The Relevance Of Hayek’s Triangle Today

Most of us are aware of the inflationary pressures in the major economies, that so far are proving somewhat latent in the non-financial sector. But some central banks are on the alert as well, notably the Federal Reserve Board, which has taken the lead in trying to normalise interest rates. Others, such as the European Central Bank, the Bank of Japan and the Bank of England are yet to be convinced that price inflation is a potential problem.

Virtually no one in the central banks, government treasury departments, or independent analysts see the real inflationary danger. There is a lone exception perhaps in Dr Zhang Weiying, the top economist at Beijing University and formally in charge of China’s economic policy, who quoted Hayek’s business cycle theory to point out the dangers of excessive deficits.[i] Whether he is listened to by his colleagues, we shall doubtless find out in due course. Otherwise, a sudden acceleration of price inflation will come as a complete surprise to our financially sophisticated markets.

This article explains why the danger lies in the structure of production, which in the West at least is seriously out of whack. The follies of post-crisis central bank monetary reflation are likely to drive us rapidly into the next credit crisis as a consequence. To understand why this is so requires us to revisit the 1930s writings of an Austrian-born economist, who was tasked by the London School of Economics with explaining to advanced students the disruption to the production process from changes in consumer demand.

Friedrich von Hayek was famously reported as the economic guru of both Margaret Thatcher and Ronald Reagan. This distinction owes its origin to his market-based approach to economics, which was in stark contrast with the statist approach that was predominant in political circles at that time, and still is today. It was simple shorthand for the media writing for a mass audience.

The distinction is nonetheless correct. Instead of spending his professorial career bending with the socialist and Keynesian winds, he continued to develop and defend free-market economic theory. As a war for hearts and minds, apart from his occasional successes, it was one Hayek lost, and the consequences of the triumphs of Keynes and socialism are reflected today in systemic instability. But that is no reason to abandon the Hayekian tradition.

Hayek made a number of important contributions to economics, including an understanding of the business cycle, which he demonstrated was driven by credit expansion, and the subsequent consequences of that earlier expansion. The root of the problem, as it is today, is the way producers of goods and services adapt to changes in demand for final goods. It is a problem seemingly ignored by policy makers. Instead they believe that monetary expansion can replace savings without negative economic consequences. This is simply not true.

Hayek illustrated the mechanism of production and the effects of capital flows in a capitalistic economy in the form of a triangle, which showed the steps in production from its early stages towards the final product in time sequence. Using this simplistic illustration he explained the effects of fluctuations of consumer demand on production. The following illustration is of Hayek’s triangle.

The triangle’s sides represent an inverted vertical axis of time, and a horizontal axis of output, the output being consumer goods. The dotted lines represent the various stages of production, typically from the gathering of raw materials and the processing of products through intermediate stages of processing, until the final products are ready for sale to consumers. The assumptions are ones of equilibrium, that is to say there is no change from technology, the distribution of stages of production are even, the quantity of money in the economy is fixed, and lastly there are no alterations in consumer choice.

This highly artificial construction is intended to isolate the factors that determine the relationship between production and consumption, a vital subject otherwise concealed from us by the noise from all the other extraneous factors.

At this point, we must dismiss the common assumption behind GDP, that it is only output that matters. The error has a long history, and goes back even to Adam Smith, who wrote,

“The value of goods circulated between the different dealers never can exceed the value of those circulated between dealers and consumers; whatever is bought by the dealer being ultimately destined to be sold to the consumers."[ii]

In the sense of the sum of added values, this is obviously true. But what matters in our context is payments, payments in the production chain and payment for the final product. The payments between the various stages of production can be many multiples of the final payment, a fact which is hidden from us by the GDP statistic. Indeed, it is only partly revealed to us by the business-to-business activities that occur in production as captured by the US Bureau of Economic Analysis’s gross output statistic.[iii]

Hayek took his triangle to the next stage, and that was to consider the relationship of money flows between intermediate processes, compared with payment for the final consumption output. The intermediate steps are given payment values. The working assumption is that they increase at an even rate as they progress towards the final product, which is likely to be the case because if the returns on one intermediate process is out of line with the others, capital flows can be expected to correct the disparity.

