Friday 18 December 2009

The Euro, the Pseudo Gold Standard

The Euros showing signs of stress lately. The Dollar climbed to $1.43, its highest in three months as the fiat race to the bottom continues. Greece's sovereign debt was downgraded with the third generation of a Papandreou residing at the helm in what looks to be another Greek catastrophe. Spain somehow continues to mask the mess it finds itself in. At some point the poison will inevitably seep through. Meanwhile with regards to the other PIIGS (yes thats two i's, Ireland and Italy) we find Ireland have launched their second cost cutting budget in an attempt to appease the other 'sounder' Euro states. According to the governments figures they have come out of recession unlike here in the UK. Italy's leader Berlusconi took a beating, literally. Although the attack was appalling, its more disturbing to see such popular support for Massimo Tartaglia, the person who carried out the senseless assault. Austria's Government followed the new global trend by effectively nationalising the countries 6th largest bank, Carinthian Hypo Alpe Adria Bank AG, with the taxpayer now becoming it's largest shareholder. It's not the only bank in trouble with the countries 4th largest, Oesterreichische Volksbanken AG, also under the governments watch. Exposure in the Balkans and Eastern Europe, Austria's banking system is looking more insolvent as time goes on. Despite what Americans say about their banking losses at least their banks are declaring them. Europe's financial system is one monstrous black box, with everyone trying to call each others bluff. Even Germany seems to be throwing out the rule book announcing tax breaks despite a widening budget deficit, however compared with many other countries double digit percentage horror shows it won't sound an alarm with the bond vigilantes.

There's been many commentaries written in relation to the Euro the single currency that's used by 16 separate nations, usually critical toward the faceless bureaucrats who reside in Brussels. However its important to understand how the Euro came about. During Bretton Woods I, when the US was on it's quasi Gold Standard, they pegged the dollar to gold allowing only foreign central banks to redeem their dollars for gold. With increased deficits by Kennedy and then by Lyndon Johnson this spending had to be paid by someone, therefore the government does what it usually does, it printed money to pay the difference. When the Bretton Woods agreement was created the Keynesian's proclaimed that redeemability of the dollar for gold would cause no issues as institutions would never need to claim. Unfortunately for them they didn't count on Jacques Ruff advisor to former French president Charles De Gaulle. 'They run deficits without tears', thus Ruff advised De Gaulle to call the Americans bluff and trade in the paper promises for something that the American Administration couldn't create out of thin air. Others followed suit.

The rest as they say was history. Bretton Woods I was abandoned, in which we moved to the current global monetary system we still have now. The erratic fluctuations of the currency markets during the seventies accompanied with widespread financial turmoil prompted many European nations to look for solutions to stabilise trade, thus the chaos became one of the prime reasons for the single monetary currency created two decades later. There was an obvious issue from the start. Two distinct tribes existed within the union, the North dominated by Germans who had previously presided over the Mark, a currency as hard as any other in its day. The other faction, the Southern Mediterranean nations a historic bunch of pansies that would use their currency at the first instance of economic trouble to try and solve their problems. During its first 10 years all seemed well but when disorder came, the Mediterranean nations suddenly found themselves in a bind. They couldn't devalue or print as they had in the past, instead they were told by the Northern circle that they must cut their deficits along with reckless spending. Don't get me wrong, the ECB have dabbled in QE however in comparison to the Drachma, Lira, Escudo or Peseta if they still existed and were in the hands of the irresolute Southern Europeans, then things would be getting a whole lot worse for such countries as we tread into unknown waters.

The Euro is in effect a Pseudo Gold Standard for some. Similar to when the majority of nations had a fully convertible Gold Standard, there are checks on Government spending such that they can not rob the public through inflation, or sidestep genuine long term fixes with short term devaluations. This is not to say the rules can't be bent, the rules are always for bending when the government is solely in charge. For example the deficit limit for states that were to join the Euro was originally set at no more than 3% of GDP. Problem being that nations such as Portugal just moved some of their deficit from the official figures to assist in their entry into the Euro to meet the criteria. After the financial crisis fiscal restraint has been put on the back burner, another crisis will need to occur before anyone gets serious again.

Like a Gold Standard, the old bundesbanks dominance on the ECB acts as a check against others that are more willing to deploy looser monetary policy. It depends if you have the stomach for such medicine as to whether you believe it is beneficial.

Many commentators state that the Euro is the problem facing countries like Greece, the reasons given are usually the very same policies that got them in the hole in the first place, in this case excessive government involvement and monetary inflation. They are usually correct on one point, that it was the Euro that exacerbated the credit boom for many such nations. Generous subsidies to promote the Euro's launch created undeserved prosperity, accompanied with negative real interest rates in such countries, meant loose lending was endemic.

Ideas that increased inflation and spending can alleviate the problems we face are wrong. They instead increase the states control and crowd out private enterprise and initiative. Not only does it fail, but it becomes an immoral path as genuine savings are stolen from the people.

One of the questions people ask is what will become of the Euro? Will it survive? Will its members fragment? Will it gain in numbers and strengthen? I don't think we can arrive at a conclusive decision on any of the above as they are all legitimate possibilities.

Fragmentation could be possible. A number of nations could drown in their own debt but we have to realise governments always bend the rules. The ECB may show a tough hand for the moment but could ease if events got out of hand. If a nation did wish to exit then imagine the stigma attached to the politician in office at the time. It would take a brave politician to declare an exit from the Euro while others in the Balkan's, Baltic's and the East are clamouring for such prestige.

Would others join the Euro as a refuge? Possibly, however if the above were to occur we could see the emergence of a new strengthened Euro. Nations such as Norway or Switzerland could join, forming what would be one of the soundest currencies in the world. They didn't join in the beginning with the current members therefore , if the weakest were weeded out they could have a change of heart. This would be the only reason I could see them joining.

Survival? I'm bearish on all fiat money. Even the Euro. There are many problems contained in Europe. It could however emerge as a genuine contender to the Dollar if the harder money circles have their way.

So is the Euro a good or bad thing? Well I'd prefer the ECB administering my nations currency rather than the current set of inept individuals who are running riot with the UK's monetary policy. German jokes aside, you have to wonder how they do it. After a crippling war they arose as the dominant power of Europe once more, a dynamic economy that produced quality products, while other Western nations industries went into decline. It dealt with unification as Communism collapsed thus inheriting a nation with years of decay that required to be rectified. She then became one of the key participants to unify Europe under the single currency opting to bin their sound Mark. Subsidies were provided to Ireland and Spain to promote the Euro, subsidies paid for by the German taxpayer. She wasn't even resource rich, importing many commodities. There was however a culture of hard work, along with the abstinence of partaking in speculative activities such as Real Estate even as the 'Anglo-Saxon' economic models mocked the Germans for relative stagnant growth in comparison. Since the arrival of the crisis the jokes have stopped and once more the Germans hold the key to Europe, to the pseudo fiat Gold Standard known as the Euro. History leads me to the opinion that I'd prefer the Germans to manage my sovereign currency. Its the same story for many others who are current members of the Euro, it just depends if their culture can adapt to a different monetary way of thinking.

Friday 4 December 2009

Britain, the Canary down the Western Coal Mine

"We used to think that you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists, and in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment as the next step."
Jim Callaghan - Speech at the Labour Party Conference, 28 September 1976

Gold prices had been on the rise for weeks, then all of a sudden fell back with a thud as we were told that only 11,000 jobs were lost in the US during November. Another Brown bounce in the polls left Cameron backtracking, austerity is so last month, instead 'growth' by government spending is now acceptable as policy is dictated by focus groups. The Middle Easts version of Las Vegas got a helping hand which was good news for many UK banks, however only a mere $80 Billion would have been at stake. Years ago it would have meant something, not today with Trillion dollar bailouts. China's vice governor at the peoples bank declared 'We must watch out for bubbles forming on certain assets, and be careful in those areas' referring to golds recent upward trajectory. Nice try, that deceit may wash with CNBC but those of us in the loop know full well that China would love to transfer much of their paper assets into hard assets such as Gold.

It's sometimes easy to forget what the average person thinks in relation to financial matters. Articles posted here are certainly not consistent with mainstream thinking. People are still on the same broken record, 'Buy a house now while prices are cheap before you get priced out', 'We are past the worst now and good times are ahead', 'The government will make a good profit for the taxpayers with the bank bailouts'. Ask people who read the financial sections of broadsheet newspapers about gold and you get told 'The price can go up as well as down' as though this is a unique quality that does not apply to other assets such as bonds, real estate or stocks. Indeed it is important to remember just what people are thinking, because you don't want to be on the same page as them. 'Repeat after me, Gold is a bubble, Central Banks can 'tame' markets, the sustainable recovery is here and there is no inflation! There is no spoon!' There's no analysis of the thunderstorm that is brewing in the distance.

