By Lee Quaintance & Paul Brodsky
March 2011
In May 2007 we wrote a lengthy piece called “The Value of a Dollar” in which we argued the following:“Consistently excessive money and credit growth has taken the US economy past the point of no return.What (policy makers) have done consistently - and will continue to do - is inflate the money supply and promote more credit, thereby sustaining asset prices at the expense of the purchasing power of the USdollar. We argue the US dollar will ultimately lose its status as the world’s reserve currency. In fact, webelieve events currently unfolding may be foreshadowing the dollar’s eventual demise and replacement.” This paper updates those views and provides further perspective.
“Truth is tough. It will not break, like a bubble, at a touch. Nay, you may kick it about all day, and it will beround and full at evening.” - Oliver Wendell Holmes, Sr.
Each passing month brings wider and deeper global economic imbalances accompanied by what we perceive to bea general misunderstanding of their cause and impact. The source of these imbalances is the global monetarysystem. It continues its trend towards demise, as it must, and current events indicate an acceleration of this trend.The current monetary paradigm was structured and developed over the twentieth centuryby liberal democraciesfor liberal democracies that, through unified sovereign management and coordination, controlled the perceptionof value and how the free world would account for it. The system was not structured to accommodate the dynamicshifts in global economics, trade incentives and political alliances brought about, ironically, by the consequences of democracy’s triumph and the emergence of large, formally closed economies into the global economy.Serious consideration as to the inadequacy of the current regime has not been addressed since the onset of creditweakness in 2007, which was and remains a manifestation of a broader currency problem. Widely differingeconomic incentives and political agendas in developed and developing economies further suggest that a new,unified monetary system is highly unlikely without substantial friction first. We suspect broad acceptance of a newsystem will ultimately come only after manifest crisis. “An event”; however, is not a necessary condition for thedemise of the current monetary regime or, for investors, substantial asset revaluation. This paper discusses:
1. Allegory of the Cave:The current global monetary system – how it works and how it differs from themonetary system as it is widely perceived, the incentive structure of various participants in thesystem, and the natural pressures on it to fail and change
2. Best Intentions & Unintended Consequences:The new monetary regime we suspect the consensusof global policy makers would like to have, and why it will not happen
3. Devaluation & Transformation: The next global monetary system, and the implications for assetsand wealth
This report includes section 1 only. Contact Paul Brodsky(pbrodsky@qbamco.com)for sections 2 & 3.
Allegory of the Cave
The current global monetary system – how it works and how it differs from the monetary system as it is widely perceived, the incentive structure of various participants in the system, and the natural pressures on it to fail and change
In Plato’s Allegory of the Cave, it was suggested that men forced to face a cave wall their entire lives would seeonly shadows of figures behind their backs. That they could not see the actual figures led them to believe, withoutdoubt, that the shadows were reality and that no other reality existed. We use Plato’s allegory to describe thestark difference separating contemporary wealth, money and the exchange of economic value from erroneouspopular perceptions of them. The fundamental difference is profound and has led to an environment in whicheconomic, financial, political and even social incentives have been greatly distorted and broadly misunderstood.
Monetary Dynamism
In 1913, the US federal government became responsible for sponsoring one fungible US currency, replacing theprevious system of disparate individual banknotes issued by independent banks. Treasury gave the FederalReserve System, a new privately-owned central bank created by Congress, exclusive rights and discretion to printand manage the supply of Federal Reserve Notes, now colloquially referred to as “dollars”. In that same year, thegovernment instituted a federal income tax payable only in dollars (1% of income), thereby ensuring the dollar’sbroad adoption.
Dollars were made exchangeable for gold at a fixed price of $20.64/ounce, which was meant to enforce monetarydiscipline on the banking system. This was thought necessary because excessive credit extension or money printingwould dilute the purchasing power of each dollar, in turn giving incentive to dollar holders to exchange theirdollars for scarcer gold. As bank regulator, the Fed was charged with making sure US banks kept adequate reservesto satisfy potential demands for gold in the event confidence in the dollar declined.
It did not work so well for the Fed (or, consequently, anyone else). From 1917 to 1929 the US monetary base grewquite substantially and bank reserve ratios declined by 50%. The credit and asset bubbles this produced led to abust in 1929, a sudden re-marking of asset values to reflect lower credit valuations, and economic dislocationsresulting from the underfunded lending system. The monetary discipline of the gold standard had been bypassedthroughout the 1920s by banks and regulators through acceptance of a policy of unreserved lending, not only inthe US but Europe as well. (We discuss this in more detail below.)
Despite this, the US dollar would become the world’s reserve currency. The US entered the two world wars afterother economic superpowers had already run up substantial debts. America benefited from heavy exports, muchof it in food and munitions during the wars. In addition, the US offered potential dollar holders deep capitalmarkets, an established court system, and a powerful military. Finally, and perhaps most important, the US hadaccumulated over 21,000 metric tons of gold, far larger than any other nation.
As World War II drew to a close dollars were broadly used in non-US bilateral trade, held in reserve by globalbusinesses and official accounts, and the primary currency used to quote the global exchange of goods, servicesand assets. Thus, the US dollar was firmly established as the world’s only reserve currency and its hegemony wasunchallenged. In 1944 in Bretton Woods, New Hampshire, the US and the UK framed a new monetary orderintended to govern commercial relations among free market economies in the post-War era. The most importantoutcome of Bretton Woods was that major global currencies would be exchangeable into US dollars, which in turnwould be exchangeable into gold at $35.00 (President Roosevelt devalued the dollar to $35/ounce in 1934).
This system would ostensibly maintain currency discipline among global sovereign trade partners. Again, if they didnot practice sound money policies then they would see their currencies exchanged for gold. However, once againthe Bretton Woods system did not address the fundamental flaw that allowed governments and banking systemsto ignore the gold-exchange discipline -- fractional reserve lending, which allowed lending institutions to continuesynthesizing future demand for money by issuing credit that would not have to be exhausted. This allowed allgovernments and banking systems to more or less cheat together, to manage money and credit growth beyond (orin spite of) contradictory natural commercial incentives. (We discuss this in more detail below.)
QB ASSET MANAGEMENTwww.qbamco.com 3 See Important Disclosures at the end of this report.In 1961, Yale economist Robert Triffin warned that a national currency that also serves as an international reservecurrency poses natural conflicts for its policy makers, who must navigate both domestic and international aims.The specific dilemma would be that the flow of dollars into and out of the US could not occur at once to meetopposing objectives, and would thus create a wide and unsustainable negative balance-of-payments account forthe issuer of the reserve currency.
Indeed in the late 1960s, US trade partners began exchanging their dollar reserves for official US gold holdingsafter the US ran significant deficits from costs associated with domestic preferences -- executing the Vietnamconflict and expanding entitlement programs. In 1971, after US gold reserves had already been depleted from over21 thousand to about 8,300 metric tons, President Nixon defaulted on the dollar/gold exchangeability featurenegotiated in 1944 at Bretton Woods. Dollars and all other global currencies had officially lost theirasset-backed status. Adebt-backed monetary system had begun.
And so began the modern era in which there would be no explicit or implicit monetary discipline. Public, for-profitbanking institutions had a license to effectively print the coin of all realms. Since 1971 commercial banks havebeen able to lend money into existence by issuing unreserved credit. Since the 1980s, investment banks have alsobeen able to do the same thing, by marketing structured fixed-income product to bond buyers through a “shadowbanking system”. By issuing debt without practical limitation governments could also spend without fear of immediate budgetary discipline. The combination of a fractional reserve lending system and a debt based currencywas the perfect recipe for a super-cycle of credit boom and bust. Thus explains 1971 to 2011.
