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