What’s Wrong With the Global Economy?

The problem goes much deeper than Trump or tariffs.

By Ruchir Sharma

                                                                                                                Credit Nicholas Konrad

Global markets were seized by fear last week that trade wars were slowing growth in Germany, China and the United States. But the story here is bigger than President Trump and his tariffs.

The postwar miracle is over. Since the financial crisis of 2008, the world economy has been struggling against four headwinds: deglobalization of trade, depopulation as labor forces shrink, declining productivity and a debt burden as high now as it was right before the crisis.

No major economy is growing as fast as it was before 2008. Not one is growing faster than 10 percent, the rate experienced by the Asian “miracle economies” before the crisis. In almost every country, the national discussion focuses on what must be done to revive growth and ignores the fact that the slowdown is driven by forces beyond any one government’s control. Instead of dooming ourselves to serial disappointment and fruitless stimulus campaigns, we need to redefine economic success and failure.

Germany is one of at least five major economies on the verge of a recession, which is typically defined as two consecutive quarters of negative growth. But the real issue is whether that definition still makes sense in a country with a shrinking labor force like Germany’s.
Its working population has been declining for years and is expected to fall to 47 million from 54 million by 2039. And it’s not alone in this. Forty-six countries around the world — including major powers like Japan, Russia and China — now have shrinking populations.

Demographics are usually the main driver of economic growth, so it is basically inevitable that these countries will now grow at a much slower pace. And we are not talking about minor population declines. Projections for 2040 show China’s working-age population falling by 114 million, Japan’s by 14 million.

With a shrinking labor force, these economies will inevitably slow and, at times, contract. To keep calling two negative quarters in a row a “recession” implies that this outcome is somehow abnormal or unhealthy. That will no longer be the case.

To avoid overreacting, the discussion about economic health needs to shift to measures that better capture satisfaction and contentment, like per capita income growth. In countries with shrinking populations, per capita incomes can continue to grow so long as the economy is shrinking less rapidly than the population.

This helps explain why, for example, Japan isn’t facing more social unrest. Its economy has grown much more slowly than that of the United States in this decade, but because the population is shrinking its per capita income has grown just as fast as America’s — around 1.5 percent per year.

Shrinking populations also help explain why unemployment is at or near multi-decade lows, even in countries with serious growth worries, like Germany and Japan. Gainfully employed Germans and Japanese won’t really feel as if their countries are in a slump until per capita G.D.P. growth turns negative — which may prove to be a more useful way to think about recessions in this new era.

The definition of success also needs to change. Many emerging countries still aspire to the double-digit growth rates experienced by what were known as the “Asian miracle economies” from the mid-1960s to the early 1990s, when populations and trade were booming. But no economy had grown so fast before then, and as population and trade surges recede, it’s unlikely any country can repeat those feats.
As growth downshifts, even little miracles are disappearing. Before the 2010s, it was common for one in every five economies to be growing at 7 percent or more annually. Now, among the world’s 200 economies, just eight, or one in 25, are on track to grow 7 percent this year. Most of those are small economies in Africa.

When the news emerged that China’s economy had slowed to just 6 percent, a new low, many investors and analysts rang the alarm bells. But the reality is that economies rarely grow as fast as 6 percent if the population is not booming too. Not only did China’s working-age population growth turn negative in 2016, but it is one of the countries hardest hit by slumping trade, declining productivity and heavy debts. If the Chinese economy really were growing at 6 percent in this environment, it would be cause for celebration, not alarm.

The benchmark for rapid growth should come down to 5 percent for emerging countries, to between and 3 and 4 percent for middle-income countries like China, and to between 1 and 2 percent for developed economies like the United States, Germany and Japan. And that should just be the start to how economists and investors redefine economic success.

This rethink is overdue. The number of countries with shrinking populations is expected to rise to 67 from 46 by 2040, and the decline in productivity growth is in many ways reinforced by heavy debt burdens and rising trade barriers. Redefining the standard of economic success could help cure many countries of irrational anxieties about “slow” growth, and make the world a calmer place.

Ruchir Sharma, author of “The Rise and Fall of Nations: Forces of Change in the Post-Crisis World,” is the chief global strategist at Morgan Stanley Investment Management and a contributing Opinion writer.

Volatile Year Coming

By John Mauldin

We have reached Labor Day weekend which, in the US, is a holiday for honoring work and workers. If you’re a Baby Boomer like me, you also grew up knowing school was about to start again. We didn’t do the mid-August thing back then. The first day of school was the day after Labor Day. That meant entering a new grade with unknown challenges.

As adults we do the same in our work—and managing your investments counts as “work.” So today I want to talk about the coming year’s class schedule. We face some tough subjects, and if we get through them, it may mean we get to go on to yet another year with even tougher ones.

I think the last few weeks marked a turning point in the economic narrative. It’s more than the trade war. A sense of vulnerability is replacing the previous confidence—and with good reason. We are vulnerable, and we’ll be lucky to get through the 2020s without major damage.

But that’s getting ahead of ourselves. Let’s talk about the risks facing us in the next year or so and the economic environment in which we will face those risks. I think that environment is one of potential supply shocks, subpar growth, and increasing volatility… among other things.

Supply Shocks Ahead

For some reason, NYU professor and economist Nouriel Roubini is often called “Dr. Doom.” He and I have been friends over the years, and I got to know him pretty well when Shane and I randomly rented an Airbnb in the same NYC building where he had a penthouse apartment. He was gracious with his time and we had more than a few late-night talks in which I felt no sense of doom. But he is indeed currently bearish on the economy.

Nouriel explained his outlook in a recent Project Syndicate piece, The Anatomy of the Coming Recession. To summarize, at a time when the world economy is already slowing for cyclical reasons, we also face three potential shocks, any one of which could trigger a recession.

  • The US-China trade and currency war

  • A slower-brewing US-China technology cold war (which could have much larger long-term implications)

  • Tension with Iran that could threaten Middle East oil exports

The first of those seems to be getting worse. The second is getting no better. I consider the third one unlikely, because neither the US nor Iran would benefit from military conflict. But someone could miscalculate.

