Today's New Paradigm

Doug Nolan

Friday, May 15, 2015

As an analyst of Bubbles, I’ve grown convinced of some things: First, it’s vital to recognize Bubble distortions early before they become deeply ingrained in markets and economic structures (when policymakers turn even more timid). Second, there is always an underlying source of Credit fueling the Bubble. Third, there are typically major distortions that mask the riskiness of the underlying Credit – government involvement is invariably a major factor along with heavy risk intermediation. Fourth, each Bubble has its own nuances that ensure it can inflate undetected for too long. Fifth, the longer a Bubble inflates the greater the scope of market misperception and structural impairment. And, finally, Bubbles burst when market misperceptions eventually succumb to reality, a development that tends to unfold in the Credit underpinning the boom.

I didn’t think it would come to this. When I began chronicling the “global government finance Bubble” more than six years ago, I saw a backdrop conducive for the biggest Bubble yet: desperate central bankers mindlessly determined to print Trillions, buy Trillions of securities and inflate market values tens of Trillions, while at the same time using zero rates to force savers into risky securities. Yet I never imagined we’d get to mid-2015, with a 5.4% unemployment rate, record stock prices, record M&A, booming corporate debt markets and abundant signs of froth (i.e. Palo Alto, upper-end real estate, Manhattan condos, art, etc.) – and rates would remain stuck at zero. I didn’t expect global bond and currency markets to prove so accommodating.

But here we are - at the precarious stage. I’ve posited that the more deeply systemic a Bubble the less conspicuous its effects. Yet this global Bubble has reached such extremes that obvious signs of excess have sprouted out everywhere – most conspicuously with European debt, M&A, Chinese equities, global sovereign bonds, biotech, etc. And with things turning more overt, there’s now some Wall Street research addressing the topic.

Citi Equities Research (Robert Buckland, Mert Genc, Beata Manthey, Cosimo Recchia, Jonathan Stubbs and Ayush Tambi) published an interesting report late this week, “It’s Bubble Time.” This insightful research is worthy of discussion. I excerpted from the Citi report and then followed with my own thoughts.

From “It’s Bubble Time”: “Bubble Breeders - Previous ageing bull markets have been associated with asset price bubbles. They are often based around a convincing idea (Secular Stagnation?), and fuelled by excess liquidity. They are big enough and last long enough to destroy many contrarian investors.”

From the experience of the past two decades, so-called “bull markets” were not so much “associated with asset prices bubbles” as they were outright manifestations of historic financial Bubbles. “Tech Bubble” market distortions were prevalent in Credit and equities markets by the mid-nineties. Even greater “mortgage finance Bubble” market distortions took root soon after the post-“tech Bubble” reflation was commenced.

A “convincing idea” – or good story – is essential. I’ll add that if sufficient “money” and Credit are thrown at a system a pretty “good story” is bound to pop out. Periods of new technologies clearly provide fertile ground for Bubbles – and are arguably essential to epic Bubbles. As we’ve witnessed now for better than 20 years – and certainly was the case in the two decades prior to the 1929 Crash – a flurry of technological advancement can wield powerful price impacts – along with economic upheaval and instability. Policy confusion is assured.

By their nature, the final phase of an epic Bubble will indeed “destroy many contrarian investors.” There’s a confluence of important dynamics at play. First, during final Bubble phases, officials are by then responding to serious fundamental deterioration with heightened policy desperation. So-called “bears” - positioned based on negative fundamental factors – are squashed by the policy whirlwind. Meanwhile, flows gravitate to the most bullish and aggressive (tending to be those content to overlook weak fundamentals and fragilities).

Such a backdrop foments dangerous Bubble Dynamics. “Money” chases inflating risk markets, while a depleted few retain the resources or willingness to take the other side of this “bull” trade. The upshot is a self-reinforcing market supply/demand imbalance. Over time, as bull market psychology and speculative impulses build, unhinged markets succumb to upside dislocation and “melt-up” dynamics: Too many anxious buyers facing a dearth of sellers.

Benjamin Strong’s “coup de whiskey to the stock market” and the fateful 1927-1929 speculative blow-off illustrate this dynamic. And I point to the summer of 2012 – “do whatever it takes” central banking and the unleashing of global open-ended QE – as the original catalyst for global securities markets upside dislocation.

From Citi: “Bubble Bursters – Rate hikes eventually burst bubbles, but it usually takes a least three to stop the juggernaut. We do not expect the third Fed hike until 3Q16. In the meantime, expensive stocks may keep getting more expensive.”

I would argue that Bubbles are burst by an inevitable reversal of speculative flows and attendant shift in market perceptions. Responding to increasingly conspicuous excess, central bankers will tend to raise rates (too little and too) late in the Bubble cycle. Still, it’s late-cycle “Terminal” excess that dooms Bubbles. Much belated rate increases had little to do with either “tech” or mortgage finance Bubble collapses.

“Tech” collapsed after a reversal of a spectacular market “melt-up” dislocation. Derivatives markets were instrumental – providing speculative leverage - for the upside dislocation and then during the downside collapse. Markets abruptly turned illiquid. “Hot money” rushed for the exits, while too many desperately attempted to buy market insurance and/or place bearish bets. The mortgage finance Bubble burst when “hot money” sought to exit subprime mortgage securitizations and derivatives. Excess associated with over $1 Trillion of subprime CDOs issued in 2006 ensured subprime’s demise. Fed rate policy had little to do with the timing of the collapse.

From Citi: “We suspect that asset price bubbles are formed by four key forces: 1) A new paradigm story supported by convincing fundamentals, 2) Surplus liquidity, 3) A demand/supply imbalance, 4) Business/benchmark risk amongst asset managers… New Paradigms: Every bubble is based on a good story. Tulips are beautiful flowers. 17th Century Far East trading opportunities were vast. Japan’s economic performance post WW2 was spectacular. The internet represented a transformational technology advance. Many of these stories were based on convincing fundamental evidence – they really were new paradigms which would go on to change the world. However, when combined with abundant capital, these great ideas were often accompanied by unsustainable asset price bubbles. What might be the current new paradigm? At a macro level, the most obvious candidate is ‘secular stagnation’ – a world where growth, inflation and interest rates are likely to stay low for the foreseeable future. Fixed income assets are the obvious beneficiaries.”

This is insightful analysis. Yet one cannot discuss Bubbles without a central focus on Credit. As such, I would add that “surplus liquidity” is a fundamental characteristic of inflating asset markets. Speculative markets create their own self-reinforcing liquidity. Liquidity is created in the process adding leveraging in search of bull market returns, while borrowing throughout the economy increasingly finds its way into bubbling markets. Moreover, the expectation for ongoing abundant liquidity becomes integral to bull market psychology. The underlying source of Credit and its progressive vulnerability goes unappreciated.

From Citi: “Demand/Supply Imbalance: The next key ingredient of a bubble is a demand/supply imbalance. High demand for a new investment idea usually overwhelms the supply and leads to sharp price increases. Limited supply of land and growing populations often drive house/land price bubbles.”

This critical issue is quite complex. Similar to “surplus liquidity,” “demand/supply imbalance” is inherent to inflating “bull markets”. In the Real Economy Sphere, rising prices tends to self-adjust by dampening demand and boosting supply. In the Financial Sphere, rising securities prices lead instead to heightened demand. Unfettered finance tends to be powerfully self-reinforcing. Importantly, heightened demand for Credit can be accommodated without higher borrowing costs. Rising securities prices spur progressively intense demand.

This already problematic securities market supply/demand dynamic has been radically exacerbated by central bank policies. First, their purchases have removed Trillions of securities from the marketplace. Second, zero rates and collapsing sovereign yields have spurred Trillions into global risk markets. Third, “do whatever it takes” central banking and open-ended QE have emboldened the view that policymakers are determined to backstop global securities markets. This has had a profound impact on risk-taking. Emboldened market participants perceive that policymakers will protect against illiquidity and guard against big downside moves. Moreover, the policy backdrop ensures the availability of cheap market derivative “insurance.”

