"There is no means of avoiding a final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency system involved."
- Ludwig von Mises

Friday, December 31, 2010

Happy New Year

I will be posting again starting Monday.  I just wanted to wish everyone a Happy New Year.  We live in turbulent times and despite the circumstances we can not control, it's important to set aside some time to celebrate the things we hold dear.   Best wishes in the new year, and may you reach the goals you set yourself for 2011.


Tuesday, December 28, 2010

Professor William Black On Just About Everything

Well, almost everything.  Excellent interview on Bloomberg from yesterday.  Bill Black covers topics such as the EU and Euro Crisis, the potential European political repercussions of the deteriorating economic situation, the Chinese housing bubble, the ongoing US Banking crisis, and the US Municipal Bond crisis that Meredith Whitney recently discussed on 60 Minutes.

I have a lot of respect for Bill Black; his resume is impressive and the man has integrity. Here is a brief bio, from PBS/Bill Moyers Journal:
William K. Black, author of THE BEST WAY TO ROB A BANK IS TO OWN ONE, teaches economics and law at the University of Missouri — Kansas City (UMKC). He was the Executive Director of the Institute for Fraud Prevention from 2005-2007. He has taught previously at the LBJ School of Public Affairs at the University of Texas at Austin and at Santa Clara University, where he was also the distinguished scholar in residence for insurance law and a visiting scholar at the Markkula Center for Applied Ethics. 
Black was litigation director of the Federal Home Loan Bank Board, deputy director of the FSLIC, SVP and general counsel of the Federal Home Loan Bank of San Francisco, and senior deputy chief counsel, Office of Thrift Supervision. He was deputy director of the National Commission on Financial Institution Reform, Recovery and Enforcement.  
Black developed the concept of "control fraud" — frauds in which the CEO or head of state uses the entity as a "weapon." Control frauds cause greater financial losses than all other forms of property crime combined. He recently helped the World Bank develop anti-corruption initiatives and served as an expert for OFHEO in its enforcement action against Fannie Mae's former senior management. 

Original link Here.

I also want to mention that the discussion on MMT is far from over.  I am still working on the next topics to be covered.  Reader Rajiv has posted some excellent links on the comments section of the post:  The Power to Tax and Modern Monetary Theory.  I will be incorporating some of his points in a follow up post.

From my experience, most of the blogs I follow that see gold in the final endgame rarely discuss the actual mechanics of our monetary system - what MMT describes.  And those blogs that do an excellent job of describing MMT more often see gold as a temporary mania, and that the crisis will eventually be resolved on its own and fiat will prevail.  I hope to offer a different perspective that incorporates both MMT and gold as an endgame. Judging from some of the comments here, I am not alone in wanting to explore this topic.  And I appreciate all comments on MMT, as it is one of those oftentimes confusing topics that are best understood thru an exchange of views with others.

Friday, December 24, 2010

Merry Christmas and Happy Holidays

 "It's a Wonderful Life."  

Robert Zoellick, World Bank President Reaffirms A Global Role for Gold

I have written on Robert Zoellick's recent mention of gold HERE.  From what I recall, he pulled back somewhat on his comment, yet just two days ago, he reiterated his position.

Hat tip to Fauvi for the find:
World Bank head reaffirms gold as "reference point" to monetary system reform 
Wednesday December 22, 2010 14:30:43 EST 
PARIS, Dec 22, 2010 (Xinhua via COMTEX News Network) -- 
World Bank President Robert Zoellick reaffirmed his proposal to use gold as a "reference point" to reform the current international monetary system on Wednesday in Paris. 
"What I suggested is that gold serves as a key reference point to allow people to assess the relations between different currencies," Zoellick told the press here at the end of his meeting with French President Nicolas Sarkozy in the Elysee Palace. 
"It's an approach that we can take, others also estimate that we can establish a benchmark against prices of principal commodities," the World Bank president said in response to a journalist's question. 
"I didn't propose a gold standard, which is an important distinction because it would directly link currency to gold," said Zoellick, denying reports that he had called for a return to the " gold standard" to modify the present monetary system, which he called "Bretton Woods II." 
"The system should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values," Zoellick wrote in an article published in Monday's Financial Times. 
Some media said Zoellick's proposal to revive gold's role in guiding exchange rates worked as a shock wave to current discussions and disputes over the international monetary system. 
The "gold standard" is a system in which the standard economic unit of account is a fixed weight of gold. 
Under the Bretton Woods system, which was set up in 1944 in the United States, the U.S. dollar was directly pegged to gold -- 35 dollars equaled per ounce -- while other currencies were pegged to the dollar. The Bretton Woods fixed exchange rate regime broke down in 1971, when the United States unilaterally terminated convertibility of the dollar to gold.

Source HERE.

Misthos here.  The most important global currency relationship that exists today is the Chinese RMB and the US Dollar.  The US needs to desperately depreciate its currency to better manage debts and to increase exports, and historically, there has always been a strong currency (or gold) to devalue against.  However, China is not allowing this to happen, or at least not as fast as the US would like, and so we have the situation we have today:  A currency war of exporting inflation by the US to China.

Would gold be a better "currency" to depreciate against?  And if this is not "technically" a gold standard, isn't this policy espoused by Zoellick giving gold a recognized monetary status?  After all, those that believe that gold has a monetary status of sorts are usually ridiculed and consigned to the tin foil hat brigade.  (myself included)

Nonetheless, knowing how governments love to spend, such a policy, in my opinion would be extremely inflationary to gold.  There's a lot of debt out there, and a lot of global trade re-balancing to be done.  The real question is:  Are these goals possible, or realistic?  Or will the system breakdown on its own, forcing the gold issue upon reluctant governments?

Time will tell.

Financial Collapse as Early as the End of the First Quarter, 2011... "If that happens, paper money is worth nothing anymore..."

Just a quick break from the MMT series and from holiday visits, from Bloomberg:

Gijsbert Groenewegen, managing partner and founder of hedge fund Silver Arrow Capital Management was on Bloomberg yesterday and discussed what 2011 may hold.  He covers commodities, precious metals, equities, and the possible collapse of paper money which could occur as early as next year.

I agree with his view that gold could drop significantly as hedge funds are forced to sell their most liquid investments to cover equity losses.  But I think gold's subsequent bounce would be much stronger than the $1,500-$2,000 range Groenewegen gives, especially if sovereigns get involved and use gold once again to back their currencies.

Tuesday, December 21, 2010

The Power to Tax and Modern Monetary Theory

In this post I want to follow up on an assertion that I have made in past posts, that is, that the creation of the Federal Reserve Act of December 23rd, 1913 and the ratification of the Federal Income Tax Amendment on April 3rd, 1913, were done in tandem.  The passage of these two laws, one creating a Central Bank, the other, a Federal Taxing authority, were not coincidental.  Rather, they work together to affect economic policy, and to strengthen the Federal Government's role in the economy.

My point is to illustrate how our monetary system works, and to point out that the current system is the result of incremental changes that go back some one hundred years.  For this post, I am merely describing the technical nature of this system, and not the political and societal aspects or repercussions of it.  That will be covered in another subsequent post.

Beardsley Ruml, an economist and former Director of the Federal Reserve Bank of NY gave a speech in 1946 to the American Bar Association.  The speech was about the corporate income tax, yet he also described the role of taxation in a monetary system where there is no domestic gold convertibility of the national currency.  Keep in mind, that FDR, in 1934, by executive order, ended gold hoarding and therefore the domestic convertibility of the US Dollar to gold.  However, between foreign governments, gold convertibility existed until 1971 when Nixon ended the Bretton Woods system of gold convertibility.

