Deflation Must be Embraced

There are two problems with understanding deflation: it is ill defined, and it has a bad name. This article puts deflation into its proper context. This is an important topic for advocates of gold as money, who will be aware that sound money, in theory, leads to lower prices over time and is often criticised as an objective, because it is not an inflationary stimulation.

The simplest definition for deflation is that it is when the quantity of money contracts. This can come about in one or more of three ways. The central bank may reduce the quantity of base money, commercial banks may reduce the amount of bank credit, or foreigners, in possession of your currency from an imbalance of trade, sell it to the central bank.

The link with prices is far from mechanical, because the most important determinant of the general price level is the relative appetite for holding money, and not changes of the quantity in issue, as the monetarists would have it. All else being equal, a deflation of the money quantity can be offset by a decline in the public’s desire for cash and deposits in hand, so that the general level of prices is unaffected.

Alternatively, a fall in the general price level can occur without a corresponding monetary deflation. This happens if a general preference for holding money increases. A further consideration is a population might collectively decide, based on increased uncertainty about the future perhaps, to hoard cash instead of leaving their savings in a bank. The resulting mismatch between production on the one side, and consumption (both immediate and deferred) on the other, caused by changes in physical cash withheld from circulation, can have a noticeable effect on prices.

At times of monetary stability, price deflation is likely to occur because of economic progress. In free markets when money is sound, a healthy relationship between consumption and savings develops. Competing businesses have access to savings to invest in more efficient production of better goods, leading to improved products and lower prices. Furthermore, production chains lengthen, bringing fully the benefits of specialisation to the assembly of the component parts in every product. But crucially, this conditions can only last if money is sound, by which we mean the factors that upset overall preferences relative to goods are broadly absent.

Critics of price deflation in a sound money environment fail to understand that the level of interest rates is self-regulating. Interest rates adjust the split between consumption and deferred consumption, and do not affect the overall quantity of money. Rates rise when businesses bid for funds to finance investment in production. Businesses investing in production calculate their costs based on expected prices, and if they experience a decline in prices, that will impact on the interest rate they are prepared to pay for new investment. Therefore, Gibson’s paradox, that interest rates correlate to the general price level, is explained, and why interest rates do not correlate with the rateof price inflation, as the monetarists believe.

Sound and stable money is the optimum condition for an economy to deliver the most economic progress. These were the conditions broadly experienced in Britain during the nineteenth century through a mixture of a gold standard and free trade. Government stood to one side, and let people pursue their individual objectives. The principal error was in establishing fractional reserve banking, which permitted a credit cycle to develop, but looking through those highs and lows, economic progress delivered substantial improvements in living standards, lower prices, and the accumulation of individual wealth over time.

During the reign of Queen Victoria, which covered most of this period, prices fell while employment incomes remained generally stable. It was demonstrably a deflationary period at the price level, while being the most economically progressive in all economic history. When it is the consequence of sound money, price deflation is the ideal outcome which political leaders should embrace.

The amount of money required for this condition was set by the markets. Gold fulfilled the role of a deliverable reserve currency, being accepted internationally as true money. This meant arbitrage of prices worked effectively across borders, in turn moderating different preferences for money between jurisdictions, ensuring common price levels. This was in accordance with classical economic theory, and it worked very effectively. The first interruption to this market process came from the Bank of England, which in the wake of periodic credit-induced crises, took on the role of lender of last resort. Once the principle of intervention was established, further areas of “improvement” on free markets were bound to follow.

The world of yesteryear’s laissez-fare is not that of today. Classical economics has been replaced by post-Keynesian interventionism. The welfare state, more than free markets, drives individual expectations, particularly in the advanced economies. The combination of a free market, sound money and price deflation is now beyond our grasp without a major economic and financial reset. For that to happen, we must undergo both political and monetary upheavals, reversing the trend towards state control of everything. And that is only likely to happen through crisis, which is the context in which deflation is feared today.

A deflationary crisis

As stated above, one of the factors that contributes to monetary deflation is the contraction of bank credit. The normal trading policy of a bank is to maximise profits by ensuring, as much as possible, lending risk is properly assessed, then leveraging credit expansion on the bank’s capital base. Therefore, if a bank manages to obtain an average spread of 3% net of estimated lending risk, and lends ten times its capital, it obtains a gross return of 30% after expected loan losses. However, if there is an unexpected increase in lending risk, so that the bank is faced with the possibility of losses on its overall lending, the bank’s capital could begin to disappear rapidly. Therefore, banks can suddenly decide to contract their balance sheets to protect their capital.

The process, left unchecked, leads to a financial and economic crisis, driven by a deflation of bank credit when banks, en masse, decide to contract their balance sheets. The first economist to describe this effect in detail was Irving Fisher, who in 1932 published his Booms and Depressions. This was followed in 1933 by a paper in Econometrica, titled The Debt-Deflation Theory of Great Depressions.

Fisher’s 1933 paper formed the basis of subsequent analysis and understanding of deflation, and while his analysis of the causes of a deflationary is questionable, his central conclusion, that contracting bank credit does widespread damage, is unarguable. Banks are forced by falling collateral values on their geared balance sheets to liquidate what they can. A general panic ensues, with collateral being liquidated, driving down asset values and raising the cost of debt in real terms. Any banker who experienced a financial crisis in the nineteenth century would have been fully aware of the dynamics of a collapse in bank lending. There was, in fact, nothing new in Fisher’s discovery.

The error in Fisher’s analysis was to fail to understand that the origin of a bank credit induced deflation was the prior expansion of credit itself. This mistake was compounded by future economists, who have tended to simply conflate normal price deflation in a sound-money economy with the correction of an over-expansion of bank credit. Consequently, any decline in the general level of prices is now thought to be undesirable.

We saw this confirmed in the financial crisis ten years ago, when central banks and governments did everything to prevent prices falling. It became clear that production of goods had become over-dependant on the inflation of asset prices, which in turn had been inflated by bank credit. When that process halted because of the residential property crisis in America, bank credit (including off-balance sheet securitised finance) stopped expanding, property prices crashed everywhere, and goods remained unsold.

The free-market response was correct. Prices of big-ticket items were lowered, and production cut back. The overcapacity in the motor industry was exposed, and manufacturers slashed their prices. Workers, who understood the crisis at a practical level, were prepared to take wage cuts and work part-time. This could not be permitted by governments, scared by the spectre of deflation. The state subsidised prices by paying consumers to scrap their existing cars, and the central banks wrote open-ended cheques to stop the banks foreclosing on bad and doubtful loans.

They were scary times for everyone. The debt-deflation crisis threatened to wipe out the banks. Falling prices, and their effects on capital values could not be permitted. The reversal of inflationary wealth transfers from lender to borrower was a systemic threat. We all desperately wanted to be rescued from the consequences of prior credit inflation. Having stared into the abyss, the establishment agreed that deflation is a very bad thing, and that central banks should ensure that prices rise for ever and a day. This is now official policy everywhere.

Eventually, the error in believing that prices must continually rise, rather than gradually fall through the combination of free markets and sound money, will revisit us. The deflation and economic progress of the nineteenth century should be aspired to, and moves towards this objective are our only hope of escape from yet another, potentially worse financial crisis than that of ten years ago. There is no sign of any such move, with governments insolvent everywhere, terrified of even the mere mention of deflation.

The decade from the last credit crisis has been wasted, with no steps taken to ensure either it doesn’t happen again, or alternatively, when it happens we will not face the systemic collapse that was so frightening last time. Ten years was a reasonable time to change market and public expectations and to gradually move towards a more stable world, time that was utterly wasted.

- Source Alasdair Macleod of James Turk's Gold Money

The Inflation vs Deflation Debate Rages On

While central bankers have convinced themselves, in defiance of normal human behaviour, that consumption is only stimulated by the prospect of higher prices, there can be little doubt that the unmentioned sub-text is the supposed benefits to borrowers in industry and for government itself. Furthermore, the purpose of gaining control over interest rates from free markets is to reduce the general level of interest rates paid to lenders, further robbing them of the benefits of making their capital available to willing borrowers.

All this is in defiance of the principles behind contract law, but the courts do not accept that the unbacked state-issued currency of today is no different from the gold-backed money of yesteryear, nor the same as tomorrow’s further debased currency. Tax on interest is an added distortion, reducing net interest received by holders of depreciating currency even more. It is hardly surprising that the savings rate collapses in an economy characterised by inflation and taxed savings, leading to a relentless expansion of debt, financed by other means.

These “other means” are mostly the expansion of bank credit, which is money created simply through book-entry. The cost of creating this money is set by the wholesale money rates, which are in turn set by the banks that issue the credit. If they all expand their bank credit at the same time (and it should be noted that bankers are very susceptible to herd instincts), interest rates can theoretically fall to zero, or more practically, the marginal cost of expanding it, which on large loans is almost the same thing. And as if that is not enough, there is now in addition a combination of central banks rigging interest rates to be negative coupled with quantitative easing, which has even allowed corporate borrowers to be paid to borrow money.

As already stated, the whole point of monetary inflation is to transfer wealth from lender to borrower. In the government’s case, it is a replacement for taxes that have become so burdensome, that to increase them further either risks provoking a taxpayers’ rebellion, or is so economically damaging that even the state knows to back off. But the books must be balanced, and given the unpalatable alternative of cutting spending, funding through monetary debasement is the accepted solution.

Most central banks understand from experience that if the central bank is involved in funding the government’s spending directly, the currency will eventually descend into crisis. Instead, central banks achieve the same thing by suppressing interest rates and allowing the commercial banks to subscribe for government bonds. They are bought by the banks themselves, or alternatively by lending to others to buy the government’s debt. There are technical monetary differences between bank and public subscriptions for government debt, which must be conceded. Nevertheless, it is just as inflationary, being supported directly or indirectly by the expansion of bank credit, particularly when central banks ensure that total currency in circulation will never be allowed to contract.

