According to HAYMEN advisors, the problem is not because banks don't trust each other - the problem is that THERE IS NO MONEY LEFT FOR THEM TO LEND TO EACH OTHER.
�We have argued for years now that there is not enough money at the bottom of the levered pyramid scheme the world has put together�
In the U.S. alone, with Lehman, AIG, Bear Stearns, Fannie, Freddie, WaMu, IndyMac, Countrywide, and the rest of the companies that have failed to date (any many more "on deck"), there are $8 TRILLLION of assets already in receivership, conservatorship, liquidation, or "parked" with a big brother.
Do you think the Government will be successful in purchasing illiquid assets off of the balance sheets of troubled companies? The odds (and the assets) are against them.
How long and deep will this recession be?
We are experiencing the global deflationary bust of all time. It will deflate the values of just about all assets. Anything and everything we own will decline precipitously in value. We are not perma-bears like some others, but we must be realistic about facing this terrible economic environment. Unlike many, we don't believe the problem is either isolated from the “real� economy, or limited to the U.S. or that the world will be rescued by the invincible Chinese economy.
The world economies have already hit the iceberg
As we all know, what we see on top of the water is only 10-20% of the mass of the full iceberg. In the grand scheme of it all, there is really nothing that can be done. Both the US and the world economy are headed for a financial winter the likes of which we have never seen before (unless you happen to have been alive in 1929).
- �the most frightening chart we have seen is one that compares total credit market debt to U.S. GDP. The average of this ratio over the last 100 years has been around 155%. This ratio peaked first heading into the Great Depression at 260% (after then falling back to 130%) but has now risen to an unprecedented 350%!�
We think we will see 10-12% unemployment, a 4-5% decline in GDP, and the equity markets could drop at least 70% from peak to trough.
THE WORLD HAS LOST HALF OF ITS EQUITY MARKET WEALTH ($29 TRILLION) since last October. The negative wealth effect will be DEVASTATING
In the U.S., we are only just beginning to see the strain of tighter credit on consumer spending. As corporate earnings decrease and workers are laid off, the cycle of delinquencies and defaults will get worse.
This deflationary bust will take MANY YEARS and MANY BANKRUPTCIES to play out
We are but one year into the mother of all credit crunches and two years into a housing decline. Don't be seduced by anyone telling you that “all will be fine� anytime soon.
�...the fundamental flaw in the governmental response is that it is trying to re-lever an already massively overleveraged system in a short-term attempt to halt an unavoidable cycle of asset price deflation. This policy prescription is like treating the withdrawal symptoms of our global credit addiction with another hit of heroin. Like any addict, one hit is never enough and the only question remains is how long it takes the global economy to ask for just one more…�
- To date, some $550 Billion has been written down by the world's financial institutions. In the United States alone, there is $10 TRILLION of "Prime" mortgage debt, $1.5 TRILLION of Alt-A mortgage debt, and $1.2 TRILLION of Subprime mortgage debt. Based on our assumptions, we believe we will see cumulative losses of AT LEAST 25% in Subprime, 20% in Alt-A, and 5% in Prime. Our expected default rates and severities imply that over $2.2 TRILLION of defaulted mortgage loans would result in AT LEAST $1.1 TRILLION of REAL LOSSES in mortgages IN THE U.S. ALONE.
Â
- There are $6 TRILLION of untapped bank lines of credit not included on U.S. bank balance sheets (with very little reserved for them). This represents more than 6x the total equity of the entire U.S. banking system. The banks simply DONT HAVE THE MONEY TO LEND. This decision signed the death warrants of the "independent" broker-dealer model.
  Â
- If we assume that CDS is evenly distributed (although Lehman just proved it isn't), and that we will see S&P's predicted 23% cumulative defaults on speculative grade nonfinancials by 2010, then we will see approximately $2.6 Trillion of CDS in default (we think this number is low). If we use a 60% recovery rate (Lehman's was only 8.625%), we could see at least ANOTHER $1 TRILLION of losses in CDS contracts alone. We would argue that CDS contracts are written on more dubious assets by nature. Â Â Â
�Fannie and Freddie spreads to US Treasury bonds have hit their highest levels EVER today. Now that they are nationalized and explicitly guaranteed, shouldn't they trade at the narrowest spread ever? The bottom line is that there is no money in the global system to buy this stuff. Globally, investors are tapped out, and the leverage in the system has to come down. We have no idea how this is supposed to happen in an “orderly� fashion.�
According to HAYMEN advisors, the problem is not because banks don't trust each other - the problem is that THERE IS NO MONEY LEFT FOR THEM TO LEND TO EACH OTHER.
�We have argued for years now that there is not enough money at the bottom of the levered pyramid scheme the world has put together�
In the U.S. alone, with Lehman, AIG, Bear Stearns, Fannie, Freddie, WaMu, IndyMac, Countrywide, and the rest of the companies that have failed to date (any many more "on deck"), there are $8 TRILLLION of assets already in receivership, conservatorship, liquidation, or "parked" with a big brother.
Do you think the Government will be successful in purchasing illiquid assets off of the balance sheets of troubled companies? The odds (and the assets) are against them.
How long and deep will this recession be?
We are experiencing the global deflationary bust of all time. It will deflate the values of just about all assets. Anything and everything we own will decline precipitously in value. We are not perma-bears like some others, but we must be realistic about facing this terrible economic environment. Unlike many, we don't believe the problem is either isolated from the “real� economy, or limited to the U.S. or that the world will be rescued by the invincible Chinese economy.
The world economies have already hit the iceberg
As we all know, what we see on top of the water is only 10-20% of the mass of the full iceberg. In the grand scheme of it all, there is really nothing that can be done. Both the US and the world economy are headed for a financial winter the likes of which we have never seen before (unless you happen to have been alive in 1929).
- �the most frightening chart we have seen is one that compares total credit market debt to U.S. GDP. The average of this ratio over the last 100 years has been around 155%. This ratio peaked first heading into the Great Depression at 260% (after then falling back to 130%) but has now risen to an unprecedented 350%!�
We think we will see 10-12% unemployment, a 4-5% decline in GDP, and the equity markets could drop at least 70% from peak to trough.
THE WORLD HAS LOST HALF OF ITS EQUITY MARKET WEALTH ($29 TRILLION) since last October. The negative wealth effect will be DEVASTATING
In the U.S., we are only just beginning to see the strain of tighter credit on consumer spending. As corporate earnings decrease and workers are laid off, the cycle of delinquencies and defaults will get worse.
This deflationary bust will take MANY YEARS and MANY BANKRUPTCIES to play out
We are but one year into the mother of all credit crunches and two years into a housing decline. Don't be seduced by anyone telling you that “all will be fine� anytime soon.
�...the fundamental flaw in the governmental response is that it is trying to re-lever an already massively overleveraged system in a short-term attempt to halt an unavoidable cycle of asset price deflation. This policy prescription is like treating the withdrawal symptoms of our global credit addiction with another hit of heroin. Like any addict, one hit is never enough and the only question remains is how long it takes the global economy to ask for just one more…�
- To date, some $550 Billion has been written down by the world's financial institutions. In the United States alone, there is $10 TRILLION of "Prime" mortgage debt, $1.5 TRILLION of Alt-A mortgage debt, and $1.2 TRILLION of Subprime mortgage debt. Based on our assumptions, we believe we will see cumulative losses of AT LEAST 25% in Subprime, 20% in Alt-A, and 5% in Prime. Our expected default rates and severities imply that over $2.2 TRILLION of defaulted mortgage loans would result in AT LEAST $1.1 TRILLION of REAL LOSSES in mortgages IN THE U.S. ALONE.
Â
- There are $6 TRILLION of untapped bank lines of credit not included on U.S. bank balance sheets (with very little reserved for them). This represents more than 6x the total equity of the entire U.S. banking system. The banks simply DONT HAVE THE MONEY TO LEND. This decision signed the death warrants of the "independent" broker-dealer model.
  Â
- If we assume that CDS is evenly distributed (although Lehman just proved it isn't), and that we will see S&P's predicted 23% cumulative defaults on speculative grade nonfinancials by 2010, then we will see approximately $2.6 Trillion of CDS in default (we think this number is low). If we use a 60% recovery rate (Lehman's was only 8.625%), we could see at least ANOTHER $1 TRILLION of losses in CDS contracts alone. We would argue that CDS contracts are written on more dubious assets by nature. Â Â Â
�Fannie and Freddie spreads to US Treasury bonds have hit their highest levels EVER today. Now that they are nationalized and explicitly guaranteed, shouldn't they trade at the narrowest spread ever? The bottom line is that there is no money in the global system to buy this stuff. Globally, investors are tapped out, and the leverage in the system has to come down. We have no idea how this is supposed to happen in an “orderly� fashion.�
30 October 2008
A dam burst and helicopter drop all at once?
As I've recently been noting, the Treasury is sitting on a pile of cash- we might, recalling Fed Chairman Bernanke's idea of a "helicopter drop" of money, consider this one huge payload.
At 4PM today (when the Treasury posts its daily statement) I found that the helicopter has begun to drop its payload. $115B of TARP money was distributed, which leaves $593B left to drop.
Coincidentally, the Fed decided to drop its key rates by 50 basis points, bringing the Funds rate down to 1%.
Additionally, the Fed announced: Today, the Federal Reserve, the Banco Central do Brasil, the Banco de Mexico, the Bank of Korea, and the Monetary Authority of Singapore are announcing the establishment of temporary reciprocal currency arrangements (swap lines). These facilities, like those already established with other central banks, are designed to help improve liquidity conditions in global financial markets and to mitigate the spread of difficulties in obtaining U.S. dollar funding in fundamentally sound and well managed economies.
Of late, many financial commentators have noticed the wide spread between the Fed Funds rate and Libor rates. It seemed as if there was a dam keeping liquidity in the US and not allowing it to reach emerging markets starving for US$s.
With this Fed creation of new swap lines, that dam may be about to burst.
To recap, the Treasury has begun the release of 5% of GDP in financial sector recapitalization and direct credit market support, coupled with substantial declines in the Fed Funds rates, even more substantial increases in the monetary base and new Fed swap lines to emerging markets.
Now that's financial shock and awe!
or, if you prefer, a Tsunami allegory:
When a tsunami is unleashed, right before the waves start to hit, the water recedes dramatically and then begins to flood in....wave after wave.
Was the most recent substantial withdrawal of credit (and coincident decline in equity and commodity markets) the water receding before the Tsunami hits?
Link
At 4PM today (when the Treasury posts its daily statement) I found that the helicopter has begun to drop its payload. $115B of TARP money was distributed, which leaves $593B left to drop.
Coincidentally, the Fed decided to drop its key rates by 50 basis points, bringing the Funds rate down to 1%.
Additionally, the Fed announced: Today, the Federal Reserve, the Banco Central do Brasil, the Banco de Mexico, the Bank of Korea, and the Monetary Authority of Singapore are announcing the establishment of temporary reciprocal currency arrangements (swap lines). These facilities, like those already established with other central banks, are designed to help improve liquidity conditions in global financial markets and to mitigate the spread of difficulties in obtaining U.S. dollar funding in fundamentally sound and well managed economies.
Of late, many financial commentators have noticed the wide spread between the Fed Funds rate and Libor rates. It seemed as if there was a dam keeping liquidity in the US and not allowing it to reach emerging markets starving for US$s.
With this Fed creation of new swap lines, that dam may be about to burst.
To recap, the Treasury has begun the release of 5% of GDP in financial sector recapitalization and direct credit market support, coupled with substantial declines in the Fed Funds rates, even more substantial increases in the monetary base and new Fed swap lines to emerging markets.
Now that's financial shock and awe!
or, if you prefer, a Tsunami allegory:
When a tsunami is unleashed, right before the waves start to hit, the water recedes dramatically and then begins to flood in....wave after wave.
Was the most recent substantial withdrawal of credit (and coincident decline in equity and commodity markets) the water receding before the Tsunami hits?
Link
Copper kills superbugs no worries
Making door handles, taps and light switches from copper could help the country beat superbugs, scientists say.
A study found that copper fittings rapidly killed bugs on hospital wards, succeeding where other infection control measures failed.
In the trial at Selly Oak hospital, in Birmingham, copper taps, toilet seats and push plates on doors all but eliminated common bugs.
It is thought the metal 'suffocates' germs, preventing them breathing. It may also stop them from feeding and destroy their DNA.
Lab tests show that the metal kills off the deadly MRSA and C difficile superbugs.