The only thing more certain than periodic change in monetary regimes (1913, 1944, 1971…) is the predictablepervasive certainty that it will not occur. This time is no different. History and current conditions make a newglobal monetary order a certainty and current conditions show clearly the transformation has already begun.
Money, or So it Seems
US dollars are debt, technically (Federal Reserve notes) and in practice. Their ongoing value is supported by asystem of government oversight that ultimately relies upon convincing private counterparties to use them intransactions. As all modern global currencies are directly or indirectly benchmarked to the US dollar, they too areunreserved debt, literally and functionally owed by sponsoring sovereign governments and backed by the full faithand credit of their taxpayers.
The fundamental question all global commercial counterparties must answer upon each transaction is: “will mycurrency maintain its purchasing power until the next time I need it?” If a quorum of economic counterpartiesbegins to answer negatively, the currency in question will soon lose sponsorship and fail.
The US government will sponsor about $2.7 trillion (after QE2) inbase money (currency in circulation pluselectronic bank reserves held at the Fed). Though we and many others continually note how much the quantity of base money has risen (up from about $850 billion in 2008), the newly-bloated quantity of base money still remainsvastly insufficient to settle all dollar-based transactions. A generally-accepted system of credit extension and debtassumption has filled the void separating the quantity of base money and the perceived exchange of value forwages, goods, services and assets. This is a system of financial leverage posing as money. (See “Leveraged Debt”.)
In economies allowing lenders to create credit (and thus systemic debt) with little regard for their own reserves,actual money needed to back that credit (to repay the debt) must be created in the future. The money simply doesnot exist when the credit is created. The more credit issued by the banking system, the wider the gap separatingoutstanding debt and the base money needed by borrowers to repay their obligations. It is a lending system thatmust either fail or that must destroy the purchasing power of the currency in which the debt is denominated.Onemay draw a straight line from a baseless money system to baseless credit, to boom and bust credit cycles, tooverleveraged economies, to credit deflation and then monetary inflation, and finally to monetary system demise. Indeed, history shows a perfect record of destruction of monetary systems where assets and commerce are valuedin baseless currencies.
Wealth, Money, Price, Value & Inflation
Why can’t central banks make everyone rich by printing and distributing more money? Because money that acentral bank can create does not createwealth(sustainable purchasing power). New money may providepurchasing power to its bearer relative to the value perceived by sellers in exchange; however, an increasingmoney stock dilutes the purchasing power of each outstanding currency unit. Growth in the money stock has noimpact on aggregate wealth and actually makes existing money holders poorer because their purchasing powergets diluted.In fact, aggregate global wealth cannot be created or destroyed at all, merely shifted.
Price, or the quantity of currency needed to purchase a good, service or asset, must increase with money creation.Why? Because sellers of goods, services and assets demand the samevaluein exchange for their wares. In anenvironment of diluting money supply, prices must rise to meet stable value.So price is determined as much by thesupply and demand for money as it by the supply and demand for a good, service or asset it is used to buy
Credit is simply a claim on future money. The more credit issued and outstanding, the more claims on futuremoney. The wider the gap separating money from credit, the greater the built-in demand for money production.Thus, money and credit growth literally equals the loss of purchasing power -- which is inflation -- even if it doesnot yet appear in popular “inflation” indexes. As Milton Friedman taught, inflation is always and everywhere amonetary phenomenon.
Not Inflation
In spite of the indisputable logic above, the link connecting money and credit growth with the popular perceptionof “inflation” is broadly overlooked, even among most professional economists. In fact, seeking to determinefuture price levelsby accounting for current money and credit growth seems to be almost a disreputable theorywithin the contemporary economics community.
Rather, most economists over the last two generations have been trained in the Keynesian tradition as “politicaleconomists”. They model the discrete demand for goods, services and assets relative to their supply, within thecontext of changing fiscal policies, and try to solve for nominal changes in output and prices. Some may considerrelative currency fluctuations in their models, but very few consider absolute currency growth. As it relates to theprice level, the focus of their work tends to be projections related to the Consumer Price Index (CPI), a subjectivelymanaged index that tracks a changing basket of consumer goods and services. The percentage change in the indexhas become commonly known as “inflation”. “Real” growth is calculated by subtracting the growth in the CPI fromnominal output growth (GDP) and “real” returns by subtracting the growth in the CPI from nominal returns.
A Flawed Benchmark Metric Ensures a Distorted Economy
The Consumer Price Index is deeply flawed as a barometer of purchasing power loss. It does not count the growthin the quantity of credit (“when issued money”). Thus, it does not discount latent and necessary inflation (moneyprinting), only manifest changes in goods and services prices. Also, widespread criticisms of its method of interpreting data (subjective reliance on hedonics, use of substitution, etc.) would seem justified. At the very leastthis subjectivity compromises its integrity as an objective barometer of purchasing power loss.
Nevertheless, the CPI over time paints a fascinating portrait of naïve indifference among professional observersintent on using it. In fact, the graph below showing the CPI over the last forty years illustrates a curiously slow andreliable increase in the index that implies a level of consistency normally not found in physical science, let alonebehavioral economics. It is the “science” of winking and nodding that makes contemporary economics so dismal.
The graph also implies a fascinating attribute of modern money -- an engrained acceptance of the loss of the dollar’s purchasing power. We know from the lack of public outcry that an entire generation of consumers andinvestors has not cared about their currency losing 450% of its purchasing power (based on an indicator generally regarded as an accurate measure of inflation). People have been apathetic towards trend level “inflation” as longas wages grew in kind or, in the case of those able to invest, as long as returns-on-assets were perceived to begreater than their sense of purchasing power loss.
Did wages grow in kind with the CPI? Not quite, judging from the growth inthe minimum wage. In 1970, theminimum wage was $1.60/hour and is presently $7.25/hour, a 350% increase.1 Would benefits have made up thedifference? Yes, and then some (but not for everybody). Since 1970, defined-benefit retirement plans graduallyreplaced defined contribution plans in the US, which greatly benefitted retirees. Pensions tended to be invested inthe financial markets. Since 1970, the US equity market grew over 15 times and bonds probably compounded atleast over 400%. Assuming pensions were invested half in the stock market and half in the bond market, we canassume that benefits easily made up the difference between 350% wage growth and 450% CPI growth. Thus,Americans have not cared about the loss of the purchasing power of their currency.
There are two obvious issues that should pop out: 1) it has been necessary to invest in appreciating financial assetsto maintain one’s purchasing power, and 2) investing in financial assets has been unavailable to all workers thatcomprise the economy’s factors of production, and certainly unavailable to all workers in the same proportion.Sothen, inflation is a monetary phenomenon produced unilaterally by banking systems that places disproportionate burdens on their societies. Inflation further demands currency holders seek a financial return so that they may maintain the purchasing power from their wages.
The US dollar has been a store of wealth only if it was invested – not if it was saved. This matters, not only fromthe perspective of the inequity for all users of the currency, including the majority of wage earners comprisingsociety’s factors of production at the lower rungs of the chain, but also from the perspective of the currencylooking forward. Can financial assets provide a future return for all users of the currency sufficient to keep thecurrency viable? We think the answer to this question is a resounding “no”.
Inflation, properly counted as a monetary phenomenon or improperly counted as the increase in a subjectivebasket of goods and service prices, ensuresnominal equity prices are biased to rise over time. However, financialassets are already encumbered by debt and they cannot produce positivereal returns when adjusted for thenecessary amount of money dilution needed to produce gains. Low interest rates also imply less or negative bondreturns. In fact, it seems clear that the only reason the US dollar has been able to remain viable as long as it hasgiven a 450% compounded “inflation” rate is because asset prices have continually discounted future revenues.