So what about this Gold bubble then? People are right, however they are 5, 10, 15 years too early in calling it. People are buying the stuff because one day it will be a bubble as the Worlds Central Banks are busy blowing the next bubbles as I write. The currency and Government Bond bubbles will eventually burst causing mass inflation and creating the next bubble, commodities and precious metals. As Bernanke and Company try to assess how best to deal with bubbles, they fool the public as though these events are some mystical force that no one can control. I have a simple solution, how about stop printing so much money. We instead move from bubble to bubble, the Centrals banks policy after one pops is to inject further easy money into the system. Like some drunk who throws up after a bottle of vodka, 'I best have another to sort myself out'.

Could the US unemployment figures signal the turn with people getting back to work? Maybe in the short term, but I don't think this will be a long term trend. You have to remember governments everywhere are printing huge amounts of money and this is bound to give the so called 'prosperity' effect in the short term but it won't last, the free market hasn't healed. During the coming stagflation a lot of conventional indicators will seem to be healing when in fact the underlying fundamentals are deteriorating. For ten years after the credit crunch in 1973/74 the unemployment rate in the UK kept rising.


It didn't move up in a straight line, with periods of consolidation and even movements to the downside. When the correct path was taken it took years to fall. Numbered estimates in the news are useless, three million, four million, all have been given as figures for the short term, however no one can say for certain, all we do know is that history says it will keep rising over the long term.

For a developed country the British people sure do love their inflation. While many other nations inflation indices have plummeting like many a British Banks shares, the UK's inflation rate has remained remarkably 'sticky'. Whether its the appreciation of our assets, our rising incomes, our increased levels of debt or the fallacy that we believe the weak pound is good, we really do want to beat other nations in the race to the bottom. The yanks scream 'bloody murder' watching their beloved dollars debasement from the powers that be, not realising that one hundred years ago a British pound used to be worth $5. Anything you can do across the pond, we can do it much worse. Over the next decade I'm sure we will show the developed world what not to do. The problem I see is that British people want inflation. We want to see rising prices, we believe that this is a healthy state of affairs and will thus allow a greater level of leniency towards our policymakers compared with other nations when it comes to expansive monetary policy.

Will the BoE raise interest rates when the market forces their hand? Contrary to what people believe it is the market that controls long term interest rates. We may like to think of central banks under a paternalistic viewpoint, our saviours there to insulate us from financial destruction and chaos, to solve economic issues should they arise. Central bankers are just like their Communist Central Planning counterparts, eventually market forces get the better of them where eventually they follow the market, not set the tempo as they would have us all believe.

In order to understand how markets dictate prices such as interest rates its easier to compare the lowering of interest rates to say lowering the price of bread. If the government declared rather than liquidity not been easily accessible that the issue was now high bread prices, they therefore set forth a policy to fix the price lowering it below the market one. As suppliers begin making losses they shut down production, at the same time people consume more as they can purchase more of the product. Eventually the country runs out of bread with all stocks depleted. Rather than bite the bullet immediately the government would in all probability resort to rationing rather than admit the error of their ways with bread queues becoming a common occurrence. A black market may appear as people under their free will and against the governments law begin selling bread to one another for a price set by people, the marketplace. If however the government wishes to fix the state of affairs they must liberate the price once more, allowing the market to determine the price of production. As suppliers closed down long ago abandoning their supply networks it takes a short while for supply to meet demand once more. During this period the price of bread goes into the stratosphere as people bid up the cost of the present scarce bread. Eventually market forces will drive the cost down over time to a point of equilibrium.

How does bread relate to interest rates? Its the same principle. Governments can set the price low but eventually the market will force its hand to raise the price, with the price going into the stratosphere. This is why we had 18% interest rates when Thatcher tried to put things right, or when Paul Volker put US rates above 20%. The policy makers were just chasing the market, trying to reign in inflation which was driving the free markets interest rates haywire. During the 1973/74 credit crunch Central Banks had the same idea as now, that is they lowered interest rates in response to the recession, but the longer and lower you try to hold down these prices the higher and sharper they have to eventually rise as many an older reader will painfully remember.

The BoE could be forced to raise interest rates under a number of scenarios. They may have to raise rates if there is a currency crisis with the pound falling as investors flee. Like the bread situation above, they will put off the price liberation, instead they will put currency controls or limits on capital (like bread rationing) in order to try and provide a short term fix. Eventually the market beats them and they have to hike rates as over the long run a lack of foreign investment creates a less dynamic economy and higher inflation.

It could be forced to raise rates if inflation got out of hand with the free market demanding increased real rates of return to negate the depreciation of the currency. Even if central banks keep buying government debt at artificially low rates, private banks still lend to all of us, with this mortgage rates could rise for example. Its similar to what we see now, despite base rates at near zero average mortgage rates are far higher as the free market realises there are inflation risks over the medium to long term. They are also hedging against their potential losses as the government props them up.

However they could do none of the above. They could keep rates low, spurring on more inflation as the government can no longer afford increased rates on the ever expanding debt. They by pass the market and lend to individuals themselves at these rates. They print money directly to cover the shortfall in the various government payrolls. Currency collapse is ensured at this point as it becomes clear to all that its time to pack your suitcase. Marc Faber believes this is the conundrum America will face at some point in which its policymakers will not rise to challenge, instead they will shirk away from the correct action to take, opting for runaway inflation. At some point the stock market of such a country would be a screaming buy, just at the depths of the seemingly never ending hyperinflation when the average person has lost all confidence.

Could the UK be the Canary down the Western coal mine? There are many other nations with serious issues that have faced or will face issues sooner, but I wouldn't put them in the same tier as Britain, a nation who still has a recent innovative and industrious past. She could however, be the warning signal for many other Western nations that mass inflation and/or interest rate rises are just around the corner. Either option ain't pretty.

Friday 27 November 2009

Ascent or Descent of Money

Murray Rothbard once said, "Historians don't understand economics and economists are useless historians". As an avid reader of history, it's a common issue that I fully appreciate. One historian who is held in high esteem regarding economics is Niall Ferguson. After reading his recent book, 'The Ascent of Money', I beg to disagree. He may be on TV, he may have a fancy academic post, he may in fact be a highly intelligent person, but clever people can be as fallible as any other person. In Contrast with his other works, 'The Pity of War' or 'Empire: How Britain Made the Modern World', his recent book felt rushed, an attempt to cash in on the unfolding economic events at the time of publication. It was after all published a full year after the credit crunch.

Money, Regulation, Gold Standards, Bubbles and Greenspan are typical topics discussed, but in many of the above, confusion is the only common theme. Professor Ferguson tries to piece together various areas without the pre-requisite economic knowledge. The Achilles heel of historians is once again on display for all to see.

Money. The books title has the word. It dramatically begins with a list of aliases, however the book falls woefully short of explaining what money is, what its context is, how important it is. A passing mention regarding our sovereign monopoly of money doesn't connect the dots. If the required homework had been carried out, Ferguson would have realised that this was the key. Why do we live in seemingly free markets but they periodically crash, overproduce, mal-invest? Its our governments incompetence over money that causes this. There is no mention that money originated from the free market to overcome barter, that kings took over money for personal gain, that inflation has always been a common phenomenon under this type of arrangement. This admission sets the pace for the rest of the book - for non-critical minds a satisfying read, for others, frustrating.

Stating 'Anything can serve as money, clay, silver, paper', it is true many things have served as money but it doesn't mean they have lasted throughout the ages. Metals have generally been used as the de-facto monetary standard. On the other hand, paper, has continuously ended in runaway inflation as there is no limit to expand the supply. Unfortunately this part of history is omitted leading Ferguson to the conclusion that its 'different this time', they can suck out the liquidity, but as Winston Churchill would argue 'All fiat money has ended in inflationary disaster'. Gold Standards are rendered as inflexible, inelastic, incompatible to increase the money supply under times of extreme contraction, however only half the story is told. It is the first part, the initial unwarranted monetary expansion during the boom that causes the bust, not the lack of expansion in money after the crisis. Classic examples such as John Law in France, which lead to hyperinflation because he tried to fix the economic bust by printing more money seems to allude our academic friend. Despite coming to the conclusion that it ended in disaster and no good came from printing more money, Ferguson still believes it to be a good idea. As the quote at the top of this blog states, you either keep expanding indefinitely destroying the currency or you take the medicine.

