Golden Straws In The Wind

Life in the world of gold bullion is full of mysteries. Each mystery is like a straw in the wind, which individually means little, but tempting us to speculate there’s a greater meaning behind it all. Yes, there is a far greater game in play, taking Kipling’s aphorism to a higher level.

One of those straws is Russia’s continuing accumulation of gold reserves. Financial pundits tell us that this is to avoid being beholden to the US dollar, and undoubtedly there is truth in it. But why gold? Here, the pundits are silent. There is an answer, and that is Russia understands in principal the virtues of sound money relative to possession of another country’s paper promises. Hence, they sell dollars and buy gold.

But Russia is now going a step further. Izvestia reported the Russian Finance Ministry is considering abolition of VAT on private purchases of gold bullion.[i] We read that this could generate private Russian annual demand of between fifty and a hundred tonnes. More importantly, it paves the way for gold to circulate in Russia as money.

We should put ourselves in Russia’s shoes to find out why this may be important. Russia is the largest exporter of energy, including gas, pushing Saudi Arabia into second place. This means she is also the largest acquirer of fiat currency for energy. That’s fine if you like fiat currencies, but if you suspect them, then you either turn them into physical assets, such as infrastructure and military hardware, or gold. Russia does both.

Then there is China. China has started announcing monthly additions to her gold reserves. China is up to her neck in dollars, and the relatively minor monthly additions to her reserves really make little difference. However, the link between the gold exchanges in Moscow and Shanghai strongly suggest Russia and China are coordinating gold dealing activities.

In any event, China now dominates physical bullion markets. Deliveries (withdrawals) from the Shanghai Gold Exchange’s vaults into public hands are running at roughly two-thirds of the world’s annual mine supply. At 426 tonnes in 2017, China is the largest gold mining nation by far, and the state owns all China’s refining capacity, even taking in doré from abroad. No gold leaves this version of Hotel California.

The frequently-expressed reasoning for their gold policies is Russia and China are locked in a financial war with their largest debtor. This is not the underlying reason these nations have chosen gold as an expression of their dislike of America’s weaponization of her monetary policies. They know the difference between unbacked fiat currencies and sound money, which has been chosen by people ever since they began to use a separate commodity to intermediate in transactions.

However, it is true the Americans have weaponised the dollar, bringing an urgency to China’s and Russia’s deployment of gold. US dollars have been the world’s reserve currency for the last forty-eight years, and America, which pays for everything in costless, newly-issued dollars, now says it wants a better trade deal. It obviously assumes the dollar’s supremacy is unchallengeable and in their need for dollars China and other exporters to America will be forced to comply.

Let’s pick this apart. The US Government pays for everything in a currency which it issues at will. New dollars only gain value once they are in circulation, but the cost of production is zero, stealing their circulatory value from previously existing currency. However, the US Government is unable to balance its books without recycling some of these duff dollars into its own IOUs (Treasury stock). Because they are required to be repatriated to balance the US Treasury’s books, the US Treasury borrows them back from foreigners who might otherwise question the dollars true value. So, foreigners get a Treasury IOU eventually paid out in a currency IOU. It really is pig on pork.

So far, the foreigners have been successfully conned, though questions are beginning to be asked.

Logic suggests that the US Government getting something for nothing is as good as it gets. But President Trump thinks this is unfair, not on the Chinese and other foreigners swapping goods for ultimately worthless paper, but on America herself! He holds out for an even better deal. He demands the Chinese and others stop supplying real stuff to his people in return for his costless, dubious paper. In other words, speaking on behalf of the American People, he is now dissuading the Chinese from giving Americans something for what amounts to nothing.

Those on Planet Asia could be forgiven for looking at things rather differently. After Mao’s death and a brief period of accepting the dollar scam on the basis that demand for dollars would always ensure they could be exchanged for value, the Chinese have for a long time smelled a rat. This is why in 1983 they appointed the Peoples Bank to be in charge of liquidating dollars for gold and silver. They have gently played along with the dollar scam ever since, not wanting to be the party that exposes it for what it is.

Now it is Trump himself who has blown the whistle on the dollar. China and Russia have undoubtedly got the message from this new art of the deal. But at the heart of it is a deep, wider malaise in the fiat currency world. Understand that, and we get to the true reason why Russia and China are wary about accumulating the West’s fiat currencies. Until now, they have run with the hare and hunted with the hounds. China in particular uses fiat renminbi to drive expansion. But then if she didn’t, today’s world order would have probably collapsed in the wake of the Lehman crisis as the flaws and weaknesses of fiat currencies would have been exposed.

The next credit crisis could change everything

So far, China and Russia have resisted the temptation to act precipitously. Their economies are dependent on Western cooperation. Russia exports energy to the West, and China runs a trade surplus in goods and services. To dispense with Western trade, they need an Asia-wide self-contained market. They are building it, with China’s silk road projects and by consolidating the membership of the Shanghai Cooperation Organisation. But not all the groundwork has been done, certainly not enough to “go commando”.