An important assumption behind long-term inflation targets, currently set at 2% per annum, is that the general price level can be controlled by managing the money stock. This flies in the face of all experience, and even economic theory. During the Volcker chairmanship of the Fed, when the effective Fed funds rate rose to over 19%, there was no let-up in the growth of broad money. It grew at 6.2% that year, compared with a long-term average annual growth rate of about 5.9%. To link interest rates to the money-quantity is a common mistake by those who do not realise that interest rates regulate not the quantity of money, but its application.

The rate of US monetary expansion was reasonably constant at a little less than 6% until the Lehman crisis, yet interest rates (measured by the effective Fed funds rate) had varied between 19.1% in 1981 and 1% in 2003. US consumer price inflation had also varied between 14.4% and 1.07% on the same time-scale. There is no correlation between the quantity of money and these two statistics at all, so the control mechanisms employed, which are meant to regulate the decline in the currency’s purchasing power, are entirely bogus.

The point was sort of accepted by an official at the Bank of England last week. Richard Sharp, who is on the Bank’s financial stability committee, warned that if the UK Government increased its borrowing, it risked sliding into a Venezuela-style crisis. Undoubtedly, this comment was provoked by a growing debate over Jeremy Corbin’s proposal to borrow an extra £250bn if Labour is elected. But it raises the question over what is the difference between Venezuela’s disastrous inflation policies and those of Britain, other than scale. The answer is simply nothing.

Venezuela’s economic collapse into hyperinflation is all our final destinations as well. It is the eventual destination for all governments that depend on financing themselves by inflation. No longer are deficits being talked about as only temporary. Realistically, the accumulation of welfare liabilities, past, current and future, make it impossible to balance the books from taxation alone.

The fallacy that the state benefits from inflation ignores our central point: it transfers wealth from the masses. Far from stimulating the economy by persuading the masses to spend rather than save, it gradually grinds them down into poverty. The high standards of living in the advanced economies were acquired over decades by ordinary people working to improve their lives. The accumulation of personal wealth is vital for the enjoyment of improved standards of living. Remove earnings and wealth through currency debasement, and people are simply poorer. And if people are poorer, the finances of the state also become unsustainable.

This is why regimes that exploit the expansion of money to the maximum, such as Venezuela and Zimbabwe, demonstrably impoverish their people. It takes little intellect to work this out, yet amazingly, neo-Keynesian economists fail to grasp the point. The most appalling example was Joseph Stiglitz, a Nobel prize-winner no less, who ten years ago praised the economic policies of Hugo Chavez.[ii] Ten years on, we know the result of Chavez’s inflationary follies, which have taken Venezuela and her people into the economic abyss. Despite Stiglitz’s execrable errors, he remains an economist respected by those whose biased analyses are simply to wish reality away.

Economists and commentators fixated on the cheapening of government debt through inflation fail to distinguish between the sustainability of existing and future debt. These wishful thinkers believe that drawing a line under the past will allow governments to finance future obligations as if nothing had happened. They suppose that with a clean national balance sheet, facilitated perhaps by the issue of a platinum coin with a trillion-dollar notional value, everything will be righted. This ridiculous proposition was seriously considered in the wake of the Lehman credit crisis.[iii] It was not contemplated just to put government finances on a better footing, but as a device to permit more government borrowing.

The reality of inflation is what starts as a temporary escape route from constraints on government spending ends up being a trap from which escape becomes progressively more difficult, until it is practically impossible. Inevitably, if the state impoverishes its citizens today by debasing the currency, it will have a larger welfare bill tomorrow. It requires an accelerating rate of currency debasement to keep balancing the books.

The only solution is to halt the expansion of money. Then, to ensure it retains its purchasing power, unlimited convertibility into gold on demand by all-comers must be introduced and enshrined in law, so that no further currency can be issued by the central bank without increasing gold reserves to cover. This currency then technically becomes money-substitutes, the money being gold. Bank credit can either be curtailed by making fractional reserve banking punishable as fraud (which it was in times past, and without a banking licence, still is), or alternatively ensuring there is a discernible difference between balances credited to depositors, and the money substitutes issued by the central bank and covered by gold. Furthermore, all bank bailouts and bail-ins must cease, again by law, despite the consequences. Deposit protection must also be removed.

The reliance on regulation to control bank excesses is a mistake. Banks must be entirely customer focused, and not driven by regulation. Only then, will bankers understand that enhancing their public reputation is what keeps them in business. Unwise speculation by the bankers in the knowledge the central bank will always bail them out will cease. A split will naturally emerge between loans financed by bank deposits (mostly working capital, trade finance and similarly secure short-term liquidity requirements), and more risky loans, properly financed by bond issues.

This way, cyclical disruption by variations in the overall level of bank credit will be minimised. Money would be returned to its original purpose, for which it is best suited by being sound, which is to act as the temporary storage of production, and no more.

The sound money alternative

The alternative to inflation is to return to the conditions of sound money. It has to be sound and beyond the reach of governments as a means of inflationary financing. Deflation at the general price level is then a reflection of progress and improved living standards for all, through evolving product innovation and competition. The amount of money required in an economy must be set by markets, and it must be covered by further purchases or disposals of gold.

It should be noted here that preferences for and against holding money will always vary, even for sound money, but with sound money those variations are minimised. Variations in the general level of monetary preference can affect prices of goods and services most, so it is important the effect is lessened as much as possible. By sound money, we mean either physical gold itself, or substitutes convertible into gold on demand. And with gold or money substitutes, price arbitrage between states or regions also using sound money provides additional price stability.

These, broadly, were the conditions in Britain from 1817, when the new sovereigns were first minted, and after Britain returned to the gold standard proper in 1821. The gold standard was also adopted by other developed nations when they fell in line with Britain’s single standard, particular in the later decades of the nineteenth century onwards.

The enormous benefits and wide-spread wealth that sound money brought were traduced by socialists, such as Marx and Engels. A one-sided argument provoked envy at the wealth accumulating in the hands of successful businessmen and their families, derided as the bourgeoisie, by describing it as being at the expense of downtrodden workers. But the facts were very different, with living standards for manual labourers improving beyond all earlier recognition. Successful businesses earned their wealth through being subservient to consumers, by producing the products they wanted. If not, they went out of business. And while markets have delivered considerable benefits since, it is easy to establish that progress would have been even more beneficial to blue-collar and low-skilled workers, if free markets had been allowed to persist on their own without government intervention.

It is the stuff of obvious logic to understand that if wealth is transferred from ordinary people to the state, the people as a whole are poorer for it. It is a myth, perpetuated by the state, that wealth transferred in this way is held in trust for the population, when it fact it is destroyed.

If people are allowed instead to accumulate personal wealth, society as a whole, benefits. This is the key to understanding the benefits to a nation from sound money, because a successful economy is ultimately what gives the state its power. Before the First World War, Britain’s dominance over world trade was not due to its military campaigns; the navy and army merely protected free trade. It was the accumulation of wealth in the hands of entrepreneurs, backed by sound and reliable money accepted everywhere, that made Britain great. Its success was based on wealth creation, which accumulated in private hands with minimal government destruction.

The inflationists’ objection to sound money is that governments need to reduce their debt burden by eroding its value at the expense of their creditors. But as we have shown above, this argument is short-sighted, and ignores the mounting future obligations spawned by inflation. Instead of forcing increasing dependence on the state, sound money protects savings, allowing people to avoid state dependency. Instead of government obligations increasing over time, they decrease instead.

Following the Napoleonic Wars, the British Government was left with extremely high debts, which had to be paid down. Instead of yielding to the temptation to inflate them away, the solution chosen was to honour them with sound money. This was followed by the removal of economic distortions by the repeal in 1846 of the Corn Laws which had been mistakenly introduced in 1815, and the removal of other trade tariffs generally. Despite the gently falling prices of goods over time, the Government’s debt was reduced from over 250% of estimated GDP to only 30% before the First World War.

The return to sound money

The why and the how fiat currency must be replaced with gold as money, and fully-convertible money substitutes, has already been described. This was never fully achieved by the British government, because of a simple mistake in the implementation of the Bank Charter Act of 1844. While the Bank of England had by law to cover increases in its note issue with gold, control over the expansion of bank credit was neglected, because the consequences of making no distinction between cash and bank deposits were not properly understood. It was that mistake that permitted a credit cycle of alternate boom and bust to develop, leading to a series of banking crises in the second half of the century, and that cycle is still with us today.

A practical approach to the problem is to first recognise that central banks have succeeded in suppressing the gold price, measured against their fiat currencies. Replacing fiat currencies with gold and gold substitutes will require either a far higher gold price measured in fiat, or a massive contraction of fiat currency in issue, or alternatively some combination of the two. Furthermore, most bond markets are wildly overvalued, being priced on the back of central bank intervention. They do not reflect the risk that all fiat currencies’ purchasing powers are set for a decline. The realisation of a sharp fall in bond prices would be catastrophic for the banks that hold debt either as an investment or as collateral against loans. It is therefore likely a return to sound money will only occur for most jurisdictions after a global credit crisis, when the purchasing power of the currency is already sliding, we are in the midst of a global systemic crisis, and a return to sound money would be more acceptable, even demanded, by the public.

There is the highest degree of anticipatory certainty that a catastrophic loss of purchasing power is where fiat currencies are headed, only the time-scale being open to question. Keep Venezuela in mind. Therefore, at some point gold should begin to discount this future event, and could rise to many times its current value, expressed in declining fiat currencies. This will, in theory, make it easier for central banks possessing physical gold to consider using it as a monetary stabiliser. But given the difficulties involved and decades of neo-Keynesian fallacies, it probably will be seen as a last resort.