Despite mentioning the recent great economic powers, Germany, United Kingdom, America, Holland did he ask the question what did all of these have in common during their height? Sound Money. The United Kingdom exported sound money around the world, gold, silver or bimetallic standards, to keep a check on government abuse. All the nations listed went into decline as soon as they abandoned these principles. The Bank of Amsterdam abandoned 100% reserves, Britain abandoned its gold standard in the thirties, Nixon's closing of the Gold Window in '71 in which we have since seen a relative decline in Americas Global dominance.

One pressing issue isn't even mentioned, fractional reserve banking. Its one of the most important issues in banking and one of the reasons finance makes a disproportionate income compared with all other sectors of a modern economy. Despite what is conventional told, you don't need fractional reserve banking to run a successful economy. 100% reserve banking, where the banks can not create money out of thin air would not only give greater stability, but would be fairer for all. Savers are rewarded, peoples purchasing power would increase, all sections of society would gain equally from such a system. One of the reasons society is plagued with great income inequality is that when you inflate the currency based on no supply and demand dynamic, this excess liquidity will inevitably end up in assets such as houses, stocks and so forth. The rich in general posses more assets and when they increase in value caused by the monetary expansion their wealth increases disproportionately. For example, if houses went up 100%, then a person with the previously valued £100,000 house would gain £100,000, however the asset rich person with a £1,000,000 would gain £1,000,000 - ten times the gain, or to put it another way a 1000% more! The rich get richer while the poor get poorer. People with no assets have no such luck.

Fractional reserve banking is an immoral system. It allows the banking community to leverage, i.e. create money at will and profit from something that they can create out of thin air. Can you imagine a factory that could make products out of thin air? A civil engineer making invisible bridges and getting paid for them? This is finance, the rules the government lay down. Allowing our banks to inflate the money supply based on governments targeting their inflation metrics. The better the free market does its job, by lowering the cost of goods and services, the greater the rewards for the banking community as expansive monetary policy is the solution for falling prices. Alas this topic isn't even covered in the book.

Bubbles and Regulation are narrated upon, nevertheless critical analysis is lacking. Ferguson outlines bubbles along with expansive monetary policy but the vital connection is not made. Instead human psychology is used to explain the 'irrationality' of markets, the conventional scapegoat. If our money was sound there wouldn't be the excess money to inflate bubbles and prolong their expansion misleading people to mistake these false price signals. The liquidity would not be available to inflate bubbles as other sectors of the economy would require capital. I recently saw Ferguson interviewed after his book in which he remarks that behind bubbles you will almost always find a central banker, from John Law to Alan Greenspan. It's a shame the book misses this point.

Regulation. We need more regulation? We need to set up a regulatory committee to stop people from poking themselves in the eye, or do we? People are rational to the extent that they make informed decisions. When banks get reckless they get reckless based on the premise that they get bailed out. One of the most heavily regulated industries is banking. I work in the computer software sector and from what I know we don't have any regulation. We don't have codes of conduct in how to make software. Good software companies survive using good business processes and sound coding techniques. They don't need some bureaucrat who visits every so often to inspect the software. The market, that is people, decide what is good or bad quality and cost effective. It should be the same with banks. If a bank is unsound it fails like any other business. When banks used to be allowed to go bust, they took pride in their long history. This in turn attracted people to bank with them as they continually survived during economic crisis. All of this occurred with little or no regulation, people came to that decision on their own accord.

Take for example electronics companies who for example make Computers. Should we have a regulation that states a certain quality of hard drive should be used in order to minimise computer failures, or should we allow people to decide if they wish to pay more for a PC with greater reliability. Of course the market drives up quality. When the Japanese companies started destroying the Western electronics giants they did so not from government regulations but because of market forces, people individually making rational decisions based on build quality and innovation. The books passing comments in relation to regulators maintaining financial stability contradicts the recent economic crisis we are living through.

Described as the best historian of his generation, what premise do I a software developer, have to disagree? Was it not the clerk in a patent office who challenged classical Newtonian mechanics and set off a whole generation of physicists who questioned authority and conventional wisdom? Just because a person has an academic post or a prestigious award doesn't mean he has mastered a particular subject matter. Just as Einstein was brilliant, he was as fallible as us all. Later in his life he couldn't accept quantum mechanics and a host of other new theories, stuck in the past he slipped into insignificance despite being one of the most recognised scientist in modern history. In my opinion one of the greatest economists, Ludwig Von Mises, couldn't even get a paid academic post whilst residing in America.

Critical thinking is rarely conventional wisdom, something Professor Ferguson has forgot. His earlier books such as 'Empire: How Britain Changed the Modern World' challenged the conventional viewpoint that the British empire was inherently bad for the world, on the contrary Ferguson argues well that it was beneficial and ahead of its time. 'The Pity of War' argues that the first world war was not inevitable, people were more apprehensive than conventional wisdom makes belief. It wasn't as black and white with the infamous Archduke assassination that set off a series of chain reaction events that is narrated by many historical texts. Britain held the key, indeed she was the prime cause of the war due to unusual diplomatic moves and indecisiveness.

Ferguson states that finance is the key to modern society. Finance is vitally important but its no more important than the doctors, the engineers, the scientists, the factory workers; everyone plays a key role in society enabling living standards to rise. Finance is the heart of the economy, not the brain. It pumps credit around the economy to the sectors that require it, the brain is the scientists, innovators, entrepreneurs and inventors. These people decide how to do things better and how best to satisfy individuals desires.

Whilst reading the book the title always troubled me. Have we witnessed the 'Ascent of Money'? If that were the case would the story of money not read that people first experimented with common objects such as, shells, clay, beads then we moved to using metals. This became cumbersome so we transitioned onto a more convenient medium which behind it lay the backing of a finite metal such as gold or silver. Then people threw away the governments monopoly and allowed the market to choose what money was. Instead we witnessed the first three steps, but have now instead moved to fiat money, backwards in time to the exception, not the rule. History warns us that fiat systems have always self imploded and we are no more wiser than any previous civilisation that tried to manage paper money. The 'Descent of Money' I feel would have been a more fitting title.

Saturday 7 November 2009

Central Banks are changing their Tune

This week the IMF began sales of their Gold reserves. I have mentioned previously that the IMF have been looking to do this, however how wrong was I regarding what may happen to Golds price! Two hundred tons came onto the market and rather than the price possibly dropping, the price instead soared. The Central Bank of India gobbled it all up in a single transaction. Many articles have already been published in relation to the event, and with good reason. The shiny stuff has risen in price for the past decade, despite european central banks selling huge quantities, the most infamous being my countries sale of half our reserves known appropriately as 'Browns Bottom'. The worlds central banks are suddenly looking at Gold from a different viewpoint. The move by India shocked everyone. The next sale could see multiple buyers apply, China, Russia, Brazil and other emerging nations will be feeling anxious - "How do we get out of our paper reserves"? One day there will be a rush for the exits, a dash for the ultimate form of cash. Meanwhile Geithner and Obama parade around the globe, reassuring foreigners of their strong dollar policy, their words contradicting their actions. A sound currency does not exist with zero percent interest rates, deficits as far as the eye can see along with printing more of the stuff. You don't need to be an 'A' grade economist to see the anomaly.

It's important to remember that you can't grow gold. Gold can't be produced in a factory, or planted as a tree. There has always been a finite supply throughout history and when there's no where for investors to turn, they head to safety, historically that has been precious metals. The limited supply can be seen with the recent "Sell your Gold" adverts, dealers buying the public's jewelry, melting it down, and selling it to institutional investors. While the recession continues to force the public to liquidate their hard assets for paper cash, the paper cash investors are diversifying into such assets. One only has to look at the events last autumn, bullion dealers ran out of stock which caused the adverts you now see. Hoarding along with limited ground supply has led the dealers to impell the public to sell.

One thing you have to understand is that China is sitting on 2 Trillion Dollars of paper promises. They currently have around 1,000 tonnes of gold. $2 Trillion could buy them an awful lot more, if they can find willing sellers. The recent IMF sale was $6.7 Billion for two hundred tonnes, I'm sure you can do the maths to see China's buying potential. Compared with nations in the West, many other emerging economies still have woefully imbalanced Gold reserves as the table details (original table taken from following article).



There are many countries who have plenty more cash to convert into Gold, histories ultimate form of payment. Germany, Italy and France hold approximately 70% of their nations reserves in Gold. Compared to China, India and Russia with 1.9%, 6.2% and 4.3% respectively, if I was a betting man I would say the latters percentages will inevitably increase.