In any case, unlike 2008, which was primarily a demand shock, these threaten the supply of various goods. They would reduce output and thus raise prices for raw materials, intermediate goods, and/or finished consumer products. Hence, Roubini thinks the effect would be stagflationary, similar to the 1970s.

Because these are supply and not demand shocks, if Nouriel is right, the kind of fiscal and monetary policies employed in 2008 will be less effective this time, and possibly harmful. Interest rate cuts could aggravate price inflation instead of stimulating growth. That, in turn, would probably reduce consumer spending, which for now is the only thing standing between us and recession.

Speaking of consumer spending, more than a few analysts take great comfort in its resilience. They have a point, but much of this spending is being fueled by debt instead of rising incomes. So, at the macro level, the solution to one problem is adding to another one. Let’s turn to debt expert Dr. Lacy Hunt who, for somewhat different reasons, is as bearish as Roubini.

Subnormal Growth

Most of our problems relate, in one way or another, to debt. Possibly you are among the small minority that is debt-free but collectively, we have way too much of it. And even if you aren’t a debtor, simply having a bank account makes you a lender. And being a citizen of the city, county, state, or country creates its own set of expectations and obligations as far as debt is concerned. This matters to everyone.

Debt isn’t bad and may even be good if it is used productively. Much of it isn’t. In theory, an economy overloaded with unproductive debt should see rising interest rates due to the excess risk it is taking. Yet we are in a low and falling-rate world. Why?

Lacy Hunt explained it well at the Strategic Investment Conference last May. I summarized his two theorems in a letter soon afterward. He showed how government debt accelerations depress business conditions. This reduces economic growth, so rates fall. The data show the amount of GDP each dollar of new debt generates has been steadily declining.

This is a problem because, among other reasons, central banks still think lower rates are the solution to our problems. So does President Trump. They are all sadly mistaken, but remain intent on pushing rates closer to zero and then below. This is not going to have the desired effect.

Here’s how Lacy explained it in his latest quarterly letter.

In a normal cyclical setting, we might assume that lower real yields could boost economic growth, but under current conditions lower real yields may, in fact, merely reflect that returns on capital have declined significantly. When real yields are low or negative, investors and entrepreneurs will not earn returns in real terms commensurate with the risk. Accordingly, the funds for physical investment will fall, and productivity gains will continue to erode as will growth prospects.

On average, over the past 10 years, real 10-year government bond yields have been slightly negative in the UK and Japan and positive by a mere 10 basis points in Germany. In the past five years, when nominal interest rates were slightly negative in Japan and Germany, real yields were even more negative since modest inflation continued. In each of these cases, negative real rates have been no panacea for the growth problems. Indeed, the span of sustained poor economic performance has increased.

Now, evidence has emerged that the US real rate, while still positive, is declining and that investors here are being forced to accept lower real yields similar to investors in foreign markets. The implication: Decreased capital returns will prolong the period of poor economic growth in the United States, as has been the case in Japan and Europe. If the solution to the subnormal growth is an even faster acceleration in debt, then this cycle will continue to repeat.

If Lacy is right, as I believe he is, the Federal Reserve is on track to do exactly the wrong thing by dropping rates further as the economy weakens. The Fed also did the wrong thing by hiking rates in 2018. They should have been slowly raising rates in 2013 and after. They waited too long, as I wrote both during and after that period. This long string of mistakes leaves policymakers with no good choices now.

The best thing they can do is nothing, but that’s apparently not on the menu. Hence, they could meet the recession their own policies helped generate with policies that make it even worse. And the politics surrounding interest rate cuts don’t make it any easier.

Bond Market Insanity

We now have $17 trillion worth of negative interest rate bonds, mostly in the sovereign bond space. That is about 25% of the entire bond market and 43% of bonds outside the US.

There has never been such an animal in the taxonomy of bonds. It is as odd as the Pushmi-Pullyu from the Dr. Dolittle children’s stories. Until a few years ago, traders and investors around the world would have considered negative rate bonds as fanciful as a children’s fairytale. It turns out black swans do exist after all. (I actually saw some swimming in a park in London.)

The German government can issue 30-year bonds at a -0.22 % interest rate. I do not want to embarrass them by quoting them directly, but some name-brand investment managers think negative rates are the market saying that the German government (and presumably others) haven’t borrowed enough money. Sigh…

Mark Grant (whom I will see in Florida next week) wrote this about negative interest rates in Europe:

While the European Union is not creating “Pixie Dust Money,” at the ECB, and then buying their own nations’ sovereign, and corporate debt, to purposefully hurt the financial markets, or the United States, that is exactly the “collateral damage,” that they are causing. The nations of the EU cannot afford to pay for their budgets, or their social programs, so the ECB has moved down their borrowing costs to less than zero, in most cases.

Check out their 5-year sovereign debt yields:

Yields in the United States, and the US economy, and the dollar, are taking it on the nose precisely, and specifically, because of what the European Union is doing. There is no other reason for what is happening here except that the nations of the EU have directed the ECB, the European Central Bank has “NO” independence, to make this “Money from Nothing” and then buy both sovereign and corporate bonds denominated in euros. Now their budgets can be afforded, as they can borrow at less than zero, so they do not have to pay anything for them.

In America when we say, “The Land of the Free,” it means one thing. When they say this in Europe, it means another thing entirely!!!

It is not just governments that can borrow at negative yields. Siemens AG, a German corporation, recently sold $3.9 billion worth of bonds at an average -0.3% and the offering was oversubscribed. Some investors (pension funds) were disappointed they couldn’t buy. Danish banks are selling home mortgages at a -0.5% interest rate. You read that right; they are paying homeowners to borrow money.

