Wednesday, October 13, 2010

Monetary Mess, the Dollar, Gold—and You, Part III

(For Parts I and II of this series, scroll down and click on links in righthand column)

The current recession is the result of increased government spending and meddling in the economy over many years. In 1982 the U.S. was still the world's largest creditor. In 1985 it became a net debtor for the first time in 71 years, with an investment deficit of $110.7 billion. It became the worlds' largest debtor only three years later, and ever since, it has continued to pile more debt upon debt just like Greece.

In contrast to the simplicity and honesty of straightforward accounting under a gold-based system—where gold actually changed hands to square accounts—the present system permits Madoff-type or Enron-type accounting. Nations have simply declared some spending “off market”, “off budget” or “confidential” or employed complex financial transactions to hide the true size of their debts and deficits. The same derivatives that can legitimately be used to offset the risk of currency fluctuations can also be used to artificially massage cash flows and liabilities to present a favorable but false picture of a nation's finances.

Goldman Sachs Group Inc. produced as many as 12 swaps for Greece from 1998 to 2001. The architect of these was a top executive in the bank's London office, a woman named Antigone Loudiadis. According to the Wall Street Journal,

A complex and long-dated arrangement, the trade she set up allowed Greece to reduce its outstanding debt by converting the debt into euros and then restructuring the debt at more favorable rates. Undertaken privately, it helped mask Greece's true indebtedness until recently, when the country's finances fell under deep European Union officials as they examine how Greece fell into such dire economic straits....

By 2001, when those rates had become unattractive, Ms. Loudiadis helped Greece structure a different trade that enabled the government to continue using advantageous rates for accounting purposes....

A new “off market” swap...agreed in the future to convert yen and dollars into euros at an artificially favorable rate. Greece could use that rate when it recorded its debt in the European accounts, pushing down the country's reported debt load by more than 2 billion euros. 
Goldman pocketed as much as $300 million for structuring those and related transactions over a period of years, with Ms. Loudiadis making as much as $12 million annually in compensation.

Credit Suisse is reported to have crafted a currency swap for Greece during the same time frame. Deutche Bank executed currency swaps for Portugal, but the bank says they were within “the framework of sovereign debt management.” Portugal says its swaps complied with European Union rules. However, in reports to the Eurostat statistics authority, it classified its subsidies to the Lisbon subway as equity.

Greece for years declared large portions of its military spending as “confidential” and excluded them from deficit calculations. European regulators eventually prevailed upon Greece to count everything, as well as to correct errors and corruption that had been revealed. The result, in 2004, was a massive revision of Greek deficit figures from 2000 to 2003—but by 2004 Greece had already gained entrance to the euro.

France struck a deal under which Telecom paid the government a lump sum of 5 billion euros relating to future privatization, in return for France accepting pension liability for France's Telecom workers. The quick 5 billion euros lowered France's deficit sufficiently for it to qualify for euro-zone membership.

J.P. Morgan arranged a currency swap for Italy that allowed it to receive large payments upfront that improved its current deficit picture, while pushing less-favorable numbers into the future.

In the same way that money losing value has led nations, states, corporations, pension funds and institutions to seek alternative methods of preserving their wealth, it has led individuals to do so, too. It has long been lamented that American citizens don't save enough, that they have been burdening themselves with too much debt from mortgages, car loans, home equity loans, and credit cards. But there is no incentive to saving dollars that are losing value. Instead, inflation offers the seductive prospect of repaying debt with future dollars that are worth less. When debt becomes more attractive than saving, is it any wonder that Americans have accumulated a mountain of debt?

The more a government inflates its currency, the more incentive it creates for people to get out of it—and the shorter is the time period in which the people will tolerate holding it. As I wrote in my book Makers and Takers,

During the great inflation in Germany after WWI, workers had to be paid daily and, near the climax in 1923, hourly. Wives would meet there husbands at the factories to get their pay and spend it before it lost further value. No one could count on the money as a store of value for even an hour, prices often doubling in that time....The mark in 1923 was worth one-trillionth of its 1913 value....Franz Joseph Strauss, later finance minister of West Germany, relates that in 1921 he and his brother took a wicker basket full of money to a butcher shop to buy some meat. They set the basket down on the sidewalk while they looked at meat and prices, and the basket was quickly stolen. Not the money, just the basket. The money had been dumped on the sidewalk. In China after WWII, inflation was so rapid that restaurants would give customers estimates, not prices, for items on the menu since the prices would be higher by the time people finished eating.

Professor Gerald Swanson, Ph.D., who extensively studied inflation in South America, in 1986 wrote: “It isn't unusual for South American shoppers to see the price of bread increase between the time they enter a grocery store and the time they leave it. Savings lose their value. The only incentive is to spend.”

Of course, the dollar has not lost value as rapidly as in the above examples, and U.S. citizens, ignorant of history, assume disastrous inflation can't happen here. But it did happen here. Twice. The U.S. government printed unbacked paper money to pay for both the Revolutionary War and the Civil War. These fiat currencies were called the “Continental” and the “Greenback,” respectively.

The first military engagements of the American Revolutionary War were the battles of Lexington and Concord, fought on April 19, 1775. On July 21, 1775, despite opposition from some of the Founding Fathers, the Second Continental Congress authorized the printing of 2 million unbacked paper dollars. Just four days later, another $1 million was authorized. Another $3 million were printed before the year was out. Then $4 million more spewed forth in February 1776, another $5 million five months later, and another $10 by the end of the year. Congress authorized another $13 million in 1777, $63 million more in 1778, and $90 million more in 1779. The results were higher prices, destruction of savings, and the expression “not worth a Continental,” which meant worthless. The currency eventually had to be replaced with one backed by a precious metal, first silver and then gold

For Part IV of this series, click link

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