The transfer from a dollar-centric world to gold-backed roubles and renminbi will continue to be at a pace determined by the monetary mistakes of America. That is why the next economic downturn is so important to geopolitical outcomes. And it won’t be just a rerun of Lehman, characterised by a sudden crisis, money-printing, and heaving a sigh of relief when the banking system doesn’t collapse.

The starting-gun for the next credit crisis has already been fired. A reversal of expanding cross-border trade is in full swing. The sales of dollars by foreigners has begun. There is little doubt there is a recession ahead, the only question is of its likely depth. The massive build-up of unsustainable global debt since the Lehman crisis tells us to expect the liquidation to be substantial. The coincidental combination of the peak of the credit cycle and trade protectionism warns us of something far worse than an ordinary recession: a possible rerun of 1929-32, only this time with unsound currency instead of currencies freely convertible into gold.

It is the sheer scale of the problem which is likely to prove the undoing of fiat currencies. A deep recession will do catastrophic damage to government finances, which can only be covered by massive monetary expansion. At the same time, monetary policy is designed to ensure the general price level does not fall. This occurs when a credit crisis wipes out demand, and prices in sound money fall significantly. We know this because in 1929-32 measured in gold-backed dollars prices did just that.

It may take a few months before the purchasing power of fiat currencies begins a renewed decline. The recent strength in energy and commodity prices is worrying in this context, but it is probably too early to call it the start of a definite trend of falling purchasing powers for the dollar and other currencies, measured against the commodity complex.

Trouble is likely to start with either the dollar or the euro. In a deepening recession, the euro will struggle with escalating problems in the PIGS[ii], Brexit, US trade protectionism and systemic risks in the Eurozone’s banking system. The Eurozone could easily disintegrate. A falling dollar, over-owned in the context of declining international trade, is also a racing certainty. A race to the bottom for both currencies is becoming the increasingly obvious outcome of a slump in world trade.

Politicians are ill-equipped for a monetary crisis

Inevitably, the corruption emanating from the issuance at will of costless fiat currency leads to a deteriorating political morality. By debasing the currency, you can rob people of their wealth and earnings without their knowledge or approval. Get away with that, and the political class is on the highway to the ultimate in corruption.

In modern democracies, this is why the source of political power increasingly lies in the deception of the public, and why both control and debasement of a currency is its ultimate expression. The true purpose of the debasement of the currency is very rarely understood by a trusting public. The existence of a state-issued currency is blandly accepted as proof of its value, and no further questions are asked. The long-term decline in its value is given credibility by being declared to be official monetary policy, so everyone thinks it is a good thing. But the public are wholly unaware of the transfer of wealth from them to the state and its cronies, which is the inevitable consequence of monetary debasement.

It is anti-capitalistic in its destruction of both capital and values. The political class has been progressively leeching off the productive side of the economy to pay for its socialising schemes and for the sheer enjoyment of power. If the rate of currency debasement is slow and even, it can continue for a long time. As a destructive process, it is ultimately finite. But the pace has quickened. The Lehman crisis led to a rapid acceleration of the rate of currency debasement, which never really ceased. Debasement is about to accelerate yet again. Not only will the issuance of central bank money substantially increase to compensate for a slowing down in the rate of bank credit expansion, it is also becoming essential to finance government spending.

The likely scale of a renewed debasement of the currency threatens to alert the public to the instability of the situation, undermining confidence in unbacked currencies. Despite the stated intentions of monetary policy, its true purpose will become increasingly obvious when government revenue collapses and welfare costs rise. How convenient it will be for scaled-up quantitative easing, the printing of money to pay for government debt, to be slavishly supported by all advisors and commentators pretending to be economists. Wiser counsel, if it is listened to, will caution against the trap of relying on the destruction of currency values as the bedrock for future government finances.

What then for our politicians, who have come to rely on monetary debasement to finance their ambitions? Will they wake up to the predicament they have put us all in, and suddenly realise they must humbly genuflect at the altar of contrition, of sound money, and confess to their sins and submit themselves to public opprobrium?

Dream on, folks! They will struggle to extricate themselves with the only means at their disposal. More money. More socialism. More raping the productive economy by accelerating wealth transfer through monetary debasement. They know nothing else. They have not only deceived their voting public, but they have deceived themselves. If the world moves only half-way to a 1930s depression, the rate of monetary expansion to bridge the widening chasm between tax receipts and welfare obligations will be so great, it will likely lead to the end of the dollar, the end of the euro and the other currencies which copy them. Even the hitherto Teflon yen will be threatened with immolation.

The wise heads in China foresaw this in the last century, which is why they appointed the Peoples Bank to handle the state’s gold and silver purchases under government instruction. It is why they set up the Shanghai Gold Exchange in 2002 to allow and encourage the population to accumulate physical gold. They knew that one day, gold and silver would become the backbone of currencies again and they have ensured it is widely distributed. They knew the West’s Achilles’ heel was the modern equivalent of Genghis Khan’s mulberry-leaf paper, but without the great man’s despotic authority. In her long history, China has been there, seen it, done it, and has got the changshan.