David Kotok wrote (in another essay that I sent to Over My Shoulder members):

Lastly, there is a developing body of research that estimates how much damage negative rates and even very low rates are doing. Torsten Slok has published a partial list of those papers. Essentially, negative-rate policies and very-low-rate policies eventually become counterproductive and act as contractionary forces. See Brunnermeier and Koby, “The reversal interest rate,” January 30, 2019. Also see NBER working paper 26040 by Sims and Wu, July 2019, entitled “Evaluating Central Banks’ Tool Kit: Past, Present, and Future”

Paralyzed Business

All this bears down on us as other things are changing, too. Many relate to shrinking world trade. Trump’s trade war hasn’t helped, but globalization was already reversing before he took office. Industrial automation and other technologies are killing the “wage arbitrage” that moved Western manufacturing to low-wage countries like China. Higher wages in those places are also reducing the advantage. This will continue.

Ideally, this process would have happened gradually and given everyone time to adapt. Trump and his Svengali-like trade advisor, Peter Navarro, want it now. I think the president’s recent demand that US companies leave China wasn’t a bluff. He wants that outcome, and he has the tools to attempt to force it. The only question is whether he will.

Many responses to last week’s Digging a Hole to China letter boiled down to, “China is bad and we have to do something.” I fully agree… but the fact that we must do something doesn’t make everything feasible or advisable. I’ve shown repeatedly how tariffs are a counterproductive bad idea. Severing supply chains built over decades in less than a few years is, if possible, an even worse idea. It will kill millions of US jobs as factories shut down for lack of components.

Some say this is just more Trump negotiating bluster. Maybe so, but the mere threat paralyzes business activity. CEOs and boards (I know this because I talk to board members and sit on several boards myself) don’t make major capital commitments without some kind of certainty on their costs and returns. The president is making that impossible for many.

It is not the case, as Trump seems to think, that China or other economies can collapse and the US proceed merrily along. Like it or not, we are all connected. If US companies want to export their products, they need other countries who can afford to buy them. That’s a growing problem anyway. We don’t need to make it worse.

Gavekal’s Andrew Batson recently wrote:

The closer the US presidential election gets, the less incentive China has to deliver Trump any reward for the trade war, and the more incentive it has to let him suffer the consequences. Falling stock markets, declining exports, and a weaker Chinese currency are arguably bigger political problems for Trump than they are for China’s leadership. After all, a slowdown to below 6% GDP growth would hardly be a disaster for China.

Europe is rapidly turning into a major problem, too. Negative interest rates there are symptoms of an underlying disease. Italy is already in recession. Germany suffered its first negative quarter and may enter “official” recession soon.

Germany is highly export-dependent. The entire euro currency project was arguably a plot to boost German exports, and it worked pretty well. But it boosted them too much, bankrupting countries like Greece which bought those exports. China, another big customer, is buying less as well. A German recession will have a global effect. Automobile sales are down and Brexit could mean further declines. That would most assuredly deliver a German and thus a Europe-wide recession. And it will affect US exports and jobs.

Then there’s Brexit. At this point we still don’t know if the UK and EU will reach terms, but there is some risk of a hard end to this drama. News focuses on the damage within the UK, but it will also affect the EU countries, mainly Germany, who trade with the UK. These supply chains are no less intricate and established than the US-China ones. Tearing them down and rebuilding them will take time and money. The transition costs will be significant.

Bumpy Ride

Remember when experts said to keep politics out of your investment strategy?
We no longer have that choice. Political decisions and election results around the globe now have direct, immediate market consequences. Brexit is just one example.

A far bigger one is the looming 2020 US campaign. None of the possible outcomes are particularly good. I think the best we can hope for is continued gridlock. A Democratic Congress and White House would likely give us major spending and tax increases and possibly some form of MMT. A Trump re-election will mean four more years of volatility, probably far more intense than we have seen so far. Choose your poison.

But between now and November 2020, none of us will know the outcome. Instead, a never-ending stream of poll results will show one side or the other has the upper hand. That will generate high market volatility, inspiring politicians and central bankers to “do something” that will probably be the wrong thing.

Polls aren’t necessarily reliable, but that will be the only thing businesses and investors have to go on. And those polls will move markets in ways that we are simply not accustomed to. I expect 2020 to be one of the most volatile market years of my lifetime.

As noted above, if Roubini is right then rate cuts aren’t going to help. Nor will QE. Both are simply ways of encouraging more debt which Lacy Hunt’s work shows is no longer effective at stimulating growth. They are, however, effective at blowing up bubbles. The closer yields are to zero (or below), the more impossible it is for both small savers and giant institutions to reach their goals with fixed-income assets. They will have to take on more risk and it probably won’t end well for them.

But no matter who you are, you’re going to have a bumpy ride between now and next fall. Now is the time to get ready.

Florida and a Fire Drill

I had lots of phone calls and emails this past week from friends worrying about me being in Puerto Rico. It seems the news was all about Dorian coming to devastate us. And we did go through storm preparation. I spent Tuesday morning playing nine holes of golf with friends who had the day off for a storm preparation day. We made sure that we had the normal emergency supplies, plenty of fuel for the diesel generator, and so on. It turned out to be basically a fire drill, as the storm mostly missed Puerto Rico. We barely even got a puff of breeze and a few sprinkles. But at least we have all the essentials for next time.

Tuesday I fly to Miami, where Florida will likely be having its own hurricane preparation unless Dorian changes paths again. After an airport meeting with Jim Mellon to talk about biotech, I will meander up to Fort Lauderdale to meet Mark Grant and discuss the bond market. What’s an income investor to do? There are answers, just not easy ones like there used to be.

It’s the end of summer and Labor Day, but I always enjoy this time of year. As I said at the beginning of the letter, Labor Day still makes me feel like part of something new and changing. And in just four months, we’ll have a new decade and the new year. I hope to spend it with you, and thank you for taking time to read my musings. I do look forward to your feedback and my staff makes sure that I get to read all the emails and letters. So have a great week!

Your expecting a great deal of volatility analyst,

John Mauldin
Co-founder, Mauldin Economics

Negative Interest Rates And Gold

by: Goldmoney


- For some time now, I have maintained the wheels are likely to fall off the global economic wagon by the year-end.

