The government manipulation of the banks’ stress tests reveals another nefarious aspect market participants should be aware. Things are shaping up such that 2nd quarter earnings from banks will be equal to or “better” than those reported 1Q. The Financial Times reported today some banks would reap financial benefit by providing assistance in capital raising efforts for weaker institutions. In particular, approximately “450 million in underwriting fees.” If you add to this amount the fees generated from expected divestitures, such as the $7.3 billion deal recently completed by Bank of America, these non-recurring fees could be a welcome addition to the coffers of some financial institutions. Given that there is no economic recovery in sight but rather continued deterioration, 3Q09 results have the high probability of being disappointing. The recent market run-up has been driven on the backs of bank stocks. The trend will reverse once investors realize that nothing but hot air has been pumping it.
I keep coming back to the theme that from September through December I expect the same dynamics that played out last year to repeat this year—perhaps to a greater degree. However, the macroeconomic and geopolitical landscape is covered by traps, which could bring a market collapse quite suddenly and before September. But these sorts of events are difficult to predict, since they are what Nassim Taleb categorizes as “black swans”. One such event is the tumbling of the U.S. Dollar, which could conceivably arise from the excessive public debt. The U.S. Federal Government for example will need to raise about $2 trillion to finance its deficit and at the same time needs an additional $2 trillion to roll-over some of its debt. These are staggering figures.
As always, be aware of your environment.
Tuesday, May 12, 2009
Monday, May 11, 2009
No Stress Over Stress Tests - Part II
Over the weekend, the Wall Street Journal reported what heretofore had been a premonition: backroom wheeling and dealing between the Federales and the banksters on stress-test results. There were some handsome winners out from this negotiation. Consider Bank of America: the Feds first assessed the bank needed "more than $50 billion," but ultimately settled for $34 billion. Citigroup, for example, was deemed to need $35 billion, but they brought the figure down to $5.5 billion. Not even with the exaggerated help from the government in the form of less than rigorous testing parameters were the banks able to pass the results. Make no mistake, every bank that needed capital funding failed the test. Caveat emptor if you purchase bank stocks. Below you will find the Journal's full article.
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Banks Won Concessions on Tests Fed Cut Billions Off Some Initial Capital-Shortfall Estimates; Tempers Flare at Wells
By DAVID ENRICH, DAN FITZPATRICK and MARSHALL ECKBLAD
The Federal Reserve significantly scaled back the size of the capital hole facing some of the nation's biggest banks shortly before concluding its stress tests, following two weeks of intense bargaining.
In addition, according to bank and government officials, the Fed used a different measurement of bank-capital levels than analysts and investors had been expecting, resulting in much smaller capital deficits.
The overall reaction to the stress tests, announced Thursday, has been generally positive. But the haggling between the government and the banks shows the sometimes-tense nature of the negotiations that occurred before the final results were made public.
Government officials defended their handling of the stress tests, saying they were responsive to industry feedback while maintaining the tests' rigor.
When the Fed last month informed banks of its preliminary stress-test findings, executives at corporations including Bank of America Corp., Citigroup Inc. and Wells Fargo & Co. were furious with what they viewed as the Fed's exaggerated capital holes. A senior executive at one bank fumed that the Fed's initial estimate was "mind-numbingly" large. Bank of America was "shocked" when it saw its initial figure, which was more than $50 billion, according to a person familiar with the negotiations.
At least half of the banks pushed back, according to people with direct knowledge of the process. Some argued the Fed was underestimating the banks' ability to cover anticipated losses with revenue growth and aggressive cost-cutting. Others urged regulators to give them more credit for pending transactions that would thicken their capital cushions.
At times, frustrations boiled over. Negotiations with Wells Fargo, where Chairman Richard Kovacevich had publicly derided the stress tests as "asinine," were particularly heated, according to people familiar with the matter. Government officials worried San Francisco-based Wells might file a lawsuit contesting the Fed's findings.
The Fed ultimately accepted some of the banks' pleas, but rejected others. Shortly before the test results were unveiled Thursday, the capital shortfalls at some banks shrank, in some cases dramatically, according to people familiar with the matter.
Bank of America's final gap was $33.9 billion, down from an earlier estimate of more than $50 billion, according to a person familiar with the negotiations.
A Bank of America spokesman wouldn't comment on how much the previous gap was reduced, though he said it resulted from an adjustment for first-quarter results and errors made by regulators in their analysis. "It wasn't lobbying," he said.
Wells Fargo's capital hole shrank to $13.7 billion, according to people familiar with the matter. Before adjusting for first-quarter results and other factors, the figure was $17.3 billion, according to a federal document.
"In the end we agreed with the number. We didn't necessarily like the number," said Wells Fargo Chief Financial Officer Howard Atkins. He said the company was particularly unhappy with the Fed's assumptions about Wells Fargo's revenue outlook.
At Fifth Third Bancorp, the Fed was preparing to tell the Cincinnati-based bank to find $2.6 billion in capital, but the final tally dropped to $1.1 billion. Fifth Third said the decline stemmed in part from regulators giving it credit for selling a part of a business line.
Citigroup's capital shortfall was initially pegged at roughly $35 billion, according to people familiar with the matter. The ultimate number was $5.5 billion. Executives persuaded the Fed to include the future capital-boosting impacts of pending transactions.
SunTrust Banks Inc. also persuaded the Fed to significantly reduce the size of its estimated capital gap to $2.2 billion, after identifying mathematical errors in the Fed's earlier calculations, according to a person familiar with the matter.
PNC Financial Services Group Inc., saw a capital hole materialize at the last minute. As recently as Wednesday, PNC executives were under the impression they wouldn't need to find any new capital, according to people familiar with the matter. Thursday morning, the Fed informed PNC that it had a $600 million shortfall.
Regulators said other banks also were told they needed more capital than initially projected.
The Fed's findings were less severe than some experts had been bracing for. A weeklong rally in bank stocks continued Friday, with the KBW Bank Stocks index surging 10%. Investors were especially relieved by the relatively small capital holes at regional banks. Shares of Fifth Third soared 59%, while Regions Financial Corp.'s $2.5 billion deficit led to a 25% leap in its stock.
With the stress tests, government officials were walking a fine line. If the regulators were too tough on banks, they risked angering their constituents and spooking markets. But if they were too soft, the tests could have lost credibility, defeating their basic confidence-building purpose.
All the back-and-forth is typical of the way regulators traditionally wrap up their examinations of banks: Regulators often present preliminary findings to lenders and then give them time to respond. The process can result in changes to the regulators' initial conclusions. Some of the stress-test revisions, for instance, were made to account for the beneficial impact of the industry's strong first-quarter profits.