From Citi: “Business/Career risk: A weary client once defined a bubble to us: ‘something I get fired for not owning’. It is career-threatening for an asset manager to fight a big bubble. For example, the late 1990s TMT bubble almost destroyed the value-based fund management community. Any bond manager hoping that valuations were mean-reverting would have been fired many years ago. Big bubbles are especially dangerous. TMT stocks already represented a large part of equity market benchmarks when they rerated aggressively in the late 1990s. By contrast, Biotech stocks might currently be expensive but their small market cap means they are still not a big benchmark risk. You don’t get fired for not owning Biotech stocks now, but you did get fired for not owning TMT stocks in the late 1990s. Bubbles are obvious in hindsight, but they are very hard to fight in real time. Indeed, proper bubbles are so overwhelming that they force sceptical fund managers to buy into them in order to reduce benchmark risk and avoid significant asset outflows. As these sceptics capitulate, of course they contribute to the bubble and so force other sceptics to capitulate and so on and on until there are no sceptics left to capitulate. It makes sense for an asset management company to manage its business risk but this can end up contributing to the madness. Through this, the modern fund management is almost hard-wired to produce bubbles.”

Again, insightful analysis. I would, however, suggest that it is not so much that “modern fund management is almost hard-wired to produce bubbles” as it is that the entire financial services complex has been transformed by central banks inflating serial Bubbles. Inflation psychology has become deeply, deeply ingrained: everything revolves around purchasing securities that will benefit from ongoing central bank market manipulations and interventions. To survive has meant to climb aboard the great bull. This ensures the entire industry is now on the same side of the “trade” – with functioning “two-way” markets relegated to history. And markets will remain seductively “abundantly liquid” only so long as bullish psychology is sustained.

From Citi: “What Bursts Bubbles?: The new paradigm of this cycle is probably the Secular Stagnation story, with fixed income assets looking the obvious bubble candidates. Nevertheless, our rates strategists think it is too early to call the end of the secular stagnation trades… We also asked our regional equity strategists to identify potential bubbles in their markets… Jonathan Stubbs suggests that Low Risk (low leverage, earnings stability and price beta) stocks look like bubble candidates. European Low Risk stocks (40% are from Consumer Staples and Health Care) are trading at 5x P/BV, well ahead of the 2.5x PBV reached in 2007.”

The issue of Today’s New Paradigm is fascinating. Many see “secular stagnation” as guaranteeing that central bankers won’t bring this party to an end anytime soon – “lower for longer, QE infinity.” True enough, though I don’t see “secular stagnation” as the prevailing market perception underpinning historic securities markets Bubbles.

From my analytical framework, there’s a New Paradigm in Credit and market perceptions that operate at the epicenter of Bubble distortions. The Nineties “New Paradigm” revolved around exciting new technologies; the collapse in communism and rise of global free-market capitalism; and globalization and productivity advancements that would have central banks providing economies and markets more leash to run. For the mortgage finance Bubble, the New Paradigm perception was perpetual “loose money” ensured by the “great moderation” and the fact that policymakers would never allow a crisis in mortgage Credit and housing. Policymakers ensured that “Too Big To Fail” mortgage securities would remain liquid “stores of value” – “money-like.”

Today’s New Paradigm misperception from my perspective: Global central bankers control market liquidity and will not allow another financial crisis. Global securities markets have become too big to fail – with central bankers’ guarantees of liquid and continuous markets elevating global risk markets to the stature of “money-like”. And it is this New Paradigm that has led to monumental financial flows. Trillions have flowed into various types of markets, funds and asset-classes based on the perception of low risk. In particular, the ETF and hedge fund industries have each grown to about $3.0 Trillion.

So where do I see Credit vulnerability and the potential for a destabilizing reversal in “hot money” flows? I believe that securities-based speculative leverage has grown to unprecedented dimensions – particularly within the ETF, hedge fund and derivatives complexes. Moreover, currency “carry trade” leverage has exploded, especially after policy-induced devaluations in the yen and euro. And as I’ve been emphasizing lately, an end-of-cycle dynamic has speculative opportunities now quickly transformed into Crowded Trades. Understandably, the bulls see timid central bankers ensuring that this game runs unabated. I suspect heightened market volatility is signaling that de-risking/de-leveraging could emerge at any moment. It was another rough week for the dollar. And what about that move in gold…

Tax-free debt

The great distortion

Subsidies that make borrowing irresistible need to be phased out

May 16th 2015

THE way that black holes bend light’s path through space cannot be smoothed out by human ingenuity. By contrast, a vast distortion in the world economy is wholly man-made. It is the subsidy that governments give to debt. Half the rich world’s governments allow their citizens to deduct the interest payments on mortgages from their taxable income; almost all countries allow firms to write off payments on their borrowing against taxable earnings. It sounds prosaic, but the cost—and the harm—is immense.

In 2007, before the financial crisis led to the slashing of interest rates, the annual value of the forgone tax revenues in Europe was around 3% of GDP—or $510 billion—and in America almost 5% of GDP—or $725 billion. That means governments on both sides of the Atlantic were spending more on cheapening the cost of debt than on defence. Even today, with interest rates close to zero, America’s debt subsidies cost the federal government over 2% of GDP—as much as it spends on all its policies to help the poor.

This hardly begins to capture the full damage, which is aggravated by the behaviour the tax breaks encourage. People borrow more to buy property than they otherwise would, raising house prices and encouraging over-investment in real estate instead of in assets that create wealth. The tax benefits are largely reaped by the rich, worsening inequality. Corporate financial decisions are motivated by maximising the tax relief on debt instead of the needs of the underlying business.

Debt has many wonderful qualities—allowing firms to invest and individuals to benefit today from tomorrow’s income. But the tax subsidies have tilted the economy in a woeful direction.

They have created a financial system that is prone to crises and biased against productive investment; they have reduced economic growth and worsened inequality. They are a man-made distortion and they need to be fixed.

Debt and taxes, life’s certainties
Start with the fragility. Economies biased towards debt are more prone to crises, because debt imposes a rigid obligation to repay on vulnerable borrowers, whereas equity is expressly designed to spread losses onto investors. Firms without significant equity buffers are more likely to go broke, banks more likely to topple. The dotcom crash in 2000-02 caused losses to shareholdersworth $4 trillion and a mild recession. Leveraged global banks notched up losses of $2 trillion in 2007-10 and the world economy imploded. Financial regulators have already gone some way to redressing the balance from debt by forcing the banks to fund themselves with more equity. But the bias remains—in large part because of the subsidy for debt. Under a more neutral tax system, firms would sell more equity and carry less debt. Investors would have to get used to greater volatility; but as equity buffers got thicker, shareholders would be taking less risk.

A neutral tax system would also lead to more efficient choices by savers and lenders. Today 60% of bank lending in rich countries is for mortgages. Without a tax break, people would borrow less to buy houses and banks would lend less against property. Investment in new ideas and businesses that enhance productivity would become relatively more attractive, in turn boosting economic growth.

Removing the advantages that debt enjoys would also lead to a fairer system. Relief on mortgage payments is a subsidy that flows to people who need it least: studies show that the richest 20% of American households by income gain the most. Mortgages would become costlier. But new instruments would emerge to allow individuals to bridge the gap between current savings and future income that debt alone now closes—for example, shared-equity mortgages that divide the gains and losses from house-price movements between banks and homeowners.
Lenders and borrowers
If the arguments for getting rid of the debt distortion are overwhelming, the path to its elimination could hardly be more rocky. Politicians do not much like changes that will lower house prices. There is a big co-ordination problem: tax is a matter for national governments, and few countries will be prepared unilaterally to withdraw subsidies that might make them less appealing to footloose companies. In addition, vested interests will bleat loudly. Businesses that depend heavily on debt—banks, private-equity firms and the like—will be ready to spend some of the billions they gain from the tax subsidy on lobbying to defend it.

This argues for a staged approach. The place to start is the subsidies on residential mortgages. Not only do these subsidies increase financial fragility, they fail to achieve their purported goal of promoting home-ownership. The shares of people owning their own homes in America and Switzerland, two countries with vast subsidies, are 65% and 44% respectively—no more than in other advanced economies like Britain and Canada that offer no tax break. The wisest step would be to phase out tax relief gradually, as Britain did in the 1990s.

Getting rid of the tax breaks for corporate debt will be harder. The few countries that have tried to level the playing field have done so by giving an equivalent handout to equity. Belgium and Italy, for instance, give dividend payments and profits flowing to equity holders some of the same perks enjoyed by interest payments. But such systems are fiddly and lower a country’s tax base at a time when governments need money.

