Is the U.S. Economy Turning Japanese?
Happy days are here again in world stock markets.
Yesterday's profit-taking notwithstanding, the Dow Jones Industrial Average is flirting with 10000 and the S&P 500 is up 60% from its March low. Still, if risk-seeking behavior has returned to financial markets, much of it is funded by borrowing increasingly cheap U.S. dollars. There is also very little evidence, if any, that consumption and employment are really recovering in America.
With the U.S. government stepping in to keep markets from clearing, today's U.S. economy in many ways resembles the post-bubble Japanese economy of the 1990s. Ultra-loose monetary policy and low demand for credit, combined with high unemployment and consumer deleveraging, could lead to a prolonged slump.
Consumption, which still accounts for 71% of total nominal GDP in America, is still weak, and there remains little reason to expect it to pick up in a healthy fashion.
Aside from the well-known and related issues of high household debt and negative equity in houses, the latest U.S. employment data have highlighted the still dismal state of the job market. Average weekly earnings of production workers rose by only 0.7% year on year in September as the average number of weekly hours worked fell to a record low of 33 hours. This marks the lowest annualized weekly earnings growth since the data series began in 1964.
Meanwhile, there's an unhealthy reliance on government for growth in America's increasingly command-driven economy.
This is clear from the severe slump in car sales post "cash for clunkers." U.S. auto sales declined by 35% month on month in September to an annualized 9.2 million.
It's also clear from the enormous role now played by government in the residential mortgage market. Government-guaranteed mortgages accounted for 98% of total mortgage-backed security issuance in the third quarter.
The reality of an increasingly command-driven economy in America means that government policy is likely to become the key determinant of where investors should place their money.
For example, the near-term prospects for the housing market in the U.S. will be strongly influenced by whether the federal government extends its first-time home-buyer tax credit when it expires in November. Like cash for clunkers with autos, the risk is that such a program is simply buying demand from the future.
The other risk is the same as subprime mortgages—encouraging people to buy houses who may be better off renting. This is suggested from the growing delinquency rates on Federal Housing Administration (FHA) approved loans since the FHA has taken over from Fannie Mae and Freddie Mac as the prime way of increasing U.S. taxpayer exposure to future residential mortgage defaults.
The default rate on FHA-insured mortgages was already running at 8.1% in August, up from 5.7% a year ago.
Then there's the government involvement in the U.S. financial sector.
Over the past two years the federal government is estimated to have lent, spent or guaranteed around $11 trillion to the financial sector, broadly defined.
This is due to Washington's slavish adherence to the absurd notion that financial institutions can be "too big to fail," be they called Fannie Mae, AIG or Citicorp.
All of the above behavior invites legitimate comparisons with post-bubble Japan, where banks took years to be cleaned up as a result of regulatory forbearance.
The same kind of forbearance is preventing America's increasingly distressed commercial real-estate market from clearing. Similarly, as was the case with Japan, monetary-base growth has exploded in the U.S. over the past year courtesy of the Fed, while bank lending is declining.
This is why there is every reason to fear that America is already in a Japanese-style liquidity trap.
True, Japan's bubble economy was much more about corporate-debt excesses, most of it borrowed against land or property collateral, rather than personal debt, as is the case in the U.S. But if the comparisons between the two countries are far from precise, the Japanese example shows how investment behavior changes if a deleveraging deflationary trend becomes entrenched.
This can be seen in the dramatic change in Japanese institutional investor asset allocation between government bonds and equities.
Japanese insurance company and pension fund share of assets in domestic stocks peaked at 37.2% in fiscal 1988 (which ended March 1989, near the height of the bubble) and has since collapsed to 6.4% at the end of fiscal 2008, while their share of assets in Japanese government bonds surged to 36% in fiscal 2008 from 3.2% in fiscal 1990.
By contrast, in America institutional investors remain overweight equities and underweight government bonds.
This will change radically if the U.S. truly is in a deleveraging cycle.
Still, the process will take time. It was not until 1998 that Japanese insurance companies and pension funds had a greater percentage of their assets in government bonds than equities.
This is why Wall Street should make the most of the rally in U.S. stocks while it lasts.
The next bubble in asset markets will not be in the West but in emerging Asia, led by China.
The irony is that the more anaemic the Western recovery proves to be, the longer it will take for Western interest rates to normalize and the bigger the resulting asset bubble in Asia.
Emerging Asia, not the U.S. consumer, will be the prime beneficiary of the Fed's easy money policy.
By CHRISTOPHER WOOD
Tuesday, 27 October, 2009
Monday, 26 October, 2009
The Truth About Energy
After oscillating within a trading range for several weeks, the price of crude oil has recently broken out to a new recovery high. Now, you will recall that we have been firm believers of ‘Peak Oil’ since 2003 and we were expecting this bullish resolution.
Look. Skeptics can say what they want; it does not change the fact that our world is struggling to maintain daily flow-rates. Whether you agree with us or not, the energy reality is that the supply of conventional crude oil is very close to its peak and no other fuel source can easily fill the supply gap.
Yes, various governments are now promoting alternative sources of energy and over the following years, we expect this drive to intensify. But those sources will provide too little, too late. So there remains, today, an unbelievable degree of denial when it comes to ‘Peak Oil.’ Most people simply dismiss it as a conspiracy. Others gleefully point to alternative sources of energy, whereas some believe that the vast improvements in oil drilling technology will save the day. Do not be seduced by these delusional hopes.
Remember, crude oil is the lifeblood of the global economy and roughly 70% of it is used to power transportation.
Moreover, a vast amount of crude oil is also used up by agriculture (production of fertilizers, pesticides and irrigation systems).
In fact, modern-day agriculture can be best described as a process of converting hydrocarbons into calories. Without cheap energy, the world would certainly have trouble producing half of the current food supply and the result could be far worse.
Thus, crude oil is a key ingredient in two of the most critical processes which make modern life possible – transportation and agriculture. And shortages of this vital natural resource will result in extreme pain. In the initial stages, the price of crude oil will rise remorselessly and eventually, we will face rationing.
Now that we have established the importance of crude oil, we will explain why new drilling technology and alternative sources of energy will not make this problem go away.
First, as far as drilling technology is concerned, it is worth noting that America is home to the best oilfield technology on this planet. However, its oil production peaked in the early 1970s and has been in a relentless decline.
Furthermore, apart from America, other technologically advanced nations in the world have also failed in maintaining their daily flow-rates. For instance, after exporting crude oil for over two decades, Britain is now a net importer and its production is in a state of permanent decline. Hard data confirms that two of the most advanced countries in the world now live in a post ‘Peak Oil’ era, so what are the odds that other less fortunate nations will succeed in averting ‘Peak Oil’?
Secondly, as far as alternative sources of energy are concerned, they represent a drop in the energy ocean and will not be able to offset the depletion in crude oil.
Despite all the euphoria surrounding renewable energy, the ‘sources’ like ethanol and solar panels are net energy losers. In other words, it takes more energy to produce ethanol and solar panels than the energy you obtain from them. For sure, hybrid and electric cars will help us to some degree but you must keep in mind the fact that electricity is not a source of energy; it is a carrier of energy.
Even if electric cars become popular, how will we generate sufficient electricity?
Elsewhere in the alternative energy patch, a lot of hopes currently rest on unconventional sources of oil (especially tar sands and shale oil). Once again, this optimism is misplaced, as the increased supply from the unconventional sources will not even make a dent in the overall energy picture.
The nearby chart confirms that our world currently produces roughly 85 million barrels per day of total liquids and out of this gigantic sum, only 13 million barrels per day of oil is derived from unconventional sources.
So, when the production of conventional crude oil finally declines due to ‘Peak Oil’, it is extremely improbable that unconventional supply will be able to rise to the challenge.
Look. Skeptics can say what they want; it does not change the fact that our world is struggling to maintain daily flow-rates. Whether you agree with us or not, the energy reality is that the supply of conventional crude oil is very close to its peak and no other fuel source can easily fill the supply gap.
Yes, various governments are now promoting alternative sources of energy and over the following years, we expect this drive to intensify. But those sources will provide too little, too late. So there remains, today, an unbelievable degree of denial when it comes to ‘Peak Oil.’ Most people simply dismiss it as a conspiracy. Others gleefully point to alternative sources of energy, whereas some believe that the vast improvements in oil drilling technology will save the day. Do not be seduced by these delusional hopes.
Remember, crude oil is the lifeblood of the global economy and roughly 70% of it is used to power transportation.
Moreover, a vast amount of crude oil is also used up by agriculture (production of fertilizers, pesticides and irrigation systems).
In fact, modern-day agriculture can be best described as a process of converting hydrocarbons into calories. Without cheap energy, the world would certainly have trouble producing half of the current food supply and the result could be far worse.
Thus, crude oil is a key ingredient in two of the most critical processes which make modern life possible – transportation and agriculture. And shortages of this vital natural resource will result in extreme pain. In the initial stages, the price of crude oil will rise remorselessly and eventually, we will face rationing.
Now that we have established the importance of crude oil, we will explain why new drilling technology and alternative sources of energy will not make this problem go away.
First, as far as drilling technology is concerned, it is worth noting that America is home to the best oilfield technology on this planet. However, its oil production peaked in the early 1970s and has been in a relentless decline.
Furthermore, apart from America, other technologically advanced nations in the world have also failed in maintaining their daily flow-rates. For instance, after exporting crude oil for over two decades, Britain is now a net importer and its production is in a state of permanent decline. Hard data confirms that two of the most advanced countries in the world now live in a post ‘Peak Oil’ era, so what are the odds that other less fortunate nations will succeed in averting ‘Peak Oil’?
Secondly, as far as alternative sources of energy are concerned, they represent a drop in the energy ocean and will not be able to offset the depletion in crude oil.
Despite all the euphoria surrounding renewable energy, the ‘sources’ like ethanol and solar panels are net energy losers. In other words, it takes more energy to produce ethanol and solar panels than the energy you obtain from them. For sure, hybrid and electric cars will help us to some degree but you must keep in mind the fact that electricity is not a source of energy; it is a carrier of energy.
Even if electric cars become popular, how will we generate sufficient electricity?
Elsewhere in the alternative energy patch, a lot of hopes currently rest on unconventional sources of oil (especially tar sands and shale oil). Once again, this optimism is misplaced, as the increased supply from the unconventional sources will not even make a dent in the overall energy picture.
The nearby chart confirms that our world currently produces roughly 85 million barrels per day of total liquids and out of this gigantic sum, only 13 million barrels per day of oil is derived from unconventional sources.
So, when the production of conventional crude oil finally declines due to ‘Peak Oil’, it is extremely improbable that unconventional supply will be able to rise to the challenge.
As far as Canada’s tar sands are concerned,
Alberta currently produces roughly 1.4 million barrels of oil per day and under the best case scenario, this figure is expected to rise to just 3.5 million barrels per day by 2020. To complicate matters even further, the tar sands require huge amounts of water and natural gas.
In addition to this, the mining procedure is extremely polluting.
For example, the process of extracting ‘oil’ from bitumen releases at least three times the amount of carbon dioxide emissions as regular oil production. Accordingly, we have no doubt in our minds that Canada’s tar is not the Holy Grail.
Finally, the new oil shale discoveries in America are not going to help us either because the ‘oil’ trapped in the shale is in fact kerogen – a precursor to oil. So far, all major oil companies have struggled to convert the kerogen into usable oil and it will be interesting to see whether any of them succeeds in the future.
In any case, this conversion process is extremely expensive and we can assure you that shale will not be producing any oil at today’s prices. Recent studies reveal that the price of oil will have to rise to several hundred dollars per barrel to make this process economically feasible.
Well, now that we have covered the supply side, let us briefly discuss the demand side of the equation. According to the IEA, global oil usage in 2009 will amount to 84.4 million barrels per day and it will rise to 85.7 million barrels per day in 2010.
This means that oil demand will rise by 1.5% over the next twelve months which is in line with the growth rate over the past two decades. If this growth rate continues over the next 4-5 years, there is no way our world will be able to ramp up production.
Unfortunately, positive thoughts and wishful thinking will not change the equation. Precious time has been wasted and we have no margin of safety. We must prepare ourselves for sky-high commodity prices and periods of acute shortages, which will make wartime conditions seem rosy. In fact, we believe we are already a decade into this painful transition but let us warn you that we have seen nothing yet.
If our assessment is correct, it seems prudent to make a sizeable allocation to the energy sector.
However, given the realities of ‘Peak Oil’, we do not recommend exposure to the oil majors, as their reserves and production are in decline.
On the contrary, we urge you to invest your capital in quality upstream oil/gas companies and businesses involved in the energy services sector.
Sunday, 25 October, 2009
American Austerity Is About to Begin
While all the talk at present is about economic corners turned and markets charging ahead, no one is paying much notice to an American economy deteriorating before our eyes.
These myopic commentators seem to be simply moving past the now almost-universally held conclusion that before the crash of 2008, our economy was on an unsustainable course. If these imbalances had been corrected, then perhaps
I too would be joining in the euphoria. But evidence abounds that we have not veered at all from that dangerous path.
Last week, the Bureau of Economic Analysis reported that consumer spending as a percentage of U.S. GDP has risen to 71%, a post-World War II record.
This level is notably higher than other wealthy industrialized countries, and vastly higher than the levels sustained by China and other emerging economies. At the same time, our industrial output is contracting, our trade deficit is expanding once again (after contracting earlier in the year), and our savings rate is plummeting (after an early year surge).
The data confirms that government stimuli are worsening the structural imbalances underlying our economy.
The recent 'rebound' in GDP is not resulting from increased economic output, but merely from the fact that we are borrowing more than ever. That is precisely how we got ourselves into this mess. An economy cannot grow indefinitely by borrowing more than it produces.
Not only is such a course untenable, but the added debt ensures a deeper recession when the bills come due.
This soon-to-be-called depression will not end until the pendulum of consumer spending habits swings violently in the other direction. This will be a jarring change, but it is the splash of cold water that we need to return our economy to viability. I believe that consumer spending as a share of GDP will need to temporarily contract to roughly 50% of GDP, before eventually moving toward its historic mean of 65%. Such a move would indicate a restoration of our personal savings, a decline in borrowing and trade deficits, and an increased industrial output. That would be a real recovery.