1U.S. Department of Labor. Web: http://www.dol.gov/esa/whd/flsa/.US Consumer Price IndexSources: Bureau of Labor Statistics; Bloomberg
Current debt levels -- the product of past currency discounting -- now ensure that future revenues will be receivedin increasingly inflated dollars. So not only could wage earners not have saved dollars and other currencies andmaintained their purchasing power, wage earners today are compelled to disgorge their currencies even more andreplace them with purchasing power hedges.Inflation is Good…In a Bizarre WorldThe confusion surrounding inflation continues today. In fact, it has become generally accepted for monetary policymakers to target inflation. The Fed’s target is currently 2% and most everyone is rooting for the Fed to achieve thisgoal. Most bizarre to us is that the debate of the day is whether the Fed will drain enough reserves in time toprevent “runaway inflation”. Frankly, we do not know what that means. Inflation is money printing. It has alreadyoccurred in record amounts and the yawning gap separating outstanding debt from outstanding money insuresthere will be much more to come.By the time observers get confirmation of rising goods and service prices in the CPI basket they will have alreadybeen priced out of their purchasing power. Alternatively, if people are concerned about “deflation” (notdrainingreserves, which would be an accurate definition, but a falling CPI), then they need not be concerned. As the graphabove shows, any hiccup in the “low and slow inflation” program, such as that in 2008, is met with overwhelmingforce in the form of truemonetary inflation.Trend-level CPI as a policy mandate is almost too strange to contemplate when one considers that it ensures eachgeneration will be stripped of the real value of its production, wages and savings. To date, central bank ZeroInterest Rate Policy (ZIRP) and Quantitative Easing (QE) have successfully levitated the CPI enough to save it fromits brush with the perception of “deflation”. (We can all be pleased its trajectory has resumed apace so that thepurchasing power of savings for the next generation will seem to decline as steadily as the last.)Deflation (money draining or credit deterioration) is strangely not a policy option, perhaps because it would hurtcreditors first. However, deflation would force an economy to shift its factors of production towards industries inwhich it could compete. (We discuss this in more detail in the Section: “A Utopian Economy that Serves to Definethe Organic Economic Path”.)
The basic lapse in logic that promotes moderate inflation and fears even minimal deflation (everywhere butGermany) has left economists (including at the Fed) in the strange and uncomfortable position of having to openlytout confidence in moderate inflation as the primary economic driver. The goal of discussing confidence seems tobe to get consumers borrowing so they can spend and invest more. This new demand, in turn, would grow theeconomy. We think economists should not have goals at all, other than to accurately understand economicrelationships; but if they do, then they are mistaken to necessarily make their goals centered on “growth”.The Harmful Preference for BignessIs economic growth always preferable or are there circumstances under which contraction would serve the publicgood? We would answer this question as follows:Real growth is always preferable butnominal growth is not. Bynominal growth we mean a simple increase in aggregate economic output and by real growth we mean an increasein aggregate economic outputadjusted for the loss of its currency’s purchasing power, specifically the dilutiveeffects of money and credit growth.Growth that is not deflated for the purchasing power loss of currency means little. By way of extreme example, in2008 Zimbabwe’s economy contracted almost 19%. In 2009, it grew 5.69%? Why the miracle turnaround? Becauseits central bank diluted its currency by 231,150,889% over that year to a dollar exchange ratio of over300,000,000,000,000:1. (The Zimbabwe dollar was effectively abandoned in April 2009 and Zimbabweans havebeen using foreign currencies ever since.) It was not such a miracle after all. Anyone holding Zimbabwe dollars orassets denominated in them from 2008 to 2009 suffered from doing so even though shares of Zimbabwean stockswere some of the best performers…in nominal terms.
The purpose of discussing the extreme travails of a small economy like Zimbabwe is to show the dangers of notrecognizing the separate pathologies contributing to nominal versus real value and growth. Solving purely fornominal growth or nominal returns can be deceiving and dangerous.Sophisticated Finance, Unsophisticated EconomicsHow different is the G7 and its coordinated economic policy apparatus from discrete examples seen recently inplaces like Zimbabwe, Argentina and Russia? The only difference is in the broad perception and acceptance thatthe global monetary system managed by large, developed economies is stable because it is in factthe global system, and therefore it cannot be an aberration. This fails logic.There is no denying that outstanding advancements in technology and logistics that began and spread quicklythrough the G7 in the last generation built substantialcapital (wealth or resources used or available for use in theproduction of more wealth). However it remains unclear how widely that capital was distributed or whatproportion of assumed wealth that sustainable capital comprises. An economy can appear stronger or biggersimply by synthesizing bigger numbers through currency or credit issuance.If tomorrow the Fed were to proclaim that each one dollar bill is a three dollar bill, and told merchants they shouldstart charging three times more for their goods and services, told consumers they should expect to pay three timesmore, told employers they should pay their employees three times more in wages, and so on; then nothing in theeconomy would have changed except thenumeraire. Nominal GDP would grow more or less by three times andthere would be no change in production, productivity or employment levels. This mind exercise provides insightinto how credit-based economies can use inflation to manufacture the appearance of beneficial growth when theirsocieties are willing to judge progress in nominal terms.It seems the great majority of economists, economic policy makers, and politicians in the West have mistakennominal growth for capital growth. In classic economics using currencies with fixed exchange rates, nominalgrowth would almost equal real growth. However, in a global economy wherein all currencies are baseless --continually manufactured and judged only against each other -- nominal and real growth are two very differentthings. Nominal growth and asset values are meaningless during periods of substantial money and credit growth –the more money and credit growth, the more meaningless.
Bigger is Not Necessarily…BiggerAt about $15 trillion in annual nominal output, the United States is the world’s largest economy in nominal terms.How big would it be had there been no money and credit growth over the last forty years? Much smaller.The continuing emphasis on asset prices un-adjusted for money and credit growth is the very reason asset bubblesare blown. After all, the credit must flow somewhere. We reprise the graph below to show how the US economylevered itself through unreserved credit. The green line is the growth in M3 and the blue line is output growthfrom 1970 to 2006. M3 was the only monetary aggregate that included overnight repurchase agreements WallStreet banks used to finance their balance sheets. From 1994 through March 2006, M3 grew almost 12% annually.(Though Wall Street banks still rely on repurchase agreements to finance their balance sheets, the Fed ceasedreporting M3 in March 2006.)From 1994 to 2006, Wall Street continuously tapped into an ever-increasing supply of overnight credit and thenhelped distributeterm-funded debt throughout the economy.From this systemic debt mismatch the entire global economy, using the US dollar as its reserve currency, ultimately became dependent upon the Fed and its ability and willingness to fund its constituent banks overnight. This process provided the nexus upon which the value of all term credit, debt and assets rely.
From 1994 to 2000 this term credit flowed broadly into financial asset markets. When equity markets blew up in2000, it flowed into housing. When that credit finally blew in 2007 there was nowhere for it to go except back tothe Fed. This is occurring today. So while it may seem that above trend economic growth (and wealth) was createdfrom 1994 to 2006, we would argue the majority of it did not create sustainable capital and so was not realgrowth. It was not wealth at all. Unreserved credit was created that would someday have to be reconciled.