- Source, James Turk's Goldmoney

A Scheme for Linking Currency to Gold

Comparing the value of bullion held to the narrowest expression of money is likely to prove insufficient upon which to base a future monetary policy. But, given a good base of monetary gold, it is possible to set up arrangements to discourage redemptions of currency for physical gold when a gold exchange standard is fully implemented[vi]. The suggested arrangement that follows is based on the issuance of irredeemable government bonds with a coupon payable in either gold or currency at the owner’s choice (the gold bond). Furthermore, an issue of this sort could be used to improve government finances at the same time.

By issuing the gold bond at a discount to par, early buyers get an enhanced yield. This rewards them for buying a new instrument which has yet to gain its potential market recognition. The market price of the bond will become linked to the yield on physical gold once the conversion rate is set, with an additional margin for issuer risk. And if currency balances invested in such a bond are rewarded with a yield payable in gold, demand for currency redemptions into gold are unlikely to be significant, so long as the public has confidence in the issue and the gold exchange standard. So, a country putting its currency on a gold exchange standard should, with a correctly priced bond, minimise redemptions.

A sinking fund should be established at the same time as the bond is announced to buy physical gold to cover anticipated demand for coupons paid in gold. Some gold from reserves can be allocated for this purpose initially but additional gold should be bought to establish sufficient cover to add conviction to the scheme by winding down existing foreign currency reserves where they are unbacked by gold, immediately.

From here on, we shall assume this scheme to introduce a sound, gold-exchangeable currency is taken up by the Chinese government. Government finances can be expected to improve from the arrangement, to the extent that borrowing costs are reduced. For example, China’s 30-year bond currently yields 4.1% having been as high as 4.4% earlier this year. A gold-linked irredeemable Chinese bond, even allowing for issuer risk would probably yield no more than 3% at the outset, which is slightly less than the current yield on 1-year maturities. If it was issued with, say, a 2.25% coupon, it would be priced at 75.00, giving the attraction of a capital gain to private citizens as the risk premium on Chinese government bonds declines.

This will also lend support to the currency in the foreign exchanges. The gold bond should be listed in Shanghai, Hong Kong, Tokyo, Singapore, Dubai, London and Moscow so that sovereign wealth funds and other conservative long-term investors have ready access to it. New York is not on the list because it is Chinese policy to exclude the American banking system from her monetary affairs as much as possible, and the conflicts that necessarily would arise with the US government. Ultimately, for funds based outside America, the gold bond itself would come to be regarded as a gold substitute for investment purposes, integrating gold into both Chinese-led monetary and investment reforms.

There can be little doubt that if these measures are taken gold convertibility would rapidly promote the yuan to foreigners in Asia and beyond as an acceptable store of value in exchange for trade. In time, all foreign currency held in China’s monetary reserves not backed by gold would have to be disposed for gold or yuan, as being inconsistent with the new monetary policy. As stated above, China’s gold buying using dollars would start immediately and continue until the price of gold has risen to the point where the gold exchange rate is finally established.

Furthermore, with no final redemption on the gold bond, there would be no need to make any repayment provisions. This model is the one that was adopted by the British government for financing the Napoleonic Wars by issuing Consolidated 3% Annuities at a deep discount, so that investors providing war finance not only got an enhanced yield, but also a substantial capital gain when peacetime returned. The fortunes created on the return to peace played an important part in financing the industrial revolution in the early nineteenth century.[vii]

In this sense, there are good parallels between Britain’s war financing two hundred years ago, and China’s current position. In both cases government expenditure exceeded and exceeds respectively tax income by a significant margin, and neither were and are on a gold standard. Britain had temporarily abandoned her gold standard in the 1790s, before reinstating it a few years after Waterloo.

In China’s case, excess government expenditure is due to planned infrastructure spending, which is likely to be ongoing for at least another ten years and extending well beyond her borders. However, Chinese instigated capital expenditure throughout Asia will increasingly be covered by project financing through the Asian Infrastructure Investment Bank, releasing the Chinese government from much of the financing burden.

The British came out of the Napoleonic Wars with an estimated debt to GDP of about 260%. In cash terms it was considerably less, because the debt figure is the total of nominal debt in issue. This was the beauty of irredeemable Consols, because they never need to be repaid, which meant a more accurate debt to GDP figure was 180%. As an historical footnote, it is interesting they were repaid only recently.

