Memories - of 2012 and 2007

by Doug Noland

November 21, 2014



Draghi and the PBOC throw gas on a fire.
.
November 21 – Reuters (John O'Donnell and Eva Taylor): “European Central Bank President Mario Draghi threw the door wide open on Friday for more dramatic action to rescue the euro zone economy, saying ‘excessively low’ inflation had to be raised quickly by whatever means necessary… ‘We will continue to meet our responsibility – we will do what we must to raise inflation and inflation expectations as fast as possible, as our price stability mandate requires of us,’ Draghi said… ‘If on its current trajectory our policy is not effective enough to achieve this, or further risks to the inflation outlook materialise, we would step up the pressure and broaden even more the channels through which we intervene, by altering accordingly the size, pace and composition of our purchases.’ ‘Draghi all but announced that the central bank will step up monetary easing soon. Mr Maybe has become Mr Definitely,’ said Nick Kounis, an economist with ABN Amro. …Draghi's remarks were almost as dramatic as his ‘whatever it takes’ speech in the summer of 2012 with which he pulled the euro zone back from the brink. Having earlier in the week pointed to early signs of improvements, Draghi on Friday said the economic situation remained difficult and the latest business survey suggested a stronger recovery was unlikely in the coming months.”
.
November 21 – Bloomberg: “China cut benchmark interest rates for the first time since July 2012 as leaders step up support for the world’s second-largest economy… The one-year lending rate was reduced by 0.4 percentage point to 5.6%, while the one-year deposit rate was lowered by 0.25 percentage point to 2.75%, effective tomorrow… The reduction puts China on the side of the European Central Bank and Bank of Japan in deploying fresh stimulus and contrasts with the Federal Reserve, which has stopped its quantitative easing program. Until today, the PBOC had focused on selective monetary easing and liquidity injections as China heads for its slowest full-year growth since 1990… ‘This interest rates adjustment is a neutral operation and doesn’t mean any change in monetary policy direction,’ the central bank said… As China is still able to keep medium to high growth rates, it ‘has no need to take strong stimulus measures, and the direction of prudent monetary policy won’t change,’ the central bank said.”

.
In a global financial backdrop I view as the most fragile since 2012, we’ve now seen 2012-style aggressive concerted central bank stimulus measures. It will be imperative to closely monitor the various effects. One of these days, such measures will not have their desired impact. We might be getting close.

Last week I dove into somewhat theoretical “Financial Sphere vs. Real Economy Sphere” analysis. I also often fall back on the “Periphery vs. Core” framework that has been informative in an era of highly speculative markets. So after Friday’s moves by Draghi and the PBOC, let’s this week meld some analysis and segue from the more theoretical to the real.

While the policy responses are similar, there are notable differences between now and the 2012 backdrop. Importantly, following a two-year period of QE-induced “parabolic” global securities market inflation, I am arguing that the global Bubble now has serious cracks (irrespective of monetary stimulus). The S&P500 is at record highs, up almost 64% from June 2012 lows. U.S. investor bullishness is at extreme levels. Those believing policymakers have everything well under control have been repeatedly emboldened. The notion of Bubbles – worse yet, bursting Bubbles – is viewed with contempt and ridicule.

It’s worth noting that the Goldman Sachs Commodities Index is off 28% from 2012 highs, with crude down 30%. Commodities and energy complexes have been crushed, portending serious issues for scores of heavily indebted companies, industries and economies. From early-March 2012 levels, the Russian ruble is down 36%, the Brazilian real 32%, the Argentine peso 49%, the Venezuelan bolivar 32%, the South African rand 31%, the Indonesian rupiah 25%, the Turkish lira 20% and the Indian rupee 20%. I contend the (“Periphery”) EM Bubble has begun deflating, with notable fragility emerging from the likes of Russia, Brazil, Venezuela and others. I expect ongoing contagion.

The global Bubble has entered a particularly unstable phase. Desperate policy measures are exacerbating liquidity and speculative excesses. Not surprisingly, monetary stimulus has it greatest impact where Bubble dynamics retain strong inflationary biases – notably U.S. securities markets, but also stocks, corporate debt and sovereign bonds around the globe.
 
Meanwhile, “hot money” continues to exit faltering Bubbles. Importantly, this dynamic is reinforced by king dollar and the flight of speculative finance into bubbling U.S. markets.

The Treasury reported its monthly TIC (Treasury International Capital) data this past Tuesday. September saw a record $164bn inflow into U.S. “Net Long-Term Portfolio Securities.” I was reminded of the then record $136bn inflow in May 2007. With faltering Bubbles and “hot money” again on the move, we don’t have to look that far back for an insightful example of how aggressive monetary measures (responding to a faltering Bubble) fueled precarious “Terminal Phase” excess.

It’s especially instructive to recall how Bubble Dynamics played out in that fateful 2007/2008 period. The Fed’s Z.1 “flow of funds” data do a nice job. The mortgage finance Bubble was initially pierced in the spring of 2007, as losses on subprime securities initiated a self-reinforcing reversal of “hot money” flows, a tightening of mortgage Credit and waning home price inflation. The Fed slashed the discount rate 50 bps in an unscheduled meeting in August 2007.

Confident that Bernanke was ready with aggressive “helicopter” monetary stimulus, market participant were happy (gross understatement) to disregard ominous fundamental developments and focus instead on lucrative securities speculation.

First of all, the faltering Bubble was readily apparent in rapidly slowing household mortgage borrowings. After expanding at double-digit annual rates from 2001 through 2006, the home mortgage slowdown was apparent by early 2007. The rate of Household mortgage Credit growth slowed to 7.4% in Q1 2007 and was down to 5.0% by Q4.

In nominal dollars, Home mortgage debt expanded $1.080 TN in 2006. Indicative of a faltering Bubble, Q1 2007 saw Home mortgage growth slow to SAAR $831bn, Q2 to SAAR $808bn, Q3 to SAAR $536bn and Q4 to SAAR $648bn. With multi-family and commercial mortgage Credit growth still brisk, total system mortgage Credit growth remained enormous. After expanding $1.416 TN in 2006 (close to 2005’s record), growth slowed to SAAR $1.120 TN in Q1 ‘07, $1.222 TN in Q2, $999bn in Q3 and $992bn in Q4 (compared to 1990’s avg. $265bn).

It’s worth noting that air was also attempting to come out of highly speculative securities markets in 2007. There was a bout of stock market selling during the first quarter and then a much more significant downturn late in the summer, as the scope of systemic fragility began to be better appreciated. Indeed, a necessary de-leveraging had commenced – only to be reversed by Fed stimulus measures.

After expanding $326bn in 2005, $406bn in 2006 and a seasonally-adjusted and annualized (SAAR) $726bn in Q1 2007, the growth in “Fed Funds & Security Repo” (used for securities leveraging) began slowing sharply. Q2 saw growth drop to SAAR $181bn, before turning negative in Q3 (SAAR -$142bn) and Q4 (SAAR -$797bn). After “Security Brokers/Dealers” expanded holdings a record $615bn in 2006 (double 2005 growth!), holdings grew another SAAR $1.145 TN in Q1 and SAAR $826bn in Q2. Security Brokers/Dealers ballooning hit the wall in Q3 (SAAR $42bn) before contracting in Q4 (SAAR -$625bn). Some beneficial de-risking was also apparent in Security Credit. After record expansions in 2005 and 2006, Security Credit contracted slightly during Q3 2007.

I am convinced that desperate policy responses to bursting Bubbles only make things worse.
 