It also kills other dangerous germs, including the flu virus and the E coli food poisoning bug.
Although the number of cases of MRSA and C difficile is falling, the two bugs still claim thousands of lives a year.
During the ten-week trial on a medical ward, a set of taps, a lavatory seat and a push plate on an entrance door were replaced with copper versions. They were swabbed twice a day for bugs and the results compared with a traditional tap, lavatory seat and push plate elsewhere in the ward.
The copper items had up to 95 per cent fewer bugs on their surface whenever they were tested, a U.S. conference on antibiotics heard yesterday.
Professor Tom Elliott, the lead researcher and a consultant microbiologist at the hospital, said: 'The findings of 90 to 95 per cent killing of those organisms, even after a busy day on a medical ward with items being touched by numerous people, is remarkable.
'I have been a consultant microbiologist for several decades. This is the first time I have seen anything like copper in terms of the effect it will have in the environment.
'It may well offer us another mechanism for trying to defeat the spread of infection.'
Researcher Professor Peter Lambert, of Aston University, Birmingham, said: 'The numbers decreased always on copper but not on the steel surfaces.'
If further hospital-based trials prove as successful, the researchers would like copper fixtures and fittings installed in hospitals around the country.
Doorknobs, taps, light switches, toilet seats and handles and bathroom 'grab rails' could all be ripped out and replaced with copper versions.
Link
A study found that copper fittings rapidly killed bugs on hospital wards, succeeding where other infection control measures failed.
In the trial at Selly Oak hospital, in Birmingham, copper taps, toilet seats and push plates on doors all but eliminated common bugs.
It is thought the metal 'suffocates' germs, preventing them breathing. It may also stop them from feeding and destroy their DNA.
Lab tests show that the metal kills off the deadly MRSA and C difficile superbugs.
It also kills other dangerous germs, including the flu virus and the E coli food poisoning bug.
Although the number of cases of MRSA and C difficile is falling, the two bugs still claim thousands of lives a year.
During the ten-week trial on a medical ward, a set of taps, a lavatory seat and a push plate on an entrance door were replaced with copper versions. They were swabbed twice a day for bugs and the results compared with a traditional tap, lavatory seat and push plate elsewhere in the ward.
The copper items had up to 95 per cent fewer bugs on their surface whenever they were tested, a U.S. conference on antibiotics heard yesterday.
Professor Tom Elliott, the lead researcher and a consultant microbiologist at the hospital, said: 'The findings of 90 to 95 per cent killing of those organisms, even after a busy day on a medical ward with items being touched by numerous people, is remarkable.
'I have been a consultant microbiologist for several decades. This is the first time I have seen anything like copper in terms of the effect it will have in the environment.
'It may well offer us another mechanism for trying to defeat the spread of infection.'
Researcher Professor Peter Lambert, of Aston University, Birmingham, said: 'The numbers decreased always on copper but not on the steel surfaces.'
If further hospital-based trials prove as successful, the researchers would like copper fixtures and fittings installed in hospitals around the country.
Doorknobs, taps, light switches, toilet seats and handles and bathroom 'grab rails' could all be ripped out and replaced with copper versions.
Link
29 October 2008
Bailout won't work: Shakespeare
Bailout won't work: Shakespeare aussiebear NEW 10/28/2008 6:43:12 PM
I can get no remedy against this consumption of the purse: borrowing only lingers and lingers it out, but the disease is incurable.
2 Henry IV (1.2.74)
RE: Bailout won''t work: Shakespeare holdgold NEW 10/28/2008 6:53:23 PM
Polonius to his son Laertes -
Polonius:
Neither a borrower nor a lender be,
For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry.
Hamlet Act 1, scene 3, 75–77
RE: Thanx for elevating the discourse. nm cyberbear NEW 10/28/2008 7:50:44 PM
I can get no remedy against this consumption of the purse: borrowing only lingers and lingers it out, but the disease is incurable.
2 Henry IV (1.2.74)
RE: Bailout won''t work: Shakespeare holdgold NEW 10/28/2008 6:53:23 PM
Polonius to his son Laertes -
Polonius:
Neither a borrower nor a lender be,
For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry.
Hamlet Act 1, scene 3, 75–77
RE: Thanx for elevating the discourse. nm cyberbear NEW 10/28/2008 7:50:44 PM
The truth about deflation - An iTulip.com must read!
The truth about deflation - iTulip.com Forums: "With all of this panicking into dollars we get asked a lot about deflation. 'Why don't you just admit that a 1930s style depression and deflation spiral has begun and soon there will be soup lines and we'll be buying cars for $2,000 and gold will trade at $100.' The reason is that we are 100% certain that dollar appreciation that we call 'Ka' as part of Ka-Poom Theory will not turn into a deflation spiral. Cars are not going to cost $2,000, although there will be plenty of cheap used cars for sale, and gold will not go to $200. Here's why.
The essence of Ka-Poom Theory is that after the phony credit-based boom ends, first the dollar rises and inflation falls before dollar repatriation and government reflation policies kick in. We don't think the transition from disinflation to inflation is trade-able because we expect it to be chaotic. But we don't blame readers for trying, or wanting to.
This ain't deflation
We're not nit picking terminology here. We’ll show you what a real deflation spiral looks like: nothing whatsoever like the deflation we are seeing today that we have long forecast and call disinflation to distinguish it from the run-away deflations that occurred under the gold standard in the pre Bretton Woods era.
Deflation was common back in the days when there was something for a currency to deflate against for more than a brief period of time before the government got involved: gold. Even then, governments often abandoned the gold to inflate the money supply to stop deflation, especially in times of war. If you are a government and need to inflate and there's no war to fight, then make something up–like a oil shortage in the 1970s."
http://www.itulip.com/forums/showthread.php?p=57193#post57193
The essence of Ka-Poom Theory is that after the phony credit-based boom ends, first the dollar rises and inflation falls before dollar repatriation and government reflation policies kick in. We don't think the transition from disinflation to inflation is trade-able because we expect it to be chaotic. But we don't blame readers for trying, or wanting to.
This ain't deflation
We're not nit picking terminology here. We’ll show you what a real deflation spiral looks like: nothing whatsoever like the deflation we are seeing today that we have long forecast and call disinflation to distinguish it from the run-away deflations that occurred under the gold standard in the pre Bretton Woods era.
Deflation was common back in the days when there was something for a currency to deflate against for more than a brief period of time before the government got involved: gold. Even then, governments often abandoned the gold to inflate the money supply to stop deflation, especially in times of war. If you are a government and need to inflate and there's no war to fight, then make something up–like a oil shortage in the 1970s."
http://www.itulip.com/forums/showthread.php?p=57193#post57193
We can't live on moonbeams and air ~ Feil
Or the orthodoxy of Equilibrium theory.
WE OFTEN believe that proverbs are true. "We learn from our mistakes" is an obvious example of a proverb that is demonstrably untrue in the rarified atmosphere of modelling for market economic policy development.
The depression of 1930, the credit squeeze of the early 1960s, the recessions of 1987 and 1991 and the current world economic meltdown all have one thing in common. They happened after a boom that people thought would never end. They resulted from market excesses and levels of consumer spending that ignored fundamental concepts such as living within your means.
The world economy in 2008 is a direct consequence of the view that markets should not be influenced by governments. The market and the consumer had to be free to make their own product development choices and consumer decisions.
Free-market economics has been the cornerstone of the Productivity Commission's philosophy for the past 30 years. At the same time Reserve Bank economists were also captured by free-market ideology. This led to their conclusion that the RBA should not intervene in the market except to manage the level of inflation.
Since then the RBA has had no role in managing Australia's foreign debt, which now stands at $650 billion.
This view followed the assumption that the debt was a consequence of transactions freely entered into by parties behaving rationally. Accordingly, the debt outcome was an efficient transaction decision.
For more than 20 years the RBA has focused its attention on inflation. This has been regarded by the past three governors of the Reserve as its fundamental task because inflation would result in higher prices, reduced consumer demand and a downturn in economic activity.
This is not really a large enough role for it. The Reserve's record of correctly guessing the right time to increase or decrease interest rates is not impressive.
In any case this is not a large enough role for the bank's high-powered staff.
The Reserve employs hundreds of clever economists and econometricians who have written a large number of erudite and well-researched papers on several issues relevant in the Australian economy. The papers are freely available in the publications section of the Reserve's website.
The Productivity Commission also employs hundreds of economists in what has become an almost inquisitorial commitment to free-market economics. They have burnt rent-seeking heretics for 30 years. They will not tolerate backsliders in their own ranks.
Many readers cannot follow the gist of the RBA and commission's research papers because they include substantial econometric analysis to model the outcomes from the data collected by the author.
Econometric modelling is a fundamental analytical tool of all professional economists. It operates on the basis that some assumptions are necessary to permit the modelling to proceed in an ordered and controlled manner.
The assumptions and conclusions should be tested empirically against outcomes and market behaviour.
Rational market behaviour is a key assumption in free-market theory. The theory is that if consumers act rationally then they will determine, through an unfettered price mechanism, the optimal way of allocating scarce resources in the market.
This theoretical assumption is wrong.
In his second edition of The Age of Turbulence, Alan Greenspan includes a new chapter on the current credit crisis. His discussion begins by patronising the reader.
"I feel sufficiently strongly about such modelling that I will pause here to address the issue. If you are not that interested in econometrics you are still welcome to read along or to meet me on the other side when the main discussion resumes on page 522."
The essence of what Greenspan says is on pages 520-521. "The essential problem is that our models - both risk models and economic models - are still too simple to capture the full array of critical variables that govern global economic reality. A model is an abstraction from the real world.
"Business cycle and financial models still do not adequately address the innate human responses that result in swings between euphoria and fear and repeat themselves generation after generation with little evidence of a learning curve.
"But forecasters' concerns should not be whether human response has been rational or irrational, only that it is observable and systematic. This to me is the large missing explanatory variable in both risk management and macroeconomic models."
The level of empirical research into Australian industry and markets by the Reserve and the commission has diminished in the past 30 years. This is because management has decided that they have arrived at some sort of eternal truth regarding the operation of the market and appropriate government policy for the Australian economy.
They justify their position by econometric models that are generally unintelligible to the rest of the population.
The models assume markets should be free of government intervention except in the case of market failure.
They have not measured the costs of such failure and they have not examined the types and levels of consumer irrationality that have persisted for decades in Australia.
For example, is it rational to have a credit card debt that requires an interest payment of 20.74%? Is it rational to waste the amount of money on alcohol, cigarettes, gambling and excessive imported consumer goods that we do?
Has it been rational to rack up deficits created by the excess of imports over exports for the past 20 years? We owe $700 billion and much of that is in US dollars.
Even more frightening is the other debt that banks, financial institutions, multinational subsidiaries and others owe overseas. These debts relate to loans not reflected in our current account data, which only covers merchandise trade and payments of interest, income and net imported services and intellectual property.
The reaction to this from the free-market economists may be to say that Greenspan is wrong. Not so long ago he had an aura of economic infallibility that was close to the papal level for religious encyclicals.
The only alternative to dismissing Greenspan's conclusion is not very palatable but is appropriate. Economists, like those in other professions, have to continue to inquire, learn and change.
They have to get out and test their hypotheses. It is too easy to sit back in the office or university and join the tribe of like-minded people. The free thinkers should not be marginalised and eliminated.
We are in a big hole but we will get out of it. We need to learn the lessons of the world meltdown. Lesson one is that we cannot make moonbeams and fresh air and live on them. The financial sector should confine its activities to storing, counting and helping us invest our money. It is not an engine of growth by itself. We have to make tangible things.
Lesson two is that we must resuscitate honest, intellectual scientific inquiry. It is absolutely necessary to develop a thesis about economic behaviour. It is then absolutely necessary to test empirically the thesis and to retest it as time passes.
Economists stopped that process of fundamental intellectual inquiry. It was much easier to recite the jargon and use the modelling that others had developed. Now is the time for some new thinking. Our best and brightest economists need to get their hands dirty.
Martin Feil is a tax and industry policy consultant and a former director of the Industries Assistance Commission.
WE OFTEN believe that proverbs are true. "We learn from our mistakes" is an obvious example of a proverb that is demonstrably untrue in the rarified atmosphere of modelling for market economic policy development.
The depression of 1930, the credit squeeze of the early 1960s, the recessions of 1987 and 1991 and the current world economic meltdown all have one thing in common. They happened after a boom that people thought would never end. They resulted from market excesses and levels of consumer spending that ignored fundamental concepts such as living within your means.