- Furthermore, for many of my interlocutors, the recent rise in the gold price is just evidence of an impending cyclical crisis, anticipating and discounting the certain inflationary response by central banks.

- In the combination of trade protectionism and an emerging credit crisis we face a problem upon which almost no formal research has been done, so it is not something that even far-thinking analysts have considered.

- We cannot know the future with certainty, but we can point to the empirical evidence following Smoot-Hawley and draw an alarming parallel with today's events.

- But our knowledge tells us there is almost certainly a large unanticipated shock ahead of us, and we should proceed in any analysis with that expectation.

The reason for persistent strength in the price of gold can be found in the changing relationship between time preference for monetary gold, and a new round of interest rate suppression for the dollar. Evidence mounts that the forthcoming recession is likely to be significant, even turning into a deep slump. Bullion bank traders are waking up to the possibility that dollar interest rates are going to zero and that pressure is likely to be put on the Fed to introduce negative rates. The laws of time preference tell us bullion banks must urgently cover their short bullion positions in anticipation of a dollar rate-induced permanent backwardation for gold, silver and across all commodities.

This article dissects the moving parts in this fascinating story.


For some time now, I have maintained the wheels are likely to fall off the global economic wagon by the year-end. Furthermore, for many of my interlocutors, the recent rise in the gold price is just evidence of an impending cyclical crisis, anticipating and discounting the certain inflationary response by central banks. But in this, we are describing only surface evidence, not the underlying market reality.

In the combination of trade protectionism and an emerging credit crisis we face a problem upon which almost no formal research has been done, so it is not something that even far-thinking analysts have considered. To my knowledge, no mainstream economist has pointed out the lethal mix these two dynamics together present. 

Very few even recognise the existence of a credit cycle, traditionally called a trade or business cycle. Not even the great von Mises called it a cycle of credit, having identified and described it with great accuracy in his The Theory of Money and Credit, first published in 1912. But a spade must be called a spade: it is in its fundament a credit cycle.

There are many Austrian economists who fully understand the credit cycle. But to it, we must add the destructive synergy of American trade policy aimed at China. Much economic research has been conducted on the causes of a credit cycle, trade cycle, business cycle, whatever it may be called. Much research has also been conducted on the economic consequences of trade tariffs. But nowhere is there to be found any research or commentary on the destructive power of combining the two.

Yet, these were precisely the conditions in October 1929, when Wall Street awoke to the certainty that Congress would vote in favour of the Smoot-Hawley Tariff Act at the end of that month. The shock of a 35% top to bottom fall in the Dow in October 1929 was only a prelude to an extended collapse following President Hoover signing it into law the following year. The economic research that followed the subsequent depression was conducted almost entirely by inflationists promoting reflation, so the destructive synergy between a credit crisis and trade protectionism has been ignored.

We cannot know the future with certainty, but we can point to the empirical evidence following Smoot-Hawley and draw an alarming parallel with today's events. Thus alerted, we can then develop a convincing theoretical case for its repeat. Every week, reports of the global economy stalling now hit the headlines, drawing the parallel even closer. Yet, with equity markets close to all-time highs, little more than a mild recession, easily batted away with a little more monetary inflation, is the general expectation.

But our knowledge tells us there is almost certainly a large unanticipated shock ahead of us, and we should proceed in any analysis with that expectation. This article postulates how early evidence from the rising price of gold suggests the shock is closer than even perennially bearish analysts expect. We shall now take the inflationary consequences of an unexpected slump as a given in order to predict the changes in the relationship between physical gold and fiat dollars; a relationship that has for the last four decades led to a massive expansion of gold derivatives.

To understand that relationship, and why it now appears to be reversing requires a working knowledge of time preference, the basis of interest; and more specifically the changing relationship of gold's time preference to that of dollars.

Interest and time preference

One's own bookcase provides the perfect illustration of time preference, which is the greater value of possession over non-possession. There will be books bought on a whim which just clutter a bookshelf and have no value. Next time there's a clear-out, they are destined for the charity shop: there's no difference in time value, being worthless to the owner today and in the future.

Then there are the first editions, which have a commercial value. Books in this category will have a high current value to you compared with their non-possession. But perhaps the books with the highest personal value are the ones that have little value to anyone else: that battered copy of Wren's Beau Geste, or the translation of Hoffmann's Struwwelpeter read to you when you were a child. You may have even visited the museum in Frankfurt dedicated to Hoffmann and his famous book of moral tales for children. The value of these books in possession is far greater than their absence, even though you rarely open their pages.

This is the basis of time preference: the greater value placed on possession than non-possession.

The books with sentimental value will have very little value to anyone else, other book lovers having their own favourites. Everyone's time preferences are different. In economic terms, we express these varying values in terms of the difference between a current value in possession and the value of non-possession, but the certainty of repossession at a future time. The discounted value of the future possession is normally expressed as an interest rate on the monetary value today.

Assuming free market Prices, in theory nearly everything of value has a time preference, an interest rate. That is, anything people value more in their immediate possession than the promise of ownership at some stage in the future. A future value, with very few exceptions, is always less than that of current ownership, and it is the difference between the two that is given to a current owner in one form or another to part with possession for a defined period of time.

The only examples that go against time preference are special cases. For example, an individual might forgo a decent salary today, in order to study so that he or she can earn more after passing a professional exam. In this case, the value of a current earnings stream is rejected in favour of potentially better prospects later. Or the philanthropist, who lends artworks for free to a public gallery so that a wider audience can appreciate them (but perhaps he does have a reward - to be thought of as a generous philanthropist and pillar of society).

The proxy for valuing time preference on goods is money, and the way it is normally expressed is as a money-rate of interest, often termed the originary rate. The originary rate of interest can be specific, assessed and applied in a single transaction such as obtaining the temporary use of a machine for a defined time. It can be a consolidated rate through the application of savings, reflecting the time preferences of the many goods and services whose possession is temporarily deferred by the saver.