Certainly, the prospect of aggressive monetary stimulus from the Bernanke Fed had major ramifications for the flow of funds and system excess during the second-half of 2007 and into 2008. Importantly, slowing mortgage Credit, a faltering Bubble and the prospect for activist monetary policy combined to throw gas on a powerful corporate debt Bubble. After expanding a blistering 9.6% during 2006, Corporate debt growth slowed to a 9.5% rate in Q1 2007.
 
Growth increased to 10.9% in Q2. And with the market then anticipating aggressive stimulus measures, corporate Credit growth surged to a 12.0% pace during ‘07’s second-half. In gross excess that would come back to bite, U.S. “Corporate and Foreign Bonds” issuance surged to a record $1.256 TN in 2007 (up 46% from 2006 growth).

It’s interesting to recall how the policy response (actual and anticipated) to the faltering mortgage finance Bubble fueled dangerous “Terminal Phase” (“still dancing”) excess throughout corporate finance (issuance, junk, M&A, financial engineering, etc.). Nowhere, however, was the “Periphery vs. Core” Bubble Dynamic more apparent than in the securitization marketplace. After almost doubling between 2003 and 2006, the (largely subprime mortgage) ABS market began to falter in 2007. Following 2006’s record $808bn expansion, ABS growth slowed to SAAR $205bn by Q2 2007 and actually began a painful contraction in Q4. Importantly, serious issues at the “Periphery” of mortgage Credit initially spurred (as market yields sank) rampant “Terminal Phase” excess at the Bubble’s “Core”. In the six quarters Q1 ’07 through Q2 ’08, GSE MBS expanded $924bn, or 24%. Total GSE Securities (MBS and debt) over this 18-month period expanded $1.400 TN, or 21.6%. I believe strongly that this central bank-incited (late-cycle) excess at the “Core” significantly contributed to the severity of the 2008/09 crisis.

Thinking in terms of “Financial Sphere Bubble” analysis, it should be noted that Financial Sector market borrowings expanded 10.0% in 2006, up from 2005’s 9.0%. Subprime and ABS issues were behind a marked slowdown in Financial Sector borrowings during 2007’s first-half. Yet with monetary policy poised to shift into overdrive, the Financial Sector expanded at a blistering 15.8% rate during Q3 2007, powered by the invigorated “Core” (GSEs, MBS and Corporate Bonds).

Credit growth could have – should have – slowed markedly during 2007. Instead, fueled by record “Core” (Terminal Phase) expansion, total system Credit expanded at an unprecedented rate – right in the face of a faltering mortgage Finance Bubble! Total Non-Financial Credit expanded a record $2.540 TN in 2007 (‘90’s avg. $720bn), while Financial Sector market borrowings grew a record $1.795 TN (90’s avg. $497bn). There was, however, a momentous problem: the Credit Bubble was unsustainable. When the overheated “Core” eventually succumbed to the forces of Bubble collapse, the system’s highly inflated price levels (throughout the Financial and Real Economy Spheres) created extreme systemic fragilities. Key risk intermediation processes were discredited (GSEs, CMOs, highly leveraged securities holdings, etc.), which ensured a collapse in private-sector Credit growth.

What pertinent lessons can be drawn from the 2007/2008 experience? First of all, policy measures that extend the life of “Terminal Phase” excess can prove catastrophic. In particular, heavy Financial Sector risk intermediation (2007: GSE, MBS, CMO) play a critical role late in the Bubble cycle, ensuring ongoing Credit expansion – hence prolonging the boom cycle. This capacity to transform high-risk Credit, market and liquidity risks into perceived “money-like” instruments seems virtually miraculous. Moreover, this process is instrumental in nurturing problematic euphoria and complacency. And as things tend to regress into late-cycle craziness, leveraged speculation and “hot money” come to play a decisive role throughout increasingly unstable markets.

Indeed, the stage had been set for very serious problems. When the down cycle’s contagion eventually arrived at the “Core,” key intermediation processes faltered – leaving a highly inflated system extremely vulnerable to a crisis of confidence and Credit collapse. Importantly, when it comes to Bubbles, the sooner they come to an end the better. Systemic risk grows exponentially, a harsh reality that central bankers refuse to acknowledge.

The scope of today’s “global government finance Bubble” dwarfs the 2007’s mortgage finance Bubble. There’s a lot more to lose in this international Bubble and so much more to worry about. Instead of “subprime,” today’s “Periphery” includes tens of Trillions of vulnerable debt encompassing many countries and billions of people. Instead of U.S. prime mortgages and corporate debt, today’s “Core” includes central bank Credit and the greatest securities Bubble the world has ever experienced.

At the “Core of the Core,” historic market euphoria has pushed excess in U.S. equities and corporate Credit to precarious extremes (relative to rapidly deteriorating global financial and economic fundamentals). Concerted global central bank stimulus measures have exacerbated the divergence between inflated securities prices and deflating prospects for global growth and profits. Worse yet, the redistribution of wealth that accompanies the policy-induced inflation of the “Global Financial Sphere” is worsening already alarming geopolitical tensions. Global central banking and “risk free” government debt are at risk of being discredited.

Why would I contemplate that central bank measures might be losing ability to keep the global Bubble afloat? Over recent weeks we’ve seen the concerted efforts of team Yellen, Draghi, Kuroda and the PBOC have minimal impact on the fragile “Periphery.” Even Friday, on the back of Draghi and the Chinese, crude oil gave back much of an earlier 2.6% gain to close the week up only 69 cents. The Goldman Sachs Commodities index was only slightly positive for the week near multi-year lows. Curiously, Italian CDS increased added a basis point this week.
 
Greek CDS traded to a 13-month high Thursday. Eastern European currencies traded down again this week. Data out of Europe has been just dreadful. Ukraine looks dangerous.

The Mexican peso declined 60 bps this week, trading at the lowest level versus the dollar since the summer of 2012. Mexico succumbing to EM contagion would be a major development.
 
Meanwhile, here at the Bubble’s “Core,” this week saw the S&P Homebuilding Index jump 3.9% and the Morgan Stanley Retail Index rise 2.1% (to a record high). Yet there were a few interesting Bloomberg headlines: “Riskiest Junk Borrowers Imperiled as Yields Jump…;” “Munis Facing First Losses of 2014 as Record Win Streak Imperiled;” “Corporate Bond Spread Versus Treasuries Widens to Most in 2014;” “Bond Record in Sight as Sales Near $4 Trillion.” Now that’s something to ponder: A record $4.0 TN of international corporate bond issuance in the face of a faltering global Bubble. Like many things these days, it brings back (bad) memories of 2007.


Notes on Russia
 
John Mauldin
 
Nov 19, 2014

 

Russia and its redoubtable president, Vladimir Putin, have been much in the news lately. The latest flurry came when Putin was taken out behind the woodshed at the G20 conference in the Philippines last weekend over his recent moves to inject more Russian troops and arms into Ukraine.
.
For today’s Outside the Box we have two pieces that deliver deeper insights into the situation with Russia and Putin. The first is from my good friend Ian Bremmer, President of the Eurasia Group and author of Every Nation for Itself: Winners and Losers in a G-Zero World. You probably caught my mention of Ian’s presentation at the institutional fund manager conference where we both spoke last weekend. He had some unsettling things to say about Russia; and so when he followed up with an email to me on Monday, I asked if he’d let me share the section on Russia with you. Understand, Ian is connected, and so what you’re about to be treated to here is analysis from way inside. (He’ll be presenting at our Strategic Investment Conference again next April, too.) 