The world economy in 2008 is a direct consequence of the view that markets should not be influenced by governments. The market and the consumer had to be free to make their own product development choices and consumer decisions.
Free-market economics has been the cornerstone of the Productivity Commission's philosophy for the past 30 years. At the same time Reserve Bank economists were also captured by free-market ideology. This led to their conclusion that the RBA should not intervene in the market except to manage the level of inflation.
Since then the RBA has had no role in managing Australia's foreign debt, which now stands at $650 billion.
This view followed the assumption that the debt was a consequence of transactions freely entered into by parties behaving rationally. Accordingly, the debt outcome was an efficient transaction decision.
For more than 20 years the RBA has focused its attention on inflation. This has been regarded by the past three governors of the Reserve as its fundamental task because inflation would result in higher prices, reduced consumer demand and a downturn in economic activity.
This is not really a large enough role for it. The Reserve's record of correctly guessing the right time to increase or decrease interest rates is not impressive.
In any case this is not a large enough role for the bank's high-powered staff.
The Reserve employs hundreds of clever economists and econometricians who have written a large number of erudite and well-researched papers on several issues relevant in the Australian economy. The papers are freely available in the publications section of the Reserve's website.
The Productivity Commission also employs hundreds of economists in what has become an almost inquisitorial commitment to free-market economics. They have burnt rent-seeking heretics for 30 years. They will not tolerate backsliders in their own ranks.
Many readers cannot follow the gist of the RBA and commission's research papers because they include substantial econometric analysis to model the outcomes from the data collected by the author.
Econometric modelling is a fundamental analytical tool of all professional economists. It operates on the basis that some assumptions are necessary to permit the modelling to proceed in an ordered and controlled manner.
The assumptions and conclusions should be tested empirically against outcomes and market behaviour.
Rational market behaviour is a key assumption in free-market theory. The theory is that if consumers act rationally then they will determine, through an unfettered price mechanism, the optimal way of allocating scarce resources in the market.
This theoretical assumption is wrong.
In his second edition of The Age of Turbulence, Alan Greenspan includes a new chapter on the current credit crisis. His discussion begins by patronising the reader.
"I feel sufficiently strongly about such modelling that I will pause here to address the issue. If you are not that interested in econometrics you are still welcome to read along or to meet me on the other side when the main discussion resumes on page 522."
The essence of what Greenspan says is on pages 520-521. "The essential problem is that our models - both risk models and economic models - are still too simple to capture the full array of critical variables that govern global economic reality. A model is an abstraction from the real world.
"Business cycle and financial models still do not adequately address the innate human responses that result in swings between euphoria and fear and repeat themselves generation after generation with little evidence of a learning curve.
"But forecasters' concerns should not be whether human response has been rational or irrational, only that it is observable and systematic. This to me is the large missing explanatory variable in both risk management and macroeconomic models."
The level of empirical research into Australian industry and markets by the Reserve and the commission has diminished in the past 30 years. This is because management has decided that they have arrived at some sort of eternal truth regarding the operation of the market and appropriate government policy for the Australian economy.
They justify their position by econometric models that are generally unintelligible to the rest of the population.
The models assume markets should be free of government intervention except in the case of market failure.
They have not measured the costs of such failure and they have not examined the types and levels of consumer irrationality that have persisted for decades in Australia.
For example, is it rational to have a credit card debt that requires an interest payment of 20.74%? Is it rational to waste the amount of money on alcohol, cigarettes, gambling and excessive imported consumer goods that we do?
Has it been rational to rack up deficits created by the excess of imports over exports for the past 20 years? We owe $700 billion and much of that is in US dollars.
Even more frightening is the other debt that banks, financial institutions, multinational subsidiaries and others owe overseas. These debts relate to loans not reflected in our current account data, which only covers merchandise trade and payments of interest, income and net imported services and intellectual property.
The reaction to this from the free-market economists may be to say that Greenspan is wrong. Not so long ago he had an aura of economic infallibility that was close to the papal level for religious encyclicals.
The only alternative to dismissing Greenspan's conclusion is not very palatable but is appropriate. Economists, like those in other professions, have to continue to inquire, learn and change.
They have to get out and test their hypotheses. It is too easy to sit back in the office or university and join the tribe of like-minded people. The free thinkers should not be marginalised and eliminated.
We are in a big hole but we will get out of it. We need to learn the lessons of the world meltdown. Lesson one is that we cannot make moonbeams and fresh air and live on them. The financial sector should confine its activities to storing, counting and helping us invest our money. It is not an engine of growth by itself. We have to make tangible things.
Lesson two is that we must resuscitate honest, intellectual scientific inquiry. It is absolutely necessary to develop a thesis about economic behaviour. It is then absolutely necessary to test empirically the thesis and to retest it as time passes.
Economists stopped that process of fundamental intellectual inquiry. It was much easier to recite the jargon and use the modelling that others had developed. Now is the time for some new thinking. Our best and brightest economists need to get their hands dirty.
Martin Feil is a tax and industry policy consultant and a former director of the Industries Assistance Commission.
Henderson has no cred ~ Howard apologist and dingbat
Picking on Steve Keen for pointing out we are doomed and calling for alternate views when the whole wealth management business is selling "stocks for the long term". I mean really, what is Henderson but an apologist for the status quo.
Steve Keen (UWS) vs. Gerard Henderson (SMH)
October 21, 2008 – 1:32 pm, by Trevor Cook
Gerard Henderson attacked Keen in the SMH this morning and Keen has promptly responded on his blog this morning (and carried in Crikey).
As Crikey reported:
On the other hand, Henderson does not convey the reality that Keen is far from being a latecomer to the idea that debt will lead to doom. In fact, much of Keen’s long career as an economist has been focused on this idea that escalating debt would eventually lead to an awful bust. For instance, Keen says in his rebuttal:
I made a submission to the Wallis Committee in July 1996, in which I warned that securitisation of loans could lead to a crisis exactly like the Subprime crisis that has now unfolded—and of course my comments were ignored.
I wrote to the RBA in June 1998 offering to hold a seminar on the “Financial Instability Hypothesis”, which is the foundation of my argument that we are likely to experience a Great Depression. The offer was declined.
Henderson was remiss in not pointing out the longevity, consistency and genuineness of Keen’s views.
In addition, Henderson’s glancing dig at the University of Western Sydney as a ’suburban’ university was a revealing insight into his own elitism:
It’s not often that a middle-aged academic from a suburban university receives such coverage in the popular press.
Indeed, perhaps Henderson could offer some guidance to journalists on which universities are suitable places to find academics for future commentary.
Steve Keen (UWS) vs. Gerard Henderson (SMH)
October 21, 2008 – 1:32 pm, by Trevor Cook
Gerard Henderson attacked Keen in the SMH this morning and Keen has promptly responded on his blog this morning (and carried in Crikey).
As Crikey reported:
On the other hand, Henderson does not convey the reality that Keen is far from being a latecomer to the idea that debt will lead to doom. In fact, much of Keen’s long career as an economist has been focused on this idea that escalating debt would eventually lead to an awful bust. For instance, Keen says in his rebuttal:
I made a submission to the Wallis Committee in July 1996, in which I warned that securitisation of loans could lead to a crisis exactly like the Subprime crisis that has now unfolded—and of course my comments were ignored.
I wrote to the RBA in June 1998 offering to hold a seminar on the “Financial Instability Hypothesis”, which is the foundation of my argument that we are likely to experience a Great Depression. The offer was declined.
Henderson was remiss in not pointing out the longevity, consistency and genuineness of Keen’s views.
In addition, Henderson’s glancing dig at the University of Western Sydney as a ’suburban’ university was a revealing insight into his own elitism:
It’s not often that a middle-aged academic from a suburban university receives such coverage in the popular press.
Indeed, perhaps Henderson could offer some guidance to journalists on which universities are suitable places to find academics for future commentary.
Another reason for the credit crunch
As for this most recent phase of the withdrawal of credit, which has caused financial crises for a series of emerging economies in eastern Europe, Asia and South America (see "Now there are runs on countries") and also global falls in share prices, it was in a way wholly foreseeable.
It was caused, to a large extent, by an exceptional and unprecedented shrinkage in the prime brokerage industry, which in turn led to a serious reduction in the volume of credit extended to hedge funds, which in turn forced hedge funds to sell assets, especially those perceived as higher risk.
This contraction in loans provide through prime brokers was the inevitable consequence of the collapse of Lehman, but also - far more importantly - of the recent conversion into banks of Morgan Stanley and Goldman Sachs.
Morgan Stanley and Goldman are - by far - the biggest prime brokers, with Morgan Stanley the number one.
But as banks, they're prevented by regulators from lending as much relative to their capital resources as they had been as securities firms.
So the US authorities should have known - and presumably did know - that by allowing Morgan Stanley and Goldman to become banks they were in effect forcing a serious contraction in the hedge-fund industry, which in turn would lead to sales of all manner of assets held by hedge funds and precipitate turmoil throughout the financial economy.
Which, as if you needed telling, only goes to show that regulatory intervention carried out with the best of intentions can have consequences that - in the short term at least - can be very painful.
It was caused, to a large extent, by an exceptional and unprecedented shrinkage in the prime brokerage industry, which in turn led to a serious reduction in the volume of credit extended to hedge funds, which in turn forced hedge funds to sell assets, especially those perceived as higher risk.
This contraction in loans provide through prime brokers was the inevitable consequence of the collapse of Lehman, but also - far more importantly - of the recent conversion into banks of Morgan Stanley and Goldman Sachs.
Morgan Stanley and Goldman are - by far - the biggest prime brokers, with Morgan Stanley the number one.
But as banks, they're prevented by regulators from lending as much relative to their capital resources as they had been as securities firms.
So the US authorities should have known - and presumably did know - that by allowing Morgan Stanley and Goldman to become banks they were in effect forcing a serious contraction in the hedge-fund industry, which in turn would lead to sales of all manner of assets held by hedge funds and precipitate turmoil throughout the financial economy.
Which, as if you needed telling, only goes to show that regulatory intervention carried out with the best of intentions can have consequences that - in the short term at least - can be very painful.
New order needed ~ China
By Gao Zugui (China Daily)
Updated: 2008-10-27 07:5
The world is facing a series of challenges, ranging from financial crisis, grain and energy safety, environmental deterioration, climate change, natural calamities and poverty to terrorism. Directly related with mankind's survival, development and security, these challenges have also accelerated transformation of the established international order.
Founded after the end of World War II, the world's existent structure once suffered severe impacts caused by national liberation movements launched across Asia, Africa and Latin America in the 1950s and 60s, oil and international financial crises in the 1970s, as well as the disintegration of the Soviet Union and upheavals in Eastern European countries in the 1990s.
With development in the past decades, other major powers have continuously narrowed their gap with the US in terms of economic strength, and a kind of power equilibrium among themselves has also taken shape. Under these circumstances, the world is thought to have entered a post-US era. The emergence of some regional groups of economies and the rapid rise of some big developing powers have promoted great changes to the world's decades-long power establishments and accelerated its steps toward multi-polarization.
That more strengthened international cooperation is needed in coping with the growing number of global issues demonstrates that any attempt to simply patch up the current international order, especially its core rules and mechanisms, could not reflect the world's changed power configuration.
For example, the world's nuclear non-proliferation system remains impotent to handle the intractable proliferation issue; the UN Environment Program (UNEP) and the Food and Agriculture Organization (FAO) are unable to effectively handle the global climate change and grain security issues; the WTO, the IMF and the World Bank (WB) have become impotent in the face of strengthened trade protectionism and deteriorating international financial crisis. The global system is now in a worsening situation and world's multilateral bodies need to be reformed, as a cover story in the Economist magazine on July 5 puts it.
But it is impossible to completely overturn the existent international order and then frame a new one. Past experiences show a gradual reform model is an acceptable-to-all option in the restructuring of the world's system.
As a matter of fact, international rules and systems have experienced some tangible changes under the efforts of the whole international community since 2005. The UN has dismantled its Trusteeship Council and set up a Peace-building Commission in its stead. The world's largest multilateral body has elevated the status of the human rights issue and listed it as one of the body's three pillars alongside the issues of peace and security. It has also substituted the more powerful Human Rights Council for the obsolete Human rights Commission and put the organ only behind the Security Council and Economic and Social Council in its importance.