Time preference is just the core consideration behind an interest rate. There will be other interest elements in addition, such as the trustworthiness and financial record of the borrower. 

But for the individual who has sacrificed the immediate satisfaction of spending the money put aside as savings, the time preference element will reflect the discounted future values of the goods and services that otherwise would have been purchased.

As well as time preferences reflecting baskets of specific goods and services, individuals will personally have different time preferences as well, as illustrated with the example of a personal library. But as is the case with any value, it is the marginal rate which is usually accepted as the market rate of interest, and therefore indicates the overall value of time preference within it. In addition, an interest rate must be greater than the sum of the originary rate and the compensation for all perceived lending risks, in order to create savings flows to feed investment.

This being the case, why is it that in financial markets, the forward price of something at a future date is usually higher than the present? The answer is simple: forward prices are not for possession, but for extending non-possession. Instead of being obliged to pay for possession today, a futures or forward price allows an individual to hang on to money for longer, rather than part with it now. 

And, assuming free markets set interest rates, with money's time preference being greater than that of the average consumer item (in order to create savings flows referred to above), plus the addition for financial risk compensation, it should always be higher than the pure time preference applied to the underlying commodity, item or even just a title to ownership.

Therefore, higher prices for future deliveries of commodities and titles to ownership in financial markets are principally a reflection of money's time preference, plus the risks associated with change of its ownership. To this should be offset the specific time-preference for individual commodities, but so long as they are in adequate supply, they will not be relatively significant compared with that of money.

This means the financial representation of time in a futures or forward contract in a properly functioning market is normally a positive cost. This condition is termed contango. We must also allow for the relative demand and supply characteristics of the underlying security between Date 1 and Date 2, which may temporarily lift a commodity's time preference above that of money. If demand characteristics are such that the value of an immediate delivery overrides money's time preference, then we have a backwardation. For example, there may be an acute shortage currently but supplies of the commodity in question are expected to be more plentiful at a future date. 

Backwardation is a temporary condition, and not the normal situation in financial markets.

To summarise so far, time preference tells us, except in a few specific cases, that the underlying or originary interest rate on money, which represents the time preference in all goods and services, must always be positive and include an extra margin to ensure savings flows occur. 

Furthermore, this is the basis for all pricing in financial markets for deferring delivery or settlement, which is called contango. In normal markets, backwardations are always unnatural and temporary, reflecting an excess of demand over supply for an earlier date over a later, but is never a general condition.

Negative interest rates create permanent backwardations

The reason it is vital to grasp the meaning and implications of time preference is to show that negative interest rates are unnatural, and do not accord with human action. It might not be obviously disruptive to financial markets when a central bank, whose currency is not the reserve currency, imposes a relatively minor negative rate on its commercial banks' reserves.

After all, a commercial bank will still charge its borrowers a positive rate, even though it may have to be imaginative when it comes to keeping depositors happy. But this is beginning to change, with both governments and large corporates now being able to issue bonds at negative rates. As we have seen from our discourse on time preference, this is a significant distortion from normality, indicating bond markets expect yet deeper negative rates in the currencies concerned.

In managing interest rates, the assumption central bankers make is that interest is the price of money. This is wrong for the reasons argued above. But instead of realising that deeper negative rates will not promote economic recovery in accordance with a cost of money approach to economic management, central banks' economic models predict deeper negative rates are necessary in the event that a significant recession materialises.

However, this is new territory for policy makers, and they are naturally cautious about the prospect of deeper negative rates. Deeper negative interest rate policies will almost certainly be preceded or accompanied by quantitative easing, which allows a central bank to anchor term rates and government bond yields at the zero bound or even in negative territory. If the world faces a global recession, monetary expansion is likely to be the only course of action open to central banks, and deeper negative rates will become central to monetary policy if a recession persists.

With the expansionary phase of the credit cycle demonstrably running out of steam, history tells us that not only are we overdue a crisis in bank credit, but the tariff war between China and America will probably synergise with the cyclical downturn in the credit cycle to trigger a slump on a scale not seen since the early 1930s.

That being the case, under our assumptions for economic prospects, deeper negative rates will become unavoidable.[i] The first to explore this dangerous territory are likely to be the ECB, the Swiss National Bank and the Bank of Japan.[ii] So far, lending rates at the Fed and the Bank of England are still in positive territory, but faced with an economic slump, that may not persist.

The Fed's interest rate is particularly important, because international financial markets price everything in dollars. And unless the Fed is prepared to see a dollar being strengthened by deepening negative rates elsewhere, the Fed may have little option but to follow.

If the Fed introduces negative dollar rates, then distortions of time preference will take a catastrophic turn. All financial markets will move into backwardation, reflecting negative rates imposed on dollars. Remember, the only conditions where backwardation can theoretically exist in free markets are when there is a shortage of a commodity for earlier settlement than for a later one. 

Yet here are backwardation conditions being imposed from the money side. It leads us to one conclusion: if negative rates for the dollar are imposed on financial markets, they will almost certainly lead to a flight out of the dollar where deposits become taxed with negative rates, not into other currencies, but into all commodities and future claims upon them. 

The current situation, where since the 1980s derivatives have inflated commodity supply, thereby suppressing prices, will be reversed. The purchasing power of dollars will be undermined by an attempted flight out of money. And it is unlikely to be long before the difference between negative time preferences between dollars and mildly positive ones for everyday items promotes a similar flight out of retail bank deposits.

That is the black and white of it. But there is a grey area of close to zero rates, when they are less than the implied rate of interest on gold, because of its time preference. Here it should be noted that gold's interest rate when sterling was on the gold standard generally varied between two and four percent, using the yield on British Consols as proxy. The Fed fund rate is already testing the lower boundary for monetary gold's historic time preference, and markets are now expecting the FFR to go lower still.

