Sunday, October 24, 2010

Monetary Mess, the Dollar, Gold—and You, Part VIII (concl.)

(For other parts of this series, click on the 2010 October links in the righthand column.)

Gold has been known and valued since prehistoric times for its natural characteristics. People all over the world have found it appealing. The importance of gold in ancient Egypt thousands of years ago is well known from the tombs of the pharaohs. Thousands of years after the Egyptians began entombing their pharaohs with golden treasures, Cosmas Indicopleustes, a noted Egyptian traveler in the sixth century A.D., wrote: “It is with their gold piece [the bezant of Constantinople] that all nations do trade; it is received everywhere from one end of the earth to the other.”  

China was a poor country for a very long time, right up until it began to veer away from communism and introduce some capitalistic, free market reforms. In only a few short decades it has achieved tremendous economic growth, but the vast majority of its people still live in abject poverty. Yet today, the government admits that private citizens own more than 3,000 tons of gold—about three times the amount the central bank controls. Where did all this gold come from? Only a very small part was acquired in the recent years of economic growth. The rest was accumulated gradually and painstakingly over many centuries, under many different political regimes, by people who saw it not only as beautiful but as an enduring store of value.

The story is much the same in India, where people for many centuries accumulated not only immense quantities of gold jewelry but silver jewelry as well. Farmers traditionally stash their savings in precious metals. Rural buyers usually account for 30-40% of gold purchases every year. India's majority Hindu population regard the Hindu festival of lights (Diwali) as an auspicious time to buy gold. This year the festival will be celebrated on November 5, but the festival season runs from September to late November, or even early December in some states. “Most of the crops would have been harvested by then and they [farmers] would be buying. Typically their reserve money goes into gold,” says Mr. T. Gnansekhar, director of Commtrenz Research. He says this year's bumper crops mean farmers will likely account for around half of the gold purchases of 400-450 tons in India this year. India is the second largest consumer of gold. For many years it held the number one spot, but in the past year it was surpassed by China. Indians traditionally favored gold jewelry, but now they are buying coins, bars and ETFs too. In the second quarter of 2010, India's demand for gold rose 38%, reaching $1.6 billion.

On the other side of the planet, gold was valued by native Americans, especially in Central America, Peru and Columbia. The desire for gold was what prompted the Spanish crown to finance Columbus' voyage with instructions to “Get gold, humanely if possible, but at all costs, get gold.Reports of profusion of gold ornaments among natives fueled the exploration and conquest of the Aztecs and the Incas by Cortes and Pizzaro.

In some cultures, private gold currencies served as the medium of exchange long before kings and governments got into the act of forcing the populace to accept fiat paper instead. The rulers never comprehended the damage created by their money illusion, which always impoverished the people and devastated the economy. It's happening again today.

In the past, after the damage was done, the people learned the hard lesson and would no longer accept unbacked paper money. Either their government would then turn to a gold-backed currency—as the U.S. did after the Revolutionary War—or some other country would, becoming the dominant monetary power and leading other nations back to gold. For example, in 1252 A.D., after a long period of monetary disarray, the city-state of Florence reintroduced gold coins, florins. Genoa quickly followed, perhaps in the same year. In 1254 Louis IX of France commenced gold coinage. Some thirty years later Venice joined in. In 1328 Germany began minting the Bavarian, which closely imitated the florin. One by one, these and other countries turned to gold when they realized the monetary stability it provided was beneficial to trade and prosperity. It will happen again. The only question is when and how.

The U.S. could return to gold now, while it still has the largest gold holding, with much less pain than after the smash-up occurs, but it won't. The politicians are not about to face up to the fact they have been wrong and have caused the problem. They like being well-paid “public servants” and playing god with the nation's economy and other people's lives and want to continue their (so-far) winning formula for staying in office: promise more benefits from more government spending, and pass more laws so “this will never happen again.” If 2,000-page laws don't work, they will pass 4,000, 8,000 or 20,000-page ones. It doesn't matter. Practically nobody in Congress reads them anyway. And certainly not the president. They couldn't even if they wanted to; the laws are simply too voluminous. Reading them wouldn't do any good anyway because they don't have the answers. All that matters to the politicians is that the laws can be held up to the public as proof the administration is “doing something” about the problems and keeping the benefits coming in return for the public keeping the votes coming.

Thus things will probably have to get much worse before the public wakes up, by which time the pain and cost will be much greater. No one knows when that will happen. But it could happen suddenly, like when a small leak develops in a dike, then erosion gradually increases the flow—and then suddenly the whole structure gives way and a flood ensues. Confidence in the U.S. dollar has been eroding, and the international monetary structure has been greatly weakened. No one knows when the end will come and the flood of dollars will flow into gold, but those with gold are far more likely to emerge better off than those without it. And more and more people are realizing this.

While Americans are preoccupied with paper (laws, regulations, fiat paper money), China has quietly become the world's largest producer of gold as well as the largest consumer. And as its people become more affluent, their appetite for buying gold is increasing. Their opportunities for doing so are also increasing through a new Chinese gold futures exchange, ETFs and even online gold sales. The government, which used to restrict how much gold citizens could own, now encourages gold buying. It runs ads on state television encouraging the rapidly growing middle class to own gold. In the second quarter of 2010, China's demand for gold jumped 187%, to $1.4 billion, second only to India's $1.6 billion.