After years of development, the reform of international rules and mechanisms is being deepened and some principles related to human rights are now under discussion to become the basic norm of international relations. The IMF has adjusted its voting power distribution and is stepping up discussion about setting up a system to monitor the Sovereign Wealth Fund and international floating capital.
To effectively deal with global climate change, food crisis and humanitarian aid, the UN, the WHO and other bodies have made a step forward in exploring a new mechanism and model to deal with global crisis and raise their international status.
The ongoing international financial tsunami is engulfing the whole world, seriously hindering the development of the world's economy. The infectious crisis, which has inflicted huge impacts upon some developed European and American nations, has also prompted the international community to muse over the direction of the world's future.
To stem the most serious economic crisis since the 1930s, calls for reforming the existing international order have remained increasingly high and efforts to set up a more cooperative mechanism to solve the plaguing issue have also been strengthened.
British Prime Minister Gordon Brown has proposed to hold a global summit between state heads of the US, EU, China, Japan and India in November or December, to discuss how to rebuild the Bretton Woods system. WB President Robert Zoellick has explicitly cautioned that the foundation of the past US-dominated international establishment has already been shaken. He has also pointed to the ineptness of the Group-7 industrialized nations in dealing with changed international situations and proposed to give Brazil, China, India, Russia, Mexico, South Korea and Saudi Arabia a role in the decision-making of some international issues to structure a new 7 plus 7 multilateral organization.
There are reasons to expect more headway the international society will achieve in pushing for a new international order after it survives the ongoing turbulence.
The author is director of the Center of Strategic Studies, China Institute of Contemporary International Relations.
Updated: 2008-10-27 07:5
The world is facing a series of challenges, ranging from financial crisis, grain and energy safety, environmental deterioration, climate change, natural calamities and poverty to terrorism. Directly related with mankind's survival, development and security, these challenges have also accelerated transformation of the established international order.
Founded after the end of World War II, the world's existent structure once suffered severe impacts caused by national liberation movements launched across Asia, Africa and Latin America in the 1950s and 60s, oil and international financial crises in the 1970s, as well as the disintegration of the Soviet Union and upheavals in Eastern European countries in the 1990s.
With development in the past decades, other major powers have continuously narrowed their gap with the US in terms of economic strength, and a kind of power equilibrium among themselves has also taken shape. Under these circumstances, the world is thought to have entered a post-US era. The emergence of some regional groups of economies and the rapid rise of some big developing powers have promoted great changes to the world's decades-long power establishments and accelerated its steps toward multi-polarization.
That more strengthened international cooperation is needed in coping with the growing number of global issues demonstrates that any attempt to simply patch up the current international order, especially its core rules and mechanisms, could not reflect the world's changed power configuration.
For example, the world's nuclear non-proliferation system remains impotent to handle the intractable proliferation issue; the UN Environment Program (UNEP) and the Food and Agriculture Organization (FAO) are unable to effectively handle the global climate change and grain security issues; the WTO, the IMF and the World Bank (WB) have become impotent in the face of strengthened trade protectionism and deteriorating international financial crisis. The global system is now in a worsening situation and world's multilateral bodies need to be reformed, as a cover story in the Economist magazine on July 5 puts it.
But it is impossible to completely overturn the existent international order and then frame a new one. Past experiences show a gradual reform model is an acceptable-to-all option in the restructuring of the world's system.
As a matter of fact, international rules and systems have experienced some tangible changes under the efforts of the whole international community since 2005. The UN has dismantled its Trusteeship Council and set up a Peace-building Commission in its stead. The world's largest multilateral body has elevated the status of the human rights issue and listed it as one of the body's three pillars alongside the issues of peace and security. It has also substituted the more powerful Human Rights Council for the obsolete Human rights Commission and put the organ only behind the Security Council and Economic and Social Council in its importance.
After years of development, the reform of international rules and mechanisms is being deepened and some principles related to human rights are now under discussion to become the basic norm of international relations. The IMF has adjusted its voting power distribution and is stepping up discussion about setting up a system to monitor the Sovereign Wealth Fund and international floating capital.
To effectively deal with global climate change, food crisis and humanitarian aid, the UN, the WHO and other bodies have made a step forward in exploring a new mechanism and model to deal with global crisis and raise their international status.
The ongoing international financial tsunami is engulfing the whole world, seriously hindering the development of the world's economy. The infectious crisis, which has inflicted huge impacts upon some developed European and American nations, has also prompted the international community to muse over the direction of the world's future.
To stem the most serious economic crisis since the 1930s, calls for reforming the existing international order have remained increasingly high and efforts to set up a more cooperative mechanism to solve the plaguing issue have also been strengthened.
British Prime Minister Gordon Brown has proposed to hold a global summit between state heads of the US, EU, China, Japan and India in November or December, to discuss how to rebuild the Bretton Woods system. WB President Robert Zoellick has explicitly cautioned that the foundation of the past US-dominated international establishment has already been shaken. He has also pointed to the ineptness of the Group-7 industrialized nations in dealing with changed international situations and proposed to give Brazil, China, India, Russia, Mexico, South Korea and Saudi Arabia a role in the decision-making of some international issues to structure a new 7 plus 7 multilateral organization.
There are reasons to expect more headway the international society will achieve in pushing for a new international order after it survives the ongoing turbulence.
The author is director of the Center of Strategic Studies, China Institute of Contemporary International Relations.
28 October 2008
How to Control a Currency Panic
Nice Piece ~ This is what must happen ~
October 28, 2008
Breakingviews.com
EDWARD HADAS and HUGO DIXON
The financial crisis has ratcheted up a dangerous notch. The currency markets have gone topsy-turvy. The authorities now have to make some pretty big and delicate moves — something like performing microsurgery in a plane in turbulent skies.
The yen has risen by 40 percent against the euro since August, with most of that occurring in October.
This month, the Australian dollar has also fallen by 25 percent and the pound by 16 percent against the American dollar. Swings of this scale are alarming when they happen in the stock market . But they are petrifying in currency markets, because they make it virtually impossible to price exports or imports.
What's going on?
Mainly, the pace of financial de-leveraging is accelerating. In particular, so-called currency carry trades — borrowing cheaply where interest rates are low, for example in Japan, and lending the funds where rates are high, such as in Australia or the euro zone — are ending abruptly.
The unwinding of these trades has jerked currencies around enough to provoke more margin calls on traders, amplifying the pressures on them to sell. Then there is fear: Investors are selling currencies of countries that import foreign capital, precipitating currency crises in eastern Europe and Korea that further hurt their economies.
This combination of de-leveraging and fear has also pushed stock markets into something like a free fall. Japan's Nikkei index is at its lowest since 1982, the MSCI index of non-Japanese Asian stocks is down 33 percent in October and Western stock markets continue the downward spiral initiated by the credit crisis.
While corporate credit, currencies and stocks are in trouble, government bonds are still strong. That's a relief, since the markets are turning to the world's governments to do something to stabilize lending between banks and corporations and, now, international cash flows.
To stop the currency panic, the world's governments should work together to set and then defend target exchange rates. That will probably require countries with big reserves of foreign currency, like China or Japan, to deploy some of the cash for the greater global good, and overspending countries like the United States and Britain to accept devaluations and lower standards of living.
It won't be easy, but the alternative — a breakdown in the global trade system — would be far worse.
Cut the Carry Trade
The expansion of the crisis from credit to foreign exchange has made even clearer the dangers of some types of speculation. In particular, the currency carry trade has been shown up as most unhealthy.
The practice of borrowing in currencies made cheap by low interest rates, like the yen, and investing in high-yield currencies like emerging markets works wonderfully so long as times are good. Speculators don't just benefit from this difference in interest rates, they can also enjoy a capital gain as the assets they jump into rise in value.
But when the market turns and the herd stampedes for the exit, capital gains turn into losses. That's what is happening now. The sharp rise in the yen and, to a lesser extent the dollar, is forcing speculators to repay their hard-currency loans before the currency mismatch sinks them, with the effect of whipsawing emerging market economies. .
For speculators, this painful lesson is ultimately salutary. Once burned to a crisp, many times shy. But the collateral damage is more distressing.
The banks that lent to the carry traders suffer. Investors like pension funds and insurers who hold the assets now being dumped by carry traders find the value of these assets are falling dangerously close to their liabilities. Exporters who sell goods in rising currencies — most obviously Japanese companies — face a huge squeeze on profits.
The currency rebalance should lead to an economic catharsis. The rise in the yen could help rebalance world trade, although the rise in the dollar works in the opposite direction. Certainly, countries like Britain, with its yawning current account deficit, could benefit from a cheaper pound.
That said, this is hardly the moment for the global financial system to face more big losses, more runs on financial assets and, in response, more government capital injections for banks and perhaps insurers.
However this crisis pans out, one thing should be clear: Huge currency speculation of the kind that made the currency carry trade a cornerstone of global finance in recent years is highly destabilizing. When this crisis is over, the authorities should aim to reduce it.
For more independent financial commentary and analysis, visit www.breakingviews.com.
October 28, 2008
Breakingviews.com
EDWARD HADAS and HUGO DIXON
The financial crisis has ratcheted up a dangerous notch. The currency markets have gone topsy-turvy. The authorities now have to make some pretty big and delicate moves — something like performing microsurgery in a plane in turbulent skies.
The yen has risen by 40 percent against the euro since August, with most of that occurring in October.
This month, the Australian dollar has also fallen by 25 percent and the pound by 16 percent against the American dollar. Swings of this scale are alarming when they happen in the stock market . But they are petrifying in currency markets, because they make it virtually impossible to price exports or imports.
What's going on?
Mainly, the pace of financial de-leveraging is accelerating. In particular, so-called currency carry trades — borrowing cheaply where interest rates are low, for example in Japan, and lending the funds where rates are high, such as in Australia or the euro zone — are ending abruptly.
The unwinding of these trades has jerked currencies around enough to provoke more margin calls on traders, amplifying the pressures on them to sell. Then there is fear: Investors are selling currencies of countries that import foreign capital, precipitating currency crises in eastern Europe and Korea that further hurt their economies.
This combination of de-leveraging and fear has also pushed stock markets into something like a free fall. Japan's Nikkei index is at its lowest since 1982, the MSCI index of non-Japanese Asian stocks is down 33 percent in October and Western stock markets continue the downward spiral initiated by the credit crisis.
While corporate credit, currencies and stocks are in trouble, government bonds are still strong. That's a relief, since the markets are turning to the world's governments to do something to stabilize lending between banks and corporations and, now, international cash flows.
To stop the currency panic, the world's governments should work together to set and then defend target exchange rates. That will probably require countries with big reserves of foreign currency, like China or Japan, to deploy some of the cash for the greater global good, and overspending countries like the United States and Britain to accept devaluations and lower standards of living.
It won't be easy, but the alternative — a breakdown in the global trade system — would be far worse.
Cut the Carry Trade
The expansion of the crisis from credit to foreign exchange has made even clearer the dangers of some types of speculation. In particular, the currency carry trade has been shown up as most unhealthy.
The practice of borrowing in currencies made cheap by low interest rates, like the yen, and investing in high-yield currencies like emerging markets works wonderfully so long as times are good. Speculators don't just benefit from this difference in interest rates, they can also enjoy a capital gain as the assets they jump into rise in value.
But when the market turns and the herd stampedes for the exit, capital gains turn into losses. That's what is happening now. The sharp rise in the yen and, to a lesser extent the dollar, is forcing speculators to repay their hard-currency loans before the currency mismatch sinks them, with the effect of whipsawing emerging market economies. .
For speculators, this painful lesson is ultimately salutary. Once burned to a crisp, many times shy. But the collateral damage is more distressing.
The banks that lent to the carry traders suffer. Investors like pension funds and insurers who hold the assets now being dumped by carry traders find the value of these assets are falling dangerously close to their liabilities. Exporters who sell goods in rising currencies — most obviously Japanese companies — face a huge squeeze on profits.
The currency rebalance should lead to an economic catharsis. The rise in the yen could help rebalance world trade, although the rise in the dollar works in the opposite direction. Certainly, countries like Britain, with its yawning current account deficit, could benefit from a cheaper pound.
That said, this is hardly the moment for the global financial system to face more big losses, more runs on financial assets and, in response, more government capital injections for banks and perhaps insurers.
However this crisis pans out, one thing should be clear: Huge currency speculation of the kind that made the currency carry trade a cornerstone of global finance in recent years is highly destabilizing. When this crisis is over, the authorities should aim to reduce it.