On Friday, some analysts questioned the yardstick, known as Tier 1 common capital, that regulators chose to assess capital levels. Many experts had assumed the Fed would use a better-known metric called tangible common equity.
According to Gerard Cassidy, an analyst with RBC Capital Markets, the 19 banks' cumulative shortfall would have been more than $68 billion deeper if the government had used the latter metric, which accounts for unrealized losses.
Federal officials said their projections reflected the most comprehensive analysis ever conducted of the industry. The test results showed that the 19 banks faced a total of $599 billion in losses over the next two years under the government's worst-case, Depression-like scenario. The Fed directed 10 banks to add a total of nearly $75 billion to their capital buffers to insulate themselves from potential losses.
Banks pressed ahead on Friday with plans to fill their capital holes by tapping public markets. Wells Fargo raised $7.5 billion in stock through a public offering. The bank originally planned to raise $6 billion, but expanded the offering, which was valued at $22 a share, due to robust demand. Shares of Wells Fargo rallied $3.42, or 14% to $28.18.
Morgan Stanley, which is facing a $1.8 billion capital hole, raised $4 billion by selling stock. Shares of Morgan rose $1.06, or 4%, to $28.20.
********************************************************
Banks Won Concessions on Tests Fed Cut Billions Off Some Initial Capital-Shortfall Estimates; Tempers Flare at Wells
By DAVID ENRICH, DAN FITZPATRICK and MARSHALL ECKBLAD
The Federal Reserve significantly scaled back the size of the capital hole facing some of the nation's biggest banks shortly before concluding its stress tests, following two weeks of intense bargaining.
In addition, according to bank and government officials, the Fed used a different measurement of bank-capital levels than analysts and investors had been expecting, resulting in much smaller capital deficits.
The overall reaction to the stress tests, announced Thursday, has been generally positive. But the haggling between the government and the banks shows the sometimes-tense nature of the negotiations that occurred before the final results were made public.
Government officials defended their handling of the stress tests, saying they were responsive to industry feedback while maintaining the tests' rigor.
When the Fed last month informed banks of its preliminary stress-test findings, executives at corporations including Bank of America Corp., Citigroup Inc. and Wells Fargo & Co. were furious with what they viewed as the Fed's exaggerated capital holes. A senior executive at one bank fumed that the Fed's initial estimate was "mind-numbingly" large. Bank of America was "shocked" when it saw its initial figure, which was more than $50 billion, according to a person familiar with the negotiations.
At least half of the banks pushed back, according to people with direct knowledge of the process. Some argued the Fed was underestimating the banks' ability to cover anticipated losses with revenue growth and aggressive cost-cutting. Others urged regulators to give them more credit for pending transactions that would thicken their capital cushions.
At times, frustrations boiled over. Negotiations with Wells Fargo, where Chairman Richard Kovacevich had publicly derided the stress tests as "asinine," were particularly heated, according to people familiar with the matter. Government officials worried San Francisco-based Wells might file a lawsuit contesting the Fed's findings.
The Fed ultimately accepted some of the banks' pleas, but rejected others. Shortly before the test results were unveiled Thursday, the capital shortfalls at some banks shrank, in some cases dramatically, according to people familiar with the matter.
Bank of America's final gap was $33.9 billion, down from an earlier estimate of more than $50 billion, according to a person familiar with the negotiations.
A Bank of America spokesman wouldn't comment on how much the previous gap was reduced, though he said it resulted from an adjustment for first-quarter results and errors made by regulators in their analysis. "It wasn't lobbying," he said.
Wells Fargo's capital hole shrank to $13.7 billion, according to people familiar with the matter. Before adjusting for first-quarter results and other factors, the figure was $17.3 billion, according to a federal document.
"In the end we agreed with the number. We didn't necessarily like the number," said Wells Fargo Chief Financial Officer Howard Atkins. He said the company was particularly unhappy with the Fed's assumptions about Wells Fargo's revenue outlook.
At Fifth Third Bancorp, the Fed was preparing to tell the Cincinnati-based bank to find $2.6 billion in capital, but the final tally dropped to $1.1 billion. Fifth Third said the decline stemmed in part from regulators giving it credit for selling a part of a business line.
Citigroup's capital shortfall was initially pegged at roughly $35 billion, according to people familiar with the matter. The ultimate number was $5.5 billion. Executives persuaded the Fed to include the future capital-boosting impacts of pending transactions.
SunTrust Banks Inc. also persuaded the Fed to significantly reduce the size of its estimated capital gap to $2.2 billion, after identifying mathematical errors in the Fed's earlier calculations, according to a person familiar with the matter.
PNC Financial Services Group Inc., saw a capital hole materialize at the last minute. As recently as Wednesday, PNC executives were under the impression they wouldn't need to find any new capital, according to people familiar with the matter. Thursday morning, the Fed informed PNC that it had a $600 million shortfall.
Regulators said other banks also were told they needed more capital than initially projected.
The Fed's findings were less severe than some experts had been bracing for. A weeklong rally in bank stocks continued Friday, with the KBW Bank Stocks index surging 10%. Investors were especially relieved by the relatively small capital holes at regional banks. Shares of Fifth Third soared 59%, while Regions Financial Corp.'s $2.5 billion deficit led to a 25% leap in its stock.
With the stress tests, government officials were walking a fine line. If the regulators were too tough on banks, they risked angering their constituents and spooking markets. But if they were too soft, the tests could have lost credibility, defeating their basic confidence-building purpose.
All the back-and-forth is typical of the way regulators traditionally wrap up their examinations of banks: Regulators often present preliminary findings to lenders and then give them time to respond. The process can result in changes to the regulators' initial conclusions. Some of the stress-test revisions, for instance, were made to account for the beneficial impact of the industry's strong first-quarter profits.
On Friday, some analysts questioned the yardstick, known as Tier 1 common capital, that regulators chose to assess capital levels. Many experts had assumed the Fed would use a better-known metric called tangible common equity.
According to Gerard Cassidy, an analyst with RBC Capital Markets, the 19 banks' cumulative shortfall would have been more than $68 billion deeper if the government had used the latter metric, which accounts for unrealized losses.
Federal officials said their projections reflected the most comprehensive analysis ever conducted of the industry. The test results showed that the 19 banks faced a total of $599 billion in losses over the next two years under the government's worst-case, Depression-like scenario. The Fed directed 10 banks to add a total of nearly $75 billion to their capital buffers to insulate themselves from potential losses.
Banks pressed ahead on Friday with plans to fill their capital holes by tapping public markets. Wells Fargo raised $7.5 billion in stock through a public offering. The bank originally planned to raise $6 billion, but expanded the offering, which was valued at $22 a share, due to robust demand. Shares of Wells Fargo rallied $3.42, or 14% to $28.18.