For too long the West had a monopoly of talent and capital, corrupt regimes around the world ensured this. Battles between the far left and right in South America, Asia's experiment with Communism, Eastern Europe held back by the Iron Curtain, Middle Eastern states squandering the oil bonanza of the seventies and of course Africa's various despotic rulers. For too long during the 20th Century statism looked like the solution to peoples problems, when in fact it was the cause. Many talented individuals migrated to the West in search of a better life for their families. The collapse of Communism along with the revolution in telecommunications saw to it that many emerging nations began to realise their potential. Why emigrate to the West when they now have the same intellectually challenging jobs at home? Many Western countries still have one trump card - longevity in respect to human rights. No matter how bad my government messes up I always know I will be able to say what I want. I always know that the right path will eventually be trodden. I always know that Britain was the first nation to overthrow a monarchy on the continent during its Civil war, thus beginning the process towards the present inherently stable democratic system that has endured for centuries. The above may not seem much, but its amazing how we can all take this for granted. It won't stop the shift of power from West to East. Gold, it seems, is also moving in the same direction.

Friday 16 October 2009

Japan a Deflation Death? - Nope Stagflation

Gordon Brown this week announced what can only be described as a car boot sale of UK PLC's bric-a-brac goods, an attempt to sooth markets regarding the budget deficit. Many of the items have been for sale before, but I'm sure the government in their current desperation will be willing to accept lower offers this time around. I agree with privatisation in getting the state out of our lives, but a student loan book and a crossing in Kent are hardly big ticket items, never mind the fact that they are assets that generate money. Thatcher sold the majority of the family silver during the eighties privatisation bonanza however contrary to common belief there's plenty more the state could sell. Institutions such as the NHS, education the road infrastructure and so forth could all be sold, but these are not politically palatable areas that the public can swallow, meaning they are off limits for any politician that doesn't want to ruin their career. The Prime Minister once more began another Keynesian rant stating that the Conservatives proposals would lead to the same problems experienced by Japan for the past two decades. The title 'Prudent Chancellor' seems ever more absurd as time goes on, his emphasis on yet more needless spending in an attempt to bankrupt the nation. It doesn't matter if its Americas Great Depression or the lost decade in Japan, economists, politicians and journalists all seem to draw the wrong conclusions. What Gordon Brown in fact proposes are the very same policies that were pursued during both periods above and resulted in stagnation. Japan didn't get ravaged by the 'dangers of deflation', it was instead a good old classic stagflation.

Many Keynesian economists are still baffled by Japan. Over the years, policy after policy has been proposed by their school of thought, all of which involve some form of government action, but time and time again they all seem to fail. The classic Keynesian rebuttal whenever these policies fail is "Well, the authorities didn't do enough". Just like they apparently didn't do enough during the Great Depression. Yet put forward the question regarding Americas 1920-21 Depression and all Keynesian theory goes out of the window. Here Warren Harding, Americas president at the time, cut government spending, cut taxes and in fact did very little during a time when the economy was contracting at an alarming rate with the measure of unemployment rising faster than during the subsequent Great Depression. Yet the economy with market forces in full control, liquidated unprofitable lines of production and subsequently America during the 1920's experienced one of the greatest economic booms in history. The unemployment rate came dramatically down in no time at all, without government spending to alleviate this process as we are now all told. Herbert Hoover, who was later to become Americas President during the next depression, unsurprisingly didn't agree with Harding's polices, a pre-cursor of what was to come. Don't mention any of this to the Keynesian's though, it will give them a real headache.

What did Japan do when their bubble burst? Cut taxes? Cut Government spending? Liquidate? They of course carried out the exact opposite. Their Government debt used to be as low as the UK's before its recent exponential trajectory however Japans now stands at 200% plus and keeps growing. They propped up their infamous zombie banks, crippling the pricing mechanism that is so vital for an economy to prosper. Increases in taxes will choke the economy as rising social costs increase. In order to assess what really happened we need to deal with the aspect of deflation, or what is currently assumed as the bogeyman to economic growth. Japan never entered a downward death spiral of prices, that consistently fell year on year, in fact the lowest their CPI hit during this time was -1%. During the mid-nineties it spiked back up to 2%. There was only around 6 years of official deflation during the two decades using the Governments metrics. What gave the impression of price deflation was in fact asset price deflation. Both real estate and stock prices completely collapsed and have not returned since, instead stagnating for years. The reason why they never recovered to their previous highs was exactly what the Government did, they took over and tried the command economy approach. Roads to nowhere, propping up banks that were insolvent, not allowing private enterprise to take over the means of production. Rather than money going into the private sector, Japanese savings that were accrued during their economic miracle were funneled into Government bonds, wasteful Government consumption. It was quite simply a classic stagflation, that is still ongoing.

The UK are now pursuing similar policies and will go into a long period of stagnation unless the current direction is reversed. However it is useful to try and make further sense of Japans situation during that time, compared with our own. When the crunch came for Japan they ran budget surpluses, had high domestic saving rates for years and were a creditor nation. The UK on the other hand has the complete opposite and relies heavily on overseas investors to buy our Government bonds. Japan only began to run double digit Government deficits eight years later. They were able to sell their bonds to domestic citizens. They were still obtaining plenty of foreign currency as they exported more than they imported. The UK has already printed in excess of 10% GDP to pay for the debts, is running a huge budget deficit only two years after the current financial crunch and for the past decade its citizens have had low savings rates.

So what does all the above mean? Quite simply the UK is in a much more highly inflationary situation that Japan was. Japan's government couldn't really print money until over 10 years later as a last resort due to there being ample savings to pay for the Government debt. Japans government created their budget deficit, the UK has a structural one in which politicians are notorious for not tackling the shortfall. While Japans significant industries, electronics and car manufacture, continued to grow with global demand, the UK's key revenue streams, finance and North Sea, are in decline.

Another key factor is if the Government Bond market is in a bull or bear market. During Japan's economic disaster the bond market was in a bull market. Interest rates kept falling, people still had faith in many paper financial assets. Since 1981/82 Government Bonds have been in a bull market however these things always move in cycles, typically we should be seeing the end to this trend at some point. 25 years plus is a good run and in the near future this will turn into a long, grinding bear market, we may have already crossed that point. In a bear market, interest rates on bonds rise, which means Governments have to increasingly spend more on interest payments, diverting money away from spending such as health or education. Recently the CEBR said interest rates will stay low for the foreseeable future during the first half of the next decade, however that would mean the bond bull market lasting for over three decades, a highly improbable situation.

History is always an important guide to future trends, however it is crucial to compare given contexts in their current time frame. I have seen articles recently stating that Britain had debts in excess of 200% of GDP after the Napoleonic wars, indeed I have mentioned it myself before, however this didn't count for much when the UK went broke in 1976 with debts as meager as 48% of GDP. In the prior scenario the UK was the global superpower but a much bigger factor was that the UK didn't have a Welfare State. There was little government expenditure, with the majority of taxes just going to pay off the debt as alternative expenses didn't exist. Contrast that with current Government spending in which the interest payments are now comparatively small along with a rainbow of other Governmental expenditure, we see how context is key. Somehow, within the time frame of 150 years, Britain had transformed itself from one of the leaders of laissez faire, into a nation that was almost turning Communist in 1976. An ever expansive state, a declining currency, an economy with little productive purpose, meant investors wouldn't lend the UK any more money, despite the debt being around a quarter the level than that of the early nineteenth century.

Japan recently has around the same debt as the UK did 200 years ago and is still able to pay for it. It's dangerous to compare Britain with Japan, as Britain will not be able to sustain a public debt level that high. Japan built this debt up during a bull market in Government bonds and had savings to pay for it. The UK doesn't have either of those luxuries. It's one of the key concepts that many forecasters and economic commentators overlook, the fact that interest rates can rise over time and enter bear and bull markets. Payments for the interest are already predicted to soar as the debt increases based on the current low rates, but what about if those rates double 10 years from now? The government admits the earliest they can balance the books is around then therefore debt is almost certain to keep going up.

Do not believe predictions regarding long term interest rates and the level of debt a country can absorb, no one can forecast precise figures in these areas. Instead look at the fundamentals. Are the government balancing the books? Has the printing press been shut down? Has liquidation occurred? Until fundamentals return then stagflation looks the most likely outcome here in the UK. Just like Japan, only I fear much worse.