Then we turn to a piece that my friend Vitaliy Katsenelson published last week in his monthly column in Institutional Investor. I need to preface this one by mentioning that Vitaliy was born in Murmansk, Russia, where he lived until age 18, when his family emigrated to the US. Fast-forward 23 years, and today Vitaliy is Chief Investment Officer for Investment Management Associates in Denver and author of the highly successful Active Value Investing: Making Money in Range-Bound Markets and The Little Book of Sideways Markets. That’s quite a journey, and Vitaliy has some very strong feelings about the country he left as well as the one he came to. In his intro to today’s piece he admits,

[This is] one of the most emotionally taxing things I ever wrote. A few days ago my wife looked at me and said, “When are you going to be done with it; this article is bringing you down.” She was right. 

But I think you’ll agree that when Vitaliy recently subjected himself to a 7-day news diet of nothing but Russian media, the better to comprehend current Russian attitudes, he resurfaced with some valuable insights. 

And I can’t leave our deliberations on all things Russia and Putin without mentioning again Marin Katusa’s new book, The Colder War, which I featured in Outside the Box two weeks ago. It’s a compelling survey of the history and dynamics of world energy markets and the role that Putin seeks to play in them. 

Geopolitically, the world seems to be a calmer place as we head into the Christmas season, with the significant and glaring exception of Russia. And remember, falling oil prices will seriously impact an already stressed Russian economy. 

But before we turn to the eye-opening if somber notes below, I want to share with you a fabulous story from my friend Art Cashin, who is one of the world’s great raconteurs. I make sure to have dinner with Art whenever I’m in New York. In addition to his wisdom concerning the markets, he simply has the best stories. The last dinner (also attended by Barry Ritholtz and Josh Brown) was at an establishment called Sparks, an old New York watering hole and famous steakhouse not far from Grand Central Station. 

Art shared the following story with us and had us in tears. Back in the day, the New York Stock Exchange was a mighty interesting place with a very curious cast of interesting and interlocking personalities. It has calmed down some over the decades, but the stories … well, let’s just let Art tell it. 

For years, one of the communal tables at the Luncheon Club would issue a group challenge. They would all set a target for losing weight by some date a couple of months out. The one who weighed up furthest from their target had to buy dinner for the others.

In 1985, the loser was Maurice (Monk) Meyer of Henderson Brothers. Among the others were Jack (Jackie D) D’Alessandro, Pat McCarthy, Bill Fitzpatrick, and Roger Hochstin.

They decided to turn the event into a sort of a Christmas party and scheduled the dinner for the week before Christmas. They made reservations at Sparks Steakhouse. 

As the day approached, there was an unexpected development. Mafia kingpin Paul Castellano was gunned down, along with his driver, on the sidewalk outside Sparks.

Nevertheless, the show must go on. 

When the fated date arrived, the group decided to meet at the Luncheon Club bar for some rehearsal cocktails. They rehearsed for a couple of hours and then headed for Sparks. 

As they arrived, around 7:00, there were some early hints it might be a bumpy evening. When they walked in, the hostess asked if they had reservations. “Only about the food,” snapped Pat McCarthy. That was followed by the maître d’ asking where they’d like to sit, only to hear Roger say, “In the non-shooting section, please.” 

Once they were seated, they ignored the menu and ordered more cocktails and several bottles of wine. For the next three hours, they ignored the pleas of several waiters and the maître d’ to order some food to go along with the wine and drinks. 

In the meantime, Roger may have been getting bored. He noticed another table with six Japanese men in their twenties and one older man, who looked maybe 60. 

Somehow, Roger found a Chinese takeout menu from Chou Lu in his pocket. He put his napkin over his arm as though he were a waiter and went over to the table of Japanese men and began reading the menu in a form of broken Chinglish that would have embarrassed even the producers of the old Charlie Chan movies. Things like “Pork Flied Lice.” 

Ironically, only the older man spoke English, and he seemed to think it was a wonderful joke. He told Roger that Roger’s table seemed to be having a wonderful time and asked if he might join it briefly. 

Roger brought him over and introduced him around. There was a pleasant exchange for about 15 minutes and then Jackie D asked him where in Japan he came from. They man replied – “Actually, I’m from Okinawa.” Bill Fitzpatrick darkened and said, pointedly, “My favorite uncle was killed on Okinawa by you people during the war.” The man quickly excused himself. 

Pat McCarthy reminded Bill that he had not had an uncle in the war. Jack turned to Pat and said, “That doesn’t matter; Bill went through the barrier about two drinks ago.” 

Anyway, the waiter finally prevailed upon the boys to order entrees by 10:00. Meanwhile, Maurice was sinking fast. He had come out despite a bad case of the flu, since he was the designated payer. It quickly became evident that Meyer would not make it much past 10:30. He called for the check.
 
As they were about to help Meyer to his feet, Jackie D noticed that McCarthy had had his untouched entrée put into a doggie bag. Not wanting to be outdone, Jackie reached down and put his medium rare petite filet in his inside jacket pocket without benefit of a doggie bag. 

At the coatrack, Jackie attempted to help Meyer get his overcoat on. In doing so Jack lifted his own hand high and out. That swept his jacket off to the side, revealing a shirt dripping with blood from the medium rare filet in his pocket. 

Perhaps recalling Castellano’s recent fate, one woman at a table spotted Jack’s shirt and screamed, “My God! He’s been shot!” 

Everybody in the restaurant hit the deck, including the maître d’ and our adventurous group. When everyone got back to their feet, the maître d’ told the boys they were never allowed back – collectively or individually. 

In a huff, the boys headed off to the John Barleycorn. 

Art can go on all night with stories like that. You really should put them into a book, Art.

You have a great week. I am off to the gym, where The Beast will continue to try to whip this poor old body into some similitude of shape.

Your still smiling from all the great stories analyst,
 

John Mauldin, Editor
Outside the Box


Notes on Russia
.
By Ian Bremmer

Nov. 17, 2014

 
the russians are taking every opportunity to escalate an already plenty hostile relationship with the united states and some selected allies. the g20 summit was particularly negative on that front, with russian president putin bringing along some warships to australia, while canadian prime minister stephen harper led a rope line of western leaders calling putin a scoundrel and a liar. putin left early, claiming a need to catch up on sleep and some other business to attend to.
like in ukraine.
 
i had a chance to talk with some senior russians last week, including two advisors to the kremlin. they explained that putin expected his offer of a ceasefire in southeast ukraine would be sufficient to get the americans to tolerate a status quo, while bringing the europeans to the table with some sanctions reductions. that didn’t happen: instead a coordinated harder line policy stayed in place, while the americans and germans looked set to put more sanctions in place unless the russians actively backed down. despite mounting economic pressure on the europeans, the frozen conflict/long game the kremlin was playing didn’t look like it was going to succeed.
 
and so the kremlin moved backed to escalation, dramatically expanding their direct military presence in the region – confirmed by nato and the typically-conservative osce, denied by the russian government – and announcing plans to build up troops in crimea. they’re preparing both sides to consolidate their territory, initially through taking the port city of mariupol...potentially then a land-bridge between eastern ukraine and crimea and beyond (odessa being the most obvious place). the most likely path is the kremlin now looking for provocations to “go further” – they’ve already expressed a level of outrage around the ukrainian government severing economic ties to the separatist region – then the fiction of ceasefire is erased and the russians/separatists take more territory. ultimately, whatever the formalized “governance” structure, the kremlin is moving towards making crimea and southeast ukraine a singl e place.
 
there’s very little the ukrainians can do. the ukrainian military will remain badly outgunned, and the local populations in the region remain fairly anti-kiev, even if they’re skittish about the notion of russian takeover. we’ll see a pickup in international calls to provide arms for the ukrainian military, but they’ll be rejected, most particularly by the united states. at best we’ll see a step up in intelligence and training support, to little consequence.
 