Here is the relevant portion of his speech:
It Happened 
If we look at the financial history of recent years it is apparent that nations have been able to pay their bills even though their tax revenues fell short of expenses. These countries whose expenses were greater than their receipts from taxes paid their bills by borrowing the necessary money. The borrowing of money, therefore, is an alternative which governments use to supplement the revenues from taxation in order to obtain the necessary means for the payment of their bills. 
A government which depends on loans and on the refunding of its loans to get the money it requires for its operations is necessarily dependent on the sources from which the money can be obtained. In the past, if a government persisted in borrowing heavily to cover its expenditures, interest rates would get higher and higher, and greater and greater inducements would have to be offered by the government to the lenders. These governments finally found that the only way they could maintain both their sovereign independence and their solvency was to tax heavily enough to meet a substantial part of their financial needs, and to be prepared ---if placed under undue pressure --- to tax to meet them all. 
The necessity for a government to tax in order to maintain both its independence and its solvency is true for state and local governments, but it is not true for a national government. Two changes of the greatest consequence have occurred in the last twenty-five years which have substantially altered the position of the national state with respect to the financing of its current requirements.
The first of these changes is the gaining of vast new experience in the management of central banks.
The second change is the elimination, for domestic purposes, of the convertibility of the currency into gold. 
Free of the Money Market
Final freedom from the domestic money market exists for every sovereign national state where there exists an institution which functions in the manner of a modern central bank, and whose currency is not convertible into gold or into some other commodity. 
The United States is a national state which has a central banking system, the Federal Reserve System, and whose currency, for domestic purposes, is not convertible into any commodity. It follows that our Federal Government has final freedom from the money market in meeting its financial requirements. Accordingly, the inevitable social and economic consequences of any and all taxes have now become the prime consideration in the imposition of taxes. In general, it may be said that since all taxes have consequences of a social and economic character, the government should look to these consequences in formulating its tax policy. All federal taxes must meet the test of public policy and practical effect. The public purpose which is served should never be obscured in a tax program under the mask of raising revenue. 
What Taxes Are Really For
Federal taxes can be made to serve four principal purposes of a social and economic character. These purposes are: 
As an instrument of fiscal policy to help stabilize the purchasing power of the dollar; 
To express public policy in the distribution of wealth and of income, as in the case of the progressive income and estate taxes; 
To express public policy in subsidizing or in penalizing various industries and economic groups; 
To isolate and assess directly the costs of certain national benefits, such as highways and social security. 
In the recent past, we have used our federal tax program consciously for each of these purposes. In serving these purposes, the tax program is a means to an end. The purposes themselves are matters of basic national policy which should be established, in the first instance, independently of any national tax program. 
Among the policy questions with which we have to deal are these:  
Do we want a dollar with reasonably stable purchasing power over the years?  
Do we want greater equality of wealth and of income than would result from economic forces working alone?  
Do we want to subsidize certain industries and certain economic groups?  
Do we want the beneficiaries of certain federal activities to be aware of what they cost? 
These questions are not tax questions; they are questions as to the kind of country we want and the kind of life we want to lead. The tax program should be a means to an agreed end. The tax program should be devised as an instrument, and it should be judged by how well it serves its purpose. 
By all odds, the most important single purpose to be served by the imposition of federal taxes is the maintenance of a dollar which has stable purchasing power over the years. Sometimes this purpose is stated as "the avoidance of inflation"; and without the use of federal taxation all other means of stabilization, such as monetary policy and price controls and subsidies, are unavailing. All other means, in any case, must be integrated with federal tax policy if we are to have tomorrow a dollar which has a value near to what it has today.
Misthos here.  So there you have it, right from a Federal Reserve official.  And for those that support a flat tax:  I don't see that happening any time soon.  I will address this in the next post,  but I'll give you a hint - a flat tax limits the power of special interests to affect consumer behavior.  The mortgage interest rate deduction is one such example.  Also keep in mind, that in Ruml's day there was a gold standard of sorts between nations, but in the US, for the domestic population, gold convertibility had ended just over a decade earlier.  

And although the gold standard existed at the time of the creation of the Federal Reserve and the Federal Income tax - the two still worked together in managing the money supply. 

As for the source of this speech, it is none other than Warren Mosler.  I scoured the internet for a more direct source - like the NY Federal Reserve - to no avail.  Mosler's article, with the complete Ruml speech, can be found HERE.

Thursday, December 16, 2010

Modern Monetary Theory , or How the US Monetary System Really Works

This will be a series of posts that will be dedicated to Modern Monetary Theory (MMT).  I want to make one thing clear - although MMT is viewed as a theory, it is really a description of how the US monetary system actually works.

I am going to be posting essays on MMT piecemeal - baby steps, if you will.   There's a reason for that. Intellectually, it is not a difficult theory to comprehend.  the problem with understanding MMT is that we have all been lied to, or misinformed our entire lives as to how the monetary system works.   There are great misconceptions and these misconceptions have been reinforced by the media, by politicians, and by analysts.  I shouldn't be too hard on them, because honestly, most believe in what they say.

Some foundational knowledge that should help us get through this includes definitions of common concepts:

Free-floating currency:  A currency is free floating when it is openly traded and is not backed by anything or pegged to any other currency.  The US Dollar is free floating, which means that it is not pegged to the value of any other currency, and it is not backed by gold or any other commodity.  Thus, the US Dollar has no limitations on its creation.  It is therefore, free of any constraints to creation.  It is not tied to a certain weight of gold, nor is it tied to another currency.  The Chinese Yuan, on the other hand, is pegged to the US Dollar.  So the People's Bank of China needs to "manipulate" the Yuan so it retains a consistent value against the US Dollar.

Redeemable or Convertible Currency:  A currency that is redeemable or convertible is one that can be exchanged for a commodity, like gold.  Under a true gold standard, paper money was officially backed by gold or silver, and could be exchanged at the bank for those metals.  What was the effect of this?  People that lost faith in the currency could redeem it at a set price.  And government was constrained by this - it could never "print" at will for fear of a gold run - meaning, the government would run out of gold.

Here's what a redeemable currency looks like:

See where it says "In Gold Coin"?  That means you can exchange this dollar for gold. Actually, it was also called a gold certificate because of its redeemability.

Today, we have this:

It is not a certificate, but a note.  See the top phrase: "Federal Reserve Note"?  A Note is a promise to pay.  It is debt backed money, which is money created between the Federal Reserve and the US Treasury.  Thus, today's US Dollar is also described as an irredeemable or nonconvertible currency.  It is what it is, and since you have to pay the US Government in US Dollars, you don't have much choice, right?  But more on that later...

Operationally Constrained:  You will hear this phrase when we discuss the US Government's ability to create money.  What this means is that the US Government does not need to raise debt or collect taxes to spend money.  It is not "operationally constrained."  It can spend money at will, and if it has a deficit, it creates new money, regardless of "budgetary constraints."

Money Creation

I want to mention that for my EU readers, this will seem extremely strange.  The EU has a different system because it does not have a Central Treasury.  Although the ECB can create money from nothing, it is more constrained by EU member politics, and the budgetary constraints set by the Maastricht Treaty.

But for the US, money is created between the Federal Reserve, and the US Treasury. Edward Harrison of Credit Writedowns wrote on this last August:

So how does it work for government? Well, the Wikipedia entry for the Federal Reserve has a pretty good summary of how the Fed operates as the government’s bank:
In its role as the central bank of the United States, the Fed serves as a banker’s bank and as thegovernment’s bank. As the banker’s bank, it helps to assure the safety and efficiency of the payments system. As the government’s bank, or fiscal agent, the Fed processes a variety of financial transactions involving trillions of dollars. Just as an individual might keep an account at a bank, the U.S. Treasury keeps a checking account with the Federal Reserve, through which incoming federal tax deposits and outgoinggovernment payments are handled. As part of this service relationship, the Fed sells and redeems U.S.government securities such as savings bonds and Treasury bills, notes and bonds. It also issues the nation’s coin and paper currency. The U.S. Treasury, through its Bureau of the Mint and Bureau of Engraving and Printing, actually produces the nation’s cash supply and, in effect, sells the paper currency to the Federal Reserve Banks at manufacturing cost, and the coins at face value. The Federal Reserve Banks then distribute it to other financial institutions in various ways. During the Fiscal Year 2008, the Bureau of Engraving and Printing delivered 7.7 billion notes at an average cost of 6.4 cents per note.
The banking relationship piece is pretty much the same as it is for me and you. The government has a bank through which it pays for stuff. But that bank also acts like the government’s investment bank too, offering bond deals of government debt as an investment bank does for corporate debt. So far, so good.