In the meantime, the higher the spending percentage climbs, the more painful the ultimate decline becomes.
Consumers and governments must spend less so their savings can be made available to businesses for capital investments. Businesses, in turn, will produce more products and employ more people – increasing domestic prosperity. However, rather than allowing a painful cure to return our economy to health, the government prefers to numb the voting public with a toxic saline-drip of deficit spending and cheap money.
The primary factor that enables our government to peddle economic snake oil is the dollar's unique role as the world's reserve currency, and our creditors' willingness to preserve its status. By buying up dollars and loaning them back to us through Treasury debt, productive countries give American politicians carte blanche to play Santa Claus.
Ironically, as foreign governments finance our spending spree, they are simultaneously scolding us for our low savings rate. At the recent G20 meeting in Pittsburgh, all agreed – including President Obama - that resolving the global economic imbalances was a top priority. By definition, this would require Americans to spend less and save more. However, with foreign central banks continuing to buy our debt, the President has shown no political will to encourage this change.
Normally, if politicians run up the government deficit, voters soon suffer the unpleasant consequences of higher inflation and rising interest rates. Yet, if foreign central banks keep supplying the funds, these consequences are indefinitely postponed. As a result, there is no need for American politicians to ever make the tough choices required to solve our problems.
Instead, the burden may fall squarely on the citizens of those governments doing all the lending. The conflict is that within the creditor states, a vocal minority actually benefits from this subsidy (owners of Chinese exporters, for example) while the overwhelming majority fails to make the connection. Thus, foreign politicians have the same incentives as ours to keep playing the game.
The bottom line is that foreign governments can lecture us all they want about the need for prudence but if they keep lending, we'll keep spending.
Any parent knows that if you give your child a curfew yet never impose any penalties when it's violated, it will not be respected.
My gut feeling is that foreign governments are tiring of our conduct and on the verge of finally imposing some discipline. That means the dollar's days as the world's reserve currency are numbered, and the days of American austerity are about to begin.
Peter Schiff
These myopic commentators seem to be simply moving past the now almost-universally held conclusion that before the crash of 2008, our economy was on an unsustainable course. If these imbalances had been corrected, then perhaps
I too would be joining in the euphoria. But evidence abounds that we have not veered at all from that dangerous path.
Last week, the Bureau of Economic Analysis reported that consumer spending as a percentage of U.S. GDP has risen to 71%, a post-World War II record.
This level is notably higher than other wealthy industrialized countries, and vastly higher than the levels sustained by China and other emerging economies. At the same time, our industrial output is contracting, our trade deficit is expanding once again (after contracting earlier in the year), and our savings rate is plummeting (after an early year surge).
The data confirms that government stimuli are worsening the structural imbalances underlying our economy.
The recent 'rebound' in GDP is not resulting from increased economic output, but merely from the fact that we are borrowing more than ever. That is precisely how we got ourselves into this mess. An economy cannot grow indefinitely by borrowing more than it produces.
Not only is such a course untenable, but the added debt ensures a deeper recession when the bills come due.
This soon-to-be-called depression will not end until the pendulum of consumer spending habits swings violently in the other direction. This will be a jarring change, but it is the splash of cold water that we need to return our economy to viability. I believe that consumer spending as a share of GDP will need to temporarily contract to roughly 50% of GDP, before eventually moving toward its historic mean of 65%. Such a move would indicate a restoration of our personal savings, a decline in borrowing and trade deficits, and an increased industrial output. That would be a real recovery.
In the meantime, the higher the spending percentage climbs, the more painful the ultimate decline becomes.
Consumers and governments must spend less so their savings can be made available to businesses for capital investments. Businesses, in turn, will produce more products and employ more people – increasing domestic prosperity. However, rather than allowing a painful cure to return our economy to health, the government prefers to numb the voting public with a toxic saline-drip of deficit spending and cheap money.
The primary factor that enables our government to peddle economic snake oil is the dollar's unique role as the world's reserve currency, and our creditors' willingness to preserve its status. By buying up dollars and loaning them back to us through Treasury debt, productive countries give American politicians carte blanche to play Santa Claus.
Ironically, as foreign governments finance our spending spree, they are simultaneously scolding us for our low savings rate. At the recent G20 meeting in Pittsburgh, all agreed – including President Obama - that resolving the global economic imbalances was a top priority. By definition, this would require Americans to spend less and save more. However, with foreign central banks continuing to buy our debt, the President has shown no political will to encourage this change.
Normally, if politicians run up the government deficit, voters soon suffer the unpleasant consequences of higher inflation and rising interest rates. Yet, if foreign central banks keep supplying the funds, these consequences are indefinitely postponed. As a result, there is no need for American politicians to ever make the tough choices required to solve our problems.
Instead, the burden may fall squarely on the citizens of those governments doing all the lending. The conflict is that within the creditor states, a vocal minority actually benefits from this subsidy (owners of Chinese exporters, for example) while the overwhelming majority fails to make the connection. Thus, foreign politicians have the same incentives as ours to keep playing the game.
The bottom line is that foreign governments can lecture us all they want about the need for prudence but if they keep lending, we'll keep spending.
Any parent knows that if you give your child a curfew yet never impose any penalties when it's violated, it will not be respected.
My gut feeling is that foreign governments are tiring of our conduct and on the verge of finally imposing some discipline. That means the dollar's days as the world's reserve currency are numbered, and the days of American austerity are about to begin.
Peter Schiff
WHO WOKE THE DRAGON
China is a sleeping dragon. Let it sleep. If it wakes, it will shake the world.
Napoleon Bonaparte
It has been said God doesn’t speak to mankind because mankind doesn’t listen. Be that as it may, it is certainly true that England didn’t listen to Napoleon’s warning regarding China. Contrary to Napoleon’s advice, England woke China up.
In this struggle, too, central bankers are losing control. Only by selling more and more of their gold have they been able to slow gold’s rise. Today, literally, they are scrapping the bottom of the barrel as they are running out of deliverable gold.
Toronto analyst Rob Kirby’s recounting of the behind-the-scenes activity that recently drove up the price of gold is but one example of this on-going battle. On the last day in September, Kirby reported large buyers of gold entered the futures market and demanded immediate physical delivery on the September contract.
The counterparties, allegedly JP Morgan Chase and Deutsche Bank, both complicit in the
central bank suppression of gold, counter offered with premiums 25% above spot if the contracts could be settled with paper money instead of physical gold but the buyers refused, sending gold to record highs as the banks scrambled to deliver gold they did not own.
Questions were also raised about the quality of the gold bars delivered. Evidently, the bars provided by the Bank of England had to be re-cast as to meet the .999 quality necessary for delivery; and Professor Antal Fekete in his current article, The Gold Basis Is Dead—Long Live The Gold Basis, adds more to the controversy surrounding deliverable gold.
Reports are circulating that similar audits of certain Asian depositories have already produced “good” delivery bars (400 oz or 12.5 kg gold bricks) that have been gutted and stuffed with tungsten — a metal whose specific weight approximates that of gold, so that the famous test of Archimedes (fl. 287-212 B.C.) based on the Law of Buoyancy, designed to expose fraudulent goldsmiths, would be inapplicable.
The shortage of deliverable gold may, in fact, be the reason for the 17,500 ounces of gold bullion missing from the Royal Mint of Canada, almost exactly ½ tonne gone without a clue from a secure government facility. It is reasonable to suspect that government conveyance may have played a part in this unresolved crime.
Central bankers and governments are increasingly desperate to cap gold’s price and government chicanery cannot be ruled out, indeed, it almost can be assumed in these times.
GOLD, GOLD AND MORE GOLD
Only the lost will find the way
Napoleon Bonaparte
It has been said God doesn’t speak to mankind because mankind doesn’t listen. Be that as it may, it is certainly true that England didn’t listen to Napoleon’s warning regarding China. Contrary to Napoleon’s advice, England woke China up.
CHASING THE DRAGON
In 1999 China was a source of cheap labor, the dot.com bubble hadn’t yet burst, the financial deregulation allowed by the repeal of Glass-Steagall still had to work its destructive magic and global growth appeared to be endless. Life, however, was about to change.
In 2000 the dot.com bubble burst and in 2007 the largest bubble in history, the US real estate bubble collapsed freezing credit markets around the world. Investment banks Bear Stearns and Lehman’s fell, stock markets crashed and out of the rubble of change China emerged as a world power.
CAPITALISM’S JOURNEY TO THE EAST
Capitalism propelled England to world dominion by allowing England to wage war on credit. Capitalism, however, requires constant economic expansion and when capitalist economies contract, they collapse in a monetary phenomenon called a deflationary depression.
This is the reason economists in credit-based economies fixate on economic growth. In credit-based economies stagnant growth leads to parcus nex, economic death.
Without growth, capitalist economies cannot survive as levels of constantly compounding debt, created by previously issued credit, will overwhelm a country’s productive capacity to service and/or retire that debt.
Constantly compounding debt is therefore the devil’s whip which necessitates the continual expansion of credit-based economies; and, to ensure that expansion, capitalism needs to constantly recycle its savings.
When savings are not recycled, economies slow and recessions and/or depressions result.
Soon after the US went off the gold standard in 1973, the US began running large trade deficits with Asian countries. First Taiwan in the 1970s, Japan in the 1980s, then China in the 1990s and 2000s, with each succeeding decade and each new trading partner, US trade deficits increased as did the profits of Asian manufacturers. But unlike other nations, Asian nations didn’t spend their profits, they saved them.
After 1971 when the US reneged on its gold obligations under Bretton-Woods, the US was able to pay Asian manufacturers with fiat paper money instead of gold-convertible dollars; and US trade deficits soon became so large that any bar owner would have recognized the US as a deadbeat.
Inevitably, the flow of US paper dollars diverted by Asia’s high savings rate caused the West’s juggernaut of credit and debt to slow; and, like a dysfunctional circulatory system, the growing savings of the East eventually began to affect the West’s ability to absorb its now quickly rising levels of compounding debt.
U.S PAPER DOLLARS AND ASIAN GOLD RESERVES
But instead of slowing the outward flow of its dollars by slowing its purchases of Asian goods, the US instead pressured Asian manufacturers to recycle their dollars back into the US; and, in the 1970s, after heavy US pressure, Taiwan decided to do so, but instead of buying manufactured goods from the US, Taiwan bought gold.
If balancing the trade deficit were the sole US objective, Taiwan’s purchases of gold would have sufficed but the real US trade objective was for Taiwan to recycle US dollars in the form of US goods and services, not gold bullion.
Despite their public statements about gold, Western central bankers are well aware of the role gold plays in monetary systems: and, because of the West’s desire to retain financial dominance, the US didn’t want Asian countries owning more gold bullion.
When threatened with trade sanctions, Taiwan succumbed to US pressure. The US, however, was about to encounter an even larger problem regarding its increasingly negative balance of trade—Japan.
By the 1980s, Japan’s exports to the US dwarfed Taiwan’s. Edwards Deming’s theories of quality had catapulted Japanese manufacturing to the forefront of global competitiveness and the Japanese advantages of superior quality, lower prices and greater efficiency decimated American competition in automobiles, electronics, and consumer items.
But the US couldn’t force Japan to buy US goods as it had Taiwan; because in the 1980s the US badly needed Japanese savings to fund its multi-trillion dollar military buildup. Reagan’s explosive military spending had tripled the US national debt in only eight years, radically shifting US priorities from selling US goods and services to funding its now enormous budget deficits.
The US did however exert pressure on Japan’s central bank to limit its gold
purchases and, as a result, Japan’s gold holdings today comprise only 2.3% of its total reserves.
After 1980, the recycling of Asian savings into US debt had become a necessity if the US was to continue its debt-based spending, spending which for the next 25 years was to be the primary driver of global growth.
The 25 year US consumer bubble (which Japan enabled by purchasing larger and larger amounts of US debt) helped Japan to survive a deflationary contraction caused by the collapse of its speculative bubble in 1990 as US consumers increasingly stocked up on Japanese cars, electronics and consumer goods during this period.
During the 1990s and 2000s, Japan and China willingly invested their savings in US Treasury debt to increase exports to the US. The US encouraged this practice because without borrowing Asian savings, the US couldn’t spend money it didn’t have.
In the 1990s and 2000s, China bought increasing amounts of US Treasuries. Buying US debt was a quid pro quo China could not resist. Entry into the restricted arena of power is not easily come by and China’s increasingly large purchases of US debt removed any objections the US might have raised regarding the transfer of US technology and manufacturing to China.
Between 1996 and 2006, in their quest for profit, American multinationals transferred the bulk of America’s technological expertise and manufacturing capabilities to China, a transfer that was to transform China into a world power. China would never be the same—and neither would America.
What profiteth a nation should it gain share-holder value and lose its place in line
ENTER THE DRAGON
The world China is entering as a new power is in disarray; and those who currently wield power are the most vulnerable, as their paper money, the foundation of their suzerainty, is increasingly suspect.
Although an IOU can pass for money, it is not The confluence of record debt levels in the West as savings in the East reached record levels has altered our world in a way not yet understood: UK and US control over global credit is ending and it was this control over credit that was responsible for their extraordinary geopolitical influence.
The lynchpin of this control since WWII has been the US dollar which is now falling in value; and China, with over a trillion dollars invested in US debt, has the most to lose when the dollar falls.
That China is driving the change for a new currency is understandable as the universal dictum regarding the preference for paper or gold is as follows: Sellers of good and services preferpayment in gold and silver while purchasers prefer to pay with paper money
That Russia and China, both former communist powers, support the return of gold and silver whereas the US and UK, both capitalist powers, do not is understandable.
This is because the power of capitalism lies in its substitution of credit for gold and silver, a monetary slight-of-hand which England and the US leveraged for financial gain and world dominion—over Russia and China.
The ability to print money in a world where everyone is for sale is an immense advantage
The capital of capitalism is, in actuality, a smoke and mirrors shell game wherein credit and debt are substituted for money; and, as long as the game of capitalism expands no one is the wiser because the fraud is so subtle.
Capitalism, however, is no longer expanding. It is contracting.