There are two significant nations amongst a number of Asian states which could introduce sound money before or during the next credit cycle crisis, if they choose to, assuming they possess adequate undeclared physical gold. In the case of Russia, her banking system has already been pre-conditioned for severe monetary turbulence, thanks to Western sanctions and a collapse in the price of oil. Furthermore, her economy is oriented towards energy and commodity exports, whose values can be expected to decline less rapidly than Western currencies when the decline of Western currencies accelerates.

Russia is aggressively buying gold, joining China in her attempt to dominate physical gold markets. It is clear Russia sees gold rather than dollars as being important to her monetary and economic future. China has also demonstrated her understanding of gold. Having secretly accumulated it since 1983, China then encouraged her citizens to acquire it for themselves since 2002, and in the last few years embarked on a policy of gaining access, influence and control over foreign physical gold markets, such as London. Most recently, through a state-owned enterprise she plans to remonetise gold for day-to-day payments, in partnership with Goldmoney.

It is unclear at this stage to what extent these two dominant Asian states view gold as a monetary objective, as opposed to a strategic weapon to use against a belligerent America. There may be a divergence of views, with Russia more willing to destabilise the West by introducing a gold-backed rouble, than China by introducing a gold-backed yuan. However, it is unlikely that Russia and China will act independently, preferring to act together, taking a second tier of Asian nations with them, such as Iran, Turkey and other members of the Shanghai Cooperation Organisation.

China is almost certainly moving towards incorporating gold into her domestic monetary system, as outlined above. Her domestic monetary system is ring-fenced with capital controls from internationally circulating yuan, for which her policy has focused on improving its marketability as an international trade settlement currency. At some stage, these objectives are likely to come together, because the yuan is undermining the role of the US dollar, leading to its continuing weakness and therefore, a rising gold price. The timing of international developments is no longer closely controlled by China, because timing is shifting to the markets.

China must know that moves towards incorporating gold into the international yuan, or even threatening to do so, will drive US, EU and Japanese currencies relatively lower. Bond yields in these currencies will rise in response to price inflation, and that will almost certainly contribute to further currency destabilisation. China’s exporters will suffer, an undesirable consequence perhaps, but manageable. However, for the meantime we can only conclude China, Russia, and all the other allied Asian states await developments before going ahead with any form of gold convertibility.

For the West, it is another matter. Monetary economics remains dominated by neo-Keynesian thinking, which pursues economic planning and state control until free markets cease to exist. Official responses to the next debt-driven credit crisis will move away from sound money, rather than embrace it. Central banks are certain to throw more base-money at the banks and large corporations, to stop them going bust. Interest rates will be reduced to accommodate escalating government borrowing, and there will be more quantitative easing. Central bankers have no other response to adverse credit conditions.

Last time, a decade ago, there was a rush for liquidity. This time, thanks to ten years of “extraordinary measures”, the liquidity is there in spades. Only if you are a Nobel prize-winning economist perhaps, will you then ignore the inevitable collapse of the currency’s purchasing power and the hardship faced by ordinary people. You will declare the outlook for economic growth is good, like Professor Stiglitz regarding Venezuela ten years ago. It is at this point that China and Russia might decide to pull the trigger on gold convertibility.

Elsewhere, there is no appetite, no intellectual capacity, for a return to sound money. The West, particularly America, may feel it is the victim of a financial war against it, making them more belligerent. Putting that to one side, Western nations will have wound back the clock to the early 1920s, when Germany, Austria, Russia, Poland, Bulgaria, and Hungary all suffered currency collapses, their currencies being unbacked by gold. It is out of the ashes of a far larger global currency collapse in the coming years that a return to gold as the only money, and the return of circulating currency being fully convertible money-substitutes, is the eventual outcome.

- Source, Gold Money

Europe, Brexit and the Credit Cycle

Europe’s financial and systemic troubles have retreated from the headlines. This is partly due to the financial media’s attention switching to President Trump and the US budget negotiations, partly due to Brexit and the preoccupation with Britain’s problems, and partly due to evidence of economic recovery in the Eurozone, at long last. And finally, anyone who can put digit to computer key has been absorbed by the cryptocurrency phenomenon.

Just because commentary is focused elsewhere does not mean Europe’s troubles are receding. Far from it, new challenges lie ahead. This article provides an overview of the current state of play from the European point of view, and seeks to identify the investment and currency risks. We start with Brexit.

At least there’s some money on the table

Last week, sufficient agreement had been obtained from the Brexit negotiations to allow the EU’s negotiators to recommend to the Council and the European Parliament to proceed to the next step, which is to discuss trade. That has now been approved.

There were three areas agreed in outline: the money, estimated at up to €50bn, the rights of EU and UK citizens, and the Irish border. Only one of these matters, the other two being little more than side issues deployed by the EU negotiators to squeeze as much money as possible from the British.

Yes, it was about the money. As I’ve pointed out before, Brussels’ administration costs are almost the same as Britain’s net annual contribution of €8bn.[i] Without the UK, the EU is in serious financial trouble, particularly when Brussels plans to set up its own standing army, and integrate all the member states into united states of Europe. It used the myth of Britain’s on-going commitment to financing future projects to come up with estimates of up to €100bn, when no liability for these projects, the RAL, or reste à liquider actually exists.

While the main-stream media focused on Britain’s problems, it missed the simple truth that the EU faces a far larger problem. Pace observing Libertarians; an overtly free market approach, with Britain just walking away was never politically practical. It would have created enormous damage for Europe. In the circumstances, the British negotiators held their nerve, and won the game of chicken.

What came out of last week’s agreement was basically a fifteen-page statement of intent, the detail to be worked on later. It was, as has subsequently been pointed out by two Brexit-supporting cabinet ministers (David Davis and Michael Gove) no commitment at all, no more than a gentlemen’s agreement. Also, on the money question, Brussels will have to itemise the expenses Britain is liable for to an expected maximum of €50bn. Given that legally Britain has no liability for that highway project being planned in, say, Slovenia, Brussels can still go whistle.

There are line items that are justifiable, such as Britain’s stake in the ECB, and indeed in the European Investment Bank, which is based in London. There are the pensions for MEPs and other Brussels staff of British origin offsetting the value of these stakes. And so on. The money will end up being a fudge, because the gap between the net liabilities between Britain and the EU is probably less than €10bn either way.

The way round this, to save Brussels from itself, is to agree to a two-year interim period, during which current arrangements will be extended, and Britain will continue to pay membership fees of €16bn over the two years. Anything over that will have to be properly expensed, which means further money should not be used to finance Brussels’ establishment costs. Brussels needs to make alternative arrangements after Britain finally leaves, presumably getting Germany, France, and other leading members to up their ante. The transitional arrangement will ease Brussel’s pain in this respect.

Main-stream media and Remainers alike have all stated that the difficult negotiations lie ahead. They are wrong. Agreeing an outline on the money was the sticking point. On trade, which we now move onto, there is a fundamental difference between negotiating a trade agreement where none existed before, and Brexit. Britain already complies with all EU trade regulations, a fact which is accepted by all member states. The British government seeks to pass all these regulations onto the British statute book, so there will be no reason for not continuing with current trade arrangements with the EU.

There can be little doubt that in time, EU and UK trade regulations will drift apart. But this is not a problem either, because anything sold from Britain (or from elsewhere into the EU for that matter) will have to conform to EU regulations. Similarly, UK product sold in the US has to comply with US regulations. Tariffs are a separate subject, so any tariffs imposed on British products post-Brexit is a purely political matter.

Assuming the transition period of two years is implemented, that means the new trade arrangements will apply from March 1921. However, the agreement must be completed by March 2019, unless elements of it are deferred into the transition period. This will give time for industry to lobby both Brussels and individual governments for no tariffs, which we can be sure is the preferred outcome for the large international corporations, particularly when their supply chains are spread round multiple EU jurisdictions, including the UK.

Therefore, trade in physical goods is likely to continue on more or less the current free trade basis, not least because without a satisfactory agreement from the British point of view, Brussels will get no money.

There is much kerfuffle about services, which in sentiment echoes the debate twenty-plus years ago about Britain having to join the euro. What we are seeing is lobbying through the media by large financial corporations, notably the powerful American banks, to protect their investment in London. Post-Brexit, will they move their operations to Frankfurt, Paris, or possibly Milan? Will they hell as like.

These centres are parochial backwaters, dominated by insular nationalistic and bureaucratic cultures. Foreign-owned businesses are effectively second-class to local organisations, effectively barred from making local acquisitions. It was never a problem in London. Why was it that despite the introduction of the euro without sterling, forecast to drive businesses from London to Frankfurt and Paris, the major European players chose to base their investment banking activities in London? Because that is where the international business is. This will not change, post-Brexit, one iota.

It is feared the EU will insist services such as euro clearing leave London for an EU location. To the extent that governments have control over these matters, there is nothing London can do about it, Brexit or no Brexit. But where these services are provided is a mostly a matter for the banks, not governments. This is the uncomfortable truth for the EU. Financial services are only under their control from a regulatory point of view. And if they over-regulate, which is normal for the EU, service providers simply decamp. Brexit should therefore encourage a bit of competition for Brussels regulators, to the benefit of us all.

While the Remainers in London continue to make what is essentially an emotional case against Brexit, Brexit is likely to end up attracting more financial business to London, as migrating businesses exploit its independence from EU anti-market attitudes and legislation.

There is one thing that came out of last week’s agreement, which is only inferred, but vitally important. And that is Britain’s liabilities go no further than an agreed budget settlement. The reason this is so important will become more obvious later in this article, but basically it means that in the event of a systemic meltdown, Britain has no further liability for the EU’s financial and economic system. Arguably, that applies from now.

