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Gold Leasing: The Case Of The Disappearing Gold

From Jeff Thomas Of International Man

The Disappearing Gold

During the Cold War, Germany moved much of its gold to New York in case the USSR invaded Germany. It was assumed at that time that the US would be a safer storage location, and of course, they could always ask to have it returned if they wished.

But German citizens have become increasingly worried about the security of the 1,536 tonnes of German gold reputedly held at the Federal Reserve in New York. This has resulted in the Bundesbank pursuing repatriation of the gold, beginning with a request to view it in the basement of the Federal Reserve Building, where it is claimed to reside.

Of course, the German government had received periodic assurances from the Fed that the gold is there; however, the issue began to get a bit sticky recently, when the Fed refused a request for inspection.

The world then raised a collective eyebrow, and, whilst not panicking over this development just yet, closer attention has come to bear, not only on the Fed, but on any institution that is entrusted with the storage of gold for other parties.

Concern spread to Austria, where a question arose in Parliament as to where Austria’s gold is stored. The answer provided was that 80% of it (224.4 tonnes) is in the UK. (It was claimed that the reason for this is that, if a crisis of some kind were to occur, it could be more easily traded from London than from Vienna.)

Seems reasonable enough, except that the return of the gold to Austria, if it were requested, may be a bit difficult, as the gold seems to have been leased out by the UK.

To many, a second eyebrow might go up at this point. Lease out the wealth of another nation? Isn’t this a bit… irresponsible?

The New Gold Shuffle

Not to worry, it’s done all the time. In fact, the practice has been endorsed by none other than Alan Greenspan, former Chairman of the Fed. The gold is leased to a bullion bank, which typically pays one percent interest to the Fed, with a promise to return it on a specified date. The bullion bank then sells the gold on the open market and uses the proceeds to buy Treasury bonds, which will net a three to four percent return.

The nicest thing about such an arrangement is that the lessor continues to claim it on his balance sheet as a line item: “gold and gold receivables.” After all, an asset that we have leased out is still an asset, even if it has now been sold by the lessee.

In effect, this means that, if you bought a gold bar today, it is possible that it is a bar that was shipped from the Bundesbank to the Federal Reserve decades ago and is presently listed by the Fed on its balance sheet as “gold and gold receivables.”

Both you and the Fed are claiming to possess the same gold bar. The fly in the ointment, of course, is that only one bar can be the actual bar. The other is a receivable and therefore is an asset on paper only. This, of course, means that there is less gold in the world than has been claimed. How much less? That’s anyone’s guess.

The New Risks

But even if it became generally known that the Fed (and others) are holding paper, rather than physical gold, couldn’t we carry on as before? What could go wrong? Here are some immediate possibilities:

  • If there were a dramatic rise in the price of gold and the lessor were to call in the return of the gold by the bullion bank, the bullion bank could easily lose far more than the small two to three percent margin it had been enjoying.
  • If there were a crash in the bond market and hyperinflation set in, the bonds that the bullion bank had purchased could become worthless.
  • If the nations who shipped their gold to London and New York for safekeeping were to request their return, the storage banks could only deliver if they were to purchase gold at the current rate. If that rate were significantly above the rate at which the gold had been leased to the bullion banks, the storage banks would sustain a significant, possibly unsustainable, loss.

That’s quite a bit of risk.

In the present market, there are any number of possible triggers that could cause the people of Germany, Austria, or a host of other nations to demand that their gold be returned home. Indeed, pressure is on the increase. The governments who have shipped out their gold for “safekeeping” would have a lot of explaining to do to their constituents, if the storage banks are not forthcoming.

So, is it time for the odiferous effluvium to hit the fan? Not quite yet. Before that occurs, there will still be some dancing around by the Fed and others.

The Fed has already stated, in so many words, “We’re sorry, but we can’t let you have all your gold at one time, but we’d be prepared to send it to you over a period of years.”

For many observers, the present situation should be well beyond the point of the raised eyebrow. It should be glaringly apparent that the amount of gold presently claimed to be in storage in the world’s banks is, to a greater or lesser extent, overstated.

Continuing the Charade

The Bundesbank should, of course, now say, “I’m afraid that’s not good enough. It’s our gold. We’ve advised you how much of it we want back now, and we must insist that you produce it immediately.”

If they were to take this perfectly logical step and the Fed refused, there could be a run on the banks, and, very possibly, within as short a period as twenty-four hours, a worldwide bank holiday might be declared with regard to gold.

However, this is not what will transpire. Neither logic nor sound banking practices are the object here. The object is to maintain the charade that exists within the banking community. The Bundesbank is just as fearful of a run as the Fed and will be only too willing to accept the Fed’s terms.

What must be borne in mind is the root cause of the request. It was not the Bundesbank itself that originally wanted the transfer to take place; it was the German people who, quite rightly, have become distrustful of the fact that their gold has been in New York for so long and want to see it repatriated. It is not the banks who wish to correct the situation. Not one bank wishes to expose the inappropriate practices of any other bank. Their loyalty is to each other and not to their depositors.

So, is that it? Have we heard the last of this issue? I think not. The cat is out of the bag at this point, and the depositors’ distrust and uncertainty will not be quelled by the counter-offer. Tension will continue to mount amongst depositors, and, at some point, the situation will reach an impasse.