THE EAST MEETS WEST—AGAIN
The symmetry of history is as wonderful to behold as it is surprising to those who do not understand it.
In the 1800s, England “woke” China by forcing China to accept British opium under the guise of free trade; but it was actually China’s refusal to accept England’s paper money that caused England to invade China.
The First Opium War or the First Anglo-Chinese War was fought between the British East India Company and the Qing Dynasty of China from 1839 to 1842 with the aim of forcing China to allow free trade, particularly in opium.First OpiumWar
After defeating China, England’s sales of opium eliminated England’s need to pay China with silver. But today, the question of paper money and its questionable value has again reappeared in the relationship between China and the West.
Today, just as then, the intent of the West is to leverage its paper money in order to maintain its advantage in paper-based capital markets; but, today, circumstances are far different.
Today, China is awake.
PAPER MONEY AND GOLD
China’s rise to power in this new era is truly akin to Rising in an empty city where the previously powerful have lost control. The US and UK and others, including Japan—the Japanese yen for leverage having cost it dearly—have fallen victim to the very system by which they controlled others.
Burdened by increasingly onerous amounts of defaulting debt as their credit-based economies contract and collapse, they are now reduced to printing more and more money desperately hoping to outrun the compounding debt they themselves created.
Deflation is a monetary black hole that once in motion can’t be escaped To support the declining value of their paper currencies, central bankers in the West and Japan are struggling to control the price of gold, the one indicator that mirrors the declining value of paper money.
In this struggle, too, central bankers are losing control. Only by selling more and more of their gold have they been able to slow gold’s rise. Today, literally, they are scrapping the bottom of the barrel as they are running out of deliverable gold.Toronto analyst Rob Kirby’s recounting of the behind-the-scenes activity that recently drove up the price of gold is but one example of this on-going battle. On the last day in September, Kirby reported large buyers of gold entered the futures market and demanded immediate physical delivery on the September contract.
The counterparties, allegedly JP Morgan Chase and Deutsche Bank, both complicit in the
central bank suppression of gold, counter offered with premiums 25% above spot if the contracts could be settled with paper money instead of physical gold but the buyers refused, sending gold to record highs as the banks scrambled to deliver gold they did not own.
Questions were also raised about the quality of the gold bars delivered. Evidently, the bars provided by the Bank of England had to be re-cast as to meet the .999 quality necessary for delivery; and Professor Antal Fekete in his current article, The Gold Basis Is Dead—Long Live The Gold Basis, adds more to the controversy surrounding deliverable gold.
Reports are circulating that similar audits of certain Asian depositories have already produced “good” delivery bars (400 oz or 12.5 kg gold bricks) that have been gutted and stuffed with tungsten — a metal whose specific weight approximates that of gold, so that the famous test of Archimedes (fl. 287-212 B.C.) based on the Law of Buoyancy, designed to expose fraudulent goldsmiths, would be inapplicable.
The shortage of deliverable gold may, in fact, be the reason for the 17,500 ounces of gold bullion missing from the Royal Mint of Canada, almost exactly ½ tonne gone without a clue from a secure government facility. It is reasonable to suspect that government conveyance may have played a part in this unresolved crime.
Central bankers and governments are increasingly desperate to cap gold’s price and government chicanery cannot be ruled out, indeed, it almost can be assumed in these times.
GOLD, GOLD AND MORE GOLD
Only the lost will find the way
Fantasy Housing Numbers
There are two sources for most housing data in the United States. One source is the National Association of Realtors (NAR). Given that this organization represents only people who sell U.S. residential real estate for their livelihood, this is an extremely biased entity – with an obvious agenda. They represent the more reliable source for data.
The other major source of data is the U.S. government, itself. I have written volumes on the legendary excesses of the U.S. government in manufacturing numbers which are ever-further divorced from the real world.
As an example, at the beginning of this year, when the Case-Shiller index was reporting that the collapse in U.S. housing prices had reached their most extreme level (a year-over-year decline of 19%), the U.S. government was reporting that U.S. home prices were rising.
As with many other U.S. government “statistics”,
Pay absolutely no attention to government housing propaganda.
While it is possible to critically analyze mere exaggerations, there is no analytical value to numbers which are simply invented – and in direct contradiction with what is actually happening in markets.
This leaves the biased NAR as the “best” source for most U.S. housing data.
In a report released Friday the NAR stated that existing home sales had increased to a level of 5.57 million units – the highest since July 2007, crowed the NAR. That was right about the time that the U.S. housing crash first turned really ugly. However, those days are already long-forgotten by the NAR.
Lawrence Yun, the giddy “chief economist” of this organization is claiming that U.S. “housing inventories” have now fallen to a level equal to 7.8 months of supply – and a supposed 15% decline from just the beginning of this year.
This is where the NAR severs all ties with reality. The NAR also acknowledged that “distressed sales” which include foreclosure sales, sales of “repossessed” homes (i.e. “walk-aways”) and “short sales” accounted for just 29% of all sales in its latest report (similar to numbers reported for most of this year).
Thus, with U.S. housing sales at their highest level in more than two years, the banks controlling all this “distressed” real estate are on pace to sell only about 1.5 million “distressed properties” this year.
In fact, foreclosures alone are on pace to hit about 4 million units this year – after more than one million foreclosures in the third quarter alone. “Repossessed” homes are on pace to add roughly an additional half-million “distressed properties” to this inventory. I'm unaware of any aggregate statistics on “short sales”, but as a favored choice for both homeowners and banks (versus the alternative of foreclosure), these also obviously total in the hundreds of thousands (at least).
Reported in a commentary on the U.S. housing sector about six weeks ago “U.S. foreclosures/repossessions on track to hit 5 million in \'09” the total amount of “distressed properties” in the U.S. - generated in just this year – is roughly 5 million units.
With U.S. banks on pace to sell about 1.5 million distressed properties this year, this leaves 3.5 million additional units which are being added to the inventory of empty/unsold homes in the U.S.
What this means is that U.S. banks by themselves are holding as much inventory (from just this year) as Yun claims exists in the entire U.S. housing market.
Put another way, the only way in which the NAR's “inventory” number would have any validity is if not one, single U.S. homeowner had a home listed for sale.
Returning to the real world, 25% of U.S. mortgage holders are “underwater” on their mortgages, with more than 10,000 additional U.S. homeowners entering the foreclosure process every day – and millions more homeowners only a (missing) paycheque away from joining that category. In other words, there are millions of highly-motivated sellers – easily surpassing the 3.5 million housing units which U.S. banks have added to their existing inventory of unsold homes.
Keep in mind that U.S. banks have been accumulating empty/unsold properties for roughly two years – as “distressed sales” have never kept pace with the rate at which banks are accumulating these properties since the U.S. housing collapse began.
A conservative estimate is that they are currently holding roughly 5 million empty/unsold units – equal, by itself, to a year's worth of consumption.
Add to that the millions of U.S. homeowners desperate to sell in order to avoid foreclosure, and the return of large numbers of speculators to this market and this represents at least another 5 million units of inventory – since speculators don't buy-and-hold houses, but rather put them back on the market (either immediately, or after some cosmetic changes).
As a result, none of these speculator-purchases remove any inventory from this market.
True, in theory, speculators can rent-out the homes they purchase.
However, with U.S. housing vacancies already at their highest level in 23 years and still soaring higher “Rising U.S. vacancies mean ALL real estate going DOWN” the combination of crumbling rental prices and huge over-supply means that any speculator foolish enough to become a “landlord” rather than simply trying to “flip” properties is doomed to be just another foreclosure victim.
There have been a number of recent reports attempting to “pump” this market – which actually claim that buyers are having a hard time finding “distressed properties” to buy. Don't believe a word of this nonsense.
As a Canadian, I have been getting spam in my own e-mail every day - “alerting” me to the wonderful “investment opportunities” of buying distressed U.S. real estate.
In recent weeks, this has increased to several pieces of spam every day. Presumably such spam is also bombarding Europeans, and investors in any other countries who actually have some spending power.
Ultimately, what this means is that in the real world, there are about 10 million units of “inventory” - which represents nothing more than “REO” homes (those held by the banks), the properties being flipped by speculators, and “distressed” homeowners who are desperate to sell.
This estimate excludes any “normal” sellers in the market (i.e. people simply wishing to move to relocate of their own volition).
Thus, the “official” inventories of unsold homes represent less than 1/3rd of actual inventory, and most likely only about ¼.
The reality is that U.S. housing inventories have risen to their highest level in history – and added millions of units to the 19 million empty homes which existed a year ago.
When stacked up against real inventories, the sales of only 5 million units this year sets up another nasty “leg” downward for this market by itself. However, as I (and an increasing number of other commentators) are reminding people the second spike in mortgage-resets for the dreaded “ARM mortgages” (adjustable-rate mortgages) is just about to begin
The other major source of data is the U.S. government, itself. I have written volumes on the legendary excesses of the U.S. government in manufacturing numbers which are ever-further divorced from the real world.
As an example, at the beginning of this year, when the Case-Shiller index was reporting that the collapse in U.S. housing prices had reached their most extreme level (a year-over-year decline of 19%), the U.S. government was reporting that U.S. home prices were rising.
As with many other U.S. government “statistics”,
Pay absolutely no attention to government housing propaganda.
While it is possible to critically analyze mere exaggerations, there is no analytical value to numbers which are simply invented – and in direct contradiction with what is actually happening in markets.
This leaves the biased NAR as the “best” source for most U.S. housing data.
In a report released Friday the NAR stated that existing home sales had increased to a level of 5.57 million units – the highest since July 2007, crowed the NAR. That was right about the time that the U.S. housing crash first turned really ugly. However, those days are already long-forgotten by the NAR.
Lawrence Yun, the giddy “chief economist” of this organization is claiming that U.S. “housing inventories” have now fallen to a level equal to 7.8 months of supply – and a supposed 15% decline from just the beginning of this year.
This is where the NAR severs all ties with reality. The NAR also acknowledged that “distressed sales” which include foreclosure sales, sales of “repossessed” homes (i.e. “walk-aways”) and “short sales” accounted for just 29% of all sales in its latest report (similar to numbers reported for most of this year).
Thus, with U.S. housing sales at their highest level in more than two years, the banks controlling all this “distressed” real estate are on pace to sell only about 1.5 million “distressed properties” this year.
In fact, foreclosures alone are on pace to hit about 4 million units this year – after more than one million foreclosures in the third quarter alone. “Repossessed” homes are on pace to add roughly an additional half-million “distressed properties” to this inventory. I'm unaware of any aggregate statistics on “short sales”, but as a favored choice for both homeowners and banks (versus the alternative of foreclosure), these also obviously total in the hundreds of thousands (at least).
Reported in a commentary on the U.S. housing sector about six weeks ago “U.S. foreclosures/repossessions on track to hit 5 million in \'09” the total amount of “distressed properties” in the U.S. - generated in just this year – is roughly 5 million units.
With U.S. banks on pace to sell about 1.5 million distressed properties this year, this leaves 3.5 million additional units which are being added to the inventory of empty/unsold homes in the U.S.
What this means is that U.S. banks by themselves are holding as much inventory (from just this year) as Yun claims exists in the entire U.S. housing market.
Put another way, the only way in which the NAR's “inventory” number would have any validity is if not one, single U.S. homeowner had a home listed for sale.
Returning to the real world, 25% of U.S. mortgage holders are “underwater” on their mortgages, with more than 10,000 additional U.S. homeowners entering the foreclosure process every day – and millions more homeowners only a (missing) paycheque away from joining that category. In other words, there are millions of highly-motivated sellers – easily surpassing the 3.5 million housing units which U.S. banks have added to their existing inventory of unsold homes.
Keep in mind that U.S. banks have been accumulating empty/unsold properties for roughly two years – as “distressed sales” have never kept pace with the rate at which banks are accumulating these properties since the U.S. housing collapse began.
A conservative estimate is that they are currently holding roughly 5 million empty/unsold units – equal, by itself, to a year's worth of consumption.
Add to that the millions of U.S. homeowners desperate to sell in order to avoid foreclosure, and the return of large numbers of speculators to this market and this represents at least another 5 million units of inventory – since speculators don't buy-and-hold houses, but rather put them back on the market (either immediately, or after some cosmetic changes).
As a result, none of these speculator-purchases remove any inventory from this market.
True, in theory, speculators can rent-out the homes they purchase.
However, with U.S. housing vacancies already at their highest level in 23 years and still soaring higher “Rising U.S. vacancies mean ALL real estate going DOWN” the combination of crumbling rental prices and huge over-supply means that any speculator foolish enough to become a “landlord” rather than simply trying to “flip” properties is doomed to be just another foreclosure victim.
There have been a number of recent reports attempting to “pump” this market – which actually claim that buyers are having a hard time finding “distressed properties” to buy. Don't believe a word of this nonsense.
As a Canadian, I have been getting spam in my own e-mail every day - “alerting” me to the wonderful “investment opportunities” of buying distressed U.S. real estate.
In recent weeks, this has increased to several pieces of spam every day. Presumably such spam is also bombarding Europeans, and investors in any other countries who actually have some spending power.
Ultimately, what this means is that in the real world, there are about 10 million units of “inventory” - which represents nothing more than “REO” homes (those held by the banks), the properties being flipped by speculators, and “distressed” homeowners who are desperate to sell.
This estimate excludes any “normal” sellers in the market (i.e. people simply wishing to move to relocate of their own volition).
Thus, the “official” inventories of unsold homes represent less than 1/3rd of actual inventory, and most likely only about ¼.
The reality is that U.S. housing inventories have risen to their highest level in history – and added millions of units to the 19 million empty homes which existed a year ago.
When stacked up against real inventories, the sales of only 5 million units this year sets up another nasty “leg” downward for this market by itself. However, as I (and an increasing number of other commentators) are reminding people the second spike in mortgage-resets for the dreaded “ARM mortgages” (adjustable-rate mortgages) is just about to begin
[Note: this chart only includes data up to January 2007, so it does not include all future, mortgage resets – since U.S. banks were still creating more of these mortgages in 2007.]
As the graph above illustrates, the U.S. has already suffered through the first spike in these mortgage resets – indeed, this market is currently in a brief lull, between the end of the last spike and the beginning of the next.