Here’s the thing though: The Fed also is there on the money creation side, as the Wikipedia quote attests. The government creates currency. It literally makes the money we use. That is an important difference between government and us. Moreover, that money is not tied to any physical commodity like gold. That’s why you will often hear MMT’ers quip that sovereign debt or taxes don’t fund the government’s spending in a fiat currency system. What they are saying is that the government creates currency – and, therefore, as it’s creator they can buy stuff with money they create without funding it first.

Taxes give the fiat currency value by forcing people to use that specific currency in order to discharge their tax obligation. From an accounting perspective, they merely expunge a liability on the government’s balance sheet ledger. They don’t fund spending per se. There is a vestigial tie to taxes as a ‘funding’ source in that the U.S. government is required to issue debt in the form of Treasury bonds, bills or notes to cover deficits But this is a relic of the gold standard mandated by Congress which has not prevented the government from deficit spending. Legal tender laws make the currency widely distributed and entrench it as the money of choice within an economy. In a fiat currency system, sovereign government debt doesn’t serve an important currency function like funding deficits.

As I wrote last year:

From the government’s perspective, there is no functional difference between any of its obligations like bank notes, electronic credits, or treasury bills and bonds. As the Ten pound note says, “I promise to pay the bearer on demand the sum of [fill in the blank sum][fill in the blank fiat currency].” 
So, the U.S. government could legitimately stop issuing bonds altogether if it wanted to. When people complain about the admittedly enormous government debt, they don’t think of the mechanics of the issue. As I see it, in a fiat money environment, the first function of the Treasury bonds is to serve as a vehicle to add or subtract reserves in the system to help the Federal Reserve hit a target Fed Funds rate. The second is to give holders of government obligations a return on their investment. After all, bank notes or bank reserves don’t pay much if anything.
-If the U.S. stopped issuing treasuries, would it go broke?

I hope that makes it clear how few constraints there really are on government as compared to you or me.

I like to think of it this way. Imagine I am the creator of currency in our country, let’s call the currency "The Harrison," paper notes with little pictures of Benjamin and William Henry Harrison on them that I print up in my basement print shop. Now Harrisons have no intrinsic value. They are valuable only insofar as they are widely circulated in exchange for goods and services. And they retain that value only insofar as their supply remains limited. If I reel off a bunch of Benjamins to buy Treasury bonds, it will not necessarily erode the value of the Harrison if those Benjamins sit in bank vaults without being lent out.

Imagine one day I decide to buy a few tanks for a military expedition abroad. I go to my basement and reel off a gazillion Harrisons equal in value to the tanks.* I then march down the street to the Government Bank and deposit the money in my account. Then I march down to the tank dealer and give him a check written on my Government Bank account of equivalent value to the Harrisons and the tanks. He gives me the tanks. I didn’t earn the money I used through collecting taxes, now did I? Technically, I didn’t actually have to issue any debt to do this. Nothing was ‘funding’ my purchase except the money I just created.

All of this is a bit scary. I think fiat money is dangerous because the temptation to just print money is always there – and there are few constraints to this. I imagine that if people realized that governments have this much control and so few constraints, they would be worried. But that is the essence of how our fiat monetary system works.

Misthos here.  So what I wanted to accomplish with this post was to objectively describe the mechanics of the US monetary system.  I will be writing on the policy implications and my opinions as to how this system will ultimately unravel in future posts.  Included in these posts will be the creation of the Federal Reserve and the Federal Income Tax, how such a system interacts with trading partners that have a different system and buy our "debt", and the consequences of that and how the private banking system, particularly the largest banks, have hijacked the US Government.

I also want to point out, as I have mentioned in other posts, that the US does not rely on China or any other country to fund itself.  Nonetheless, politicians and many analysts frequently cite this when they speak of the national debt.

But I want to end this post with a quote and an interview, that to me, sums up the US monetary system and also shows just how misunderstood our monetary system is.

Warren Mosler, a well known MMT'er, was a candidate for US Senate, and back in June, he was interviewed on Fox Business.  In that interview he said something that threw everyone off guard.  The interviewer, honestly, or intentionally, seemed confused.  Personally, I don't think he was confused.   Here is what Warren Mosler said:
"For the US Government, government spending is not operationally constrained by revenues and therefore taxes function to regulate aggregate demand and not to collect revenue per se."

Wednesday, December 15, 2010

Nicole Foss takes on Gonzalo Lira: Hyperinflation or Deflationary Collapse?

I don't mean to hype this as some type of economic debate smackdown, but I just don't feel confident on either side of the hyperinflation vs. deflation collapse debate.  I just don't. There are just too many variables that are difficult to predict.   And honestly, I can envision both scenarios playing out.  Hopefully, with the upcoming series on Modern Monetary Theory (thanks Jim Slip) I land in one camp or another.  I think it's important to understand how our modern monetary system works in order to make accurate predictions.

Jim Rickard's Pentagon Speech and Presentation Available to the Public

Quick post here.  Jim Rickards just tweeted this - it is the link for those that want to see his presentation on Economics and National Security - for those that are not familiar with this or Jim Rickards, see my post:  Jim Rickards on the Gold Standard: "You will either get there smart or get there ugly."  I have not seen this yet, it is slow to load, but I plan on reviewing it later tonight.

Included are links to the video, slide presentation, and audio.

Link to presentation  HERE.

Greek Protests Turn Violent as Former Government Minister Attacked by Crowd

First it was Prince Charles and Duchess Camilla Parker-Bowles that were under attack by an unruly mob.  Now it is happening in Greece.

From the UK Telegraph:
Kostis Hatzidakis, who is now an opposition MP, was left with blood pouring from his head after being chased and beaten by dozens of protesters. 
He was set upon by up to 100 youths, who shouted "Thieves" and "Shame on you" when he emerged from the Greek parliament building on Constitution Square, in central Athens. 
Protesters hurled lumps of concrete and paving stones at riot police, set fire to cars and smashed shop fronts.
Here is a video of the protests:

Source HERE.

Another video with footage of the attack on the former government minister HERE.

Tuesday, December 14, 2010

Slovak Parliamentary Speaker Sulik Openly Considers Slovakia's Interests: Plan B, Exit Euro

Slovak Parliamentary Speaker Richard Sulik wrote an opinion piece in the business newspaper Hospodarske Noviny in which he openly discussed Slovakia's potential exit from European Monetary Union.  To my knowledge, this is the first high level politician to publicly say that exiting the Euro should be on the table.  His reason for a "Plan B"?  The current (mis)handling of the Euro and  the conflict of Euro membership and national sovereignty that smaller countries experience.