Russia was late to this party, but the transformation in her understanding of the West’s monetary affairs was swift. America tried to use the dollar as a weapon to cripple Russia, but President Putin wasn’t to be panicked. He appointed a bright young woman, Elvira Nabiullina to head up the Central Bank of Russia. She reformed the banking system, strengthening commercial banks and replaced the Brussels-based SWIFT interbank messaging system with its own, which will link up with the Central Asian ‘stans, China, Iran and even Turkey. This will insulate Russia from Western banking crises, a point missed by Western commentators who only see isolationism. And it is Nabiullina who has overseen the selling of dollar reserves for gold bullion.

Russia and China have distanced themselves from the west’s financial system, so it can collapse without taking them down. Obviously, there will be collateral damage, but nothing unforeseen. They will be aware of the political consequences, so will not want to precipitate anything with their actions. Let the West destroy itself and for China and Russia not to be made the fall-guys.

- Source, James Turks Goldmoney, read more here

Post Tariff Considerations

Following President Trump’s imposition of 25% tariffs on all Chinese imports, it is time to assesses the consequences. Already, we have seen a contraction in US-China trade of 20% in the first three months of 2019 compared with the same quarter last year, and also compared with the average outturn for the whole of 2018.[i] This contraction was worse than that which followed the Lehman crisis.

In assessing the extent of the impact of Trump’s tariffs on the US economy, we must take into account a number of inter-related factors. Clearly, higher prices to US consumers will hit Chinese imports, which explains why they have dropped 20% so far, and why they will likely drop even more. Interestingly, US exports to China fell by the same percentage, though they are about one quarter of China’s exports to the US.

These inter-related factors are, but not limited to:

• The effect of the new tariff increases on trade volumes
• The effect on US consumer prices
• The effect on US production costs of tariffs on imported Chinese components
• The consequences of retaliatory action on US exports to China
• The recessionary impact of all the above on GDP
• The consequences for the US budget deficit, allowing for likely tariff income to the US Treasury.

These are only first-order effects in what becomes an iterative process, and will be accompanied and followed by:

Reassessment of business plans in the light of market information
A tendency for bank credit to contract as banks anticipate heightened lending risk
Liquidation of financial assets held by banks as collateral
Foreign liquidation of USD assets and deposits
The government’s borrowing requirement increasing unexpectedly
Bond yields rising to discount increasing price inflation
Banks facing increasing difficulties and the re-emergence of systemic risk.

We can expect two stages. The first will be characterised by monetary expansion will little apparent effect on price inflation. Putting aside statistical manipulation of price indices, this is the current situation and has been since the Lehman crisis. It will be followed by a second phase, following an acceleration of currency debasement. It will be characterised by increasing price inflation, and ultimately the collapse of purchasing power for unbacked fiat currencies.

The trade framework

The simple accounting identity at national level linking trade with changes in the quantity of money and credit is comprised of three factors: the budget deficit, the trade deficit, and changes in total savings. They are captured in the following equation:

(Imports – Exports) = (Investment - Savings) + (Government Spending – Taxes)

In other words, a trade deficit is the net result of a shortfall in the combination of a savings surplus over industrial investment and the budget deficit. For a detailed explanation as to why this is so, see Trade wars – a catalyst for economic crisis. The equation tells us that it is the expansion of money and credit which gives rise to trade imbalances, which is why when there is no change in the savings rate and in the absence of other factors the twin deficits arise. Otherwise, monetary inflation would lead directly into price inflation, the effect in a closed economic system.

Mainstream economists often disagree with this point, having discarded Say’s law. Say’s law explains the division of labour. It maintains that we specialise in our own production to buy all the other things we require and desire, and money is just the intermediation between our production, consumption and deferred consumption (savings). It was the iron rule of pre-Keynesian classical economic theory and allowed no latitude for state-issued money that was inflated into the system. Keynes had to disprove it (he did not – his definition was deliberately misleading) in order to develop his inflationist theories and create an economic role for intervening governments. It was this fundamental error of post-Keynesian economics that has led to successive economic crises, despite the ability of ordinary economic actors to adapt to government interference.

Understand this, and it follows that money and credit not earned through production can only lead to the importation of products from exogenous sources, or alternatively, fuel a rise in prices to reflect the increased quantity of money circulating between consumers and domestic producers. Free trade, the ability to substitute lower-priced goods from abroad for domestic equivalents, reduces the price impact of monetary inflation. If it wasn’t for the availability of foreign substitutes, price inflation would be far higher, which is why tariffs on imported goods only serve to push up price inflation.

Unintended consequences

Obviously, being a tax on imports, tariffs benefit the Treasury’s finances; a fact which President Trump continually boasts about. To be precise, a 25% tariff on all Chinese imports in the remaining five months of the current fiscal year (based on the first quarter of 2019) can be expected to raise $45bn, which reduces the Office of Management’s budget deficit estimate of $1,092bn[ii] for fiscal 2019 to $1,047bn. The tax benefit is therefore relatively minor, and likely to be more than offset by the recessionary consequences of higher tariffs on government tax revenues and welfare costs. This article will go into more detail why this is so.