While the size of the US economy in nominal terms may be unparalleled, it is very unclear whether it would be thelargest economy were it to be judged in terms of annual unleveraged, sustainable capital created (real growth).Further, it seems indisputable that credit needed to synthesize nominal output growth finds its way into financialassets (now including real estate because it is funded through securitization). The finance-based monetary systemis the cause of financial asset bubbles.Meanwhile, the irreconcilable leverage on the US balance sheet suggests that the US and all other economiesrelying on 1) US consumers for revenues, 2) US dollars as a benchmark for their national currencies, and 3)financial assets denominated in all currencies to produce a financial return that provides positive real savings; aresusceptible to a systemic collapse in the current global monetary regime. How did it get to this point?Economic & Financial RelativismWhy does a bond trader make three times more money than a neurosurgeon? Does society really value a personwho can leverage others’ future obligations more than and one who can repair three or four lives a day? Areasonable person would obviously place the bond trader with the pro athlete and conclude that in certaincircumstances society rewards scarcity over personal preference. So what are the circumstances at play?In a credit-centric economy it is critical to sustain the general perception that currency is tangible, that it haslasting real value. The easiest way to do this is to use complex models to quantify value. As we have established,currency is debt and so bond traders doing bond math can quantify this abstraction. The problem, however, is thatthey can only quantify value in relative terms, compared to some future notion of purchasing power loss or toother bonds and currencies. Indeed, it is a rare person clever enough to do math in his head while ignoringsystemic leverage that necessarily produces negative absolute real interest rates.The question of which occupation would be “more deserving” must be an individual one. We get Tom Brady andothers get Lionel Messi but few get Stephen Hawking and virtually no one gets (or should get) Billy Bondtrader.Nevertheless, society rewards guys that best leverage other peoples’ money – including the neurosurgeon’smoney. In an economy that rewards leverage, a physician can only leverage her time.
Wall Street today is a poorly understood concept, even among many of those who work there and report on it.Conceptually, finance is all about helping capital formation, bringing working capital to capital producers. However,intermediating between capital producer and investor becomes a trickier business as capital itself becomes asmaller and smaller portion of an economy.When the means of financing capital formation outstrips the organic need for capital formation, and thebusinesses devoted to financing capital formation have incentive to grow, and the policy and regulatory bodiesoverseeing those businesses give in to short-term political desires, then systemic economic incentives unite toleverage the system. Investment and commercial banking becomes the tool to lever the economy, whether or notcapital is created.How can the financial industry get away with distributing non capital producing financial products when there aretwo sides to every transaction? Wouldn’t the market balk at buying and owning financial assets promising negativereal returns? The answer is theoretically yes but practically no. In a credit-based economy where wage earners areinsured they cannot save and retain their purchasing power, and where investors become used to owning financialassets, and where direct investors carry leverage on their own balance sheets, and where institutional investorsare judged relative to indexes or against each other; the principal objective of the marketsbecomes generatingrelative returns.This allows sustainable economic fundamentals and financial markets to go their separate ways. Financial gainbecomes the highest priority among asset holders and those catering to them.Maintaining or increasingpurchasing power across all economic and market conditions over timeis not a generally-accepted investmentobjective (boy, the looks we get by suggesting it should be).This perverse state of affairs shortens investment horizons and givesthe marketsincentive to chase returns.Pressure builds on investment funds to go along with momentum or speculate on momentum reversals. Otherwisetheir constituent investors will withdraw their money and their fees will decline. Fundamental analysis and assetswith sustainable valuations are de-emphasized. Quantifiable measures for risk are hidden as leverage grows andmarket volatility declines.
Eventually something unforeseen happens, asset liquidity takes priority and most assets become correlated andfall. (Rinse, repeat.) It is all perfectly rational behavior because the “money” invested is in reality other people’scredit. The capital markets have little to do with capital creation or creating lasting wealth. They simply make andtransfer credit in various forms like stocks, bonds and derivatives.
The Exorbitantly Privileged
Valery Giscard d’Estaing, the French Minister of Finance under Charles de Gaulle in the 1960s, coined the term“exorbitant privilege” to describe the extreme benefits that accrue to the sponsor of the world’s reserve currency.The US, he noted, could never be short its own currency and so it never need fear a balance of payments shortfall(or fear missing a coupon payment). Later in the decade, Nixon Treasury Secretary John Connally glibly told hisEuropean counterparts that the dollar “is our currency but your problem”. It was good to be the king.
Americans can no longer claim sanctuary in its currency. The dollar has become most everyone’s problem andprivilege may only be enjoyed by a few. When excessive global credit is naturally compelled to contract, as it istoday, the most privileged of privileged, the most holy of holies, the most supreme among us, appears to be theworld’s largest banks.
An objective study of the past shows that this outcome is as it would have to be because banking systems havebeen at the center of resource allocation in developed economies. Banks lend money into existence by issuingcredit that must be repaid in money.They lend money they have not earned, charge borrowers interest on it, and force borrowers to surrender property if they are not paid . They used to do this at the behest of kings on behalf of kings, but now they do this with the endorsement of democratic governments on behalf of themselves. As MayerAmschel Rothschild (1744-1812) famously said: “Permit me to issue and control the money of a nation and I carenot who makes its laws.”
Economic Cycles -- A Century of Conditioning
Since 1913, the only limitation on large banks to extend credit has been the approval of their regulators, who inturn answered to their parliaments, who in turn have had to answer to the people…but over frequent electioncycles. Political incentives suggest there has been constant pressure on banks and their regulators to continuelending regardless of economic conditions. Meanwhile, the incentive structures of bank personnel andshareholders suggest there has also been pressure on governments to maintain liberal bank reserve ratios. Thus,money had to become a politically-corrupted media of exchange rather than a means of storing the fruits of production.
As a result, credit extension and debt assumption are at the center of Western commerce to an even greaterdegree than when money was exchangeable for gold. When nominal credit and debt balances expand, so doescommerce and economies in nominal terms. Of course credit and debt balances may theoretically contract. Thisused to happen occasionally when politicians, monetary policy makers and banks were willing to be onlylong-termgreedy , allowing occasional and brief credit contractions (i.e. “recessions”). Credit excesses were digested at suchtimes and businesses and individuals would soon come back to borrow, leading nominal output higher. Such creditmanagement describes what most economists have come to view as the “economic cycle”.
Most economic observers in the current era seem to presume that economic cycles arise out of the naturalcondition of man and his “animal spirits”, which sway back and forth between greed and fear. We believe peopledo not have incentive to behave this way. Men and women would work and save their wages for futureconsumption if their wages were denominated in a store of value, not in media of exchange produced andoverseen by institutions with incentives to dilute it. Whether or not consumers, producers and investors in societyexplicitly recognize it, they are given incentive to borrow through the credit build-up phase and they have becomeconditioned to expect shallow periods of digestion while credit excesses are flushed.
This familiar system was irreparably compromised by the sheer magnitude of systemic leverage that was built intothe system by 2006. Underlying commerce became dwarfed by asset and debt values that comprised the system’sbalance sheet and which had to support each other. This financial leverage became highly susceptible to smallchanges in commercial activity, trade patterns, finance rates and demographics. The substantial economic volatilitythis leverage engendered was further exaggerated by pressures from exogenous economies not beholden tomaintaining the credit-centric monetary regime. This state of affairs had to arrive eventually
Since the functional breakdown of Bretton Woods in 1971, the purchasing power value of dollars has been insuredonly by the assets of the Federal Reserve System. The Fed’s tangible assets are Treasury’s official gold holdings,marked at $42/ounce, plus the market value of its premises. Recently it has been forced to expand its balancesheet to include mortgage-backed securities and Treasury obligations. The Fed is not thought to be a credit riskbecause, even though it is owned by overleveraged private banks, it is implicitly backed by the US Treasury, whichmay ostensibly collect income taxes in the currency and in whatever amount the Fed can owe.
The magnitude of the systemic leverage that has been created in the US and that continues today is substantial.The top row in the table above shows the US Monetary Base. We can see it almost doubled from 1994 to 2006 andthen Quantitative Easing increased it substantially in the last few years. Yet despite this enormous growth in basemoney, there still is not nearly enough money in the system to repay US dollar-based claims. The second rowshows that the Fed would have to manufacture about 5 times more dollars than exist today merely for theTreasury to be able to meet its obligations (which would also presume no one else had base money). This is anobvious problem both fundamentally and for the global perception of dollar hegemony.