All those who presently have gold in a banking institution would be prudent to keep an eye on the present situation. We might consider taking delivery of any gold we have in a bank, wherever it may be. Regardless of what form it is in, from ETFs to allocated gold, we would do well to assess the degree to which we feel our gold is at risk. In doing so, we may determine that a gold account is more at risk in, say, a New York or London bank than a Swiss bank. (Not all banks will be equal in terms of risk.)

If we do resolve to divest ourselves of bank-related precious metal holdings, it would be prudent to take action soon. (Clearly, those who attempt to remove their wealth the day after a run has occurred tend to do less well than those who attempt to remove their wealth the day before the run.)

We might also consider whether a possible run may become systemic, causing a bank holiday on all the bank’s activities, thus freezing any currency that we may have on deposit. We may conclude that it is prudent to only retain in our bank enough money to allow cheques to clear – an amount sufficient to cover a few months’ expenses.

In the near future, we may well find that a significant amount of gold that is claimed to exist in the world will “disappear.” Whilst we cannot control this eventuality, we may be able to save the gold that is being held in our names from disappearing.

"The Winners Of The New World", Circa February 2000

Because humor is always the best and only cure to pervasive central planning that has made a mockery of traditional investing and capital allocation, and because nobody delivers unlimited sheer, unadulterated humor quite as well as one James J. Cramer when he is “recommending” stocks, here is the full text of Jim Cramer’s “The Winners of the New World” speech delivered in February 2000. Because it really never is different this time.

James J. Cramer is the keynote speaker at the 6th Annual Internet and Electronic Commerce Conference and Exposition, held at the Jacob Javits Center in New York City. From

February 29, 2000

The Winners of the New World

You want winners? You want me to put my Cramer Berkowitz hedge fund hat on and just discuss what my fund is buying today to try to make money tomorrow and the next day and the next? You want my top 10 stocks for who is going to make it in the New World? You know what? I am going to give them to you. Right here. Right now.

OK. Here goes. Write them down — no handouts here!: 724 Solutions, Ariba, Digital Island, Exodus,, Inktomi, Mercury Interactive, Sonera, VeriSign and Veritas Software.

 We are buying some of every one of these this morning as I give this speech. We buy them every day, particularly if they are down, which, no surprise given what they do, is very rare. And we will keep doing so until this period is over — and it is very far from ending. Heck, people are just learning these stories on Wall Street, and the more they come to learn, the more they love and own! Most of these companies don’t even have earnings per share, so we won’t have to be constrained by that methodology for quarters to come.

There, now that that’s done with, can we talk about the methodology that produced those top 10 so that you can understand how, in a universe of a gazillion stocks, we arrived at those, so you too can figure it out? I hope we can because I have another 10 and still another 10 and another. They all do the same thing: They make the Web faster, cheaper, better and easier to access anywhere, anytime. They allow you to get on the Web securely anywhere in the world. They make the Web economy the only economy that matters. That’s all they do.

We try to own every one of them. Every single one. And if I had my druthers, I wouldn’t own any other stocks in the year 2000. Because these are the only ones worth owning right now in this extremely difficult, extremely narrow stock market. They are the only ones that are going higher consistently in good days and bad. I love every one of them, just as I loathe the rest of the stock universe.

How did this stock market get like this, to where the only people who can make a dime in it are the people who are interested in the most arcane subject, the moving of data from one space to another, via strange new machines and software? How did it get to the point where nothing else matters, most particularly the 90% of the stock market I have studied for the last 20 years? How did all of that knowledge become totally irrelevant and the only stocks that work are the stocks of companies that didn’t exist five years ago and came public in the last two or three years?

Let’s start with the world in the early 21st century, a world where capital is abundant for a chosen few and nonexistent for just about everybody else. It is a world where the whole of Wall Street and Silicon Valley is at your fingertips if you are creating the infrastructure for the New Economy, and a world where neither Wall Street nor Silicon Valley could give a darn about you if you are using that infrastructure.

Or in other words, we don’t care if General Motors (GM_) and Ford (F_) are going with Oracle (ORCL_) or with i2 (ITWO_) for their new parts procurement process. We don’t want to own GM or Ford on any occasion. In fact, we would rather own the loser in that tech bake-off than the winner in nontech, because in this new world, there is so much business to be done for the i2s and the Oracles that the capital will remain plentiful for them, win or lose a particular piece of business.

Just yesterday I found myself wishing I had bought i2 when it lost out to Oracle for the giant business-to-business contract for the Big Three automakers. Others had the same idea because i2, the loser Friday, was up much more Monday than GM and Ford could be this year. i2 can own the world because the company with the access to cheap capital always wins. And the companies with no access have to lose.

Or, closer to home. We in the stock market don’t care that The Inc., a company I helped create, has built a compelling new brand, has more than 100,000 paid subscribers and has $100 million in the bank. We just want to know which companies employs to publish each day. We want to know who the host is, which publishing tool works best, which wireless strategy is adopting and how does it automate its email? (By the way, the answers are Exodus, Vignette, Motorola and Kana  — all at or near their 52-week highs as languishes at its 52-week low, a triumph of the arms merchants over the combatants if there ever were one.)