I used google translator to translate the essay into english.  Here is the full translated essay, emphasis mine:
Slovakia's efforts to join the euro area have been motivated by the prospect of a stable currency and solid rules. Specifically, I referring to the Maastricht criteria (in particular the maximum three percent deficit), Article 125 of the Treaty of Lisbon (every State shall be liable for its obligations alone) and the internal rules of the European Central Bank (redeem bonds Member States). I remember well how "strict guardians of Lithuania adopted the euro because the reference year exceeded the deficit by 0.07 percentage point. I also remember how Miklos trained first and then the beginning. Everything is quiet and we strpeli kvitovali also convinced that we will become members of the association, which comply with the rules.
Today, two years later, unfortunately, I have to say that the rules apply equally to all, or currently do not pay at all and that the proceedings of the European Commission is the responsible approach properly far. Already "rescue" Greece is mainly about saving the profits of foreign banks. Greeks have lived 30 years beyond their circumstances, because they ruled irresponsible socialists who they recently ruled us, and banks to earn it fair that you charge a premium on the interest for possible insolvency. Ireland is a similar case, with the only difference being that the banks decided to play the casino and real estate bubble inflated. State supported them in that, initially weakening control mechanisms and state guarantees. 
Responsible approach eurozone leaders would let banks share the outages incurred and not "produce" more and more new money that the ECB buys bonds of the Member States. It is irresponsible to other Countries' debt extended by eurovalu countries themselves and thus were into trouble. This way you can save Greece and Ireland, Portugal can be. Try the following to "save" Spain is gambling with the euro, let alone Italy. Italy's debt is higher than half the debt of Greece, Ireland, Portugal and Spain together.
Therefore it is high time, Slovakia ceased to blindly believe chatter area leaders and prepared a plan B.This is a reintroduction of the Slovak koruna. When we're too small a country to have a significant impact on the EU to act, we must at least protect the value created and composed of people living in Slovakia.

Source HERE.

Although Slovakia is not a large member of the EU by any means, and exiting the Euro is a logistical and operational nightmare, open challenges to the "benefits" of EU membership are not to be taken lightly.  They are indicative of a lack of EU leadership and of conflict and distrust amongst fellow EU member states.

I'm expecting more of this in the future.

Meanwhile, the issue of a Euro Bond is still being hotly debated with little apparent agreement amongst the larger EU members.  In my recent posts about the evolution of fiat money, I tried to describe the two approaches that are being taken: one by the US and the other by the EU.  The EU was difficult to assess, and that remains so.  Why?  There is absolutely no clear leadership in the EU.  EU policy is ad hoc - much more than US policy. However, the underlying issue: the exponential growth of unmanageable debt in a fiat debt based monetary system will never be fully addressed until the system collapses.  What we are witnessing right now are pathetic attempts to prop up an unsustainable system that is nearing its terminal phase.

Monday, December 13, 2010

All About Gold

I do not intend to give investment advice through this blog, rather, my intention is to chronicle the end game of the current global monetary system.  Gold, however, is part of this blog's thesis as it is my contention that it will once again be part of the new emerging global monetary system.   This will occur most likely as a reaction to the breakdown of the current monetary system, not as an organized, planned replacement of the current monetary system.  The transition will not be smooth.

That said, Charlie Rose just recently had an excellent interview on gold, and its relation to the current global fiscal crisis and the (mis)handling of fiat money by central banks around the world.  His guests are heavyweights:  James Grant, John Hathaway, and Peter Munk.  Many of my views are well described by Charlie Rose's guests.

Click the image below for the interview on Charlie Rose:

Thursday, December 9, 2010

Economic Collapse goes mainstream, it's no longer an Alex Jones topic. CNBC: Pentagon Prepares for Economic Threats to US National Security

I have reported on this in the past, citing interviews of Jim Rickards.

From CNBC, the Pentagon, through wargame series "Unified Quest 2011" is acting out various scenarios and their implications to national security.  Some include:

"Army studying implications of large scale economic breakdown."

"Would force the Army to maintain domestic order amid civil unrest."

"Army to deal with fragmented global power and drastically lower budgets."

Remember when Ben Bernanke said the issue of subprime was "contained?"  This is not just a subprime issue, it is not just a national budget issue, it is not just  a trade imbalances or currency issue.  It's all of them combined together and more.  And how does such a perfect storm come to be?  It all boils down to the long term implications of debt based fiat paper money.  We are witnessing the end of a global monetary system.  I will soon begin a new series of posts on the real-life implications of the end of such a monetary system.  Such a monetary system creates large distortions in economies, and ultimately, those distortions self-correct on their own.  It's simple mathematics.

Tuesday, December 7, 2010

Jim Rickards on the Gold Standard: "You will either get there smart or get there ugly."

Of all the analysts that I follow, James Rickards is probably by far the one I tend to most agree with.  He approaches the current economic crisis using a blend of economics, monetary theory, and geopolitics.  Most analysts, especially professional economists only focus on one, or at best, try to combine two.

For those that are not familiar with Rickards, here is a snippet of his bio from King World News:
James G. Rickards is a writer, lawyer and economist with over 30 years experience in global capital markets. He is Senior Managing Director at Omnis, Inc., a consulting firm in McLean, VA and is the leading practitioner at the intersection of global capital markets and national security. His advice to clients from 2002 to 2006 included early warning of impending financial collapse, the rise of sovereign wealth funds, the decline of the dollar and the sharp rise in gold prices years in advance of these events. He has held senior executive positions at Citibank, Long-Term Capital Management and Caxton Associates. In 1998, he was the principal negotiator of the rescue of LTCM sponsored by the Federal Reserve Bank of New York. His clients include private investment funds, investment banks and government directorates in national security and defense.

King World News just released an interview with Jim Rickards (link here).  Here is a summary of his most salient points with my own commentary:

1) His central premise, like mine, is that we will ultimately end up with a gold standard.  The question that really remains is: Will the process be a smooth, managed one, or will it be ugly and chaotic?  So far the road we are taking is the chaotic one.  It is obvious in the desperate attempts taken by Fed Chariman Bernanke, the bloated US budget, and continued dollar debasement, among other things.  Keep in mind that there is no real global cooperation, if anything, global economic conflict is the de facto approach to this crisis.

2) If there is an economic collapse or currency crisis, expect US Military operations inside the homeland to maintain domestic order.  Rickards does consulting for the various branches of the US Military and will be delivering a presentation in Arlington Virginia to Senior Military Officers regarding the ongoing economic crisis and how it pertains to them.

But here's the kicker.  Jim Rickards holds no punches when he describes Ben Bernanke's stewardship of the US Dollar and its effect on National Security.  Jim Rickards ends the interview with this, emphasis mine:

"A lot of my clients are in the National Security area so I work a lot with the Department of Defense and you know, the Director of National Intelligence and we obviously spend a lot of time thinking about threats to national security.  And I spend a lot of time in the counter terrorism field and terrorism finance and other aspects of that.  And if I had to rank threats to national security I would rank Ben Bernanke above Osama bin Laden.  Osama bin Laden's capabilities have been greatly degraded... make no mistake about it he is a very serious threat.. but he's on the run.  Whereas Ben Bernanke is not on the run.  He's sitting in a very high office but he's actually a greater threat because of what he is doing to destroy the US Dollar."

Misthos here.  I agree with Richards to a point.  But I also look at it this way:  Fiat debt based paper eventually devalues anyway as the supply must grow to handle the ever growing amount of debt in the system.  Bernanke is actually doing the only thing he can - outside of trying to convince the US government to institute a gold standard.  Bernanke's actions are thus unavoidable.  Has Bernanke also served the interests of Wall Street better than any other segment of the US Economy?  I say yes.  But we must separate the moral issues (banksters raping the country for fat bonuses) with the mathematical issues (debt based fiat creates trade imbalances and unserviceable debt overhangs).

3) Rickards also does some basic math - comparing the current monetary supply, based on different approaches, with official gold reserves to arrive at a gold price that is much higher than it is today.

I have covered this line of thinking in the past in my post: Gold will be a bubble until it isn't.  In that post, I argue that when a gold standard comes about, sovereigns will price gold well above the current market rates because to do otherwise would be highly deflationary.  Thus, the gold "bubble" does not end in a mass exodus out of positions, but it ends on a somewhat fixed price due to official Sovereign  involvement.  Remember past bubbles like tulips, real estate, and dotcom stocks?  Which of those bubbles involved a commodity or security that was held as an official reserve by sovereigns?  None.  Only gold and currencies are held as reserves, so you can't expect gold to end as real estate or dot com stocks did.  There's a reason Central Banks and Treasuries around the world store gold.  For those that understand history, that reason is becoming more apparent every day.