The best approach is gradually to phase out tax breaks for debt at the same time as lowering the corporate-tax rate. That would make the policy revenue-neutral, and would also defuse the risk to governments who want to push ahead but fear losing a war waged on tax competition.

Acting in concert or alone, countries should act soon. When interest rates are low, as now, the sweeteners for debt are smaller and thus easier to remove. When rates rise—as, inevitably, they will—the subsidy will become more valuable. This is the moment to tackle the great debt distortion. There may never be a better chance.

Ending the debt addiction

A senseless subsidy

Most Western economies sweeten the cost of borrowing. That is a bad idea

May 16th 2015

THE field for the title of world’s worst economic distortion is a crowded one. Fuel subsidies in the emerging world are one contender; the implicit government guarantee that props up big banks another. But it is a less noticed and more pervasive warping of the economic fabric that is the most damaging. Despite the fact that the world is mired in debt, governments make borrowing costs tax-deductible, cheapening debt and encouraging borrowers to pile on more.

Tax breaks for debt come in two principal forms. Interest payments on mortgages are tax-deductible for personal tax purposes in at least some way in America and over a dozen European countries, including Belgium, Italy, the Netherlands, Spain, Switzerland and most Nordic states. And across the world firms can deduct interest payments to debt-holders from their taxable earnings. In contrast the dividend payments and retained profits that flow to shareholders are taxed in most places.

The global convention that debt should enjoy tax perks emerged as much by accident as design.

Its original proponents could not have imagined the scale of debt that now exists (global debt stands at 286% of GDP today). Britain made interest paid by firms tax-deductible in 1853.

America allowed the partial deduction of interest for firms in 1894, a decision which was overturned as part of a Supreme Court ruling in 1895. A muddle of laws, judgments and a constitutional amendment partly restored the interest deduction in America from 1909 to 1916.

One aim was to help the indebted railroad industry. The full deductibility of interest was eventually permitted in 1918 as part of a package to help companies struggling with the effects of the first world war. Mortgage-interest deduction was allowed in 1913, at a time when few Americans had mortgages. It was only after the second world war that this perk became associated with the political aim of boosting home-ownership.

Today, tax breaks for debt are embedded in all economies and viewed as the natural order of things. For a half-accident of history they have grown mighty big. There are three ways to demonstrate their scale. First, their cost in forfeited tax revenue soared to between 2-5% of GDP a year in the rich world just before the crisis. In 2007 Britain and the euro zone spent more on subsidies for debt than on defence.

Second, the value of tax breaks is large relative to the assets they are linked to. In America their present value (the value in today’s money of the potential tax benefits for borrowers) equates to perhaps 14% of the value of the stock of homes and 11% of the assets of firms. These calculations discount the tax saved by 3%, the yield on long-term Treasuries, and exclude the benefits accruing to financial firms and to partnerships.

A third way of showing the size of the tax distortion is to see how it affects the calculations that borrowers make. The annual interest payments on a $1m mortgage can be reduced by over a quarter as a result of interest deductibility. A big American firm typically pays an after-tax interest rate of 3% on debt, while the cost of equity (based on the annual return that shareholders expect) is 8% or more. About half of that gap is explained by tax breaks.

Colonel Mustard, with a subsidy
Debt subsidies did not cause the financial crisis. Corporate-tax rates in many countries fell in the run-up to the crash, lowering the potency of the tax perks. Most multinationals run solid balance-sheets. In America rich households get much of the benefit of the mortgage-interest relief—and few of those defaulted.

Yet a bias in the global tax system probably made the crisis worse, says Simon Johnson of the Massachusetts Institute of Technology. It boosted the overall level of debt and created pockets of distress. The Netherlands had the world’s most generous tax subsidies of mortgages, worth 2% of GDP a year, more than double the level in America. It built up one of the highest levels of mortgage debt, which still hangs over the economy. And many corners of the corporate world took lots of risk.

Leveraged buy-outs and commercial real estate relied on heavy borrowing, made cheaper by tax breaks, and generated heavy losses. In the latest stress tests conducted by the Federal Reserve and European Central Bank, the corporate sector accounted for 30-40% of expected banking-system losses.

Banks, inevitably, took most advantage, gaming the tax rules with devastating results. Most issued “hybrid” securities that were treated as debt by the taxman but as capital by credulous regulators. In the crisis hybrids did not act as a buffer that absorbed losses. About a third of big Western banks’ capital was made up of these instruments. Had they raised equity instead, fewer banks would have wobbled, says Ruud de Mooij of the IMF. The resulting financial crisis left a debt burden that largely remains (see chart 1).

I’ll be at your side forever more
None of this is to deny the importance of debt. It serves many useful economic functions. It allows money to travel through time and across social divides. A firm that is short of cash but that has good prospects can raise funds and repay them tomorrow. A rich or frugal person with more money than they wish to spend can lend to those whose outlays exceed their income.

Bosses like debt because it allows them to raise funds while keeping full control of their firms, as long as they meet their payment schedule. Savers like to own bonds or make loans because those interest payments are usually a safe stream of income. If the borrower gets in trouble, creditors have first claim on their assets. Debt can take complex income streams and make them regular. Everything from Korean shipbuilders’ cash flows to the royalties from David Bowie’s song, “Space Oddity”, have been fashioned into bonds offering predictable payment schedules.

Nor is there a logical limit to the amount of debt. One man’s debt is another’s asset. Global debts should cancel out to zero. A thicker web of debt contracts is taken as a sign of economic sophistication, not impending insolvency. “Credit is the vital air of the system of modern commerce,” said Daniel Webster, an American senator, in 1834. “It has excited labour, stimulated manufactures, pushed commerce over every sea.” Emerging economies have long been told that “financial deepening” is essential to pay for the new roads and factories that they need.

Beyond a certain point, though, debt seems to be bad for the economy. The Bank for International Settlements (BIS), a club of the world’s central banks, reckons the threshold is 85% of GDP for household debt, and 90% of GDP for non-financial corporate debt. Most rich countries breach, or are close to breaching, at least one of those benchmarks.

Excess debt hurts growth in two ways. In the rich world most new debts do not finance new productive assets like factories or machines; they just reshuffle claims on existing assets. But these debts still need a big financial industry to administer them, says Stephen Cecchetti, now of Brandeis International Business School and before of the BIS. That sucks resources from the rest of the economy.

Debt also hurts growth by creating fragility. Fixed payments mean that households and firms are more sensitive to downturns, cutting their spending deeper and faster in response, or going through disruptive defaults. The economy’s middle-men—banks—create a second layer of trouble since their solvency is especially sensitive to shocks. If banks have lots of short-term debt that needs to be rolled over, then they become vulnerable to runs.

The fragility of debt stands in contrast with another financial instrument—equity or shares.

Unlike interest, the dividends paid to equity holders can be cut if things go wrong, without triggering a default. Equity does not expire, so does not need to be refinanced. The benefits of this flexibility were shown in the 2000-02 dotcom stockmarket crash. The losses then were $4 trillion, more than the $2 trillion global banks suffered in 2007-10. Yet there was no credit crunch. In a crisis, equity bends while debt breaks. Despite this, equity has been a fading form of finance in the rich world. The net amount of corporate equity issued in America has been shrinking for a decade. In contrast, between 2007 and 2014, debt in the non-financial sector—governments, households and firms—rose in 41 of 47 of the planet’s big economies, relative to their GDP, says Richard Dobbs of McKinsey, a consultancy (see chart 2).

The closest there is to a rule governing the right level of debt is the theory of Modigliani and Miller. It says that the capital structure of a firm cannot alter its value (assuming a world without tax). Its operating profits and riskiness remain the same, no matter how its funding is sliced and diced into equity, debt or other instruments. The theory does not specify what the right level of debt or equity might be but it makes clear that firms should not regard one form of financing as better than the other. Broadly speaking the same principle should apply to household balance-sheets too.

Yet in the real world, there is a strong bias towards debt. What explains this? The tax break is one factor, but not the only one. The bias also reflects the wiring in humans’ brains. Savers are prone to think that the fixed flow of payments offered by debt is safer than it actually is. When asset prices (in particular property) rise, borrowers are tempted to think that they will rise further and use debt to buy more assets in order to magnify their profit.

The bias towards debt created by tax and psychology has been amplified by powerful forces in the global economy that have led to more financial deepening, says Adair Turner, a former chairman of Britain’s Financial Services Authority and the author of a forthcoming book called “Between Debt and The Devil”.