Tuesday 6 October 2009

Osbourne gets started with the Tough Medicine

"... on the back of a Bullingdon club membership card. Osborne is a lightweight wielding a heavy axe aimed at hardworking families"
Derek Simpson, joint general secretary of Unite in response to how the recent proposed Conservative cuts were for formulated

"It cannot be right to single out public sector workers to pay the price of putting it right ... Those who did so well out of the boom should now be asked to make their fair contribution through higher tax rates for the highest earners."
Brendan Barber, TUC's general secretary


It's taken a while but substance is beginning to emerge from the main political parties about how the deficit will be reduced. After months of talk with no action George Osbourne and the Conservatives have finally thrown out all caution to the wind, announcing what are unpopular polices. The public sector are now taking note that's its not just the private sector that has to take the pain from the recession. With the Governments finances in disarray its time to get to the heart of the real issue, the state is simply too large for society to afford.

George Osbourne and the Conservatives have said that any public sector worker on an annual salary over £18,000 a year will now face a pay freeze during 2011 with caps on pensions. Greeted with the usual workers union militancy, or cries that the conservatives are the same bunch of public school toffs, the real issue however is, how will this square with the public? There is a risk that this policy along with others such as raising the pension age marginally, may alienate sections of voters who are regular Tory supporters. With such a lead in the polls, have the Conservatives committed politicide?

I personally think its a very good move, if disagreeing on the policy. There are still some disillusioned members of the public that believe we need to spend more on public services, but many now realise spending cuts are a reality, its either that or huge tax rises to pay for it. By safeguarding existing jobs, but cutting pay, the Conservatives appeal to many in the private sector who have had it rough of late by enacting similar pay restraints already witnessed by many in the private sector onto public sector workers. I also think they appeal to public sector workers as they are not proposing to cut any jobs. This is an honest approach as people realise cuts have to come, as opposed to Labour's rhetoric of bottomless pits of money to spend. If they did come to power then they need to build a platform of trust with the public and state their intentions clearly otherwise industrial relations would become more fragile.

The problem is the size of the current deficit. We won't get real substantial policies until after the next general election because if a party announced the cuts that would be required, it really would be handing the opposition the election on a plate. The cuts proposed under usual circumstances would be huge, but in the context of a 12-14% GDP deficit they hardly register. That's the problem, cuts take time to implement as I have mentioned before, however the UK does not have time. Official public debt is around the 60% level already. Within a year it will be above 70%. By the time the public sector pay freeze is due in 2011 it will be well above 80% probably nearer 90%, a level which the market will become ever more uncomfortable with.

The other problem is interest rates. They are as low as they can go and the only way for them to go in the future is upwards. The Government bond market is the next bubble. It has been in a bull market for well over two decades now and at some point in the future this will turn leading to increases in the returns investors ask for. With all the debt building up, interest payments on the debt rise, however even if the government did manage to balance the books in the next decade, when interest rates rise so do the interest payments diverting available funds away from departmental spending. This in itself can cause another budget deficit, as increased spending on the debt can get out of hand. Recently the UK has been moving away from selling longer term bonds to shorter termed ones, this is what is known as a rollover issue. As the bonds are issued in shorter terms when they expire if interest rates are higher then the government has to resell the debt at higher rates and pay more and more, causing a further squeeze to occur. There's also the issue that the UK relies on foreigners to buy our bonds, around 40% of them are now owned by non UK citizens. If overseas investors think that the UK is insolvent the printing presses may have to be ramped up further still, even if inflation gets out of hand in the years to come (see my previous post regarding the bond bubble for this process).

How can you claw back the deficit we have? We can't even look at history as the highest we came post Second World War was only half the level now. During periods of war its incomparable as a war economy means rationing, major hardship, sacrifice and in the end massive inflation after it ends. What about Latvia or some other Baltic nation? They currently have a currency peg so its hard to make comparisons as they attempt to try an internal devaluation. Recent polices such as public sector pay cuts in the region of 30% is real pain, not a freeze on pay. That's what's happening there, but then this is what real fiscal restraint entails. Bailed out by the IMF they have no other option in the short term. Their loan priced in Euro's ensures no default by the printing press, unlike the Wests approach. Latvia 'only' has around a 9.5% deficit.

Of course we won't get 30% pay cuts in the future, the politicians will let the currency take the pain. Members of the public have become conditioned to associating rising asset prices and wages as wealth, rather than increases in purchasing power. Its the latter the government will go for.

I personally don't agree with the Tory policy of capping pay in the public sector to avoid job cuts. The problem is it doesn't fix anything as the real problem is that the UK's public sector has become too large in recent years. Rather than addressing the root problem, cutting labour used by the public sector and re-deploying it into the productive private sector, the politicians wish to keep the current system on life support, a classic stagflationary policy. Preventing labour redeployment into other more productive purposes will cause further stagnation.

How much does a pay freeze really save? If the private sector is still weighed down with the same public sector then how can this really help in the long term? Another recent Tory policy was to cut the tax paid by small businesses for people they hire and this illustrates the above point perfectly. Government can't create jobs and wealth, only the private sector can perform that function. Don't get me wrong the government could take half the unemployed people, give them jobs to dig holes, then get the other half to fill them back in - unemployment problem solved! The problem is this doesn't create wealth, its governments role to create the conditions for people to create jobs for themselves and that means getting out of the way. Only the private sector can increase productivity and this was a policy I strongly agreed with.

The problem with the deficit is the fact that the irreversible damage was done years ago. Labour were running budget deficits during the largest credit boom in history. I remember at the time mainstream commentators such as the BBC's Evan Davis mentioning it on a regular basis, even hinting subtle messages that the financial shenanigans would come back to haunt us. It's for this reason that I see no way back. Politicians will continue dithering, with no real rush of urgency to get their books balanced. Why? Because they only act when a real crisis comes along, when the market calls time. Thatcher carried out her cuts under a backdrop of a genuine broke Britain. As recent as one hundred years ago, Britain had been the largest creditor-export nation in the planet, however just over half a century later that all changed. No sound investor would lend the nation money, with only the IMF, a bureaucratic organisation, were the only ones that paid for Britain's fiscal prolificacy. A period of strikes, industry failure, rampant inflation - whoever will be in power after the next election won't have these in the back of their mind. Not yet anyway. I see Cameron as more of a Ted Heath Prime Minister rather than Thatcher, Labour messed up in the 60's but Heath didn't really tackle anything. Then Labour got in later during the seventies and messed things up again. This drove Thatcher to do what she did, the decay had gone on for too long. Osbourne has begun with policy cuts, but real action will only take place once the real crisis unfolds.

Friday 2 October 2009

Whats the deal with house prices?

You can't seem to escape news regarding the property market, regardless of how insignificant it is. Both the UK's main indexes, the Nationwide and Halifax, have been putting together recent small upticks. Historically when house prices turn they don't reverse for years. Could it be different this time? It's never different, in fact this is how it always works in history, prices drop a bit, drag a long for a while or show slight upwards movements, then the process repeats for years. The housing market is so illiquid it is always very hard to determine what a market price is.

I have become tired of news regarding house prices. Throughout my adult life I have heard nothing else, the news gives greater coverage to the value of your home then real issues that occur throughout the world.

House prices are one of the most misunderstood asset classes. A while back I said that houses are historically a poor investment (a house is a home, but many believe them to be the best investment you can make) and I think many people would find that hard to believe as we have been continually told for the past 10 years that houses are the best investment. During the boom, pundits and experts were proclaiming that houses had the largest returns, yet also had the least risk associated with them compared with stocks and bonds (in fact many said no risk). This is what happens during a bubble, history is disregarded with risk/reward concepts turned upside down.

However when history is examined prices of homes performed poorly against all other assets. We can run through the numbers to illustrate this. If we take the Dow Jones during its 1980's and 1990's bull market along with the upturn in the current decade, it went from around 850 in 1982 to 14,000 in 2007. This equates to a return of 1657%. The Gold bull market during the seventies, went from around $35 to $850, a return of 2428%. Even if you disregard $850 as a top as this price was only achieved for one day, gold consistently hovered around the $450 mark for years after, a return of 1285%. So what about housing? This is where we come to the relative poor performance of home prices. Using the Nationwide's figures from a low in 1982 of around £67,000 to £186,000 in 2007 - a return of 277%. This was under two of the greatest housing bull markets in history. Even if we take the recent boom it gave around 250% returns on average. So to summarise:
  • Stocks - 1657%
  • Gold - 1285%
  • Housing - 277%
Of course the figures I have used are by no means rigorous, they just illustrate the performance of particular asset classes during their bull market. So what gives the impression that returns on a house are so great? One word, leverage. Most people that buy a house have to take out a mortgage and subsequently only put 10% or so down. Therefore any gains that are made seem all the greater. If you bought a house for £100,000 with £10,000 down, if the house rises 10% in price then you have doubled your money. This is the power of leverage. However in the event that the asset falls in price this is where the story gets a lot more painful. Just as gains are amplified, losses are also increased. The house would only have to fall 10% in value for your deposit to be cleaned out.