The big difference between the first spike and the second is that unemployment was only beginning to be a serious problem for the solvency of U.S. homeowners during the first spike, while the 2nd spike will occur with employment conditions at their worst level in 70 years. (“Shadowstats.com” puts current U.S. unemployment at over 20% and rising).
Thus, the next spike in mortgage resets was also guaranteed to cause another down-leg in this market – by itself. Roughly $600 billion worth of such real estate (its current, nominal value) is due to implode onto this market over the next two years.
When we combine this with a “shadow inventory” of at least seven million units more than the laughable numbers from the NAR, and an unemployment problem which will be much worse next year than this year, the overwhelming evidence is that the next leg down for the U.S. market will be at least as bad (if not worse) than the previous leg down.
For the U.S. financial sector, this next crash in residential housing comes just as the crash in U.S. commercial real estate has worsened into a crisis of its own.
Combine this with record rates of delinquency which are simultaneously occurring with every other category of bank credit to U.S. consumers, and obviously the losses ahead for the U.S. financial sector will greatly exceed the losses already incurred.
To my regular readers, I apologize for the continual need to repeat much of this analysis. However, as I have observed before, there is only one way to counter a relentless campaign of propaganda – through continued repetition of facts.
Stay focused on the “big picture” and do not allow yourself to be deceived by either fraudulent “statistics”, absurd “spin”, or the occasional, positive “blip” in this market.
In even the worst crashes, nothing goes down in a straight line. Given that the U.S. experienced a collapse in its housing market more than three times worse than the worst year of the Great Depression (based on data from the highly respected housing economist Robert Shiller), a “dead-cat bounce” for this market was overdue.
At best, this lull in “the eye of the hurricane” will last to the end of this year. Early next year, the new spike in mortgage-resets will begin.
At that point, U.S. banks (who have up until now totally ignored this oncoming disaster) will have to confront this next crisis – which will most likely be characterized by the U.S. media as a “surprise”.
By this point in time, there can be no excuse for responsible adults to be “surprised” by developments in the U.S. economy.
The same fools and shills who were “pumping” U.S. markets and the U.S. economy at the peak of the U.S. bubble (and Wall Street Ponzi-scheme) are pumping again.
Meanwhile the fundamentals for the U.S. economy continue to deteriorate.
It is only the fact that the U.S. government pretends there is no inflation in the U.S. economy which allows it to pretend that some aspects of the U.S. economy are experiencing a tiny improvement.
Even then, most of the statistics it spews are not improvements but simply a reduction in the rate of collapse.
The U.S. propaganda-machine has completely erased this important logical distinction.
When the Titanic had already taken on almost enough water to drag it to the bottom of the Atlantic, would rational passengers on that doomed ship really be encouraged to hear that the ship was “only” taking on water at a slower rate .
Jeff Nielson
The Snowball of Derivatives
The Specter of a Second Black Swan
Banking sector consolidation (via acquisition of failed banks) and the generalized bailout of bondholders, actions both promoted by governments, have aggravated the problems of “too big to fail” and “moral hazard”. Hence incentives for reckless behavior have actually heightened.
So far there has been lots of talk within the G-20 and other forums but little action to tackle the problem at national and especially at transnational levels. As Nouriel Roubini and others have pointed out, one could argue that systemic risks have in fact increased relative to the pre-crisis period. A follow-up financial meltdown would be devastating. Governments should not only hope for the best but act swiftly to forestall the worst .The arrival of a Taleb’s second black swan on stage would mean complete chaos.
Governments should urgently agree on binding disclosure, oversight and enforcement of tighter rules on derivatives at the national and supra-national level.
If only for the simple reason that now their fiscal and monetary leeway for future financial rescues is much diminished. After the first round of bail outs, debt to GDP levels of developed countries already exceed 100% of GDP and nobody really knows what the ratios would be if all guarantees and unfunded liabilities were to be brought above the line.
Derivatives were the invisible 800-pound gorilla in the room. After accounting for them - even abstracting from counterparty risks - leverage ratios were a multiple of those reported in the books .
It was the failure of Lehman Bros that drew the attention to the ultimate implications of this huge snowball rolling down the hill .
In the eve of the bankruptcy of Lehman, the International Swap and Derivatives Association (ISDA) had to improvise an unprecedented trading session on Sunday, September 14th 2008 to enable market participants to carry out trades and offsets of derivatives; further, the effectiveness of the transactions was contingent on Lehman filing for bankruptcy by midnight.
This was the first large-scale real life “Walrasian auctioneer” - a fictional textbook Deus ex Machina who does not allow actual trades to take place until all contracts of market players are mutually consistent. And it was precisely this exercise of contingent trading that shed light on the magnitude of AIG financial troubles.
The largest supermarket of default insurance was carrying in its books Credit Default Swaps marked at up to twice the values used by Lehman.
All the ingredients for the perfect storm were in place.
In order to forestall collapse, AIG’s creditors (including not only all major banks but also life insurance and retirement policy holders) had to be bailed out under the disguise of a de facto nationalization of AIG.
One of the problems is that the snowball of swaps and derivatives has not shrunk much.
The notional value of swaps and derivatives surveyed by the ISDA - by no means the real total which is unknown to us - amounts today to US$ 454 trillion or eight times the World’s GDP (just marginally lower than the value at the trigger of the crisis).
This figure involves a gross credit exposure of US$ 26 billion or close to twice the GDP of the USA and a, more relevant, net credit exposure of US$ 4 trillion, a figure twice the total equity position of all US banks.
All these figures are lower bounds; part of the problem is that we do not know what the real magnitude is.
The central question is: will the G-20 (within BIS, IMF or any other) reach binding agreements on switching the lights on and enforcing an orderly unwinding and gradual shrinkage of the snowball of derivatives? Or will they procrastinate and let the snowball continue to roll downhill in the dark?
The “Achilles heel” of the international financial system continues to be the ocean of derivates, particularly those negotiated over-the counter (OTC), including but not limited to Credit Default Swaps (CDS).
If the economic recovery holds there may not be any major hassle with orderly settlements. By contrast, if a double –dip hits us and its second leg is deep enough – however small the probability - then cash-strapped governments will have to choose between a second round of massive financial subsidies or else have creditors assume the losses and let banks fail.
The first would likely lead to hyperinflation and the second to a collapse of the “house of cards” of the payments system and financial chaos, a 1930s style depression.
In my view, the G-20 needs to move quickly on inter alia four specific reforms:
Dealing with the flow.
First, all new swaps and derivative contracts should, at a minimum, be traded and even issued through “clearing houses” and, preferably, to the extent feasible traded on stock exchanges. This will deal with the “flow problem”. Tight constraints need be imposed on OTC “consenting adults" dealing in the dark, for at the end of the day “tax-payers” end up being a party to the deal and thus should not be taken for granted (i.e. no taxation without representation.)
Dealing with the stock. Second, as to the “stock problem”, central banks should establish compulsory daily reporting of all derivative positions (counterparty, exposure, credit risk, collateral, etc) of their supervised institutions, including those carried out by their subsidiaries abroad. Central banks should be required to report weekly this information to the BIS, IMF, or any other suitable institution.
Risk taking. Third, off-balance sheet operation should be tightened and swaps and derivative positions restricted as close as possible to risk management and hedging.
The open positions of pure intermediaries in swaps and derivatives should be subject strict ceilings (i.e. no more glut of AIG –type naked Credit Default Swaps). One case of success in limiting off-balance sheet operations was the restrictions to securitization introduced by the Bank of Spain years ago.
Special resolution regime. Forth, the establishment of an automatic, special resolution regime affecting unsecured lenders of banks and other intermediaries .
As Willem Buiter has put it, if the market value of a bank’s equity shrinks below a trigger then unsecured creditors should automatically receive a letter saying “ congratulations as of today you have become a shareholder of Bank XYZ.“
Warren Buffet was surely right on mark years ago when he said, “derivatives were financial weapons of mass destruction.”
But even Buffet’s own holding company, Berkshire Hathaway, carries a fair amount of derivatives, including the sale of long term puts on the US stock market index.
The most naïve and really incredible development of international public policy over the last ten years or so has been the Basel II guidelines for regulatory reform.
It is hard to understand how on earth regulators could embark on a trip to outsource credit and market risk management to the supervised banks themselves.
The so-called Advanced Internal Rating –based Approach allowed banks to develop in-house risk management models to quantify their own capital adequacy requirements. And this proposal came after we all had the benefit of witnessing how in 1998, the very inventors of the options pricing formula -
Nobel prize winners R. Merton and M. Schools - blew up with their own models the hedge-fund Long Term Capital Management.
Clearly, Albert Einstein was not kidding when he said that: “Two things are infinite: the universe and human stupidity; and I am not sure about the universe”.
Banking sector consolidation (via acquisition of failed banks) and the generalized bailout of bondholders, actions both promoted by governments, have aggravated the problems of “too big to fail” and “moral hazard”. Hence incentives for reckless behavior have actually heightened.
So far there has been lots of talk within the G-20 and other forums but little action to tackle the problem at national and especially at transnational levels. As Nouriel Roubini and others have pointed out, one could argue that systemic risks have in fact increased relative to the pre-crisis period. A follow-up financial meltdown would be devastating. Governments should not only hope for the best but act swiftly to forestall the worst .The arrival of a Taleb’s second black swan on stage would mean complete chaos.
Governments should urgently agree on binding disclosure, oversight and enforcement of tighter rules on derivatives at the national and supra-national level.
If only for the simple reason that now their fiscal and monetary leeway for future financial rescues is much diminished. After the first round of bail outs, debt to GDP levels of developed countries already exceed 100% of GDP and nobody really knows what the ratios would be if all guarantees and unfunded liabilities were to be brought above the line.
Derivatives were the invisible 800-pound gorilla in the room. After accounting for them - even abstracting from counterparty risks - leverage ratios were a multiple of those reported in the books .
It was the failure of Lehman Bros that drew the attention to the ultimate implications of this huge snowball rolling down the hill .
In the eve of the bankruptcy of Lehman, the International Swap and Derivatives Association (ISDA) had to improvise an unprecedented trading session on Sunday, September 14th 2008 to enable market participants to carry out trades and offsets of derivatives; further, the effectiveness of the transactions was contingent on Lehman filing for bankruptcy by midnight.
This was the first large-scale real life “Walrasian auctioneer” - a fictional textbook Deus ex Machina who does not allow actual trades to take place until all contracts of market players are mutually consistent. And it was precisely this exercise of contingent trading that shed light on the magnitude of AIG financial troubles.
The largest supermarket of default insurance was carrying in its books Credit Default Swaps marked at up to twice the values used by Lehman.
All the ingredients for the perfect storm were in place.
In order to forestall collapse, AIG’s creditors (including not only all major banks but also life insurance and retirement policy holders) had to be bailed out under the disguise of a de facto nationalization of AIG.
One of the problems is that the snowball of swaps and derivatives has not shrunk much.
The notional value of swaps and derivatives surveyed by the ISDA - by no means the real total which is unknown to us - amounts today to US$ 454 trillion or eight times the World’s GDP (just marginally lower than the value at the trigger of the crisis).
This figure involves a gross credit exposure of US$ 26 billion or close to twice the GDP of the USA and a, more relevant, net credit exposure of US$ 4 trillion, a figure twice the total equity position of all US banks.
All these figures are lower bounds; part of the problem is that we do not know what the real magnitude is.
The central question is: will the G-20 (within BIS, IMF or any other) reach binding agreements on switching the lights on and enforcing an orderly unwinding and gradual shrinkage of the snowball of derivatives? Or will they procrastinate and let the snowball continue to roll downhill in the dark?
The “Achilles heel” of the international financial system continues to be the ocean of derivates, particularly those negotiated over-the counter (OTC), including but not limited to Credit Default Swaps (CDS).
If the economic recovery holds there may not be any major hassle with orderly settlements. By contrast, if a double –dip hits us and its second leg is deep enough – however small the probability - then cash-strapped governments will have to choose between a second round of massive financial subsidies or else have creditors assume the losses and let banks fail.
The first would likely lead to hyperinflation and the second to a collapse of the “house of cards” of the payments system and financial chaos, a 1930s style depression.
In my view, the G-20 needs to move quickly on inter alia four specific reforms:
Dealing with the flow.
First, all new swaps and derivative contracts should, at a minimum, be traded and even issued through “clearing houses” and, preferably, to the extent feasible traded on stock exchanges. This will deal with the “flow problem”. Tight constraints need be imposed on OTC “consenting adults" dealing in the dark, for at the end of the day “tax-payers” end up being a party to the deal and thus should not be taken for granted (i.e. no taxation without representation.)
Dealing with the stock. Second, as to the “stock problem”, central banks should establish compulsory daily reporting of all derivative positions (counterparty, exposure, credit risk, collateral, etc) of their supervised institutions, including those carried out by their subsidiaries abroad. Central banks should be required to report weekly this information to the BIS, IMF, or any other suitable institution.
Risk taking. Third, off-balance sheet operation should be tightened and swaps and derivative positions restricted as close as possible to risk management and hedging.
The open positions of pure intermediaries in swaps and derivatives should be subject strict ceilings (i.e. no more glut of AIG –type naked Credit Default Swaps). One case of success in limiting off-balance sheet operations was the restrictions to securitization introduced by the Bank of Spain years ago.
Special resolution regime. Forth, the establishment of an automatic, special resolution regime affecting unsecured lenders of banks and other intermediaries .
As Willem Buiter has put it, if the market value of a bank’s equity shrinks below a trigger then unsecured creditors should automatically receive a letter saying “ congratulations as of today you have become a shareholder of Bank XYZ.“
Warren Buffet was surely right on mark years ago when he said, “derivatives were financial weapons of mass destruction.”
But even Buffet’s own holding company, Berkshire Hathaway, carries a fair amount of derivatives, including the sale of long term puts on the US stock market index.
The most naïve and really incredible development of international public policy over the last ten years or so has been the Basel II guidelines for regulatory reform.
It is hard to understand how on earth regulators could embark on a trip to outsource credit and market risk management to the supervised banks themselves.