Morgan Stanley, which is facing a $1.8 billion capital hole, raised $4 billion by selling stock. Shares of Morgan rose $1.06, or 4%, to $28.20.
Saturday, May 9, 2009
No Stress Over Stress Tests
The recent government-enacted “stress tests” of banks reveal some serious flaws. One of the errors was pointed out by the Financial Times, which reported that,
“During the tests, policymakers made adjustments after first-quarter operating revenues were stronger than forecast, reducing demands for equity by nearly $20bn compared with original estimates based on data for the end of 2008.”
This tells us that if year-end 2008 operating results would have been used, the required capital needed to be raised should be approximately $95 Billion. Yet, the mirage of 1Q09 results further highlights the extent the government authorities went to ensure banks recorded a profit. For a detail discussion of the shenanigans that led to the “stellar” reported bank revenues, see my post here. Moreover, the original estimate to use 2008 data is even more questionable because 1) some banks will not continue to benefit from assets which most likely will be sold in the near future (e.g. Citi), 2) it is unlikely that what had become traditional sources of income for banks (e.g. CDO issuance, securitizations) will continue in the future. Regulators could have used another year, say, 2003, when the use of leverage by banks was less. Of course, this was not going to happen because capital needs would have easily risen to triple digits.
Take a closer look at Citi, for example. The Federales estimated earnings (ex-provisions) for this year and next to total $49 billion, which is approximately the yearly average going back to 1999 (excluding 2008). If the government used this average as guidance, it is deficient because it is not a forward-looking estimate. A reasonable earning parameter “stress test” would have been to use, for example, 50% of aforementioned figure.
All considered, what the public has received are cooked books and cooked results, and if one does not take adequate precaution, somebody is going to get cooked. The stock market has not considered any of this. If it had, it would not have climbed higher the day after the “stress test” results were released.
Paul Krugman’s La La Land
Mr. Krugman, like a typical Keynesian, holds onto distorted views. About a year ago he posted the following in his blog to express his belief of malevolent vs. benign inflation. Of course, Keynesians adore price inflation because it is the only way that the real value of wages would decline, which is a required proposition to keep employment high in light of expansionary fiscal and monetary policies they endorse during recessions. That being said, while I don’t fully agree with the likes of Milton Friedman, he was right to point that price inflation is always and everywhere a monetary phenomena. Mr. Krugman cites the following example to promote his view:
In Mr. Krugman’s example of Harry and Louise, the former can raise prices all he wants—irrespective his motives. What Mr. Krugman fails to note is who will do the bidding and how will the transaction be settled? The customer, of course, but with what money? If an economy (assume produce only one good) has a money stock of, say, $100, and the asking price of the good by Harry is $200, it is impossible for price inflation to occur beyond $100. However, if the central bank increases the money supply to $500, someone will offer to buy at the $200 asking price. Someone will come along, however, and bid $300. Hence an economy experiences price inflation.
The same logic applies to the so call wage-price spiral. That is, higher wages cause price increases. This is a fallacy. Wage demand can increase but if there is no commensurate increase in the money supply, all things being equal, it is impossible prices to increase without demand-side increases.
Keynesians avoid confronting and openly challenging this fact. That is why they rarely mention it in their publications. With this backdrop, it is silly to presume the Federal Reserve balance sheet expansion from $800 billion last August to nearly $2.4 trillion currently will not be inflationary. Any kind of “expectations” management not rooted on fundamental truth will eventually unravel, which will lead to sharp increases in the CPI—although rest assure the government will massage the statistics to deflate them. When that will happen is anyone’s guess? But it’s practically a foregone conclusion that mass inflation (anything above 15-20% annual price increases) is on its way.
"Imagine that there are two entrepreneurs, Harry and Louise, both of whom change prices only at fairly long intervals — say, once a year. Other things equal, Harry want his average price over the next year to be about the same as Louise’s; Louise wants her average price to be about the same as Harry’s. But their price setting takes place on different dates...In this situation, inflation can feed on itself: Harry raises his price above Louise’s, because he expects her to raise her price in the future, and she does the same thing when it’s her turn."
In Mr. Krugman’s example of Harry and Louise, the former can raise prices all he wants—irrespective his motives. What Mr. Krugman fails to note is who will do the bidding and how will the transaction be settled? The customer, of course, but with what money? If an economy (assume produce only one good) has a money stock of, say, $100, and the asking price of the good by Harry is $200, it is impossible for price inflation to occur beyond $100. However, if the central bank increases the money supply to $500, someone will offer to buy at the $200 asking price. Someone will come along, however, and bid $300. Hence an economy experiences price inflation.
The same logic applies to the so call wage-price spiral. That is, higher wages cause price increases. This is a fallacy. Wage demand can increase but if there is no commensurate increase in the money supply, all things being equal, it is impossible prices to increase without demand-side increases.
Keynesians avoid confronting and openly challenging this fact. That is why they rarely mention it in their publications. With this backdrop, it is silly to presume the Federal Reserve balance sheet expansion from $800 billion last August to nearly $2.4 trillion currently will not be inflationary. Any kind of “expectations” management not rooted on fundamental truth will eventually unravel, which will lead to sharp increases in the CPI—although rest assure the government will massage the statistics to deflate them. When that will happen is anyone’s guess? But it’s practically a foregone conclusion that mass inflation (anything above 15-20% annual price increases) is on its way.
Thursday, May 7, 2009
Banking Swindles, Public Relations, and Other Government Follies
On the afternoon of Thursday, May 07, 2009, the U.S. government will make public the results of the so-call stress tests of the largest 19 banks. This entire process is nothing more than a public relations stunt to give the appearance to investors that all is ‘honky dory’ with the banks. But as I pointed out on a recent post, the balance sheet problems of banks are very significant. The government’s market interference is merely postponing the day of reckoning by conscientiously manipulating and concealing the actual shape of the largest financial institutions. Given the propensity of human nature to reap the benefits of the proverbial ‘free lunch,’ market participants have been practically cheerleading and applauding government efforts. This concealment cannot continue for a prolonged period of time. I expect by September this house of cards will start crumbling. In the meantime, illusions will be given that we have or are “turning the corner.” Don’t believe it. It is coming from politicians (and those who benefit from their actions) who have nonexistent credibility.
These are some of the steps the government has de facto legalized extortion—otherwise known as assisting the banks.
1. The Federal Reserve System exorbitant expansion of its balance sheet is aimed at “helping” the banks by taking on dodgy assets from the banks’ books and replacing them with less risk ones (like Treasurys). This has lessened the write-downs and write-offs financial institutions must undertake. Even with this manipulation, the IMF reckons that approximately $550 billion more in write-downs are on the way.