If for a moment we assume there will be a limited impact on consumer demand from increased tariffs, the effect on prices at the margin would be to drive them sharply higher for all consumer goods in the product categories where Chinese supply is a factor, with some spill-over into others. Price inflation would simply begin to escalate. But given the indebtedness of the average American consumer, the ability to pay higher prices is obviously restricted, suggesting that overall demand must suffer, not just for imported Chinese goods, but for domestically-produced goods as well. It is therefore likely there will be both an impact on price inflation and a fall in consumer demand.

Besides the effect on consumers, manufacturers relying on part-manufactured Chinese imports and processed commodities now face cost pressures from tariffs which they may or may not be able to pass on to consumers. The cost pressures on manufacturers are bound to lead to a reassessment of their business models. This will be communicated to their bankers as increased lending risk, and they in turn will almost certainly restrict credit availability. The credit cycle would then move rapidly into a contractionary phase as both businesses and their bankers take fright.

Anyone who has analysed post-war credit cycles will be familiar with these dynamics. We are probably not there yet, despite the warning shot from financial markets in the fourth quarter of 2018. For now, the initial softening of consumer demand has led to a general assumption that monetary policy will ease sufficiently to prevent little more than a mild recession, benefiting capital values. Government bond yields have eased, and arbitrage across bond markets has ensured investment grade corporate bond yields have declined as well. Since end-November when the central banks began to ease monetary policy, the effective yield on investment grade corporate bonds, reported by Bank of America Merrill Lynch, has fallen from 4.8% to 4%. This is hardly an assessment of increasing lending risk.

As well as bond markets, equity markets are also expecting monetary easing, instead of a gathering crisis, and have rallied along with bonds. Clearly, financial markets have not noted the seriousness of trade protectionism, having become complacent while trade restrictions have generally eased in recent decades. However, market historians will note that this brief recovery phase was also the pattern in stock markets between October 1929, when the Smoot-Hawley Tariff Act was passed by Congress, and April 1930, two months before President Hoover signed it into law. If the correlation with that period continues, equities could be in for a substantial fall (in 1929-32 it was 88% top to bottom).

In the Wall Street Crash, equities fell as collateral was liquidated into falling markets. Non-financial assets, such as property, similarly lost value and productive assets (plant, machinery etc.) failed to generate anticipated cash flows. This nightmare was famously described by Irving Fisher, and has continued to frighten economists ever since.

While debt was a problem in 1929, it was generally confined to corporate borrowers and speculators. Today’s context of Fisher’s nightmare is in record levels of government, corporate and consumer debt. The potential disruption from the unwinding of the credit cycle is therefore worse today. Trump’s trade protectionism so far is targeted at one country, unlike Smoot-Hawley which was across the board. At first glance, Smoot Hawley was more dangerous, but it is the lethal combination of tariffs and the end of the expansionary phase of the credit cycle which should concern us.

The credit cycle with its periodic crises is both a given and overdue. The addition of trade tariffs will act as a catalyst to make things worse. Inflation and unemployment will rise, and as unemployment rises, government welfare costs will too. Being mandated, it will be impossible for the US Government to reduce them without revising the law. We can only guess the effect on the borrowing requirement, but with the Office of Management’s forecast deficit for fiscal 2019 at $1,095bn, perhaps over $1,200bn might be closer to the mark. The full impact is likely to be felt in 2020, when it could top $1500bn.

The cost of borrowing will escalate

With government borrowing already escalating, the interest rate burden on the government will become a very public issue. The following chart becomes the baseline for the government’s future borrowing costs.

Interest costs are already running away, before the addition of two other factors; a more rapidly accelerating borrowing requirement (as discussed above) and higher interest rates. After an initial round of monetary easing, higher interest rates can be expected to arise from a combination of three further factors. The most obvious is the increased rate paid by a borrower placing ever-greater demands on the bond market as the recession deepens.

With a gathering US and therefore global slump developing, foreigners will also become sellers of dollars and US Treasuries, simply because they do not need and cannot afford to run substantial dollar balances and investments. A foreign corporation may not like its home currency compared with the mighty dollar, but when costs and losses at its operating base need covering it has no option but to sell its dollars. Foreigners selling dollars and US Treasuries put all the funding onus on US residents, in conditions which, thanks to tariffs, are leading to increasing prices.

The impact of rising price inflation is bound to lead to higher nominal interest rates. While domestic investors can be expected to buy US Treasuries at supressed yields while recessionary fears persist, their appetite for guaranteed losses will be strictly limited. Commentators who have foreseen this difficulty expect quantitative easing to be reintroduced to guarantee affordable funding for the government. The argument in favour of more QE accords with the likely monetary response to collapsing consumer demand. It resolvs both the capital needs of hard-pressed banks and government funding demands.