China's goal to have its central bank accumulate 10,000 metric tons of gold in ten years may seem ambitious, but let's try to put this in perspective. The 2,000 tons owned by the ETFs are worth about $83 billion as of this month. So 10,000 tons should be worth five times that, or $415 billion. But China already has about 1,000 tons, meaning it needs 9,000 to reach its goal. So we subtract $41.5 (half of the $83 billion for 2,000 tons) from $415 billion, leaving $373.5 billion for the remaining 9,000. Of course, as we noted earlier in this series, China is well aware that if it started buying aggressively, it would drive up the price; it certainly could not buy 9,000 tons for $374 billion. But China has $2.45 trillion! If China paid $450 billion for 9,000 tons of gold, it would still have over $2 trillion dollars left, still by far the largest hoard of dollars on the planet. Realistically, it would have to pay far more than $450 billion—which it could well afford to do—if that amount of gold were available. But the world's annual production of gold is only about 2,400 tons. If the central banks are unwilling to sell, where is all the gold China would like to buy going to come from? The IMF does not have enough gold to alter the long-term scenario on more than a temporary basis, even if it decided to sell its entire stock. It is not going to do that since it is unlikely to take an action that would all but guarantee its future existence would be irrelevant. Besides, any sales would have to be approved by the member nations, which is not going to happen.

China could certainly afford to pay a much higher price for gold—certainly much higher than in our example—but no one can say what that might be or how high the price of future available supplies might be. At the same time, however, the value of her remaining dollars would decline drastically, and no one can say how low it might go. China is understandably leery of the outcome of such a trade-off. It would prefer to add to its gold holdings incrementally or off-market without stimulating a buying frenzy in the markets and hope that the dollar does not suffer a sharp fall from U.S. deficits and inflation in the meantime.

China would love to buy gold from the IMF because this is gold that would not be traded in the market, but there are other ways, too, of acquiring off-market gold. China has the world's sixth largest gold mine reserves and is rapidly developing new mines and expanding exploration. Domestic production provides a way for the government to buy gold directly that never reaches the world markets. This year China initiated another way to increase its gold holdings without going into the open market. The state-controlled China National Gold Group Corp., the nation's largest gold company, recently signed a long-term contract to buy gold concentrates from the large Kensington Mine in Alaska.

Even if China acts with restraint on purchasing gold in the open market, worldwide demand for gold is increasing from other sources, as we have pointed out. At some point the flow of money into gold may become a flood that leads China to join the crowd and buy before worldwide demand pushes the price even higher. Meanwhile, the value of China's dollar assets in U.S. treasuries will be declining from Obama's deficit budgets and the Federal Reserve's easy money policies. These will further increase the incentive for China to unload U.S. treasuries. The Chinese government has been extremely patient about giving Obama a chance to demonstrate that his spending policies will stimulate the economy and end the recession. But eventually it will be obvious to everyone that those policies are not working and, in fact, have made the problem worse.

Now, three years after the collapse of the housing/mortgage market, the prospects there are worse than ever. Last month 102,000 homes were foreclosed, the highest total ever. And the owners of 11 million homes owe more than their homes are worth. This problem is not going away and is going to put further strains on the economy and the dollar.

Allan Greenspan made two important points in two very recent interviews: 1) housing prices are right on the edge where a further price decline will create a new huge wave of foreclosures, and 2) interest rates are going to go up substantially as the U.S. need to borrow is bumping up against the limit at which buyers are willing to purchase U.S. treasury securities. As interest rates go up, the value of government bonds goes down. So China will see the value of its massive investment in U.S. treasuries decreasing at a time when the price of gold is increasing, giving further argument for unloading some of its treasuries and further reason not to buy more of them. Remember, too, that China's favorable trade balance, which accounts for its massive $2.45 trillion dollars, is almost certain to continue growing. That country is going to have even more dollars to invest as gold looks more attractive and U.S. treasuries look increasingly unattractive.

Yu Yongding is a member of the state-backed Chinese Academy of Social Sciences and a former advisor to the central bank. In August he wrote, “I do not think U.S. Treasuries are safe in the medium-and-long run.”

Looking ahead, Li-gang Liu, head of China economics at ANZ Bank, said “For the renminbi [also referred to as the yuan] to become a convertible currency, other than credible policies you also need credible gold backing.” 

In the end, gold will win over fiat paper. It always has.

Postscript:  When I began writing this series, China's held $2.4 trillion in foreign exchange reserves.  As I was writing, new figures showed it rose to $2.45 trillion, so I made the revision in my writing.  Now the People's Bank of China has made data available for the third quarter 2010.  The central bank's stash of dollars jumped by $194 billion in the third quarter, resulting in a total of $2.648 trillion as of September 30.  And there is every reason to believe this trend is going to continue.

Friday, October 22, 2010

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

(For previous parts in this series, scroll down and click on the links in the righthand column.)

Private investors have been seeking a store of value in the same way as the nations' central banks. Alarmed by Greece's monetary problems, Europeans have led an exodus out of the euro and into gold coins, bars and exchanged-traded gold funds (ETFs). In scarcely two weeks in May 2010, the Austrian mint sold 243,500 ounces of gold, compared to 205,000 for the entire first quarter. Adrian Ash, head of research at Bullion Vault, an online gold trading service, said, “We saw very strong flows of money from European customers,” a demand he attributed to “anxiety over the euro.” In May, 39% of Bullion Vault's new customers came from the euro zone, compared to an average of 21% since the start of 2009. The South African Mint increased Krugerrand production by 50% in May on brisk European demand.

European concerns have spread to the U.S., as well as other countries. The U.S. Mint is running short of gold coins. Sales of American Eagle one-ounce gold coins tripled in May from the previous month. Sales of American Eagles totaled 449,000 ounces in 2005 but 922,500 by September 2010. Buffalo coins, which the U. S. Mint makes of pure gold, were sold out in September. Other gold coins such as Krugerrands have also been selling well in the U.S. and elsewhere.