Consider global imbalances, first. Exporters such as China build up savings and invest them abroad. In theory they could buy equities. But had China invested its foreign reserves in American shares, it would now own about a fifth of the S&P 500 index and have de facto control of corporate America, a politically impossible position. So the exporting countries bought safer and less controversial debt instead—75% of the rise in foreign ownership of American securities between 2004-08 was in the form of debt, most of that mortgage and corporate bonds.

Income and wealth inequalities within economies also amplify the impulse towards debt. Rich people have a lower propensity to spend than most, so the more they earn the more they save.

That money has to be recycled into the financial system, creating more financial instruments.

Those in need of capital are often poor people with stagnant incomes. In practice debt is the only way to funnel money to them. You cannot, after all, buy shares in a household. Subprime debt secured against houses seemed safe.

A third and final accelerant is the financial industry. Its natural impulse is to create new instruments to drum up business. And it much prefers creating debt to equity. Debt is the magic ingredient that makes modern finance possible. Risky cash flows can be packaged into apparently steady payments, making it easy to reassure—or deceive—customers. Arbitrage (exploiting differences in price between similar assets) is only profitable if magnified by leverage. By using layers of debt with different seniority, risk can be transformed in almost infinite ways.

The financial industry also has its own distortions that encourage it to issue debt on its own balance-sheet. Banks—and in America, the housing agencies Fannie Mae and Freddie Mac—proved to be government-backed, an implicit guarantee that makes their borrowing costs artificially low. What is more, bank executives are often paid on the basis of badly designed profit measures, such as return on equity, that are flattered by leverage. All of which means that debt would retain some of its allure even without the tax breaks.

If you take a walk, I’ll tax your feet
Some, but not all. So what would happen if these subsidies were removed? It would be a revolutionary step because the breaks are embedded in the way firms and homebuyers behave.

That suggests it would cause some short-term disruption. But the longer-term pay-off could be immense.

Start with the short term. So far as withdrawing mortgage relief goes, the historical examples are muddy. Britain’s mortgage-related tax perks contributed to a house-price boom in the 1980s but their abolition in 2000 did not stop another bubble from inflating. The sheer complexity of today’s financial industry adds to the murkiness. But it seems likely that there would be an initial jolt to house prices if the subsidy were withdrawn. The Netherlands saw a price drop of about a tenth when it cut mortgage subsidies in 2012. An equivalent drop is likely in America given the value of the subsidies relative to the housing stock. The direct pain would be felt by the well-off—almost 90% of the value of the mortgage-interest tax break goes to households making over $75,000 a year. But lower house prices would be uncomfortable given that 17% of households have negative equity. The same is true in the euro zone, which is battling deflation.

As for corporate tax, much would depend on how policymakers went about reform. The purest option is to abolish corporate tax entirely—and instead have one layer of tax levied on the income individuals receive from investments in firms. That would remove a vast amount of complexity from the system and limit the incentive for tax-dodging and lobbying by firms. But cutting corporate taxes would be politically toxic at a time of stagnant wages for many workers around the world.

Two alternative approaches exist. The first balances the scales between debt and equity by levelling down: creating an equivalent tax break for shareholders. This system, which is in place in parts of Europe and is known as the “allowance for corporate equity” (ACE), permits firms to make a certain level of profit without incurring tax. The trouble is that, on its own, it would lead to a drop in tax revenues—Belgium introduced ACE in 2006 and saw corporate-tax revenues halve. It has recently introduced a “fairness tax” to try to recoup some revenue.

The second approach balances the system by levelling up: making interest taxable on the same basis as shareholders’ profits. This would hugely expand the tax base, allowing a drop in the headline tax rate. Robert Pozen of Harvard Business School reckons that if firms could only deduct two-thirds of their interest costs, the headline rate of corporate tax in America could be cut from 35% to 25% while keeping tax revenues stable. Using his figures, were interest-deductibility to end completely, the tax rate could fall to about 15%.

On paper, the impact on firms of either approach should be small. If the absolute tax take from firms remained unchanged, then their enterprise value (debt plus equity) would be unaffected.

Firms’ underlying cash flows and risk profiles would be the same. Companies would simply rejig their mix of debt and equity.

In the real world, things would be bumpier. An ACE system might boost firms’ values, since the aggregate tax bill might fall. The alternative approach of taxing interest would be more disruptive—although not to big non-financial firms. Were interest deductibility to be abolished and the tax rate cut so that tax revenues were flat, only 8% of the S&P 500 index of American firms, and 6% of the top 2,000 global firms, would see their profits drop by over a fifth (excluding financial firms).

But outside the public markets, taxing interest would bash a cohort of firms with low margins or that have over 75% of their balance-sheet funded by debt. In America the obvious victims are utilities, cable-TV firms and commercial real-estate firms. Many leveraged buy-outs would be in trouble. One private-equity chief warns, “You’re opening up a Pandora’s box…It would cause massive disruption and market turmoil.” Firms might rush to list their shares and issue new equity, causing the overall stockmarket to fall in the face of the extra supply of shares.

Taxing interest would hurt bits of Main Street, too. Small firms find it hard to raise equity.

Farmers would find it more expensive to get loans to smooth the seasonality of their incomes. In Europe and Asia indebted holding companies are often used to control corporate empires: some of these structures would wobble.

The financial industry would be profoundly affected. Assume that banks were taxed on the interest paid on their debt (but not on their deposits), and the headline tax rate dropped by a third. For HSBC, a global bank, profits would not have changed much last year. But that reflects the fact its cost of debt is close to zero. At some point central banks will raise rates.

Were HSBC’s cost of debt to rise to 5%, the tax change would wipe out a quarter of its profits.

It would have to charge its customers more.

Whichever tax reform took place it would prompt a flurry of evasive action. Financial firms would try to reclassify their debts as deposits. Unless governments tried to unify their corporate-tax and personal-tax codes, businesses would change their legal status to evade tax.

For example, if interest were taxed, more American firms might become “pass through” entities such as partnerships, where tax is levied at the personal, rather than corporate, level.

And unless the reform was global, multinational firms would surely try to issue debts in countries that still offered tax relief. A vast edifice of cross-border finance contracts would be rearranged.

Dismantling the doomsday machine
In the long run, however, the rewards from reform could be great. The surge in debt seen since the turn of the century might be halted (see chart 3). A neutral tax system would tilt the world’s balance-sheet away from debt towards equity. It would appear more volatile—like a corset, debt masks nature’s wobbles—but actually be more flexible. The pillars of the financial system—borrowers, savers and financial intermediaries—would all work differently.

Today four-fifths of the stock of global financial assets is debt or deposits. This mix would change, with more shares being issued and new equity instruments being invented. There would be a wave of experimentation with equity-linked mortgages, in which a share of the risk of a house-price change is assumed by lenders or third-party investors. Today these products are penalised by the tax system, says Jason Furman, the chairman of the Council of Economic Advisers at the White House. “Landlord companies” might emerge that listed their shares and invested in the equity of people’s houses.

Savers would join a modern cult of equity. Today pension and insurance funds are obsessed with debt, egged on by regulators who ask them to hold “safe” bonds regardless of their price.

In this brave new world, savers would have to get used to owning equity products whose price moved up and down. Dividends from shares would replace interest income from bonds. Those payments could be cut in a downturn—in 2008-09 American dividends dropped by a fifth. That would prevent a crisis but hurt pensioners who live off investment income.

Borrowers would have to change their ways, too. Lower house prices would help the young and poor, but they might find it harder to get conventional mortgages. Renting is one alternative—the 20th century’s obsession with home-ownership might ebb. Allowing third parties to own a share in a home might be another. Companies would issue more shares. It is hard to see any big downside to this. A more equity-focused culture might help younger firms get up and running, perhaps one reason why Marc Andreessen, a venture capitalist in Silicon Valley, backs tax reform.

Lastly, the financial system would have to shift its emphasis towards arranging equity contracts between savers and firms and households. This would be far easier in America, where capital markets dominate—getting mutual funds to buy stocks instead of bonds is relatively simple. In Europe and Asia, where banks suck up most savings and recycle them as loans, the process would be harder. But around the world banks would shrink.

Reforming the bias in the tax system is not the stuff of public campaigns. A vast web of contracts has been woven around a fiscal technicality, guarded by huge vested interests.