Therefore, ahead of the next credit crisis, QE is the logical planners solution to stabilising an economy. It worked in the wake of the Lehman crisis. The inflationists are ready to try it again. Attention is even being paid to modern monetary theorists, the ultimate inflationists, who argue that increased government spending, so long as it is not inflationary at the price level, is good for the economy. It is the inflation assumption that could unwind it all.

- Source, Goldmoney, read more here

Cyber Wars and All That

Huawei is hitting the headlines. From ordering the arrest of its Chief Financial Officer in Vancouver last December to the latest efforts to dissuade its allies from adopting Huawei’s 5G mobile technology, it has been a classic deep state operation by the Americans. Admittedly, the Chinese have left themselves open to attack by introducing a loosely-drafted cybersecurity law in 2016/17 which according to Western defence circles appears to require all Chinese technology companies to cooperate with Chinese intelligence services.

Consequently, no one now knows whether to trust Huawei, who have some of the leading technology for 5G. The problem for network operators is who to believe. Intelligence services are in the business of dissembling, which they do through political puppets, all of which are professionals at being economical with the truth. Who can forget Weapons of Mass Destruction? More recently there was the Skripal poisoning mystery: the Russians would have been bang-to-rights, if it wasn’t for Skripal’s links through Pablo Miller to Christopher Steele, who put together the dodgy dossier on Trump’s alleged behaviour in a Russian hotel.

The safest course is to never believe anything emanating from a government security agency, which does not help hapless network operators. They, and the rest of us, should look at motives. The attack on Huawei is motivated by a desire to impede China’s technological progress, which is already eclipsing that of America, and America is using her leadership of the 5-eyes intelligence group of nations to impose her geostrategic will on her allies. The row in Britain this week escalated from a cabinet-level security breech on this subject, to American threats of withholding intelligence from the UK if UK companies are permitted to order Huawei 5G equipment, to the sacking of the Minister of Defence.

A threat to withhold intelligence sharing, if carried out, only serves to isolate the Americans. But you can see how desperate the Americans are to eliminate Huawei. Furthermore, the Huawei controversy is part of a wider conflict, with America determined to stop the Chinese changing the world’s power structure, moving it from under America’s control. When China was just a cheap manufacturing centre for low-tech goods, that was one thing. But when China started developing advanced technologies and began to dominate global trade, that was another. China must be put back in its box.

So far, all attempts to do so appear to have failed. Control of Afghanistan, seen as an important source of minerals ready to be exploited by China, has been a costly failure for the West. Attempts to wrest control of Syria from Russia’s sphere of influence also failed. Russia is China’s economic and military ally. America failed to bring Russia to her knees, so now the focus is directly on destroying, or at least containing China. China has already outspent America in Africa, Central and South America, buying influence away from America in her traditional spheres of influence. Attempts to neutralise North Korea are coming unstuck.

In truth, there is an undeclared war between China and Russia on one side, and America and her often reluctant allies on the other. It will now escalate, mainly because America increasingly needs global portfolio flows to cover her deficits.

America’s financial war strategy

Behind the cyber war, there is a financial war. In the financial war, America has the advantage of its currency hegemony, which it exercises to the full. It has allowed Americans to have lived beyond their means by importing more goods than they export, and the government spends more than it receives in taxes. In order to achieve these benefits, inward capital flows are necessary to finance them. To date, these have totalled in current value-terms some $25 trillion, being total foreign ownership of dollar assets and deposits.

America’s policy of living beyond its means now requires more than just recycled trade flows: inward portfolio flows are required as well. Global portfolios, comprised of commercial cash balances as well as investment money, periodically increase their exposure to other regions, potentially leaving America short. The problem is resolved by destabilising the region that has most recently benefited from capital investment, to encourage money to return to dollars and thus America’s domestic markets. Now that she is due to escalate infrastructure spending both in China and along the new silk roads, it is China’s turn.

This will be the opinion of Qiao Liang, who was a Major-General in the PLA and one of its chief strategists.[i] It was his explanation for the South-East Asian crisis of 1997, when a run started on the Thai baht and spread to all neighbouring countries. In the decade prior to the crisis, the region saw substantial inward capital flows, so much so that countries such as Malaysia, the Philippines and Indonesia ran significant deficits on their balance of payments. This conflicted with the US’s trade balance, which was beginning to deteriorate. The solution was the collapse of the South-east Asia investment story, which stimulated the re-allocation of investment resources in favour of the dollar and America.

Qiao Liang cites a number of other examples from the Latin-American crisis in the early-1980s to Ukraine, whose yellow revolution reversed investment flows into Central Europe. This did not go to plan, with over a trillion dollars-worth of investment coming out of Europe, most being redirected to the Chinese economy, which was the most attractive destination at that time. Through the new Shanghai-Shenzhen-Hong Kong Stock Connect, in April 2014 China facilitated inward investment and the ability for foreign investors to realise profits without going through exchange controls.