Leave it to the professionals to make their living from property, for the rest of us it should always be viewed for its primary function, a home.

With the bull market figures above you can see how people have got it wrong when they talk about the recent 'commodity bubble' or the current 'gold bubble'. Gold in dollars has only gone up around 300% since its low. Its only just above its all time high 30 years ago. History says bull markets in these types of assets have much further to go. Another good indicator is the Dow to Gold ratio. In recent history when stocks are in a bear market and commodities are in a bull market this ratio gets close to around 1:1 meaning an once of gold is the same value in dollars as the Dow Jones index. We are around 9:1 currently, however what happens if the Dow increases over the years to come as the government continues to inflate all asset classes? The gold target moves. 15,000, 20,000, 50,000 Dow? However high it goes, until fundamentals return to the stock market, I'm sure golds price will match it at some point in the future.

When the news reports on house prices, they always make statements like "Good news, house prices are on the rise" or "Bad news, house prices have fallen". Why is it that rising house prices is deemed to be good news? Many would find it odd if the journalist said "Good news, bread has risen again in price", but that's what they are saying with housing. The higher they go, the richer we are? Not at all, it just means there is more domestic currency in circulation and that rising prices are symptom of this action. Not too long ago when I was a teenager I remember being able to buy a good half a dozen sweets and chocolates with a pound. You could buy a mars bar for around 20-25p. I recently went to buy chocolate for my partner and couldn't believe the prices now. It was around 50-55p for the same bar. You would struggle to buy two items with a pound these days. Maybe the media should report this as good news, or if they ever fell in value report it as bad news.

Of course we are hearing all the usual babble as to why house prices will rise forever, the old myth of supply and demand, there is not enough houses. I always forget how we have waiting lists to buy houses as they are rationed out, or like under a Communist regime we form queues to buy our house. I always feel for those poor estate agents, their windows empty, as there no supply to meet demand or people resort to homelessness. Last time I looked there was plenty of houses to buy, in fact I get a paper full of them every week. Its more pounds that pushes prices up, not supply and demand. It becomes supply and demand issues when you start to see some of the above happening.

The recent reported 'rise' in prices will run out of steam at some point. The governments and central banks have declared war on anyone holding cash. Many people have turned to stocks or houses to place their money rather than in a bank earning nothing, but it won't last. QE have enabled the government to buy up bonds with the bailouts they gave to banks used to push up stock prices. The FTSE-100 recently had its largest quarterly gain, larger than during the tech bubble mania. As I've said before, bubbles are not inherent human 'flaws' or greed and so forth. They are caused by the exact expansive monetary polices we see today. Once you understand this, the financial system becomes a whole lot clearer. In fact you start seeing where the next bubbles will occur. There will be great volatility in many asset classes over the years to come as the governments try to inflate everything. This includes the price of our homes.

Sunday 27 September 2009

British Pound Devaluation Delusions

"It does not mean that the pound here in Britain, in your pocket or purse or in your bank, has been devalued."
Harold Wilson, British Prime Minister, after the Pounds devaluation in 1967

"A weak currency arises from a weak economy which in turn is the result of a weak Government."
Gordon Brown, During the Pounds devaluation after it was withdrawn from the ERM


Mervyn King the Bank of England's Governor has been causing a stir in the markets this week. Despite Sterling being a flawed currency it hasn't stopped Mervyn King from making comments that he feels a weaker currency is beneficial for the UK. Undeterred by the pound losing around a quarter of its value, it seems that the BoE still feel the need to send it lower. US-centric reporting has been emphasising the Federal Reserves draconian monetary actions, but yet it is the UK that leads the way in QE and the destruction of its currency. Labour Governments always seem to be in power when the pound gets a pounding. 1931, 1967, 1976 and recently 2008 and beyond. If Neil Kinnock had won the 1992 election like so many believed at the time, they would have got the whole set for the past one hundred years. So what does it matter that the pound has devalued of late? Is it as black and white as 'it will boost our exports', that the media and business pundits proclaim? I agree with the quote above, not Harold Wilson's, but Gordon Browns. Over the long term, Governments that use their currencies to try and solve their economic troubles are doomed to fail. If you try to alleviate trade deficits with this mechanism over the short term it may succeed, but eventually more devaluations will be required in order to 'boost' exports again.

Implications of Devaluations

An examination of the devaluation is required to understand what benefits/disadvantages it brings. Governments always claim that this will lower the cost of our exports, which it does, but no analysis is paid to what actually occurs. If we examine a factory that exports goods, they may be struggling to compete, say against similar German products. A devaluation would instantly lower the cost of the good on the export market. The German Government, for example, may hold steadfast and are not willing to allow their currency to depreciate by the same margin. The British company without doing anything have instantly gained a cost advantage, in effect a free handout. The German company on the other hand has to look for savings itself. Management immediately begin cost cutting, increase productivity or improving their processes. They look at their product, they start to innovate or add extra features or improve the quality to justify the short term price dynamic that has just occurred. The British management does not need to do the above. They can produce the exact same product, using the same processes as there is no immediate need to innovate.

Also something much worse occurs. For the sake of the example say the two products, German and British, now are priced at €500 and €400 respectively after the devaluation, whilst previously they were €500 and €550 respectively. The British management now can increase the price over the short term, to say €450 as they are still cheaper than the German products. This extra margin may go into inflating workers pay, or other company benefits. Not only have no product or business improvements happened, but the British company is also rewarding itself.

The Import Dynamic

Misreporting in the media leads us to believe that the cost of our overseas holiday is the biggest headache when the value of our currency goes down - if only. When the currency takes a fall the whole nation is immediately given a pay cut, all our imports now go up in price. If we have to buy raw materials or products produced abroad it now costs us more, our purchasing power has effectively fallen. In the example given above, if the British company has to import any materials to produce its end product these will drive up their costs. Also the public now have to pay more for the product in question. The cost may seem to have reduced to €450 but remember its all relative, the British people are still getting paid in pounds. People can't buy the same amount of products as imports go up. A price spiral starts. The mechanic who imports car parts from abroad must now charge the public more for car repair work. There are an infinite number of other business transactions that take the same format as the given example. All these costs eventually come back to the British company as their workers require higher wages to cope with the higher prices. This in turn keeps driving the cost of the product higher. Meanwhile in Germany, they have continued innovating lowering their costs through business improvements, driving costs down in order to compete and in turn producing a better end product. The end products cost after a year or two, could now be say €400 and €500, for the German and British companies respectively. The British company is back where it started but in a worse condition, as they have fallen further behind in terms of productivity and end product quality.

The above process can develop into a vicious spiral, with the British company loosing further export share and demanding further devaluation in order to 'boost' exports. There is no simple fix, if a currency goes down in value it doesn't help anyone.

What needs to occur is to let the market take the pain, not the currency. This may mean higher unemployment in the short term, but people and companies get competitive again. Any nation in history who has enjoyed an export boom has done so on the back of a strong domestic currency. Britain during the 19th Century, Germany and Japan through the second half of the 20th Century, the US when they rose as the global superpower. However times change. For the past 30 years or so US politicians have put forward the benefits of a lower Dollar for jobs and exports, but over the years it hasn't worked. Workers wages continue to decline, and US companies continue to disappear.

In Japan from the end of the second world war up until just before the lost two decades, the Yen dramatically appreciated against the US dollar. Yet Japanese exports during the same time frame also increased. Westerners used to joke that Japan only produced kimonos or tiny cheap ornaments. Japan subsequently underwent a huge economic development, beating the West on car manufacture and electronics to such a point that it has now become hard to name a handful of Western electronics companies. In 1970 the Yen was valued at around 357 to the US dollar. Within 20 years it was 146, more than doubling in value. During the lost two decades it hasn't moved much further, to around 90, however its worrying that its still appreciating despite the stagnation of the Japanese economy during this time.

Where does this leave the British Pound?

It's worrying when the people responsible for the defence of a currency welcome devaluation and even believe that this will solve the economic imbalances we face. You can't solve a domestic economies shortcomings by debasing the currency. The British Pound has resumed what it was prior to the late seventies and early eighties. It's once again the whipping boy in the currency markets. Investors beware, the British Pound will not be a place to be for the foreseeable future.

Friday 18 September 2009

The 'China Hedge' and Western Zombies

Earlier this week the Chinese Government did something that Governments don't usually do. State television began promoting Gold and Silver as a good investment.