America last seriously considered the idea in 1992, and beyond some tweaks to the tax code in
Belgium, Britain, Italy and the Netherlands, there has been little sign of reform. But the moment for change may never be better.

Interest rates are low, profits are high and house prices stable. As rates increase from rock-bottom levels, interest costs will rise, inflating the size of the distortion. The tax subsidy on the vast debts of rich countries will head back towards the levels seen just before the crisis in 2008.

And the debt machine will kick into overdrive again.

lunes, mayo 18, 2015



What's Next for Gold?

 By: Axel Merk
Monday, May 11, 2015

Will gold zoom higher with Greece on the brink of default? Or will it crash as the Fed pursues an "exit?" Why has gold not rallied with the recent retreat of the dollar? To understand where gold may be heading, keep in mind that this shiny metal isn't changing; it's the world around it that is. We contemplate why investors may want to hold gold as part of their portfolio.
Currency Wars: Are we winning?
In today's world where the utterance of a pundit may move markets, it may be helpful to go back to basics to allow investors to make up their own mind as to what drives markets and what may be a good investment. As such, gold is simply a precious metal, a rare, naturally occurring chemical element that tends to be less reactive than most elements. These attributes have allowed gold to be the preferred choice as money:
  • Gold's chemical characteristics make it a formidable store of value because it doesn't change, doesn't deteriorate over time. More so, because gold is rare, a lot of value can be stored in a small space: A "London Bar" - to the layman only known from James Bond or other movies, weighs about 400 troy ounces and is worth about half a million dollars.
  • And gold is fungible and can be broken down into smaller pieces, such as minted into coins or smaller bars. As such, gold is suitable as a medium of exchange.
With the advent of fiat currency, many have said gold's golden days are over because it is more cost effective to electronically wire money across the globe than to ship gold. There is also an electronic market for gold, although it is dominated by institutions with only a few firms offering consumers the ability to exchange gold electronically.

Naturally, many buying gold tend to do so because of its characteristics as a store of value.

Mind you, some critics object that gold is a store of value given that the price of gold dropped from over $800 an ounce in 1980 to almost $250 in 1999 and 2001. When it comes to purchasing power preservation over long periods, however, gold has shown to preserve its purchasing power, as, for example, a gallon of milk cost about the same in gold 100 years ago as it does today; or, to use a frequently cited example, the same applies to a tailored suit. Conversely, when it comes to the U.S. dollar, we know its purchasing power has been eroding:

Purchasing Power of the Dollar 1913-2013

Indeed, we are concerned many currencies, not just the U.S. dollar, are at risk of losing their store of value.

A key reason why cash is not good at preserving purchasing power is the government issuing it has lots of debt: a government in debt has an incentive to debase the purchasing power of its currency. This isn't just a criticism of the U.S. government, but governments in general. What's different about gold is that governments can't "print" it.

Many agree that cash might not be good at preserving purchasing power, but that one should be investing in productive companies instead, but was that a good idea in 1929 or 2000? Severe declines followed those stock market peaks. Someone arguing that regardless of those painful periods of stock market declines, stocks are a good long-term investment; many refer to such a person as a prudent long-term investor. Another person making the argument gold has fared well in the long-run is shrugged off as a gold bug.

Talking about prudent investors, most investment advisers don't advocate putting all of one's money into the stock market. Instead, they preach diversification. Except that, I would argue, textbook diversification may not work in an environment where most asset prices might be elevated. Central banks around the world, in our analysis, have compressed risk premia, meaning risky assets don't appear particularly risky anymore, as evidenced by low volatility in the equity markets or low yields in the junk bond market. I hear stories about shifting from one sector in the equity market to another, as that other sector may perform better in a rising rates environment. That may well be, but if both equities and bonds were to plunge, is it sufficient consolidation to lose less money by being slightly better positioned?

What about an environment where
  • stocks may be expensive;
  • bonds may be expensive;
  • cash may not be safe in the sense that purchasing power is at risk.
In this context, we believe gold is worthy of being considered, even if it is not "productive." In fact, it may be worth considering precisely because it is not productive, because gold just is. It's the world around gold that changes, not the gold itself. As such, yes, the price of gold will vary.

It's part of the reason why gold has been cited as both an inflation and deflation hedge: in an inflationary environment, the value of cash versus gold may decline; in a deflationary environment, asset prices in general may decline versus gold (notably if there are defaults). So let's look at the price of gold since 1970:

Gold Price 1970-2015

As the chart above shows, the price of gold clearly does not always go up. When all is said and done, however, the annualized return from 1970 until the end of March this year was 8.2% per annum, while exhibiting a correlation to equities of zero.

The zero correlation to equities is nothing short of stunning. We have all experienced the price of gold move together or in opposite direction with the stock market on certain days. But that they amount to a net zero correlation is quite amazing. The reason this is so special is that the two key elements investors may want to be looking for when considering to add to their portfolio is:
  • Whether the return stream generated has a low correlation to other assets in the portfolio; and
  • Whether there is an expectation of a positive return.
If both of these conditions are met, one can start discussing how much to add to a portfolio.

With regard to correlation, we think gold is a candidate investors may want to consider, especially in an environment where many other asset classes are highly correlated. An important reason for this low correlation may be the low industrial use of gold. While jewelry demand may give gold a bit of cyclicality, the low general industrial use may be a key driver why the price of gold has such a low correlation to stocks and many other asset classes.

What about the other aspect: positive returns. How is it possible that gold, this piece of metal that's not productive, that it has had its price increase by an average of over 8% per annum? The results for long periods tends to outstrip inflation. There may be many drivers, but the simplest answer may well be that published inflation numbers under-state actual inflation. Other possible answers include increased demand (partially due to global population growth, if nothing else) while increasing supply isn't that easy. In some ways, this may be irrelevant, because the real question is what will happen to the price of gold going forward.

What is intriguing about gold is that many acknowledge gold has been a good investment in the past, but going forward, they don't think it's going to rise in value. And that's where we can finally turn to the current environment.

The reason I'm a bit skeptical about Greece driving gold higher is because I don't think Greece drives the markets all that much these days. With many warnings about a Greek default one would think that the market has had time to prepare for it. Outside of Greece, the fear of "contagion" as a result of Greek default is limited these days because financial institutions have had years to prepare for a Greek default. Much of Greek debt is now held by the International Monetary Fund (IMF); as well as the European Central Bank (ECB) and European Union. In our assessment, losses on Greek debt won't wreck the financial system, likely not even any financial institution, as losses have been "socialized." This socialization of losses is foremost a political problem. I don't rule out that the price of gold may be affected, but it may be difficult to devise a profitable gold investment strategy purely based on Greece. A longer-term strategy buying gold in anticipation that more debt might be monetized may be more worth considering. Although we think this belongs in the long-term bucket, a similar bucket as is required for dealing with long-term entitlement issues in the U.S.

To me, the below chart is one of the most compelling arguments why, going forward, gold may be no worse an investment than in the past. We don't know where the price of gold is going to be tomorrow, but we have made promises in the U.S., just as in much of the developed world - that may be difficult to keep. The temptation to debase the purchasing power of the debt is great.

Federal Revenue, Spending and Deficit

Notably, even as rates may be moving higher in the U.S., will real interest rates, i.e. rates after inflation, be positive? The last paragraph published by the Fed's FOMC has now included many times what we interpret to be all but a promise to be late in raising rates: "The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run."

In plain English, we believe the Fed will be behind the curve. Bill Gross calls for a "new normal" that may see interest rates top out at 2%. Our question is: where will inflation be if interest rates top out?

I have discussed this view that we may not see positive real interest rates for an extended period over the next decade with some policy makers. A response I received from a Fed official was that this view is unlikely correct because it wouldn't create a stable equilibrium. My response to that was that I never said this would be stable...

Big banks flag dangers of financial bubble in oil and commodities

Barclays warns that the latest commodity boomlet has charged ahead of economic reality across the world: 'Watch out: this rally may not last'

By Ambrose Evans-Pritchard

8:18PM BST 11 May 2015

Oil has jumped 40pc since January, even as the US, China and the world economy as a whole have been sputtering Photo: Alamy
The big global banks have begun to warn clients that the blistering rally in oil and industrial commodities in recent weeks has run far ahead of economic reality, raising the risk of a fresh slump in prices over the summer.

Barclays, Morgan Stanley and Deutsche Bank have all issued reports advising investors to tread carefully as energy and base metals fall prey to unstable speculative flows in the derivatives markets.