The $70 trillion dollar figure in the third row is a conservative estimate of total dollar-denominated claims (othershave used over $100 trillion). These claims include Treasury debt and other unfunded federal obligations, as wellas mortgage, auto, consumer, corporate, state and municipal debt. Seventy trillion in dollar denominated debt ontop of $2.7 trillion in currency and bank reserves with which to repay it meansthe US economy is levered roughly 26 to 1. Certainly the gap doesn’t need to close completely – there will always be credit balances larger than thebase money stock. So then is a credit-based global monetary system necessarily unstable?
A Truly Unsustainable Regime
One may argue (and most economists implicitly do), that a highly leveraged economy is not necessarily unstablebecause there would never be a reason to replace all economic activity with actual money or a reason to convertall assets to money. The thinking is that all buyers and sellers of goods, services and assets within the systemwould never want to settle all accounts and convert everything to cash at once. This further implies that thesystem can run as long as wage earners accept credit for their labor and asset owners accept credit for theirproperty. It is generally accepted that as long as the popular demand on the currency is only as media of exchange,not as a store of value, then the system can endure. So some argue that credit may be perpetually extended anddebt may be continually assumed and economic leverage may be continually built.
This is patently false. A credit-dominated monetary system is inherently unsustainable and must eventually fail.History shows that credit build-ups run smoothly until they are no longer supportable by commerce and thefactors of production that produce it.
A credit build-up is a regressive process. As credit permeates through the system driving prices higher, low wageearners reach a point where they can no longer use their wages to maintain their relative standards of living orsave their wages to defer consumption. Economic incentives will first drive them to be more productive.Eventually, they too must use credit to maintain their standards of living. Workers struggle to service debt becausethe growth in wages does not keep pace with the necessary increase in money and credit production. Aggregateconsumption in terms of unit sales naturally falls, which forces employers to use less labor. Unemployment risesand a negative economic feedback loop begins.
Ultimately, ever higher aggregate credit/debt balances must require the majority of an economy’s factors of production (labor and capital producers) to accept capital redistribution (from indebted wage earners and capitalholders to creditors and money leveragers).
During the end of this cycle, property is transferred disproportionally from those with access to less credit to thosewith access to more credit -- unless the political dimension inserts itself to prevent that, which it inevitably sees asits function. Expedient intervention comes in the form of even more money printing. The purchasing power valueof aggregate wages and savings are continually diluted for those working and saving in inverse proportion to thesystemic leverage that government subsidizes.
So in theory and as we are seeing in practice, the current global monetary system is only as stable as thewillingness of commercial counterparties (private sector and government) to take on more credit and debt inexchange for goods, services, labor and assets. The great and obvious flaw is that in a credit based monetarysystem wealth is not gained through labor or saving.
In the end, a decline in confidence in the media of exchange serves to de-leverage the broader economy bycollapsing the wide gap separating outstanding claims on base money (debt) from base money itself. The broaderrisk from this is that the regressive nature of such inequity is destined to be popularly recognized by societies’factors of production – the conditions that typically lead to social unrest.
Managing the Unstable Monetary System
When the markets or economy stumble politicians across the ideological spectrum tend to pressure monetarypolicy makers for solutions to recapture short term nominal growth, even if those solutions (easy money andattendant financial engineering) may create or deepen longer-term structural economic problems. Exhibit A is thevirtual consensus – not even up for debate among rational people – that Treasury and the Fed saved the economyfrom Depression in 2008 and that doing so was a good thing.
Would we be mad to think otherwise? It is a matter of preference. Treasury and the Fed should not haveintervened in 2008 if they wanted a long term fix. Yes, had they not intervened then there would have beenwidespread defaults, bankruptcies and bank insolvencies, as well as higher unemployment than that experienced.However, if the 1930s are any guide, weak banks including many of the largest ones would have failed, asset priceswould have adjusted to provide positivereal rates of return, wage rates would have been revalued to a morecompetitive global scale, workers would have shifted towards more sustainable industries, and employment andasset prices would already be starting to rise.
To intervene should not be presumed “a given” but should be recognized as a policy preference that may or maynot reflect the preferences of society. Obviously, most businesses and laborers would opt for intervention if andwhen asked if they would like help in the near term. It is safe to assume then that policy makers are on solidpolitical footing in satisfying the preferences of their constituents by printing money. It is the easy choice.Would enduring a difficult period of necessary digestion have been worth it? Again, we can debate thishypothetical question but we raise it because it may not be as theoretical as it first seems. We believe the G7 willexperience this choice again, perhaps sooner than most think (if the Fed truly does stop with QE2?). With eachpassing period suspending debt reconciliation the consequences grow greater.Political behavior should be expected among elected officials. A recent example is the Dodd-Frank legislation thatattempted to enforce rules on commerce and market behavior rather than address the root cause of economicimbalances – systemic leverage and the source of it, fractional reserve lending and the monetary system itself.Indeed, getting more credit to businesses and consumers was not only accepted wisdom but a bipartisan objective.Political calculation also seems to have taken over the ostensibly “independent” role of monetary policy makerswho seem to be solving for short-term financial fixes. For example, the Fed is aggressively seeking to furtherleverage aggregate private sector balance sheets today to increasenominal growth and asset prices. Thealternative, de-leveraging the system by doing nothing or by actively embarking on more restrictive monetarypolicies, is not an option discussed seriously. The build-more-credit-to-suspend-asset-and-debt-reconciliationpolicy is so engrained into conventional policy that “independence” at the Fed is seen as “politically non-partisan”,rather than pursuing monetary policies with political agnosticism.Indeed, monetary policy makers and others have expressed great relief that unlike the 1930s, the contemporarymonetary system has more flexible currencies with which to provide monetary support. If it were possible to havea candid conversation with the Chairman of the Fed, we suspect he would defend this support by noting thatwidespread credit defaults would legally shift ownership of assets from debtors to creditors, beginning withdebtors at the lowest economic rung. He might argue this would negatively impact the economy. Though thiswould be true, it also seems to be more of a political issue about which a monetary body should not care.
The Fed’s True Mandate
The Fed claims its mandate is to effectively stabilize prices (in US dollar terms) within the context of optimal USemployment. However, the Fed is only licensed to control the quantity of money and credit and so its ability toachieve this objective is directly linked to the efficacy of changing money and credit stocks on price andemployment. Are they always closely linked
It seems they most certainly are during periods of credit build-ups, when the Fed can control the pace of it. But thetwo do not seem to be linked in the rare but inevitable period when the population is already highly levered andthe credit bust arrives. At these times, debt service takes priority because debtors recognize that the benefit of taking on more debt is small compared to the capital or utility from consumption the new debt would produce.When the Fed Chairman clearly and repeatedly argues that the most critical indicator of inflation is the expectationof inflation, (as Alan Greenspan and Ben Bernanke have both done), then he is declaring that the Federal ReserveSystem is in the business of managing expectations, of subjective analysis, of reflexive speculation and preemption.The Fed is in the business of building and maintaining confidence that adequate growth without punitive inflation ispossible and sustainable, in the US and implicitly abroad, and that it can do all this by using its only tool – adjustingthe stocks of US money and credit. This is not possible as a secular mandate. That the Fed can achieve its objectives is, as they say in diplomaticcircles, not completely factual. As with all games of confidence, it is a great and utter prevarication. The publicbusiness of the Fed – projecting confidence in such a manner that a quorum of smart people won’t question thelogic or consequences of its actions – is a pursuit worthy of challenge and likely to be challenged.In QEI, the Fed manufactured money (a few keystrokes) and then used it to buy assets from the banking system.This was a bailout of “systemically critical” banks, not of private sector debtors. It was openly discussed that thebanking system must be strong so it can then lend to businesses and consumers (re-leverage the system). Whythen didn’t Treasury use the new money the Fed created to send homeowners checks with which to pay downtheir mortgages? Wouldn’t that have served the same purpose and even have been economically stimulative?Instead, the Fed gave newly created money to the banking system to stabilize their balance sheets.In QE2, the Fed is creating money and giving it to the government. It is telling Congress and the public that inflationis not a worry because it has the means of withdrawing excess reserves whenever it wishes.