How did this bizarro world where nine-tenths of the companies I have followed as a stock picker for the last 20 years are losers and one-tenth are winners? To answer that question, you have to throw out all of the matrices and formulas and texts that existed before the Web. You have to throw them away because they can’t make money for you anymore, and that is all that matters. We don’t use price-to-earnings multiples anymore at Cramer Berkowitz. If we talk about price-to-book, we have already gone astray. If we use any of what Graham and Dodd teach us, we wouldn’t have a dime under management.

So how do we sort through which stocks get bought and which stocks get assigned to the waste bin?

We have a phrase on Wall Street. It’s called raising the bar. If you can raise the bar, or brighten the outlook for your company, if you can see your growth accelerating, your stock will go higher and you will be given the currency to expand, acquire and do whatever you want. That’s the secret of the quintessential New Economy stock: Cisco (CSCO_). This giant networker has the ability to control its own destiny. It can, as my colleague Adam Lashinsky says at TSC, buy any company it wants to. It can pay any price. Because it has a currency that it better than U.S. dollars: It has Cisco stock. It can do that because it raises the bar every quarter!

But what about the Old Economy stocks? Can Merck raise the bar? Can Pfizer? Can U.S. Steel? Or Phelps Dodge? Union Pacific? No, no, no, no, no and no. So what happens to them? Despite the billions in buybacks and the plethora of strong buys that the Street has put out about these companies, their stocks have no traction. They just stumble along, rising and falling haphazardly with every whim and quizzical speech of the Federal Reserve chairman that still controls their destiny. If Greenspan indicates that there is more tightening ahead, these traditional companies, the ones that you measure with traditional matrices, get pole-axed as we worry about where the capital will ultimately come from if credit gets choked off, while the arms merchants in the Web war, with capital to burn, just go higher.

It is no secret that the Dow, made up principally of companies that can’t raise the bar, is down 12% while the Nasdaq, which is made up of companies that can raise the bar, is up 12%. And in the self-fulfilling jungle that is Wall Street, only growth can maintain growth!

So how do we find what are the great growth companies, knowing that growth and not cheapness of stock to company is what matters? We have to look for the fastest-growing industries and then select the companies that can make the infrastructure happen the fastest and the cheapest in those industries. The growth must be positively organic, if not viral. There must be heavy technological barriers to entry. And there must be an ability to scale without any thought to human cost. These companies must be able to dominate their businesses or be willing to become part of a larger institution that dominates.

So, whom does that eliminate? First, any company that is a commodity producer simply can’t be owned, no matter what. The New Economy makes those be simply a function of low-cost producer with no ability ever to raise price. This, of course, is the crying shame of the way the Fed is trying to break the economy because the only place that could stand for a little inflation is in the deflationary commodity industries. But their inflation revolves around the ability to build inventory to anticipate future price hikes and the Fed is taking short rates to a height that makes it uneconomic to stockpile.

Second, it eliminates any bricks-and-mortar company that doesn’t embrace the Net. To not embrace the Net is to give a cost edge to a competitor who does. It does so because the Net removes the middleman that was a product of the regional economy. There is $4 trillion worth of wholesaling that gets instantly eliminated by the Net. Before only the largest orders could be processed by the biggest companies because it was too expensive otherwise. Now all orders can be processed by the biggest companies through the Web. There is no need for the jobber or the wholesaler. Obviously, if you are still using that old distribution network, you can’t compete against those who do.

Third, it eliminates any industry that does not have a proprietary brand. This is one of those weird features of the Web that people haven’t woken up to yet, but it will seem obvious a few months from now. In the New World’s economy, the desire to “name your own price” is too great to squelch. An outfit like priceline will change the very nature of brands in this country. It won’t destroy the premium brand, but it will force everyone else out of the market. Why? Because the way priceline works is that we are trying to buy the premium brand for the price of the off-price brand. That means the off-price brands, whether they be Colgate or Dial or Hunt’s or Ralston, are simply doomed by the Web. Why would you ever buy the second- or third-best when you can get the best via priceline for the same price as the lower tier? Ahh, that’s a real killer. It leaves only the top brands to vie for supermarket space. The others won’t be worth carrying. They won’t move! Oh yeah, same goes for the airlines and the hotels and just about everybody else.

Fourth, it just destroys retail as we know it. Why? Because the companies that embrace the Web more vigorously will eventually be pitted against other companies that embrace the Web more vigorously, creating a virtual constant price war, the kind of war that Marx, of all, actually predicted would happen to capitalism. It will happen to retail once everyone realizes that Amazon recreated Wal-Mart online because it will forever have access to cheap capital. Why do I say forever? Because at a certain point, it will be done with its buildout and will effectively be able to cherry-pick whomever it wants to destroy while having it be subsidized by other areas. It will be Home Depot vs. Wal-Mart vs. Amazon in the end. Nobody else. And that’s only if Home Depot figures out it better get on the Web and fast.