Oil has jumped 40pc since January even as the US, China and the world economy as a whole have been sputtering, falling far short of expectations.
“Watch out: this rally may not last. The risks for a reversal in recent commodity price trends are growing,” said analysts at Barclays.
“There is a huge disconnect between the price action in physical markets where differentials are signalling over-supply and the futures markets where all looks rosy.”

Miswin Mahesh, the bank’s oil strategist, said a glut of excess oil is emerging in the mid-Atlantic, with inventories rising at a rate of 1m barrels a day (b/d). Angola and Nigeria are sitting on 80m barrels of unsold crude and excess cargoes are building up in the North Sea and the Mediterranean.

Morgan Stanley echoed the concerns, warning that speculators and financial investors have taken out a record number of “long” positions on Brent crude on the futures markets even though the world economy keeps falling short of expectations. “We have growing concerns about crude fundamentals in the second half of 2015 and 2016,” it said.

Shale producers in the US are taking advantage of the artificial surge in prices to hedge a large part of their future output, more or less guaranteeing that the US will continue to pump 10m b/d and wage a war of attrition against high-cost producers in the rest of the world.

A comparable dynamic is playing out in the copper market, where net long positions have jumped 60pc since the start of the year and helped power the longest rally in copper prices since 2005, even as industrial output grinds to a halt in China.

The warnings come as a draft report from OPEC painted a gloomy picture of energy industry, predicting that oil wouldn't touch $100 in the next 10 years.

The mini-boom in energy and metals has taken on huge significance since it is being taken as evidence that global recovery is under way and that the dangers of a deflationary spiral have abated. Barclays said that this in turn is a key factor driving up global bond yields, and therefore in repricing the cost of global credit.

If the commodity rally is being driven by investor exuberance in the derivatives markets – rather than a genuine recovery in the world economy – it is likely to short-circuit before long and could even lead to a relapse into deflation. It is extremely difficult for central banks to navigate these choppy waters, raising the risk of a policy mistake.

Fresh data suggest that the US economy may have contracted in the first quarter, and is currently growing at a rate of just 0.8pc, below the US Federal Reserve’s stall speed indicator.

Deutsche Bank has also warned that the energy rally is showing “signs of fatigue”, with near-record inventories in the US, and little likelihood of further stimulus from central banks at this stage to keep the game going. “We see fresh downside risks to crude oil prices heading into the summer,” it said.
Durable oil rallies are typically driven by OPEC cuts but this time the cartel has boosted supply by 500,000 b/d to 31m as Saudi Arabia tries to drive marginal drillers out of business across the world.

Contrary to expectations, America’s shale producers have yet to capitulate. The rig count has fallen by more than half but output has held up longer than expected. While a few drillers have gone bankrupt, others are already signalling plans to crank up production.

Houston-based EOG said it expects to boost output in the third quarter at the Eagle Ford basin in Texas, benefiting from dramatic gains in technology that are cutting shale costs at an astonishing speed. Devon Energy has raised its growth target to 25pc to 35pc this year, having cut its production costs by a fifth in the first quarter.

Tactical stockpiling of crude oil by China and other countries has masked the scale of oversupply but oil analysts say this effect may be fading. The deep economic slowdown in resource-hungry emerging markets has snuffed out the commodity supercycle. There is little sign yet of a durable rebound.

China is still slowing as President Xi Jinping deliberately engineers a deflation of the country’s investment bubble. A series of cuts in the reserve requirement ratio and interest rates – including a 25pc reduction over the weekend – merely offsets “passive tightening” caused by capital outflows and rising real borrowing costs. It is not yet a return to ‘"stimulus as usual".

Not everybody is willing to throw in the towel on crude oil. Michael Wittner, from Societe Generale, said US output will decline in the coming months as the delayed effects of lower investment start to bite, ultimately vindicating the Saudi's shock strategy of flooding the market.

Crude stockpiles tend to build up from March to May. This is the “window of greatest vulnerability for a crude price correction”, Mr Wittner said. That window will be closing within weeks.

The Real Reason China Is Buying Up The World's Gold

  • China's central bank is buying huge quantities of gold.
  • China wants the yuan to become a reserve currency, but does not want a "strong yuan".
  • China wants the leverage to control all currency values, which requires control of the gold market.
China has spent the last 6 years importing thousands of tons of gold and buying all of its own domestic production. According to Koos Jansen, the China Gold Association (CGA) Yearbook listed net imports in 2013 at 1,524 tonnes, with an additional 428 tonnes from domestic production, a sum total of 1,952 tonnes. In 2014, China imported at least 1,250 tonnes and domestically mined 452 tonnes, for a sum total of 1,702 tonnes. Total imports amounted to more than 410 tonnes in the first two months of 2015 alone, which is a big jump from 2014 demand.

On April 20, 2015, Bloomberg Intelligence estimated that The People's Bank of China tripled its holdings of gold bullion, since April 2009, to 3,510 metric tons. That means, more or less, the Chinese government has purchased virtually all of its domestic gold production over the last 6 years.

The estimate is based on trade data, domestic output and the figures published by the China Gold Association. That means that the Chinese government is the second largest gold-holder in the world, outmatched only by the USA, which claims an alleged hoard of 8,133.5 tons of the yellow metal.

Bloomberg speculates that China is buying gold because it intends to bolster the acceptability of the Chinese yuan in international commerce. The line of thinking is that large gold holdings make currencies more credible candidates for reserve currency status. Yet, a gold-backed currency is not likely to impress the staunchly anti-gold IMF, or increase the likelihood that the Chinese yuan will be added to SDR. Just the opposite.

The IMF was founded by western nations, and the nation with the largest number of voting shares is the United States. For historical reasons, most Western nations, and particularly the USA, continue to be anti-gold. During the 1920s, America gave lip-service to being on a so-called "gold standard".

However, in common with most western nations, it printed far more paper money than the gold reserves could back up.

When a recession hit in 1929, national gold reserves could not cope with the increased demand for redemption. By 1933, most western nations ended up defaulting on their gold redemption obligation to individual holders of their currencies. As part of a post-default anti-gold campaign, gold ownership in the USA became illegal from 1933 to 1974. Individuals continued to be subject to criminal sanctions until America defaulted on its inter-governmental gold debts. Post-default relief from pressure on US gold reserves caused American gold trading to become legal again.

This long history of currency and gold standard mismanagement caused the insertion of article 4, Section 2b of the IMF's Articles of Agreement. It specifically prohibits member states from fixing currencies against gold. As a result, with hopes of stabilizing its emerging market currency, instead of fixing the yuan against gold, starting with the Asian Financial Crisis of 1998-1999, China fixed against the US dollar. In July 2005, the "fix" was changed to a managed float. The renminbi strengthened by 21% between 2005 to 2008. In August 2008, the policy changed back again. China 're-pegged' until June 2010 when pressure from the USA caused them to drop the peg again. For more on China's exchange rate policy, see this.

China's fix and/or managed "float" both insure a weak yuan. This causes Chinese goods to be cheaper than similar goods sold by western counterparts. That is a huge competitive advantage.

It supports employment and, therefore, political stability. Simply put, so long as the vast majority of Chinese workers are gainfully employed, they are less likely to revolt. The chance that China will suddenly give up a decades-long cheap currency policy, and destroy that stability, is nearly zero. China's leadership is not buying gold to go on the gold standard. It simply wants the power to set reserves and, therefore, currency values, particularly the yuan vs. US dollar ratio.

A recently declassified transcript of a recorded conversation between former US Secretary of State, Henry Kissinger and his Undersecretary for Economic Affairs, Thomas O. Enders, helps in gaining a better understanding of this issue. It reads, in pertinent part, as follows:
Mr. Enders: It's against our interest to have gold in the system because for it to remain there it would result in it being evaluated periodically. Although we have still some substantial gold holdings - about $11 billion - a larger part of the official gold in the world is concentrated in Western Europe. This gives them the dominant position in world reserves and the dominant means of creating reserves. We've been trying to get away from that into a system in which we can control ... 
Secretary Kissinger: But that's a balance-of-payments problem. 
Mr. Enders: Yes, but it's a question of who has the most leverage internationally. If they have the reserve-creating instrument, by having the largest amount of gold and the ability to change its price periodically, they have a position relative to ours of considerable power. For a long time we had a position relative to theirs of considerable power because we could change gold almost at will. This is no longer possible - no longer acceptable. Therefore, we have gone to Special Drawing Rights, which is also equitable and could take account of some of the less-developed-country interests and which spreads the power away from Europe. And it's more rational in ... 
Secretary Kissinger: "More rational" being defined as being more in our interests or what?
In other words, whoever controls the price of gold against their own currency controls the price of gold against any other currency that gold is denominated in. When China increases the number of yuan it takes to purchase one ounce of gold, the dollar will respond by rising in value, even though China will not be pegging its yuan directly against the dollar. The dollar's rise could only be capped by a concerted effort by the USA.