The so-called Advanced Internal Rating –based Approach allowed banks to develop in-house risk management models to quantify their own capital adequacy requirements. And this proposal came after we all had the benefit of witnessing how in 1998, the very inventors of the options pricing formula -
Nobel prize winners R. Merton and M. Schools - blew up with their own models the hedge-fund Long Term Capital Management.
Clearly, Albert Einstein was not kidding when he said that: “Two things are infinite: the universe and human stupidity; and I am not sure about the universe”.
Canada vs. U.S. -- The New Realty
The Canadian Real Estate Association said the average sale price of a home last month was $331,602 last month, a 13.6% from a year ago. After bottoming out in January, sales activity in Canada is up ...Yasmin Denner remembers the tough questions when she bought her first house in Toronto in the 1990s.
"I had 15% down but that wasn't enough. They wanted to know where I'd gotten the money from," said the self-employed IT specialist with a laugh as she recalled Canada's borrowing environment.
Flash forward 15 years. She and her husband Trevor moved to the United States, settling in the suburbs outside of Washington D.C. where they bought a relatively spacious 3,000 square foot home for their future family of three.
As the U.S. house market roared, and credit was easy to come by, Ms. Denner said she saw more than a few neighbours pull up stakes and buy twice as much house only to find themselves in trouble a few years later when the market went sour.
"I have a friend who was at a dinner party at one of these McMansions, something like 6,000 to 8,000 square feet. She asked why it was so cold in the house and was told it was too expensive to heat," says Ms. Denner.
There is something about the way she was raised in Canada that told her not to bite off more house than she could chew, even in the face of lax mortgage rules and tax benefits that allow you to deduct the interest on your mortgage from your income.
"We considered a bigger house. Sure you can write your interest off but it's not that much money. Still it's tempting for people here," says Ms. Denner, adding most of the transplanted Canadians she knows remained conservative as the American housing market exploded.
While the U.S. market has paid dearly for its rapid with an almost three-year slowdown, Canada's housing market has bounced back in a mere eight months. The Canadian Real Estate Association said the average sale price of a home last month was $331,602 last month, a 13.6% from a year ago. After bottoming out in January, sales activity in Canada is up 63% from the low
Perhaps Canadians are inherently more conservative than Americans and that has kept the market steadier but Don Lawby, the chief executive of Century 21 Canada, says we also have a more structured housing market.
As the U.S. housing market was approaching its peak four years ago, many in the Canadian real estate community were lobbying loudly for U.S. style breaks like mortgage interest deductibility - a popular measure that hardly encourages you to pay down the debt on your home.
"I own a home in the U.S. I get the maximum loan I can get, then I go out and buy a new car a, new boat. But what happens when suddenly my home is worth less. I've got a car, a boat and a house I can't sell," says Mr. Lawby. "People in the U.S. see the value of their home more as an ATM than in Canada."
Mr. Lawby says the banks in Canada deserve a lot of credit for not creating products with low interest payments up front that eventually give way to balloon payments. No money down loans have been banned by Ottawa for government insured mortgages and interest-only loans where you pay no principal are rare in Canada.
But one of the biggest differences between the Canadian market and the U.S. market is the ability to walk away from your housing commitment. In the U.S. people have handed over the keys to their bank as the value of their homes has shrunk below their mortgage.
Don't try it in Canada, says real estate lawyer Steve Brett. "In the U.S. obviously if you have the ability to walk away there is less of an incentive to stay and tough it out. We simply don't have that here to the same extent."
What would have happened in Canada if the market had not improved and prices declined say 25% - something that occurred in Toronto in the late 1980s?
"If you just say hand your keys back to the Bank of Montreal, the bank is entitled to take back possession of your property and resale it under the terms of the mortgage for the best price they can get," says Mr. Brett.
But if the best price they can get is less than your mortgage, you have a problem because most Canadians sign a personal guarantee when they get a loan. "If [the bank] suffers a loss after they've repaid themselves the principal, the interest, all of the costs including legals fees, real estate commission and fixing up the property, they are entitled to sue the owner," says the lawyer.
Once the bank has a judgement against you saying you owe them money, it will follow you forever. Try getting another mortgage with an outstanding judgement. The judgement automatically attaches itself to any future property you buy. With a judgement against you, the bank can also try and garnishee your wages.
But what's the reality? Would the banks actually pursue this route? That's exactly what happened in the 1980s. "Walking away from a property isn't a possibility at all, if you've got other assets," says Mr. Brett.
Bank of Montreal director of Mortgages John Turner agrees walking away from property will trigger an action against you if there is not enough equity in the home to cover a mortgage and associated costs.
It's not just the rules in place, Canadians don't want many of the products found in the United States. "We've done some research and Canadians are more conservatives than our cousins south of border. we are wired differently," says Mr. Turner. "Our products are different because that's what people want."
He admits if Canadians were offered more exotics mortgage products, there would be some interest. But Mr. Turner adds there is more of an advisory focus here to steer people away from certain products. "There are more brokerage intermediaries in the U.S. The fiduciary responsibility remains with the banks here in Canada," says Mr. Turner, adding mortgage brokers in Canada act more as a go between for the banks and customers.
Even some in the real estate industry admit Canada's conservatism has probably paid off. Brian Johnston, president of Monarch Construction, says it's probably been a blessing.
"I was with a friend, who is living in Iowa, and he was telling he didn't have a mortgage on his house but he's Canadian. He's unlike everybody else there who has big mortgage on their house because it's a tax planning strategy," said Mr. Johnston.
Now that the Canadian market is showing much better consistency will it quiet down demand for changes in Canada that makes buying a home easier?
"If I was sitting in the Canadian Home Builders' Association I would say don't ask for changes," says Mr. Johnston, "because finance is going to tell you, ‘looked what happened in the U.S.'."
Don't get the idea, the Canadian market is perfect.
It has had its speculators. Some parts of the country like Alberta and Saskatchewan have seen price appreciation of 50% in those markets over a year and have pulled back since.
But Marc Pinsonneault, senior economist with National Bank Financial Group, said it has hasn't been as dramatic and has been much more short-lived.
"Their market was stimulated by exotic mortgage products and you add it together with everything else and fueled house prices more than was reasonable," says Mr. Pinsonneault. "Clearly you can say it's not something we've had in Canada."
gmarr@nationalpost.com
Saturday, 24 October, 2009
The war over the dollar versus gold
A fierce war of words has erupted in recent weeks between the two major camps in monetary circles. The first camp – the gold bulls/dollar bears – have been loudly voicing their twin belief that the gold price is poised to skyrocket while the dollar price is perched for a collapse. The other side – the gold bears/dollar bulls – are making the counter claim the gold price is setting up for a crash.
Both sides have spared no expense in trying to convince the investing public of the merits of their respective arguments. In just the past couple of weeks I’ve received in the mail two elaborate promotional campaigns for financial advisory services. One of those packages contained on the outside envelope following warning:
“ALERT: Dollar Crash Looms! Your Last Chance to Evacuate the Greenback Before the Stampede Begins.” The other package contained the following words on the envelope:
“Shocking report reveals why GOLD is about to CRASH, not soar. Savvy traders are about to make a fortune SELLING gold to millions of panicking investors.”
Of these two promotionals, I received in the span of two weeks two copies of the mailing alerting of the dollar crash. I can only surmise that this particular mailing “pulled” very well for the publisher and probably for good reason: the public fears a dollar collapse much more than a gold crash.
According to one sentiment poll mentioned on CNBC recently, nearly 98 percent of all respondents were bearish on the U.S. dollar. Assuming this figure is anywhere near accurate, this has to be an all-time record for bearish sentiment on the greenback.
Before we examine the claim of the “coming gold crash,” let’s examine the dollar crash scenario. Is it possible that the “powers that be” would allow the mighty greenback to cascade to new depths, eroding purchasing power for millions of Americans in the process? After all, no government has ever outlived its currency.
Why would the federal government allow the dollar’s value to be sabotaged at the expense of its own survival? The possibility of an outright dollar implosion must therefore be seen as a slender one.
There is another train of thought espoused by some that a slow, steady decline of the dollar’s exchange value, rather than being a catastrophic event, is actually good for the U.S. David Jennett, editor of the Investment Letter, is an advocate of this theory. He writes,
“Far from being a sign that things are heading for a disastrous crash, the weaker dollar is a sign that American manufacturers will once again be given a fair chance to prove to the world that they are a low cost, high quality producer.”
Echoing this sentiment, Adrian Van Eck writes in the October issue of his Money Forecast Letter,
"There is, I admit, a measure of national pride when the dollar is treated as the king of the business and financial world. There was a dollar rally during the [2008] crash, but now you can see the dollar is falling again. That allows U.S.-based producers to win orders around the globe based on quality and not a message of cheap prices.”
Even within the gold community there are some who don’t buy into the “dollar crash now!” scenario. In an interview I conducted recently with James Hesketh, President and CEO of Atna Resources, a Colorado-based gold production and exploration company, Hesketh said, “The gold price is pushing the limits to new highs on the back of a weakening U.S. dollar.
At some point here the Treasury and the Federal Reserve will have to step in and support the dollar. They’re basically throwing the dollar under the bus, so to speak. Our continued deficits will continue to weaken the dollar. Effectively what they’re doing is devaluing the savings of every person in this country.
And that is not something that cannot continue to go on indefinitely, so they will have to take moves to both tighten the belt and support the dollar. And that will stop the advance of gold when that happens.” He adds, however, that there “doesn’t appear at this point in time that there’s any political will to make those moves.” Hesketh foresees “if not a continued strengthening then a stabilization [of the gold price’ at these levels.”
From a short-term technical standpoint we can see in the daily charts of both the dollar index and the gold futures price a potential juncture in the making. The dollar index is testing the lower boundary of a downtrend channel as shown below.
The dollar is hugging the lower channel boundary and threatening to break under it. If this happens, though, it will create a “channel buster” which in turn will set up a potentially sharp rally. The previous two breaks below the lower channel boundary in August and September (circled) produced just such a snap-back, albeit a temporary one.
A third “channel buster” below the downtrend channel would probably create an even bigger snap-back, especially given the overcrowded nature of the dollar bear related trades.
Clif Droke
Both sides have spared no expense in trying to convince the investing public of the merits of their respective arguments. In just the past couple of weeks I’ve received in the mail two elaborate promotional campaigns for financial advisory services. One of those packages contained on the outside envelope following warning:
“ALERT: Dollar Crash Looms! Your Last Chance to Evacuate the Greenback Before the Stampede Begins.” The other package contained the following words on the envelope:
“Shocking report reveals why GOLD is about to CRASH, not soar. Savvy traders are about to make a fortune SELLING gold to millions of panicking investors.”
Of these two promotionals, I received in the span of two weeks two copies of the mailing alerting of the dollar crash. I can only surmise that this particular mailing “pulled” very well for the publisher and probably for good reason: the public fears a dollar collapse much more than a gold crash.
According to one sentiment poll mentioned on CNBC recently, nearly 98 percent of all respondents were bearish on the U.S. dollar. Assuming this figure is anywhere near accurate, this has to be an all-time record for bearish sentiment on the greenback.
Before we examine the claim of the “coming gold crash,” let’s examine the dollar crash scenario. Is it possible that the “powers that be” would allow the mighty greenback to cascade to new depths, eroding purchasing power for millions of Americans in the process? After all, no government has ever outlived its currency.
Why would the federal government allow the dollar’s value to be sabotaged at the expense of its own survival? The possibility of an outright dollar implosion must therefore be seen as a slender one.
There is another train of thought espoused by some that a slow, steady decline of the dollar’s exchange value, rather than being a catastrophic event, is actually good for the U.S. David Jennett, editor of the Investment Letter, is an advocate of this theory. He writes,
“Far from being a sign that things are heading for a disastrous crash, the weaker dollar is a sign that American manufacturers will once again be given a fair chance to prove to the world that they are a low cost, high quality producer.”
Echoing this sentiment, Adrian Van Eck writes in the October issue of his Money Forecast Letter,
"There is, I admit, a measure of national pride when the dollar is treated as the king of the business and financial world. There was a dollar rally during the [2008] crash, but now you can see the dollar is falling again. That allows U.S.-based producers to win orders around the globe based on quality and not a message of cheap prices.”
Even within the gold community there are some who don’t buy into the “dollar crash now!” scenario. In an interview I conducted recently with James Hesketh, President and CEO of Atna Resources, a Colorado-based gold production and exploration company, Hesketh said, “The gold price is pushing the limits to new highs on the back of a weakening U.S. dollar.
At some point here the Treasury and the Federal Reserve will have to step in and support the dollar. They’re basically throwing the dollar under the bus, so to speak. Our continued deficits will continue to weaken the dollar. Effectively what they’re doing is devaluing the savings of every person in this country.
And that is not something that cannot continue to go on indefinitely, so they will have to take moves to both tighten the belt and support the dollar. And that will stop the advance of gold when that happens.” He adds, however, that there “doesn’t appear at this point in time that there’s any political will to make those moves.” Hesketh foresees “if not a continued strengthening then a stabilization [of the gold price’ at these levels.”
From a short-term technical standpoint we can see in the daily charts of both the dollar index and the gold futures price a potential juncture in the making. The dollar index is testing the lower boundary of a downtrend channel as shown below.
The dollar is hugging the lower channel boundary and threatening to break under it. If this happens, though, it will create a “channel buster” which in turn will set up a potentially sharp rally. The previous two breaks below the lower channel boundary in August and September (circled) produced just such a snap-back, albeit a temporary one.
A third “channel buster” below the downtrend channel would probably create an even bigger snap-back, especially given the overcrowded nature of the dollar bear related trades.
The gold price, on the other hand, is testing the extreme upper limit of an accelerating uptrend channel that has been in force since July. The attempt of the gold price to break out above the upper channel boundary is an upside “channel buster.”
These patterns often result in an overextended price and tend to create at least a temporary exhaustion of the uptrend, rendering the price vulnerable to a correction. Gold hasn’t had a worthwhile correction in some time, so any further attempt at rallying above the trend channel upper boundary would provide the pretext for a correction.