So why is the Chinese Government telling its people to buy Precious Metals? Of course I have previously mentioned the Chinese Government increasing their own holding of gold but now it is telling its citizens to follow the same strategy. To me it would seem their leaders must realise that the economy is in a bubble and whatever they try and do, China is heading for a hard landing. The trick with governing people is to try and provide the illusion of prosperity. Its what the West did during the housing bubble. Despite average workers incomes stagnating, people were content as their home was rising in value, giving them a false sense of wealth. People didn't mind that NHS waiting lists got worse, Governments role in the economy expanded along with deficits so long as their homes kept appreciating. When that disappeared, then people became restless. Recently with the 'green shoots' (read another dose of inflation from the government) people again believe how good it is that their houses will hopefully hold or increase in value and we can return to the old days of easy living. The problem comes when people realise the green shoots were in fact weeds, and that the asset prices will fall back - then we go back to unrest.

The Chinese Government aware of this dilemma, seem to be trying to hedge their citizens from the global depression. Their exports continue collapsing, millions of jobs are being lost, the Baltic shipping index is once more on the slide similar to 2008 before the financial carnage occurred. To cover their citizens against this and falling stocks and real estate they are encouraging people to buy precious metals. As recent as 7 years ago citizens were banned from owning such assets. This illustrates how radical the policy is. What does this mean for the price of such assets? I do not know. All I know is that the Chinese Government, again, seem to have studied their history and see where we in the West are now leading the whole world. China has grown phenomenally in the past 30 years, but its still America, Europe and Japan who have the most influential economies. It seems that we wish to create a new set of zombie institutions just like Japan did to try and maintain our illusion of past 'prosperity'.

Western Zombie Banks

"At the moment the investment slump is being compensated by public spending. As long as global growth is supported by public help, we cannot talk of sustainable growth"
Yves Mersch, ECB Council Member

Whenever I mention to people that what we are doing is creating Zombie Banks that will stagnate the economy for years just like Japan I am greeted with exactly the same comments before the housing bubble burst. "It's different this time", "We are not like Japan", "It won't happen here". Well it will happen and as the years go on it will become more evident to everyone.





We haven't learnt anything from the events last year. Bankers are getting their bonuses once more. Banks have merged creating even larger "too big to fail" institutions with the Government guaranteeing all of them. They will use Lehman from now on to scare people, to legitimise further government involvement. Politicians don't dare bring up any previous discussions regarding reforms as they all try to maintain this illusion of prosperity but it won't work. Earlier posts back before Lehman collapsed that I wrote had some hopeful comments, on what needed to be done - saving, the abandonment of wasteful consumption, independent thinking. However I thought we would try and prop up everything, repeating the same mistakes of history with everyone tricked into believing the governments 'solution'. We should have made sure there were more Lehman's. Its just finance. People would have rebuilt their lives. We would still would have all our tools, skills and infrastructure.

So how long will China pursue Gold?

As I have previously mentioned China are acquiring gold to try and build a reserve currency contender against the US Dollar. I have read many articles on how the USD is going to collapse or be replaced by the Euro or some other currency. But as I've said before where is the alternative? The Euro has too many soft nations such as Spain, Italy and Greece. If it was just the sounder economies such as Switzerland, Germany, France, Norway then maybe there would be a sounder alternative. The Chinese RMB is pegged and that's before we come onto the smaller size of the economy compared to the US. I can not see the government letting the RMB float freely while the current crisis is present, they will keep it under control not risking further dislocation that could ensue by allowing it trade in the markets. The Japanese economy has gone nowhere for two decades and despite what people may say that they are due a boom I can't see it happening. The Government has to walk the right path first and I'm yet to see it.

If China did wish to challenge the USD as an alternative world reserve currency then the only way I can see other nations taking up the offer would be to peg it to Gold. The Chinese could then say "sure you can have your paper dollars backed up by American Governments lies as they continue to devalue them, or you can use our currency, fully convertible into Gold". Whoever holds the reserve currency status has a huge advantage in that they can export their inflation to others just like the US has been doing for decades. China and Russia may discuss alternative world currencies but they would both secretly prefer their own nations currency as the reserve standard. In order for China to do this they still have to accumulate a lot of gold. The 1,000 tonnes they already have would not be enough. China still has a lot more to accumulate, just as the gold bull market still has a lot further to go.

Friday 11 September 2009

The Social Question

"We need some more Lehmans so we can get out of this. Over the past 20 years Messrs Greenspan and Bernanke introduced crony capitalism to the West which is leading to a lost decade[s]. Market fundamentals are that failures should collapse and be replaced by creative new forces rather than being propped up as zombies... Marx is singing in his grave there in London as the US government now controls the auto, mortgage, insurance, banking, et al industries and he has not fired a shot. Letting Lehman fail was perhaps the only thing governments have done right during this whole drama."
Jim Rogers, Chairman Rogers Holdings (recent comments)

"I take advantage of one of the beautiful flaws of capitalism which is that the capitalist will sell you the rope to hang himself if he can make a buck. So they only think about money - they do not really care what I believe, which is upsetting on some levels."
Michael Moore, when asked about how he gained the funding for his new film

"They [financial crises] are all different, but they have one fundamental source. That is the unquenchable capability of human beings when confronted with long periods of prosperity to presume that it will continue...The bankers knew that they were involved in an under-pricing of risk and that at some point a correction would be made"
Alan Greenspan, recent comments regarding the financial crisis

Questions of equality have been asked for hundreds, even thousands of years, however it was not until the Industrial Revolution that the topic became a major talking issue for many intellectuals. The emergence of competitive markets did not create equality, the opposite was observed as income gaps grew and have continued to grow as time passed. Two forms of egalitarian views emerged, the Jacobin violent revolution in which people would be educated to accept the new system imposed on them, or a gradual evolutionary process where the people would demand Socialism. In short centralised totalitarianism or through democracy. The twentieth century will be seen as a great experiment with statism, country after country have attempted to plan economies through central authorities all of which have failed. The fundamental question is not how can we make societies more equal which is mistaken as the ultimate goal, but how can we raise everyone's living standards.

The quotes given above are from a range of individuals, each with a different viewpoint on the recent events and social system we live in. One fundamental premise of an economic system is how to best use societies resources. Despite what is told from romantic socialists we live in a world of scarcity. We only have a certain amount of natural resources, a limit on the hours we work and a finite labor force. These factors mean that society needs a mechanism in which to direct all of the above in the most effective way to meet peoples needs. There are generally two sides of this coin - a free market directed by prices or a centrally planned system whereby Government can direct the above. We currently live in a combination of the two.

Another key concept of economics is the idea of wealth. What is wealth? Is it money? Material items? Spiritual enlightenment? I am not a material person however such possessions is a good measure. It may be as simple as the food that we eat. We all take this for granted where we have the option to eat ourselves to death but our ancestors as near as 150-200 years ago experienced famine on a regular basis. Karl Marx's famous Communist Manifesto was written during the 1848 European uprisings against a backdrop of crop failure and mass starvation throughout the Continent (the most infamous was the Irish Potato famine). Therefore a good economic model is to supply an adequate amount of goods and services that people wish to consume. We all have wants and desires in life. We would all like to own fancy cars, extravagant homes with endless means to consume but we can't. To obtain these goods and services we have to produce and we are all only so productive therefore have a limit to how much we can consume. So how do we get the most bangs for our bucks? This is where the two opposing systems come into play. One promotes free markets where people will be driven to do things they want on their own accord. The other, is where the government has to plan to ensure we all can enjoy equal spoils of our labor.

A free market can only deliver more material goods for us all to enjoy. Central planning, as history has shown and economic theory proves creates stagnation and falling living standards. The principle behind free markets is to lower the price of goods and services thereby increasing societies purchasing power - the true driver of wealth, which is what free markets are so good at. I can buy infinitely more than my father could when he was my age, and likewise his father. A market ensures this process will occur by enabling entrepreneurs and capital in competition to innovate thereby increasing general productivity. The incompetent fail, leaving the competent to take over, as Joseph Schumpeter put it, creative destruction. The other viewpoint is that the government can handle this process. They can centrally plan and co-ordinate resources and supply goods and services for the good of people. The problem with this system is how do you determine the competent people? How can you ensure competition and that governments will not abuse their monopoly power.