putin’s military efforts are also stepping up outside ukraine: the “unknown” but clearly russian submarine off sweden, a russian nuclear armed exercise during an intelligence meeting in denmark; bomber patrols in the gulf of mexico. they’re all bluster, but a clear message to america and its allies...and pose a far higher potential for accidents – one scandanavian airlines flight recently made an emergency alteration to its flight path when a russian military jet suddenly appeared in front of it.
 
the likelihood of moscow backing down in this environment is near zero. the sanctions aren’t having a meaningful impact on the russian economy (yet) and the popularity of the kremlin isn’t taking a hit. the speech from former soviet general secretary mikhail gorbachev – no fan of putin, but clearly pointing the finger at the west for russia’s troubles – makes that clear. and it’s getting harder for the americans to find an out. german chancellor angela merkel continues to be the best opportunity for compromise, but her relationship with putin is now only barely functional (the kremlin advisors i spoke with said this was the single biggest misstep from putin to date – they believed his bilateral conversations with her were too aggressive and led merkel to feel misled; neither believed the relationship could be salvaged near-term). and so russians are now presuming the sanctions environment will be there for the long haul, and are thinking about the longer term economic implications.
 
i’d now say that’s meaningful before we get to russia’s 2018 elections: further sanctions causing steep recession leading to unrest in the regions, which begins to metastasize to the cities. that would spook russian elites, some of whom could split from the kremlin. the key early warning indicator would be meaningful defections of any insiders to the west. but critically, we’re at least a year or two away from that. by which time ukraine has been economically devastated, while the strategic shift of russia-china is thoroughly entrenched.
 

Putin’s World: Why Russia’s Showdown with the West Will Worsen
 
By Vitaliy Katsenelson
 
Institutional Investor, Nov. 17, 2014
 
My father, Naum Katsenelson, painted this watercolor, “Dolls Become Humans,” two years after we came to the United States in 1993. This is the only “thematic” picture my father ever painted.
 
 
If you look at the picture carefully you’ll see the silhouette of Lenin in the clouds (representing the past). On the far left there is a Stalin doll and a line of people going to prison. Across from Stalin on the right there is a doll of Brezhnev (you’ll recognize him by his large, distinct eyebrows). On the building on the right there is an image of Gorbachev. Look carefully at the faces in the foreground (representing the present and the future): as they get closer to you they become more humanized – transforming from dolls into humans. The man in front of the woman draped in the American flag is my father; the boy with the Star of David on his chest is me.
 
This was an aspirational picture. In 1993 the Soviet Union fell apart. Russia’s future looked bright – although it was in chaos, it was a democracy. The dolls here are an analogy for robots, suggesting uniformity of thought. As I was composing this I called my father and asked him if he’d paint the same picture today. He said, “No. Today’s picture would look very different.”
 
I spent three months aggravating over the following article. It was one of the most emotionally taxing things I ever wrote. A few days ago my wife looked at me and said, “When are you going to be done with it; this article is bringing you down.” She was right.
 
I grew up hating America. I lived in the Soviet Union and was a child of the cold war. That hate went away in 1989, though, when the Berlin Wall fell and the cold war ended. By the time I left Russia in 1991, the year the Soviet Union collapsed, America was a country that Russians looked up to and wanted to emulate.
 
Twenty-three years later, a new version of cold war is back, though we Americans haven't realized it yet. But I am getting ahead of myself.
 
After Russia invaded Crimea and staged its referendum, I thought Vladimir Putin's foreign excursions were over. Taking back Crimea violated plenty of international laws, but let's be honest. Though major powers like the U.S. and Russia write the international laws, they are not really expected to abide by those laws if they find them not to be in their best interests. Those laws are for everyone else. I am not condoning such behavior, but I can clearly see how Russians could justify taking Crimea back – after all, it used to belong to Russia.
 
I was perplexed by how the Russian people could possibly support and not be outraged by Russia's invasion of Ukraine. But I live in Denver, and I read mostly U.S. and European newspapers. I wanted to see what was going on in Russia and Ukraine from the Russian perspective, so I went on a seven-day news diet: I watched only Russian TV – Channel One Russia, the state-owned broadcaster, which I hadn't seen in more than 20 years – and read Pravda, the Russian newspaper whose name means "Truth." Here is what I learned:
 
If Russia did not reclaim Crimea, once the new, illegitimate government came to power in Ukraine, the Russian navy would have been kicked out and the U.S. navy would have started using Crimean ports as navy bases. There are no Russian troops in Ukraine, nor were there ever any there. If any Russian soldiers were found there (and there were), those soldiers were on leave. They went to Ukraine to support their Russian brothers and sisters who are being abused by Ukrainian nationalists. (They may have borrowed a tank or two, or a highly specialized Russian-made missile system that is capable of shooting down planes, but for some reason those details are not mentioned much in the Russian media.) On November 12, NATO reported that Russian tanks had entered Ukraine. The Russian government vehemently denied it, blaming NATO for being anti-Russian.
 
Malaysia Airlines Flight MH17 was not downed by Russia or separatists. It was shot down by an air-to-air missile fired by Ukraine or a NATO plane engaged in military exercises in Ukraine at the time. The U.S. has the satellite imagery but is afraid of the truth and chooses not to share it with the world.
 
Ukraine was destabilized by the U.S., which spent $5 billion on this project. As proof, TV news showed a video of Senator John McCain giving a speech to antigovernment protesters in Kiev's Maidan Square. It was followed by a video of Vice President Joe Biden visiting Ukraine during the tumult. I wasn't sure what his role was, but it was implied that he had something to do with the unrest.
 
Speaking of Joe Biden, I learned that his son just joined the board of Ukraine's largest natural gas company, which will benefit significantly from a destabilized Ukraine.
 
Ukraine is a zoo of a country, deeply corrupt and overrun by Russian-haters and neo-Nazis (Banderovtsi – Ukrainian nationalists who were responsible for killing Russians and Jews during World War II).
 
Candidates for the recent parliamentary election in Ukraine included Darth Vader (not kidding), as well as a gay ex-prostitute who claims to be a working man's man but lives in a multimillion-dollar mansion.
 
I have to confess, it is hard not to develop a lot of self-doubt about your previously held views when you watch Russian TV for a week. But then you have to remind yourself that Putin's Russia doesn't have a free press. The free press that briefly existed after the Soviet Union collapsed is gone – Putin killed it. The government controls most TV channels, radio and newspapers. What Russians see on TV, read in print and listen to on the radio is direct propaganda from the Kremlin.
 
Before I go further, let's visit the definition of propaganda with the help of the Oxford English Dictionary: "The systematic dissemination of information, especially in a biased or misleading way, in order to promote a political cause or point of view."
 
I always thought of the Internet as an unstoppable democratic force that would always let the truth slip out through the cracks in even the most determined wall of propaganda. I was wrong.
 
After watching Russian TV, you would not want to read the Western press, because you'd be convinced it was lying. More important, Russian TV is so potent that you would not even want to watch anything else, because you would be convinced that you were in possession of indisputable facts.
 
Russian's propaganda works by forcing your right brain (the emotional one) to overpower your left brain (the logical one), while clogging all your logical filters. Here is an example: Russian TV shows footage of schools in eastern Ukraine bombed by the Ukrainian army. Anyone's heart would bleed, seeing these gruesome images. It is impossible not to feel hatred toward people who would perpetrate such an atrocity on their own population. It was explained to viewers that the Ukrainian army continued its offensive despite a cease-fire agreement.
 
Of course if you watched Ukrainian TV, you would have seen similar images of death and despair on the other side. In fact, if you read Ukrainian newspapers, you will learn that the Ukrainian army is fighting a well-armed army, not rebels with Molotovs and handguns, but an organized force fully armed by the Russian army.
 