Fifth, it wipes out everybody who straddles the Old and New Worlds. Let’s take the brokerage industry. If you are trying to preserve a price point, because you need those margins, you can’t and you become roadkill. Same with journalism. If you are free online and cost offline, you will eventually not be able to charge offline. Why not? Because the Hewlett-Packards and Intels and Ciscos are bent on making the online version far superior to the offline version. And they will do it. They, too, have the access to capital to make it happen.

I can tell you from that we have substantial cost advantages over our printed cousins. We can come out around the clock. We don’t require paper, ink, delivery people or trucks. In that sense, we are much more like television, personal television, which is why we were wrong initially to think we could charge for basic news, and right to think we can charge a huge amount for proprietary analysis that can make you money.

The struggle between the offliners and the onliners in banking will also pan out just like these other industries, with huge wins for those with a fresh online culture and hideous losses for those who don’t see it coming or are slow to adjust. If you have to preserve your giant branch network and the costs that come with it while someone else perfects secure wireless Internet transactions, you can forget about it. You can’t afford to compete. How can Bank of America compete with Nokia as a way to bank? How can Goldman Sachs compete with Yahoo! as a way to invest? Isn’t Nokia, with its wireless machine that goes everywhere a better bank than one that needs branches? Isn’t Yahoo!, with its access to all of the information and quotes in the financial world a better place to buy stocks than Goldman?

Of course they are.

So, if you can’t own the retailers, and you can’t own transports, and you can’t own banks and brokers and financials and you can’t own commodity makers and you can’t own the newspapers, and you can’t own the machinery stocks, what can you own?

A-ha, that just leaves us with tech. That’s why we keep coming back to it. That’s why, despite the 80% increase in the Nasdaq last year, we are looking at another record year now. It is by that process of elimination that I have picked my top 10. And my next 10 and my next 10 after. Only those companies are worth owning. The rest?

You can have them.

Thank you.

China's Broken Shock Absorber

Authored by Daniel Cloud,

(A review of Mark DeWeaver’s Animal Spirits with Chinese Characteristics)

Analysts who’ve only started paying attention to the country in the last decade often seem convinced that China has no real business cycle, or a very mild one, that because its economy is centrally planned, it’s free from the fluctuations in investment that cause booms and recessions in countries that lack the scientific guidance of a Leninist single-party state. This convenient belief, however, is mostly an artifact of the period over which they’ve been observing its economy.

In what’s generally, since at least the 1950’s, been a short, very high-amplitude cycle with a roughly seven year period, the period between 1992 or 1993 and 2007 or 2008 is unique. It has a “soft landing” (or as DeWeaver calls it, a “long landing”) in its middle that was unlike any other slowdown China has experienced in its post-World-War II economic history.  The boom of the early 1990’s wasn’t followed by the usual bust. Instead, after a fairly mild slowdown, another boom period began towards the end of the decade, without the usual deep cyclical trough between expansions.

DeWeaver’s explanation of this anomaly suggests that it is unlikely to be repeated. We’re probably living, now, with a China that’s back to the sort of violent swings in economic activity, and repeated struggles with inflation, that have been characteristic of most of its recent history. To understand why, it’s necessary to understand his explanation of the nature of the cycle itself.

In the economy of a country whose political system is some form of liberalism, changes in the level of productive activity are a consequence of changes in the level of investment by private companies, which presumably reflect changing perceptions of risk, and of potential rewards. In the Chinese economy, however, which, as DeWeaver convincingly demonstrates, is still very much dominated by enterprises in which some part of the government has a controlling stake, soft budget constraints and the primarily political motivations of most participants mean that calculations about risk often play little role in economic decision-making. In the pure “prestige projects” he describes in such Kafkaesque detail, even the idea of a reward is conspicuously absent.

This state of affairs, DeWeaver tells us, is exacerbated by the Chinese style of economic planning, which emphasizes the achievement of quantitative targets for things like provincial GDP. In effect, the system is a series of tournaments, in which officials are repeatedly, throughout their careers, pitted against each other in a competition to see who can outperform the plan the most in each planning period. Along with this formal system of planning is an informal system of government by “the central legitimation of local elites”, in which decisions about how to meet the quantitative targets are left to provincial and lower-level authorities, though the supposedly uniform and transparent targets themselves come down from the top.

What must also always come down from the top, DeWeaver tells us, is any impulse at all to rein in or slow the pace of expansion. Since officials at all levels are competing with each other to outperform any target they’ve been given, their incentives are entirely in favor of investing as much as possible whether it makes any sense to do so or not. Not only is this their best path to promotion – something everyone, after so many rounds of this game, certainly knows, by now – but more building means more opportunities to line your own pockets, by using companies you or your relatives own as contractors.

The problem with the sort of frenzied construction of uneconomic steel mills and international airports and amusement parks and solar farms and palatial government buildings and so on that this impulse results in is that there really isn’t much about the process that would make it likely that the mix of goods and services the Chinese economy actually needed, to embark on the next stage of modernization, was the one that happened to be produced by it. What is far more likely to be produced is some other mix of goods, perhaps of acceptable quality, if quality was one of the explicit plan targets, but not really the right mix, because its composition is largely the result of short-term gaming of the planning system by the officials responsible for interpreting and implementing the plan, rather than any sort of general market equilibrium.