For more independent financial commentary and analysis, visit www.breakingviews.com.
Musings on deflation ~ It's here ~ But what's next?
I've been thinking about a lot about exactly what is happening in the world economy these days. I decided to break down the actual facts and see what can be gathered from them.
Arguments in favor of deflation:
1) collapsing commodity prices
2) rising dollar
3) collapsing housing prices
4) falling stock prices
5 falling MZM
Those are very good arguments for deflation. However, there are weaknesses to each of these arguments.
1) commodity prices have collapsed over the past three months, but they haven't done so in a historical deflationary way. For example, farm prices began declining in 1927, and general prices didn't decline in the cities until 1930.
Why this is significant is that classic deflation takes time to build up for the same reasons that classic inflation takes time to build up. It simply doesn't happen this fast.
Now this doesn't preclude deflation happening today. It only means that what is happening is not a classic case of deflation.
An alternative explanation would be a massive deleveraging by global hedge funds. They invested heavily in commodities and they have now been forced to sell. This is not the same thing as deflation. It's more like the collapse in commodity prices and real estate in the late 1980's.
2) this is the weakest case for deflation. The most obvious thing wrong with it is the rise of the Japanese Yen. The Yen is not a reserve currency, yet it is rising against the dollar. Why? Because it is an unwinding of leverage.
I should also note that prices have not come down in he grocery store. If the dollar really was rising, don't you think that the price of food would come down?
3) collapsing house prices certainly have a deflationary effect, and is probably the strongest case for deflation.
4) while technically deflationary, this has never been directly associated with deflation. Stocks crashed in 1974 and 2002 without there ever being deflation.
5) now we get the most interesting, and applicable, part of the argument.
In fact the MZM is not falling significantly. So far only the rate has changed, not the overall stock. There was a far bigger decline from 2001 to 2004.
What's more, the Fed's credit is exploding. The deflationist argument that it won't make it through to the rest of the economy is interesting, but unproven. If deflationists are wrong in this regard then they are going to be wrong in a very big way.
6) we also have the massive bailouts. Deflationists say they haven't had any effect yet. But the fact is that they haven't really been rolled out yet. Today is the first day that we are seeing the full effects of the bailouts, and this is merely the leading edge.
So does all this prove that we aren't having deflation? Not at all. No one will be able to say for certain except in hindsite.
But it does give very strong case that what we are experiencing is deleveraging and no deflation.
Any comments from people other than Viper?
RE: Great Summary imo nm aussiebear NEW 10/27/2008 2:37:36 PM
RE: Forest and trees John... SuperCycleBear NEW 10/27/2008 3:21:34 PM
I think we're getting too close to the trees John and missing the forest.
There is absolutely NO doubt in my mind we are currently in the midst of one of the greatest deflationary episodes in history. To deny it is to dogmatically and pigheadedly deny the obvious. We would not have had the massive intervention to slow the financial collapse, if it were not the case. The result of that intervention .has produced the benign deflationary "LIST" you formed
However, as you point out it is not the typical deflation as few have resulted in (or from) changes to the global financial architecture - like this one seems likely to do.
As the architecture is going to change (but to what no one is quite sure, yet) so too will policies and strategies for navigating the fin. markets. Therein the difficulty lies. How can one take advantage of a new system if the details are to be 2nd guessed. I reckon it will involve a reduction in the role of the USD and a link to some extent to a tangible non financial asset that will give the medium of exchange some intrinsic value - hence the belief that gold will better than hold its real value over time - not nominal value but real value.
The USD rally is the final hurrah for the old system. It will be interesting to see who is going to step up to the plate and buy the USD$125 000 000 000 bonds.
Arguments in favor of deflation:
1) collapsing commodity prices
2) rising dollar
3) collapsing housing prices
4) falling stock prices
5 falling MZM
Those are very good arguments for deflation. However, there are weaknesses to each of these arguments.
1) commodity prices have collapsed over the past three months, but they haven't done so in a historical deflationary way. For example, farm prices began declining in 1927, and general prices didn't decline in the cities until 1930.
Why this is significant is that classic deflation takes time to build up for the same reasons that classic inflation takes time to build up. It simply doesn't happen this fast.
Now this doesn't preclude deflation happening today. It only means that what is happening is not a classic case of deflation.
An alternative explanation would be a massive deleveraging by global hedge funds. They invested heavily in commodities and they have now been forced to sell. This is not the same thing as deflation. It's more like the collapse in commodity prices and real estate in the late 1980's.
2) this is the weakest case for deflation. The most obvious thing wrong with it is the rise of the Japanese Yen. The Yen is not a reserve currency, yet it is rising against the dollar. Why? Because it is an unwinding of leverage.
I should also note that prices have not come down in he grocery store. If the dollar really was rising, don't you think that the price of food would come down?
3) collapsing house prices certainly have a deflationary effect, and is probably the strongest case for deflation.
4) while technically deflationary, this has never been directly associated with deflation. Stocks crashed in 1974 and 2002 without there ever being deflation.
5) now we get the most interesting, and applicable, part of the argument.
In fact the MZM is not falling significantly. So far only the rate has changed, not the overall stock. There was a far bigger decline from 2001 to 2004.
What's more, the Fed's credit is exploding. The deflationist argument that it won't make it through to the rest of the economy is interesting, but unproven. If deflationists are wrong in this regard then they are going to be wrong in a very big way.
6) we also have the massive bailouts. Deflationists say they haven't had any effect yet. But the fact is that they haven't really been rolled out yet. Today is the first day that we are seeing the full effects of the bailouts, and this is merely the leading edge.
So does all this prove that we aren't having deflation? Not at all. No one will be able to say for certain except in hindsite.
But it does give very strong case that what we are experiencing is deleveraging and no deflation.
Any comments from people other than Viper?
RE: Great Summary imo nm aussiebear NEW 10/27/2008 2:37:36 PM
RE: Forest and trees John... SuperCycleBear NEW 10/27/2008 3:21:34 PM
I think we're getting too close to the trees John and missing the forest.
There is absolutely NO doubt in my mind we are currently in the midst of one of the greatest deflationary episodes in history. To deny it is to dogmatically and pigheadedly deny the obvious. We would not have had the massive intervention to slow the financial collapse, if it were not the case. The result of that intervention .has produced the benign deflationary "LIST" you formed
However, as you point out it is not the typical deflation as few have resulted in (or from) changes to the global financial architecture - like this one seems likely to do.
As the architecture is going to change (but to what no one is quite sure, yet) so too will policies and strategies for navigating the fin. markets. Therein the difficulty lies. How can one take advantage of a new system if the details are to be 2nd guessed. I reckon it will involve a reduction in the role of the USD and a link to some extent to a tangible non financial asset that will give the medium of exchange some intrinsic value - hence the belief that gold will better than hold its real value over time - not nominal value but real value.
The USD rally is the final hurrah for the old system. It will be interesting to see who is going to step up to the plate and buy the USD$125 000 000 000 bonds.
Time to buy Silver is my guess
A big supply shock may be in the works.~ kev
In a moment, I’d like to describe a new development in silver that should prove quite bullish to the price, but first I’d like to review some continuing facts that are significant in their own right. It would appear that the confluence of many factors point to sharply higher silver prices dead ahead. Yes, I know the price has recently collapsed. Ironically, it is that very price smash that is the basis for the coming price launch higher.
Since the recent top in July, the price of silver has undergone a dramatic collapse. As proven by data released in government reports, a large U.S. bank or two sold a massive number of COMEX silver futures contracts into the top and subsequently has covered a good number of those short contracts on the resultant price decline. Quite simply, this is the single most important factor behind the price collapse. The latest data appear to indicate that the price decline is now largely behind us.
The latest data in the Commitment or Traders Report (COT) indicate a near-record shift in market structure over the past three months. The total net commercial silver short position has been reduced by approximately 50,000 contracts (250 million ounces). This is an absolutely massive amount of commercial buying, and has pushed many COT measurements to their most extreme bullish readings in years. Similar commercial buying has occurred in COMEX gold futures.
Make no mistake, this massive commercial buying was no accident. This was precisely why silver and gold dropped sharply, namely, to enable the commercials to buy at the expense of speculative long liquidation. The commercials don’t do anything on this scale by accident. To think otherwise is naïve. Ask yourself this - if silver’s price smash did indicate we faced a long term future of lower silver prices, then why would the commercials, the dominators of the market, buy every contract they could get their hands on?
By no small coincidence, other unusual factors suggest silver prices should soon embark on a significant price rally. A notable increase in demand for 1000 oz bars can be seen in tightening price differentials between nearby futures contract months and by reports in the physical market, a marked increase in deliveries in the nearby October silver delivery contract, as well as recent withdrawals in COMEX silver inventories from those taking delivery on October futures. All are supportive of a pending shortage in 1000 oz silver bars, the industry unit of trade. When the shortage of 1000 oz bars becomes apparent, all talk that silver has only experienced a "retail" shortage, will be dashed. Coupled with the bullish COT structure, it adds up to strong upside price potential ahead.
But the sharply lower price of silver and other commodities has introduced a new bullish development that, quite frankly, I had not anticipated. It has resulted in unintended consequences that all should recognize shortly. So potentially bullish is this new factor that it appears to be on the order of a coming shock to the silver pricing structure.
It is said, in the world of commodities, that the cure for low prices, is low prices. In other words, according to the law of supply and demand, low prices discourage production and encourage consumption to the point at which the low prices are replaced with higher prices. The unprecedented deep declines in the price of silver and base metals, such as copper, lead, zinc, and nickel promise to disrupt the production of these metals. After all, no one can produce at a loss indefinitely. Almost without exception, the price of all these industrial metals has fallen deeply below the cost of production for most producers. This is not just anticipatory, as daily reports confirm continuing mining production cutbacks. In addition, smelter cutbacks, especially in China, the world’s largest refiner, have been ongoing for months.
What makes the sudden price declines so unusual is that have apparently occurred not so much due to specific supply/demand fundamentals in the metals in question, but more to general dark sentiment about general overall concerns about prospective industrial demand and credit issues. All commodities have been smashed, almost indiscriminately. But there is a highly unusual feature to the price declines. For the first time in half a century or longer, the price declines have come at a time of generally low inventory levels, in marked contrast to prior price declines.
Normally, the industrial metal cycle tops out with high prices amid high inventories. Then, the high prices diminish demand, which in turn pressures price, often to levels below the cost of production. Mines react to the low prices by curtailing production or shutting down, which stimulates demand and eats up the high inventories. When inventories reach levels too low to support further draw downs, prices rise until the next peak in prices and inventories. These normal free market cycles take years to unfold.
This time, prices have collapsed even though inventories are on the low side. Therefore, in spite of the fears of reduced industrial consumption, because of the sharply lower prices, production promises to fall faster, and the already low inventories can’t support draw downs for long. Although it is not currently widely expected, even in recessionary times, shortages can and will occur if supply (production and inventory draw downs) can’t satisfy demand, even though that demand may be reduced.
Separately, the resource boom over the past five years was characterized by a noteworthy lack of increase in additional production capacity of most non-ferrous metals. Now, with dramatic postponements and cancellations of new mining projects, due to economic and credit concerns, there will be significantly less production available if and when shortages occur.
The net result for silver could be profound. Not only is the current price below the cost of production for mines in which silver is the primary source of revenue, but the price of base metals like zinc, lead and copper, is also below the cost of production. Since the by-product silver from the mining of these three metals account for a full 60% of total silver mine production (400 million oz out of a total 670 million oz annually), the expected reduction in base metal production will have an exaggerated impact on silver production. Throw in the 200 million oz primary annual silver mine production and the vast majority of total silver mine production is in jeopardy. Finally, recycled silver of some 200 million ounces is perhaps the most price sensitive of all. Talk about the unintended consequences of sharply lower prices.
This is the first time since I have been studying silver that total production has been in such sudden danger of a sharp decline. In fact, it would appear to me that this could be the perfect bullish storm for silver. Please consider the facts. World silver inventories are the lowest they have been in hundreds of years, thanks to a century of industrial consumption. This is precisely at the same time of the most serious threat to production in memory. More than any commodity, silver has been demonstrating real signs of tightness, even before impending widespread production cuts.