Turning aside from the dollar, another area in which there seems to be a consensus concerns the state of the economy. Apprehension over the state of the financial markets have clearly spilled over into the economic outlook.
But are these fears founded? In an earlier commentary we looked at the New Economy Index (NEI), which provided some hope for a positive retail sales outlook for the all-important months of November and December.
In spite of the internal weakness in some area of the market, the NEI actually strengthened this week as one of the components of this index, Amazon.com, exploded to a new recovery high. In doing so it pushed the weekly NEI reading to its highest level for the year.
As previously discussed, the NEI directional trend tends to lead retail economic performance by 2-4 months. A stronger than expected retail sales for this holiday season is therefore anticipated. The most salient implication of this year’s stock market recovery is the potential for economic recovery, intermediate-term. Lest we forget the old bromide: the stock market leads economic performance by 6-9 months on average.
I don’t expect this time to be the exception to this rule.
Clif Droke
The cataclysm awaiting gold is just disclosure
Economics and commodities.
It is the imbalance between supply and demand that drives the price of anything, including, of course, the price of any commodity.
Take the situation with oil, which has doubled in price over the last year.
On Aug. 14 the International Energy Agency released a report based on a study on the oilfields that make up 75 percent of world supply showing that not only is production declining but it is declining at double the rate of just two years ago, now 6.7 percent per year.
The IEA concludes that for the first time in history supply, not demand, is going to drive prices.
In other words, though demand has dropped dramatically due to the economic collapse, the oil industry is struggling to meet even the reduced demand, which is why prices have risen so quickly.
Saudi Arabia sits on 20 percent of the world's oil reserves and produces 12 percent of the world's daily oil output. Imagine some sort of cataclysmic event that took out Saudi Arabia's reserves and producing capacity. Wouldn't economics tell us that the price of oil would make an astronomical jump, as the world, which needs 86 million barrels each day, somehow would have to manage with just 75 million? Wouldn't economics tell us that to ration the drastically diminished supply, the price would have to go drastically higher?
It is very difficult if not impossible to imagine a cataclysmic event that would knock out not only Saudi production but its reserves too, but nonetheless it is a good intellectual exercise to contemplate the laws of economics.
You would also agree that if such an event happened, the adjustment in the price of oil would be so rapid that changes in the money supply would be irrelevant. In other words, the change in price would not be a monetary phenomenon but one of simple supply and demand imbalance.
Imagine that some cataclysmic event suddenly reduced physical stocks of gold above ground from 210,000 tonnes to only 160,000 tonnes. In other words, 50,000 tonnes of gold just vanished in this cataclysmic event.
In such circumstances what would happen to the price of gold?
This would be equivalent to the imaginary cataclysmic event that we just considered that made 20 percent of world oil reserves suddenly unavailable. It would represent 21 percent of all above-ground gold stocks just disappearing.
Wouldn't you agree that from an economics standpoint the resulting stampede to redistribute 160,000 tonnes in a market that believed 210,000 tonnes was not only available but had actually been sold would drive the gold price to unimaginable levels?
What sort of cataclysmic event could trigger this?
Revealing the true condition of the gold market could trigger it.
From the most recent work of the Gold Anti-Trust Action Committee there are strong indications that the London bullion market operates on a fractional-reserve basis. It would appear that at least 64,000 tonnes of gold have been sold via unallocated accounts against a maximum reserve of only 15,000 tonnes.
The cataclysmic event in gold could be triggered by an audit or simply by purchasers asking for delivery of their gold.
Re: New York University economics professor Nouriel Roubini Interview
I couldn't expect you to know as much as GATA about the gold market because GATA has spent 10 years researching this opaque market and you have not. But as an economist I am sure that if what GATA says is right, then the future direction and magnitude of the gold price are not in doubt at all.
Further, with this supply-and-demand problem in the gold market, inflation and deflation do not have to enter the discussion, because the adjustment in price could happen so quickly that the fiat money supply could remain totally static. Adrian Douglas
It is the imbalance between supply and demand that drives the price of anything, including, of course, the price of any commodity.
Take the situation with oil, which has doubled in price over the last year.
On Aug. 14 the International Energy Agency released a report based on a study on the oilfields that make up 75 percent of world supply showing that not only is production declining but it is declining at double the rate of just two years ago, now 6.7 percent per year.
The IEA concludes that for the first time in history supply, not demand, is going to drive prices.
In other words, though demand has dropped dramatically due to the economic collapse, the oil industry is struggling to meet even the reduced demand, which is why prices have risen so quickly.
Saudi Arabia sits on 20 percent of the world's oil reserves and produces 12 percent of the world's daily oil output. Imagine some sort of cataclysmic event that took out Saudi Arabia's reserves and producing capacity. Wouldn't economics tell us that the price of oil would make an astronomical jump, as the world, which needs 86 million barrels each day, somehow would have to manage with just 75 million? Wouldn't economics tell us that to ration the drastically diminished supply, the price would have to go drastically higher?
It is very difficult if not impossible to imagine a cataclysmic event that would knock out not only Saudi production but its reserves too, but nonetheless it is a good intellectual exercise to contemplate the laws of economics.
You would also agree that if such an event happened, the adjustment in the price of oil would be so rapid that changes in the money supply would be irrelevant. In other words, the change in price would not be a monetary phenomenon but one of simple supply and demand imbalance.
Imagine that some cataclysmic event suddenly reduced physical stocks of gold above ground from 210,000 tonnes to only 160,000 tonnes. In other words, 50,000 tonnes of gold just vanished in this cataclysmic event.
In such circumstances what would happen to the price of gold?
This would be equivalent to the imaginary cataclysmic event that we just considered that made 20 percent of world oil reserves suddenly unavailable. It would represent 21 percent of all above-ground gold stocks just disappearing.
Wouldn't you agree that from an economics standpoint the resulting stampede to redistribute 160,000 tonnes in a market that believed 210,000 tonnes was not only available but had actually been sold would drive the gold price to unimaginable levels?
What sort of cataclysmic event could trigger this?
Revealing the true condition of the gold market could trigger it.
From the most recent work of the Gold Anti-Trust Action Committee there are strong indications that the London bullion market operates on a fractional-reserve basis. It would appear that at least 64,000 tonnes of gold have been sold via unallocated accounts against a maximum reserve of only 15,000 tonnes.
The cataclysmic event in gold could be triggered by an audit or simply by purchasers asking for delivery of their gold.
Re: New York University economics professor Nouriel Roubini Interview
I couldn't expect you to know as much as GATA about the gold market because GATA has spent 10 years researching this opaque market and you have not. But as an economist I am sure that if what GATA says is right, then the future direction and magnitude of the gold price are not in doubt at all.
Further, with this supply-and-demand problem in the gold market, inflation and deflation do not have to enter the discussion, because the adjustment in price could happen so quickly that the fiat money supply could remain totally static. Adrian Douglas
Has the dollar stabilized or is there risk of a further plunge in its value?
Some discussions of the dollar’s recent fall have a tone of impending doom.They worry that the 15 percent drop of the last 6 months could accelerate out of control. The recent decline has not been the result of manipulation, but that’s not saying that the dollar has reached a new equilibrium. This post will take on the question:
Has the dollar stabilized or is there risk of a further plunge in its value?
One way to rephrase this is to ask whether the dollar is reasonably valued right now. A classic measure is to take a bundle of goods (some groceries, some transport, some electronics, etc.) and ask what exchange rate would make that bundle cost the same in a pair of countries.
The Organization for Economic Cooperation and Development (OECD) is one of several groups that produces these Purchasing Power Parity (PPP) estimates.
With these numbers, one can argue that it should take about $1.67 to buy a British pound. As I write this, the exchange rate is $1.63 – pretty close, with the dollar slightly overvalued. Other currencies look much different, though. For Germany, a PPP rate of 1.11 dollars to the euro compares with the current rate of 1.49. Instead of the PPP rate of 130 Japanese yen to the dollar, the rate is 91. In those cases, the dollar is badly undervalued.
While we’re playing with PPP exchange rates, we might as well check in on China.
We’ve just been told that China is not a currency manipulator, but the PPP exchange rate is 3.4 RMB to the dollar, versus the market rate of 6.83 RMB to the dollar. That says several things. First, China’s currency is seriously undervalued.
Second, PPP exchange rates are imprecise and can vary a lot. More careful estimates of China’s undervaluation run from 20-40 percent, not 100 percent. Finally, we can see that PPP rates offer only loose, long-term guidance about where currencies might go. They say very little about what will happen in the next six months.
In part, that’s because exchange rates are driven by investment decisions, not just the consumption of goods. Investors in Frankfurt and Tokyo ask whether they will make more money lending in euros or yen, or whether they would make more converting to dollars and buying American stocks or bonds. If they do invest in the United States, they’re going to have to venture a guess about what exchange rates they will face when it’s time to retrieve their funds.
How do they know what those rates will be?
Here we land in the world of the Keynesian Beauty Contest, in which you get a prize for selecting the most popular contestant. While objective measures of beauty may offer a clue, the subjective preferences of the other voters are most important.
Applying this to exchange rates, we know objectively that currencies tend to suffer when countries have uncontrolled fiscal spending and growing debt. Persistent large trade deficits also suggest that a currency is due for a fall.
Those are the situations facing the dollar. But the dollar retains value so long as everyone wants it – a self-supporting popularity. The concern is that a falling dollar will convince investors that their counterparts no longer find the dollar so beautiful and that a sharp unraveling in the dollar’s value could follow. In this scenario, the dollar wouldn’t fall without limit: at some point, US exports and facilities would look irresistibly cheap.
But such downward spirals – the flip side of bubbling enthusiasm – can be dramatic and wrenching.
We thus have two contrasting views about where the dollar might go. On the one hand, cross-country price comparisons don’t look too bad for the dollar. They seem to support the more comforting story that the dollar’s recent fall is just the unwinding of its extraordinary rise as investors reacted to the crisis.
On the other hand, the descent of the last six months looks very much like the start of a rush for the exits would look, as investors abandon the dollar and give in to their concerns about U.S. prospects.
It was just such a situation that prompted Harry Truman to cry out for a one-handed economist. In this case, though, the uncertainty is essential to the story.
That’s one of the valuable economic insights that emerged unscathed from the recent crisis. To quote John Cochrane from the University of Chicago: “the central empirical prediction of the efficient markets hypothesis is precisely that nobody can tell where markets are going.” In a nutshell, if we knew for sure that the dollar were to fall another 15 percent in the next six months, the fall would occur right now. Financial titans like George Soros would borrow dollars and buy other currencies, guaranteed to receive glorious returns. That would push the dollar down immediately.
So the dangers are real, but uncertain.
They are particularly troubling because the bad scenario could have lasting effects. It could undermine confidence in the dollar that has supported its role as the world’s principal reserve currency.
This potential has already led to calls for dethroning the dollar in such official transactions.
We really need not pay attention to the man behind the curtain
The dollar has been drooping.
A broad measure of the dollar's value against other currencies fell to a 14-month low. Depending on the commentator, this is either a global vote of no-confidence in the United States; or it is good news, a return to normality as worldwide fears subside.
Without exactly leaping between Paul Krugman and his latest sparring partners, there are a number of questions one might ask about the dollar's recent decline. This post kicks off a short series to consider four of them, beginning with: Is the drop in the dollar "natural" currency depreciation or the result of "manipulation?"
The dollar has fallen roughly 15 percent from its recent high this spring.
When we see sharp movements in a price, it's natural to look for an active protagonists driving those movements. Every now and then in the past, we've found some. There have been attempts to corner markets in silver, wheat, and even salad oil.
Each of these instances involved attempts to drive up a price and some were spectacular failures, but that's not what sets them apart from the case of the dollar. The market for currency absolutely dwarfs these other markets.
The last time statistics were gathered on this (late 2007), the average daily turnover in foreign exchange markets was $3.2 trillion and growing rapidly (up 69 percent since the 2004 survey).
To put this in perspective, if we divide U.S. GDP over 240 business days in a year, it was about $0.06 trillion ($60 billion) in 2008. So every business day, the value of currency transactions averaged about 50 times the total value of U.S. output.
The implication is that it's very hard to manipulate the value of the dollar. In fact, this enormity of the market for dollars is one of its great strengths as a reserve currency; no one wants to keep their wealth in a thinly-traded currency that can be easily manipulated.
As a general rule, the U.S. government doesn't even try to move the dollar around, and it gets to print the stuff. Every Treasury secretary since Robert Rubin has chanted the mantra "a strong dollar is in the U.S. interest" to avoid making any news that might move the markets in unpredictable ways.
But how can it be "natural" for the dollar to drop as far as it has in the last six months? Ever since the dollar was de-linked from gold almost four decades ago, the value of the dollar is determined continually in those massive global markets.
The markets are populated by investors and traders, some with business ideas, some with money to save, some with goods to buy and sell. Some of them want to turn their dollars into euros to buy some French wine, others wish to turn their yen into dollars to buy some oil, a Treasury bond, or an American office complex. Exchange rates balance dollar buyers against sellers.
That means, in part, that we can have many explanations for what happens in these markets. The dollar could go up because American vinophiles turned to Sonoma Valley, or because the U.S. commercial real estate market became more attractive.
One popular explanation for the dollar's rise and fall in the recent crisis is offered by Paul Krugman: "the dollar rose at the height of the financial crisis as panicked investors sought safe haven in America, and it's falling again now that the fear is subsiding."
That certainly seems to be part of the explanation.
But it gives the impression that all is well, that we have returned to normal and there's little to worry about on the currency front. In fact, there is no indication that we've reached a long-term equilibrium and there is a serious basis for worries about the dollar's fall.
Has the dollar stabilized or is there risk of a further plunge in its value?
Reserving Judgment
The U.S. dollar enjoys a privileged position in the world.
The federal government can print up the little slips of green paper and exchange them for barrels of oil or digital cameras. That trick is not unique to the United States; almost all countries print money and spend it at home.
The difference is that the dollar can be so easily spent abroad and that foreigners are so willing to hold on to large quantities of those little slips of papers, instead of trading them back in for American-made goods.
This raises the question: Is the dollar likely to be replaced as the world's reserve currency?
There have certainly been similar shifts in the past.