What viewers were not shown was that the cease-fire had been broken before the fighting resumed. The fact that Putin helped to instigate this war was never mentioned. Facts are not something Russian TV is concerned about. As emotional images and a lot of disinformation pump up your right brain, it overpowers the left, which capitulates and stops questioning the information presented.
 
What I also learned is that you don't have to lie to lie. Let me give you an example. I could not figure out how the Russian media came up with the $5 billion that "America spent destabilizing Ukraine." But then I found a video of a U.S. undersecretary of State giving an 8.5-minute speech; at the 7.5-minute mark, she said, "Since Ukrainian independence in 1991 … [the U.S. has] invested more than $5 billion to help Ukraine." The $5 billion figure was correct.
 
However, it was not given to Ukraine in three months to destabilize a democratically elected, corrupt pro-Russian government but over the course of 23 years. Yes, you don't have to lie to lie; you just have to omit important facts – something Russian TV is very good at.
 
Another example of a right-brain attack on the left brain is "the rise of neo-Nazism in Ukraine." Most lies are built around kernels of truth, and this one is no different. Ukraine was home to the Banderovtsi, Ukrainian nationalists who were responsible for killing tens of thousands of Jews and Russians during World War II.
 
Putin justified the invasion of Crimea by claiming that he was protecting the Russian population from neo-Nazis. Russian TV creates the impression that the whole of Ukraine is overrun by Nazis. As my father puts it, "Ukrainians who lived side by side with Russians did not just become Nazis overnight."
 
Though there may be some neo-Nazis in Ukraine, the current government is liberal and pro-Western. Svoboda – the party whose members are known for their neo-Nazi and anti-Semitic rhetoric – did not get even 5 percent of the votes in the October election, the minimum needed to gain a significant presence in parliament. Meanwhile the TV goes on showing images of Nazis killing Russians and Jews during World War II and drawing parallels between Nazi Germany and Ukraine today.
 
What also makes things more difficult in Russia is that, unlike Americans, who by default don't trust their politicians – yes, even their presidents – Russians still have the czarist mentality that idolizes its leaders. Stalin was able to cultivate this to an enormous degree – most Russians thought of him as a father figure. My father was 20 when Stalin died in 1953, and he told me that he, like everyone around him, cried.
 
I keep thinking about what Lord Acton said: "Power corrupts, and absolute power corrupts absolutely." The Putin we scorn today was not always like this; he did a lot of good things during his first term. The two that stand out the most are getting rid of the organized crime that was killing Russia and instituting a pro-business flat tax system. The amount of power Russians give their presidents, however, will, with time, change the blood flow to anyone's head. Come to think of it, even Mother Teresa would not have stood a chance in Russia.
 
A few weeks ago Putin turned 62, and thousands of people took to the streets to celebrate his birthday. (Most Americans, including this one, don't even know the month of Barack Obama's birthday.)
 
In my misspent youth, I took a marketing class at the University of Colorado. I remember very little from that class except this: For your message to be remembered, a consumer has to hear it at least six times. Putin's propaganda folks must have taken the same class, because Russian citizens get to hear how great their president is at least six times a day.
 
We Americans look at Putin and see an evil KGB guy who roams around the country without a shirt on. Russians are shown a very different picture. They see a hard-working president who cares deeply about them. Every news program dedicates at least one fifth of its airtime to showcasing Putin's greatness, not in your face but in subtle ways. A typical clip would have him meeting with a cabinet minister. The minister would give his report, and Putin, looking very serious indeed, would lecture the minister on what needed to be done. Putin is always candid, direct and tough with his ministers.
 
I've listened to a few of Putin's speeches, and I have to admit that his oratory skills are excellent, of a J.F.K. or Reagan caliber. He doesn't give a speech; he talks. His language is accessible and full of zingers. He is very calm and logical.
 
Russians look at the Putin presidency and ask themselves a very pragmatic question: Am I better off now, with him, than I was before he came into power? For most the answer is yes.
 
What most Russians don't see is that oil prices over the past 14 years went from $14 to more than $100 a barrel. They are completely responsible for the revival of Russia's one-trick petrochemical economy. In other words, they should consider why their economy has done better the past decade, and why it may not do as well going forward. Unless Putin was the one who jump-started China's insatiable demand for oil and other commodities that drove prices higher, he has had very little to do with Russia's recent "prosperity."
 
I place prosperity in quotes because if you take oil and gas riches away from Russia (lower prices can do that with ease), it is in a worse place today than it was 14 years ago. High oil prices have ruined Russia. They have driven its currency up, making its other products less competitive in international markets. Also, capital gravitates toward higher returns; thus oil has sucked capital from other industries, hollowing out the economy. After the Soviet Union collapsed, Russia had a chance to broaden its economy; it had one of the most educated workforces in the world. Sadly, it squandered that opportunity. Name one noncommodity product that is exported from Russia. There aren't many; I can think only of vodka and military equipment.
 
But most Russians don't look at things that way. For most of them, their lives are better now: No more lines for toilet paper, and the stores are full of food. Their personal liberties (such as freedom of speech and freedom of the press) have been taken away from them, but many have so much trust in their president that they don't mind, whereas others are simply complacent.
 
Today we see three factors that influence oil prices and are working against Russia: Supply is going up with U.S. shale drilling; demand growth will likely decline if the Chinese economy continues to cool; and the dollar is getting stronger, not because the U.S. doing great but just because the rest of the world is doing worse. If oil prices continue to decline, this will expose the true state of the Russian economy.
 
When I visited Russia in 2008, I sensed an anti-American sentiment. NATO – which in Russia is perceived as a predominantly American entity – had expanded too close to Russian borders. Georgia tried to join NATO, but Russia put a quick end to that. Russians felt they extended a friendly hand to the U.S. after 9/11, but in response America was arraying missiles around its borders. (The U.S. says they are defensive, not offensive; Russians don't see the distinction. They are probably right.)
 
The true colors of this new cold war came to light recently. In August 2008, according to Henry Paulson, the U.S. Treasury secretary at the time, "top level" Russian officials approached the Chinese during the Olympics in Beijing and proposed "that together they might sell big chunks of their GSE (Fannie Mae and Freddie Mac) holdings to force the U.S. to use its emergency authorities to prop up these companies."
 
This incident took place just weeks before the collapse of Lehman Brothers. The U.S. economy was inches from revisiting the Stone Age. The proposed Russian-Chinese maneuver could have made such an outcome more likely. The Federal Reserve would have had to step in and buy Fannie's and Freddie's debt, and the dollar would have taken a dive, worsening the plunge in the U.S. economy. Our friend Putin wanted to bring the U.S. economy down without firing a single shot, just as he annexed Crimea from Ukraine.
 
Today anti-American sentiment is much greater in Russia. European sanctions are seen as entirely unjustified. Here is why: Crimea had a "democratic referendum," and the Ukrainian conflict is believed to be not of Russia's doing but rather an American attempt to destabilize Russia and bring Ukraine into NATO. In his annual speech at the Valdai conference last month, Putin said America had pushed an unwilling Europe into imposing sanctions on Russia.
 
America is perceived as an imperialistic bully that, because of its economic and military power, puts its own self-interest above everyone else's, and international law.
 
Putin uses anti-Americanism as a shiny object to detract attention from the weak Russian economy and other internal problems. In the short run, sanctions provide a convenient excuse for the weakening Russian economy and declining ruble. They have boosted Putin's popularity (at least so far). As the Russian economy gets worse, anti-American sentiment will only rise.
 
This new version of the cold war has little in common with the one I grew up in. There are no ideological differences, and there is no arms race (at least not yet, and let's be honest: Today neither country can afford one, especially Russia). At the core of it, we don't like what Russia is doing to its neighbors, and Russia doesn't like what we do to the rest of the (non-EU) world.
 