Being the gateway for foreign investors, our story now moves to Hong Kong. According to Chinese and Russian intelligence sources, America tried to destabilise it with covert support for the Occupy Hong Kong movement between September and December 2014. The Fed ended its QE that October, and international capital was needed back in the US. The Americans had also escalated the row over the Spratly Islands and Scarborough Shoal at the beginning of that year, which effectively halted free trade negotiations between China, Japan, South Korea, Macau, Taiwan and Hong Kong. The Chinese hoped this potential free trade area could be expanded to include the ASEAN FTA, which would then have been the largest in the world by GDP and an area in which they could develop the renminbi as the reserve currency.

These plans were effectively scuppered, but China was not provoked into a public response by these actions. Instead, they started reducing their US Treasury holdings in their dollar reserves from $1.27 trillion to $1.06 trillion in 2016 – not a great fall, but demonstrating they were not recycling their trade surpluses into dollars.

All that happened at a time when both the American and global economies were expanding – admittedly at muted rates. Trump’s trade protectionism has changed that, and early indications are that the US economy is now stalling. Tax revenues are falling short, while government expenditures are rising. America now urgently needs more inward capital flows to finance the growing budget deficit.

If Qiao Liang were to comment, doubtless his conclusion would be that America will increase its attack on China to precipitate disinvestment and reallocation to the dollar. And so, the attacks have begun; first by trying to break Huawei. Now, the mainstream media, perhaps with off-the-record briefings, are claiming China and Hong Kong are facing difficulties.

Last week, the Wall Street Journal published an article claiming China’s banks are running out of dollars. Clearly, this is untrue. China’s banks can acquire dollars any time they want, either by selling other foreign currencies in the market, or by selling renminbi to the People’s bank. They have their dollar position because they choose to have it, and furthermore all commercial banks use derivatives, which are effectively off-balance sheet exposure. Furthermore, with the US running a substantial trade deficit with China, dollars are flooding in all the time.

Following the WSJ article, various other commentators have come up with similar stories. How convenient, it seems, for the US Government to see these bearish stories about China, just when they need to ramp up inward portfolio flows to finance the budget deficit.

There is, anyway, a general antipathy among American investors to the China story, so we should not be surprised to see the China bears restating their case. One leading China bear, at least by reputation for his investment shrewdness, is Kyle Bass of Hayman Capital Management. According to Zero Hedge, he has written his first investment letter in three years, saying of Hong Kong, “Today, newly emergent economic and political risks threaten Hong Kong’s decades of stability. These risks are so large they merit immediate attention on both fronts.”[ii]

If only it were so simple. It is time to put the alternative case. Hong Kong is important, because China uses Hong Kong and London to avoid being dependent on the US banking system for international finances. And that’s why the US’s deep state want to nail Hong Kong.

Lop-sided analysis

Bass is correct in pointing out the Hong Kong property market appears highly geared, and that property prices for office, residential and retail sectors have rocketed since the 2003 trough. To a large extent it has been the inevitable consequence of the currency board link to the US dollar, which broadly transfers the Fed’s inflationary monetary policy to Hong Kong’s more dynamic economy. Bass’s description of the relationship between the banks, the way they finance themselves and property collateral is reminiscent of the factors that led to the secondary banking crisis in the UK in late-1973. Empirical evidence appears to be firmly on Bass’s side.

Except, that is, for a significant difference between events such as the UK’s secondary banking crisis, and virtually every other property crisis. Hong Kong is a truly international centre, and the banks’ role in property transactions is as currency facilitator rather than lender. In 2017, Hong Kong was the third largest recipient of foreign direct investment (substantially property) after the US and China. FDI inflows rose by £104bn to total nearly $2 trillion. Largest investors were China, followed by corporate money channelled through offshore centres.[iii]

So, yes, Hong Kong banks will be hurt by a property crisis, but not as much as Bass implies. It is foreign and Chinese banks that have much of the property as collateral. It is not the Hong Kong banks that have fuelled the property boom with domestic credit, but foreign money.

Bass fails to mention that a collapse in property prices and the banking system is unlikely to be confined to Hong Kong. Central banks have made significant progress in ensuring all banking systems are tied into the same credit cycle. Unwittingly, they have simply guarenteed that the next credit crisis will hit everyone at the same time. It won’t be just Hong Kong, but the EU, Japan, Britain and America. Everyone will be in difficulty to a greater or lesser extent.

Interestingly, the Lehman crisis, which occurred after Hong Kong property prices had already doubled from 2003, caused strong inflows to develop, driving the Hong Kong dollar to the top of its peg. The situation appears to be similar today, with US outward investment at low levels, but near-record levels of foreign ownership of dollar assets. Despite Hong Kong’s foreign direct investment standing at $2 trillion, the prospect of capital repatriation to Hong Kong should not be ignored.

Probably the most important claim in Bass’s letter is over the future of the currency peg operated by the Hong Kong Monetary Authority (HKMA). He claims that the “aggregate balance”, which is a line-item in the HKMA’s balance sheet, is the equivalent of the US Fed’s excess reserves, and that “Once depleted, the pressure on the currency board will become untenable and the peg will break.”