But the real gold-buying story is the ETFs. These are a relatively new development, with the first one, SPDR Gold Shares (GLD), appearing in November 2004. When people buy shares of stock in such a fund, the fund buys an equivalent amount of gold, which is stored in vaults. When shares are sold, the fund sells an equivalent amount of gold. The ease and simplicity of the process has resulted in investors pouring billions of dollars into these funds on stock exchanges in the U.S., Paris, London, Australia, South Africa, Mexico, Singapore, and some other countries. As of October 6, 2010, SPDR alone held well over 41 million ounces of gold, valued at $56,357,447,760.40. Collectively, the ETFs hold about $83 billion in gold. This graph shows the phenomenal growth of a dozen major funds: 

In October, 2010, gold ETFs held over 2,000 tons of gold. This is nearly double that of the central bank of China and more than most of the central banks of the ten largest gold-holding countries, according to the World Gold Council:

                                            in tonnes (metric tons) 
1               U.S.                      8,133.5
2               Germany               3,406.8
3               Italy                      2,451.8
4               France                  2,435.4
5               China                    1,054.1
6               Switzerland           1,040.1
7               Japan                       765.1
8               Russia                      668.6
9               Netherlands              612.5
10              India                       557.7

In addition to the above, the International Monetary Fund holds 2,966.8 metric tons and the European Central Bank 501.4 metric tons. You might easily assume these two institutions plus all the nations' central banks must control most of the world's gold. You'd be wrong. They control only 18% of the gold in human hands. Jewelry, with 51%, accounts for more above-ground gold than all other uses combined. Industrial use, mainly dental, biomedical, and electronic, accounts for 12%. That leaves about 17% taken up by investment.

Overall, investment demand doubled in 2009. According to Gold Fields Mineral Services, this was the first time in three decades that investment demand exceeded jewelry demand. In 1998 investors accounted for less than 7% of demand. In 2009 they accounted for 39%. In the second quarter of 2010, they bought more than 50% of all gold sold.

An extremely significant development is that buyers increasingly want to take possession of physical gold, whether they are dealing in the futures market or buying coins or bars from dealers. They are not buying and selling for paper profits. At the CME Group's Comex, the world's largest metals futures exchange, investors took delivery of 39% more gold so far this year compared to last year.

The demand for storage facilities for gold coins and bars has led to a scramble for vault space by banks and private vault services. First State Depository Co. says it has increased storage capacity three times this year and is considering buying property next door so it can provide even more. Responding to increased demand, the World Gold Council in June announced a $9 million investment in Bullion Vault, the world's leading gold ownership service, which stores 21 tons of gold for 20,000 customers in vaults in Switzerland, London and New York. Vaulting firms Via Mat International of Switzerland and Ocasa of Argentina are expanding. J.P. Morgan Chase will open a new vault in Singapore, and Barclays Capital is seeking to expand its space in London.

The shortage of secure storage for gold investors was compounded last November when the large British bank HSBC required small investors to take possession of their gold stored in the bank's 4.2 million-ounce storage facility in New York City. It said it needed the space to meet the demands of large institutional investors. This was upsetting not only to the small-account owners but to dealers who sent their customers to HSBC. Goldstar Trust Co., of Canyon, Texas, had been an HSBC customer for 15 years and was sending more than 1,000 new accounts each month to them. But HSBC no longer wanted their business because the big investors piling into gold were more lucrative.

We are receiving steady inquiries for storage from high-net-worth individuals,” said Barry Wainstein, global head of foreign exchange for Scotia Capital. Its precious metal division, Scotia Mocatta, has a 4.8 million-ounce storage facility in New York and has been expanding its vault in Toronto.

Hedge fund manager John Paulson, whose fund made $3.7 billion by betting on the collapse of the subprime mortgage market, is now a big investor in gold. In a speech to the New York University Club in September 2010, he said 80% of his assets are in gold, spread between ETFs, physical bullion and shares in gold mining stocks. Billionaire George Soros has also become a big investor in gold. Since people do not accumulate great wealth by being stupid, maybe their current investments deserve our attention.

Investors often choose geographic diversity in storing their gold. Countries such as Switzerland and Canada are seen as posing fewer geopolitical risks than most others, and their banking systems did not require the massive bailouts that accompanied banking failures in the U.S. Also, many U.S. citizens, remembering that Franklin Roosevelt confiscated most privately held gold in the 1930s, are leery of storing gold in regulated banks in the U.S., fearing such a policy might be repeated. They may also be leery of disclosure agreements between the U.S. and foreign governments regarding foreign banks, hence an interest in non-bank storage facilities even for legitimate holdings. Sprott Asset Management in Toronto recently added storage for about 250,000 ounces at the Canadian Mint. Owners of its ETF may redeem their shares at the mint and take possession of bullion. SPDR and other gold ETFs sold in the U.S. commonly store their gold in London, Zurich and in the U.S., but they do not allow shareholders to redeem their shares for bullion.

Why is there so much interest in owning physical gold? Because it is a store of value. There is no longer any currency in the world that is a reliable store of value. As further evidence of this, look what has happened with the currency markets. Trading has become vastly larger, more volatile and riskier as people try to escape the effects of monetary instability and governments' efforts to manipulate currencies in the absence of a sound international monetary system. Currency trading volume is now $4 trillion per day, according to the Bank for International Settlements, which makes a survey every three years in April. By comparison, stock trading in the U.S. in April averaged $134 billion. Even the giant market in U.S. Treasuries averaged only $465 billion per day in April. Previous surveys by the BIS showed daily currency volumes of $3.3 trillion in 2007 and $1.9 trillion in 2004. There are now 44 currency ETFs, compared to only one in 2004.

Globalization, of course, causes an increase in currency trading, but that in itself does not create instability. With reliable currencies of a gold-based international monetary system, currency trading would grow in an orderly manner as commerce expands, rather than from attempts to offset or profit from currency fluctuations with quick in-and-out trading.

For Part VIII,  the concluding article of this series click link

Wednesday, October 20, 2010

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

(For previous parts in this series, scroll down and click on the links in the righthand column.)

At the end of last year, according to Robert F. Wilmers, chairman and CEO of M&T Bank Corporation, the total outstanding debt of Fannie and Freddie “either held directly on their balance sheets or as guarantees on mortgage securities they'd sold to investors, was $8.1 trillion. That compares to $7.8 trillion in total marketable debt outstanding for the U.S. government.” And it's going to get worse, because the government has directed them to lose money by modifying mortgages to prevent foreclosures. The banks have already repaid $136 billion of the $205 billion they received, and GM, Chrysler and AIG are working to make repayments, but Fannie and Freddie are designed to lose more money going forward. The Congressional Budget Office estimates the taxpayers' cost of keeping Fannie and Freddie operating will be $380 billion over the next ten years. But this is based on an assumption that the housing market will “normalize” as the recession ends, which may very well be overly optimistic.