The criticisms of U.S. foreign policy voiced by Putin in his latest Valdai speech are shared by many Americans: The U.S. is culpable in the unresolved, open-ended Afghanistan adventure; the Iraq War; the almost-bombing of Syria, which may have destabilized the region further; and the creation of the Islamic State, which is in large part a by-product of all of the above. Yet Putin's abominable Ukrainian excursion and the thousands of lives lost were never mentioned.
 
But there is also something less tangible that is influencing Russia's behavior: a bruised ego. During the good old Soviet Union days, Russia was a superpower. It mattered. When it spoke, the world listened. The Russian people had a great sense of pride in their Rodina (Mother Russia). Today, if Russia did not have nuclear weapons, we'd pay much less attention to it than we do. Pick a developing country without oil whose president you can name. (Okay, we Americans can't name the president of almost any other country, but you get the point.)
 
Anti-Americanism and Putin's popularity will both rise as the Russian economy weakens. For instance, Putin took his own people hostage when he imposed sanctions on imports of European food. The impact on Europe will not be significant (the Russian economy is not very large in comparison to the European Union), but Russia is very dependent on these imports. In the U.S. consumers spend about 13 percent of their earnings on food, but in Russia that number is almost three times larger. Therefore, food inflation hurts Russians much more. Yet as food inflation spiked, so did Putin's popularity and anti-Americanism. Even declining oil prices will be explained as a anti-Russian manipulation by the U.S.
 
Unfortunately, the only thing Russia has going for it today is its nuclear weapons. Russia has started to remind us of its military recently. According to NATO, the alliance "has conducted over 100 intercepts of Russian aircraft in 2014 to date, which is about three times more than were conducted in 2013."
 
Every article needs a conclusion, but this one doesn't have one. I am not sure what this new cold war means for the world. Will Russia start invading other neighboring countries? Will it test NATO resolve by invading Baltic countries that are part of NATO? I don't know. Economic instability will eventually lead to political crises. We have plenty of economic instability going on around the world.
 
I'll leave you with this thought: On March 7, 1936, the German army violated the Treaty of Versailles and entered into the Rhineland. Here is what Hitler later said:
 
"The forty-eight hours after the march into the Rhineland were the most nerve-racking in my life. If the French had then marched into the Rhineland, we would have had to withdraw with our tails between our legs, for the military resources at our disposal would have been wholly inadequate for even a moderate resistance."
 
Those two days determined what Germany would do next – build out its army and start World War II.
 
Comparing Putin with Hitler, as one of my Russian friends put it, is "absolutely abominable" because it diminishes Hitler's atrocities and overstates by a mile what Putin has accomplished to date. Yet it feels as if we are at a Putin-of-1936 moment. Will he turn into a Putin of 1939 and invade other countries? I don't know. But the events of the past nine months have shown Putin's willingness to defy international law and seize the advantage on the ground, betting – correctly so far – that the West won't call his bluff.
 
As Garry Kasparov put it, while the West is playing chess, responding tactically to each turn of events, Putin is playing high-stakes poker. We ignore Putin at our own peril.
 
 
Vitaliy Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. To receive Vitaliy’s future articles by email or read his articles, click here.


As The “Sanctions War” Heats Up, Will Putin Play His ‘Gold Card’?

by John Butler

November 19, 2014


The topic of ‘currency war’ has been bantered about in financial circles since at least the term was first used by Brazilian Finance Minister Guido Mantega in September 2010. Recently, the currency war has escalated, and a ‘sanctions war’ against Russia has broken out. History suggests that financial assets are highly unlikely to preserve investors’ real purchasing power in this inhospitable international environment, due in part to the associated currency crises, which will catalyse at least a partial international remonetisation of gold. Vladimir Putin, under pressure from economic sanctions, may calculate that now is the time to play his ‘gold card’.

A BRIEF HISTORY OF THE CURRENCY WAR

“We’re in the midst of an international currency war. This threatens us because it takes away our competitiveness.” Brazilian Finance Minister Mantega uttered these words in September 2010, about two years after the spectacular global financial crisis of late 2008. During and following the crisis, the euro declined by around 25% versus the dollar. The pound sterling declined by nearly 30%. And while the Brazilian real also declined initially, it subsequently regained these losses in less than a year, unlike either the euro or pound. Dramatic swings in currency values can have a material impact on relative rates of economic growth. And when global economic growth is weak, the temptation to devalue and take some global market share from competitors is strong. “The advanced countries are seeking to devalue their currencies,” claimed Mantega.[1]

The decline in the value of the euro in 2008-11 was of special importance because it exposed a key fault-line across the euro-area: That between the competitive exporters of the North, such as Germany, Poland and the Czech and Slovak Republics; and the less competitive importers of the South, such as Italy, Spain, Portugal and Greece. With the euro weaker, the exporters’ economies were booming. Yet the fallout from the financial crisis fell hardest on the least competitive euro members, threatening the solvency of their banks and, by extension, the sustainability of their governments’ finances.

Thus there emerged a ‘civil currency war’ in the euro-area, which is still being fought at the ECB in Frankfurt and in the national capitals. The South is facing default and multiple countries have considered withdrawing from the euro, threatening the entire project. The North remains reluctant to provide bail-outs without a substantial quid-pro-quo in the form of a meaningful restructuring of the chronically uncompetitive southern economies.

Although the crisis remains unresolved to this day, various compromises were reached in 2012 that have bought an unknown amount of time. Whether that time has been used wisely is highly debatable, and one or more rounds of bail-outs and possibly another acute crisis (or multiple crises) lies ahead.

A dramatic escalation in the global currency war took place in Japan in 2012, following the election of Prime Minister Shinzo Abe, who campaigned on a platform of proposed radical measures to get the Japanese economy moving again. Thus he wasted no time in deploying the most obvious weapon: currency devaluation. From October 2012 to February 2013, the yen devalued by some 25%.

While this did have the result of providing some short-term stimulus, the overall effect was smaller and shorter-lived than hoped. Thus the Bank of Japan took additional measures recently to weaken the yen further. As of this writing, the yen has fallen by a further 15%. And that’s not all: Abe is now promising to halt a planned increase in sales tax and has called a snap election as a de facto referendum on his radical economic policies. Further yen weakness following this announcement suggests that the financial markets expect that Abe will prevail and follow-through accordingly.

This large cumulative yen devaluation is an attack on Japan’s competitors in the global export markets, in particular those for technologically advanced manufactured goods. Germany, Poland, South Korea, Taiwan and Brazil are in this group and no doubt the weaker yen is one reason why growth in these countries has been slowing of late.

Germany and Poland, however, now find they are fighting a three-front currency war: Versus Japan for export market share; versus the US, EU and NATO over the issue of economic sanctions against Russia; and on the continuing front within the euro-area itself, where recently both countries dissented from a recent ECB quantitative easing (QE) initiative to purchase asset-backed securities.[2] How Germany, Poland and other countries caught in the crossfire of the currency and sanctions wars react will in turn have an impact on their trading partners, and so on. The associated negative consequences for global financial markets could be substantial.

RUSSIA, NATO AND THE ‘SANCTIONS WAR’

In recent years, there has been a series of increasingly serious confrontations between US allies and Russia, beginning with the Georgian war of 2008, continuing with the Syrian crisis of 2013 and then, most recently, in Ukraine. While each of these crises has been serious in its own way, not until now have they had an overt international economic dimension. This is because the Ukraine crisis has unleashed a ‘sanctions war’ that has escalated to the point of doing real economic damage not only to Russia, but to Germany and Poland, two of Russia’s largest trading partners.