2. The low interest rate environment, which is a direct result of monetary policy by the Federal Reserve, has allowed banks to practically execute the carry trade of borrowing short and lending long. Banks borrow and pay almost nothing on interest, and subsequently lend the proceeds long-term. In other words, banks pay, say 1% on the borrow funds, and lend the money at, say, 4.5%. Given that consumer credit is tumbling, most of the fees earned by banks has come from refinancing. This is not continuous cashflows. These non-recurring fees may carry through the 2nd quarter reporting season, but not much more after that.
3. Balance sheet manipulations led by the “politization” of the Financial Accounting Board. Mark-to-market rules, which is the mechanism by which a bank’s trading book is adjusted to reflect its most recent valuation, were in effect suspended. This allowed financial institutions to disguise problem assets. This fact alone should have sent shivers to the market, but it simply brushed it off. Furthermore, it is almost impossible given this directive to assess the true value of bank assets.
4. A number of banks, most notoriously Citigroup, engaged in an accounting trick call “credit value adjustment.” The “adjustment” allows firms to record as a profit the amount of the decline in value of its issued debt. For example, if at the beginning of the quarter Citigroup’s debt traded at $100, but it is currently trading at $75, Citigroup records a $25 profit. The assumption is that the company can purchase its own debt at the discounted price. Of course, the bank does not do this because it does not have the money; but for accounting purposes, this is legitimate. Instead of the actual term used, this should be call “creative value enhancement.”
5. Goldman Sachs, the master of deception, switched from reporting earning results on a fiscal year basis ending in November. It will now report on a calendar year basis. The result of this switch: Not accounting a huge loss in December 2008 in their most recent quarterly earning report. On that month alone, the firm lost about $780 million. This would have cut into the $1.8 billion “profit” reported.
As previously mentioned, these manipulations have occurred under the watchful eye and in some instances endorsed by government manipulators, who purport to act for the benefit of the “people”. There is a cliché that says that if you have friends like these who need enemies. One can sweep trash under the rug and hope no one notices. Soon enough, however, people will notice. When that happens, you have better be out of the stock market or be shorting it.
These are some of the steps the government has de facto legalized extortion—otherwise known as assisting the banks.
1. The Federal Reserve System exorbitant expansion of its balance sheet is aimed at “helping” the banks by taking on dodgy assets from the banks’ books and replacing them with less risk ones (like Treasurys). This has lessened the write-downs and write-offs financial institutions must undertake. Even with this manipulation, the IMF reckons that approximately $550 billion more in write-downs are on the way.
2. The low interest rate environment, which is a direct result of monetary policy by the Federal Reserve, has allowed banks to practically execute the carry trade of borrowing short and lending long. Banks borrow and pay almost nothing on interest, and subsequently lend the proceeds long-term. In other words, banks pay, say 1% on the borrow funds, and lend the money at, say, 4.5%. Given that consumer credit is tumbling, most of the fees earned by banks has come from refinancing. This is not continuous cashflows. These non-recurring fees may carry through the 2nd quarter reporting season, but not much more after that.
3. Balance sheet manipulations led by the “politization” of the Financial Accounting Board. Mark-to-market rules, which is the mechanism by which a bank’s trading book is adjusted to reflect its most recent valuation, were in effect suspended. This allowed financial institutions to disguise problem assets. This fact alone should have sent shivers to the market, but it simply brushed it off. Furthermore, it is almost impossible given this directive to assess the true value of bank assets.
4. A number of banks, most notoriously Citigroup, engaged in an accounting trick call “credit value adjustment.” The “adjustment” allows firms to record as a profit the amount of the decline in value of its issued debt. For example, if at the beginning of the quarter Citigroup’s debt traded at $100, but it is currently trading at $75, Citigroup records a $25 profit. The assumption is that the company can purchase its own debt at the discounted price. Of course, the bank does not do this because it does not have the money; but for accounting purposes, this is legitimate. Instead of the actual term used, this should be call “creative value enhancement.”
5. Goldman Sachs, the master of deception, switched from reporting earning results on a fiscal year basis ending in November. It will now report on a calendar year basis. The result of this switch: Not accounting a huge loss in December 2008 in their most recent quarterly earning report. On that month alone, the firm lost about $780 million. This would have cut into the $1.8 billion “profit” reported.
As previously mentioned, these manipulations have occurred under the watchful eye and in some instances endorsed by government manipulators, who purport to act for the benefit of the “people”. There is a cliché that says that if you have friends like these who need enemies. One can sweep trash under the rug and hope no one notices. Soon enough, however, people will notice. When that happens, you have better be out of the stock market or be shorting it.
Wednesday, May 6, 2009
The Mirage of Recovery
Occasionally there are excellent articles that truly encapsulate what is currently happening in the U.S. economy. There has been a marked and sustained upward movement in financial markets over the six weeks, based on presumptions that "green shoots" of recovery are evident. However, this is nothing more than a sham. By year-end 2009, the stock market will be a lot lower than the level we see right now--possibly the Dow falling below 6,000. In order to understand our current economic status, one must adequately assess the historical background and the effects of the policies enacted. All leads to an unhappy ending. While lengthy, it is certainly a good investment of time to read it. It can save you A LOT of money if you act accordingly.
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The mirage of recovery
By Hossein Askari and Noureddine Krichene **
Source: http://www.atimes.com/
Over recent days, observing a sudden increase in car sales and record profits of "bankrupt" banks, Federal Reserve chairman Ben Bernanke has announced that recovery of the US economy was under way. Treasury Secretary Timothy Geithner echoed the same message and even "globalized" his prediction of a recovery for the world economy. President Barack Obama saw "glimmers of hope". While these three top US policymakers were rushing to announce recovery, economist Paul Krugman exuded skepticism, saying "do not count your recoveries before they are hatched".
US policymakers' optimism seems to be founded on their grandiose reflationary programs. Obama has launched an unprecedented stimulus package at US$787 billion, followed by the largest US fiscal deficit ever, at $1.85 trillion, or 13% of gross domestic product (GDP). Underlying the stimulus package and the fiscal deficit was a Harvard income multiplier of 1.5, implying an increase in the US real GDP by about $4 trillion, or a record 30% per year. The basic economics advocated by the Obama team were simple: trillions of dollars in stimulus package and government expenditures would boost real aggregate demand for consumption and investment and automatically lead to economic recovery and full employment. Their mechanical multiplier model provided a strong reason for Obama to announce a premature economic recovery.