Saturday, December 4, 2010

Don't Forget, We Have Already Recently Stared Into the Abyss

Many of you have already seen this clip, but I still believe it is worth remembering.  As you may recall, the current (ongoing) crisis flared up in the Fall of 2008.  US Congressman Paul Kanjorski, who then held the Capital Markets Subcommittee Chair, describes in this interview the chain of events that transpired in 2008.

Recall, the Fall 2008 crisis was about buying up subprime mortgages and stopping the derivatives market from imploding, and taking down the entire global financial system.  But recently released information (The Fed's global lending spree of $3 trillion) tells us that things were much worse.  And now, we no longer are faced with just a mortgage crisis, or a banking crisis, but a sovereign crisis.

I bring this clip up for those that have not seen it before, and as a reminder to those that have.  But there is one more reason I bring this up.  How is Europe reacting to its crises?  Is there really a focused crisis management policy, or are European leaders reacting to both the crisis and the competing interests of its member states?

Thursday, December 2, 2010

Is China Preparing for the Ultimate Fiat Collapse by Grabbing All the Gold It Can?

In a prior post: China Gold demand to likely surpass India in 3-4 years, I speculated:
"China still has the gold bug. Here's an article confirming the widely held view that China is accumulating gold in a manner that does not upset the markets. It is buying from internal production (its own mines), and it has been encouraging its people to buy gold. I call it the unspoken Chinese "get that gold within our borders and we'll figure it out later" gold policy.
Well, from Bloomberg today, emphasis mine:
China Gold Imports Soar Almost Five Fold on Inflation
China’s gold imports jumped almost fivefold in the first 10 months from the entire amount shipped in last year as concern about rising inflation increased its appeal as a store of value, said the Shanghai Gold Exchange.
Imports have gained to 209 metric tons compared with 45 tons for all of 2009, Shen Xiangrong, chairman of the bourse, told a conference in Shanghai today. The country is the world’s largest producer and second-biggest user.
Even the Chinese government is pro-gold accumulation, and is fostering this policy with new rules. The article continues:
Relaxed Rules
China’s plans to relax gold trading rules may boost demand and increase trading volumes on the Shanghai Gold Exchange, the bank said.
Gold imports this year by India have already exceeded 2009 levels as consumers boost jewelry purchases, the World Gold Council said Nov. 17. Imports totaled 624 metric tons by the end of the third quarter, compared with 559 tons in all of 2009, according to the London-based industry group today.
“A possible interest rate hike in China won’t damp Chinese investor interest in gold,” the Shanghai exchange’s Shen said. “Even if China adds 50 basis points, it would still be a negative interest rate environment given inflation is running at more than 4 percent.”
Behind the multi trillion paper currency bank and sovereign bailouts, behind the broken price discovery mechanisms affecting markets around the world that are erroneously telling us that all is well, there lies a quiet but giant race to gold. The unavoidable fiat collapse is accelerating, and so too, is the sovereign race to accumulate gold.

Ron Paul on the $3+ Trillion Global Bailout by the Federal Reserve

Ron Paul, being honest as usual...

He also says he is making the assumption that he will be the chairman of the House Financial Services Committee, which oversees the Federal Reserve. Let's hope so.

The global banks and the Federal Reserve make the former USSR's command economy look like amateur economics.  These Banksters know how to command and control an economy, and unlike their former inspirational comrades of the USSR, they're not happy to just reside in some dusty dachas either.  These guys have more ambition and motivation for acquiring bling at any cost (private planes, yachts, multiple homes), than gangsta rappers ever had.

Wednesday, December 1, 2010

The Euro: Après moi le déluge

(This is a continuation of my Part III of my Fiat Evolution Series.  Due to my schedule I did not post the final part of that essay, and to be honest, I am still torn as to recent developments and my view of the Euro's ultimate fate. The best I can do is describe the two paths the EU faces)

The expression "Après moi le déluge" has been attributed to the King of France, Louis XV.  I think it is an appropriate expression to describe the possible breakup of the EU due to a failure of the Euro.  The expression, loosely translated, means: "After me, the flood."  Louis XV was a fiscal disaster, and he knew it.  The Treasury was in a shambles, and it has been said that the expression: "Après moi le déluge" was uttered by him to describe the day of reckoning that awaited France.  Fifteen years after his death, the French Revolution broke out, and his  successor and grandson, Louis XVI met his fate with the guillotine.

I make this analogy because at the beginning of Louis XV's reign, he was very popular.  Debt splurges often have that consequence, the times are great.  Consumption increases, people work, money flows.  But then, there is always a day of reckoning.  I have written about this in the past:  That the Euro, based on debt, allowed for extreme imbalances in consumption and trade surpluses to develop.  Lifestyles in the periphery nations improved, and the economies of nations such as Germany became models for the world to follow.

But it was illusory, as all debt based pyramid schemes are.  And now we find ourselves with extreme debt levels in violation of the Maastricht treaty - across the board, and extreme trade imbalances that hinder any rebalancing or growth.

So what does that mean for the Euro's evolution?  In the beginning of this series I mentioned that the EU wants the Euro to "act like gold."  That is, they wanted to control its creation through controlling governments' debts, they mark to market their gold holdings quarterly, and they put in place strict deficit guidelines.  This is in marked contrast to the US Dollar fiat policy.

As we are seeing now, Euro stewarship was a failure.  However, I hold the Banks more accountable than the governments.  Banks always control money through their decisions to lend.  That is what Banks do - it is their business to measure risk and lend accordingly.  Well, they failed to measure risk accurately.  All of them.  And now, due to the Banks' pivotal role in the monetary system, the Banks will not pay the price of rampant irresponsible lending, the people will.  And loss of sovereignty will follow.

These are not national bailouts.  They are Bank bailouts.  Let's be clear about that.  Just as in the US, QE2 is a masked Bank bailout as well.

And so, the Euro faces two paths:

Path One - Austerity

This is the path that has been taken to date.  It is a return to fiscal responsibility, and a return to make the Euro what it was intended to be: a strong reserve currency challenging the dollar and unifying Europe.  But will austerity succeed?  Will making the Euro act like gold, in a competing for devaluation fiat world, keep the Euro alive?  I'm afraid not.

Beneath the title of this blog is a quote by Austrian economist Ludwig von Mises:

"There is no means of avoiding a final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency system involved." - Ludwig von Mises

What von Mises describes are two scenarios that follow a period of extreme credit growth.  The EU, with austerity, is following the first approach, the US with QE2, is following the second path.  The first leads to immediate depression, the second to ultimate currency collapse.  Those are the choices, those are the two corresponding outcomes.

Austerity will be a political failure.  Why?  Because austerity ultimately socializes irresponsible bank and government losses on the people.  And not just any people, but the "little" people the most.  These are the people that protest and riot.  The political repercussions can not be underestimated.  And like the aftermath of Louis XV's reign, there will be an uprising when the "little" people feel the pain.  I'm not saying it will be as extreme as the French Revolution - and I hope not.  But the real concern here is that the anger of the populace will lead to the disintegration of the EU, and thus, the end of the Euro.

The economic repercussions of the end of the Euro would be catastrophic.  All sovereign debt markets will be suspect.  Interest rates would skyrocket, and economies, faced with flat or minimal gdp growth can not handle high interest rates.  It's a basic question of mathematics.  How can a country successfully manage it's debts if the interest rate on its bonds post Euro is 9-12%, but its GDP is .5-2%?

Path Two - The EU follows the US Fiat Model.

As I described in Part I, the US has revolutionized (in a bad way) fiat money.  With QE and trillion dollar deficits as far as the eye can see, money creation has been taken to a new level - without the limitations of risk measurement that the private banking sector faces.

But in order to do this, the EU needs a central Treasury to work with the ECB, and what follows, is an EU wide income tax, just as the US has.  See Part I on why the Fed was created at the same time as the Federal Income Tax.  Is Europe politically ready for such integration?  And how long can such a fictitious monetary system last?  A commentator on this blog, Dave Narby posted a quote from Greg Hunter:

"If a country could simply buy its own debt with zero downside, I say we should have been doing this all along."