So far, the Russian economy has held up reasonably well, but recent developments suggest that a deep recession is on the way. Lower prices for oil—Russia is a huge exporter—will hit the Russian economy hard. Moreover, with the Russian currency plunging by over 30% in recent months, consumer price inflation is going to rise sharply.

So what is Russia to do? Putin is rumoured to be preparing a major programme to reduce corruption and improve economic efficiency, but even if this is successful, it is going to take time, and it can’t be expected to fully offset the effect of sanctions. Unless they are lifted soon, Russia is facing a period of economic misery.[3]

For the US and NATO, Russian economic misery is precisely what the sanctions war is all about: Cause enough pain, so the thinking goes, and Putin will allow Ukraine to crush the rebellion in the eastern part of the country and possibly re-annex the Crimea. While I am not an expert in these matters, it strikes me as highly unlikely that Putin will give in under the pressure. He is popular in Russia, not only because, up to now, he has overseen a prolonged period of strong economic growth but also because he is regarded by Russians as a strong leader standing up for Russia’s national interests. Ordinary Russians support their ethnic bretheren in eastern Ukraine and Crimea. They would be horrified if Russia allowed Ukraine to crush the rebels. Also, because of the sanctions, Russians will blame the US and NATO for the coming economic downturn, not Putin.

If I’m right that Putin stands his ground in Ukraine and remains highly popular notwithstanding the inevitable recession, then what does this imply for the currency wars generally? First, it implies that Germany, Poland, Slovakia and most other Russian trading partners are going to face a sharp economic deterioration as well. In all cases, this is going to have some political effects. In those countries with weak governments and unpopular leaders, the opposition may support ending the sanctions as an expedient way of gaining power. Indeed, in Slovakia the government has already voiced opposition to further sanctions.[4]

Second, it implies that, rather than just sit back and take the pain, Russia is going to seek to reduce its economic dependence on the West. This is already in evidence, with Putin having signed major deals in the energy and defense industries with China and India, among other countries. Stronger Russian ties with the other BRICS, or other countries for that matter, may be of some concern to the US, but in most cases there isn’t much the US can do about it.

One crucial aspect of Russia’s dependence on the West is the global use of the US dollar as the primary international transaction and reserve currency. It is thus no surprise that the recent Russian energy deal with China—involving the construction of a large gas pipeline between the two countries—is to be financed and transacted in the Chinese yuan rather than the dollar.

Not only Russia, but the BRICS in general have regularly expressed their dissatisfaction with the dollar-centric global monetary conventions, including the Bretton-Woods legacy institutions of the IMF and the World Bank.[5] Hence the BRICS have set about building their own parallel institutions and have signed a number of bilateral currency-swap deals with each other and non-BRICS trading partners in order to reduce dollar dependence. While all these initiatives nudge the BRICS and, by implication, the global economy generally, away from the dollar, the process is slow and, absent an international monetary crisis, is likely to take years.

For Russia, however, the need to shore up the economy and the currency is exigent. It cannot wait for the gradual evolution of the international monetary system to reduce the impact of sanctions. So what else might Russia do in the near-term?

A GOLDEN ROUBLE?

One intriguing possibility is one which Russia has, in fact, contemplated before: Backing the currency with Russia’s gold reserves.[6] In the late 1980s, as the Soviet Union was breaking up, the rouble was in free-fall and inflation was soaring. Russia had essentially zero access to global capital markets and relied on oil exports for hard currency with which to trade with other nations. In 1989, Premier Gorbachev invited two prominent US economists to Russia, where they met with senior economic policy officials and recommended precisely this as the best way to stabilise the rouble. One of the two was former Fed governor Wayne Angell; the other, Jude Wanniski of ‘supply-side’ economic fame. In 1998, Mr Wanniski wrote that he “became alarmed about the financial collapse in Russia,” and decided to “write a piece on how to fix Russia right away, before it was in complete chaos.” In the Wall Street Journal editorial that followed, Mr Wanniski explained the longer history of the gold-backed rouble idea:

In September 1989, the Soviet government of Mikhail Gorbachev invited me to Moscow for nine days to discuss my unorthodox views on how the U.S.S.R. could make the conversion to a market economy. I’d been arguing that the process had to begin by fixing the ruble price of gold at a credible rate of exchange, which I believed then would be a relatively easy thing to do. I still believe that.

Last week, the former U.S. vice-presidential candidate for the Republican Party, Jack Kemp, wrote a letter to President Bill Clinton. In it he urged him to ask Mr. Yeltsin and his prime-minister nominee, Viktor Chernomyrdin, to consider the gold solution as the quickest and easiest way to end the financial crisis without more suffering by the Russian people.

But gold is preferable in this situation because the Russian government could announce that it will defend the ruble in terms of gold at a rate of 2,000 rubles per ounce and because it has control of the ruble but not the foreign currencies of a currency board. That is, Russia need not have gold ingots backing every last ruble in circulation in order to keep the gold-ruble price stable. It can do so by managing the supply of ruble liquidity, which the government can do easily by buying and selling ruble interest-bearing bonds to Russian banks. It should also make an unlimited amount of the gold-ruble bonds available to ordinary people.

This is how Alexander Hamilton solved the financial crisis that faced the administration of George Washington in 1791. America’s first Treasury Secretary fixed the dollar to gold and promised creditors they would be paid all they were owed at par, with interest. In 1947, West German Finance Minister Ludwig Erhard ended a similar financial crisis by pegging the Deutsche mark to gold. At these times, neither the U.S. nor the German government had any gold. The gold promise worked because their own people understood that their governments were not insolvent, but simply faced a short-term cash crisis. In the same way, the Russian state today has small liabilities, perhaps $200 billion, compared to the assets it possesses, which easily amount to $10 trillion. The state, after all, owns almost everything in 11 time zones, which it acquired in the 1917 revolution. All of these assets can be used to back up the exchange rate by converting them at the ruble price of gold.

On hearing that their government promises to pay ruble debt at a 2,000-to-one gold price — which implies a dollar/gold rate of 7 to 1 at the moment — the Russian people would have to decide if the promise was credible. Would they rather have a gold-ruble bond paying interest at a hard rate of 7 to 1, or a ruble note paying no interest at a collapsing rate of 17 to 1? The question suggests the people would rush to convert ruble notes into ruble bonds.

As it is, the Russian people are transacting among themselves using $40 billion in U.S. currency, while the value of the ruble money supply implodes toward zero. A government gold/ruble peg would quickly bring the people to their banks with dollars, asking for the now more valuable rubles. In short order, the government would have enough dollars to pay Western banks the interest they are owed. As the Russian government creates new ruble liquidity to meet increased demand, the problems with insolvency at Russian banks also are resolved. And as domestic commerce now would flow through ruble tax gates instead of dollar barter, Mr. Yeltsin would be able to pay all back wages in tax rubles instead of fiat money. By fixing to gold instead of a currency-board basket, Russia would be able to collect a bonanza in seigniorage.

If President Clinton wished to follow through on his promise to help President Yeltsin, he could ask his Treasury department to buy $3 billion to $4 billion of the gold-ruble bonds from its Exchange Stabilization Fund. If this happened tomorrow, Russia could meet its dollar obligations this week. If there were any further doubts among Russians about the credibility of a gold ruble, they would dissolve upon seeing the U.S. government actually buying their sovereign ruble debt.

The Russian government would soon be able to hasten an economic expansion through supply-side tax reforms. But first things first. A ruble as good as gold is what Dr. Angell ordered in 1989 and it is what the doctor orders now.[7]

The situation back in 1989 or 1998 was, thus, similar to if even more serious than that faced by Russia today. But if the sanctions war escalates? Things could get worse. Is Mr Putin or his senior advisers aware of what was contemplated above? That gold could provide a workable solution to stabilise the currency and economy? A distinct possibility. How likely is it that they will make this move?