The full cost of subsidizing mortgages remains hidden because it is off the official balance sheet, but the GSEs have already cost the taxpayers nearly $150 billion. When Treasury first bailed them out in September 2008, Congress put a limit of $200 billion ($100 billion each) on federal assistance. When that appeared insufficient, the limit was raised to $400 billion. Then on Christmas Eve 2009 the administration raised the infinity. No limit whatsoever, for the next three years. Christmas Eve was a time when the public and the media would give little attention to the matter, and something had to be done before December 31. Otherwise, congressional approval would be needed to raise the $400-billion limit. Without that approval, negative net worth for Fannie and Freddie would force them by law into receivership, which would wind them down. The administration was preparing for the possibility of Fannie and Freddie exceeding the CBO estimate of $380 and even the previous $400 billion limit, perhaps by a wide margin. Thus, despite the government's efforts to convince the public that it has handled the problems of Fannie and Freddie effectively, those two will continue to bleed red ink and erode confidence in the dollar.

In 2008, a Standard & Poor's study found the taxpayer risk from Fannie and Freddie, combined with other government-guaranteed agencies, “yields a potential fiscal cost to the government of up to 10% of GDP.” The Wall Street Journal April 4, 2008, wrote, “With total GDP at somewhat north of $14 trillion, that would put the Fan and Fred bailout cost at $1.4 trillion. Yowza. This 'fiscal burden' would be so large, in fact, that S&P figures it could even jeopardize the AAA credit rating of the U.S. government.”

Last year, French President Nicolas Sarkozy joined Russia, China and other emerging countries in calling for an end to the dollar's reign as the primary international currency. And the United Nations Conference on Trade and Development endorsed moving away from the central role of the dollar in the world monetary system.

The U.S. announcement in 1971 that it was ending the final link between gold and the dollar led to the collapse of the Bretton Woods system of fixed exchange rates in 1973. From 1976 to 1980 the International Monetary fund eliminated the use of gold as a common denominator, abolished the official price of gold, and ended the obligatory use of gold between the IMF and its member countries. Also, it sold approximately one-third (50 million ounces) of its gold holdings “following an agreement by its member countries to reduce the role of gold in the international monetary system,” says an IMF fact sheet.

Naive social reformers and politicians have long dreamed they could create a better world if political power could overcome the restraint gold-anchored money imposed on their good intentions, because it prevents runaway government spending. But their dream to reduce, or even ultimately eliminate, gold from the international monetary system suffered a rude awakening by what has been happening to the dollar cut lose from gold. France, which had been the largest seller of gold, now says it will sell no more gold. A report by the Austrian central bank last year said the rise in gold prices and “the concomitant depreciation of the U.S. dollar over the past few years have shown clearly how important gold is as an instrument for a central bank.” Germany's Bundesbank, the world's second largest official holder of gold with 3,417 tons has indicated it is now more willing to hold and buy gold than to sell. Russia has been buying regularly, bought about 100 tons in the past year, and says it intends to continue buying and increasing the percentage of its reserves in gold.

Ever since the IMF began selling its gold, that additional supply—or even the threat of it—has had a tendency to hold down the market price of gold. But the situation has now changed, because of demand. On September 18, 2009, the IMF approved the sale of 403 metric tons of gold (one-eighth of its holdings of 3,217 tons) to shore up its own finances and enable loans to poorer countries. The IMF sold 200 tons to India and the remainder to three smaller countries.

China has by far the world's largest holding of dollars, $2.45 trillion. Spokesman Cheng Siwei said Beijing is dismayed by the Fed's recourse to easy credit. He said China fears U.S. printing of money will lead to inflation and a hard fall of the dollar, which would seriously reduce the value of China's holding. So it has been diversifying into other investments. At the end of May 2010, China had reduced its holdings of U.S. Treasuries to $867 billion, down from $900.2 billion the previous month and the record $939.9 billion in July 2009. It has been buying commodities such as copper, iron, aluminum, lead, zinc and oil. It has been buying euros, other currencies and bonds of other countries and the ECB. It has been buying companies, factories, banks, and real estate all over the world. In 2009, China increased its gold holding by 76%, to 1,054 tons. It would love to buy much more, but as Siwei said, “When we buy, the price goes up. We have to do it carefully so as not to stimulate the markets.” China's Assets Supervision and Administration has set a goal of accumulating 10,000 metric tons of gold in the next ten years.

The chart below shows why China wants more gold. You can see that as of the end of last year, gold comprised only one and a half percent of its vast reserves. Notice, too, that India, Russia and Brazil, which are large countries with rapidly growing economies, also have very small percentages of their official reserves in gold.

Countries which are running current-account surpluses and don't have their own domestic production are the most logical future buyers. We have already noted the gold purchases by the central banks of India and Russia. According to the IMF, among the countries with the largest dollar surpluses behind China and Russia are Malaysia, Singapore, Kuwait, Saudi Arabia and Venezuela. 2009 was the first year since 1987 that central banks bought more gold than they sold. There are likely to be no shortages of buyers for future sales.

You won't see major players be blatant about increasing their gold exposure, but it is a trend we've been witnessing in the past few months,” noted Kathy Lien, director of currency research at GTF Forex in New York on June 8, 2010. “For the most part, whether they openly admit it or not, central banks are increasingly worried about their exposure to euros.”

For Part VII of this series, click link

Monday, October 18, 2010

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

(For previous parts in this series, scroll down and click on the links in the righthand column.)