Control over the worldwide currency markets is why China wants to control the gold market.

It is already taking affirmative steps to establish that control, and that is what is behind the announcement that the Shanghai Gold Exchange will establish a yuan-based gold fix before the end of 2015. The chairman of the SGE, Xu Luode, has been not been shy about it. He has very openly stated that China intends to control the gold market. He stated:
The international board will form a yuan-denominated gold price index system named "Shanghai Gold". Shanghai Gold will change the current gold market "consumption in the East priced in the West" situation. When China will have a right to speak in the international gold market, pricing will get revealed.
The yuan-based gold price, in other words, will be set at the SGE, which is nothing more than a clearing house similar to exchanges in the West, in that it is sponsored by banks. The difference is that the Shanghai Gold Exchange is sponsored by Chinese banks with direct government support.

Even in the $5 trillion + London currency and gold markets, which are supposedly the most transparent in the world, a few large banks managed to manipulate and control the price of both gold and paper currencies. These banks are even now paying multi-billion dollar fines to various regulators, in an attempt to avoid prosecution.

In contrast to the predominantly private London banking structure, the largest most important banks in China are key tools of central planning and largely state-owned. Yet, under the guise of a "free market", the Chinese government will set the price of gold. The "market", indirectly controlled by China through its state-owned banks, is a convenient mirage. China's leaders will be able to unilaterally increase or decrease the yuan based gold price. The exchange rate, therefore, between the yuan and US dollar must automatically change too, because both currencies denominated against gold.

If China increases the number of yuan required to buy a troy ounce of gold, for example, the USA must allow the dollar gold price to rise with it. If not, the yuan will fall against the dollar.

In other words, China will determine the value of the US dollar on world markets, not the USA.

That shifts the power and leverage away from Washington DC and toward Beijing, and will have a dramatic effect on the financial strength of the US government.

Signeurage is the revenue arising out of creating money. This is because it costs nearly nothing to print paper money, and even less to "print" its electronic version. Yet, this money can be used to buy real things, like oil, houses, cars, plant and equipment. As the printer of the world's reserve paper currency, the USA receives a huge signeurage payment every year. The dollars are printed, used to pay for stuff purchased from foreign lands, and then stored overseas in various places, including central bank vaults, and the mattresses of Russian babushkas.

Every nation and person buying dollars and/or dollar denominated bonds gets to pay, in part, for America's social programs, newest aircraft carriers, stealth fighter jets, drones etc..

Worldwide financial instability since 2008 resulted in the absorption of about $3 trillion dollars newly printed by the Federal Reserve, for one example. The US government has had the benefit of the equivalent of hundreds of billion dollars every year. It will be hard, maybe impossible, to replace that income.

The ancient Chinese strategist, Sun Tsu, is clearly the inspiration for China's massive gold accumulation. If you read his famous book, The Art of War, you may note that he recommended destroying enemies by attacking their economic base, rather than by mounting overt physical attacks. That is exactly what China is doing to the USA. America's policy-makers have stumbled into China's trap.

Once China has enough gold, it will bid up the yuan-denominated price into the stratosphere.

Once it does that, there are only three choices. First, maintain credibility and the reserve currency status by refusing to change the price of US dollar denominated gold. If it does that, domestic industries will be crippled by Chinese competition, because the yuan will become very cheap in relation to the dollar.

Second, allow the dollar denominated price of gold to skyrocket in synch with the yuan denominated price. That will end the US dollar's reserve currency status. Third, kow-tow to Beijing, seeking a seal of approval from China for any serious financial maneuvers.

None of America's choices are good ones. At this point, no matter what the USA does, China wins.

Making things worse is the fact that it will be nearly impossible to prove China is a "currency manipulator" based on the IMF rules. China will simply point to the SGE, explain how the price is set by supply and demand, and win any arbitration brought against it.

It is impossible to know the exact date China will launch its final effort to strip America of its power and authority in the world. But, the current massive gold buying is clearly the main step necessary to do so. China is determined to take power, revenues and international leverage away from the USA.

Meanwhile, hapless US policy makers appear to be blissfully unaware of what the Chinese are planning.

The Trouble with Cash

By: Alasdair Macleod
Thursday, May 14, 2015

When interest rates are zero and it costs a bank to look after your money it becomes an unattractive asset. Banks in some jurisdictions (such as Switzerland, Denmark and Sweden) are even charging customers interest on cash and deposits. And if you go to your bank and withdraw large amounts in the form of folding notes to avoid these charges you will be lucky if you are not treated as a sort of pariah. For the moment, at least, these problems do not extend to sound money, in other words gold.

There are two distinct issues involved with government-issued currency: zero-to-negative interest rates, which all but eliminate any interest turn on deposits for the banks, and a systemic issue that arises if too many people withdraw their money from the banking system.

The problems with the latter would become significant if enough people decide to effectively opt out of holding money in the banks.

Conversion of bank deposits into physical cash increases reserve ratios, restricting the banks' ability to create credit. However, while the banks are contractually obliged to supply physical cash to anyone who wants it, a drawdown on bank deposits is a bad thing from a central bank's point of view.

A desire for physical cash is, therefore, discouraged. Instead, if the option of owning physical cash was removed and there was only electronic money, deposits would simply be transferred from one bank to another and any imbalances between the banks resolved through the money markets, with or without the assistance of a central bank. The destabilising effects of bank runs would be eliminated entirely.

In the current financial climate demand for cash does not originate so much from loss of confidence in banks, with some notable exceptions such as in Greece. Instead it is a consequence of ultra-low or even negative interest rates. The desire for cash is therefore an unintended consequence of central banks attempting to inject confidence into the economy. The rights of ordinary individuals to turn deposits into physical cash are therefore resisted by central banks, which are focused instead on managing zero interest rate policies and suppressing any side effects.

Central banks can take this logic one step further. Monetary policy is primarily intended to foster investor confidence, so any tendency for investors to liquidate investments is, therefore, to be discouraged. However, with financial markets getting progressively more expensive central bankers will suspect the relative attraction of cash balances are increasing. And because banks are making cash deposits more costly, this is bound to increase demand for physical notes.

Monetary policy has now become like a pressure cooker with a defective safety-valve. Central bankers realise it and investors are slowly beginning to as well. Add into this mix a faltering global economy, a fact that is becoming impossible to ignore, and a dash-for-cash becomes a serious potential risk to both monetary policy and the banking system.

There is an obvious alternative to cash, and that is to buy physical gold. This does not constitute a run on the banking system, because a buyer of gold uses electronic money that transfers to the seller. The problem with physical gold is a separate issue: it challenges the raison d'être of the banking system and of government currencies as well.

This is why we can still buy gold instead of encashing our deposits, for the moment at least. It can only be a matter of time before people realise that with the cash option closing this is the only way to escape an increasingly dysfunctional financial system.

World War II and the Origins of American Unease

By George Friedman

May 12, 2015 | 08:00 GMT

We are at the 70th anniversary of the end of World War II in Europe. That victory did not usher in an era of universal peace. Rather, it introduced a new constellation of powers and a complex balance among them. Europe's great powers and empires declined, and the United States and the Soviet Union replaced them, performing an old dance to new musical instruments. Technology, geopolitics' companion, evolved dramatically as nuclear weapons, satellites and the microchip — among myriad wonders and horrors — changed not only the rules of war but also the circumstances under which war was possible. But one thing remained constant: Geopolitics, technology and war remained inseparable comrades.

It is easy to say what World War II did not change, but what it did change is also important. The first thing that leaps to mind is the manner in which World War II began for the three great powers: the United States, the Soviet Union and the United Kingdom. For all three, the war started with a shock that redefined their view of the world. For the United States, it was the shock of Pearl Harbor. For the Soviet Union, it was the shock of the German invasion in June 1941. For the United Kingdom — and this was not really at the beginning of the war — it was shock at the speed with which France collapsed.