EU’s economic prospects

The likelihood of a systemic meltdown occurring, before the transition period ends, is moving towards certainty, with a growing possibility it might happen by March 2019. With all the niggles, such as Italian non-performing loans and wildly overpriced sovereign debt, future historians might reveal Britain’s constructive approach to Brexit negotiations was partly informed by the importance of not rocking a cranky Eurozone boat.

That notwithstanding, the European Central Bank is doubtless encouraged by its apparent success in stabilising the Eurozone economy, and in seeing it grow at last. It has taken negative interest rates and asset purchase programmes over a prolonged period to arrive at this happier state of affairs.

This linking of cause and effect is accepted by mainstream economists. After all, they have fed on the bread and milk of Keynes’s principles concerning the role of the state in the economy, and the contribution it can make to smoothing the cycle of boom and bust by inflating the money supply at appropriate moments. However, for those of us prepared to dig a little deeper, we come away with an understanding that the ECB’s actions have been more about keeping the banking and financial system afloat than fostering genuine economic recovery.

The supposed economic benefits from the ECB’s interfering are little more than a conjuror’s prestidigitation. But those of us who understand the true scale of economic destruction that results from the ECB’s actions must acknowledge one thing: the ECB has been an effective firefighter. Through a mixture of using the printing press and pure bluff, it has prevented, or rather deferred, systemic bank failures, notably in Portugal, Italy, Greece and Spain.

The banking systems in the PIGS were not just insolvent, but thoroughly bust. They still are. The ECB used the network of national central banks to both conceal capital flight from these systemic risks and to ensure fresh money is issued to cover it. Meanwhile, bank balance sheets have been stabilised by simply rigging the bond markets, through a combination of creating bond shortages by way of its aggressive asset purchase programmes, and offering the banks zero-cost loans to fund themselves and to buy bonds as well. These are mostly sovereign bonds, issued by profligate socialistic governments, conveniently given a zero-risk weighting by Basel regulations.

If these actions had been floated as a prospective strategy before being initiated, a rational critic would have concluded Mario Draghi had lost his marbles. The fact that they have worked, so far at least, is the bluff. Draghi has the support of other central bankers, who drink from the same policy well. Economic commentators are also in the ECB’s pocket. Obfuscate the whole by introducing elements of policy piecemeal, and we are all fooled, because we want to be fooled.

It has been about step-by-step survival; the true cost of these monetary policies having been deferred. Deferred, and not addressed, means these policies are being set up to fail at a future point in time. What we have witnessed is an extreme version of the application of money and credit in the early stages of the credit cycle.

The credit cycle exists anyway, consisting of repeating central bank stimulus, price inflation, and inevitably the debt crisis that follows. These events are made immeasurably worse this time by the intense stimulus of asset purchase programmes and by the extreme rigging of bond markets through negative interest rates.

It is in this context we must consider the pick-up in Eurozone GDP. GDP is no more than the money-total of final transactions in those parts of the economy included in the GDP statistic. When it increases, it does so not because of economic progress per se, but because money is shifting from the financial sector to non-financials, from the unrecorded to the recorded elements of GDP.

The shift has been slow until recently, because the money-making opportunities have been in financial activities, thanks to the ECB. But these have reached such significant bubble-like conditions, that even speculators in bitcoin might pause in wonderment. The German two-year Schatz bond yields minus 0.74%. In other words, markets have become so rigged by the ECB that lenders are paying interest annually to the German government to hold and protect their money.

There has been some recovery from earlier extremes, because this bond’s yield was even more negative last February (-0.96%). Perhaps it shows that some confidence is returning to the Eurozone economy, because banks are beginning to lend to non-financials. But we all know what that means: prices of goods and services start rising. And when they start rising, the ECB has a problem it can no longer deal with by fudge and bluster.

Price inflation is slowly beginning to increase, though the rise is muted by a strong euro. Fortunately for the ECB, the euro is likely to continue to be strong over the next year or so, if only because it reflects Germany’s stellar export performance and a weakening dollar. At the least, it gives time for the ECB to reduce and cease its asset purchase programme, and to manage a return towards monetary normality.

One can visualise the ECB’s strategy. Bond prices will be eased gently lower while the banks expand credit profitably towards recovering non-financials. Weaker banks will be encouraged to work with their national central banks and governments to remove bad debts into resolution vehicles, and to raise core capital. And as confidence returns into the banks in the PIGS, their economies will turn the corner, consumer confidence and tax revenues will increase, putting government finances on a sounder footing.

It’s not hard to guess this is the ECB’s likely strategy, because at this point in the credit cycle, all central bankers think this way. And they always, without fail, end up in crisis. The crisis arises when money begins to leave the realm of financial speculation for more profitable opportunities in the non-financial economy. Those are coming about, partly because despite central bank tinkering, and partly because life goes on, including for businesses. Also, China with her new silk road is creating important two-way trans-Asian trading opportunities.

The bank credit to finance these opportunities will come out of Eurozone bond markets at the same time as the ECB is reducing its asset purchase programme. Doubtless, the ECB understands this and hopes that it will be a gradual process, taking five or more years, and hopes it can be smoothed by targeting bond prices with interest rate policy.

But by then the price effect of bank credit expansion will almost certainly begin to push up the general price level, even though the euro may remain strong. This is because irrespective of the rise in the euro and raw material prices priced in declining dollars, supply bottlenecks and shortages will develop. The link between the flood of money into non-financials and rising prices then becomes alarmingly active.

So, what happens when it becomes obvious prices are rising, and the ECB is demonstrably behind the curve? The bond markets, having already fallen, then crash, taking all financial assets with them. The ECB can sit on zero interest rates as long as its likes, but in the process, it becomes zero relevance. The market will be pricing assets. And the banks, which remain alarmingly leveraged, are exposed to systemic failure. The headline equity to debt ratio is in the order of 5.5%, but there are higher risks within that average. Germany’s is 3.9%, Ireland 4.3%, and Netherlands 2.7%, to name but a few.[iv] And that assumes the banks are telling the truth about their own balance sheets.

Those living in hope might point out there are other forms of liquidity, such as deposits held at national central banks. True, but there’s no way of knowing whether or not these are encumbered in some way, and furthermore, fudges such as mark-to-inflated-markets and mark-to-myth are baking asset-related losses into the liquidity cake already.

All major jurisdictions are locked into a destructive credit cycle, which given the increase in debt since the last crisis, seems assured to make the next one considerably worse. We must then ask ourselves who is going to lead us into the next crisis. Most people would probably say China, because of her massive credit expansion. Some would say Japan. You cannot rule them out. But when you consider where the greatest price distortions are and the slimmest capital margins in the banking system, it has to be the Eurozone.

The euro in the next credit crisis

The euro as a currency is the newest of the majors, having replaced the national currencies of the individual Eurozone members. Its validity as money regresses to nothing specific, though an Italian might think it more stable and valid as money than the old lira, because it has a significant element of the old Deutsch mark in it. But equally, a German might think it is less stable and valid as money than the mark, because it combines weaker currencies. There appears to be some confirmation of these natural views, because Germans privately are the most active buyers of physical gold and gold ETFs in the Eurozone, while others seem content to hold euros.

These differing opinions are a potential source of currency instability, because if the German public take more fully to the view that the ECB is not addressing the threat of price inflation sufficiently, they are likely to reduce their preference for euros more significantly in favour of other monetary media. We see this in the pick-up in German citizens’ gold demand already, which increased from 103.8 tonnes in 2014 to 187.6 tonnes in 2016.,

More recently, another alternative to the fiat euro has become available. Bitcoin and other cryptocurrencies are seen by growing numbers of the public as an alternative to depreciating fiat currencies. And unlike gold, which has a large reservoir of above-ground stocks, cryptocurrencies offer the promise of rapid gains due to restricted supply.

Of course, governments could get together and attempt to ban them. But for a ban to work, there would at the least have to be agreement at the G20 level to prohibit all banks from effecting money transfers to and from cryptocurrency service providers. Even that might not work, because they exist as a peer-to-peer network, and transactions would still take place, and they would operate as currency alongside fiat.

It seemed more likely governments will try to regulate cryptocurrency service providers, and that is now happening. The future for bitcoin and others, at least for a few years, appears assured. The reason this is important for the euro’s prospects is as a portmanteau currency it is theoretically more vulnerable to being undermined by money-preferences switching from it to cryptocurrencies than for any of the other major currencies.

Assuming the cryptocurrency phenomenon is still running at the time of the next credit crisis (possibly in 12-18 months’ time), it could have a major impact on the purchasing power of all fiat currencies, but especially the euro at a time when the major central banks will feel the need to dramatically expand the quantity of currency in circulation, in order to save the banking system.

Britain will have its own troubles, and it is very likely that it will not have fully disengaged from the EU. But at least it was agreed last week that Britain’s obligations to the EU are limited to matters in the past. It could prove to be a timely escape.

- Source Alasdair Macleod of James Turk's Gold Money

Alasdair MacLeod: How Much Gold and Silver is Enough?

When is enough, enough? How much financial protection in the form of gold and silver will you need in the coming collapse? This changes and depends on your personal financial situation. Alasdair MacLeod of James Turk Gold Money explains.

- Source, Reluctant Preppers

Will Bitcoin Replace Gold's 10,000 Year History as a Store of Value?

Alasdair Macleod, runs FinanceAndEconomics.org, and is on the GoldMoney board, talks about gold and crypto-currency and the future for both.

Will gold continue to stand the test of time? Will its 10,000 year history as a store of value suddenly be erased? Unlikely.