Consequently, booms, in China’s post-war economic history, have tended to end in shortages of key commodities, or bouts of severe inflation, as the inappropriate mix of goods produced resulted in excess demand for the under-produced ones. The central planners have had no choice, at this point, but to tighten policy in various drastic and clumsy ways, so these booms almost always ended in busts. (Though not in the middle and late 1990’s.) Since the incentives for investment DeWeaver describes are insensitive to risk, however, many projects get carried on despite these contractions in activity and demand, so cyclical troughs have tended to be marked by extreme gluts of particular goods, pig iron or rolled steel or windmill farms or office buildings, often the ones most emphasized by the planners in the previous period. (As China’s economic miracle unfolded in the ‘80’s and ‘90’s, the tendency towards gluts seemed to have permanently eclipsed the tendency towards shortages  – until, that is, towards the top of the last cycle in ’07 or ’08, suddenly everyone in the world began to talk about peak oil…)

Aside from really spectacular ones like the Great Leap Forward, few of these booms and busts have been heard of by many people outside of China. Certainly few in the West now remember the so-called Great Leap Outward of the late 1970’s, though that was the precursor of everything that’s happened since.  In that event, an economic expansion was prolonged slightly past the point when shortages would normally have forced its termination, by a policy of opening to the outside world, which allowed the import of scarce parts and supplies. Political sponsorship for the trade initiative came partly from the so-called “oil faction”, which had both hard currency, and a pressing need for outside help.

The problem with this strategy, then, was the country’s lack of foreign exchange, and its chronic trade deficit. But if it could follow the same path as its capitalist East Asian neighbors, and use its highly literate and very inexpensive workforce to become an export powerhouse, the imperfections in the mix of goods and services the planning process always resulted in could be redressed in world markets. Under-produced goods could be imported, prolonging booms, and during cyclical troughs, overproduced goods could be exported. Market prices would be supplied to the Chinese economy from outside, giving planners some rough idea of what a genuine equilibrium would actually look like, and the imperfections in their estimations could be dealt with through trade.

So that is what Deng Xiaoping and the rest of the people running things, after the Gang of Four were disposed of, decided to try to do. The move closer to an equilibrium mix of goods and services, and the ability to correct gluts and shortages by using world markets, greatly improved the efficiency with which scarce commodities were allocated, and laid the foundations for the economy’s boom years. (I suppose one could call this economic model “parasitic planning”, since it is central planning that relies on the existence of undistorted price information from the outside world for its viability, but it might make just as much sense to call it the “Japanese model”, given the level of planning MITI engaged in, back when its plans still mattered.) A certain amount of market liberalization, and the partial privatization of, first, agricultural, and then other kinds of land, added momentum to the long expansion.

Most Westerners seem to be under the impression that exports were the “engine of growth” for China’s economy, in this period, that it’s demand from the outside world that has fuelled the rapid growth of the last two decades. The truth is more complicated. China is a large country, with a large economy, and value added to exported goods has never been a large enough fraction of GDP to directly account for very much of its growth. The real role of the export sector seems to have been the more complex one described above – it served as a guide to relative equilibrium prices, and a source and sink for under-produced or over-produced commodities. This role is not too different from that played by the Japanese export sector, during that country’s postwar period of rapid economic growth.

In its early phases, DeWeaver tells us, there were some difficulties with the implementation of this strategy. Trying to build export industries without doing enough for domestic consumers led to renewed shortages and severe inflation in the late 1980’s, culminating in the demonstrations by workers and students in 1989, and their brutal suppression. But by the early 1990’s the plan was working. Exposure to the quality discipline of world markets, as well as the information about relative scarcities and marginal rates of substitution encoded in their prices, and the advanced technology of the capitalist world, along with some market liberalization in an economy that nevertheless remained dominated by the State, produced rapid gains in in productivity at the same time. Asset markets overheated in some parts of the decade, but goods markets never really got tight, and in the long slowdown, the almost infinite capacity of the foreign consumer to absorb Chinese goods meant that surplus production could be exported, rather than simply destroyed.

In effect, China now seemed to face infinitely elastic supply and demand curves for every tradable good, and didn’t need to be anywhere near general equilibrium, in isolation, to experience the very rapid growth its highly educated and very inexpensive labor force made possible. Under these fortuitous but inherently temporary circumstances, the remarkably long expansion that took place between the early ‘90’s and ’07 or ’08, with a “long landing” in the middle, was possible –  once.

Why only once? There are two practical problems with the strategy in the longer term.

The first is that you may well be building the wrong thing. Becoming a very specialized cog in the global manufacturing system, in this particular way, doesn’t quite seem to set you up for the transition to a knowledge society, perhaps because all you’ve had to do, to get to this point, is solve a bunch of engineering problems. You’ve got the external trappings of modernity – without a Parliament, or real laws, or a Newton, or independent universities, or genuine newspapers, or a working system for the protection of patents and other kinds of intellectual property, or any of the other vital organs of a real modern society… Because those things take a little longer to develop, and require a somewhat different political system. So there’s a transition needed, at this point, to another, rather dissimilar kind of society, and many new opportunities for failure, or very qualified success, along the way.