China’s government debt is considerably less at just under 50%, but still rising. China is blessed with a savings rate of close to 50% of GDP as well, so further issues of a gold-linked bond into the domestic market should be heavily subscribed. Once the current expansion of infrastructure spending diminishes, the Chinese government will easily return to a budget surplus, paying down its debt more rapidly than the British did in the 1800s.

I would suggest China undertakes the monetarisation of gold in two stages. The first would be to issue the new gold loan outlined above. Proceeds of the new gold bond would be used to finance government expenditure, to purchase existing bonds in the market for cancellation, and to build a sinking fund to provide cover for future coupon demands in gold. The price relationship between coupons paid in gold and yuan will be fixed at a later date and will be the rate for the gold exchange standard once it is set. It cannot be set at the outset, because it is clear that for gold to be rehabilitated into China’s monetary system, and consequently the likelihood it will be elsewhere, will require a far higher gold price than at present. In price theory, it is the introduction of a new use that will set a higher marginal price. That will be the second step, which is announced in advance when the new gold bond is first issued but at a rate yet to be decided.

- Source, James Turks Goldmoney

Gold’s Monetary Rehabilitation

There is a quiet revolution taking place in the monetary vacuum that’s developing on the back of the erosion of the dollar’s hegemony. It is perhaps too early to call what’s happening to the dollar the beginning of its demise as the world’s reserve currency, but there is certainly a move away from it in Asia. And every time the Americans deploy their control over global trade settlement as a weapon against the regimes they dislike, nations who are neutral observers take note and consider how to protect themselves, “just in case.”

Vide Europe over the Iran issue. And Turkey. These are rifts in NATO. Countries in Africa, and elsewhere are now taking China’s money. And to please the Chinese, Gambia, Burkina Faso, Panama and the Dominican Republic have all recently severed diplomatic relations with Taiwan. Small fry perhaps, but a weathervane showing which way the wind is blowing.

We’ve seen Russia set up an alternative to SWIFT in order to be free from American monetary interference in pan-Asian trade. We’ve seen China take major steps to exclude the dollar from her trade as much as possible and to enhance the role of her own currency. And now we have a schism over Iran between America and the Europe it set up after WW2 through the mechanism of the CIA-controlled American Committee for United Europe in 1948.

It is unprecedented, and today America obviously cares less for her relationship with European allies than she hates Iran. There can be little doubt that America’s undeclared war against the land of Omar Khayyam is intended to undermine its economy and create the conditions for internal revolution. The Iranian rial has continued its collapse, and the theocratic government has played into US hands by shutting down “unauthorised” money-changers, with Grand Ayatollah Nasser Makarem Shirazi calling for the execution of money changers to help end the currency crisis. The black-market rate for rials has rocketed as a result, and according to Professor Steve Hanke whose department at John Hopkins University makes a study of these things, the true rate of price inflation has jumped to 74.8%.

For the ordinary Iranian, gold has always been the ultimate money, while their government’s rials are to be rapidly passed on to someone else. America’s sanctions and the government’s actions merely reinforce that message. Time will tell whether America’s attempt to undermine Iran’s theocracy succeeds, but history suggests it is unlikely. And at a national level, Iran is driven by American actions into accepting anything but dollars in payment for her oil exports. She would like euros, and given the EU is still trying to sell her capital goods, that makes sense. But no commercial bank dares facilitate payment in any currency under the threat of US sanctions and penalties.

That leaves only three possibilities beyond America’s influence: Chinese yuan, Russian roubles, and gold, all independent from the West’s banking system. It is no wonder the new yuan for oil contract in Shanghai, perhaps with a little help from China’s state-owned banks, has got off to a roaring start. We can all understand the desire to lock in oil prices for future delivery, in this case it is in return for yuan issued by the People’s Bank of China. However, in the future Iran will be able to spend the bulk of her yuan on other raw materials, using a range of yuan futures contracts as a bridge to them from her oil.

