign Exchange & Gold, which he describes as "a really special place to work because it is a link between the markets and the central banks." In other words if confused why gold is imploding on any/every given day, and/or why the EUR is soaring on news of a failed ECB sterilization, now you know who to thank.

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.

Our biggest concern here on the cusp of 2013 is the current odd combination of extreme complacency about the risks presented by extend-and-pretend macro policy making and rapidly accelerating social tensions that could threaten political and eventually financial market stability. Before everyone labels us ‘doomers’ and pessimists, let us point out that, economically, we already have wartime financial conditions: the debt burden and fiscal deficits of the western world are at levels not seen since the end of World War II. We may not be fighting in the trenches, but we may soon be fighting in the streets. To continue with the current extend-and-pretend policies is to continue to disenfranchise wide swaths of our population - particularly the young - those who will be taking care of us as we are entering our doddering old age. We would not blame them if they felt a bit less than generous. The macro economy has no ammunition left for improving sentiment. We are all reduced to praying for a better day tomorrow, as we realise that the current macro policies are like pushing on a string because there is no true price discovery in the market anymore. We have all been reduced to a bunch of central bank watchers, only ever looking for the next liquidity fix, like some kind of horde of heroin addicts. We have a pro forma capitalism with de facto market totalitarianism. Can we have our free markets back please?

Global Central Banks agree to another year of access to FRBNY FX Swap Lines

If there is one thing better than Marc Faber providing a free, must-watch (and listen) 50 minute lecture on virtually everything that has transpired in the end days of modern capitalism, starting with who caused it, adjustable rate mortgages, leverage, why did the Fed let Lehman fail, why was AIG bailed out, quantitative easing, Operation Twist, where the interest on the debt is going, which bubbles he is most concerned about, a discussion of gold and silver, and culminating with his views on a world reserve currency, is him saying the following: "The views of the Keynesians like Mr. Krugman is that the fiscal deficits are far too small. One of the problems of the crisis is that it was caused by government intervention with fiscal and monetary measures. Now they tells us we didn't intervene enough. If they really believe that they should go and live in North Korea where you have a communist system. There the government intervenes into every aspect of the economy. And look at the economic performance of North Korea." Priceless.

Consider the consequences of the efficient subsidizing the inefficient. As long as the surplus generated by the efficient is larger than the cost of supporting the inefficient, the system can continue. But once the cost of subsidizing the inefficient exceeds the surplus generated by the efficient, the system is doomed to eventual insolvency. There is one way to fill the deficit, of course: borrow money. This is the strategy being pursued by the Status Quo in developed and developing economies alike. As long as the inefficient are protected from competition and amply subsidized, there are no incentives to become more efficient. In effect, becoming more inefficient is rewarded.  What happens when the efficient sectors that are propping up a vast array of inefficient sectors falter? The politically expedient answer is of course to borrow more money. But that creates another kind of financial fragility. Borrowing money only masks the fragility for a time, while adding another layer of fragility beneath the apparently prosperous surface.

Warren Buffett is one of America’s biggest bailout beneficiaries, having profited hugely from buying into firms whose assets were subsequently bailed out. Shortly after the crisis began in 2008, Warren Buffett loaned money to, and bought options from, Goldman Sachs, seemingly with the knowledge the bailout of AIG — a counterparty to which Goldman had massive, massive exposure — would take place. Dimon as Treasury Secretary would intend more of the same. Dimon and Buffett and others like them believe in having their cake and eating it. Buffett and Dimon surely have in mind more cronyism, bailouts and free lunches, but the reality of the next four years and beyond may be very different indeed.

Excessive monetary stimulus and low interest rates create financial bubbles. Seymour Pierce's Thunder Road report notes that central banks are creating the ultimate bubble in money itself, as they fight the downward leg in this Long Wave cycle. This is the biggest debt bubble in history. Each time deflationary forces re-assert themselves, offsetting inflationary forces (monetary stimulus in some form) have to be correspondingly more aggressive to keep systemic failure at bay. The avoidance of a typical deflationary resolution of this Long Wave is incubating a coming wave of inflation. This will not be the conventional “demand pull” inflation understood by most economists. The end game is an inflationary/currency crisis, dislocation across credit and derivative markets, and the transition to a new monetary system , with a new reserve currency replacing the dollar. This makes gold and silver the “go-to” assets for capital preservation.

Well, my fellow Slope-a-Dopes, although this will undoubtedly be a dreadful decidedly devastating disappointment to many of you, I have chosen to put away my almighty artistically asinine alliteration pen for this Sunday's super significant spectacularly special EP.  Instead of dazzling you with my proficient pathetically putrid pitiful prose, I will focus my alertly astute attention on a stupefyingly serious subject.

Since the 2nd Liberty Act of 1917 birthed the debt ceiling, due to issues financing USA's entry into World War I, CNBC's Rick Santelli notes that there has been many documented 'violations'. However, as Rick so vociferously points out President Obama's comment yesterday on the debt limit and highlights the fact that "to have an unlimited amount of money to call upon is too much power power for one person. It's always in our country been about checks and balances but I think this administration just wants more checks and no balancing of the checkbook." Rick is right, of course, and the current diatribe from Geithner and Obama yesterday on the possible 'removal' of the debt limit beggars belief - and yet has become a negotiating point to be 'traded'. While some argue the premise of the debt limit for a reserve currency nation is nonsense, Santelli sums it perfectly in ten little words: "Debt Ceiling Is Not The Problem. Debt Is The Problem," adding the debt ceiling, as we have pointed out regularly, is an important (perhaps the most important) issue facing us currently (and inseparable from the supposed 'austerity' of the fiscal cliff - lower spending growth not lower spending).

It’s estimated that the pound sterling made up around 64% of the world’s official FX reserves in 1899. It had fallen to about 48% by 1913.  As you'll likely glean from the graphic below, Addogram notes that historic recurrence seems to like operating in base-100 when it comes to reserve currencies. The dollar's share of global (official allocated) FX reserves has fallen from 72% in 1999 to 62% at present. As we have pointed out before - reserve currency status doesn't last forever...

Oaktree Capital's Chairman Howard Marks went on a rather more politically-positioned rant in his latest missive (pdf here) but one section caught our eye more than others given the current imbroglio:

The bottom line is that if we don't want to be Greece, we can't act like Greece. Something has to be done... and soon. Every year in which we add another trillion dollars to the national debt (and tens of billions to the annual interest bill) - and every year the excessive entitlement promises are allowed to compound - makes it harder to solve the problem.

A dismally honest reflection follows...