Unfortunately, the sort of planning process DeWeaver is describing isn’t likely to ever result in transition even to a consumer economy, let alone a knowledge society, partly because all the incentives are skewed in the other direction, towards investment, not consumption, or the nurturing of individual creativity, towards the more Stalinist or Maoist approach of trying to use the sheer quantity of investment to make up for its poor average quality. The whole mechanism is designed to extract the consumer’s surplus, and use it for the goals of the State. In fact, what a consumer-driven economy must do is just exactly what such an economy doesn’t do. It doesn’t produce the things it consumes, and it doesn’t consume the things it produces, because it produces some rather arbitrary mix of goods, an artifact of a politicized planning process that is nowhere near the market clearing basket of goods and services.

Perhaps more relevant to readers in the rest of the world, at the moment, however, is the other long-term problem with the strategy. Simply put, it’s that the price elasticity of demand and the price elasticity of supply for particular goods in the world economy aren’t ever actually infinite. Sooner or later, you will need so much oil, or copper, to continue growing at the same rate, or must export so many personal computers and televisions and phones and other useless little screens, that your own actions start to affect the prices of these commodities. You become so large, relative to the world, that it isn’t possible to analyze the world economy without taking your own actions into effect, any more – so the imbalances in your economy simply become imbalances in the economy of the world as a whole. The strategy of letting the outside world absorb your mistakes and correct your deficiencies can’t work any more, at that point, because there no longer is an actual “outside” world, there’s just the one globalized world you’re now the beating heart of.

In retrospect, there was at least one unmistakable sign, in the second half of the last decade, that we had already reached this point with China. (Besides the apparently geometric increase in the number of useless little screens per American consumer.) As the impact of the country’s expected growth trajectory on global demand and supply became clearer, the price of oil continued to move up and up and up from its low of only a decade earlier, well below twenty dollars, to a price much closer to a hundred and fifty dollars a barrel.  China’s absolute consumption of crude was still only half that of the United States, but with the Chinese economy growing so much more rapidly than any developed one, a very large fraction of the marginal addition to demand in each period was coming from it. There was no corresponding new source of supply. It was becoming obvious (to everyone but the people who make policy in developed countries, who seem to perceive only what organized interests encourage them to perceive) that things couldn’t go on like this indefinitely, that soon there wouldn’t be enough oil to go around.

In the end, it was the price mechanism that adjusted demand to supply, by triggering a financial crisis that reduced consumers’ incomes, in the developed world, to a level consistent with a more stable oil price. Now, four years later, the world economy seems to be able to grow at whatever pace would keep the price of Brent below $110 – but not any faster than that. Each successive bout of monetary stimulus has had to be abandoned once the price gets much over that point. With that price now creeping up over $113 dollars per barrel, again, the Fed is already beginning to make unnerving comments about ending its now supposedly “eternal” commitment to QE a bit early, say later this year. They may have to. If they just blindly persisted in the stimulus, as they’ve previously threatened to, they’d be likely to simply push the price of oil up to a new all-time high, which would both cause another recession, and make the nature of the underlying problem painfully obvious to the voter, so it seems quite likely they’ll flinch, again, this time, in the end, just as they did on the last two occasions.

The apparent inability of Western policymakers to even perceive the “super-spike” of oil prices in the summer of 2008, which immediately preceded and very probably precipitated the financial crisis in the United States later that year (by forcing low-income consumers to choose between buying gas and paying their mortgages) as an oil shock is somewhat bizarre, but the inappropriate nature of the policy response, which has mostly consisted of printing money, raises the suspicion that it reflects genuine confusion, and not the disingenuous refusal to engage with reality it looks like from the outside. Since the Fed never seems to have understood that an oil shock was the problem it encountered in 2008, in the first place, the thing that burst the housing bubble it had deliberately inflated, it may never have even occurred to them to worry about the growth of Chinese demand.

Oil prices have stayed rather high for most of the period since, rising every time more monetary stimulus is applied, and then falling a bit when the authorities back off. The tightness in supply that has caused these high prices seems to have come as such a surprise to the rest of the world that they still have trouble seeing it as real. But for those of us who were already familiar with China’s business cycle, and aware of the growing contribution of Chinese growth to growth in the world economy as a whole, it is more or less what we expected. At this point, it is perfectly natural for the saw-toothed pattern of the normal Chinese business cycle to begin to superimpose itself on the longer, slower cycles of the Greenspan-era, US dominated world economy, because much of the growth in the world economy is now coming from China. In this scenario, shortages of key commodities at the top of the cycle, and gluts of certain other commodities at its bottom (including, sadly, labor) are just exactly what you’d expect to see.

What is perhaps a bit more unexpected is the situation we’ve all seen in the last four years, when we’ve had both things – a glut of (rather artificially) cheap labor, and manufactured goods, and a simultaneous shortage of oil. It’s tempting to call this situation “stagflation”, but the official inflation rate, in the developed world, has remained fairly low.