The Fed formally denies it is monetizing debt through QE. How can it deny such a charge? By adopting a definitionof monetization as apermanent swap of new money for debt, the Fed maintains it will drain bank reserves oncethe economy does not need its help. Indeed, Alan Greenspan recently stood up for the Fed’s ability to withdraw“excess bank reserves” on TV. He claimed that the Fed could easily drain reserves prior to bank multiplication of them into more credit that would trigger “too much inflation”. We agree the Fed could mechanically drainreserves. But why would it when doing so would engender the exact economic scenario it is desperately fightingtoday? Why should anyone believe central banks will ever drain reserves when the “economy gains its footing”?
In the end the public debate is off point. The source of instability in the system is a dramatic shortage of currentreserves with which to reconcile existing unreserved (unfunded) debt obligations. Debating reserve removal is akinto discussing a weight loss program for an anorexic. So why is the Fed printing money and giving it to the bankingsystem and government? Because helping banks helps its shareholders and helping government helps its overseer.
If the Fed were to sit by idly at a time when the US economy is naturally compelled to shift resources and capital tomore efficient, sustainable and competitive factors of production, then nominal growth would surely fall andunemployment would rise. But for how long before a stronger, more sustainable economy would emerge? Theclear answer is too long for the Fed’s masters.
The idea that a central bank lets the economy be the economy except when “animal spirits” in the private sectorforce it act as the adult, which was (and remains) the Fed’s reputation (never actually true), has been so obviouslyand publicly debunked that even academic economists (with consciences) would be challenged to teach it
The one reliable polestar on which observers can bank is that in an overleveraged global economy the Fed andother economic policy makers would rather protect the integrity of the banking system than the structural basis onwhich the broader commercial economy sits. Draining reserves is out of the question and always will be for theFed, as it always has been.The ultimate role of a central bank is paper alchemy -- to turn unreserved credit intobase money reserves, and it seems more likely each day that this is shaping up to be their ultimate act
Watch What They Do
We have watched the Fed and other central banks professionally since the 1980s as traders and investors. Ourview is that one should not fight the Fed, ever, because it can and will print endless money and extend infinitecredit (to itself, if need be) to protect the nominal value of assets, credit and the property that collateralizes it. Butthat does not mean one should take monetary policy or its rationalizations at face value.
We were stunned (stunned!) during Chairman Bernanke’s March 1 testimony when he declared there was notenough gold to support the US money supply. Surely he knows, as we all should, that at a higher gold price there isplenty of gold to support not only the US dollar but all global currencies. Perhaps, it must be asked, does theChairman’s job description include necessary public deception rationalized by some notion of the common good --that notion being that a popular preference for gold would diminish the preference for the currency that centralbanks manufacture, and therefore would diminish the power over economies narrowly given to governments andbanking systems
To grizzled bond traders this high brow pump and dump of dollars makes it easier to discount baseless policyjawboning. (Does the SEC have jurisdiction over the Federal Open Market Committee?)
Almost laughably on cue, the Financial Times also reported on March 1 that Italian banks, seeking to improve theircapital ratios ahead of this summer’s stress tests, petitioned the Bank of Italy to value gold at market prices. As thepaper reported; “the lenders, which are shareholders in the central bank, are lobbying for their (gold) stakes to bemarked to market. That way, the Bank of Italy’s gold reserves, and the surging price of the precious metal, wouldat a stroke transform their capital ratios.” The Fed Chairman should take note: the value of gold, like the value of Google’s equity market capitalization, is not just dependent on the amount of shares outstanding. It is alsodependent upon its price
For those that have read our past discussions about how we think the future will play out, this should seem quitefamiliar. The process of marking gold to market in terms of a currency is a devaluation of that currency. It is theprocess of monetizing assets, not debt. (We will have much more to say on this in the third section of this paper.)
Gillian Tett, also writing for the Financial Times, further highlighted recent activities undertaken by the SwissNational Bank, which tried desperately last year to cheapen the Swiss franc. Currency intervention is nothing new,but it seems that the SNB was unsuccessful and was left with SFr 21 billion in losses for its trouble. As Tett pointedout, the SNB’s losses were offset by its gold holdings, which appreciated; however, the SNBs owners are growingnervous that the central bank has increased its risk profile. This, she points out, may only be a symbol of a farlarger problem: “The European Central Bank owns an (ever swelling) pile of periphery eurozone bonds; the Fed’sbalance sheet has more than doubled in size, to $2,500 billion, as it has gobbled up mortgage-backed bonds andTreasuries; and the Bank of England also holds a large pile of gilts and mortgage assets.”So central banks in developed economies have entered the capital markets full force. They are the only marketparticipants with printing presses and mandates from their treasury ministries to keep their host economies afloatand they are not above shading the truth to their market competitors. They are printing money to buy financialassets, distorting market prices and value, exaggerating an already dangerous level of systemic moral hazard,ultimately insuring increasing – not decreasing -- market and economic volatility, and, it must be said, issuing falseclaims. Their balance sheets have just begun to swell with paper no one else wants or can afford to carry.
Plan B
The policy of backing creditwithcredit is being manifested transparently. Government-sponsored debt isincreasing so that governments can continue funding shortfalls in tax revenues the private sector cannot provide.In effect, governments and banking systems in developed economies are self-dealing so that their economies donot have to mark-to-market the liquidation value of debt and the assets the debt supports. As politicians bickerabout fiscal trivia, central banks blame everyone but themselves, economic participants in developing economiescontinue building capital, and economic and market observers in the developed world hope for the best; aggregatedebt is not being extinguished. In fact, it is being reliably expanded.
The unstated policy objective may seem to be to bide time until the non-financial private sector collectivelydecides, (against all logic, ability and overt signs), to once again produce and consume ridiculous quantities of goods, services and assets (lever itself up further). This cannot work.
Thankfully, we think there is a logical Plan B, which is to inflate already leveraged currencies and transfer bad debtinto “bad banks” (i.e. central banks). This process has already begun.
Our Logic
Inflation is already here and there will be much more of it coming. The constituencies hurt by inflation are netsavers, bond holders, people living on fixed income and future taxpayers. Still, there is nary a peep in the markets.There several reasons for this:
There are relatively few people that would have positive net worths today were current asset liquidationvalues adjusted for the debt that encumbers them
The bond vigilantes that Bob Rubin told President Clinton he had to please or else they would raise ratesand jeopardize his political agenda are either are no longer mandated or paid to care aboutreal returns or, ahem, have migrated into precious metals because virtually all bonds offer negative real rates
The generation that is retired now, (not to mention the majority of practicing economists of all ages),have been conditioned to judge the loss of purchasing power by watching the Consumer Price Index orother baskets of goods and services, currently running at about 1.5%, year over year
The table is set for US dollar hyper-inflation, which would not trigger debt defaults but would meaningfully reducethe popular burden of debt repayment.