Makes sense, right?  But what happens when every country on earth, as surely they will, follows suit?  The entire global financial system will end in a crack up boom as governments compete to placate the needs of their oligarchs and general populations.  You think there is a currency war now, well, Fiat in extremis, done globally, would be the WWIII of currency wars.  Gold would be in the six figures in no time!

But there is one more final path.  Well, not exactly a fiat evolutionary path, as it replaces the Euro and changes the Euro area.  It's the disintegration, or possibly splitting up of Europe.  Disintegration as a policy is highly unlikely.  No one wants to end the EU.  But a splitting up of the EU into two currency zones would be something I would not rule out.


The central thesis of this blog is that fiat money will be replaced by gold, in some form, after a period of chaotic defaults and geopolitical conflict.  Currencies and Credit will face so much distrust that the market and governments will be forced to rely on gold, as it is not manipulated, and is not someone else's liability. I wanted to describe the final evolution of fiat before the system ends.  These are the days that policymakers globally, are scrambling and implementing policies ad hoc to stop the debt dam from bursting.  From what I am seeing.  No real solutions have been implemented that address the underlying causes of this global financial crisis, only  temporary band-aids that delay the inevitable.

Think about it.  Since this crisis began in 2008, multiple explanations have been given as to how it came about:

First, many said "No one could have predicted this."  And then, it was blamed on greedy subprime homeowners, and so it was "contained."  Also blamed were consumption motivated credit card users.  Well, that didn't last long.  So it was the greedy banks and the derivatives market.  Which morphed into bad fiscal policies enacted by irresponsible nations like Greece.  And now under attack, are the pensions promised to seniors.  If we constantly change who to blame, do we really understand what is going on?

Has anyone in government or central banking addressed the underlying issue - that all debt based monetary systems, due to the exponential growth of interest, ultimately end?   I wrote this yesterday on a message board from Market-Talk, a very good greek financial blog, as part of a debate.  I repeat it here, sorry for the poor grammar, as it was written in haste:
People do not understand what money is. Money is created through debt. Debt needs to be created for money to be created.
It is basic double-entry book keeping. Anyone that has taken an accounting course should understand this concept.
In double entry book-keeping, one entity’s debt is another’s asset. For example, let’s look at the relationship between Germany and Greece. German Banks lent money to Greece. Therefore, Greece has a liability, that is, they owe money to German Banks, and German Banks have an asset - they own a Greek debt that pays them interest.
If you forgive the debt, you destroy the asset. The two co-exist. Now how healthy are German Banks? French Banks? Can they handle a debt write down of Greece? of Ireland? What about Spain? In the end, who is really getting bailed out in Greece?
European banks are a mess. I remember watching Jim Cramer on CNBC in the US. He was explaining how he worked a desk in Wall Street and how they bundled debt. He said when a debt salesperson had trouble selling bonds, they would say: “Sell it to the Germans, those idiots will buy anything.”
That’s what happens to countries that amass a large trade surplus at the expense of everyone else. They accumulate so much money, all they can do with it is buy the risky debts of their trading partners. Look at China, how much US garbage debt do they own? Suckers!
But if you look at the big picture, debt accumulates because of interest. Whereas in the example above, say Greece received 100 million Euros from a German Bank. Well, 100 Euros were created. But you know what? That German bank wants 100 Euros plus 5.5% per year interest back.
So in a debt based system, the amount of debt in the system always outgrows the amount of money available to service that debt. 
No monetary system is permanent. The current monetary system began in 1971 when the US went off the gold standard. The post WWII monetary system called Bretton Woods ended when the US effectively defaulted on its gold obligations. Yes, the US has recently defaulted.
The current system arose from that default. The current system is 100% debt based. That means money is not convertible and can expand exponentially - far larger than the value of underlying assets in the system.
If all monetary systems have an end due to the exponential growth of credit in the system, then I submit that the current 100% debt based monetary system we have today will also end. But its end will be the most catastrophic of all as it relies on credit more than any other monetary system that existed before.
It’s not a Greek thing. It’s not even an EU thing anymore. It’s basic mathematics. It’s a pyramid scheme that has reached its apex.
Game over

So long as governments ignore the real causes of the crisis, the unfortunate train wreck will continue.

Tuesday, November 30, 2010

Fiat Evolution Part III

In Part I, I discussed the emerging US Fiat Model, and in Part II, I described the emerging EU Fiat Model.  But as the current Euro crisis plays out, we may see the EU following in the footsteps of Ben Bernanke - that process is unfolding right now.  The overall theme of this series of posts is that we have entered a new era.  An era of fiction, an era of success without failure, of backstops and bandages.  It is an era of suspended disbelief; of delaying a cruel and unavoidable reckoning of reality.

Things will look as they always have.  Most people will sense something is amiss, but will never fully appreciate the sea change that is occurring.  Policymakers will temporarily succeed in creating an atmosphere of business as usual; that things are OK and we'll get through it.  They will temporarily succeed, but long term, their failure is certain.

The Sovereign Bond Markets are Dead; Long Live the Sovereign Bond Markets!

Historically, sovereign bond markets have been a source of funding for government activities.  This remains true for the individual EU member states, but not for the US Federal Government.  Unlike the EU member states, the US issues its own free floating currency and denominates its debt in its own currency.  So if the US needs money, it prints it, or in modern times, a keyboard stroke credits an account.

But the US maintains a bond market to control the amount of money and influence the cost of money in the global financial system.  By having the world reserve currency, the US must continually create money to keep up with the growing world economy.  This has been described as the "exorbitant privilege," that is, to a degree, the US can export its inflation and get a free lunch in the process.  Other countries can not do this.

The Primary Dealers which are the Commercial Banks (which ares also shareholders in the Federal Reserve System) always make sure that US Government debt is purchased.  They pick up any slack, so to speak.  Thus, and I want to make this clear, there will never be a failed US Government auction!  So not only does the debt not finance US Government spending, but the system is created so that the debt is always sold.  Always.

As I mentioned in Part I of this series, QE2 is really a replacement of a normal, healthy, functioning private banking sector and a normal, healthy, functioning sovereign bond market.  The US never really relied on foreign bondholders such as China to finance it's debt. (See my post Part I)  Furthermore, the interest the Federal Reserve now accumulates from Treasury purchases is mostly returned to the government.  The US government is essentially receiving an interest free "loan."  This is turn affects all interest rates, so in a way, yes there is a free lunch.  But that too will end. I will explain below.

The EU, on the other hand, is in shackles.  Each country needs to go to the sovereign bond market as a begger.  And if the sovereign bond market doesn't like the way the government is managing its budget, the interest rates soar.  And so, we have seen Greece and Ireland backstopped by the IMF, EU, and ECB.  There will be more.  Portugal is likely next, and Spain isn't too far behind.

Thus, the Sovereign Bond Market in the Western World at least, is dead, but it is also still "functioning."  It is a walking zombie, or a comatose patient on life support.  It is dead in the US because without the Federal Reserve buying up Treasuries from the Primary Dealers, there would be a failed auction.  The Federal Reserve is now the largest holder of US debt.  Fiat money in the US has now evolved into a complete fiction.  The housing industry, and soon to be state budgets, will all be supported by a fictional monetary system controlled by the Fed.  Price discovery?  Please....  There is no such thing.  Jim Rickards recently addressed this:

The Sovereign Bond Market is just about dead in the EU, because without the IMF, EU, and ECB, there would be a flood of government insolvencies and European-wide Banking collapses.  The ECB has been actively trying to keep rates low by buying up government debt by, you guessed it, creating money out of thin air.