Essentially, US sanctions are forcing Iran onto a yuan standard for her foreign trade. Furthermore, China is there to pick up the pieces the West abandons because of American sanctions, driving Iran into an increasing dependency on China. The new Silk Road, the Chinese-built 200kph railway between Tehran and the eastern city of Mashad, as well as other Chinese-led rail projects are opening up Iran in a purely Eurasian context, marginalising American power. Iran’s problem with this, if there is one, is international yuan markets are not yet developed enough to make full use of hedging instruments. But Iran’s demand for sophisticated financial tools, as well as from other nations in Asia turning their backs on America, is bound to hasten their development.

I have written several times in the past about the importance of yuan-denominated deliverable gold futures in this context, and the evidence that the two markets offering these contracts, Hong Kong and Dubai, are cooperating in establishing additional vaulting facilities in China, roping in other gold centres in South-east Asia as well. In the case of gold, where physical delivery measured in tonnes is tight, the Chinese are ensuring as far as possible that deliverable liquidity will be there.

Additionally, last week the London Metal Exchange, owned by the Hong Kong Exchange and Clearing (HKEX), admitted it is considering introducing yuan contracts for base metals as well. We can safely assume that while the HKEX is an independent commercial entity, its strategic objectives are closely aligned with and encouraged by the Chinese government. Not only do the Chinese dominate gold markets in Asia, but last year HKEX successfully introduced regulated precious metal contracts in London. There can be little doubt that HKEX will be an important platform for expanding international markets for the Chinese currency. And at some time in the future, a state like Iran will be able to use not only yuan contracts to sell commodities in order to buy other commodities, but to use them as a stepping-stone to mobilise state-owned gold for payments as well.

Our topic is now moving on to gold being actively used as money instead of fiat currencies. While this point is not yet being considered by Western commentators, we can be sure it is by the forward planners in Asian governments. It’s not for nothing India is trying everything to get hold of its citizens gold. To an extent, gold is already used as money by governments, which is why they are still included in monetary reserves. But they are there as a backstop, the money of last resort, no one’s liability. What we could be seeing with the development of international yuan currency markets is a platform that links the use of gold to trade settlement.

This insight means we must look at both the Chinese and Russian policies on gold in a new light. Assumptions in the markets seem to be that China and Russia only see gold as a dollar hedge, or alternatively their accumulation of gold is either to balance the US’s holding of 8,133 tonnes, or alternatively (if you believe the American’s are lying about their reserves) Chinese and Russian gold is there to be used like a sword of Damocles held over the dollar. It would be wrong to dismiss these theories out of hand, but surely, they miss the point. You don’t carefully plan to become a dominant world power, edging out the Americans and their dollars, without careful forward planning of monetary affairs.

There is irrefutable evidence that China has been planning for a post-dollar world since shortly after her leadership threw in the towel on communism and embraced free markets. The regulations appointing the People’s Bank with sole responsibility for gold and silver date all the way back to 1983, since when we can confidently assume the PBOC has quietly accumulated gold on behalf of the state at prices that varied between $250-500 over a nineteen-year period. We know this, because in 2002 the PBOC then permitted private ownership, setting up the Shanghai Gold Exchange to facilitate physical acquisition. This would only have happened after the state had had a clear run at accumulating sufficient physical gold for its future purposes. And, as the largest gold mining nation for many years by far, with state monopolies in refining domestic production, recycling scrap and refining imported doré, there should be no doubt over her policy towards her accumulation of gold bullion.[ii]

Since 2002, the Chinese government has actively encouraged its nationals to accumulate physical gold and judging by net withdrawals from the Shanghai Gold Exchange vaults, the public possesses roughly 18,000 tonnes from more or less a standing start.[iii] My estimate for state ownership of bullion, based on contemporary prices, an analysis of capital inflows in the 1980s, followed by trade surpluses in the 1990s and before the public were permitted to buy in 2002, is approximately 20,000 tonnes. Even so, that may be not be enough gold bullion owned by the state at current prices to operate a simple gold exchange standard, being the equivalent value of ¥5.22 trillion, compared with currency in circulation of ¥7.15 trillion.[iv] For comparison, when President Roosevelt devalued the dollar to $35 in January 1934, the US Treasury held gold worth $7.44bn at the new price against currency in circulation of $5.72bn. Therefore, if the Chinese government has 20,000 tonnes, and if it is to have the same currency cover as America had on 31 January 1934, at current exchange rates gold would have to be priced at $2,317.