Bernanke's optimism is the result of the aggressive monetary policy that he forced under the George W Bush administration and has continued to expound under Obama, irrespective of the devastation it has caused to the banking sector and subsequent fiscal bailouts. Bernanke has gained the reputation of the doctor of the "Great Depression" and proponent of monetary anarchy. For him and his school of thought, inflation seems to be of little concern. His aggressive monetary policy has sent the US economy, and with it the world economy, into financial collapse and recession.
Yet, doctor Bernanke kept strong faith in his aggressive anti-Great Depression medicine. Besides forcing interest rates to zero, never seen in the monetary history of the US, he decided to unleash money supply by expanding the credit of the Federal Reserve from $700 billion prior to August 2007 to $2.3 trillion by end April 2009. Doctor Bernanke's reasoning was simple: zero interest rates combined with unlimited credit to the sub-prime markets ought to hike up aggregate demand in such a powerful way that it blasts away recession and secures fast growth and full employment.
The recent cheers for Geithner were based on similar reasoning, however, transplanted at the world economic level. A Group of 20 stimulus package of $5 trillion, on the top of a commitment by the G-20 countries to undertake the most expansionary fiscal and monetary policy, combined with free lending to any country in any amount, that would in their view guarantee a fast and strong world economic recovery.
Neither G-20 policymakers nor the US seem to recognize that the current recession was the product of overly expansionary fiscal and monetary policies during the past decade. Obviously, these policies yielded a temporary high demand-led economic growth during the 2002-2007 period accompanied by the highest commodity price inflation in recent memory; however, they also triggered a food and energy crisis, general bankruptcies in form of meltdown of sub-prime loans, an economic recession and trillion of dollars of bailouts in the US and Europe that socialized financial losses. These bailouts will weigh on economic growth for a long time in the future.
These same policies are now being replayed around the world. The supporters of these policies claim to be innovative as if for the first time in history they were implementing voluminous fiscal expansion and the free printing of money. Yet these policies were used time and again in the past with startling examples such as the German hyperinflation in 1920-23, Latin American hyperinflations in 1950-1985, and the more recent Mobutu and Mugabe hyperinflations.
In all cases where these policies were tried, there was devastating inflation, a substantial decline in real income and a considerable impoverishment and social malaise. Notwithstanding historical evidence against rapid monetary and fiscal expansionism, G-20 policymakers and the US now believe in success of super inflationary policies.
US policymakers diagnosed the current crisis as lack of demand for goods and services and large excess savings in the form of a piling up of food and energy goods in the US, and totally dismissed the large external deficits that reached about 6% of GDP in recent years and negative national savings. They believed in deflation when housing, food, and energy inflation was crippling the economy. The refusal to link the Bush administration's war spending and excessively expansionary fiscal and monetary policies and the current financial crisis has been a main stratagem in the speeches of Fed officials.
Bernanke blamed the financial crisis on China and on oil exporters who invested their balance of payments surplus in the US, leading to low interest rates and a credit boom in the US, thus denying Fed influence on interest rates and credit creation. Certainly, Bernanke did not understand that China and oil exporters do not decide the US current account deficit.
Often, Bernanke has noted that the Fed's mandate from the Congress was to promote maximum sustainable employment and stable prices. The failure of the Fed to achieve either or both objectives has been quite recurrent over the past decades. Bernanke's aggressive policy since August 2007 has even triggered stagflation: rising unemployment and inflation. It would be more natural to have a central bank with one single mandate - to preserve the value of money.
Bernanke has simply dismissed traditional central banking and decided, based on his own Great Depression doctrine, to go beyond the twin mandates that were prescribed by the Congress and to create high-risk instruments that go beyond traditional government bonds held by a central bank for open market operations. No central bank has the mandate to lend directly to non-depository banks or to the private sector. That would constitute a violation of standard central banking practice. No government in the world would allow its central bank to violate its mandate and hold assets other than government bonds and member banks' discounts. The arbitrary and overly discretionary power of Bernanke can be illustrated by the following passage from Bernanke:
"More recently, the Federal Reserve has also initiated a lending program, with the cooperation of the Treasury, designed to free up the flow of credit to households and small businesses. Among the forms of credit on which the program is currently focused are auto loans, credit card loans, student loans, and loans guaranteed by the Small Business Administration. We are currently reviewing other types of credit for possible inclusion in this program. ... Restoring stability to the market for housing and home mortgages has been a particular area of concern. To address this problem, the Fed has employed a third type of policy tool - namely, buying securities in the open market. The FOMC [Federal Open Market Committee] has approved purchases of well over $1 trillion this year of mortgage-related securities guaranteed by the government-sponsored mortgage companies, Fannie Mae and Freddie Mac. Buying mortgage-related securities helps to drive down the interest rates that consumers pay on mortgages, and, indeed, the rate on a traditional 30-year fixed-rate mortgage has recently fallen to less than 5%, the lowest level since the 1940s." (Speech delivered at Morehouse College, Atlanta, Georgia, on April 14, 2009.)
Bernanke does not seem to understand the nature of credit. A bank lends deposits it receives from its depositors and from repayments of loans. When borrowers do not pay back, the bank no longer has the capital to lend. Bernanke interpreted the credit freeze as a liquidity problem and had little idea about the extent of frozen portfolios. His massive liquidity injection translated into a mountainous buildup of banks' holding of excess reserves that reached $862 billion as of end-April 2009 against less than $2 billion prior to September 2008.
Bernanke was fooling the public by saying he wanted to free up the flow of credit to households and small business, forgetting that most of outstanding loans to households and small business were simply lost and written down. He forgot the bailouts he extended under the Troubled Asset Relief Program to banks in replacement of lost portfolio. He was oblivious about the nature of credit.
Banks accord credit to borrowers from the savings of their depositors. The Fed does not receive deposits from households; it is not intermediating between savings and lending and therefore cannot be considered to be freeing up credit. It is purely creating money out of thin air. As such, the Fed has become a taxing authority that confiscates wealth and redistributes it to lucky borrowers. The new mandate for taxation and redistribution has been self-attributed by Bernanke. Other new mandates were insuring the highest car sales and highest credit card, student, and small business loans. Bernanke has also extended his role to the housing market, with the aim of preventing a downward adjustment of housing prices and pushing down interest rates. Bernanke wanted to renew the speculative euphoria that characterized the housing market under his predecessor Alan Greenspan.
Bernanke does not believe in any regulation of the financial system. By pushing trillion of dollars in liquidity to the sub-prime market, he is likely to bankrupt the Fed within a few short years. Loans pushed on borrowers will never be repaid. Moreover, consumer loans by definition finance consumption. Contrary to investment loans that generate income for their repayment, consumer loans generate no income and cannot be repaid. A stress test applied to the Fed itself would surely predict a huge lost portfolio.