Partly this is an artifact of the way inflation is measured – basically all of the “growth” that the US economy has had in the last four years is a product of the hedonic adjustment, an unsatisfactory solution to an impossible measurement problem, which shows the inherent limits of economic analysis in general. But the Yuan’s peg to the dollar means that the Fed is also, in effect, making monetary policy for China, since the Chinese authorities must mirror the Fed’s actions to avoid changing the price of a Yuan in dollar terms.  In China, the Fed’s policies have been much more inflationary. Wages and prices in the US are held down by competition from cheaper workers and lower-cost producers in China – but China itself has no such sink to dump its inflation on, so when Bernanke prints, to prop up the value of assets owned by rich consumers in the developed world, and finance the profligacy of the American State, it’s poor migrant workers in Wuhan who go without supper.

This inflationary impact has been exacerbated by the response of China’s own economic policy-makers to the crisis. By 2008, after a decade and a half of rapid and relatively smooth growth, the institutional memory of the old business cycle had apparently been largely lost, as a result of the natural human tendency to assume that any good thing that lasts longer than originally expected will, therefore, last forever. Consequently, the response to the oil price super-spike of 2008 was not to tighten policy, as it might have been in previous iterations of the cycle. This was China’s moment in the sun, and nothing so trivial as brute facts about the scarcity of particular physical things could be allowed to mar it.

Instead of tightening, the planners applied massive stimulus, mostly in the form of easier credit for whatever career-advancing (but quite probably uneconomic) projects local government officials wanted to start. The problem was apparently conceived of as one of managing another soft landing, and bringing forward the next leg of the long expansion. If many of the projects would have a very low return, in the end, well, the government could absorb any losses, and pass them on to taxpayers, or to depositors, once a long boom was again underway. (Like the US, China funds its bankers’ incompetence by encouraging them to collude in repressing returns to private savers.)

Unfortunately, there was no protracted boom this time. There was only a relatively short one, peaking in 2009, which rather swiftly resulted in increased inflation.  China’s exports were now so large, relative to the economies of its customers, that only increased, and increasingly distorting subsidies would produce any more growth on that front. The resource constraints epitomized by the global oil price (although other vital commodities – clean air, for example – were becoming scarce as well) couldn’t be made to go away just by printing money, as they could have been when the price elasticity of supply for the commodities China imports was effectively infinite, back in the ‘90’s.

As a result, this last cyclical upswing was unusually short – the authorities had to start tightening again after only a year or two of renewed expansion. That meant that the hope that the eventual losses resulting from the low-quality local-government projects undertaken as stimulus could easily be absorbed by the banks (or rather, their depositors) during another long boom was revealed as a forlorn one. Eager to get rid of these increasingly dangerous white elephants, the banks began securitizing the loans they’d made to these projects in the form of “wealth management products” that would allow individuals to take over the loans, and earn a higher interest rate than they could with a bank account.

Local government projects that were on the verge of default could simply sell more bonds to the trusts associated with these WMP’s. Of course, they would then have to sell even more bonds, at some later point, to some other WMP trust, to pay off the interest and principal on those bonds, but that was a problem for later…  In 2012, loans made by these sorts of trusts, according to UBS, made up almost half of all credit extended in China. Few people outside of the country seem to have quite focused on the inevitable compounding of loans to pay the interest of loans to pay the interest on loans to un-economic projects that this implies, but the problem, considered in terms of the share of the banking system that’s involved in it, is obviously much worse than the sub-prime problem ever was in the US. It has all of the features of a classic financial crisis, since the WMP’s, in the final analysis, are probably mostly just complex Ponzi schemes. While money was still flowing out of bank accounts and into WMP’s, the game could keep going, but now that almost half the bank accounts have been used up in this way, there’s nothing left in the cookie jar. A ponzi scheme always collapses once there’s no new money left to be sucked into it, and we seem to be close to that point, so the short-term outlook isn’t bright.

An anomalously long expansion, in the ‘90’s and the first three quarters of the next decade, was followed by an anomalously short one, because of an inappropriate policy response based on expectations built up during the long expansion. The new short cycle may still have another bounce left in it, if we’re lucky, but given the rate at which WMP loans are growing, a financial crisis or panic, somewhat analogous to the events in Japan at the beginning of the 1990’s, seems equally likely as an immediate outcome. Even if the authorities do find some way to print enough money to get out of this particular trap, though, from a longer-term perspective, the illusion of a smooth and uninterrupted growth trajectory is now over.

If the Chinese economy can continue growing rapidly at all, in the face of persistently high oil prices and the incompetence of the country’s policy makers, it will now once again begin to do so in a saw-toothed way, with each peak marked by a spike in world oil prices (which will eventually explore new highs) and each trough marked by more exported unemployment, as the country continues to try to dump its mistakes in management onto an already-crumpling world economy. The problem with Deng Xiaoping’s plan is that it has succeeded – not in permanently solving the Chinese economy’s problem with the wildness of its tutelary animal spirits, but in sharing that problem with the rest of us, so we can all have the pleasure of living with the colorful though inconvenient consequences of Maoist central planning.

The remarkable lack of interest in China’s business cycle, by analysts outside the country – many China “experts” seem locked into the role of permanent booster or apologist, or else of perennial Sinophobe, and miss such tiny nuances as the violent fluctuations that have typified the post-war history of the world’s second largest economy – make Deweaver’s book, and its explanation of the nature and causes of those cycles, a very useful one, perhaps the most useful book on the subject to come out since Gavin Peebles’ masterful Money in the PRC. The book’s only major defect – one it shares with many of the products of publishers like Palgrave – is its price, which puts it out of the reach of the casual reader. But if understanding the cycles and likely future of China’s economy is actually an urgent practical problem for you, it may be worth investing in a copy anyway.