Russia began accumulating gold only more recently and is now aggressively building her official reserves. Whether she has accumulated bullion “off balance sheet” is not known but should not be dismissed. Based on her official reserves at 1,910 tonnes worth RUB5.0 trillion, it does not cover M0 yet (RUB8.44 trillion)[v] but a rise in the gold price to $2,200 will do so, and a gold price of $2,860 would be required to match the Americans in 1934. In fact, for both Russia and China if gold is to have a monetary role it would have to be at a far higher price than it is today.

- Source, James Turk's Gold Money

EU Banks are Insolvent, Disaster is Coming

The disruption of an Italian withdrawal from the euro would be fatal for the EU’s banking system on at least four levels.

The support from the ECB for the Italian banks would be withdrawn, which would have the potential to allow a cascade of bank failures in Italy to develop, either as a result of bad debts crystallising within the system, or due to balance sheet deterioration from falling Italian government bond prices.

Problems for banks will arise when past loans remain denominated in euros, while their balance sheets are transitioned into a new, weakening currency. The Italian banks lack the margins to weather lop-sided balance sheets, whose assets are denominated in a declining currency relative to the currency of their liabilities.

There will be a rush for residents in other Eurozone countries to reduce and eliminate their Italian commitments, amounting to a banking run against the whole country. The only political solution would be to impose draconian capital controls between Italy and the rest of the world, including other EU member states.

Lastly, there is the threat to the ECB and the euro-system itself.

These require little elaboration, expect perhaps for the threat to the ECB and the euro-system. The ECB has been buying large quantities of Italian bonds, effectively financing the Italian government’s excess spending, at yields that are ridiculously low. In effect, the ECB has put itself in an impossible position, and as the Italian situation worsens, the debate over the fate of TARGET2 imbalances is bound to intensify. These are shown in the chart below, which is of balances at end-March.

So long as the euro-system holds together, we are reassured that these imbalances do not matter. However, with the Italian central bank in debt to the system to the tune of a net €447bn, how these imbalances would be dealt with on an Italian exit from the euro without a collapse of the system is an interesting question. And it is worth noting that Spain’s central bank is also in the hole for €390bn, just in case the Spanish electorate, or even the Catalans or Basques get ideas of leaving as well.

The Bundesbank is owed a net €896bn and will be extremely nervous about Italy. The ECB itself also owes a net €235bn to all the national central banks. When the ECB buys Italian government debt, the Banca d’Italia acts on its behalf. The Italian bonds are held at the Banca d’Italia, and the money is owed to it. To the extent the ECB has bought Italian bonds, the overall negative balance at the Banca d’Italia is reduced, so its deficits with the other national banks in the system are actually greater than the €447bn shown, by the amount owed to it by the ECB.

In short, it is hard to see how Italy can leave the euro without the ECB having to formally guarantee all TARGET2 deficits. It is not impossible and the guarantee is already implied, but the ECB won’t want anyone questioning its own solvency, so we can safely assume an exit will not be permitted, for one simple reason: the system and the banks in it are only solvent so long as the system is unchallenged.

The question over Italy’s euro membership may not arise anyway, because the new coalition does not yet know what it wants. The Italians must also be dissuaded from their desire for debt forgiveness, for the same reasons the Greeks were similarly deterred. And as the Greeks found, trying to negotiate with the EU and the ECB was like talking to a brick wall. The Italians will experience the same difficulties. We can dismiss any idea that because Italy is a far bigger problem, they have negotiating clout. A brick wall remains a brick wall.

So far as Brussels and Frankfurt (the home of the ECB) are concerned, they are always in the right. The European project and the euro are more important than the individual member nations, and their electorates have no say in the matter. We often take this to be arrogance, which is a mistake. It is worse: like Marxists, the eurocrats have unarguable conviction on their side. Across the table will sit the Italians, with no political beliefs worth mentioning, and all too readily frightened by the consequences of their own actions.

This is the way the EU works. Inevitably, in a faceless statist system such as this there are always problems at the national level to deal with. Then there are localised difficulties, such as Deutsche Bank, whose share price tells us it is failing. But in that event, it will doubtless be rescued because of its enormous derivative exposure, the containment of eurozone systemic risk, and German pride. The ECB has shown great skill at bluffing its way through these ands other problems and is likely to continue to succeed in doing so, except for one particular circumstance, which is the crisis stage of the credit cycle.

