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 scrutiny...by 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

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

(For Part I of this series, click here)

Just like national governments and international businesses employ derivatives to protect themselves against currencies that are losing value, states and local governments have turned to derivatives for the same reason. But protective efforts that served well against inflation proved costly when the bubble burst. Anthony Luchetti writes:

Hundreds of U.S. municipalities are losing money on interest-rate bets they made during the bull market in hopes of protecting themselves from higher rates. The deals backfired when rates fell, shriveling the sums paid to municipalities....

The Los Angeles city council approved a measure...to try to renegotiate an interest-rate deal with Bank of New York Mellon Corp. and Belgian-French bank Dexia SA. The pact, reached in 2006 to help fund the city's wastewater system, currently is costing the city about $20 million a year....

In Pennsylvania, 107 school districts entered into interest-rate swap agreements from October 2003 to last June [2009]. At least three have terminated them. Under one deal, the Bethlehem, Pa., school district had to pay $12.3 million to terminate a swap...

As of June 10, 2010 the Illinois Teachers Retirement System's list of derivatives it owns ran seven pages. Its pension fund was the fourth-riskiest investment portfolio for a pension fund in the U.S., with 81.5 percent of its investments considered risky. It lost $88 million on derivatives in 2009. For 2010, it lost an estimated $515 million on them as of March 31. Its $33.72 billion pension fund is now underfunded by $44.5 billion, or 60.1 percent, according to the Commission on Government Forecasting and Accountability.

The Service Employees International Union says locals in Chicago, Denver, Kansas City, Mo., Philadelphia, Massachusetts, New Jersey, New York and Oregon have all lost money on swaps, ranging from a few million to over $100 million dollars a year.

But that is by no means the end of the string of losses from government policies that have been destroying the value of money. Remember how the collapse of residential mortgages in the U.S. triggered massive losses for governments, banks and other financial institutions around the world, particularly in Europe? They held huge investments in securities tied to U.S. home mortgages and suffered losses of hundreds of billions of dollars from the ensuing defaults. Well, foreign banks now face a similar threat from a Greek default because they own large quantities of Greek bonds.

Because countries in the euro zone share a common currency, there was no risk of currency fluctuations among countries in the zone. As a result, banks, insurance companies and pension funds in every euro-zone country became the biggest investors in bonds issued by other euro-zone countries. In the case of Greece, 90 percent of its public debt is held by foreigners, who could be expropriated by a default. French and German banks have by far the largest exposure to Greek debt. (Is it a coincidence that those are the two countries which led the effort to bail out Greece?)

The recession has made things worse. There are now other euro-zone countries besides Greece with debt burdens well above the euro-zone limit of 60 percent of GDP. Scornfully known as PIGS (or PIIGS, if Italy is included), these countries have the following debt-to-GDP ratios, according to the International Monetary Fund: Portugal 85.9%; Ireland, 78.8%; Greece, 124%; Spain, 66.9%; and Italy 118.6%. In May 2010, Fitch Ratings lowered Spain's AAA credit rating to AA, putting it in line with a similar rate cut by Standard & Poor's the previous month. Fitch said that government's debt is likely to reach 78% of GDP by 2013, compared to less than 40% before the 2007 financial crisis and the subsequent recession. Collectively, internationally active banks in the 16 countries in the euro zone hold $1.58 trillion, or 62% of the debt of the PIGS, according to the Bank for International Settlements. That leaves 38% spread around the rest of world, further exporting the problems.

Greece accounts for only 2 percent of euro-zone GDP, and Greece, Ireland and Portugal together account for only about 6 percent. But Spain accounts for 11 percent. It has a trillion euro economy, the fourth-largest of the 16 nations in the euro zone, and the ninth largest in the world. It also has 20 percent unemployment and a million vacant homes from that nation's housing bubble. According to Morgan Stanley, 32% of Spain's $748 billion debt is held by German banks and 25% by French banks. And 51% of Portugal's $165 billion debt is owned by Spanish banks. And U.S. banks hold more than $1 trillion in European debt. So you can see how intertwined the banks are and how easy it would be for problems to spread worldwide, just like the housing bubble did.

The global interconnectedness of banks is also shown by an example from Ireland. Patrick Honohan, Governor of the Central Bank of Ireland, who also sits on the ECB governing council, said the real estate bubble fueled by Irish banks was financed to a large extent from abroad. He said between 2003 and 2008, “net indebtedness of the banks to the rest of the world jumped from 10% of GDP to over 60%.” He noted that many big loans to property developers are unlikely to be repaid. Peter Johnson, M.I.T. professor and former chief economist of the International Monetary Fund, and Peter Boone, of the London School of Economics, earlier this year wrote:

Ireland's banks are today probably insolvent. Who can afford to repay their mortgages when wages are falling and unemployment is rising? Irish house prices continue to speed downward. This [Ireland's austerity program] is not an example of a 'careful' solution—it is a nation in a financial death spiral....

If one country must make a substantial and painful fiscal adjustment, eventually the rest will follow. The implication for bondholders is obvious: Edge toward the door. Bond yields will stay high or creep up, until the next crisis and contagion. The problems could easily jump beyond Europe.

The United Kingdom is not a member of the euro zone, but it, too, has debt problems. In recent months the ratings agencies have warned it could lose its AAA rating unless it comes up with a tough, credible program to cut its deficit. The deficit was 10.4% of GDP for the last financial year but is now said to be approaching 12%. The public debt is now 70% of GDP and rising. A disturbing indication of concern about U.K. finances is the rapid rise in investor purchases of credit default swaps to protect against a U.K. default. The size of this protection roughly doubled in the first four months of 2010, a far sharper run-up than Greek CDS last fall.

In a speech on April 15, 2010 Jurgen Stark of the ECB told a Washington audience that the euro zone wasn't the only region facing major fiscal challenges. He said, “Outside the euro area, bringing the public debt ratio back to safer regions appears even harder for the United Kingdom, the United States and Japan.”

It is governments that have created the problems of massive public debt in countries all over the world. They alone are responsible for government spending and monetary policies. They are quick to blame the banks, Wall Street, hedge funds, “speculators,” the real estate industry, Chinese imports, deregulation, credit default swaps or any other handy scapegoat for the credit bubble they themselves produced by their laws and regulations. And now they demand—as a cure (!)—more of the laws and regulations that caused the problem in the first place, and which will allow them to further disguise what's been going on and to extend it.

“Under a properly functioning gold standard, the U.S. would not have been able to borrow itself to the threshold of the poor house,” says James Grant, one of the most astute monetary analysts and long-time editor of Grant's Interest Rate Observer. When accounts had to be settled by a nation parting with its gold, the system was self-correcting. A credit inflation that permitted the U.S. to accumulate a $2.45 trillion debt with China would not have occurred. The U.S. abandoned the dollar's final link to gold in 1971, and it has consumed more than it has produced (measured by international trade balance) every year since 1976. According to the government's own inflation calculator on its Bureau of Labor Statistics website, the U.S. dollar has lost more than 95 percent of its purchasing power since the Federal Reserve Act of 1913, and more than 81 percent since 1971. The BLS bases its inflation calculator on the Consumer Price Index. Other methods of calculation show even greater inflation, as in this example:

The chart is by Dr. Arthur Laffer from an article in the Wall Street Journal June 10, 2009. I recommend you read the full article. It explains, “The percentage increase in the monetary base [since September 2008] is the largest increase in the past 50 years by a factor of 10....The currency-in-circulation component of the monetary base...has risen by a little less than 10% while bank reserves have risen almost 20-fold.” The full effect of this is yet to be felt.

For Part III of this series, click on this link