- Source, Jay Taylor Media

James Turk: A Moment Of Crisis For Central Planners

Given what the central planners have thrown at gold and silver the last six years, a 1.1% ‘plunge’ is not only a welcome relief, it is giving us an important message. The conclusion from this event is that 40,000 Comex contracts trading in a span of 10 minutes did so little damage to the gold price, it is a clear sign that the central planners are up against an immovable force. And we know what that force is — all the national currencies they are printing and debasing from QE and their other schemes is not only going into daVinci’s and other tangible assets, it is also going into gold and silver.

So here is what we face, Eric. Will the central planners dare throw another 40,000 contracts at the market to try reaching their sweet spot and risk having to come up with more physical metal for that portion of the buyers asking for delivery? Or are gold and silver finally going to break out of their respective bases and head higher, ending this period of extreme undervaluation? Only time will tell, of course, but instead of more base building or a drop back to the central planners’ sweet spot, I expect an upside breakout soon, and the tightness in the physical market suggests it may be just days away.”

- Source, James Turk via King World News

Bullion Banks Desperate To Trigger Sell Stops

They have been trying to push silver lower for weeks in an attempt to reach that target area in order to create that wave of selling by triggering the sell stops. It’s a game that they have been playing for years.

Triggering those sell stops will give the syndicate of bullion banks, who act as agents for the Fed and other Western central banks, an opportunity to cover many of their short positions in the silver market. Thus, they have been selling loads of paper silver in a desperate attempt to thwart the tidal wave of buying coming into the Comex. And it is a tidal wave.

Also of importance is the fact that the EFPs have ballooned in recent days, particularly for gold. Flat gold and silver prices in the face of soaring Open Interest would be a blatant sign of price manipulation. So the central planners are frantically shifting their shorts to the London OTC market in an attempt to keep Comex open interest from soaring, but all of their selling has been to little avail. Despite numerous attempts to crack silver, they have failed. The same is true for gold.

The central planners even got the mainstream media working for them. For example, a few days ago Bloomberg reported: “Mysterious Gold Trades of 4 Million Ounces Spur Price Plunge.” Obviously the word “plunge” was meant to scare, but hidden in the article was the actual result of this huge sale. To quote the article, there was “a sell-off, sending prices down as much as 1.1 percent.”

- Source, James Turk via King World News

The War In The Gold and Silver Markets Heats Up

Both gold and silver have done a lot of base building, and the breakout from their bases is getting close. Last time we spoke I wasn’t ready to hazard a guess when the breakout would happen because there is no way to predict when a base will end with a breakout. And there still isn’t. But look at the following chart showing the daily spot silver price in London.

Even though both gold and silver are positioned pretty much the same, I want to use this silver chart because its picture is much clearer. Also, even though both metals are trading backwardated in London, the backwardation is much deeper in silver, so it has greater upside potential when the breakout occurs. Meaning, the gold/silver ratio will fall as silver outperforms gold.

The point here, Eric, is that silver looks very close to a breakout and ready to start climbing higher. The chart above also shows the head-and-shoulders pattern that we have previously spoken about (highlighted in green rectangles). The three downtrend lines show how silver keeps getting beaten back in its attempts to break higher, which it is once again trying to do as it moves day-by-day toward the point of the large triangle.

- Source, King World News

James Turk: Despite Pullbacks, A Huge Bull Move Is Coming

That one-day reversal led to another small uptrend, and here we are again with silver testing support once more. But note the big uptrend line going back to this summer’s low price. That uptrend remains intact. What it all means, Eric, is this picture for silver is very positive. And gold is much the same. But returning to my original point, we continue to watch their bases develop. While doing so, we should continue to accumulate physical gold and silver in anticipation of much higher prices in the months immediately ahead.

- Source, James Turk via King World News

Key Chart Forecasts A Major Surge In The Price Of Silver

There are few things as boring as watching the precious metals form a base, Eric. Sometimes this process can seem endless, like at present. Unfortunately, there is no way to predict when a base will end. But when it does, a breakout from a base always sends the precious metals higher…

All we can do is be 100% ready, watch and wait, and not be distracted by thinking that the base forming process will never end. We should instead be focusing on the fact that gold is already up 11% this year, while silver has risen almost 7%. By any normal measure, these are good results, but I expect more to come as we head toward the close of the year.

There are some key points to keep in mind. Most importantly, the low price in both gold and silver occurred in December of 2015. That’s nearly two years ago. Since then, both gold and silver have been in rising uptrends within the huge bases both metals are forming. There is no reason to expect those uptrends will end any time soon, given all the reasons that will eventually send gold and silver much higher. These reasons include the banking and other financial problems we see all over the world as well as the mountains of debt that governments are building. These debts will never be repaid with the same purchasing power of the money used by the lenders to finance those debts, particularly in today’s world of central bank financial repression and low-to-zero interest rates. Inflation is visibly rising and is going to get worse.

All of this means that we should not be misled by the relative quiet in the precious metals at present. The following silver chart of daily spot prices in London indicates that the precious metals are setting up beautifully, Eric. So we should be getting ready for what looks like a big move higher in silver as well as gold as we move toward the end of the year (see chart below).

There a few key points about this chart. First, we see the clear reverse head-and-shoulders pattern silver formed over the quiet summer months. Physical silver was being accumulated during this period. When this buying eventually overpowered the shorts, silver broke above the neckline of the head-and-shoulders pattern, and climbed higher until hitting resistance in the $1820 area. As is not uncommon after a break-out, silver then retraced back to the support zone, which I’ve marked on the chart between the two horizontal lines.

The big one-day swoon into the support zone with the same day upside reversal on Oct 6th is significant. The central planners tried to push silver lower, but failed. The only thing that happened was a lot of sell stops were hit, enabling the big players to cover shorts.

- Source, James Turk via King World News

James Turk Discusses The Use Of Leverage In Gold and Silver

Leverage is the use of credit or borrowed capital to increase the earning potential of your investment portfolio. But like everything else in finance, higher returns mean higher risk, so leverage is not for everyone.

Nevertheless, leverage can be a useful tool for those accepting the risk. If you choose to use it to maximise the return of your gold and silver, there are two key factors to getting it right.

First, use leverage when the trend is in your favour. So how do you identify the trend? Here are a couple of popular methods.

1) Moving Average – A moving average is constructed by calculating the daily closing price over a period of time. Different time periods can be used for different markets, but for gold and silver, the 21-day and 200-day moving averages are popular measures of short-term and long-term trends.

When using moving averages, the rule is to be in harmony with the trend. This is accomplished by owning gold and silver when their price is above the moving average and the moving average itself is rising. Conversely, if you are trading precious metals as opposed to accumulating it, be out of the market if either or both of these conditions are not met.

It sounds easy, but it’s not. To assist you in identifying the trend, trendlines can be particularly helpful when used in conjunction with a moving average, as illustrated in the following chart of silver’s daily closing price in London.

Note the clear uptrend in the silver price and the downtrends. Note also that a new uptrend in price is just beginning because the silver price is above its 21-day moving average, which itself is turning higher and rising. If history is any guide, now is the time to buy and possibly leverage your purchase with additional silver, if you believe the risk/return suits your investment criteria.

2) Higher Lows – Prices can also point out the trend. For example, the gold price declined from its record high of $1910 per ounce in August 2011 to December 2015 when it reached $1055. Then prices began to rise. Gold eventually retraced that rise, and in December 2016 fell back to $1125, 6.6% above the low price a year earlier.

This year there have been two further retracements occurring after the gold price rose. These advances and retracements are normal patterns, but the important point is that the low price in March was higher than the previous low in December 2016. Similarly, the July low price was higher yet again.

This pattern of rising lows is telling us that the gold price is in an uptrend, as can be seen in the following chart of gold’s weekly closing price in London, with its 21-week moving average that is also rising. So as is the case with silver, now is the time to buy gold and possibly leverage your purchase with additional gold, if you believe the risk/return suits your investment criteria.

Traders and investors have been using these and other techniques throughout the ages to identify price trends. They are not fool proof; nothing is when it comes to investments. But these techniques are useful tools that have proven helpful over time.

View leverage to also be a tool, and like any tool, it needs to be used wisely – or not at all.

- Source, Gold Seek

Yellen and Carney Are Signalling that the Time is Right to Buy Gold and Silver

We will be lucky if this expansionary phase lasts beyond the end of 2018, given the restricted headroom for increases in interest rates for the four major currencies. But there’s one asset that is poorly understood in western financial markets, and that’s physical gold.

In the short term, the prospect of rising interest rates can be expected to be read as a negative factor for precious metals. This is because market speculators in Western capital markets are used to trading gold as the mirror image of the dollar. If the dollar is strengthening, gold will weaken. If interest rates are rising, the dollar strengthens. Therefore, the logic goes, sell your gold. This may be true during the recovery phase of the credit cycle, when increases in interest rates, or just the threat of them, will be judged by markets as an anticipatory action, leading to a stronger currency.

In the expansionary phase, central banks react belatedly, for the reasons described above. It changes the fundamental relationship between monetary policy and the gold price from that which persisted in the recovery phase of the credit cycle. We have seen gold suppressed during the recovery phase, once fears of financial and system collapse receded, but the dollar price of gold has more recently been rising, erratically perhaps, since December 2015. Bond yields bottomed out six months later, with the yield on the 5-year US Treasury nearly doubling to 1.9% today. We can take this as evidence of an evolution in market relationships, because gold and short-term bond yields are both rising. This change in relationship effectively confirms we have already moved from recovery to expansion in the credit cycle.

Central banks are already behind the curve, and will become more so. The gold price can be expected to strengthen during the expansionary phase of the credit cycle, reflecting the declining purchasing power of fiat currencies and the trend towards negative real interest rates. This was certainly the case in the US’s expansionary phase of the late 1970s, when dollar inflation was threatening to escalate out of control.