What really sets silver apart from the other industrial metals that may quickly go into related shortage situations if prices remain depressed, is the special dual role of silver, as both a vital industrial material and as a primary investment asset that can be owned directly by investors of all means. Silver, like gold, is an asset desired by investors, particularly when financial conditions are unsettled. Copper, lead and zinc are not such assets. So whereas we can have easily see industrial shortages and sharply higher prices for base metals, even in a recession, if production declines enough, those sharply higher prices will not be accompanied by ordinary investors rushing to buy zinc coins or bars of lead. That, most definitely, will be case in silver.
In fact, as I wrote last week, it is not just that investors are likely to buy silver, there is already an historic silver investment rush in force. And this investment rush is even more significant since it has developed only in the past three years, after decades of net investment selling of silver. Again, I couldn’t make these things up if I tried. And please remember, even in a recession with lower industrial demand, if users can’t get the silver supplies they need, they will panic at some point and rush to build inventories.
I did not anticipate the brutal decline to below $9 an ounce. Fortunately, those who hold real silver on a non-margined basis, my consistent public advice, still hold their silver. The rise in premiums of many items, particularly U.S. Silver Eagles, has minimized the pain of the decline. New buyers, however, have just been given a gift beyond description. The collapse in price has had nothing to do with the merits of silver, but will have everything to do with the coming explosive rally. The uneconomic low price will shock the price higher.
In a moment, I’d like to describe a new development in silver that should prove quite bullish to the price, but first I’d like to review some continuing facts that are significant in their own right. It would appear that the confluence of many factors point to sharply higher silver prices dead ahead. Yes, I know the price has recently collapsed. Ironically, it is that very price smash that is the basis for the coming price launch higher.
Since the recent top in July, the price of silver has undergone a dramatic collapse. As proven by data released in government reports, a large U.S. bank or two sold a massive number of COMEX silver futures contracts into the top and subsequently has covered a good number of those short contracts on the resultant price decline. Quite simply, this is the single most important factor behind the price collapse. The latest data appear to indicate that the price decline is now largely behind us.
The latest data in the Commitment or Traders Report (COT) indicate a near-record shift in market structure over the past three months. The total net commercial silver short position has been reduced by approximately 50,000 contracts (250 million ounces). This is an absolutely massive amount of commercial buying, and has pushed many COT measurements to their most extreme bullish readings in years. Similar commercial buying has occurred in COMEX gold futures.
Make no mistake, this massive commercial buying was no accident. This was precisely why silver and gold dropped sharply, namely, to enable the commercials to buy at the expense of speculative long liquidation. The commercials don’t do anything on this scale by accident. To think otherwise is naïve. Ask yourself this - if silver’s price smash did indicate we faced a long term future of lower silver prices, then why would the commercials, the dominators of the market, buy every contract they could get their hands on?
By no small coincidence, other unusual factors suggest silver prices should soon embark on a significant price rally. A notable increase in demand for 1000 oz bars can be seen in tightening price differentials between nearby futures contract months and by reports in the physical market, a marked increase in deliveries in the nearby October silver delivery contract, as well as recent withdrawals in COMEX silver inventories from those taking delivery on October futures. All are supportive of a pending shortage in 1000 oz silver bars, the industry unit of trade. When the shortage of 1000 oz bars becomes apparent, all talk that silver has only experienced a "retail" shortage, will be dashed. Coupled with the bullish COT structure, it adds up to strong upside price potential ahead.
But the sharply lower price of silver and other commodities has introduced a new bullish development that, quite frankly, I had not anticipated. It has resulted in unintended consequences that all should recognize shortly. So potentially bullish is this new factor that it appears to be on the order of a coming shock to the silver pricing structure.
It is said, in the world of commodities, that the cure for low prices, is low prices. In other words, according to the law of supply and demand, low prices discourage production and encourage consumption to the point at which the low prices are replaced with higher prices. The unprecedented deep declines in the price of silver and base metals, such as copper, lead, zinc, and nickel promise to disrupt the production of these metals. After all, no one can produce at a loss indefinitely. Almost without exception, the price of all these industrial metals has fallen deeply below the cost of production for most producers. This is not just anticipatory, as daily reports confirm continuing mining production cutbacks. In addition, smelter cutbacks, especially in China, the world’s largest refiner, have been ongoing for months.
What makes the sudden price declines so unusual is that have apparently occurred not so much due to specific supply/demand fundamentals in the metals in question, but more to general dark sentiment about general overall concerns about prospective industrial demand and credit issues. All commodities have been smashed, almost indiscriminately. But there is a highly unusual feature to the price declines. For the first time in half a century or longer, the price declines have come at a time of generally low inventory levels, in marked contrast to prior price declines.
Normally, the industrial metal cycle tops out with high prices amid high inventories. Then, the high prices diminish demand, which in turn pressures price, often to levels below the cost of production. Mines react to the low prices by curtailing production or shutting down, which stimulates demand and eats up the high inventories. When inventories reach levels too low to support further draw downs, prices rise until the next peak in prices and inventories. These normal free market cycles take years to unfold.
This time, prices have collapsed even though inventories are on the low side. Therefore, in spite of the fears of reduced industrial consumption, because of the sharply lower prices, production promises to fall faster, and the already low inventories can’t support draw downs for long. Although it is not currently widely expected, even in recessionary times, shortages can and will occur if supply (production and inventory draw downs) can’t satisfy demand, even though that demand may be reduced.
Separately, the resource boom over the past five years was characterized by a noteworthy lack of increase in additional production capacity of most non-ferrous metals. Now, with dramatic postponements and cancellations of new mining projects, due to economic and credit concerns, there will be significantly less production available if and when shortages occur.
The net result for silver could be profound. Not only is the current price below the cost of production for mines in which silver is the primary source of revenue, but the price of base metals like zinc, lead and copper, is also below the cost of production. Since the by-product silver from the mining of these three metals account for a full 60% of total silver mine production (400 million oz out of a total 670 million oz annually), the expected reduction in base metal production will have an exaggerated impact on silver production. Throw in the 200 million oz primary annual silver mine production and the vast majority of total silver mine production is in jeopardy. Finally, recycled silver of some 200 million ounces is perhaps the most price sensitive of all. Talk about the unintended consequences of sharply lower prices.
This is the first time since I have been studying silver that total production has been in such sudden danger of a sharp decline. In fact, it would appear to me that this could be the perfect bullish storm for silver. Please consider the facts. World silver inventories are the lowest they have been in hundreds of years, thanks to a century of industrial consumption. This is precisely at the same time of the most serious threat to production in memory. More than any commodity, silver has been demonstrating real signs of tightness, even before impending widespread production cuts.
What really sets silver apart from the other industrial metals that may quickly go into related shortage situations if prices remain depressed, is the special dual role of silver, as both a vital industrial material and as a primary investment asset that can be owned directly by investors of all means. Silver, like gold, is an asset desired by investors, particularly when financial conditions are unsettled. Copper, lead and zinc are not such assets. So whereas we can have easily see industrial shortages and sharply higher prices for base metals, even in a recession, if production declines enough, those sharply higher prices will not be accompanied by ordinary investors rushing to buy zinc coins or bars of lead. That, most definitely, will be case in silver.
In fact, as I wrote last week, it is not just that investors are likely to buy silver, there is already an historic silver investment rush in force. And this investment rush is even more significant since it has developed only in the past three years, after decades of net investment selling of silver. Again, I couldn’t make these things up if I tried. And please remember, even in a recession with lower industrial demand, if users can’t get the silver supplies they need, they will panic at some point and rush to build inventories.
I did not anticipate the brutal decline to below $9 an ounce. Fortunately, those who hold real silver on a non-margined basis, my consistent public advice, still hold their silver. The rise in premiums of many items, particularly U.S. Silver Eagles, has minimized the pain of the decline. New buyers, however, have just been given a gift beyond description. The collapse in price has had nothing to do with the merits of silver, but will have everything to do with the coming explosive rally. The uneconomic low price will shock the price higher.
Biggest U.S. Export by far was bad paper
The bundling of consumer loans and home mortgages into packages of securities -- a process known as securitization -- was the biggest U.S. export business of the 21st century. More than $27 trillion of these securities have been sold since 2001, according to the Securities Industry Financial Markets Association, an industry trade group. That's almost twice last year's U.S. gross domestic product of $13.8 trillion.
The growth over the past decade was made possible by overseas banks, which saw the profits U.S. financial institutions were making and coveted the made-in-America technology, much as consumers around the world craved other emblems of American ingenuity from Coca-Cola to Hollywood movies. Wall Street obliged, with disastrous results: two-thirds of a trillion dollars in bank losses, about 40 percent of them outside the U.S.
''Securitization was based on the premise that a fool was born every minute,'' Joseph Stiglitz, a professor of economics at Columbia University in New York, told a congressional committee on Oct. 21. ''Globalization meant that there was a global landscape on which they could search for those fools -- and they found them everywhere.''
Eager Adopters
European banks, in particular, were eager adopters. Securitizations in Europe increased almost sixfold between 2000 and 2007, from 78 billion euros ($98 billion) to 453 billion euros, according to the European Securitization Forum, a trade organization.
Three Icelandic banks borrowed enough to buy $228 billion of assets, most of them securitizations, turning the country's financial system into a hedge fund. All three banks have been nationalized by the government, leading Prime Minister Geir Haarde to advise citizens to switch from finance to fishing.
In Germany, one bank, Landesbank Sachsen Girozentrale, bought $26 billion worth of subprime-backed investments, putting the state of Saxony on the hook for $4.1 billion.
In Japan, Mizuho Financial Group Inc., the nation's third- largest bank, acquired an entire structured-finance team, which proceeded to lose $6 billion issuing mortgage-backed securities.
Shadow Banking
The damage reaches all the way to Australia, where the town council of Wingecarribee, a municipality outside Sydney with a population of 42,000, bought $20 million of securities from Lehman Brothers Holdings Inc. Now, Lehman is in bankruptcy, the town council is in court and the securities are worth about 15 cents on the dollar.
Securitization is a shadow banking system that funds most of the world's credit cards, car purchases, leveraged buyouts and, for a while, subprime mortgages. The system, which pools loans and slices up the risk of default, made borrowing cheaper for everyone, creating a debt culture that put credit cards in wallets from Seoul to Sao Paolo and enabled people to buy luxury cars and homes. It also pumped out record profits for banks, accounting for as much as one-fifth of their revenue over the last decade.
Beginning about three years ago, investment banks revved the system's engine to boost earnings. They raised revenue by funding more subprime mortgages and cut costs by relying increasingly on the $4.2 trillion sitting in U.S. money-market funds. As it turned out, those decisions would prove fatal.
'Powerful Technology'
''It's a powerful technology that has been driven beyond the speed limit,'' said Juan Ocampo, a former consultant at New York-based advisory firm McKinsey & Co. who wrote a 1988 book popularizing structured finance. ''For the last five years, instead of going 65 mph, they've been gunning it to 140 mph, 150 mph.''
Before the invention of securitization, banks loaned money, received payments and profited from the difference between what the borrower paid and the bank's funding cost.
During the mid-1980s, mortgage-bond traders at Salomon Brothers devised a method of lending without using capital, a technique at the heart of securitization. It works by taking anything that has regular payments -- mortgages, car loans, aircraft leases, music royalties -- and channeling the money to a trust that pays bondholders principal and interest.
Off-Balance-Sheet
The word ''securitization'' implies safety. Investors with less appetite for risk buy higher-rated securities and get paid first at lower interest rates. Those with a bigger appetite get paid later and receive more interest.
Securitization's biggest innovation was the use of off-balance-sheet accounting. If a bank couldn't sell a bond or didn't want to, the asset could be sold to a trust within a so-called special-purpose entity, incorporated in a place such as the Cayman Islands or Dublin, and shifted off the books. Lending expanded, and banks still booked profits.
With this new technology, a bank could originate $100 million in loans, sell off some to investors, transfer the rest to a special-purpose entity and not have to hold any capital. The profit could be as much as 1.25 percentage points of the amount loaned, or $1.25 million for every $100 million issued.
''The banks could turn a low return-on-equity business into one that doesn't use any equity, which was the motivation for this,'' said Brad Hintz, a Sanford C. Bernstein & Co. analyst and former chief financial officer at Lehman. ''It becomes almost like a fee business because it requires no capital.''
'Capture the Prize'
Like most new products, securitization found a market at home before going abroad. Bankers at Salomon and First Boston Inc. raced from bank to bank to convince issuers it was the wave of the future.
William Haley remembers a 10 a.m. meeting in 1987 at Imperial Thrift & Loan Association in Glendale, California. As Haley, at the time a 33-year-old Salomon banker, and his team walked into the conference room to make a pitch, the First Boston team was walking out.