While banks have already been bankrupted and are no longer ready to play out in the hands of Bernanke again, he has decided to go on his own, turning a central bank into an all-encompassing institution, showering free money to consumers and reaching out once again to ninja's - no income, no job, no asset, borrowers. The injection of over $1.25 trillion in mortgages is already setting off another speculative wave, with speculators surging everywhere after high commissions and profits and enticing borrowers into cheap loans that are secured by Bernanke's Fed.
Bernanke considered the rise in car sales as a sign of economic recovery. When Bernanke has become himself the car dealer of the US, handing out luxury cars for free, could this rise in car sales be considered as a sign of recovery? Certainly, the rise in car sales did not reflect savings and growth in the economy. It only reflected Bernanke's overly cheap monetary policy. Bernanke's successor will be saddled with trillions of dollars in bad loans and faced with uncontrollable inflation. A Fed saddled by a mountain of bad debt should be the cause of serious concern for Obama.
Most astonishing of Bernanke's magic tricks is to turn bailout banks into record-profit-making banks in such a record time, while Geithner is still setting up his toxic asset banks. The TARP money served to pay bonuses to managers. Why not use some for paying bonuses to stockholders? Moreover, the Fed is paying an interest on excess reserves held by banks following massive liquidity injection. That interest could be considered as another subsidy to banks that contributes to create illusory profits and the mirage of economic recovery. Banks' profits are not rising from real economic activity and are pure bailout money and subsidies from the state.
How much credibility could be accorded to the soothsayers Bernanke and Geithner? It would be safer to talk about recovery when it really has occurred and strengthened over a period of a few quarters, not through distorted indicators such as those manipulated by Bernanke, but through real GDP growth and a pick up in general employment. If durable growth occurs in such incredible fiscal and monetary chaos, then the disastrous experience of countries that undertook these policies would be baffling. Namely, Zimbabwe should not have experienced four digit inflation and its employment and real income should have grown at highest possible rates.
High US inflation, while not admitted by US policy makers, has eroded real income, had reduced dramatically food consumption, and has certainly caused rising unemployment. The more an economy is inflated, the more its real activity is deflated and the more unemployment rises. The creation of money out of thin air could lead to starvation. Others have called it counterfeiting. Counterfeiters could bring as much stimulus and confiscation as does Bernanke's money creation.
Paul Volcker applied prudent central banking soon after his appointment as Fed chairman in 1979 and achieved a durable recovery in a financial environment of strong and healthy banks by tightening monetary policy and allowing the federal funds rate to remain at 19% for several quarters. He did not invent tricks. Bernanke had caused financial disorder by pushing his theory of anti-Great Depression ever since he was appointed as a governor in 2002 and later as a chair of the Fed in 2006.
He announced recovery with zero interest rates, bankrupted financial system, unorthodox central banking, and most expansionary money creation in the US history. He has kept on inventing tricks and showing genius and innovation. Certainly there is a huge dichotomy between Volcker's plain-vanilla prudent banking and Bernanke's advanced and dangerous financial engineering. But it can be easily solved when we recognize that all roads lead to Rome.
While the Volcker recovery proved to be real, the Bernanke pick-up has so far been a mirage. Bernanke has announced that the Fed credit is to expand to $4 trillion by end-2009. Besides the effects of a breakout of the swine flu, over the coming months and years we also have the results of the Bernanke credit breakout to look forward to.
**Hossein Askari is professor of international business and international affairs at George Washington University. Noureddine Krichene is an economist at the International Monetary Fund and a former advisor, Islamic Development Bank, Jeddah.
***************************************
The mirage of recovery
By Hossein Askari and Noureddine Krichene **
Source: http://www.atimes.com/
Over recent days, observing a sudden increase in car sales and record profits of "bankrupt" banks, Federal Reserve chairman Ben Bernanke has announced that recovery of the US economy was under way. Treasury Secretary Timothy Geithner echoed the same message and even "globalized" his prediction of a recovery for the world economy. President Barack Obama saw "glimmers of hope". While these three top US policymakers were rushing to announce recovery, economist Paul Krugman exuded skepticism, saying "do not count your recoveries before they are hatched".
US policymakers' optimism seems to be founded on their grandiose reflationary programs. Obama has launched an unprecedented stimulus package at US$787 billion, followed by the largest US fiscal deficit ever, at $1.85 trillion, or 13% of gross domestic product (GDP). Underlying the stimulus package and the fiscal deficit was a Harvard income multiplier of 1.5, implying an increase in the US real GDP by about $4 trillion, or a record 30% per year. The basic economics advocated by the Obama team were simple: trillions of dollars in stimulus package and government expenditures would boost real aggregate demand for consumption and investment and automatically lead to economic recovery and full employment. Their mechanical multiplier model provided a strong reason for Obama to announce a premature economic recovery.
Bernanke's optimism is the result of the aggressive monetary policy that he forced under the George W Bush administration and has continued to expound under Obama, irrespective of the devastation it has caused to the banking sector and subsequent fiscal bailouts. Bernanke has gained the reputation of the doctor of the "Great Depression" and proponent of monetary anarchy. For him and his school of thought, inflation seems to be of little concern. His aggressive monetary policy has sent the US economy, and with it the world economy, into financial collapse and recession.
Yet, doctor Bernanke kept strong faith in his aggressive anti-Great Depression medicine. Besides forcing interest rates to zero, never seen in the monetary history of the US, he decided to unleash money supply by expanding the credit of the Federal Reserve from $700 billion prior to August 2007 to $2.3 trillion by end April 2009. Doctor Bernanke's reasoning was simple: zero interest rates combined with unlimited credit to the sub-prime markets ought to hike up aggregate demand in such a powerful way that it blasts away recession and secures fast growth and full employment.
The recent cheers for Geithner were based on similar reasoning, however, transplanted at the world economic level. A Group of 20 stimulus package of $5 trillion, on the top of a commitment by the G-20 countries to undertake the most expansionary fiscal and monetary policy, combined with free lending to any country in any amount, that would in their view guarantee a fast and strong world economic recovery.
Neither G-20 policymakers nor the US seem to recognize that the current recession was the product of overly expansionary fiscal and monetary policies during the past decade. Obviously, these policies yielded a temporary high demand-led economic growth during the 2002-2007 period accompanied by the highest commodity price inflation in recent memory; however, they also triggered a food and energy crisis, general bankruptcies in form of meltdown of sub-prime loans, an economic recession and trillion of dollars of bailouts in the US and Europe that socialized financial losses. These bailouts will weigh on economic growth for a long time in the future.
These same policies are now being replayed around the world. The supporters of these policies claim to be innovative as if for the first time in history they were implementing voluminous fiscal expansion and the free printing of money. Yet these policies were used time and again in the past with startling examples such as the German hyperinflation in 1920-23, Latin American hyperinflations in 1950-1985, and the more recent Mobutu and Mugabe hyperinflations.