Some time in the first half of the last century, the dollar took over the exalted position long held by the British pound. Nor are the questions about the dollar's status as a reserve currency merely conservative fantasies aimed at stirring doubts about President Obama's leadership.
As with so many other things, this idea was made in China. Alarmed by his country's exposure to a potential slide in the dollar, the head of China's central bank floated the idea of a global currency to replace the dollar.
The Russians liked the idea.
The United Nations and the IMF were intrigued.
If we're to hold auditions for a new dominant global currency, we can start by considering the job description.
We're really looking for three things in an aspiring new currency:
▬It must be widely traded.
▬It must be linked to deep and open capital markets.
▬It must provide a stable store of value.
The dollar excels on the first two counts.
Given the size of the U.S. economy, the dollar has a broader reach than any other currency. U.S. capital markets (bonds, stocks) feature enormous trading volumes; that means that a government wishing to adjust its reserve position by selling Treasury bonds generally need not worry about whether it can unload them.
The dollar concerns stem from fears about U.S. fiscal incontinence. The Obama administration often deflects such concerns by arguing that it is necessary to run large deficits in a time of economic crisis. This conflates the short-term and long-term deficit problems. The administration declared early on that America's fiscal position was unsustainable because of burgeoning entitlement costs, especially in health care.
Yet the plans under consideration would likely increase overall health spending while raising the government's share of costs. Nor has the administration earned much credibility for its promises to offset costs.
The situation beyond health care does not look much brighter.
Runaway deficits can spiral out of control and have frequently ended in bouts of serious inflation, as governments print money to cover costs. That directly undermines the currency's role as a store of value. Inflation means that those green slips of paper buy less tomorrow than they do today.
Hence, the search for a successor to the dollar. But a review of the serious applicants suggests the dollar's position is secure, at least for a while.
At the front of the line is the euro.
It already accounts for almost 30 percent of global reserve holdings, compared to the dollar's roughly 60 percent. The euro zone certainly has the economic size to be a viable contender. But the recent crisis has shown up some serious weaknesses in the currency.
First, there was the question of how the euro zone would deal with bank failures, as in Ireland and Iceland. The European Central Bank does not have the full panoply of powers enjoyed by U.S. federal bank overseers. Europe also faces its own deficit problems, exacerbated by the fact that some members are more profligate than others.
In line behind the euro are the British pound and the Japanese yen. The economies are smaller, but still large enough to be contenders. Yet British debt problems are even more serious than those in the United States. Japan's fiscal problems are severe as well, offset only by that country's great propensity to save.
Beyond the yen and the pound, we come to the long shots, such as the Chinese yuan or the Brazilian real. For all its eagerness, China is disqualified because it does not have an open capital account (the opposite of deep capital markets; good luck unloading those RMB bonds). Brazil recently got a small taste of what it is like to be a favored currency and started running in the other direction. After the real appreciated 36 percent against the dollar this year, the Brazilians decided to start taxing investment flows.
So who's left? Just the imaginary currencies. These are artificial constructs like the IMF's SDR (special drawing rights). It's not widely traded; there are no deep SDR capital markets; nor are there any special guarantees about its prospects as a store of value. It has gained a following because it seems to offer an escape from all the failings of the other currencies. In fact, the SDR is nothing more than a basket of those very currencies.
So the dollar's reign looks likely to continue for a while. It's not a very resounding victory -- champion because everyone else fell over -- but a win is a win, as the cliché goes.
It does beg the question:
Is it a win? Has the U.S. benefited from the dollar's special role? More particularly, what do the dollar's role and value mean for U.S. foreign policy?
The federal government can print up the little slips of green paper and exchange them for barrels of oil or digital cameras. That trick is not unique to the United States; almost all countries print money and spend it at home.
The difference is that the dollar can be so easily spent abroad and that foreigners are so willing to hold on to large quantities of those little slips of papers, instead of trading them back in for American-made goods.
This raises the question: Is the dollar likely to be replaced as the world's reserve currency?
There have certainly been similar shifts in the past.
Some time in the first half of the last century, the dollar took over the exalted position long held by the British pound. Nor are the questions about the dollar's status as a reserve currency merely conservative fantasies aimed at stirring doubts about President Obama's leadership.
As with so many other things, this idea was made in China. Alarmed by his country's exposure to a potential slide in the dollar, the head of China's central bank floated the idea of a global currency to replace the dollar.
The Russians liked the idea.
The United Nations and the IMF were intrigued.
If we're to hold auditions for a new dominant global currency, we can start by considering the job description.
We're really looking for three things in an aspiring new currency:
▬It must be widely traded.
▬It must be linked to deep and open capital markets.
▬It must provide a stable store of value.
The dollar excels on the first two counts.
Given the size of the U.S. economy, the dollar has a broader reach than any other currency. U.S. capital markets (bonds, stocks) feature enormous trading volumes; that means that a government wishing to adjust its reserve position by selling Treasury bonds generally need not worry about whether it can unload them.
The dollar concerns stem from fears about U.S. fiscal incontinence. The Obama administration often deflects such concerns by arguing that it is necessary to run large deficits in a time of economic crisis. This conflates the short-term and long-term deficit problems. The administration declared early on that America's fiscal position was unsustainable because of burgeoning entitlement costs, especially in health care.
Yet the plans under consideration would likely increase overall health spending while raising the government's share of costs. Nor has the administration earned much credibility for its promises to offset costs.
The situation beyond health care does not look much brighter.
Runaway deficits can spiral out of control and have frequently ended in bouts of serious inflation, as governments print money to cover costs. That directly undermines the currency's role as a store of value. Inflation means that those green slips of paper buy less tomorrow than they do today.
Hence, the search for a successor to the dollar. But a review of the serious applicants suggests the dollar's position is secure, at least for a while.
At the front of the line is the euro.
It already accounts for almost 30 percent of global reserve holdings, compared to the dollar's roughly 60 percent. The euro zone certainly has the economic size to be a viable contender. But the recent crisis has shown up some serious weaknesses in the currency.
First, there was the question of how the euro zone would deal with bank failures, as in Ireland and Iceland. The European Central Bank does not have the full panoply of powers enjoyed by U.S. federal bank overseers. Europe also faces its own deficit problems, exacerbated by the fact that some members are more profligate than others.
In line behind the euro are the British pound and the Japanese yen. The economies are smaller, but still large enough to be contenders. Yet British debt problems are even more serious than those in the United States. Japan's fiscal problems are severe as well, offset only by that country's great propensity to save.
Beyond the yen and the pound, we come to the long shots, such as the Chinese yuan or the Brazilian real. For all its eagerness, China is disqualified because it does not have an open capital account (the opposite of deep capital markets; good luck unloading those RMB bonds). Brazil recently got a small taste of what it is like to be a favored currency and started running in the other direction. After the real appreciated 36 percent against the dollar this year, the Brazilians decided to start taxing investment flows.
So who's left? Just the imaginary currencies. These are artificial constructs like the IMF's SDR (special drawing rights). It's not widely traded; there are no deep SDR capital markets; nor are there any special guarantees about its prospects as a store of value. It has gained a following because it seems to offer an escape from all the failings of the other currencies. In fact, the SDR is nothing more than a basket of those very currencies.
So the dollar's reign looks likely to continue for a while. It's not a very resounding victory -- champion because everyone else fell over -- but a win is a win, as the cliché goes.
It does beg the question:
Is it a win? Has the U.S. benefited from the dollar's special role? More particularly, what do the dollar's role and value mean for U.S. foreign policy?
Friday, 23 October, 2009
China’s Dragons: Oil, Gold, and the US Dollar
The end of the de facto petrodollar standard has profound and lasting implications for the US dollar, oil, and gold. The US is the epicenter of the global financial crisis and economic downturn, but the US continues to exercise disproportionate control of the oil trade and to enjoy the unique status of the US dollar as the world reserve currency.
The inflationary policies of the US government and Federal Reserve have damaged the US dollar to the point that it is increasingly seen as a destabilizing force in the world economy. To make matters worse, it was principally the US that manufactured the financial derivatives that still menace the global financial system China has opted out
There is growing recognition that the US economy is on an unsustainable course and this fact has fueled an international movement towards a new world reserve currency.
China has emerged as a major player in the currency chess game and in the gold market, and China is the second largest consumer of oil. China is the largest US creditor holding $797.1 billion in US Treasury debt and a net creditor nation with reserves equal to $2.273 trillion.
Nonetheless, China is leading the charge against the petrodollar standard and the US dollar’s privileged status as the world reserve currency. China is not merely seizing the opportunity presented to it by the global financial crisis but is pursuing an ongoing economic strategy that includes a larger domestic market for its own goods and services, greater influence over the global economy, a stronger yuan, and a secure energy supply.
“The good fighters of old first put themselves beyond the possibility of defeat, and then waited for an opportunity of defeating the enemy. To secure ourselves against defeat lies in our own hands, but the opportunity of defeating the enemy is provided by the enemy himself.” – Sun Tzu, The Art of War, circa 610 BCE
Developing and implementing a new world reserve currency is a nontrivial proposition and it will take time.
However, in practical terms, the key factor that stands in opposition to a new reserve currency is the petrodollar standard. The petrodollar standard allowed the US to print vast quantities of US dollars without high domestic price increases because steady international demand strengthened the US dollar, thus moderating prices in the US, e.g., the prices of oil and of gold.
The petrodollar standard, which can be undone in a relatively short period of time, is the Achilles’ heel of the US dollar’s world reserve currency status. What is more important, however, is that ending the petrodollar standard will put massive upward pressure on prices in the US: a fact that few have recognized.
While the US monetary base has roughly doubled since the start of the financial crisis in 2008, the money created to recapitalize US banks remains in the banking system and has yet to influence prices in the US (aside from the prices of inflation hedges such as gold and silver, which are in high demand).
The most broad measure of the US money supply (M3), no longer officially measured, has actually declined according to Berkeley, California-based Shadow Government Statistics. Thus, the most useful monetary inflation analysis is that of Paul van Eeden, President of Cranberry Capital, Inc. Mr. van Eeden’s Actual Money Supply (AMS) model indicates a 12-month moving average of 8.44%.
Interestingly, from a technical perspective, the GSCI chart exhibits a clear inverse head and shoulders pattern followed by a breakout to the upside. Spurred by the financial crisis, China began putting its massive reserves to work in wide ranging global investments, , systematically trading its US dollars for resources and other hard assets.
China’s Seven Dragons
The five dragons of the ancient Chinese zodiac (fire, earth, metal, water, and wood) are suggestive of China’s tremendous natural resources, which include coal, iron ore, oil, natural gas, mercury, tin, tungsten, antimony, manganese, molybdenum, vanadium, magnetite, aluminum, lead, zinc, uranium, as well as the world's largest hydropower potential.
The inflationary policies of the US government and Federal Reserve have damaged the US dollar to the point that it is increasingly seen as a destabilizing force in the world economy. To make matters worse, it was principally the US that manufactured the financial derivatives that still menace the global financial system China has opted out
There is growing recognition that the US economy is on an unsustainable course and this fact has fueled an international movement towards a new world reserve currency.
China has emerged as a major player in the currency chess game and in the gold market, and China is the second largest consumer of oil. China is the largest US creditor holding $797.1 billion in US Treasury debt and a net creditor nation with reserves equal to $2.273 trillion.
Nonetheless, China is leading the charge against the petrodollar standard and the US dollar’s privileged status as the world reserve currency. China is not merely seizing the opportunity presented to it by the global financial crisis but is pursuing an ongoing economic strategy that includes a larger domestic market for its own goods and services, greater influence over the global economy, a stronger yuan, and a secure energy supply.
“The good fighters of old first put themselves beyond the possibility of defeat, and then waited for an opportunity of defeating the enemy. To secure ourselves against defeat lies in our own hands, but the opportunity of defeating the enemy is provided by the enemy himself.” – Sun Tzu, The Art of War, circa 610 BCE
Developing and implementing a new world reserve currency is a nontrivial proposition and it will take time.
However, in practical terms, the key factor that stands in opposition to a new reserve currency is the petrodollar standard. The petrodollar standard allowed the US to print vast quantities of US dollars without high domestic price increases because steady international demand strengthened the US dollar, thus moderating prices in the US, e.g., the prices of oil and of gold.
The petrodollar standard, which can be undone in a relatively short period of time, is the Achilles’ heel of the US dollar’s world reserve currency status. What is more important, however, is that ending the petrodollar standard will put massive upward pressure on prices in the US: a fact that few have recognized.
While the US monetary base has roughly doubled since the start of the financial crisis in 2008, the money created to recapitalize US banks remains in the banking system and has yet to influence prices in the US (aside from the prices of inflation hedges such as gold and silver, which are in high demand).
The most broad measure of the US money supply (M3), no longer officially measured, has actually declined according to Berkeley, California-based Shadow Government Statistics. Thus, the most useful monetary inflation analysis is that of Paul van Eeden, President of Cranberry Capital, Inc. Mr. van Eeden’s Actual Money Supply (AMS) model indicates a 12-month moving average of 8.44%.
The average monetary inflation rate, estimated at approximately 8% per year over the past 38 years, compounded annually, shows that the US money supply increased by roughly 1,863% since 1971. However, according to the US government, prices in the US have increased only 533% since 1971, a 1,330% differential. The number of US dollars exploded on a global basis to accommodate the growth in US dollar transactions, i.e., international trade, especially oil, and currency reserves.
China is the second largest US trading partner and the primary source of the chronic US trade deficit. As trading partners, the Chinese and US economies are linked by the US dollar, but compete for oil, currently priced in and purchased with US dollars. China needs more oil and wants to buy it with Chinese yuan.
By buying gold and encouraging gold ownership, the Chinese government is betting against the US dollar and positioning the yuan to become a universally accepted transaction medium. China is quietly diversifying out of US dollars, buying resources and hard assets. Ending the petrodollar standard will allow China to buy oil in yuan and make the yuan a more viable currency internationally while, at the same time, clearing the way to take on a larger role in the global economy.
With currencies being debased throughout the western world in the hope of saving banks, stimulating economic activity and restoring trade. Until the US reverses course, or until a new reserve currency is in place, gold will continue to shine.