The Fed’s actions so far have been unequivocally clear: It is not a provider of monetary and economic discipline. Itis not an independent mechanism for balancing the availability of money and credit with the long-term economicinterest of the United States or the global economy. The Fed and other central banks seek to inflate prices slowlyduring a normal credit build-up (as the CPI graph shows), and when the bust comes they inflate even more. Centralbanks are first and foremost enablers of money and credit growth regardless of the season. Presently, they havethe means, incentive and political cover to inflate their monetary bases infinitely and indefinitely
There are only two ways to ease systemic debt burdens: 1) let credit deflate and endure the pain of widespreadbank failures and asset depreciation or 2) inflate (de-value) the money needed to repay the debt. If this choice isnot made and executed in the political dimension, then it will occur naturally in the global economy. We are fastapproaching the point at which a stark choice must be made between saving the central banking system and realnet creditors OR saving private banks and real net debtors.
We think bad debts that cannot be extinguished will find their way onto central bank portfolios where they will die. The most logical course to expect is for the Fed to continue inflating the US monetary base, which should continueto pressure other central banks to do the same with their currencies. Central banks will become the necessary“bad banks” in developed economies. (We will discuss this in more detail in the third section of this paper.)
The End of Banking
Should we fear for the safety of the banking system? No. We should not mistake banking systems for banks.Individual banks are fungible vehicles within banking systems. In a baseless monetary regime, individual banks –even those with substantial market share and political power – are systemically unimportant because deposits arecredits that are not backed by anything on hand. There should be no pretense anymore that anything exists in abank vault that implies safety for depositors. (The notion of a bank run, like that at Northern Rock in England in2007, is utterly quaint. The poor depositors lined up around the block were actually waiting for electronic creditsfrom the Bank of England.)
The only practical cost of bank failure is the cost of changing the signs on the door (or online). Of course, the costto investors in the bank’s capital structure, to the bank’s employees, and to systemic confidence among alldepositors can be quite high.
The non-regulatory component of central banking is no longer necessary. Government funding could be easily andtransparently accomplished without central bank open market operations having to act as intermediary. Treasuryministries could distribute their debt directly to private dealers and/or the public at large. Credit could be priced bythe markets -- lenders competing directly for borrowers.
The Politics of It All
Whether or not there was once good reason to endorse and promote a centralized credit-based monetary system,it is quite difficult for an objective observer to see its value today. Indeed, the natural inequities promulgated byfractional reserve lending are beginning to enter the public consciousness. This has taken on a political tinge.
Self-described Libertarians seeking to “end the Fed”, Tea Party politicians threatening to maintain debt ceilinglimits, and others looking for significant spending cuts, have been the first responders. Those most concerned withindividual liberties would naturally recognize first the almost complete centralization of economic and politicalpower in the banking system. (Banking systems seem to have gained power over their governments becausegovernments are indebted and are now relying on central banks for funding.)Conservative politicians want to slash spending and reduce taxes. However, given the late stage and magnitude of the leverage, such fiscal measures now seem more theoretical than practical. Spending cuts and tax relief maywork towards improving the aggregate balance sheet of governments, and would theoretically raise private sectorincentives that historically lead to output growth; but the amounts that would have to be cut from public budgetsto make a difference would almost certainly have an immediate deleterious impact on near term employment,wages and tax revenue, which would lead to “unacceptable” output contraction. Practically, it seems a non-starter.Some are calling for a return to the gold-exchange standard. This too seems to be a political non-starter, at leastcurrently. However it is a subject that we think will gain notice and acceptance as debt overwhelms public balancesheets, as debt service continues to gain priority over budgets, and as more conventional political solutions fallaway. Individuals and the few politicians that have openly discussed a gold or gold-exchange standard have beenon the fringe right, politically speaking; and so this issue has become popularly thought of as a “conservative” one.There is more than a little irony in this popular perception.We think liberal-minded politicians will ultimately embrace a hard money system. As we have attempted to show,the true source of the systemic credit and debt build-up has been fractional reserve lending, which is a regressivemeans of wealth distribution. It benefits high earners and investors at the expense of those that do not have“excess savings” to invest. As we have seen, this system benefits the working class least because it shiftssustainable purchasing power from the factors of production to lenders and leveragers with the deepest pockets.And as we are seeing presently, when the credit bubble bursts this system hits the working class hardest because ithas very little cushion.
It would seem that lawmakers holding the view that government should, can and does adequately oversee a fairerdistribution of resources than lessaiz faire economies would recognize the futility of the current system? This doesnot seem to be the case yet
Those thinking of themselves as more liberal do not seem to recognize that the working class would be better off,and would gain social, economic and political power if it was allowed to become the economy’s factors of production again. Hard money and the wages paid in it could be saved as a store of value. Laborers at all wagelevels and those that produce necessary resources and capital could save today for consumption tomorrow. Wethink liberal politicians will be forced to acknowledge this as conditions deteriorate.We think politicians across the political spectrum will eventually be forced by voters to support a gold-exchangestandard (over the temporary disapproval of banks). It would appear to shift power back to the people. A gold-exchange standard will again be popularly seen as the answer. However, as history shows repeatedly, the realissue is not the money per se but fractional reserve lending. We would guess fractional reserve lending wouldremain the law of the land and so banks will be able to inflate another day. (More on this in Section 3.)Is such a turn of events really possible? Yes. Most everyone is ambitious: some for love, some for respect, some formoney, some for truth, some for justice. The same is no doubt true of politicians. In the US, politicians runningagainst the center are already beginning to win. It seems only a matter of time before liberal forces form a party to challenge its political establishment, as the Tea Party has done on the right. Those on extreme ends of the political spectrum would then have a great enemy in common – the banking system and centrist politicians that support it.While the temptation among politicians to consider the arguments of banks must be strong, (not to mention thedifficulty of refusing the substantial campaign funding they offer), it would seem that broad respect, popularityand votes would accrue to politicians thatrun against the banks. This would not be novel. In fact, political successfrom front-running monetary system change is an extrapolatable probability. Those expressing outrage derivedfrom the perceived cause of gross financial inequity at economic turning points include Andrew Jackson, WilliamJennings Bryan, Vladimir Lenin, FDR, Fidel Castro, Ronald Reagan, and Lech Walesa to name a few.
A Utopian Economy that Serves to Define the Organic Economic Path
The natural tendency of man is to want more and keep more for his labor, which means the natural tendency of theglobal economy in times of political failure is to become more economical .
A theoretical two-factor global economy including only the US and China would easily resolve all economicimbalances and serve the public (itself). US workers and Chinese workers producing the same good would competeon more or less the same wage scale using the same currency. Wealth would flow to the most efficient producerand/or the most innovative. When one side gained advantage, workers on the other side would either workcheaper or migrate into fields offering other opportunities. Global prices would be consistently driven lower (orelse new competition would enter), but price declines would be commensurate with affordability. Why? Becausethe currency in which global wages were earned would be explicitly tied to the price of goods, services and assets.
Price would reflect lasting value. Saving yesterday’s wages would purchase more tomorrow as competition,innovation and population growth would continually drive prices lower. Nominal prices would be the same as realprices because the growth in the global money stock would match the rate of growth in the supply of whateverbacked the currency (gold?). There would still be credit and banks in this Utopia but credit would be collateralizedby borrower and lender, which means debt would be extinguished once loans served their purpose. Credit wouldbe priced discretely. Banking and shadow banking would continue but would be smaller businesses.