A rising gold price also accords with rising commodity prices, all measured in declining fiat currencies. We are already in the initial stages of credit expansion, signaled by the wake-up call from Ms Yellen and Mr Carney, so it also serves as a signal that industrial commodity prices will rise. Their prices are already rising, so the markets are telling us the purchasing power of the dollar, as well as the other fiat currencies, are commencing a new decline measured in industrial materials. And while in the very short-term precious metals may need to adjust further to the change in credit cycle relationships, above all, Yellen and Carney are effectively signalling that the time is right to buy gold and silver.

- Source, Alasdair Macleod of James Turk's Gold Money

The Upcoming increase in Interest Rates

Last week, both Janet Yellen of the Fed and Mark Carney of the Bank of England prepared financial markets for interest rate increases. The working assumption should be that this was coordinated, and that both the ECB and the Bank of Japan must be considering similar moves.

Central banks coordinate their monetary policies as much as possible, which is why we can take the view we are about to embark on a new policy phase of higher interest rates. The intention of this new phase must be to normalise rates in the belief they are too stimulative for current economic conditions. Doubtless, investors will be reassessing their portfolio allocations in this light.

It should become clear to them that bond yields will rise from the short end of the yield curve, producing headwinds for equities. The effects will vary between jurisdictions, depending on multiple factors, not least of which is the extent to which interest rates and bond yields will have to rise to reflect developing economic conditions. The two markets where the change in interest rate policy are likely to have the greatest effect are in the Eurozone countries and Japan, where financial stimulus and negative rates have yet to be reversed.

Investors who do not understand these changing dynamics could lose a lot of money. Based on price theory and historical experience, this article concludes that bond yields are likely to rise more than currently expected, and equities will have to weather credit outflows from financial assets. Therefore, equities are likely to enter a bear market soon. Commercial and industrial property should benefit from capital flows redirected from financial assets, giving them one last spurt before the inevitable financial crisis. Sound money, physical gold, should become the safest asset of all, and should see increasing investment demand.

Assessing potential outcomes of this new phase of monetary policy is a multi-dimensional puzzle. There’s the true state of the economy, the phase of the credit cycle, and the understanding, or more accurately the lack of it, of the relationships between money and prices by policy makers. This article is aimed at making sense of these diverse factors and their interaction. We start by examining the intellectual deficit in economic and price theory to improve our understanding of where the policy mistakes lie, the resulting capital flows that will determine asset values, and therefore the likely outcomes for different asset classes.

Interest rate fallacies
The most egregious error made by central banks and economists alike is the assumption that gradually raising interest rates acts as a brake on the rate of economic expansion, and therefore controls price inflation. Economic commentators generally regard interest rates as the “price” of money. It is from this fallacy that the belief arises that manipulating interest rates has a predictable effect on the demand for money in circulation relative to goods, and therefore can be used to target price inflation. This line of reasoning makes even a sieve look watertight. Interest rates are the preserve of the future exchange of goods relative to today, and have nothing to do with the quantity of money. They only determine how it is used. In a free market, rising interest rates tell us that demand for credit is increasing relative to demand for cash, while falling interest rates indicate the opposite. What matters are the proportions so allocated, and not the total.

Therefore, if a central bank increases interest rates, it will be less demanded in the form of credit. In the past, before consumer credit became the dominant destination of bank credit over industrial production, increasing interest rates would discourage marginal projects from proceeding, and it would make many projects already under way uneconomic. Raising interest rates therefore acted to limit the production of goods, and not the demand for them. In the first stages of a central bank induced rise in interest rates, the limit placed on the supply of goods is even likely to have the effect of pushing prices higher for a brief time or encouraging import substitution, given the stickiness of labour markets because a rise in unemployment is yet to occur.

It should be apparent that management of interest rates before consumer debt came to dominate credit allocation was never going to work as a means of regulating the quantity of money, and therefore price inflation. Nowadays, new credit allocation is less angled at increasing and improving production, and its greater use is to finance mortgages and consumption. This is particularly true in the US and UK, but generally less so elsewhere.

Therefore, the consequences of managing interest rates are different from the past in key respects. Raising interest rates does not, in the main, reduce consumer demand for credit, except on mortgages, which we will come to in a minute. Credit cards and uncollateralised bank overdrafts typically charge as much as 20% on uncleared balances, even at times of zero interest rate policy, demonstrating their lack of interest rate sensitivity. The same is true of student debt.

Interest on motor loans and similar credit purchases are set not by central bank interest rate policy, but by competition for sales of physical product. Manufacturers have two basic sources of profit: the margin on sales, and the profits from their associated finance companies. It matters not to them how the sum of the two add up. If wholesale interest rates rise, squeezing their lending margins, they can subsidise their finance operations by discounting the price of their products. Alternatively, by expanding credit, and assuming they have the capacity to do so without committing additional capital, the marginal cost of that credit expansion is tied to extremely low wholesale deposit rates. This is the benefit to a manufacturer of having a captive bank: expanding credit out of thin air to finance sales is low cost.

However, changes in mortgage rates do influence demand for consumer credit. Mortgage repayments for most home-owners are their largest monthly outgoings, and therefore a rise in rates restricts spending on other goods and services. Furthermore, house prices are set in the main by the cost of mortgage finance, so a rise in interest rates on mortgages has a negative impact on house values. Falling house prices are likely to make consumers more cautious.

The last thing the Fed and the Bank of England will wish to entertain is raising interest rates to the point where a house price collapse is risked. Understandably, they are very much aware of the economic consequences. In the US, roughly two-thirds of consumer debt is home mortgages. Furthermore, the last credit cycle crash was so obviously centred on residential property that central bankers and bank regulators are sure to be sensitive to trends in mortgage lending. But this is the only form of consumer borrowing that responds to increases in interest rates.

The belief that interest rates correlate with the rate of inflation is unfounded, as demonstrated by Gibson’s paradox. It springs from the fallacy that an interest rate is money’s price. The basis of monetary policy is therefore fundamentally flawed.

It should now be clear that there is a lack of knowledge at the most senior levels in central banks about the economic role of interest rates, and therefore the whole basis of monetary policy. A second fallacy is the belief that demand for credit can be micro-managed through quarter point changes in interest rates. Not only is this a reactive policy that seeks to close stable doors after the horses have bolted, but it ignores the reality that the credit cycles engineered by the central banks are the root of the problem. They cause a build-up of non-productive borrowing and investment that is only viable at artificially suppressed interest rates. Increases in interest rates, however small, will eventually trigger the sudden recognition of these distortions in the form of an interest-rate induced economic crisis. The point is that the moment a central bank begins to stimulate credit through monetary policy, it begins to lose control over subsequent events. How they then play out is our next topic.

The price effects of credit expansion

The link between changes in the quantity of credit and the effect on prices is far from simple. Credit expansion leads to balancing increases in deposits held in bank accounts, but the category of deposit-owner determines where price inflation occurs.

In the early stages of a post-crisis economic recovery, increased deposits are predominantly acquired by financial market participants, and therefore early in the recovery phase of the credit cycle financial assets begin to inflate. As bankers and brokers spend a share of their gains on non-financial items, the profits and earnings of their suppliers improve as well. These range from solicitors, accountants, restauranteurs, and builders to purveyors of luxury goods. The benefits of early credit expansion gradually raise the general price level in financial centres and within commuting distance of them, as well as in fashionable holiday resorts habituated by these early receivers of new money. As time passes, further credit expansion benefits a wider population, and prices begin to rise more generally. The effect of absorbing new money into an economy is akin to throwing a stone into a pond and watching the ripples spread outwards, until they are undiscernible.

All this assumes that the desire to hold money, rather than reduce exposure to increased money balances, remains constant. Unfortunately, this can also vary considerably.

On the scale of values, the desire to hold money can vary from zero, in which case money is completely valueless, to infinite, in which case goods have no value. The former extreme happens to unbacked state money very occasionally (both Zimbabwe recently, and Germany in 1923 come to mind). The latter is impossible, because humanity needs to buy at least food, clothing and shelter. Therefore, the effect of changes in the desire to hold money relative to goods can have a significant impact on prices, a factor wholly beyond the central banks’ control.

Consequently, there are two major elements driving the relationship between the quantity of money and prices to consider, as the credit cycle progresses: who is benefiting from credit expansion, and variations in the general desire to hold money relative to spending it. In this credit cycle, those that have benefited most so far have been predominantly people holding financial assets, where price inflation has been rampant. The news last week, that Janet Yellen and Mark Carney now think a more aggressive interest rate policy is appropriate, tells us that their institutions have detected a shift in the application of credit. This being the case, the engine of price inflation will become refocused from financial assets towards the economy as a whole.

In other words, demand for bank credit from non-financial businesses is picking up, and banks are more willing to lend to them. It is undoubtedly this development that has encouraged the Fed to rein in the expansion of bank credit by reversing quantitative easing. But while there will always be some room on bank balance sheets to expand credit, most of the increase in credit aimed at non-financial activities must come from the sale of financial assets, particularly short-term US Government bills and bonds. And if the Fed tries to reduce its balance sheet at the same time, the fall in bond prices will be greater for it.

Therefore, bond yields will rise, possibly quite sharply, and the central banks have no option but to sanction increases in short-term interest rates. Hence the interest rate signal, which instead of being a leading indicator of trends, as everyone believes, reflects developments already in the market, being led by demand for non-financial credit.

The increase in the supply of credit to non-financial businesses will increase the bank balances of their suppliers as the credit is drawn down, leading to a temporary increase in their holdings of money relative to goods. These deposits in turn are then spent on goods and services.

Demand for goods and services, over and above that already supplied to consumers in the form of mortgages, credit cards, auto and student loans, will therefore have an additional credit stimulus from money flows previously tied up in financial assets. Ownership of cash and deposit balances held at the banks shifts from participants in financial markets towards suppliers of goods and services, which they will then spend on components in the consumer price index.