The federal guarantee on mortgages was also a major factor in the housing bubble. Fannie and Freddie don't make loans. They are forbidden from doing so. Instead they buy mortgages from banks, bundle them into securities, and resell these to investors. This “securitizing” of mortgages doesn't require them to hold a mortgage on its books any longer than it takes to package and resell it. Once a mortgage is off the books, the agency's capital is freed up to do the same thing all over again. Hence the potential for a credit bubble. Even though the mortgages were sold to other investors, Fannie and Freddie for a fee still guaranteed that payments would be made on the loans. So when the banks—who got into the business pioneered by Fannie and Freddie—divided the securitized mortgages and repackaged them in SIVs (structured investment vehicles) and CDOs (collateralized debt obligations), the mortgage payments were still federally guaranteed. This made them attractive even to foreign governments and investors who didn't really understand these highly complex investments. All that mattered was the implicit safety that they were backed by the U.S. government. It didn't matter, as the Financial Crisis Inquiry Commission later pointed out, that Fannie and Freddie were twice as leveraged as Bear Stearns, a global investment bank that was an early casualty of the financial crisis.

Entirely separate from their function of buying mortgages from banks and reselling them with a federal guarantee, Fannie and Freddie also held mortgages and mortgage-backed securities for their own accounts. As of Febuary 2008, they each held a portfolio of more than $700 billion of these investments, which they could buy on the open market with borrowed money. Because of the federal guarantee, the GSEs were able to borrow (by issuing bonds) at very favorable rates. They made profits on the difference between their borrowing costs and the interest they received from the mortgages or mortgage-backed securities. Then they bought interest-rate swaps or other derivatives to ensure that the interest rate spread stayed positive. However, when interest rates fell, the derivatives declined sharply in value. For example, for the second quarter of 2010, Freddie Mac reported a loss of $4.7 billion with $3.8 billion of this coming from derivatives, due to low interest rates.

Federal policies also helped inflate the housing bubble in other ways. For example, the ability to claim tax deductions from interest on mortgages distorted housing prices. Because the tax deduction rises with the size of the loan, there was an impetus toward higher-priced homes and larger mortgages. The deductions “began effectively subsidizing gambles on fluctuations in housing prices,” says Dennis J. Ventry, Jr., an acting law professor at the University of California, Davis. States with the biggest mortgage interest deductions were among those hardest hit by the collapse. California ranked first in deductions, Nevada third and Florida eighth.

Another influential government factor was the Fed control of interest rates. Following the collapse of high-tech stocks (the “dot-com” bubble) in 2000, Alan Greenspan steadily brought interest rates down to 1 percent in June 2003 and kept them low for an extended period, fearing raising them too soon would be inflationary. This policy subsidized credit and stimulated home buying—and also home building in an already over-built industry—by helping to push the rates on long-term mortgages to the lowest levels since Freddie Mac began keeping track in the early 1970s. At the same time, it sent the banks looking for higher returns to mortgage bonds, which had not only attractive yields but the safety of AAA ratings and the government guarantee.

Lack of confidence in the dollar's historical ability to serve as a store of value, due to Fed monetary policies, also motivated people to purchase homes for this purpose. Within the experience of most people, homes appreciated while the dollar depreciated. People also turned to the stock market as an alternative store of value that would stay ahead of inflation, but that market proved too volatile to be fully satisfactory. Homes, however, were regarded as more stable, a “safe” investment and one likely to appreciate with what appeared to be an inevitable trend to inflation. That meant the prospect of paying off mortgages with depreciating dollars. Adding in the tax deduction for interest on mortgage payments, and home buying came to be viewed as virtually a “sure thing.”

On July 21, 2010 President Obama signed into law the most sweeping overhaul of the financial system since the Great Depression. At the signing of the bill, he claimed it provided “the strongest financial protection for consumers in the nation's history” and they would never again have to “foot the bill for Wall Street's mistakes.”[!] He said nothing about Fannie or Freddie. The 2,300 page law, which is longer than all previous financial regulations in U.S. history combined, doesn't cover them. It will require federal regulators to write hundreds of new—and costly—regulations that will apply only to banks and private financial institutions. Do you suppose omitting Fannie and Freddie from the new law had anything to do with the fact that as of 2008 they had almost 150 lobbyists and, according to Politico, spent almost $200 million on lobbying and campaign contributions in the previous decade? Federal Election Commission data shows the money went to 354 senators and congressman, with Senator Barrack Obama receiving the second most money, behind only Chris Dodd. As you may recall, Dodd was the Senate sponsor and a principal architect of the Dodd-Frank financial overhaul bill the President signed. The Center for Responsive Politics reports the peak year of Fannie and Freddie spending for lobbying was 2004, when it reached $26 million.

Yet in an April 2010 address, President Obama stated his financial regulatory proposals were struggling in the Senate because “the financial industry and its powerful lobby have opposed modest safeguards against the kinds of reckless risks and bad practices that led to this very crisis.” That is a statement of either flagrant dishonesty or flagrant ignorance.

I have written more extensively on the housing bubble in a 4-part essay “Mortgage Crisis, the Dollar and its Future” at link, which I recommend you read.  But I have included some explanation of the housing debacle here because it relates to the unfolding situation of Greece's monetary crisis. It is far larger than the general public realizes, has not been “solved,” leaves the U.S. far more vulnerable to contagion from the Greek fallout, and has ramifications for the international monetary system in the future that few understand. 

For Part VI of this series, click link

Friday, October 15, 2010

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

(For previous parts in this series, scroll down and click on the links in the righthand column.)

Governments in the developed countries now inflate their money by expanding credit rather than by printing more paper currency. This is a far more powerful method, more complicated, and thus not so obvious to the general public. It enables politicians to disguise the cost of social and economic benefits they promise in return for the votes to keep themselves in office. And it makes it easy for them to blame others (e.g. banks, brokers, “speculators,” etc.) for the problems caused by government credit expansion and the regulatory bureaucracy. Then they pose as saviors by advocating more of the same and claiming that will “prevent this from ever happening again.”