Aggregate production would rise with population growth and innovation. People that save their wages would havethe option of increasing their leisure time or working more to gain more savings. Individual workers could workfewer hours and their employers would be able to retain productivity levels by hiring more workers. Capital wouldbe distributed to labor and the factors of production in proportion to productivity and innovation
Geopolitics
The ability to print the coin of the realm and encourage unlimited credit creation has certainly had its advantagesfor the US and the G7. By increasing the nominal size of the global economy through credit that cannot beextinguished, (but not advertising it), the West helped force formerly closed economies to open their markets if they wanted to be able to afford global resources, which were being valued at credit-inflated prices. Whether itwas an ingenious premeditated conspiratorial plan or merely the consequence of bungling political ineptitude, thegreat credit build-up in the West certainly had an impact on geopolitics.Contrived plan or not, the impact of the past credit build-up and the inability of the G7 to collapse its debt withoutinflicting pain on itself poses a very different balance of power currently. The way we see it, leaders in the Westare perpetuating the popularly held view that credit equals wealth so that producers of global resources willcontinue to accept that credit in exchange. Leaders in centrally-planned economies seem willing to play along withthe credit-equals-wealth game only until they have sufficient access to sustainable resources.It seems to an outside observer to be a game of chicken. To oversimplify again, in a two-factor global economyconsisting of a centrally-controlled authoritarian political regime (like China) and a more democratic, transparentone (like the US), the centrally-controlled economy is continuing to synthesize growth by distributing its owncurrency (pegged to the dollar) to its workforce in order to produce more exports and to over-build domestically.The more transparent economy is continuing to synthesize growth by distributing its currency to the rest of theworld in order to engender more consumption and to over-build.Everyone has an inflation problem. The difference separating economies is that inflation is showing up more inChina today because China has to print Yuan whereas the US can inflate the rest of the world through credit that noone counts as inflation.All the world’s currencies are in great danger of being mauled and all the world’s policymakers are trying to outrun each other, rather than trying to outrun the inflation bear. Maybe the solution to theuprisings in the Middle East and North Africa would be to extend the people credit (and call it money) with whichto buy food? (Or would that expose the fraud?)This brings up a very practical dilemma facing global governments today. As granularly connected and transparentas global businesses and individuals have become and will continue to be in ever greater numbers, the function of government in commercial matters is pressured to decline. Global access to the Internet connects globalproduction and consumption and naturally reduces the power of governments that has heretofore come betweenman’s tendency to want more and keep more for his labor and government’s tendency to control that channel.Each reader may have a particular preference for the proper magnitude of government economic involvement, butthe critical point here is that it should be becoming clear to all that government lies between two consentingglobal commercial counterparties. When economic borders start to seem as silly to uneducated laborers in Chinaas they no doubt do to Jeff Immelt today, then governments will find their authority and power have beenundermined. People in free societies everywhere seem to be intuiting this already, and the younger among usseem to have a greater appreciation for it.Governments are institutions, and so even if they are led by brilliant men and women they will be slow on theuptake. The upcoming elections in the US may be the last in which US politicians can invoke “us vs. them” patrioticthemes to gain favor among the very workers they intend to keep globally uncompetitive. (Next time, “us vs.them” might be taken as “us vs. government”.)ExpectationsCapital ownership and the power over production in developed economies must and will revert back to the factorsof production. Their inherent incentives, along with the potentially antagonistic official policies of central plannersin large and competitive developing economies, can and likely will overwhelm the best efforts of Western policymakers and the best interest of banks.
It would seem that a controlled, government-sponsored systemic change would be the preferred outcome.However, over-indebted populations should not be able to come to terms with the inequity of their economicsystems before even more capital is transferred from the factors of production (stressed debtors) to banks andother leveragers with deeper pockets. The potential for growing debtor non-compliance and even social unrest,given the preponderance of debtors in credit-based economies, seems a legitimate concern
We presume Western lawmakers are overlooking systemic inequity because, (if they have given it any thought atall), they would prefer a slow and methodical change in the system to a sudden one. We further presume therationale in this would be that a sudden economic de-leveraging would lay bare the fundamental inequities andrisk indicting the system’s purveyors (themselves). However, just because taking it slow may be preferred, thereality is that a smooth transition is impossible. The debt is only being transferred, not extinguished.
It would further seem that banking institutions would have incentive to compromise preemptively so that theymight salvage some wealth and power. However, the shareholders and bondholders of individual bankinginstitutions would doubtful agree to take substantial losses or to be wiped out. Given the public capital structuresof banks and the fiduciary demands of bank owners and managements, there could not be a preemptivecompromise sufficient to bring adequate relief. Banks would have to mark down the value of their assets (publicloans) by too much to remain solvent.We think it is most likely that both creditors, represented by central bankers and fiduciaries overseeing bankcapital structures, and debtors, represented by increasingly angry and aging debtors, consumers and frightenedpoliticians, will come to loggerheads. A liquidation event of Western banks is certainly possible, if not probable.(Again, we caution against thinking of bank liquidation events in terms of “bank runs”, as in the past. In baselessmonetary systems that allow infinite money production, all bank depositors would be made whole in nominalterms immediately via electronic credits. There is no gold in bank vaults for which depositors need compete.)
The Right Analogue but with A Different Outcome
The Great Depression was a credit event, brought about by excessive net unreserved lending in the 1920s. A betterterm for it would be “The Great De-Leveraging” because the notional value of credit contracted suddenly andseverely to reconcile the amount of actual money in the system (which then was the quantity of dollarsexchangeable into gold). The gold-exchange standard did not allow policy makers to fight credit contraction in the1930s by issuing even more unreserved credit. As a result, bank loans could not be paid back, which forced banksto write down the value of their assets or, more predominantly, to close.
Though there have been disruptions to banking systems and economies so far from 2007 to 2011, central banks’abilities for substantial monetary printing have suspended the extreme credit deterioration that would haveotherwise occurred. This seems to have led to a feeling of cyclicality among most politicians, policy makers,economists and investors. Such a perception could not be more inaccurate. Aggregate balance sheets have notbeen repaired. Aggregate debt has not been extinguished. In fact, debt has grown substantially since 2008. Thesame credit deflationary pressures exist today that existed in 1929 and 2007 (only larger). Nothing has beenreconciled.
Central banks are boxed. While they have the tool to suspend credit deflation denied them in 1929 (moneyprinting), their aggregate economies cannot produce enough real growth (nominal growth in excess of money andcredit growth) to exit from the global debt trap. The outcome we see is global monetary default, but unlike the1930s, we think default will come inreal termsfor most debtors. They will repay creditors to satisfy loan covenantsbut they will do so with inflated dollars. This would be the most expedient way out of the debt trap for politiciansand the only way that promises to maintain peace and even future prosperity. Aggregate global wealth will not belost, as it cannot be lost, but it will change pockets in substantial magnitude.
Timing the Change
Historian Niall Ferguson has been lecturing recently that empires, like ant hills and rain forests, are complexadaptive systems. Hapsburg Spain (16thcentury), Bourbon France (18thcentury), Ottoman Turkey (19thcentury) and Post-War Britain (20thcentury) had different, unpredictable catalysts that historians now point to as triggers totheir demise. However Ferguson rightly observes that each empire had one great and obvious vulnerability incommon that made it easy for them to succumb to failure: unsustainable debt-to-revenue levels
Ferguson believes the US is an empire approaching what physicists might call “self-organizing criticality”, acondition that attracts energy precisely to thecritical point at which the system will transform. In such a stateconditions change from apparent stability to instability quite suddenly. This presumes economies can bearrhythmic (which all experienced traders and investors would confirm is the normal state of the markets). Thecatalyst or amplifier can only be known in hindsight, and in fact is relatively unimportant
We have not called the United States an empire, but we will suggest it controls the global monetary empire, or asBill Bonner and Addison Wiggin wrote years ago; an “Empire of Debt”. We have told investors for four years thatstep-shift change could take a long time or paradigm shift could come next week. The current monetary regime,which is a complex adaptive system, appears to be in a state of relative equilibrium currently when viewed in itsown terms, such as exchange rates, price levels, state sponsorship and unity, and participant compliance. The onlything we think we know for sure is that the tinder on the forest floor is piled high and it is very dry.
This report includes section 1 only. Sections 2 & 3 will seek to address anticipated political and marketreactions. Contact Paul Brodsky(pbrodsky@qbamco.com)for sections 2 & 3.
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