Credit expansion in favour of the non-financial sector also increases nominal GDP, which is simply a money total that measures consumption. At last, say the pundits, the economy is picking up. Profit forecasts will be revised upwards. Yet, the rise of government bond yields will be calling time on equity bull markets, which in truth have only reflected suppressed interest rates and bond yields held down by extra credit supply absorbed by financial markets.

The central banks’ nightmares have only just started. They have already lost control of interest rates, because the banks have begun to lend to Main Street, hence Yellen and Carney’s warning of interest rate increases. Equities and bonds, central to earlier policies of wealth creation are turning into engines of wealth destruction. We are now entering a period when the cost of credit, measured in real terms, is about to fall to the lowest level in the credit cycle.

Why real interest rates will become more negative

As the non-financial economy inflates on the back of credit expansion, the character of the credit cycle undergoes significant changes. As we have seen, bank credit is withdrawn from financial activities, to the detriment of financial asset values. It leads to significant selling of short-term government bonds by the banks and the loss of bullish momentum in equity markets, which then enter a bear market. The public tends to be buyers of equities at this stage, because analysts will be revising their profit forecasts upwards, seemingly justifying market valuations. But the error that the public makes is to assume share prices are driven by valuations, when they are driven by monetary flows.

The flow of bank credit from financials into non-financials will gather pace, encouraged further by falling bond prices, and the banks reducing their assessments of lending risk to the non-financial economy. The banks can even end up competing to lend, and suppress their lending rates by the simple expedient of expanding credit. If a significant number of banks are competing in this manner, deposit rates in the money-markets will be suppressed in turn, reducing their average cost of deposit funding, irrespective of the Fed funds rate.

Meanwhile, price inflation begins to accelerate as increasing quantities of bank credit end up being spent on goods and services. The combination of an increase in the general price level and competition to lend will, in real terms, lead to negative interest rates once higher price inflation is considered. The continuing suppression of nominal rates by central banks, doubtless worried about wealth destruction in financial markets, is likely to result in the greatest level of negative real rates of the entire credit cycle. The central bank is reluctantly forced to raises its lending rates in a belated attempt to keep up with economic developments. While this has been the evolving situation from the start of this expansionary phase, it will then become increasingly obvious that the public’s preference for money will swing progressively towards preferring goods, as they realise that money’s purchasing power is accelerating its decline.

Spending on goods of a higher order, or capital goods, increases as well, driven not only by reassessments of the nominal value of their production, but also by the desire to reduce cash balances. But unless bank credit contracts, the money disposed by one party ends up being owned by another, who will equally not wish to hang on to it. This is particularly noticeable in purchases of residential and commercial property, late in the credit cycle.

Contrary to the impression often given by financial commentators, property is not a financial asset, being non-financial in both origin and use. The fact that rentals give a monetary return is no different from any other non-financial, or productive asset. Property becomes an obvious destination for investors’ money fleeing falling values in financial assets.

Despite initial rises in nominal borrowing costs and bond yields, property becomes increasingly viewed as a solid asset, and as protection from the decline in money’s purchasing power. Obviously, the price performance of different categories of property can be expected to vary, depending on their exposure to rising nominal interest rates. Residential property markets, when they are highly dependent on mortgage finance, are likely to underperform. The growth of online sales has suppressed the utility of shopping malls and high street retail space. But despite these problems, there is little else available for capital fleeing bond and equity markets. For investors, bricks and mortar are seen to be the natural alternative to financial assets and a depreciating currency, late in the credit cycle.

Again, it is all about flow of funds. Follow the money. Only this time, instead of inflating investment values, the prices that will be inflated are of goods, services and their associated capital assets.

Not all jurisdictions are the same

All major nations are subject to the credit cycle. Attempts by central bankers to coordinate monetary policies through regular meetings at The Bank for International Settlements and at G20 meetings have ensured the eventual crisis phase will be truly global. Furthermore, the global distortions from first stoking up credit demand and then failing to control the consequences are magnified because of this coordination.

To further confuse observers of this multi-dimensional puzzle, in between credit crises the rate of progression from the recovery phase to expansion varies, and the volume of the credit flows, relative to the size of an individual economy, first into and then away from financial markets, varies as well. This leads to significant anomalies. The US and UK have very high levels of consumer credit exposure, and residential mortgage totals are also elevated. The expansionary phase has been running for some time in South East Asia, perhaps replicating the conditions that led to the Asian crisis in the late 1990s. The switch in interest rates will be greatest in Japan and the Eurozone, where negative interest rates persist, but these jurisdictions overall have a greater propensity to save than their Anglo-Saxon confrères. China plans to expand her way out of the eventual credit crisis, relying on state control through ownership of the banks. Russia, Australia, the Middle East and Africa are tied to a cycle of commodity prices, driven in turn by the expansionary phase of the global credit cycle.

Different places, different strokes. But at least the bones of the credit cycle are being laid bare. Eventually, the expansionary phase of the credit cycle becomes so obviously out of control that central banks will have little option but to try to protect their currencies’ rapidly declining purchasing power. This was the decision faced by Paul Volcker in 1981, when he was the Fed’s chairman. He raised the Fed funds rate to a staggering 20% that June. This time, Ms Yellen (if she is still in office) need only raise the FFR by a few percentage points before the crisis is triggered, given the high levels of accumulation of unproductive debt in the US economy today.

The lower ceiling for a rise in nominal rates becomes a limitation on the duration of the expansionary phase. It will be apparent a lot more quickly that central banks have very little room for manoeuvre on interest rates. The authorities might even try to put off the crisis phase by imposing price and wage controls, in the knowledge that at best, they might buy some time.

- Source, Alasdair Macleod of James Turk's Gold Money

The Path for Oil

Last week oil finally broke out of its narrow trading range of USD45-55/bbl (Brent) it has been trading in since mid-2016. The final push over USD55/bbl last week was driven mainly by concerns over Turkey President Erdogan threatening to shut down an oil pipeline bringing crude from the Kurdish controlled region in Iraq, should the Kurds vote for independence.

However, the rally was short lived and oil prices moved sharply lower again as it became clear that, despite the rhetoric, the oil kept flowing, at least for now. This pushed prices back to USD55/bbl at the time of writing, the same levels as at the beginning of the year. However, what the market seems to be missing is that the oil balance is fundamentally different from the beginning of the year. More specifically, over the past few months we have witnessed a global oil market shifting from years of surplus into deficit.

Global petroleum inventories have been building since 2014 on the back of relentless growth in US crude oil production. Initially OPEC decided to let things play out. They were reluctant to cut back output to accommodate US production growth, knowing that over the long run that would be a losing strategy as it would simply cost OPEC market share while the pressure on prices would remain. As a result, prices collapsed in the second half of 2014 and inventories began to build rapidly. The price decline eventually led to sharp cuts in CAPEX among US producers and US oil output began to contract in 2015. From that point global Inventories no longer built at the same speed, yet the market remained in a slight surplus. OECD inventories stopped building altogether but stocks remained at elevated levels. In order to speed up the inventory normalization process, OPEC decided in late 2016 to curtail production nevertheless. While initially this led to some price recovery, oil prices soon began to decline again as the market believed that the OPEC cuts were insufficient to bring down inventories meaningfully.

However, the more data we receive, the more obvious it becomes that inventories, particularly in the West, have been in a seasonal deficit for months now. While in the first quarter of 2017, the global oil market was still in surplus and global inventories were building (faster than the seasonal trend), this seasonal surplus shifted to a seasonally balanced market in 2Q17 and by 3Q17 we were in a seasonal deficit (see Figure 1).

More importantly, even as global inventories were building earlier this year, most of this occurred in non-OECD countries (Chinas SPR absorbed a lot of the surplus) while inventories in the OECD countries have been in a seasonally adjusted deficit for many months now (see Figure 2). In the US, the draws in total petroleum stocks was particularly impressive as we have been writing for some weeks.

The market so far has largely ignored this trend as it seems to be more focused on growing US production. The weekly petroleum status report published by the US Department of Energy (DOE) every Wednesday suggests that US production growth went from negative year-over-year at the beginning of this year to over 1mb/d as of now. This would, so the argument goes, soon put an end to the inventory normalization.

However, as we have pointed out before, the weekly DOE petroleum report has been overstating US production growth for months. This is mainly due to two reasons. First, there is a base effect. Production growth looks so impressive because the DOE had reported a sharp decline in US production in summer 2016 in the weekly data. However, the more accurate monthly data (according to the DOE the monthly data is not a revision of the weekly, it is simply a different and more accurate dataset) shows that this decline was heavily overstated (leading to an understated production figure). Understating production in one year will lead to an overstated year-over-year production growth figure for the same period the following year (see Figure 3) which is what we are seeing now.

Second, similar to how the weekly data understated production last year, it is overstating production this year. More specifically, in the weekly production data, US output rose to 9.4mb/d by July 2017. However, the monthly data shows that production only reached 9.2mb/d. Putting all these numbers together, year-over-year production growth in 2Q2017 was only 303kb/d and not 527kb/d as reported in the weekly data, a delta of 224kb/d. This divergence grew to a whopping 377kb/d in July (monthly production growth of 556kb/d vs weekly 993kb/d).

This poses some severe doubts over the 1mb/d year-over-year production growth figures for August and September as reported in the weekly data. We believe that the weekly data for August and September will be revised down sharply once the monthly data comes out. If the revisions of the past three months are any indication, true output was likely flat over the past two months (up 600kb/d year-over-year). But if the revisions are as large as the one for July, production has actually declined over the past two months. In a nutshell, contrary to what the market currently seems to believe, US shale production is unlikely to grow at 1mb/d year-over year in a USD50/bbl price environment.