The book is available from Amazon; the URL is…

Morgan Stanley On Europe: "We're Getting Worried"

We have noted the similarities between the current risk rally and previous years but Morgan Stanley’s Laurence Mutkin is “getting worried” that investors expect the second half of this year to be different (and consistently bullish). Much of the current risk-on rally around the world was sparked by Draghi’s “whatever it takes” moment theoretically reducing the downside tail-risk in Europe. Well, systemic risk in Europe is now at recent lows…

and just as in 1H12 and 1H 11, core yields are rising notably, peripheral spreads compressing, money-market curves are steepening, and 2s5s10s cheapening.


Of course, he notes, 2013 is different from previous years (OMT for example) but much rests on how ECB’s Draghi responds to the recent (LTRO-repayment-driven) rise in EONIA forwards. Albert Einstein reportedly said that insanity is doing the same thing over and over again and expecting different results. Applying that to the European bond market – for the third time running, the year has opened well but it would be insane to expect a different outcome (than the typically bearish reversion) this time?


Via Morgan Stanley,

…how low could Core 2-year yields go? Shockingly, we think they could retrace nearly all the recent sell-off, under the conditions that

  • (1) banks’ weekly 3y LTRO repayments fall to near zero (even if the first repayment of the February tranche at end-Feb is as big as the first repayment of the December tranche last week); and
  • (2) systemic sovereign stresses re-assert themselves; and/or 
  • (3) president Draghi forcefully states that the ECB will prevent a sharp rise in EONIA.

In the near term, therefore, much depends on how ECB president Draghi responds to the recent rise in EONIA forwards at next week’s Press Conference. Our economists doubt he’ll lean heavily against the rise in rates, but we hope he’ll avoid the mistake his predecessor made in blithely characterizing the rise in EONIAs after the 1y LTROs’ expiry in 2010 as being no more than evidence of the improving health of the banks.


An End to the Rally?

Peripheral spread has tightened considerably since the OMT announcement. We have argued that the “magic” of the OMT has reduced tail risk events and hence bought time for peripheral countries’ economies to stablise and recover. This has been the case: yields have fallen and market confidence risen, leading to encouraging signs:

  • Converging current account balances in core-peripheral
  • Improving funding conditions for the banking system, evident in LTRO repayments; peripheral deposit flows stablised; and Target 2 balances and foreign ownership of Spanish and Italian government bonds showed signs of improvement

However, do the signs of improvement warrant further tightening? The answer is less certain than it was three months ago in our view. Given the level of peripheral spreads, the risk of a reversal is rising, due to a few critical factors:

  • Rising funding cost because of LTRO repayments: The larger than expected initial LTRO repayment has taken the markets by surprise and led to a rise in the money market rates and short-end core rates. Despite its possibly being a sign of a stronger banking system, the rising funding costs directly reduce the carry and attractiveness of owning peripheral bonds, in particular relative to Germany given rising German yields. 
  • End of further easing in a fragile recovery: With a seemingly stronger banking system and funding markets, ECB’s rhetoric became less dovish than markets expected in the January meeting. However, the weaker parts of the banking system as well as peripheral sovereigns are still relying on low funding costs to aid any further recovery.

    If the end of further easing is signaled and priced in by the markets, the fragile recovery could be dampened fairly quickly, given the rise in funding costs. So far we have already seen a small tick up in the Monetary Transmission Index for Spain. 

  • Valuation: Both Spain and Italy spreads versus Germany have tightened close to or through the lows reached following the 3yr LTROs. Despite the market’s acknowledgement that the OMT is a more credible backstop, valuations are less appealing now: Italy is overvalued and Spain is close to fair value.

  • Debt sustainability prospects for peripheral sovereigns have already worsened slightly this year, due to the combination of a stronger euro and higher absolute yield levels. 0-5y Spain and Italy yields are +30bp vs January’s lows; and our FX strategists estimate that the euro’s recent rally has made it some 5% and 12% overvalued for Spain and Italy respectively  – an additional drag on nominal growth prospects. As yet, this deterioration in the outlook for debt dynamics has been pretty negligible. But if core rates push higher and take peripherals with them, the market could focus more on debt sustainability again.

Advice From The Department Of Homeland Security: "If Attacked By A Shooter, Grab Some Scissors"

Via Michael Krieger of Liberty Blitzkrieg blog,

Advice From The Department Of Homeland Security: “If Attacked By A Shooter, Grab Some Scissors”

We first heard about this from a New York Post article on the topic.  Then we watched the video for ourselves.  It’ll make you want to defund the Department of Homeland Security (DHS) immediately.  While the whole “grab scissors” to defend oneself during a mass shooting is pretty amusing, the more disturbing part is that 90% of the video just consists of people on their knees in cubicles cowering in fear or running panicked with their hands in the air.  All the while police in black uniforms and “assault weapons” race in to save the day!  The video is a great representation of how the DHS views the citizenry.  Feeble, helpless, pathetic little children.  You’ve gotta watch it for yourself!