Negative dollar interest rates and gold

This leads us to consider how a negative dollar interest rate will affect the price of gold. Gold is different from other commodities, because it is also a medium of exchange. And while it may not be commonly used as such in capital markets, it is widely retained by central banks and diverse parties as a monetary store of value.

Gold has a monetary time preference of its own, in accordance with time preference theory. And when gold was money, expressed as such through money substitutes, we know from the British experience in the nineteenth century, gold's time preference usually held above two percent, and that was still roughly the case reflected in gold's lease rate since the 1980s.

In the 1980s gold was increasingly used as the collateral for a carry trade, leading to an explosion in business for the London bullion market. The underlying position was that central banks had accumulated bullion as part of their monetary reserves, and the gold price was generally falling. As bullish conditions died, gold's time preference fell. Central banks and government treasury departments added to this trend, being prepared to lease their gold in large quantities to specialist banks in the bullion market.

At that time, a bullion bank could lease gold from a central bank and use it as collateral to invest in US Treasury bills. Gold's time preference was reflected in a lease rate of typically 1.5-2% (though there were some spikes to 3-5%). Lease rates rhymed with evidence of gold's originary rate established in the nineteenth century.

Meanwhile, 6-month UST bills yielded about 6% or more, giving bullion banks a fat profit over the lease rate. While figures were never published, Frank Veneroso, at that time a leading independent gold analyst, gave a speech in Lima in 2002 estimating central bank gold leases and swaps were between 10,000 and 15,000 tonnes. In other words, up to half of all central bank gold was out on lease or swapped.

Since those days, the London forward market has continued to grow. Bullion banks extended their operations to offer bullion accounts for wealthier individuals around the world, almost entirely on an unallocated basis. Unallocated accounts allow a bullion bank to own the gold deposited with it and to leverage its use as collateral for carry trades and other opportunities of interest rate arbitrage. This market became so developed that insiders have postulated that for every ounce of physical bullion in the possession of bullion banks there could be a hundred of paper liabilities.

We have no way of knowing the true level of paper gold leverage today. A working assumption that actual gearing is closer to between ten or twenty times seems more realistic, given Bank for International Settlements statistics of OTC swaps and forwards and LBMA vaulting statistics, allowing for ETF and other custody holdings, segregated from bullion bank ownership. 

To this must be added the banks' unallocated customer account liabilities which go unrecorded.
In any event, we can be certain that in recent decades a positive gold lease rate led to a substantial systemic uncovered position, likely to be still institutionalised, given the evidence from the LBMA's daily clearing statistics.

The dollar interest rate that matters today is the wholesale market rate, USD LIBOR of a term that matches a gold lease. At the time of writing, 12-month USD LIBOR shows at 1.949%. The gold 12-month forward rate is roughly the same, implying the lease rate is zero. Clearly, with gold lease rates reflecting no time preference for gold, its supply into wholesale markets is being severely restricted. Look at it from a central bank's point of view: if a lease is coming due, there is no incentive to renew it, particularly given the unquantifiable counterparty and systemic risks that may arise in the current global economic climate.

We can conclude that the basis for highly geared interest rate arbitrage by borrowing gold is running into a brick wall. Not only is there no incentive for lessors but also there is also a diminishing appetite for lessees, because the opportunities are vanishing. Synthetic gold liabilities are being gradually reduced, not only by ceasing the creation of new obligations, but by buying bullion to cover existing ones. This will have been particularly the case when the USD yield curve began to invert in recent months (itself a backwardation of time preference), and was the surface reason, therefore, that the gold price moved rapidly from under $1200 to over $1500.

Bullion banks are now faced with the prospect that the Fed will reduce interest rates to zero again, even without a systemic crisis such as Lehman. Traders, who are not often deeply analytical, will almost certainly link gold's move in the wake of the Lehman crisis, once dollar liquidity concerns subsided, from under $750 to over $1900, with dollar rates being suppressed at the zero bound. If rates return there and LIBOR remains positive, that will be a reflection of systemic risk, not time preference. Meanwhile, gold's time preference will almost certainly be increasing as markets attempt to discount a new wave of base money expansion when the Fed attempts to stabilise the US economy and manage government finances.

Bullion bank traders can see therefore, the day has arrived when gold's time preference exceeds that of the dollar by an increasing margin. Furthermore, there is the growing threat of negative dollar rates, as economic conditions deteriorate. Putting other considerations aside, the switch in time preferences suggests a bullion bank's future trading strategy should be the polar opposite of their current position. Instead of holding a small stock of gold to finance a large dollar position, logically they should maintain a small reserve of dollars to finance a larger position in physical gold.

It is for this reason that not only is the gold price rising, but is likely to continue to rise, appearing to defy all expectations. It is impossible to quantify the extent to which the gold price will rise as the bullion banks scramble to unwind or even reverse their habitual short positions, but if there is a surprise it is likely to be on the upside.

The consequences

As well as being modified by its specific supply and demand conditions, Gold's time preference is essentially for its moneyness, represented by its use as a medium of exchange and store of value. The moneyness aspect links it to its exchange value for all commodities, and it is this aspect of gold's qualities that should warn us that a backwardation in gold, emanating from negative dollar interest rates, will herald a general backwardation in commodities as well.

We must not forget that markets anticipate events where they can, so with a recession threatening to turn into a slump and with a looming credit crisis in the wings the prospect of negative rates will be increasingly priced into the relationship between commodities and fiat dollars. Assuming economic prospects darken because of the coincidence of American tariffs and the emerging crisis stage of the credit cycle, it will be check-mate for central banks.

They were never appointed nor are they technically equipped to save the currency at the expense of widespread bankruptcies, not just in the private sector, but of their governments as well. And that is what markets will be faced with.

The current situation has striking similarities with the 1930s, and the prospects for the global economy are driven by the same broad factors. With the gold standard then and not now the price effects are already showing differences. Nor was there a bubble of hundreds of trillions of outstanding derivatives then as there are today. 