The financial crisis began with Fannie Mae and Freddie Mac, the largest factors in housing and banking, which are among the most heavily regulated aspects of the economy. These agencies are where the credit expansion occurred that made them larger than the Federal Reserve—and even larger than the gross domestic product of Japan, the third-largest economy in the world. This credit bubble was not the product of free markets or capitalism but the antithesis. It was the product of federal laws, regulations, politics and malfeasance by regulatory agencies.

The banks are regulated by four separate agencies: the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, and the Office of the Comptroller of the Currency. Fannie and Freddie are federally chartered “government sponsored enterprises” (GSEs) that were regulated primarily by the Office of Federal Housing Enterprise Oversight (OFHEO) until 2008 when it was merged with various other agencies into a new Federal Housing Finance Agency. Congress and the President have control of the GSE budgets and programs in every sense. They exempted them from state and local taxes, authorized them to sell mortgage-backed securities, provided them with unlimited guarantees on their mortgages and the ability to borrow at preferential rates. There never was a shortage of regulatory agencies or powers to regulate. Or special advantages.

Fannie Mae was founded in 1938 in response to many homeowners losing their homes to foreclosure during the Great Depression. In 1968 the federal government converted Fannie Mae into a private shareholder corporation to remove its accounts from the balance sheet of the federal budget. This was a time of increased spending for Lyndon Johnson's Great Society and the Viet Nam war. So, like the Greek government in more recent times, the LBJ administration chose to hide the extent of its spending by simply removing a large expenditure from government accounting. In 1970 the government created Freddie Mac to supplement Fannie Mae.

In 2003 Freddie Mac was fined $125 million by OFHEO for accounting irregularities, and in 2007 it was fined $50 million by the SEC for accounting fraud. In 2006, OFHEO discovered “a wide variety of unsafe and unsound practices” at Fannie Mae. Its report stated: “Fannie Mae's faults were not limited to violating accounting and corporate governance standards, but included excessive risk-taking and poor risk management as well.” Fannie Mae was fined $400 million and ordered to restate its earning from prior years by an estimated $11 billion.

The Federal Housing Administration (FHA) is actually older than Fannie Mae, having been founded in 1934. It, too, was part of Franklin Roosevelt's New Deal effort to expand credit to home buyers in the depression and enhance his popularity with voters. While much smaller than Fannie and Freddie before the recent collapse of the mortgage bubble, it has since grown enormously. Yet John Berlau, a scholar at the Competitive Enterprise Institute, says it had significant involvement in the bubble: “The collapse of whole segments of the housing market can be traced to FHA-subsidized mortgage products.” FHA loans, he says, “have been at the center of some of the worst excesses of the housing boom, including mortgage fraud, loans made without income verification, and property 'flipping' with inflated appraisals.” Senator Susan Collins, who headed a 2001 Senate investigation, said, “The federal government has essentially subsidized much of this fraud.” FHA mortgages originally required down payment of 20 percent, but that was whittled down over the years to 3 percent.

During the Carter administration, the Community Reinvestment Act of 1977 (CRA) purported to remedy “redlining”—racial discrimination by banks denying mortgages in black neighborhoods. The evidence for such discrimination was feeble and misleading. Most applicants were approved regardless of race, and the slightly higher rejection for minorities reflected their poorer credit history. But the banks were now required to open new branches in low-income areas and to have a certain percentage of their small-business loans and home mortgages located there. They were also prevented from opening new branches in other—untroubled—areas if they failed to maintain this ratio.

From 1977 to 1991, $9 billion were announced for CRA lending commitments. Then came the 1992 Federal Housing Enterprises Financial Safety Act, also known as the GSE Act. This contained 'affordable housing' requirements which resulted in Fannie and Freddie acquiring $6 trillion in single-family loans over the next 16 years. According to Edward Pinto, former chief credit officer at Fannie Mae:

Acorn and other community groups were informally deputized by then House Banking Chairman Henry Gonzalez to draft statutory language setting the law's affordable-housing mandates....The goal of the community groups was to force Fannie and Freddie to loosen their underwriting standards, in order to facilitate the purchase of loans made under CRA....Thus a provision was inserted into the law whereby Congress signaled to the GSEs that they should accept down payments of 5% or less, ignore impaired credit if the blot was over one year old, and otherwise loosen their lending guidelines.

Initially, the affordable-housing mandate was set at 30 percent of single-family mortgages purchased by Fannie and Freddie. In 1995, Henry Cisneros, President Clinton's secretary of housing and urban development, directed Fannie and Freddie to buy the mortgages of low- and moderate-income borrowers amounting to 42 percent of their annual business volume. His successor Andrew Cuomo upped that to 50 percent and directed the GSEs to buy mortgages from borrowers with “very low income.” Banks ended up having to make more and more “subprime” loans and agreeing to dangerously lax underwriting standards—no down payment, no verification of income, interest-only payment plans, and weak credit history. By 2007, HUD's affordable housing regulations required 55 percent of all the GSE loans to be made to borrowers at or below the median income, with almost half of these required to be low-income borrowers.

The credit bubble was now inflated to the bursting point. But when it burst, it was not government but the banks that took the blame. The virulently anti-business and anti-capitalist Obama was quick to decry the “fat-cat bankers on Wall Street,” the “greedy” and “irresponsible” lenders who pushed subprime mortgages on the poor and vulnerable who couldn't afford them and now were losing their homes. The Obama-adoring news media, still in love with him since the early days of the presidential campaign, flooded the public with stories about how the economic misery was due to businesses run amuck in the reckless pursuit of profit and the lack of regulation. What was needed, according to the politicians, commentators and opinion makers who dominated the media coverage was greater regulation “to prevent this from ever happening again.” The question of whether the problems had been caused by regulation in the first place never seemed to come up.