Gold investment and central bank demand will likely remain strong because gold can function as a commodity, as a currency and also, unlike the US dollar, as a store of value immune from the hazards of currency devaluation caused by monetary inflation. As the only financial asset without counterparty risk, the historical reasons for holding gold, all but forgotten during the 1990s, have never been more clear.
The end of the petrodollar standard and eventually of the US dollar’s world reserve currency status combined with increased demand for oil and gold, particularly on the part of China, is a fundamental restructuring of the global economy already in progress.
US Dollars, Asian Tigers
While commodity prices, measured in US dollars appear to be rising, one of the fundamental forces behind the upward trend is the decline of the US dollar. Commodity prices are not rising as much in real terms as is suggested by their nominal prices because the US dollar is declining in value. As the US dollar falls, the prices of commodities, measured in US dollars, rise.
The perfect storm for the US dollar comprises the consequences of past decades of monetary inflation punctuated by the dot-com and housing bubbles; excessive levels of debt in the US economy (hampering a US economic recovery); the poor condition of US banks whose balance sheets, still burdened with toxic assets, continue to deteriorate; an expanding Federal Reserve balance sheet that includes toxic assets; extraordinary spending by the US federal government driven by Keynesian economic policies and by what are most probably economically unworkable socialist programs; rapidly declining foreign appetite for US debt; quantitative easing (“money printing”); near 0% interest rates and a growing US dollar carry trade; not to mention the imminent end of the petrodollar standard, and the eventual end of the US dollar’s status as the world reserve currency.
At the start of the global financial crisis and economic downturn, the US dollar rallied in a global flight to the then perceived safety of US dollars and US Treasury bonds. However, pressures on the US dollar have mounted and it has begun a precipitous decline.
What is important about the US Dollar Index (USDX) is that other currencies in the basket (the Euro, the Japanese yen, the British Pound, the Canadian dollar, the Swedish krona, and the Swiss franc) are also loosing value as a result of inflationary central bank and government policies, but not as quickly as the US dollar.
The USDX was created in 1973, two years after the US dismantled the Bretton Woods system (where the value of the US dollar had been pegged to the price of gold and other currencies were pegged to the US dollar) and one year after former US President Richard Nixon opened relations between the US and China.
Today, the sleeping giant, noted by Napoleon, is wide awake, and Asian currencies are rising against the US dollar. China is issuing yuan denominated bonds and growing Asian demand for key commodities, particularly oil, can be expected to maintain upward pressure on prices measured in US dollars.
The economic might of the four Asian Tigers (Hong Kong, Singapore, South Korea, and Taiwan) would have been inconceivable when the USDX was created. Today, the Group of Twenty (G-20) Finance Ministers and Central Bank Governors includes representatives from China, India, Japan, South Korea, and Indonesia, and the International Monetary Fund (IMF) includes the so-called BRIC countries (Brazil, the Russian Federation, India, and China) in addition to Japan and oil producers Saudi Arabia and Venezuela.
Whether the USDX remains today an accurate or meaningful measure of US economic power from a global perspective is unlikely. In any case, US and European economies and banks are currently in quite poor condition compared to those of Asia; a fact that does not support rising currency values for western countries.
China’s population of 1.333 billion, compared to roughly 308 million in the US, represents the largest emerging market in the world, and China’s already substantial consumption of resources is growing rapidly. With a population 4.3 times larger than that of the US, Chinese consumption need reach only 23% of that of the US, on a per capita basis, to equal total US consumption.
Conversely, if the Chinese were to consume half as much as Americans on a per capita basis, total Chinese consumption would be more than twice that of the US. Changes in the behavior of Chinese consumers already have the potential to create disruptive shifts in commodity markets on a global basis, and China’s rising influence is only just beginning to be felt, e.g., in the gold market.
The S&P Goldman Sachs Commodity Index (GSCI), which contains 24 commodities (including energy, industrial and precious metals, agriculture, and livestock), is designed to minimize the impact of events that affect individual commodities and to respond in a stable way to world economic growth.
Interestingly, from a technical perspective, the GSCI chart exhibits a clear inverse head and shoulders pattern followed by a breakout to the upside. Spurred by the financial crisis, China began putting its massive reserves to work in wide ranging global investments, , systematically trading its US dollars for resources and other hard assets.
China’s Seven Dragons
The five dragons of the ancient Chinese zodiac (fire, earth, metal, water, and wood) are suggestive of China’s tremendous natural resources, which include coal, iron ore, oil, natural gas, mercury, tin, tungsten, antimony, manganese, molybdenum, vanadium, magnetite, aluminum, lead, zinc, uranium, as well as the world's largest hydropower potential.
Together, Asian countries account for 60% of the earth’s human population and control major portions of world resources such as corn, cotton, gold, rice, rubber, silver, water, and wheat to name only a few.
If the Chinese calendar had been invented more recently it might include more specific varieties of each animal, such as a gold dragon in the metal category and an oil dragon in the earth category, thus there would be seven celestial dragons rather than five.
The Oil Dragon
Total Asian demand for oil, lead by China’s 7,880,000 bbl/day, exceeds US consumption. In fact, the consumption of just China, Japan, and the four Asian Tigers is greater than that of the entire EU. Taken as a whole, Asian demand for oil is more significant for the price of oil than the US or the EU. The price of oil in 2009 has risen as Asian economies began to recover, despite lower US consumption.
Rising Chinese demand for oil is now a fixed feature in the otherwise changing global economic landscape. A weaker US dollar and a stronger Chinese yuan serve to guarantee that China will have the oil it needs.
Although not as hard hit by higher oil prices as less developed countries (which could be priced out of the market entirely) would be, the US economy could be crippled by high oil prices. As shown by the West Texas Intermediate Crude Oil index (WTIC), the price of oil is rising sharply.
Both the US and China import roughly twice as much crude oil as they produce. With a weaker dollar, US oil imports, currently roughly $400 billion annually, will represent a larger external drain on the US economy, which could prove to be disruptive. The reactionary US strategy is to increase domestic oil production and to develop alternative energy sources in order to reduce dependency on foreign oil.
Unfortunately, US oil production cannot increase quickly enough or to high enough levels to ameliorate the impact of much higher oil prices. Presently, there is no alternative energy technology that can supply enough energy at a low enough cost to have a significant impact on US oil consumption in the near term. An anemic US economy combined with a weaker currency means that the US is ill equipped to absorb inevitably, much higher oil prices.
The Gold Dragon
Oil is the most important factor of the US dollar’s value for two reasons. Since the founding of the Organization of the Petroleum Exporting Countries in the 1960s (currently Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela), oil has been priced in and sold in US dollars worldwide.
Since the Bretton Woods system ended, the effect of the OPEC cartel’s price fixing actions has been to establish an implicit commodity-based value for the US dollar. In other words, after the Bretton Woods system, the value and the world reserve currency status of the US dollar was implicitly supported by oil rather than gold. Any nation accepting US dollars in trade knew what the value of US dollars was measured in oil.
Once oil is no longer priced in US dollars, the US dollar, in practical terms, will no longer be the world reserve currency, i.e., US dollar transactions will decline sharply on a global basis. This conclusion has already been recognized by central banks. In the second quarter of 2009, US dollars accounted for only 37% of new central bank assets, , compared with 70% in the past. Rather than US dollars, central banks favor Euros, Yen, and gold. Central banks have also become net buyers of gold or are repatriating gold reserves
Following the replacement by Iran (the third largest oil producer) of the US dollar with Euros for foreign trade in September, 2009, rumors of secret talks between Arab states, China, Russia, Japan and France, allegedly regarding replacing the US dollar with a basket of currencies including the euro, Japanese yen, Chinese yuan, and gold. Talks between Russia and Iran regarding conducting oil transaction in rubles were officially acknowledged a few days later by Russian Information Agency Novosti (RIA Novosti).
Neither development is at all surprising because world leaders have been calling for the replacement of the US dollar as the world reserve currency since 2008. It’s safe to say that all of the BRIC nations, especially China and Russia (the world’s 8th largest oil producer), oppose the petrodollar standard and are in favor of a new reserve currency (Brazil’s largest trading partner, formerly the US, is now China).
It seems unrealistic to imagine that currencies tied to growing economies with higher production and lower levels of debt would not be preferred over those of stagnated economies. If political strength follows economic strength, the petrodollar standard will soon take its place in history alongside the defunct Bretton Woods system.
Setting aside all other considerations, the price of gold would be $815 per ounce today based only on US dollar monetary inflation using Paul van Eeden’s AMS model, i.e., 30% below the spot price (approximately $1,060 US at the time of this writing). Mr. van Eeden has accounted for the increase in gold over time.
It is worth noting that the price of gold, when adjusted for inflation, is nowhere near its 1980 peak. The current situation is fundamentally different from the brief but acute 1980 gold price bubble. John Williams of Shadow Government Statistics maintains that the US government has understated inflation and recently said that “If the methodologies of measuring inflation in 1980 had been kept intact, gold [adjusted for inflation] would have to hit $7,150 to be the equivalent of the 1980 record
According to data from the World Gold Council (WGC) and metals consultancy GFMS, demand for gold is currently greater than the supply by as much as 1000 tons per year. The WGC and GFMS have correctly identified two distinct economic spheres comprising gold supply and demand.
In the western economies, jewelry and industrial demand are weak, but investment demand is strong, while outside the western economies broad gold demand continues to grow. India remains the largest buyer, while gold demand in China is rising. China has been aggressively adding gold to its reserves and has not only made it legal for Chinese citizens to own gold but is encouraging gold ownership.
The potential influence of increased, long-term Chinese demand on the price of gold cannot be ignored.
Monetary inflation and supply and demand considerations are not the whole picture. There is a much deeper reality. For nearly four decades, gold, priced in US dollars, was implicitly linked to oil and the resulting demand for US dollars moderated the affects of monetary inflation on prices in the US.
The end of the petrodollar standard and the resulting global decline in demand for US dollars will cause the price of gold to rise significantly. The value of the US dollar changed qualitatively after 1971 when it became an irredeemable pure fiat currency, no longer backed by gold; a fact that has been masked by the petrodollar standard.
Higher demand for gold also reflects a growing recognition that the US dollar and other currencies currently being devalued are not reliable stores of value. In fact, the US dollar has not been a store of value at all for 38 years during which massive quantities of fiat money, including trillions of petrodollars, flooded the global economy.
The weakness of the US dollar exposed by the financial crisis, i.e., its inability to function as a reliable store of value regardless of its utility as a transactional medium, points exactly to the strength of gold. The decline in international demand for US dollars, rejected as a failed store of value, indicates strong demand for gold in the foreseeable future.
18th-century French philosopher and writer Voltaire once said that “paper money eventually returns to its intrinsic value - zero”. Understandably, Voltaire failed to consider a world where all money was purely transactional rather than a store of value, and where the relative values of currencies were managed in a loosely coordinated manner by central banks and governments through manipulation of the money supply, interest rates, etc.
In theory, such a world could function indefinitely provided that currencies were relatively stable; provided that currencies were widely accepted and interchangeable; provided that large trade imbalances did not destabilize the system; and provided that currencies were not debased excessively, i.e., in a reckless or irresponsible manner, which would lead to a variety of economic problems. However, Voltaire’s inability to imagine such a world may be insufficient cause to dismiss his observation.
It seems possible that Voltaire’s superficially antiquated understanding was precisely that “paper money” can never function in the long run as a store of value, i.e., that it will inevitably, either by accident or by design, be mismanaged, and that it will always, eventually, be rejected, thus rendering its intrinsic value clear.
History certainly supports Voltaire’s view in that fiat currencies tend to perish. As recently as 1999, referring to the sale of British gold reserves, Alan Greenspan, then Chairman of the US Federal Reserve, said that “Fiat money paper in extremis is accepted by nobody. Gold is always accepted.” As the Chinese discovered in the 11th century, money has a qualitative dimension and for “paper money” that dimension is confidence. In contrast, because it is a tangible asset that required an investment of human labor and other resources to produce, the value of gold does not ultimately, in extremis, depend solely on the unreliable subjective feeling of confidence.
Xiangqi (Chinese Chess)
There is increasing international recognition of the fact that there is no foreseeable end point to the devaluation of the US dollar. The inflationary policies of the US federal government and Federal Reserve have all but exhausted confidence in the US dollar both at home and abroad, above all as the world reserve currency.
This entirely rational loss of confidence is the root cause of expanding multinational efforts to end the petrodollar standard and to eventually establish a new world reserve currency.
A reversal of the escalating challenge to the petrodollar standard and the movement away from the US dollar as the world reserve currency would require oil producers and industrialized nations, including China, to rally in support of the US, but it is precisely this group (a group that includes OPEC members, the BRIC countries, members of the G-20, and voting members of the IMF), that is seeking to free itself from US dollar hegemony.
Rather than attributing the petrodollar standard and the status of the US dollar as the world reserve currency to the wealth, power and influence of the US, critics assert that the wealth, power and influence of the US is illegitimate and that it is the result of undeserved privileges; privileges that have been abused at the expense of nations that do not enjoy unfair advantages and that must now be forfeited.
Skeptics regarding the rise of China as a major economic power doubt that China can profit from a weaker US dollar through a stronger yuan or develop a sufficient domestic consumer market quickly enough to offset reduced exports. However, while China contributes to US consumption as an export-dependent supplier, as well as a financier, their exposure to losses resulting from a declining US dollar is limited.
A stronger yuan would mean that, after a period of adjustment, China would import more goods and services and that, in real terms, wages of Chinese workers would increase, thus supporting a higher standard of living. What is more important is that a stronger yuan, implicitly backed by growing gold reserves (not to mention by a large and fully modern navy is exactly what will guarantee China’s oil supply.
The struggling US economy, burdened with excessive levels of debt, cannot support a sustained rise of the US dollar against the currencies of growing economies in Asia.
Growing demand for resources, especially oil, as well as gold, contrasted with the inflationary policies of the US, will maintain the upward trajectory of commodity prices measured in US dollars indefinitely.
In the near term, the end of the petrodollar standard will cause a sharp decline in the value of the US dollar and a marked increase in the prices of oil and of gold measured in US dollars.
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