Well, let’s consider the international context. Were Russia to back the rouble with gold today, this would be a far more credible policy than it could ever have been back in 1989 or 1998, when Russia’s government was less stable and less popular, and Russia’s economy was less well-integrated with those of China, Germany and other major economies. Moreover, in recent years Russia has amassed a huge amount of gold reserves.[8] Indeed, at current market prices, Russia’s gold reserves would back a whopping 27% of the narrow rouble money supply! That is a high ratio, far in excess of any other major country and also in excess of the US Fed’s original stipulated gold coverage minimum. Moreover, Russia is a large net exporter, notwithstanding the sanctions, so Russia’s gold reserves, by implication, are likely to continue to grow, rather than decline.

This credibility is also reinforced by the Russian economy’s relatively low debt. Without a large debt to service, there is little temptation or need to inflate the currency. Indeed, Russian interest rates are currently around 10%, implying a generous relative return on rouble cash balances. Imagine the rouble were to be convertible into gold, AND rouble interest rates remained at 10%. This implies a nearly risk-free arbitrage of 10% between the rouble and gold. You can bet than a large number of international investors would quickly sell some gold, dollars, or other currencies, and acquire some roubles, pocketing the hefty interest rate differential. That would support the rouble, possibly leading to a large re-appreciation vis-à-vis the dollar and other currencies left unbacked by gold. Rouble interest rates could then decline, perhaps to quite low levels, where an equilibrium would eventually be reached. It could have worked in 1989, or 1998. It is far more likely to work today.

COULD A GOLDEN ROUBLE CATALYSE A GLOBAL REMONETISATION OF GOLD?

There is another aspect to consider, however, which is the possible impact this policy would have on the dollar and the international monetary system. Recall that, as the primary global reserve currency, the dollar circulates in vast quantities abroad, where it forms the bulk of the monetary reserves of central banks. This is in part what allows the US government and economy generally to finance themselves at such low interest rates. But other factors equal, if the dollar suddenly faces competition from a credible, gold-backed currency, it is likely that, at a minimum, central banks are likely to diversify at least some of their dollar reserves into interest-bearing, gold-backed roubles. Countries importing oil from Russia would have an additional incentive to do so as they would be able to pay for Russian oil imports in roubles and avoid sanctions. Speculators (or investors) anticipating an eventual internationalisation of the rouble would front-run these developments, pocketing a nice return over time.

The implied upward pressure on US interest rates would be perhaps small initially, but even a small rise in US interest rates would spell trouble for a US economy that is so highly leveraged to low rates. Growth would slow. The Fed could try to offset this by engaging in renewed QE, but that could add fuel to the fire, resulting in aggressive selling of dollars in the foreign exchange markets. In an extreme but hardly impossible scenario, the dollar could lose reserve status entirely, something that would be devastating for the US economy. While a sharply weaker dollar would help US competitiveness and exports over time, it would crush the dollar’s effective international purchasing power (eg for oil and other resources) and result in soaring consumer price inflation. The combined negative impact of higher interest rates on growth and rising consumer prices on inflation would make the stagflationary 1970s look like a picnic.

As I argue in my book, THE GOLDEN REVOLUTION, a loss of reserve status for the dollar would have vast repercussions for the international monetary system.[9] While a gold-backed rouble could challenge the dollar to a certain extent, it is unrealistic to think that an economy the size of Russia’s could back the dominant global reserve currency. No, as the dollar’s share declines, most probably multiple alternative currencies begin to serve as reserves. This is where things get interesting, however. Other factors equal, as a currency is used as a reserve, it strengthens that currency. That might be unwelcome in some economies heavily geared toward exports.

Thus dethroning the dollar does not end the currency wars but rather could escalate them further instead as one country after another tried to offset dollar weakness by weakening their own currencies. This sort of ‘race to the bottom’ was seen in the 1920s and 1930s, culminating in US President Roosevelt’s executive decision to devalue the dollar by some 60% in 1934. In that instance, however, the dollar remained backed by gold and by what was by far the largest global economy at that time.

Not so today. The global economy has become increasingly multipolar, with both the euro-area and China roughly as large as the US. Moreover, the US has a huge accumulated and external debt, implying a growing risk of debasement and devaluation in future. As it stands today, only 2.3% of the narrow US money supply is backed by gold. Thus the US is simply no longer in a position to be a ‘monetary hegemon’, providing the global reserve currency.

But as all large economies have their own debt or other financial issues with which to deal, no major currency is in a position to replace the dollar as the pre-eminent reserve. This implies that the global monetary system is highly unstable. The dollar is hardly the only currency at risk of debasement and devaluation. Game theory implies that a race to the bottom is distinct possibility and it is unclear whether the dollar would lead or follow in that race.

As I further argue in my book, this combination of economic multipolarity and the instability of the current global monetary equilibrium is highly likely to result in at least a partial if not full remonetisation of gold, with an associated, large rise in price. Gold is the ideal way for countries to settle their trade imbalances in a world in which trust in currency stability is lacking. Accumulating reserves that can be summarily devalued by trading partners in a currency war is not a rational policy. Yet something must function as a reserve asset if trade is to take place at all. Gold provides that ‘something’ as supply is stable and it cannot be arbitrarily devalued. Backing currencies by gold would thus greatly increase trust and, thereby, facilitate international trade.

Those familiar with the 1870s will note that there are now strong parallels with that important decade. Following German unification and the US recovery from the Civil War, both of these economies were catching up rapidly with Britain. Japan had begun to industrialise. Under these multipolar conditions arose spontaneously, absent formal diplomacy, the classical gold standard system that would underpin decades of arguably the fastest sustained global economic growth ever experienced in history.[10]


SO, WILL PUTIN PLAY THE ‘GOLD CARD’?

Let’s now return to Russia and leave aside a biased western perspective for the moment. Putin has arguably accomplished more for Russia than has any other contemporary leader of a major country. Yes, he may be something of an autocrat, but please show me one major developed country that has never been ruled by an autocrat. (The USA began its life under George III and borrowed the bulk of its legal code and political culture from the UK.) Under Putin’s leadership, Russia has maintained its territorial integrity, something that had been left in question following the collapse of the Soviet Union, and Russia retains a formidable military capable of defending its vast frontiers (although not capable of policing the world). The economy has grown rapidly and, while still resource-dependent, has begun to diversify in various ways. (Keep in mind the young USA was regarded by Europeans as a largely resource-dependent economy.) Russia has built strong economic and political ties not only with the BRICS but also many smaller economies in Eurasia and elsewhere around the world. Russia has only a small accumulated national debt, implying that this will not be a drag on future growth, as is likely to be the case in the US, EU and Japan. Russia also has an advantageous tax system, with a top 13% rate of income tax. Yes, Russia remains an economically unequal society, but we know what has happened to inequality throughout the developed economies in recent decades, not just following the 2008 global financial crisis.

Given these achievements, Putin is not a leader to be taken lightly and we should pay attention when he says it it his desire to end the ‘dictatorship of the dollar’, as he did just this week. [11] Perhaps he will indeed play the gold card he has hidden up his sleeve and thus kill two birds with one stone: shore up the rouble and Russian economy on the one hand; dethrone the dollar on the other. A period of international monetary and associated economic chaos might ensue, but with Russia suffering already under unwelcome sanctions and thus with relatively less to lose, Putin might calculate that now is the time to make his move. He may have already achieved his place in the Russian history books but imagine how he will be regarded in world history books if he sets in motion that which culminates ultimately in the return to some form of global gold standard.