In all cases where these policies were tried, there was devastating inflation, a substantial decline in real income and a considerable impoverishment and social malaise. Notwithstanding historical evidence against rapid monetary and fiscal expansionism, G-20 policymakers and the US now believe in success of super inflationary policies.
US policymakers diagnosed the current crisis as lack of demand for goods and services and large excess savings in the form of a piling up of food and energy goods in the US, and totally dismissed the large external deficits that reached about 6% of GDP in recent years and negative national savings. They believed in deflation when housing, food, and energy inflation was crippling the economy. The refusal to link the Bush administration's war spending and excessively expansionary fiscal and monetary policies and the current financial crisis has been a main stratagem in the speeches of Fed officials.
Bernanke blamed the financial crisis on China and on oil exporters who invested their balance of payments surplus in the US, leading to low interest rates and a credit boom in the US, thus denying Fed influence on interest rates and credit creation. Certainly, Bernanke did not understand that China and oil exporters do not decide the US current account deficit.
Often, Bernanke has noted that the Fed's mandate from the Congress was to promote maximum sustainable employment and stable prices. The failure of the Fed to achieve either or both objectives has been quite recurrent over the past decades. Bernanke's aggressive policy since August 2007 has even triggered stagflation: rising unemployment and inflation. It would be more natural to have a central bank with one single mandate - to preserve the value of money.
Bernanke has simply dismissed traditional central banking and decided, based on his own Great Depression doctrine, to go beyond the twin mandates that were prescribed by the Congress and to create high-risk instruments that go beyond traditional government bonds held by a central bank for open market operations. No central bank has the mandate to lend directly to non-depository banks or to the private sector. That would constitute a violation of standard central banking practice. No government in the world would allow its central bank to violate its mandate and hold assets other than government bonds and member banks' discounts. The arbitrary and overly discretionary power of Bernanke can be illustrated by the following passage from Bernanke:
"More recently, the Federal Reserve has also initiated a lending program, with the cooperation of the Treasury, designed to free up the flow of credit to households and small businesses. Among the forms of credit on which the program is currently focused are auto loans, credit card loans, student loans, and loans guaranteed by the Small Business Administration. We are currently reviewing other types of credit for possible inclusion in this program. ... Restoring stability to the market for housing and home mortgages has been a particular area of concern. To address this problem, the Fed has employed a third type of policy tool - namely, buying securities in the open market. The FOMC [Federal Open Market Committee] has approved purchases of well over $1 trillion this year of mortgage-related securities guaranteed by the government-sponsored mortgage companies, Fannie Mae and Freddie Mac. Buying mortgage-related securities helps to drive down the interest rates that consumers pay on mortgages, and, indeed, the rate on a traditional 30-year fixed-rate mortgage has recently fallen to less than 5%, the lowest level since the 1940s." (Speech delivered at Morehouse College, Atlanta, Georgia, on April 14, 2009.)
Bernanke does not seem to understand the nature of credit. A bank lends deposits it receives from its depositors and from repayments of loans. When borrowers do not pay back, the bank no longer has the capital to lend. Bernanke interpreted the credit freeze as a liquidity problem and had little idea about the extent of frozen portfolios. His massive liquidity injection translated into a mountainous buildup of banks' holding of excess reserves that reached $862 billion as of end-April 2009 against less than $2 billion prior to September 2008.
Bernanke was fooling the public by saying he wanted to free up the flow of credit to households and small business, forgetting that most of outstanding loans to households and small business were simply lost and written down. He forgot the bailouts he extended under the Troubled Asset Relief Program to banks in replacement of lost portfolio. He was oblivious about the nature of credit.
Banks accord credit to borrowers from the savings of their depositors. The Fed does not receive deposits from households; it is not intermediating between savings and lending and therefore cannot be considered to be freeing up credit. It is purely creating money out of thin air. As such, the Fed has become a taxing authority that confiscates wealth and redistributes it to lucky borrowers. The new mandate for taxation and redistribution has been self-attributed by Bernanke. Other new mandates were insuring the highest car sales and highest credit card, student, and small business loans. Bernanke has also extended his role to the housing market, with the aim of preventing a downward adjustment of housing prices and pushing down interest rates. Bernanke wanted to renew the speculative euphoria that characterized the housing market under his predecessor Alan Greenspan.
Bernanke does not believe in any regulation of the financial system. By pushing trillion of dollars in liquidity to the sub-prime market, he is likely to bankrupt the Fed within a few short years. Loans pushed on borrowers will never be repaid. Moreover, consumer loans by definition finance consumption. Contrary to investment loans that generate income for their repayment, consumer loans generate no income and cannot be repaid. A stress test applied to the Fed itself would surely predict a huge lost portfolio.
While banks have already been bankrupted and are no longer ready to play out in the hands of Bernanke again, he has decided to go on his own, turning a central bank into an all-encompassing institution, showering free money to consumers and reaching out once again to ninja's - no income, no job, no asset, borrowers. The injection of over $1.25 trillion in mortgages is already setting off another speculative wave, with speculators surging everywhere after high commissions and profits and enticing borrowers into cheap loans that are secured by Bernanke's Fed.
Bernanke considered the rise in car sales as a sign of economic recovery. When Bernanke has become himself the car dealer of the US, handing out luxury cars for free, could this rise in car sales be considered as a sign of recovery? Certainly, the rise in car sales did not reflect savings and growth in the economy. It only reflected Bernanke's overly cheap monetary policy. Bernanke's successor will be saddled with trillions of dollars in bad loans and faced with uncontrollable inflation. A Fed saddled by a mountain of bad debt should be the cause of serious concern for Obama.
Most astonishing of Bernanke's magic tricks is to turn bailout banks into record-profit-making banks in such a record time, while Geithner is still setting up his toxic asset banks. The TARP money served to pay bonuses to managers. Why not use some for paying bonuses to stockholders? Moreover, the Fed is paying an interest on excess reserves held by banks following massive liquidity injection. That interest could be considered as another subsidy to banks that contributes to create illusory profits and the mirage of economic recovery. Banks' profits are not rising from real economic activity and are pure bailout money and subsidies from the state.
How much credibility could be accorded to the soothsayers Bernanke and Geithner? It would be safer to talk about recovery when it really has occurred and strengthened over a period of a few quarters, not through distorted indicators such as those manipulated by Bernanke, but through real GDP growth and a pick up in general employment. If durable growth occurs in such incredible fiscal and monetary chaos, then the disastrous experience of countries that undertook these policies would be baffling. Namely, Zimbabwe should not have experienced four digit inflation and its employment and real income should have grown at highest possible rates.