This time, the monetary sins since the ending of the Bretton Woods agreement seem set to come home to roost all of a sudden, even if dollar rates are lowered towards zero and only stay there.
But if they go negative and the more below zero that they go, the greater the backwardation on the whole commodity complex. The more rapidly commodities will be bought so the dollar, taxed with negative rates can be sold, and the quicker market actors will devalue the currency.

With all other fiat currencies referenced to the dollar, it will mark the start of a process that is likely to collapse the entire fiat currency system. Bullion banks which are too slow to recognise the change and have not shut down their gold obligations will be forced to steal their customers allocated gold, or go to the wall, adding to the disruption. All commodity derivatives will face a period of rapid contraction of open interest, in lockstep or one pace behind those of gold.

Instead of central banks stabilising the system by monetary easing, the easing itself will guarantee the crisis. The development of a problem in gold markets, driving the gold price rapidly higher while some banks are caught napping, is likely to anticipate a wider financial and systemic crisis. 

Therefore, with gold's sudden move higher coupled with its persistent strength we can reasonably certain that we are seeing the start of the dismantling of the dollar-based monetary system, and that gold has much further to go.

[i] For more on why this is so, see
[ii] The Danish and Swedish central banks are also in the vanguard of the movement.

BlackRock has rattled the private equity industry

The fund manager’s initiative is good for investors but comes at a strange time

Patrick Jenkins

BlackRock has entered the private equity arena when deal prices are at record highs © Bloomberg

What’s wrong with private equity? Not much, if you look at the numbers. Record dealmaking, record fund sizes, record amounts of cheap debt to juice profits. That’s made everyone a winner. Investor returns are outpacing other asset classes. Private equity firms, and their staff, are enjoying bumper pay days.

BlackRock, though, sniffs a competitive opportunity. The world’s biggest asset manager — with nearly $7tn of funds at the last count — has so far only dabbled in alternative investments. But its debut primary private equity deal last week, when its new Long Term Private Capital fund bought the bulk of the Authentic Brands marketing business for $870m, signalled a fresh departure.

Larry Fink’s business owns more listed equities than almost anyone else. But as the launch blurb for the LTPC fund makes clear, public companies are going out of fashion: the number of US groups has nearly halved in 20 years.

Moving into private equity seems logical. It should secure a slice of a higher-margin business at a time when public equity managers are suffering an ongoing squeeze on fees.

Aping his record in listed equities, Mr Fink’s plan is to take business from the incumbents by disrupting what he sees as a cosy and costly business model. LTPC will undercut their fees and derisk investments by reducing the debt levels of portfolio companies.

One rattled senior executive at a big buyout firm said: “BlackRock incinerated the fee structure in equity funds. Are they going to do the same for private equity?

The pitch has been enough to raise nearly $3bn from five big investors, led by the Minnesota State Board of Investment, plus a small chunk of BlackRock’s own cash.

The group is coy about the exact fees it will levy but it is fair to assume they will be substantially less than the 2 per cent management fee plus 20 per cent “carry”, or performance fee, that is the private equity norm. As the LTPC fund grows towards its $12bn target, BlackRock says the management fee will fall further.

So far, so laudable. But this is not a risk-free initiative.

For one thing, valuations make this an odd time to break into private equity: deal prices are at record highs. The Authentic Brands transaction is estimated to have been done at a multiple of 16 times core earnings.

For another, the private equity bubble is widely expected to burst. The downward trend in interest rates means the pin-prick won’t come from higher debt costs, as seemed likely six to 12 months ago. But the risk of recession across much of the west now seems high, potentially dangerous for highly leveraged companies that often have little headroom if business dips. BlackRock’s plan is to cut debt levels, but that cuts potential returns.

Of potential concern, too, is another quirk of BlackRock’s model: making its fund a “perpetual capital” vehicle, rather than the traditional 10-year structure. This is not unprecedented. There has been a clutch of perpetual capital launches from established operators of late. Brookfield is poised to create a $5bn fund, with a potential open-ended structure, into which it would reverse Genworth, a Canadian mortgage insurer acquired last week.

But the open-ended nature has obvious pitfalls. Returns are designed to be lower. And there is no set time horizon for investors to be paid out.

Most seriously there are obvious, if crude, parallels with the liquidity mismatches that have haunted the likes of GAM, H2O and Woodford in recent months. If investors are not tied in for a fixed period and are allowed, in theory, to make short-term redemptions, it is easy to see the scope for stress when the underlying assets are unwieldy holdings in a small number of private companies.

Some perpetual vehicles are stock-exchange listed, boosting potential liquidity. BlackRock’s recipe for dealing with the issue is to limit investor redemptions to an annual three-month window, with an initial tie-in until 2022. Investors can sell to others in the fund or to a new investor if one can be found. Underlying holdings could also be sold. But the model is untested in a stressed market.

Investors should welcome BlackRock’s entry to the market, with its promise to cut the cost and the risk of private equity. For Mr Fink and his team, though, it is not without danger.

Finger on the button

America should not rule out using nuclear weapons first

A nuclear shift would alarm allies

IN 1973 Major Harold Hering, a veteran pilot and trainee missile-squadron commander, asked his superiors a question: if told to fire his nuclear-tipped rockets, how would he know that the orders were lawful, legitimate and from a sane president? Soon after, Major Hering was pulled from duty and later kicked out of the air force for his “mental and moral reservations”.

His question hit a nerve because there was, and remains, no check on a president’s authority to launch nuclear weapons. That includes launching them first, before America has been nuked itself. The United States has refused to rule out dropping a nuclear bomb on an enemy that has used only conventional weapons, since it first did so in 1945.

Many people think this calculated ambiguity is a bad idea. It is unnecessary, because America is strong enough to repel conventional attacks with conventional arms. And it increases the risk of accidents and misunderstandings. If, when the tide of a conventional war turns, Russia or China fears that America may unexpectedly use nukes, they will put their own arsenals on high alert, to preserve them. If America calculates that its rivals could thus be tempted to strike early, it may feel under pressure to go first—and so on, nudging the world towards the brink.