Ludwig Von Mises, one of the greatest economic thinkers in history, proclaimed that Socialism was doomed to fail before it had even begun. When various states succumbed to Communist regimes everyone agreed that you may have issues with incentivising people. How would you get people to do the less desirable jobs, say work in a dark mine in dangerous conditions - even the Socialists recognised this issue, and tried to solve the problem with honour parades and so on. However Ludwig Von Mises ignored this concept. He assumed that you could create a society in which everyone worked for the cause, the collective. He said it would fail not because people wouldn't do the work but for another more rational reason. He argued how will the government know what to tell the people to do? Without prices how would the resources be channeled? Coining the phrase 'planned chaos' he said any socialist system for a complex modern society would inevitably collapse, it was only a matter of time. This wasn't at a time we find ourselves in now, where all these systems have collapsed, this was back in the 1920's when Socialism was the in thing.

Of course this idea was challenged. Many said "Well we have equations, we will just use these" or "We will just find the entrepreneurs and place them in government positions". Von Mises rebutted the above on quite logical grounds. If you give someone a cushy government job on a regular wage you take away the entrepreneur, his capital and his capitalist instinct. When an entrepreneur sets up a company he tries to meet a consumer demand. He risks his capital and his time and for these reasons he will work day and night, always on edge to ensure he delivers quality service or products better, than his competitors as cost effective as possible. Would Bill Gates have created Microsoft if he had been in a government job. Would Microsoft have turned out the way it did if he didn't quit university, did not work late nights and did not have to risk his own capital? I doubt it. Its all this that ensures effective use of economic resources, placing the competent who prove themselves in charge of economic resources. A bureaucrat on £60,000 a year will never do as good a job as someone with no such security.

When we come to equations this is always a distraction in economics. Back when Britain was the leader of the world, the nations leading classical economists such as David Ricardo, Adam Smith and John Stuart Mill were in an age when everything was being mathematised. Science and technology was conquering the planet. With this backdrop they began trying to use mathematics to explain economics, however their models never really worked. This tradition carried on, right up until the present where economists still try and use it for the macro sphere. Economics is not a science and it never was. In micro you have concepts such as prices, supply and demand but no specifics. Then we jump into macro and all the economists tell you we can 'predict' this or 'solve' this because we have equations. If it was like science then why couldn't they predict the credit crunch? Science can predict all types of natural events to pin point precision but economists can't seem to predict the future any better than the average person on the street. The problem is you can't mathematise human actions. You can't mathematise future trends and technologies. The future is uncertain and impossible to model.

Of course many could not see this, so again Ludwig Von Mises in his typical genius fashion, just accepted the formulas for the sake of argument. He said even if you could create formulas to model the economic picture, then how would you obtain the inputs for them? Collecting data is prone to error and a time consuming activity so as soon as you get the data it is already out of date. In a constantly changing world it would be impossible to create accurate models to direct the means of production. Central Bankers acknowledge this concept today by using the famous saying for constructing monetary policy 'its like trying to drive using the rear view mirror'.

In a market with prices, the most competent who anticipate consumer demand survive, while the ones who forecast less successfully go out of business, thus releasing societies scarce resources for the competent to use. Despite what the left proclaim about 'excessive profits', profits and loss are the markets pricing mechanism. The future is uncertain, therefore profit just means you forecasted in the correct direction, losses mean you made a wrong forecast.

In history too, we can see ample examples of Capitalism pitted against Socialism. Korea, a country that was split by war is a fine example. One nation followed state planning, the other free markets. Back in the fifties the South was actually poorer however it soon caught up and then some. Now we see how South Korea has elevated its people to some of the most prosperous living standards on the Continent while North Korea continues to decline. For years the economy has been contracting. As Ludwig Von Mises states, under Communism you are in a constant depression. Recessions and depressions can only occur under government involvement.

Russians for years had product shortages as the state set prices of goods too low. Newspapers were so cheap that people bought them not to read the news but for alternative uses such as wrapping paper. Prices had been fixed by the state for decades with no relation to the actual costs of production. Russia only lasted as long as it did due to its resources. It sold anything it could to the West in an attempt to hold the country together, Oil, Gas, Iron Ore, Gold. As the commodities boom ended in the early 1980's so did Russia's income of hard currency, leading to a gradual collapse from within.

Under a year ago I visited Cuba, a country still run under Communist principles. People were under rationing, I saw queues outside closed shops, the shopkeeper coming to the door occasionally before opening with people asking him if he had any particular products (there were not many shops though, you were also lucky to get your allocated rations). University graduates were working as luggage boys or laundry maids, wasting their education as there were no other options. Rather than tipping currency for the cleaning maids, we tipped shampoo and toiletries as these are far more valuable than the governments worthless currency that can't buy any goods. After recently being hit by a hurricane they are rebuilding their homes with asbestos. Despite the health hazards society is too poor to afford the alternatives. For decades Cuba was propped up by Russia, buying their sugar for four times the market price, and practically giving them oil. After Russia collapsed Cuba could no longer get hard currency and technology, Castro's solution was to open the gates to tourism. This is what saved the regime in recent times, again a free market propping it up. They still have major issues and you could sense the bitterness the local people have towards the economic system. As one of our tour guides remarked, "This is supposed to be our Leninist-Marxist workers paradise".

The solutions many social commentators propose are just the above. Government systems and they never work, its always the free market that has to prop them up. They denounce that the rich are getting richer while the poor are getting poorer, but the poor get richer too as long as they are in a free market. As society accumulates increased capital and productivity these gaps widen as other nations fall behind under kleptocratic regimes with dictators, for example continents such as Africa. Many areas in Asia were poorer than Sub-saharan Africa 50 years ago. Asia then decided to open up their economies, respect property rights thus encouraging capital and expertise to invest there. Japan is already treated as a first world nation despite 60 years ago been seen as a basket case by the West.

When commentators such as Naomi Klein or George Monbiot argue that Globalisation exploits the poor, it does the complete opposite by alleviating poverty, in fact it enriches us all. Costs are lowered thus increasing purchasing power of developed nations, and developing nations are given access to capital, not only for machines but enhancing their human capital to raise their living standards.

"It's human nature, unless somebody can find a way to change human nature, we will have more crises and none of them will look like this because no two crises have anything in common, except human nature."


A quote again from Alan Greenspan. Despite what he says in public he knows the real cause of financial bubbles and crisis. He may blame markets or peoples irrational behaviour, but history again has shown it to be expansive monetary policy. When he wrote with Ayn Rand he lambasted central banks for their interference in markets. As time passed he became more involved in government affairs. Reveling in the role, labeled by the press as the 'Maestro', how he lies in public I do not know. Like with most bubbles throughout history you will find a central banker or a government authority behind it, creating inflationary booms and busts which we now label as the 'business cycle'. In the past it was fraudulent Gold deposit banking which governments encouraged. It was a less transparent way to debase currencies through intermediaries such as banks, there was also the added bonus of a scapegoat too. Banks also benefited as profits could be privatised in the boom, losses socialised during the bust. This trick fools many Socialists into believing capitalism is unstable, or as Marx liked to think it overproduced thus creating inevitable booms and busts. But this isn't true free market economics. Governments are the cause of recessions and bubbles through economic mismanagement. Private banks didn't under price risk, they had too much money from the central banks therefore as the inflationary boom kept going they lent it out recklessly as they don't make money by sitting on it. They had already lent to all the creditworthy borrowers but were still being thrown money by the central banks, therefore lent it to individuals that could never repay the debts.

A free market is the answer to the social question, we just haven't lived in one. Disparities in wealth should not concern individuals, as it is just a measure of how productive an individual is compared with another. Many may look enviable at rich successful entrepreneurs but they create the wealth and jobs for us all to enjoy. They increase all of our purchasing power and drive up living standards by creating new processes and markets. We help them with our labor, but at any point we are all free to become an entrepreneur. Companies are there to serve consumers and have little power, its only Governments that can give them more power then they should such as the past two decades with the banks. If people no longer wished to drink Coca Cola then the company would cease to be. Markets give people choices and treats humans as individuals, respecting ones rights. They drive living standards up across society this is the end goal, not equality. Individuals will always be 'unequal', each one of us has different talents and a free market allows individuals to make the best use of those talents. This is the answer to the Social Question. Socialism can never solve the social question it creates "equality" by impoverishing us all. It is nothing more than slavery to the state.

"Liberalism and capitalism address themselves to the cool, well-balanced mind. They proceed by strict logic, eliminating any appeal to the emotions. Socialism, on the contrary, works on the emotions, tries to violate logical considerations by rousing a sense of personal interest and to stifle the voice of reason by awakening primitive instincts."
Ludwig Von Mises

"Capitalism means free enterprise, sovereignty of the consumers in economic matters, and sovereignty of the voters in political matters. Socialism means full government control of every sphere of the individuals life and the unrestricted supremacy of the government in its capacity as central board of production management."
Ludwig Von Mises