And so, Sovereign Bond Markets are a fiction.  They are on artificial life support and will remain so until the system collapses.  And no one is admitting this!!!  Here's an example of a typical politician/economist's rhetoric :  Greek Finance Minister George Papconstantinou recently said that the extension of the repayment period of IMF/EU loan funding would allow Greece to go to the international markets for funding next year.  What is he smoking?!!!  Greece's debt to GDP percentage will be much WORSE next year.  Does he believe that Greece will get an interest rate below 9%?  And I'm being optimistic with the 9% figure.

If your GDP grows less than the interest on your debt, you are INSOLVENT, or soon to be.  Think about it.  If your debt is growing at 6% (if you're lucky), but your GDP is growing at 2% (if your're lucky) how do you think that story will end?  Do these economists own calculators?  Do they understand the laws of mathematics?  But this isn't a Greek thing, it affects Ireland, Portugal, and soon Spain, and maybe even France.

The US and Modern Monetary Theory - Avoiding the Laws of Thermodynamics

There are many out there that smugly preach that the US will never have a failed auction, and thus, things are just peachy. Many describe themselves as Modern Monetary Theorists (MMT'ers) They have a right to be smug because they are some of the few people that understand how the US system actually works. Most others are clueless. Many have been right about this crisis, but for the wrong reasons.

But what the MMT'ers ignore are the geopolitical consequences of basing your monetary system on a "free lunch" paradigm. They also ignore the convenient fact that the US has the world's reserve currency - for now. I mention this because MMT'ers think in a sterile, economic environment. By ignoring the geopolitical consequences of such a monetary system, they ignore the ultimate end game. That's why I like to focus this blog on the " interwoven fields of geopolitics, economics, and monetary theory" as I write in the intro to my blog. Because that's how the real world works.

So what do I mean by the geopolitical constraints of a monetary system? Well, let's forget how money is created for a moment. Let's look at why we have money. Money is used to allocate the world's resources - who gets what and why. Money is used to build armies and fight wars. Money is used to control others. So the more money you can create, the more you can consume and control, compared to others.

Guess what? China and Russia know about the US's dirty little secret. They understand that having the world's reserve currency gives the US an economic advantage over them. They also understand that QE2 is the next phase of the evolution of Fiat Money that gives the US the ability to continue business as usual despite skyrocketing budget deficits and a national debt that will never be manageable.

And what is China and Russia doing about it? They are increasingly ignoring the US dollar. They are entering into non-dollar denominated bilateral agreements. They are openly challenging US economic hegemony. They are calling for the end of the US economic free ride. I write about this in more detail in my post: The Next Largest Nuclear Powers, China and Russia, Openly Challenge US Economic Supremacy.

Thus, the US debt-based paper dollar will likely meet its end through geopolitics, not a failed government auction, as most believe. MMT'ers completely ignore this variable in their analysis.  My belief is that things will get extremely complicated within the next two years.  Current geopolitical bullying evidenced thru the North/South Korean confrontation and the closer ties between Russia and Germany, and Russia and China, tell me that the process to a new monetary system is accelerating.

The EU is an Utter Clusterfuck - The Two Roads to Hell

(sorry due to time constraints, to be continued tomorrow!)

Saturday, November 27, 2010

The Next Largest Nuclear Powers, China and Russia, Openly Challenge US Economic Supremacy

Two very recent developments have transpired that I think warrant mention. I will be incorporating these developments in my Part III of my Fiat Evolution series. But as this blog has always emphasized: it is geopolitics that in the end, will determine the next monetary system. Will it be through geopolitical cooperation or conflict?  That's the question.

We have all seen the many photo ops at the recent G20 Summits, the empty promises, the fake smiles, the multitude of pronouncements of "lofty goals" etc.. But now that the most recent G20 Summit is but a couple weeks behind us, China and Russia are openly challenging US Economic, and by association, US Military, might. Keep in mind that the US has the world's reserve currency. It prints money with a lot less inflationary impact that other countries would normally face. Why? Because the US Dollar by far, is the most used international currency in global trade. This actually REQUIRES that the US print excess money to keep the global economy growing. But it also creates the Triffin Dilemma: the US needs to also consistently run trade deficits in order to "export" its dollars. That is not a sustainable model, as trade deficits cannot mathematically run forever.

But back to the open challenges to US Supremacy, first, from Bloomberg:

PBOC Researcher Calls on U.S. to Sell Gold Reserves, People's Daily Says
The U.S. should cut its government spending and sell some gold reserves to balance its budget and fund its recovery, the People’s Daily overseas edition reported, citing Xia Bin, an adviser to the People’s Bank of China.
The U.S. has to resolve its “twin deficits” in the government budget and the current account, Xia was quoted as saying. Three ways that may help the U.S. achieve that target include reducing military expenses, selling part of its gold reserves and relaxing some export limits on technology, he said.
“The U.S. has more than 8,000 tons of gold reserves; why can’t it sell some of it since the country wants to raise funds for economic recovery but doesn’t want to add more burden to the fiscal deficit,” Xia told the newspaper. He didn’t mention whether China would be willing to purchase any gold from the U.S.
So let's translate this.  China is basically telling the US to 1) sell its gold reserves, 2) reduce its military, and 3) give China more access to its technologies.  Now I know that this comes from an advisor to the People's Bank of China, but to me, it is not some last minute random trial balloon.  This is real.  China is openly questioning the US's role in the world, and by association, questioning the US Dollar's role.  China is speaking to the US the way Germany lectured Greece earlier this year.

This is cause for concern.  We are speaking about a rising power challenging the current (let's face it) Imperial Power.  Rome was just told to step down!  This amidst the recent North/South Korean confrontation, the yet to be fully explained "missile launch" off the coast of California, and the Russian/Chinese deal to omit the US Dollar from their trading.

To me, these events are all tied together (with the possible exception of the recent "missile launch" that has yet to be officially explained).  There will be no global cooperation in a transition to a new monetary order.  Sarkozy will lead the G20 next year as France assumes the G20 presidency.  But it will be pointless, he is no de Gaulle, and the world is becoming increasingly fractured.

And now, this from Russia:

Vladimir Putin said it is "quite possible" that Russia will one day join the eurozone and create a currency that would eclipse the US dollar as the global reserve standard.
Speaking at a conference in Germany the Russian prime minister, who is in the country for talks with Chancellor Angela Merkel, said he was convinced the euro would stabilise and strengthen despite the current sovereign debt crisis.
He said: "Yes, there are problems. But the economic policy of the European Central Bank and of the governments of leading European economies ... convinces me that the stability of the euro will be ensured."
He added: "We know there are problems in Portugal, Greece, Ireland and the euro is wobbling a bit. On the whole it is a solid, good currency and it should take its place, its role as a reserve currency."
Speaking at the same event, Josef Ackermann, chief executive of Deutsche Bank, echoed Mr Putin and said he could imagine Russia joining a common European currency.
Now this is a little more complicated.  What is the goal of this pronouncement?  Is Russia trying to jab at the US Dollar, and the US's role in having the world's reserve currency?  Is Russia giving an open vote of confidence to the flailing Euro because it has so much at stake in the Euro?  Does Russia want to someday merge economically with Germany - one is rich in natural resources, the other in manufacturing know-how?  I say it's all of the above.
And so, we are facing a world that seems to me to be lacking order.  These are the times that history shows are watershed events.  There are only two outcomes here in classical geopolitical theory:  1) Either the existing  hegemon reasserts its power or 2) a new hegemon assumes leadership.  Neither scenarios occur peacefully.  I am not saying that a major war is at hand.  But I believe that we will be witnessing proxy wars in the near future.  Look to Iran, North Korea, and Venezuela.  They seem to be the next battle grounds.
And what does this mean to the current monetary order?  As conflict escalates, and the US Dollar is used less in foreign trade or is continually openly challenged or avoided, the US will be faced with a decision: to deploy its guns or gold, or both.  Nations store gold and weapons for a reason.  Historically, the nation with the most guns and gold wins.  But Russia is the one that can tip the balance here, as it has increased its ties to both China and the EU.  In my view, a gold backed dollar is not out of the question.  The US is becoming increasingly alone, and its paper money is being questioned.  Once one country goes the way of gold, all else are forced to follow, as all fiat money immediately collapses with the reintroduction of gold.
Which will the US deploy?  