Pearl Harbor Jolts the American Mindset

There was little doubt among American leaders that war with Japan was coming. The general public had forebodings, but not with the clarity of its leaders. Still, neither expected the attack to come at Pearl Harbor. For the American public, it was a bolt from the blue, compounded by the destruction of much of the U.S. Pacific fleet. Neither the leaders nor the public thought the Japanese were nearly so competent.

Pearl Harbor intersected with another shock to the American psyche — the Great Depression.

These two events shared common characteristics: First, they seemed to come out of nowhere.

Both were predictable and were anticipated by some, but for most both came without warning.

The significance of the two was that they each ushered in an unexpected era of substantial pain and suffering.

This introduced a new dimension into American culture. Until this point there had been a deep and unsubtle optimism among Americans. The Great Depression and Pearl Harbor created a different sensibility that suspected that prosperity and security were an illusion, with disaster lurking behind them. There was a fear that everything could suddenly go wrong, horribly so, and that people who simply accepted peace and prosperity at face value were naïve. The two shocks created a dark sense of foreboding that undergirds American society to this day.

Pearl Harbor also shaped U.S. defense policy around the concept that the enemy might be identified, but where and when it might strike is unknown. Catastrophe therefore might come at any moment. The American approach to the Cold War is symbolized by Colorado's Cheyenne Mountain. Burrowed deep inside is the North American Aerospace Defense Command, which assumes that war might come at any moment and that any relaxation in vigilance could result in a nuclear Pearl Harbor. Fear of this scenario — along with mistrust of the wily and ruthless enemy — defined the Cold War for Americans.

The Americans analyzed their forced entry into World War II and identified what they took to be the root cause: the Munich Agreement allowing Nazi Germany to annex parts of Czechoslovakia. This was not only an American idea by any means, but it reshaped U.S. strategy. If the origin of World War II was the failure to take pre-emptive action against the Germans in 1938, then it followed that the Pacific War might have been prevented by more aggressive actions early on. Acting early and decisively remains the foundation of U.S. foreign policy to this day. The idea that not acting in a timely and forceful fashion led to World War II underlies much American discourse on Iran or Russia.

Pearl Harbor (and the 1929 crash) not only led to a sense of foreboding and a distrust in the wisdom of political and military leaders, but it also replaced a strategy of mobilization after war begins, with a strategy of permanent mobilization. If war might come at any time, and if another Munich must above all be avoided, then the massive military establishment that exists today is indispensible. In addition, the U.S.-led alliance structure that didn't exist prior to World War II is indispensible.

The Soviet Strategic Miscalculation

The Soviet Union had its own Pearl Harbor on June 22, 1941, when the Germans invaded in spite of the friendship treaty signed between them in 1939. That treaty was struck for two reasons: First, the Russians couldn't persuade the British or French to sign an anti-Hitler pact. Second, a treaty with Hitler would allow the Soviets to move their border further west without firing a shot. It was a clever move, but not a smart one.

The Soviets made a single miscalculation: They assumed a German campaign in France would replay the previous Great War. Such an effort would have exhausted the Germans and allowed the Soviets to attack them at the time and place of Moscow's choosing. That opportunity never presented itself. On the contrary, the Germans put themselves in a position to attack the Soviet Union at a time and place of their choosing. That the moment of attack was a surprise compounded the challenge, but the real problem was strategic miscalculation, not simply an intelligence or command failure.

The Soviets had opted for a dynamic foreign policy of shifting alliances built on assumptions of the various players' capabilities. A single misstep could lead to catastrophe — an attack at a time when the Soviet forces had yet to recover from one of Josef Stalin's purges. The Soviet forces were not ready for an attack, and their strategy collapsed with France, so the decision for war was entirely Germany's.

What the Soviets took away from the June 1941 invasion was a conviction that political complexity could not substitute for a robust military. The United States ended World War II with the conviction that a core reason for that war was the failure of the United States. The Soviets ended World War II with the belief that their complex efforts at coalition building and maintaining the balance of power had left them utterly exposed by one miscalculation on France — one that defied the conventional wisdom.

During the Cold War, the Soviets developed a strategy that could best be called stolid. Contained by an American-led coalition, the Soviets preferred satellites to allies. The Warsaw Pact was less an alliance than a geopolitical reality. For the most part it consisted of states under the direct military, intelligence or political control of the Soviet Union. The military value of the block might be limited, and its room for maneuver was equally limited.

Nonetheless, Soviet forces could be relied on, and the Warsaw Pact, unlike NATO, was a geographical reality that Soviet forces used to guarantee that no invasion by the United States or NATO was possible. Obviously, the Soviets — like the Americans — remained vigilant for a nuclear attack, but it has been noted that the Soviet system was significantly less sophisticated than that of the Americans. Part of this imbalance was related to technological capabilities. A great deal of it had to do with the fact that nuclear attack was not the Soviet's primordial fear, though the fear must not be minimized. The primordial fear in Moscow was an attack from the West. The Soviet Union's strategy was to position its own forces as far to the west as possible.

Consider this in contrast to the Soviet relations with China. Ideologically, China ought to have been a powerful ally, but the alliance was souring by the mid-1950s. The Soviets were not ideologues. They were geopoliticians, and China represented a potential threat that the Soviets could not control. Ideology didn't matter. China would never serve the role that Poland had to.

The Sino-Soviet relationship fell apart fairly quickly.

The Soviet public did not develop the American dread that beneath peace and prosperity lurked the seeds of disaster. Soviet expectations of life were far more modest than those of Americans, and the expectation that the state would avert disaster was limited. The state generated disaster. At the same time, the war revealed — almost from the beginning — a primordial love of country, hidden for decades under the ideology of internationalism, that re-emerged spontaneously. Beneath communist fervor, cynical indifference and dread of the Soviet secret police, the Russians found something new while the Americans found something old.

France's Fall Surprises Britain

As for the British, their miscalculation on France changed little. They were stunned by the rapid collapse of France, but perhaps also relieved that they would not fight in French trenches again. The collapse of France caused them to depend on only two things: One was that the English Channel, combined with the fleet and the Royal Air Force, would hold the Germans at bay. The second was that in due course, the United States would be drawn into the war. Their two calculations proved correct.

However, the United Kingdom was not one of the ultimate winners of the war. It may not have been occupied by the Germans, but it was essentially by the Americans. This was a very different occupation, and one the British needed, but the occupation of Britain by foreign forces, regardless of how necessary and benign, spelled the end of the British Empire and of Britain as a major power. The Americans did not take the British Empire. It was taken away by the shocking performance of the French. On paper, the French had an excellent army — superior to the Germans, in many ways. Yet they collapsed in weeks. If we were to summarize the British sensibility, after defiance came exhaustion and then resentment.

Some of these feelings are gone now. The Americans retain their dread even though World War II was in many ways good to the United States. It ended the Great Depression, and in the aftermath, between the G.I. Bill, VA loans and the Interstate Highway System, the war created the American professional middle class, with private homes for many and distance and space that could be accessed easily. And yet the dread remains, not always muted. This generation's Pearl Harbor was 9/11. Fear that security and prosperity is built on a base of sand is not an irrational fear.

For the Russians, the feelings of patriotism still lurk beneath the cynicism. The collapse of the Soviet Union and the collapse of Russia's sphere of influence have not resulted in particularly imaginative strategic moves. On the contrary, Russian President Vladimir Putin's response to Ukraine was as stolid as Stalin's or Leonid Brezhnev's. Rather than a Machiavellian genius, Putin is the heir to the German invasion on June 22, 1941. He seeks strategic depth controlled by his own military. And his public has rallied to him.

As for the British, they once had an empire. They now have an island. It remains to be seen if they hold onto all of it, given the strength of the Scottish nationalists.

While we are celebrating the end of World War II, it is useful to examine its beginnings. So much of what constitutes the political-military culture, particularly of the Americans, was forged by the way that World War II began. Pearl Harbor and the American view of Munich have been the framework for thinking not only about foreign relations and war, but also about living in America. Not too deep under the surface there is a sense that all good things eventually must go wrong. Much of this comes from the Great Depression and much from Pearl Harbor.

The older optimism is still there, but the certainty of manifest success is deeply tempered.