The aggregate balance on the HKMA’s balance sheet has declined significantly over the last year, from HK$180bn to HK$54.4bn currently. The decision about changes in aggregate balances comes from the banks themselves, and for this reason they are commonly taken to reflect capital flows into and out of the Hong Kong dollar. This is different from aggregate balances reflecting actual pressures on the peg, as suggested by Bass.

The HKMA maintains a US dollar coverage of 105%-112.5% of base money (currently about 110%) and has further unallocated dollar reserves if necessary. The peg is maintained by the HKMA varying its base money, not just by managing a base lending rate giving a spread over the Fed’s fund rate, not just by influencing the commercial banks’ aggregate balances, but by addressing the three other components that make up the monetary base. These are Certificates of Indebtedness, Government notes and coins in circulation and Exchange Fund Bills and Notes (EFBNs). In practice, it is the EFBNs in conjunction with the aggregate balances that are used to adjust the monetary base and keep the currency secured in the Convertibility Zone of 7.75 and 7.85 to the US dollar.

In maintaining the peg, the HKMA prioritises maintaining it over managing the money supply. There is little doubt this goes against the grain of mainstream Western economists who believe inflation good, deflation bad. Over the last year base money in Hong Kong contracted from HK$1,695bn to HK1,635bn. Does this worry the HKMA? Not at all.

How the Chinese will act in the circumstances of a new global credit crisis is yet to be seen, but we should bear in mind that they are probably less Keynesian in their approach to economics and finance than Westerners. Admittedly, they have freely used credit expansion to finance economic development, but theirs is a mercantilist approach, which differs significantly from ours. We simply impoverish our factors of production through wealth transfer by monetary inflation. We think this can be offset by fuelling financial speculation and asset inflation. China enhances her production and innovation by generating personal savings. Wealth is created by and linked more directly to production.

The objectives and effects of monetary and credit inflation between China’s application of it and the way we do things in the West are dissimilar, and it is a common mistake to ignore these differences. The threat to China’s ability to manage its affairs in a credit crisis is significantly less than the threat to Western welfare-dependent nations whose governments are highly indebted, while China’s is not.

China is sure to see the financial and monetary stability of Hong Kong as being vital to the Mainland’s interests. Apart from the Bank of China’s Hong Kong subsidiary being the second largest issuer of bank notes, the Peoples’ Bank itself maintains reserve balances in Hong Kong dollars, which in the circumstances Kyle Bass believes likely, they can increase to support the HKMA’s management of the currency peg.

- Source, James Turk's Goldmoney

In praise of Hayek’s masterwork

Destroy personal freedom, and ultimately the state destroys itself. No state succeeds in the long run by taking away freedom from individuals, other than those strictly necessary for guaranteeing individualism. And unless the state recognises this established fact its destruction will be both certain and brutal. Alternatively, a state that steps back from the edge of collectivism and reinstates individual freedoms will survive. This is the theoretical advantage offered by democracy, when the people can peacefully rebel against the state, compared with dictatorships when they cannot.

Nevertheless, democracies are rarely free from the drift into collectivism. They socialise our efforts by taxing profits excessively and limiting free market competition, which is the driving force behind the creation and accumulation of personal wealth and the advancement of the human condition. At least democracies periodically offer the electorate an opportunity to throw out a government sliding into socialism. A Reagan or Thatcher can then materialise to save the nation by reversing or at least stemming the tide of collectivism.

Dictatorships are different, often ending in revolution, the condition in which chaos thrives. If the governed are lucky, out of chaos emerges freedom; much more likely they face more intense suppression and even civil war. We remember dictatorships through a figurehead, a Hitler or Mussolini. But these are just the leaders in a party of like-minded statists.

When comparing dictatorships to democracy we think in terms of black and white, which allow one to express concepts clearly. But reality always comes in shades of grey. Far from being always bad, dictatorships can be successful if they permit individuals to retain the freedom to improve their lives and accumulate the benefits of their success. This is the freedom to compete, make and keep profits. A dictatorship on these lines is mercantile, offsetting the absence of political freedom by allowing personal freedom to develop within the confines of state direction. This is the current situation in China and Russia.

Modern democracy is usually flawed, a cover for the state to rob Peter to pay Paul to the point where Peter is impoverished or refuses to play the game and both the state and Paul are then bereft of funds and purpose. This is the condition to which Western democracy has evolved in modern welfare states. We can all sympathise with the underlying concept: there are those in life who through circumstances fall on hard times, and if they are given a helping hand, will eventually benefit society as a whole. But it becomes counterproductive when it discourages the individual from returning to productive society. Not only is the individual’s contribution to society lost, but he becomes a burden upon it.

For its revenue the state relies on the production of many Peters. The consequence is even more Pauls. The cost of welfare increases with its scope. It becomes welfare for all, with everyone having a right to it. Each Peter ends up funding ninety-nine Pauls. This is Mediterranean Europe today, and perhaps to a lesser extent Britain and America.

With compulsion, the state no longer protects the rights of the individual. Democracy has permitted the modern state to evolve into a separate entity no longer the servant of the population.