''We exchanged some knowing looks and then tried to beat the pants off them,'' said Haley, who now works at RBS Greenwich Capital Markets Inc., a firm specializing in mortgage-backed securities that is owned by Royal Bank of Scotland Group Plc. ''There was a fierce desire to capture the prize.''
First Boston
First Boston, housed in the same New York office tower as McKinsey, was first out of the gate in March 1985 with a $192 million computer-lease securitization for Sperry Corp., a predecessor of Unisys Corp. The bank then oversaw a series of auto-loan securitizations, including a $4 billion issue by General Motors Acceptance Corp. in October 1986, the biggest corporate debt issue at the time.
Haley's project was a $50 million deal for Banc One Corp. called Certificates for Amortizing Revolving Debts, or CARDs. It was the first credit-card securitization and a blueprint for the $358 billion of such securities now outstanding. The transaction also gave the banks a way to securitize their own assets and get them off their balance sheets, which allowed the money to be lent all over again.
The strategy was detailed in Ocampo's 282-page book ''Securitization of Credit: Inside the New Technology of Finance,'' which he co-wrote with McKinsey consultant James Rosenthal. Ocampo, who received an MBA from Harvard after graduating from the Massachusetts Institute of Technology, and Rosenthal, a Harvard Law School graduate, argued that banks could be more profitable if they used securitization.
McKinsey Book
The authors examined six of the first asset-backed transactions and gave readers a step-by-step guide for how to repeat them. They said that banks that didn't embrace the new technology would be at a disadvantage, and they predicted it would become the dominant form of financing.
''The McKinsey book helped with credibility with issuers,'' said Haley. ''It wasn't that easy in the beginning. Conferences now have thousands of people, but I remember once in Beverly Hills, I gave a speech and there were maybe 25 people in the audience. They were furiously taking notes, however.''
The new technology was spread around the world by the people who worked on the First Boston and Salomon teams. Salomon's group was led by Patricia Jehle, who later founded Bear Stearns's asset-backed unit. Another member, Michael Hutchins, started the first team at a European bank when he went to Zurich-based UBS AG in 1996. A third, Michael Normile, moved to Merrill Lynch & Co., where he ran its securities business, then switched to London-based HSBC Holdings Plc in 2004. Haley built similar teams at Lehman, Chase Manhattan Bank and Amsterdam-based ABN Amro Bank NV.
The growth over the past decade was made possible by overseas banks, which saw the profits U.S. financial institutions were making and coveted the made-in-America technology, much as consumers around the world craved other emblems of American ingenuity from Coca-Cola to Hollywood movies. Wall Street obliged, with disastrous results: two-thirds of a trillion dollars in bank losses, about 40 percent of them outside the U.S.
''Securitization was based on the premise that a fool was born every minute,'' Joseph Stiglitz, a professor of economics at Columbia University in New York, told a congressional committee on Oct. 21. ''Globalization meant that there was a global landscape on which they could search for those fools -- and they found them everywhere.''
Eager Adopters
European banks, in particular, were eager adopters. Securitizations in Europe increased almost sixfold between 2000 and 2007, from 78 billion euros ($98 billion) to 453 billion euros, according to the European Securitization Forum, a trade organization.
Three Icelandic banks borrowed enough to buy $228 billion of assets, most of them securitizations, turning the country's financial system into a hedge fund. All three banks have been nationalized by the government, leading Prime Minister Geir Haarde to advise citizens to switch from finance to fishing.
In Germany, one bank, Landesbank Sachsen Girozentrale, bought $26 billion worth of subprime-backed investments, putting the state of Saxony on the hook for $4.1 billion.
In Japan, Mizuho Financial Group Inc., the nation's third- largest bank, acquired an entire structured-finance team, which proceeded to lose $6 billion issuing mortgage-backed securities.
Shadow Banking
The damage reaches all the way to Australia, where the town council of Wingecarribee, a municipality outside Sydney with a population of 42,000, bought $20 million of securities from Lehman Brothers Holdings Inc. Now, Lehman is in bankruptcy, the town council is in court and the securities are worth about 15 cents on the dollar.
Securitization is a shadow banking system that funds most of the world's credit cards, car purchases, leveraged buyouts and, for a while, subprime mortgages. The system, which pools loans and slices up the risk of default, made borrowing cheaper for everyone, creating a debt culture that put credit cards in wallets from Seoul to Sao Paolo and enabled people to buy luxury cars and homes. It also pumped out record profits for banks, accounting for as much as one-fifth of their revenue over the last decade.
Beginning about three years ago, investment banks revved the system's engine to boost earnings. They raised revenue by funding more subprime mortgages and cut costs by relying increasingly on the $4.2 trillion sitting in U.S. money-market funds. As it turned out, those decisions would prove fatal.
'Powerful Technology'
''It's a powerful technology that has been driven beyond the speed limit,'' said Juan Ocampo, a former consultant at New York-based advisory firm McKinsey & Co. who wrote a 1988 book popularizing structured finance. ''For the last five years, instead of going 65 mph, they've been gunning it to 140 mph, 150 mph.''
Before the invention of securitization, banks loaned money, received payments and profited from the difference between what the borrower paid and the bank's funding cost.
During the mid-1980s, mortgage-bond traders at Salomon Brothers devised a method of lending without using capital, a technique at the heart of securitization. It works by taking anything that has regular payments -- mortgages, car loans, aircraft leases, music royalties -- and channeling the money to a trust that pays bondholders principal and interest.
Off-Balance-Sheet
The word ''securitization'' implies safety. Investors with less appetite for risk buy higher-rated securities and get paid first at lower interest rates. Those with a bigger appetite get paid later and receive more interest.
Securitization's biggest innovation was the use of off-balance-sheet accounting. If a bank couldn't sell a bond or didn't want to, the asset could be sold to a trust within a so-called special-purpose entity, incorporated in a place such as the Cayman Islands or Dublin, and shifted off the books. Lending expanded, and banks still booked profits.
With this new technology, a bank could originate $100 million in loans, sell off some to investors, transfer the rest to a special-purpose entity and not have to hold any capital. The profit could be as much as 1.25 percentage points of the amount loaned, or $1.25 million for every $100 million issued.
''The banks could turn a low return-on-equity business into one that doesn't use any equity, which was the motivation for this,'' said Brad Hintz, a Sanford C. Bernstein & Co. analyst and former chief financial officer at Lehman. ''It becomes almost like a fee business because it requires no capital.''
'Capture the Prize'
Like most new products, securitization found a market at home before going abroad. Bankers at Salomon and First Boston Inc. raced from bank to bank to convince issuers it was the wave of the future.
William Haley remembers a 10 a.m. meeting in 1987 at Imperial Thrift & Loan Association in Glendale, California. As Haley, at the time a 33-year-old Salomon banker, and his team walked into the conference room to make a pitch, the First Boston team was walking out.
''We exchanged some knowing looks and then tried to beat the pants off them,'' said Haley, who now works at RBS Greenwich Capital Markets Inc., a firm specializing in mortgage-backed securities that is owned by Royal Bank of Scotland Group Plc. ''There was a fierce desire to capture the prize.''
First Boston
First Boston, housed in the same New York office tower as McKinsey, was first out of the gate in March 1985 with a $192 million computer-lease securitization for Sperry Corp., a predecessor of Unisys Corp. The bank then oversaw a series of auto-loan securitizations, including a $4 billion issue by General Motors Acceptance Corp. in October 1986, the biggest corporate debt issue at the time.
Haley's project was a $50 million deal for Banc One Corp. called Certificates for Amortizing Revolving Debts, or CARDs. It was the first credit-card securitization and a blueprint for the $358 billion of such securities now outstanding. The transaction also gave the banks a way to securitize their own assets and get them off their balance sheets, which allowed the money to be lent all over again.
The strategy was detailed in Ocampo's 282-page book ''Securitization of Credit: Inside the New Technology of Finance,'' which he co-wrote with McKinsey consultant James Rosenthal. Ocampo, who received an MBA from Harvard after graduating from the Massachusetts Institute of Technology, and Rosenthal, a Harvard Law School graduate, argued that banks could be more profitable if they used securitization.
McKinsey Book
The authors examined six of the first asset-backed transactions and gave readers a step-by-step guide for how to repeat them. They said that banks that didn't embrace the new technology would be at a disadvantage, and they predicted it would become the dominant form of financing.
''The McKinsey book helped with credibility with issuers,'' said Haley. ''It wasn't that easy in the beginning. Conferences now have thousands of people, but I remember once in Beverly Hills, I gave a speech and there were maybe 25 people in the audience. They were furiously taking notes, however.''
The new technology was spread around the world by the people who worked on the First Boston and Salomon teams. Salomon's group was led by Patricia Jehle, who later founded Bear Stearns's asset-backed unit. Another member, Michael Hutchins, started the first team at a European bank when he went to Zurich-based UBS AG in 1996. A third, Michael Normile, moved to Merrill Lynch & Co., where he ran its securities business, then switched to London-based HSBC Holdings Plc in 2004. Haley built similar teams at Lehman, Chase Manhattan Bank and Amsterdam-based ABN Amro Bank NV.
27 October 2008
CDO Cuts Show $1 Trillion Corporate-Debt Bets Toxic
I think its all going pear shaped here, sub-prime, alt-a, corporate CDO's and the financial implications of a sudden demand shock. The whole thing is spinning out of control because it ran on trust alone.
Oct. 22 (Bloomberg) -- Investors are taking losses of up to 90 percent in the $1.2 trillion market for collateralized debt obligations tied to corporate credit as the failures of Lehman Brothers Holdings Inc. and Icelandic banks send shockwaves through the global financial system.
The losses among banks, insurers and money managers may spark the next round of writedowns on CDOs after $660 billion in subprime-related losses. They may force lenders to post more reserves after governments worldwide announced $3 trillion in financial-industry rescue packages since last month, according to Barclays Capital.
``We'll see the same problems we've seen in subprime,'' said Alistair Milne, a professor in banking and finance at Cass Business School in London and a former U.K. Treasury economist. ``Banks will take substantial markdowns.''
The collapse of Lehman Brothers, Washington Mutual Inc. and the three banks in Iceland prompted Susquehanna Bancshares Inc., a Lititz, Pennsylvania-based lender, to lower the value of $20 million in so-called synthetic CDOs by almost 88 percent last week.
KBC Groep NV, Belgium's biggest financial-services firm, which had 377.4 billion euros ($485 billion) in assets as of June 30, wrote down 1.6 billion euros after downgrades on company- and asset-backed debt. Brussels-based KBC had 9 billion euros in CDOs as of Oct. 15, primarily linked to corporate debt, according to an investor presentation.
10 Cents
CDOs pooling asset-backed securities have been blamed for losses at the world's biggest banks, from UBS AG to Citigroup Inc. Now, corporate CDOs are starting to be affected as defaults rise and speculation mounts that the world economy is headed for a recession.
Some synthetic CDOs, tied to credit-default swaps on corporate bonds, are trading at less than 10 cents on the dollar, according to Sivan Mahadevan, a derivatives strategist at Morgan Stanley in New York.
CDOs parcel fixed-income assets such as bonds or loans and slice them into new securities of varying risk, providing higher returns than other investments of the same rating.
Credit-default swaps are derivatives based on bonds and loans and used to protect against or speculate on defaults. Should a borrower fail to meet debt agreements, the contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent. An increase in the agreement's cost indicates a deteriorating perception of credit quality.
Private Market
About $254 billion of CDOs tied to mortgages for borrowers with poor credit histories have defaulted, according to Wachovia Corp. Estimating losses on those linked to corporate bonds is difficult because the underlying debt and the structure of the transaction can vary in this private market, said Mahadevan.
Derivatives are contracts whose value is derived from assets including stocks, bonds, currencies and commodities, or from events such as the weather or changes in interest rates.
Downgrades of corporate CDOs will force investors to boost capital, according to an Oct. 17 report from Barclays Capital analysts led by Puneet Sharma in London.
Buyers of deals graded AA by Standard & Poor's and Aa2 by Moody's Investors Service, the third-highest rankings, may have to increase cushions against losses to cover the full amount of the investment, up from 1.2 percent now, Sharma said. His estimate is based on the world economy entering a ``severe'' recession.
Record Lows
Demand for synthetic CDOs helped fuel growth in the credit- default swap market and pushed the cost of default protection to record lows in 2007. That in turn drove down company borrowing expenses. Sales of such CDOs surged to $503 billion in 2006, from $84 billion five years earlier, according to Morgan Stanley.