High US inflation, while not admitted by US policy makers, has eroded real income, had reduced dramatically food consumption, and has certainly caused rising unemployment. The more an economy is inflated, the more its real activity is deflated and the more unemployment rises. The creation of money out of thin air could lead to starvation. Others have called it counterfeiting. Counterfeiters could bring as much stimulus and confiscation as does Bernanke's money creation.
Paul Volcker applied prudent central banking soon after his appointment as Fed chairman in 1979 and achieved a durable recovery in a financial environment of strong and healthy banks by tightening monetary policy and allowing the federal funds rate to remain at 19% for several quarters. He did not invent tricks. Bernanke had caused financial disorder by pushing his theory of anti-Great Depression ever since he was appointed as a governor in 2002 and later as a chair of the Fed in 2006.
He announced recovery with zero interest rates, bankrupted financial system, unorthodox central banking, and most expansionary money creation in the US history. He has kept on inventing tricks and showing genius and innovation. Certainly there is a huge dichotomy between Volcker's plain-vanilla prudent banking and Bernanke's advanced and dangerous financial engineering. But it can be easily solved when we recognize that all roads lead to Rome.
While the Volcker recovery proved to be real, the Bernanke pick-up has so far been a mirage. Bernanke has announced that the Fed credit is to expand to $4 trillion by end-2009. Besides the effects of a breakout of the swine flu, over the coming months and years we also have the results of the Bernanke credit breakout to look forward to.
**Hossein Askari is professor of international business and international affairs at George Washington University. Noureddine Krichene is an economist at the International Monetary Fund and a former advisor, Islamic Development Bank, Jeddah.
Tuesday, May 5, 2009
The Real Case for a Gold Standard
There are many perceptions concerning the usage of gold as money, many of which are either misplaced or misunderstood. A recent article in the Financial Times is a clear example of the couple of widely accepted, yet simply wrong, comments that circulate popular press. In this post I will highlight these and provide reasons that should give more clarity on the issue.
The article claims that “it is effectively impossible for gold to replace the dollar” as an international reserve currency. While this a true statement, it does not provide an explanation supporting this argument. Since time immemorial gold has served as money. This fact alone precluded governments from absolutely controlling the means of production in an economy without using outright force. This means individuals have the liberty to pursue their own affairs as they deem fit, without much interference from a central authority. Therefore, gold as an international reserve currency in effect creates a ceiling in terms of the activities governments want to perform. From about 1870 until 1913, the world operated on money fully-backed by gold. It is of no coincidence that during this time world production boon on the back of foreign investment. Monetary stability reduces risk premia, thus stimulating capital mobility. Under the gold standard all governments must surrender central bank policy tools, since overt interference in the market by printing more currency than allowed by gold deposits would lead to its sharp sell-off. Ambitious governments, i.e. those that have pursuits that extend beyond domestic borders, detest the idea of a gold standard. The gold standard was discontinued due to the advent of WWI because governments did not have the sufficient money backed by gold to pay for the human slaughterhouse (aka war); therefore they abandoned it and turned to simply printing money.
The article further claims “the logistical issues with replacing the dollar with gold as means of payment are hard to overcome.” This is an outright exaggeration and unfounded. If this were true, how could the gold standard have lasted uninterrupted between 1870-1913? The logistics of gold settlement for international transactions are not at all different than the process to clear checks between international banks. Central Banks could simply perform an accounting entry in their books to the foreign bank’s book transferring ownership of the commodity. Dollars, Yuans, Yens, Pesos, etc. would not disappear. On the contrary they would represent different names (currencies) for the same money everywhere (gold). As a result, there is no need of “actually shipping it from one continent to another, the shipping security, etc.” If a country were to print currency without the appropriate gold backing, other countries would present the first with the excess printed money for redemption. Since 1971 the world desisted from operating under a gold standard. This continues to be true today.
Mainstream economists, including the so-call “free-market” economists from the Chicago School, disdain gold as money. They claim that it is inherently unstable in terms of prices. Yet, empirically this perception is false. Take a look at the following chart. The data are obtained from the Minneapolis Federal Reserve. You will notice that the CPI is anything but stable particularly post-1971.
The article claims that “it is effectively impossible for gold to replace the dollar” as an international reserve currency. While this a true statement, it does not provide an explanation supporting this argument. Since time immemorial gold has served as money. This fact alone precluded governments from absolutely controlling the means of production in an economy without using outright force. This means individuals have the liberty to pursue their own affairs as they deem fit, without much interference from a central authority. Therefore, gold as an international reserve currency in effect creates a ceiling in terms of the activities governments want to perform. From about 1870 until 1913, the world operated on money fully-backed by gold. It is of no coincidence that during this time world production boon on the back of foreign investment. Monetary stability reduces risk premia, thus stimulating capital mobility. Under the gold standard all governments must surrender central bank policy tools, since overt interference in the market by printing more currency than allowed by gold deposits would lead to its sharp sell-off. Ambitious governments, i.e. those that have pursuits that extend beyond domestic borders, detest the idea of a gold standard. The gold standard was discontinued due to the advent of WWI because governments did not have the sufficient money backed by gold to pay for the human slaughterhouse (aka war); therefore they abandoned it and turned to simply printing money.
The article further claims “the logistical issues with replacing the dollar with gold as means of payment are hard to overcome.” This is an outright exaggeration and unfounded. If this were true, how could the gold standard have lasted uninterrupted between 1870-1913? The logistics of gold settlement for international transactions are not at all different than the process to clear checks between international banks. Central Banks could simply perform an accounting entry in their books to the foreign bank’s book transferring ownership of the commodity. Dollars, Yuans, Yens, Pesos, etc. would not disappear. On the contrary they would represent different names (currencies) for the same money everywhere (gold). As a result, there is no need of “actually shipping it from one continent to another, the shipping security, etc.” If a country were to print currency without the appropriate gold backing, other countries would present the first with the excess printed money for redemption. Since 1971 the world desisted from operating under a gold standard. This continues to be true today.
Mainstream economists, including the so-call “free-market” economists from the Chicago School, disdain gold as money. They claim that it is inherently unstable in terms of prices. Yet, empirically this perception is false. Take a look at the following chart. The data are obtained from the Minneapolis Federal Reserve. You will notice that the CPI is anything but stable particularly post-1971.
(Note: Chart was obtained from: http://www.chartingstocks.net/wp-content/uploads/2009/02/cpi.png)
The solution to the current financial and economic crisis reveals that the foundation of the present monetary infrastructure has lacked sound footing. In effect, this represents an extraordinarily large Ponzi (or Madoff?) scheme, which eventually will come to an end. This already has begun.
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