The cross-over between democracy and dictatorships
In economic terms, a high-spending statist democracy is indistinguishable from a dictatorship. Instead of promoting free markets, both create the conditions where commercial success is achieved by influencing the government. The difference is in the form this corruption takes. In the case of a high-spending democratic government, obtaining control over the regulatory process is vital for a business to secure market advantage and keeping competitors at bay. In a dictatorship corruption is usually more direct.

So long as free markets are not completely prohibited by the state, this crony capitalism thrives. From banks to pharmaceuticals, it is the way business is done today. It angers ordinary people, who are then persuaded by support-seeking politicians that big business is motivated by profit without social consideration, and that the socialising policies of the government are the solution. As the Austrian economist Friedrich von Hayek put it, the people are now embarking on the road to serfdom.

The Road to Serfdom was about the cross-over between democracy and dictatorships. Hayek wrote his famous book in 1942-44 (it was first published in 1944), drawing on the example of Germany’s contemporary experience. He showed how the organisation of a war-time economy by the state, in Germany’s case the First World War, becomes a template for central planning in peacetime. While Hayek showed that a government’s central planning of a war-time economy forms the template for peacetime central planning, peacetime planning also develops on its own.

The planners always promise a utopian view of the future. People are easily persuaded that planning for the benefit of everyone is an advancement on the sole motivation of profit. However, disagreements arise on what plan is best, reflected in the split between different political parties. The planners from different factions all have plans but no unity of purpose. The people disagree as well. What is needed is government propaganda to dispel disagreement and unite the people behind the government’s preferred plan.

The propaganda machine goes into action. Information is selectively fed into it to obtain public support for government policies. Statistics are manipulated to promote success and obscure failure. Any reporter who does not cooperate with the government line is excluded from the planners’ briefings, giving his rival journalists an advantage. He conforms. The use of the press to support state planning becomes increasingly important in covering up its failures.

The failures of central planning proliferate. The propaganda machine cannot cover up all the evidence, and the planners respond with even more planning, yet more suppression of personal freedom. There is no turning back. They argue it is not their fault, but the fault of the people failing to cooperate and comply with government policies. They argue that the people are uneducated and not responsible enough to have a say in central planning. What’s needed is someone strong enough to force the plans through. At the same time, ordinary people want a strong man to kick out the useless bureaucrats and make the plans work.

A new leader emerges. The democratic establishment see his function as temporary. When order in the planning process is restored, he will no longer be needed. But this is the cross-over point between democracy and a dictatorship. He is a Chavez, a Putin, a Lenin, a Mussolini, a Hitler. It was the latter fascists that were perhaps freshest in Hayek’s mind, but he was also fully aware of Lenin and Stalin.

Not all strongmen emerging from the chaos of planning failures turn out to be a Lenin or a Hitler. Those who follow a mercantilist path, contemporary examples being Russia’s Putin and China’s Xi, are careful to allow individuals the freedom to run their affairs without the heavy hand of the state. But they are also careful not to let democracy undermine their control: the people cannot have both and opponents to the state are ruthlessly dealt with.

Anyone intending to be Hayek’s strong leader promises to make order out of bureaucratic chaos. Those on the far left (in the UK, Corbin and McDonnell, in the US Bernie Sanders) believe the political solution to growing economic chaos is to take collectivism to a higher plain. Free-marketeers are derided by the planners as being antisocial, profit-seeking right-wing extremists. If Corbin and Sanders are to succeed in their desire for office, they must wish for an economic or political failure that damns capitalism and will see them swept into office.

Then what happens?

We will continue with Hayek’s narrative. The new leader uses the chaos that led to his election as the pretext to consolidate his power. Opposition is not permitted, because it restricts the leader’s ability to resolve matters. With dissenters excluded, democracy becomes little more than a propaganda exercise. The leader only permits people to vote for him and his party. To encourage national unity in the face of deteriorating economic conditions, a minority in society is made a scapegoat. With Hitler it was the relatively prosperous Jews. Corbin’s apparent dislike of Britain’s Jewish community is striking a raw nerve,

In truth, we cannot forecast what class or creed will be tomorrow’s scapegoat. It will depend on the nation, the strongman and his immediate supporters, their religious beliefs perhaps, and how rapidly planning undermines the economy. Wealthy communities with wealth for the state to acquire will be at risk. But one thing is for sure, increasing numbers of secret police will be deployed to supress all opposition. Dissent is dealt with ruthlessly.

Hayek went on to detail what we have subsequently seen, in Africa with Mugabe, in Venezuela with Chavez and then Maduro. These are the most egregious of many contemporary examples, mainly confined to developing nations. Now the mature economies in Europe, of America and Britain are drifting that way.

The current regimes in Russia and China are different, having become post-Hayekian political economies. They are mercantilist in nature. Individualism is allowed to flourish, with collectivism limited. But for these regimes to survive a wider global Hayekian transition from democracy to a lasting mercantile dictatorship, they will need to give up money-printing and return to sound money. This is our next topic.

- Source, Goldmoney

Count Your Wealth in Ounces, Not Dollars