Nor did the issue of whether the federal government should even be involved in the housing market. Republicans as well as Democrats overwhelmingly supported the idea that government should help the poor, the down-trodden to achieve the “American Dream” of owning a home. And they certainly did not want to incur the wrath of voters by being perceived as unsympathetic to the poor and against programs for their betterment. Rather, they wanted voters to see them as caring and compassionate—and be willing to vote for them. In 2002 President George W. Bush, having Republican control of both houses of Congress, signed the Single-Family Affordable Housing Tax Credit Act. This Renewing the American Dream program provided almost $2.4 billion in tax credits to investors and builders developing single-family housing in poor and distressed areas. In 2003 he signed the American Dream Downpayment Act, which provided $200 million per year 2004-2007 toward down payment and closing costs for home buyers.

The idea that home ownership was a socially desirable goal that should be promoted by the government led to a vast, incredibly expensive, decades-long effort, but how effective was it? Home ownership in the U.S. peaked at 69 % at the top of the housing bubble and is now 67%. But there are at least 14 countries that have higher ownership rates than the U.S., including Hungary, Iceland, and Poland. In the European Union, where most countries don't offer tax breaks and subsidies like the U.S., home ownership was just shy of 75% in 2006, according to Eurostat. Homeownership in the U.S. increased by only 3.4 percentage points over the last 20 years, the period of the the U.S. government's greatest efforts to promote it. In the Netherlands and Italy, it increased by 12 percentage points between 1991 and 2008.

Canadian banks weathered the international financial crisis much better than U.S. banks. Canada has nothing comparable to Fannie or Freddie or our Community Reinvestment Act. It does not have 30-year fixed-rate mortgages, and interest on mortgages is not tax deductible. Down payments of less than 20 percent require the mortgage holder to buy mortgage insurance. Canada's regulatory agency concerns itself with risk management and abstains from social and political objectives, such as affordable housing and diversity. Yet it has a home ownership rate of 68%, and the percentage of mortgage loans delinquent for more than 90 days is approximately one-tenth of the U.S. level. A comparison to the U.S. shows two very different housing finance systems, one much more political and riskier than the other, with no advantage to the U.S. system.

For Part V of this series, click on this link.

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

Monday, October 11, 2010

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 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

Saturday, October 09, 2010

Monetary Mess, the Dollar, Gold--and You, Part I

For years the Greek government has been spending beyond its means and borrowing to make up the difference. Just like the U.S. government. There is, however, an important difference. The U.S. dollar is the world's reserve currency, meaning the U.S. is the only country in the world that can pay back its borrowings by simply printing more of its own money.

Greece does not have that option. It can no longer manipulate (inflate) its own currency, as the U.S. does. Greece and other members of the euro zone now share a common currency whose supply is determined by the European Central Bank (ECB), which has a single mandate: to preserve the value of its currency, the euro. Membership in this monetary pact requires the individual countries to limit their budget deficits to 3 percent of gross domestic product and their government debt-to-GDP ratio to 60 percent.

Having a common standard of value has certainly benefited commerce among member countries. It eliminated the necessity and inefficiencies of constant exchanges of fluctuating currencies. It also was seen as promoting monetary stability by inhibiting profligate public spending by individual countries, financed by inflation, which historically led to great volatility among European currencies. In addition, it was seen as an alternative to the dollar, whose usefulness as a store of value was declining with a decades-long trend of increased U.S. government spending.

The Greek financial crisis arose when the government increased its initial estimated 2009 budget deficit of 3.7 percent of GDP to 12.7 percent, with the debt-to-GDP ratio going to 113.4 percent. Even the earlier 3.7 estimate failed the euro zone requirement, but this was ignored because Greece was above 3 percent every year except 2006, and several other countries had sometimes been above the 3 percent limit. But Greece's latest figures were shocking, leaving bond investors worried the country couldn't pay them off. The pact among the euro countries was supposed to prevent a single free-spending country from undermining the common currency, but that now seemed to be happening. Since Greece could not inflate its way out of debt, the alternative proposed was economic reform to significantly reduce the deficit by cutting spending, increasing taxes, and freeing up the economy. Many doubted that could or would be done under Prime Minister George Papandreou's Socialist Party government. Argentina, in a similar predicament in 2000, tried a fiscal austerity program similar to that proposed for Greece but ultimately defaulted in 2001. As a result, Argentine bond holders lost 70 percent of their money, according to Moody's Investors Service.

Mr. Papandreou warned that his country risked bankruptcy if it could not find lenders to cover its massive 300 euro ($411 billion) debt. “Every year, we have to borrow about half of what we spend,” he said. “And every year we spend more, and every year we collect less as a percentage of GDP.” In other words, the country has been piling more debt on top of debt by spending more than it is taking in. The interest rate it must pay to borrow is higher than the economy's growth rate, and the interest rate rises as the likelihood of debt default increases. The government projects its total debt will rise from its current 113.4 percent of GDP to 123 percent by the end of the 2010 and reach 148 percent in 2013.

If Greece were to fail, that might well spell the end of the euro. Germany's Finance Minister Wolfgang Schauble stated: “We cannot allow the bankruptcy of a euro member state like Greece to turn into a second Lehman Brothers.” French president Sarkozy said, “We cannot let a country fall that is in the euro zone. Otherwise, there was no point in creating the euro.”

But there is great fear that a Greek bailout will lead to other countries demanding similar rescue from similar monetary sins, which will further undermine the value of the euro. On May 3, 2010, a week after Standard & Poor's cut the Greek bond rating to “junk” status, European Central Bank president Jean-Claude Trichet said the the bank would accept as collateral any current or future Greek government bonds regardless of how much the rating companies downgraded them. Trichet had explicitly stated only a few days earlier that this would not be done; the ECB's rule had been to accept only bonds above a certain minimum rating. The new looser policy was widely interpreted as evidence of inflationary danger, detrimental to ECB's credibility and its mandate to preserve the value of the euro. In recent years the euro had strengthened against the dollar because of U.S. deficit spending, but the Greek crisis from the very start undermined confidence in the euro, whose value declined steadily since.