- Source, James Turk Goldmoney

The Gently Rotting Debt Ridden EU

The EU as a political construction is in a state of terminal decay. We know this for one reason and one reason alone: its core principle is the state is superior to its people. A system of government can only work over the longer term if it recognises that it is the servant of the people, not its master. It matters not what electoral system is in place, so long as this principle is adhered to.

The EU executive in Brussels does not accept electoral primacy. It shares with Marxist communism a belief in statist primacy instead. The only difference between the two creeds is Marx planned to rule the world, while Brussels is on the way to ruling Europe.

The methods of satisfying their objectives differ. Marx advocated civil war on a global scale to destroy capitalism and the bourgeoisie, while Brussels has progressively taken on powers that marginalise national parliaments. Both creeds share a belief in an all-powerful executive. The comparison with Marxism does not flatter the EU, and suggests it has a limited life and that we may be on the verge of seeing the EU beginning to disintegrate. Despite economic evolution in the rest of the world, like Marxian communists Brussels is stuck with a failing economic and political creed.

It has no mechanism for compromise or adaptation. A rebellion from Greece was put down, the British voted for Brexit, which is proving impossible to negotiate, and now Italy thinks it can partially escape from this statist version of Hotel California. The Italians are making huge mistakes. The rebel parties forming a coalition government want to stay in the EU but are looking to exit from the euro. Putting aside the impossibility of change for a moment, they have it the wrong way around. If they are to achieve anything, they should be exiting the EU and staying in the euro. Let me explain, starting with the politics, before considering the economics.

As stated above, the EU is quasi-Marxist, placing the state above the people. The Italian government has collaborated with Brussels to enslave its own people as vassals of the EU super-state. If there is a revolt in Italy, this is what the electorate is rebelling against. Faceless eurocrats tell the Italian people what to do and what to think. The people are discontent with both the super-state and their own weak governments.

The two parties forming the latest coalition are too frightened to blame the EU, and instead propose to beg for debt forgiveness and say they are considering leaving the euro. But without a clear vision, and understanding why the Italian electorate is discontent, this coalition will turn out, in one of Boris Johnson’s memorable phrases, to be comprised of little more than supine protoplasmic invertebrate jellies. Greece is the precedent. This makes it easy for the EU to deal with the Italians. They will get nothing.

The economic argument, that Italy would be better with her own currency, is insane. With a history of weak irresponsible governments, it is far better for the currency to be beyond Italy’s control. However, Keynesian commentators are sympathetic to the weak currency argument, believing that the euro was constructed for the benefit of Germany. Italy, along with the other Mediterranean members, is said to be paying the price. This, they allege, is the fatal flaw in the one-size-fits-all euro. This interpretation of the monetary situation is baloney. It ignores the fact that Italy’s debt rocketed after the formation of the euro, because the cost of borrowing for Italy fell towards Germany’s borrowing rates, thanks to the guarantee of eventual unification. The difference was Germany borrowed to invest in production, while the Italian government borrowed to spend. The problem today is the profligacy of the past has caught up with Italy, and its government must stop borrowing.

Setting up a lira alternative, or the mooted mini-BOTs, is an ill thought out concept that only makes matters worse. The mini-BOT proposal appears to be for an issue of certificates backed by future tax revenues to be used to pay the government’s creditors. They would then circulate like bills drawn on the state, but at a discount to reflect both their time value and the fact they are not euros. It seems to not occur to the promoters of schemes like this that the state’s creditors will insist on payment in euros.

Promoters of schemes like mini-BOTs are monetary cranks, incentivised by a desire to avoid reality. The Italian government has been using this sort of hocus-pocus for years, mostly with securitisation of future income streams, such as the national lottery. Mini-BOTs appear to be a proposal for just one more throw of the dice.

It’s hardly surprising that the Italian people are fed up with their establishment and feel they can only collectively undermine it by voting against it at election time. But it is too late, because the state, and therefore the banks, are already irretrievably bust, a fact barely concealed by the ECB’s funding of the Italian government at near-zero interest rates through the purchase of government bonds. Not only is the ECB in denial over Italy’s financial situation, but also Italy is firmly imprisoned.

- Source, James Turks Goldmoney