Elizabeth Warren, a Democratic contender for the presidency, is one of many who want to remedy this by committing America, by law, to a policy of No First Use (NFU) (see article). India and China have already declared NFU, or something close, despite having smaller, more vulnerable arsenals.

Ms Warren’s impulse to constrain nuclear policy is right. However, her proposal could well have perverse effects that make the world less stable. Many of America’s allies, such as South Korea and the Baltic states, face large and intimidating rivals at a time when they worry about the global balance of power. They think uncertainty about America’s first use helps deter conventional attacks that might threaten their very existence, such as a Russian assault on Estonia or a Chinese invasion of Taiwan. Were America to rule out first use, some of its Asian allies might pursue nuclear weapons of their own. Any such proliferation risks being destabilising and dangerous, multiplying the risks of nuclear war.

The aim should be to maximise the deterrence from nuclear weapons while minimising the risk that they themselves become the cause of an escalation. The place to start is the question posed by Major Hering 46 years ago. No individual ought to be entrusted with the unchecked power to initiate annihilation, even if he or she has been elected to the White House. One way to check the president’s launch authority would be to allow first use, but only with collective agreement, from congressional leaders, say, or the cabinet.

There are other ways for a first-use policy to be safer. America should make clear that the survival of nations must be at stake. Alas, the Trump administration has moved in the opposite direction, warning that “significant non-nuclear strategic attack”, including cyber-strikes, might meet with a nuclear response.

America can also make its systems safer. About a third of American and Russian nuclear forces are designed to be launched within a few minutes, without the possibility of recall, merely on warning of enemy attack. Yet in recent decades, missile launches have been ambiguous enough to trigger the most serious alarms. If both sides agreed to take their weapons off this hair-trigger, their leaders could make decisions with cooler heads.

Most of all, America can put more effort into arms control. The collapse of the Intermediate-range Nuclear Forces Treaty on August 2nd and a deadly radioactive accident in Russia involving a nuclear-powered missile on August 8th were the latest reminders that nuclear risks are growing just as the world’s ability to manage them seems to be diminishing.

In retreat

Argentina’s beleaguered government imposes capital controls

Fear of a populist government provokes a market crash, forcing the president’s hand

WHEN MAURICIO MACRI was elected president of Argentina in 2015, one of his first acts was to abolish capital controls that restricted buying and selling of the peso. The move symbolised Argentina’s pivot back to open markets and liberal economic reforms under his rule. On September 1st, after weeks of market turmoil, Mr Macri was forced to issue a decree reimposing controls in an attempt to shore up the currency. From now on ordinary Argentines’ purchases of dollars will be capped at $10,000 a month. Companies will face restrictions on their ability to purchase dollars in the foreign-exchange market and to pay dividends to investors abroad.

Investors are habituated to financial fiascos in Argentina but even so the news has come as a rude shock: the price of Argentina’s sovereign bonds traded in Europe tumbled by about 5% the day after the announcement. It has been a torrid summer. The country flirted with default on August 30th, when it said it would try to extend the maturity of some of its external debts. Its foreign-currency sovereign bonds now trade at only about a third of their face value. The crisis probably spells the end of Mr Macri’s time in office, is a humiliation for the IMF and a disaster for the country. Yet again Argentina finds itself a financial outcast.

Mr Macri inherited an economy in disarray but initially won the confidence of Wall Street. He began his tenure not only by floating the peso but by giving the central bank a target to tame inflation (which was measured honestly again after years of book-cooking), dismantling controls on the prices of hundreds of goods, from soap to chicken, and reaching a deal with holders of defaulted debt.

Foreign financial firms lapped it up. In 2016 Jamie Dimon, the boss of JPMorgan Chase, America’s biggest bank, told its shareholders that “Argentina can be an example to the world of what can happen when a country has a good leader who adopts good policy.” Incredibly, in hindsight, Argentina managed to flog a 100-year dollar bond at an interest rate of only 8% in June 2017. (It has since lost over 60% of its value.)

Things went downhill soon after. Mr Macri was wary of stifling economic growth and, lacking a majority in congress, was reluctant to cut the budget deficit sharply. He relaxed the central bank’s inflation target, despite racing prices. Investors cooled, in part because global interest rates began to rise, drawing capital from emerging economies back to America.

In early 2018 the peso slid rapidly, losing a fifth of its value against the dollar in just over four months. Mr Macri was forced to turn to the IMF, which agreed to lend Argentina $50bn, later extended to $57bn, its largest-ever programme.

Then on August 11th Mr Macri was resoundingly defeated by Alberto Fernández, his populist opponent in the presidential election in October, in a primary poll that acts as a dress rehearsal for that election. Mr Fernández’s running mate is Mr Macri’s predecessor, Cristina Fernández de Kirchner (no relation). Formally, the primary settled nothing.

But Mr Macri’s goose looks well and truly cooked. Investors rushed to dump Argentine assets, fearing that Mr Fernández will return to the reckless policies pursued by Ms Fernández (under whom inflation soared so high that the government fiddled the data). The Merval stock market index lost 37% the day after Mr Macri’s drubbing. The peso plunged by 25%.

The currency then slid again last week after an old ghost reappeared: a default on Argentina’s foreign debt, which has happened eight times since independence in 1816. The government announced a “reprofiling”—ie, delayed repayment—of $100bn-worth of short-term borrowings and raised the prospect that some longer-term debts might be rejigged, too. That led to a new wave of capital flight and a few days later the reimposition of currency controls.

Argentines have bitter memories of the previous time their government went to the IMF, in 2001, blaming it for the austerity and devastating sovereign default that ensued. Mr Fernández has played on the fund’s unpopularity, accusing it of being responsible for Argentina’s latest troubles and promising to renegotiate the loan.

That may work out nicely for him: fear of his presidency helped bring about the peso’s crash, which in turn makes his eventual victory more likely. But if he wins it will be a poisoned chalice: a country facing default again, cut off from international markets, and a population even more beleaguered and cynical about reform.