The problem is that there is no enforcement mechanism to ensure compliance with euro limits on budget deficits and debt-to-GDP ratio. When Helmut Kohl was the German chancellor, he wanted stiff fines for violators. That idea was rejected because it would have made the euro treaty a tough sell to European nations whose membership was regarded as essential for success of the new currency.

To save the euro now, it was deemed necessary to prevent Greek bankruptcy. German Chancellor Angela Merkel and French President Nicolas Sarkozy took the lead in arranging a bailout to save Greece from defaulting on its bonds, thus buying time for Greece to achieve the reforms necessary for economic recovery.

Governments, banks, hedge funds, and other investors use credit-default swaps to protect themselves against the risks of default on sovereign bonds such as Greece's. These insurance-like contracts pay out if the bond issuer defaults. Their prices rise when credit worthiness deteriorates. These markets work because other investors and speculators are willing to assume the risks involved, in return for possible gains, by taking the opposite position in the swaps from those seeking protection. The market in swaps and related financial derivatives is due largely to the monetary instability created by irresponsible government policies. As a result, vast sums of money are diverted to betting on future monetary policy or exchange-rate movements.

France's giant 116-year old bank Credit Agricole SA bought swap insurance against bond defaults by Greece, Italy and Germany. Spain's Banco Santander protected itself against British, German and French government bonds. Barclays bank hedged its exposure to Italy, France, Greece, Germany and Portugal. Goldman Sachs was also a credit default swaps buyer.

As of June 2008, the notional amounts (stipulated principals) of financial derivatives, according to the Bank for International Settlements, totaled $684 trillion—over 12 times the world's nominal gross domestic product! These derivatives included credit default swaps, options, forward-rate agreements, and foreign exchange contracts. All of these make it possible to bet on future monetary policy and exchange rates. And three-quarters of this massive derivatives market, “which has wreaked the most havoc across global financial markets,” says economist Judy Sheldon, “derives from the capricious monetary policies of central banks and the chaotic movement of currencies.”

On April 8, 2010 the Wall Street Journal noted, “Several years ago, when few ever imagined a European Union member could face a default risk, insurance on Greek bonds was dirt cheap—a mere $7,000 a year to insure $10 million of Greek debt for five years.” The cost reached $124,000 at the start of October 2009. Four months later it reached $425,000, compared to just $13,405 to insure $10 million of German bonds for the same period. In April 2010 the cost to insure $10 million of Greek debt was $711,000 per year, and the interest rate Greece had to pay to sell its bonds was 6.1 percentage points higher than those from Germany, a nation whose bonds were much less risky. The cost in May 2010 to insure debt of 10 million euros for five years was 163,789 euros compared to just 90,715 only two months earlier.

In the same way that governments, banks and other investors employ credit default swaps to protect themselves from default on Greek or other sovereign bonds, companies doing business internationally also find it necessary to protect themselves from monetary instability. They employ derivatives as insurance against currency and interest rate fluctuations in the countries in which they do business. Coca-Cola, for example, generates euro income equal to about $3 billion annually, and derivatives provide a way to protect against the loss of value when this revenue is converted into dollars. McDonalds hedges its euro exposure in the same way. So does Dole Foods and countless other corporations.

Derivatives for insuring against the loss of value—due to unreliable currency—impose gigantic costs on the world's economy. What would happen if there were no derivatives? Coca-Cola would have to charge more for Coke, McDonalds more for its hamburgers, and Dole Foods more for its products, in order to offset possible losses from currency fluctuations in countries where their products are sold. And Greece and other countries selling bonds would have to pay even higher interest rates to bond buyers if the latter were unable to offset the risk by purchasing derivatives.

But what if the world had a stable money? Then there would be no need for all those derivatives to protect against money itself losing value. The trillions of dollars spent on them could instead be used more productively to produce prosperity. In fact, this is what happened when the dollar was “as good as gold.” For much of our history, the dollar was exchangeable for gold or silver at fixed rates, and derivatives against monetary instability were unheard of. And before the dollar emerged as the world's currency, the British pound occupied that position because it was fully convertible into gold for roughly a hundred years before World War I, when London was the center of the financial world. Gold-backed currencies controlled inflation, led to strong employment, and fostered rising living standards. Stable money made economic calculation simpler and more accurate, thereby creating efficiencies and optimizing investments. It also preserved the value of people's savings, thereby encouraging them to save, which, in turn, increased investment capital to further enrich the people and the country. It all happened without any need to buy insurance against monetary defaults, fluctuating exchange ratios or variable interest rates.

Money is a measure of value. It must have a standard by which to gage that which it measures. Length, weight, sound, time and temperature all have units that make it possible for people to communicate easily with each other about them. If some people used a foot that contained 13 inches, a pound that contained 11 ounces, or an hour that contained 48 minutes, trade with others for goods or labor would require cumbersome conversions. The same difficulty occurs when people in different nations measure the value of anything in terms of different currencies that lack a common standard.

Over the centuries, many things were used as money, including metals, grains, cattle, furs, salted fish, salt, tobacco, whiskey, nails, fishhooks and seashells. Some worked better than others. Furs could rot or burn, while metals would not. Iron could rust, but not gold or silver. Whiskey could be spilled or evaporate and was not as uniform in quality as many other commodities. Diamonds could be exceedingly valuable, but they were not uniform in size or quality; nor could they be easily divided, another important attribute for money. Countless transactions by billions of people over thousands of years eventually led to gold becoming the preferred money because of its intrinsic characteristics. It simply worked better than anything else. Certainly it has worked better throughout history than fiat paper, which has no intrinsic value.

The advocates of unbacked paper money often argue that money is only a medium of exchange and, therefore, need not have any material value itself. But money is first and foremost a store of value; it must be a store of value before it can be a medium of exchange. If something did not have intrinsic or objective value, it would never have become money in the first place. And taking away the value from extant money—making it irredeemable in the original measure of its worth—will eventually destroy its usefulness as money, leading to replacement of the currency. Because it can no longer be trusted as a store of value.

For Part II of this series, click Monetary Mess, the Dollar, Gold—and You, Part II