Friday, November 26, 2010

Part II: The EU Emerging Fiat Model

In Part I, I addressed what this series of posts will focus on, and how the US Fiat model is currently evolving.  It has completely diverged from the private sector debt growth model that was created after the end of Bretton Woods in 1971.  I think it's important to keep in mind the economic ramifications of such a debt based model.  It fundamentally changes the banking system as laws are re-oriented (financial de-regulation, to be exact) to strengthen the financial sector.  The economy too, is thus fundamentally changed.  It migrates from a production based to a debt based consumption and speculative (ponzi model) economy.  This also affects the power structure of a nation - financial interests assume a greater role in government policy.

Some EU history

After Bretton Woods, Europe too fundamentally changed.  No longer would their dollar surpluses be exchanged for dollars, but Treasury debt.  The cold war was still raging and there was an implicit agreement amongst the Western nations.  The USSR was a threat, and Europe and other nations would buy US debt instead of exchanging their dollars for gold, in return for US "protection."  That would be NATO and the US military in general, of course.  The rest of the industrial world, as well as the Middle East, would be basically financing America's Military.

This arrangement also had the effect of allowing Europe to increase its social safety net - its expansive government benefits.  Europe didn't need to spend as much on military matters, as the US, in that bipolar  USA/USSR world, was their protector against the USSR and the Iron Curtain.  Western Europe didn't exactly get a free ride, don't forget, their accumulated surpluses were exchanged for US government debt.  Foreign Reserves/Balance sheets no longer focused on the accumulation of gold or gold backed money - which is an asset with no counterparty reliance, but now surplus gained thru trade was exchanged for US (and other countries') debts - someone else's liability.

And thus, as surpluses grew through global trade amongst the Western Industrialized world, so too did the other side of the balance sheet - liabilities.  Or as non-economist types would call them: debts.  The game became debt based.  Debt equaled consumption and wealth.  Don't get me wrong, it always had to a degree, but what changed was how nations keep "score" in global markets.  Debt was good and sought after.  Global wage arbitrage and central bank manipulation also kept debt cheap as inflation was kept in check by increased trade with what we used to call the "third world," and interest rate manipulation by central banks.

The EU, after decades of limited political integration successes, decided on a grand experiment: monetary integration, the European Monetary Union (EMU) thru the Treaty of Maastricht.  And thus, in the 1990s, the exchange rate mechanism (ERM) was born.  Before the creation of the Euro, EU member currencies would have to trade within a narrow band.  Or as someone described the process: the various EU currencies would be dancing to the drum of the Deutsche Mark, the strongest currency in the group.  Speculators did their best to knock off these currencies from their narrow preset price ceilings/floors.  George Soros' war on the British Pound was one famous example.  He successfully knocked the pound out of the ERM.

Some have even speculated that Soros was doing the bidding of others - others more powerful than him that did not want English EMU with the continent.  but I digress...

The EU Grand Experiment

But enough of the history, the best way I can describe EMU is that it requires the Euro to act as a gold standard of sorts.  It's not officially backed by gold, but gold reserves are marked to market, and stringent guidelines are set that dictate allowable member states' debt levels.  It was not enough that the member states' currencies had to maintain price stability before EMU integration, but that their respective governments needed to have manageable debt levels as well.  And so, paper money was to be as scarce yet as valued, as gold.  From Wiki:
Annual government deficit:
The ratio of the annual government deficit to gross domestic product (GDP) must not exceed 3% at the end of the preceding fiscal year. If not, it is at least required to reach a level close to 3%. Only exceptional and temporary excesses would be granted for exceptional cases.
Government debt 
The ratio of gross government debt to GDP must not exceed 60% at the end of the preceding fiscal year. Even if the target cannot be achieved due to the specific conditions, the ratio must have sufficiently diminished and must be approaching the reference value at a satisfactory pace.
But there was a problem:

Quite a few member states, in order to enter EMU and adopt the Euro, lied about their debts. Yes, some lied more than others, but the fact is, the foundation of EMU, from the get-go, was a farce.  But what's even more important now is that they are just about all in violation of Maastricht.  Remember the 60% government debt to gdp, and 3% of gdp budget deficits?  Here are statistics for last year:

The top right hand box is where a nation does not want to be - these are the countries that are in violation of Maastricht.  Quite a large club, no?

And so the EU faces a crisis.  But it is not just a crisis of complying with a Treaty from 1991, it is an actual solvency crisis.  The bond vigilantes are out in full force.  And yes, at times, it seems like they go away, but overall, they are acting the way markets should act.  That is, when economic policymakers can not succeed in keeping their countries solvent and economically viable, the market will punish them with high interest rates.  The party is over.

Making Paper Act Like Gold

So how is fiat money evolving in Europe?  Well, as I explained in Part I, the US is saying to hell with deficits, and to hell with debt monetization - if fiat money is a fiction  that can be created with a keyboard stroke, we'll just keep creating more and more of it.

Europe, on the other hand, is trying to recreate and maintain the initial goals of EMU and the Euro. They want it to act like gold.  They want their currency to be strong as opposed to the US Dollar.  But you know what?  Ironically, that policy will just ensure that the fiat Euro dies before the fiat US Dollar dies.

You know why?  Because austerity is worse than the gold standard.  It's a question of timing.  Think of it as overeating for years.  Not only do you gain weight, but your stomach expands, requiring more food to fill it.  You get hungrier more often.  Europe has been accustomed to a certain level of debt and a certain level of debt growth.  To throw Europe on a starvation diet not only accomplishes the intended goal of losing weight, but it also has unintended consequences.  You will have one pissed off and at times, weak patient.

Austerity has real consequences.  It has societal, political, and economic consequences - all destabilizing.  One only needs to read the paper to see that Europe has become a continent of weak governments, enraged citizens, and economies suffering debt destruction/depression.

And so Europe's Fiat Model is taking the gold path without a gold revaluation - which in my opinion is extremely deflationary.  That's why the US Dollar isn't tanking against the Euro post QE2.  Either you have a gold backed currency or you don't.  Period.  You can't make paper act like gold after the fact - that is, after a decade of extreme fiscal irresponsibility!  If you want gold, then revalue your currency - accordingly.  Otherwise this is what you will accomplish:

But before I say that Europe will definitely commit the suicide of its currency, I want to mention a recent development.  I always keep an open mind, because facts are always changing.  My overall opinion is that fiat will end and gold will resurface as official money in some way - by default, not by plan.  But it's the path(s) taken that may change.

It is becoming increasingly obvious that the fund the EU set up for addressing potential sovereign defaults, the EFSF rescue facility, is inadequate.  Spain is the "elephant in the room" as Nouriel Roubini recently put it.  And so, from The Irish Times:

ECB shift from lender of last resort casts doubt on independence

"THERE HAS been a most profound change in the European Central Bank’s (ECB) approach to monetary policy over the last two weeks, produced in great part by the financial crisis in Ireland.

This change has involved the ECB running for cover from its role of lender of last resort to the euro zone banking system, and in turn seeking some assistance from the European Commission with respect to co-insuring its lending to the banking system."

Full Article HERE.

And also from ZeroHedge:

Die Welt: EU Commission Is Considering Doubling Size Of European Financial Stab [sic] Fund

And so, even though this series of posts is about the two paths of Fiat Evolution, the EU may soon find itself so overwhelmed, that it may take on the US path.  I'm not saying it is a certainty, but it is possible.  As I said earlier in this article, the current EU path of handling fiat money is destined to fail before the US path does.

In the final part, which I hope to post next week, I will compare the two systems in greater detail and make some forecasts.

Happy Weekend.