- Source, James Turk's Gold Money

Oil for Gold: The Real Story

The mechanism of introducing an oil for yuan contract could hardly be clearer, yet the rumour mill went overtime into Chinese whispers. Some analysts appeared to think China was authorising a new oil for gold contract of some sort, or that China would be supplying the gold, both of which are untrue.

The purpose of this article is to put the proposed oil for yuan contract, which has been planned for some time, into its proper context. It requires knowledge of the history of how China’s policy of internationalising the yuan has been developed, and will be brought up to date with an analysis of how the partnership of China and Russia is taking over as the dominant power over the Eurasian land-mass, a story that is now extending to the Middle East.

This fulfils the prophecy of the founder of geopolitics, Sir Halford Mackinder, made over a century ago. He described the conjoined continents of Eurasia and Africa as the World Island, and that he who controls the Heartland, which lies between the Volga and the Yangtze, and the Himalayas and the Artic, controls the World Island.ii The Chinese-Russian partnership is well on its way to controlling the World Island, including sub-Saharan Africa. We know that successive Soviet and Russian leaders have been guided by Mackinder’s concept.

Events of recent months have accelerated the pace of the Heartland’s growing dominance over the World Island, and become pivotal to the balance of global power shifting in favour of the Heartland. Even political commentators in the mainstream media are hardly aware this is happening, let alone future implications. Financial commentators and economists are even less informed, despite the monetary consequences being of overriding importance for the impact on the wealth of nations and their peoples.

This is the backdrop to China’s internationalisation of her currency. To enhance our understanding of the implications of the introduction of yuan futures contracts, we must begin with the relevant monetary developments.

The Hong Kong – London axis

For a considerable time, China has followed a policy of replacing the dollar as its settlement currency for the purposes of trade. After all, China dominates international trade, and on a purchasing power parity basis, her economy rivals that of the US, and if it hasn’t done so already will soon overtake it. From China’s point of view, being forced by her trading partners to accept and pay in dollars is an irritating anachronism, a hangover from American imperialism.

Furthermore, China’s strategic military analysis has convinced her that America uses the dollar as an economic weapon, wielding it to sustain global hegemony and to support her own economy at the expense of others. Therefore, there are clear strategic reasons for China to do away with the dollar for as much of her international and trans-Asian trade as possible.iii

For America’s part, she has strongly resisted moves to have the dollar replaced as the world’s dominant trade currency. America has a tough grip on all commodities, because international physical and derivative markets are priced almost exclusively in dollars. Furthermore, nearly all currency hedging has the dollar on one side of the transaction. This allows the Americans to exercise enormous control over international markets, and even to artificially inflate commodity supplies through the creation of futures contracts, keeping prices lower than they would otherwise be. By these means, America has suppressed the relationship between monetary and price inflation, increasing the apparent stability of the dollar. This is central to the illusion of American monetary hegemony. Therefore, China’s policy of doing away with the dollar is, from the American standpoint, a fundamental challenge to her post-war global domination, and amounts to a declaration of financial war.

China’s problem in displacing the dollar is the lack of an international market for the yuan. Furthermore, with strict exchange controls limiting the ability of Chinese citizens and businesses to trade on the foreign exchanges, it was always going to be an uphill struggle to provide the necessary liquidity in the yuan to make it acceptable to foreign counterparties. China had to come up with a plan, and it made sense to use the existing financial links between Hong Kong and London to develop international markets for her own currency.

We can date public awareness of China’s strategy to June 2012, when Hong Kong Exchanges and Clearing made a successful offer for the London Metal Exchange. While noting that Hong Kong is an autonomous region, and that, officially at least, China does not meddle in Hong Kong’s affairs, China has a direct interest in important acquisitions of this sort. China is the world’s largest importer of base metals, and London is the global metal pricing centre for warehouse stocks and physical delivery.

The LME earlier this year decided to offer a series of precious metal futures contracts, priced in dollars, centred on gold. The gold contract has been a great success, something guaranteed when you bear in mind that the Industrial and Commercial Bank of China, owned by the Chinese state, is a lead sponsor of these precious metals contracts. By this action, China is parking its tanks on the London Bullion Market Association’s lawn. At some stage in the future, the LME will almost certainly offer deliverable futures contracts priced in yuan, not just for precious metals but for base metals as well.

In October 2013, fifteen months after the acquisition of the LME, Boris Johnson as Mayor of London led a trade mission to Beijing. British trade missions are a major feature of Foreign Office duties, the way Britain develops bilateral trade relationships. These trade missions, being planned through diplomatic channels, are prearranged and coordinated well in advance. Therefore, it was unusual to find that George Osborne, the Chancellor of the Exchequer, at very short notice got up a second trade mission, and met Johnson in China.

The reasons for this turn of events were never properly explained; however, we can work them out. In May 2012, David Cameron had met the Dalai Lama in London, which caused a diplomatic furore with China. Despite this earlier public spat and the point having been made, Osbourne was sent to China. While it is likely his trade mission was a cover for UK Government efforts to smooth things over, subsequent events suggest financial cooperation between Hong Kong and London was discussed, and Chinese plans to use Hong Kong and London to enhance the yuan’s international liquidity were agreed in principal. Following Osborne’s visit, David Cameron himself went to Beijing for discussions with President Xi the following month, confirming the importance to Britain of bilateral financial relations with China.

The following year, the UK took the unusual step of issuing a 3bn yuan bond, both as an indication of intent, and to help kick-start the offshore yuan market in London. This was followed by Britain being the first non-Asian nation to join the Asia Infrastructure Investment Bank as a founder member in March 2015 (announced by none other than George Osborne). The AIIB, which was set up by China and headquartered in Beijing, is the first supra-national organisation independent of the Bretton Woods institutions, which are all controlled by the US. These institutions, led by the World Bank and the IMF, as well as several regional development banks, were how the US, using the dollar, dominates the world’s finances. The establishment of the AIIB was an unwelcome development for America, and the US expressed acute disappointment that Britain had decided to join.

And lastly, after six or seven years of lobbying the IMF, the yuan was finally included in the SDR basket from 1 October last year, further promoting it as a trade settlement currency to be included in foreign countries’ reserves.

There can be no clearer evidence of China’s intention to replace the dollar with her own currency, than the sequence of events outlined above. She identified that Britain’s interests were aligned with her own, enabling her to cut out America from future developments. She has obtained arms-length control over London’s physical metal exchange. She had set up a non-dollar rival to the World Bank and IMF, ensuring future Asian development financing is under her control. And, with more than 80 member countries eventually joining the AIIB, she has successfully picked off America’s allies. The inclusion of the yuan in the SDR basket can be taken as an acknowledgement of China’s importance on the world stage.

The eventual intention is to price in yuan everything imported into and exported from China. Much trans-Asian business is already settled in yuan, and even remote Angola settles her oil sales to China in yuan. It will in time involve developing yuan futures contracts for all the tradeable commodities the state deems significant. The most important of these is a standard oil contract. But before we cover the genesis of the oil contract, we should remind ourselves about China’s gold strategy.

Cornering the physical gold market

It is only relatively recently that Western capital markets have become aware that Chinese demand for physical gold absorbs large quantities of annual mine production, and that the country is now the largest mining nation by far, extracting it at a rate of over 450 tonnes per annum. Knowledge of China’s overall demand is restricted to deliveries out of the Shanghai Gold Exchange’s vault into public hands, running at about 2,000 tonnes per annum, which with India’s public demand accounts for nearly all global mine extraction of about 3,000 tonnes.

The SGE was established in 2002, yet China began to embrace capitalism in 1980, when the first Special Economic Zone was established. China at that time showed reserves of 395 tonnes, a figure that was unchanged until 2001, when it was increased to 500 tonnes, and the following year to 600 tonnes, which it remained until 2009. Over this time, the Chinese economy enjoyed enormous capital inflows from 1980 until the early 1990s, when Western companies set up manufacturing facilities. These were followed by growing export surpluses thereafter. The Peoples Bank of China (PBOC), the state-owned central bank, was managing the currency, neutralising these flows by buying mostly dollars.

It also made sense for the Chinese to diversify the foreign exchange portfolio gained through intervention. The need to increase gold holdings would have been obvious to communist-trained economists at the heart of government. They had had the Marxist belief drummed into them that capitalism would eventually destroy itself, and the capitalists’ paper currencies with it. Rather like Germany in the 1950s and the Arabs in the 1970s, they felt it was prudent to put a significant part of their foreign exchange into gold.

Consequently, new regulations appointing the PBOC to “guarantee the state’s requirements for gold and silver” came into force on June 15, 1983.iv Private ownership of gold and silver remained banned.

It should be noted that state-owned gold declared as official reserves bear little relation to the total accumulated. Anecdotal evidence informs us that bullion is dispersed into accounts in the possession of the Peoples Liberation Army and the Communist Party. Therefore, we cannot know China’s true holdings. All one can do is make a reasonable assessment of how much gold the PBOC is likely to have accumulated since 1983 and before 2002, when private citizens were allowed for the first time to buy physical gold and silver. During this period gold had suffered the greatest bear market in the history of fiat currencies. The scale of redistribution from weak hands into stronger long-term hands was enormous, bearing in mind that Indians, the other great national buyers today, only began to buy gold in significant quantities in the early-nineties, after the repeal of the 1968 Gold Control Act in 1990. It is also known that in 1990-2000, many Middle Eastern portfolios sold gold in favour of equity investment, as did many other private investors with Swiss private bank accounts. Furthermore, central banks were leasing gold in large quantities, artificially inflating physical supply.

Taking all these factors into account, plus mine production totalling 42,460 tonnes over the period, it was easily possible for the Chinese state to secretly amass over 20,000 tonnes by 2002, through a process of gradual accumulation. As to whether they did so, we must look at the evidence from China’s gold strategy.

- Source, James Turk's Gold Money