Bankers loaded the securities with bonds and swaps offering the highest return for a given credit ranking, indicating higher risk. An AA rated European issue offered an average yield of 50 basis points over money-market rates when sold in 2006, according to UniCredit SpA analysts in Munich. Similarly rated corporate bonds paid 9 basis points. A basis point is 0.01 of a percentage point.
``The maths ended up driving the way CDO portfolios were put together,'' said Nigel Sillis, a fixed-income and currency analyst at Baring Asset Management Ltd. in London.
Credit Analysis
The banks that structured the securities and investors both failed to do ``fundamental credit analysis,'' said Janet Tavakoli, president of Tavakoli Structured Finance in Chicago. ``They were using correlation models, they were using spread models, but they weren't doing analysis on the underlying corporations.''
Fitch downgraded 422 classes of CDOs on Oct. 13 after seven financial companies defaulted or were bailed out since September. The company didn't disclose the total number of classes it rated.
Defaults and so-called ``credit events,'' which can include government takeovers, force payment of the credit-default swaps packaged in the debt. This causes losses for investors or erodes capital.
The U.S. Treasury has broad powers under a $700 billion rescue plan enacted on Oct. 3 to purchase an array of distressed assets. While Treasury Secretary Henry Paulson has said that home loans and related securities are the main focus of the plan, CDOs or other non-mortgage-related derivatives could qualify under the law. Congress would have to be notified of their inclusion.
Treasury spokeswoman Michele Davis didn't immediately respond to a request for comment.
Barclays Capital estimates that 70 percent of synthetic CDOs sold swaps on Lehman. Swaps on Kaupthing Bank hf, Landsbanki Islands hf and Glitnir Banki hf were included in 376 CDOs rated by S&P. The company ranks almost 3,000.
Fannie, Freddie
About 1,500 also sold protection on Washington Mutual, the bankrupt holding company of the biggest U.S. bank to fail, according to S&P. More than 1,200 made bets on both Fannie Mae and Freddie Mac, the New York-based rating company said.
The collapse of Lehman, WaMu and the Icelandic banks, as well as the U.S. government's seizure of the mortgage agencies, will have a ``substantial'' impact on corporate CDO ratings, S&P said in a report Oct. 16.
The government in Reykjavik seized Kaupthing Bank, the country's largest lender, earlier this month. Assets and liabilities from Landsbanki Islands and Glitnir Banki were transferred to state-owned entities, triggering default swaps.
Default Forecasts
Nonpayment on speculative-grade corporate bonds may rise to 7.9 percent worldwide in a year, from 2.8 percent at the end of the third quarter, as the credit crisis deepens, Moody's said Oct. 8. Those in the U.S. may rise to 7.6 percent, said S&P.
``As there are credit events, you'll have losses in portfolios and marking down of other assets,'' said Claude Brown, a partner at law firm Clifford Chance LLP in London.
Investors may sell the CDOs back to the banks that structured them, which will unwind protection they wrote to hedge swap transactions, Barclays said. The chain of events will push up the price of default protection and company borrowing, according to Barclays.
Banks unwinding hedges helped double the cost since April of default insurance on the lowest-ranking equity portion of the benchmark Markit CDX North America Investment Grade Index, to 75 percent upfront and 5 percent a year. That equates to $7.5 million in advance plus $500,000 annually on $10 million of debt for five years.
For European investment-grade company debt, as shown by the Markit iTraxx Europe index of credit-default swaps, the price for protecting against nonpayment may climb 50 basis points to a record 200 next year, Barclays forecasts.
Buy Now
Some investors are choosing to buy protection and determine their losses now, according to Edmund Parker, head of derivatives at law firm Mayer Brown LLP in London.
National Australia Bank, the country's biggest lender by assets, paid A$100 million ($67 million) this year to hedge the risk of loss on six company-linked CDOs totaling A$1.6 billion. It will pay a further A$60 million annually for the next five years, according to company filings.
``The upside is that you've now drawn a line on those assets and you know you're not going to lose more than your hedging costs,'' Parker said. ``Unless, of course, your counterparty goes under.''
Still, investors don't have to unwind CDOs. They could hold on until the debt instrument matures if they judge defaults won't be bad enough to prevent them getting their money back, according to Barclays Capital analysts.
Radian, CIT
Companies most frequently referenced in synthetic CDOs include Philadelphia-based Radian Group Inc., the third-largest U.S. mortgage insurer, whose stock fell 68 percent in New York trading this year. Another is CIT Group Inc., an unprofitable commercial lender in New York that dropped 83 percent. The company faces about $2.4 billion in debt repayments by the end of 2008, according to data compiled by Bloomberg.
``We feel very strongly that we have adequate claims-paying capabilities for both our financial-guarantee business and our mortgage-insurer business,'' said Radian spokesman Richard Gillespie.
CIT spokesman Curtis Ritter declined to comment, pointing to the company's statement last week that it will meet funding needs for the next 12 months.
Forecasts for ratings downgrades are ``going to force a lot of activity'' in unwinding CDOs, said Rohan Douglas, former director of global credit derivatives research at Citigroup. He now heads Quantifi Inc., a provider of valuation models for the debt. ``Buy-and-hold investors suddenly find themselves in a situation where they will have to sell these assets.''
To contact the reporters on this story: Abigail Moses in London Amoses5@bloomberg.net; Neil Unmack in London nunmack@bloomberg.net; Shannon D. Harrington in New York at sharrington6@bloomberg.net
Oct. 22 (Bloomberg) -- Investors are taking losses of up to 90 percent in the $1.2 trillion market for collateralized debt obligations tied to corporate credit as the failures of Lehman Brothers Holdings Inc. and Icelandic banks send shockwaves through the global financial system.
The losses among banks, insurers and money managers may spark the next round of writedowns on CDOs after $660 billion in subprime-related losses. They may force lenders to post more reserves after governments worldwide announced $3 trillion in financial-industry rescue packages since last month, according to Barclays Capital.
``We'll see the same problems we've seen in subprime,'' said Alistair Milne, a professor in banking and finance at Cass Business School in London and a former U.K. Treasury economist. ``Banks will take substantial markdowns.''
The collapse of Lehman Brothers, Washington Mutual Inc. and the three banks in Iceland prompted Susquehanna Bancshares Inc., a Lititz, Pennsylvania-based lender, to lower the value of $20 million in so-called synthetic CDOs by almost 88 percent last week.
KBC Groep NV, Belgium's biggest financial-services firm, which had 377.4 billion euros ($485 billion) in assets as of June 30, wrote down 1.6 billion euros after downgrades on company- and asset-backed debt. Brussels-based KBC had 9 billion euros in CDOs as of Oct. 15, primarily linked to corporate debt, according to an investor presentation.
10 Cents
CDOs pooling asset-backed securities have been blamed for losses at the world's biggest banks, from UBS AG to Citigroup Inc. Now, corporate CDOs are starting to be affected as defaults rise and speculation mounts that the world economy is headed for a recession.
Some synthetic CDOs, tied to credit-default swaps on corporate bonds, are trading at less than 10 cents on the dollar, according to Sivan Mahadevan, a derivatives strategist at Morgan Stanley in New York.
CDOs parcel fixed-income assets such as bonds or loans and slice them into new securities of varying risk, providing higher returns than other investments of the same rating.
Credit-default swaps are derivatives based on bonds and loans and used to protect against or speculate on defaults. Should a borrower fail to meet debt agreements, the contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent. An increase in the agreement's cost indicates a deteriorating perception of credit quality.
Private Market
About $254 billion of CDOs tied to mortgages for borrowers with poor credit histories have defaulted, according to Wachovia Corp. Estimating losses on those linked to corporate bonds is difficult because the underlying debt and the structure of the transaction can vary in this private market, said Mahadevan.
Derivatives are contracts whose value is derived from assets including stocks, bonds, currencies and commodities, or from events such as the weather or changes in interest rates.
Downgrades of corporate CDOs will force investors to boost capital, according to an Oct. 17 report from Barclays Capital analysts led by Puneet Sharma in London.
Buyers of deals graded AA by Standard & Poor's and Aa2 by Moody's Investors Service, the third-highest rankings, may have to increase cushions against losses to cover the full amount of the investment, up from 1.2 percent now, Sharma said. His estimate is based on the world economy entering a ``severe'' recession.
Record Lows
Demand for synthetic CDOs helped fuel growth in the credit- default swap market and pushed the cost of default protection to record lows in 2007. That in turn drove down company borrowing expenses. Sales of such CDOs surged to $503 billion in 2006, from $84 billion five years earlier, according to Morgan Stanley.
Bankers loaded the securities with bonds and swaps offering the highest return for a given credit ranking, indicating higher risk. An AA rated European issue offered an average yield of 50 basis points over money-market rates when sold in 2006, according to UniCredit SpA analysts in Munich. Similarly rated corporate bonds paid 9 basis points. A basis point is 0.01 of a percentage point.
``The maths ended up driving the way CDO portfolios were put together,'' said Nigel Sillis, a fixed-income and currency analyst at Baring Asset Management Ltd. in London.
Credit Analysis
The banks that structured the securities and investors both failed to do ``fundamental credit analysis,'' said Janet Tavakoli, president of Tavakoli Structured Finance in Chicago. ``They were using correlation models, they were using spread models, but they weren't doing analysis on the underlying corporations.''
Fitch downgraded 422 classes of CDOs on Oct. 13 after seven financial companies defaulted or were bailed out since September. The company didn't disclose the total number of classes it rated.
Defaults and so-called ``credit events,'' which can include government takeovers, force payment of the credit-default swaps packaged in the debt. This causes losses for investors or erodes capital.
The U.S. Treasury has broad powers under a $700 billion rescue plan enacted on Oct. 3 to purchase an array of distressed assets. While Treasury Secretary Henry Paulson has said that home loans and related securities are the main focus of the plan, CDOs or other non-mortgage-related derivatives could qualify under the law. Congress would have to be notified of their inclusion.
Treasury spokeswoman Michele Davis didn't immediately respond to a request for comment.
Barclays Capital estimates that 70 percent of synthetic CDOs sold swaps on Lehman. Swaps on Kaupthing Bank hf, Landsbanki Islands hf and Glitnir Banki hf were included in 376 CDOs rated by S&P. The company ranks almost 3,000.
Fannie, Freddie
About 1,500 also sold protection on Washington Mutual, the bankrupt holding company of the biggest U.S. bank to fail, according to S&P. More than 1,200 made bets on both Fannie Mae and Freddie Mac, the New York-based rating company said.
The collapse of Lehman, WaMu and the Icelandic banks, as well as the U.S. government's seizure of the mortgage agencies, will have a ``substantial'' impact on corporate CDO ratings, S&P said in a report Oct. 16.
The government in Reykjavik seized Kaupthing Bank, the country's largest lender, earlier this month. Assets and liabilities from Landsbanki Islands and Glitnir Banki were transferred to state-owned entities, triggering default swaps.
Default Forecasts
Nonpayment on speculative-grade corporate bonds may rise to 7.9 percent worldwide in a year, from 2.8 percent at the end of the third quarter, as the credit crisis deepens, Moody's said Oct. 8. Those in the U.S. may rise to 7.6 percent, said S&P.
``As there are credit events, you'll have losses in portfolios and marking down of other assets,'' said Claude Brown, a partner at law firm Clifford Chance LLP in London.
Investors may sell the CDOs back to the banks that structured them, which will unwind protection they wrote to hedge swap transactions, Barclays said. The chain of events will push up the price of default protection and company borrowing, according to Barclays.
Banks unwinding hedges helped double the cost since April of default insurance on the lowest-ranking equity portion of the benchmark Markit CDX North America Investment Grade Index, to 75 percent upfront and 5 percent a year. That equates to $7.5 million in advance plus $500,000 annually on $10 million of debt for five years.
For European investment-grade company debt, as shown by the Markit iTraxx Europe index of credit-default swaps, the price for protecting against nonpayment may climb 50 basis points to a record 200 next year, Barclays forecasts.
Buy Now
Some investors are choosing to buy protection and determine their losses now, according to Edmund Parker, head of derivatives at law firm Mayer Brown LLP in London.
National Australia Bank, the country's biggest lender by assets, paid A$100 million ($67 million) this year to hedge the risk of loss on six company-linked CDOs totaling A$1.6 billion. It will pay a further A$60 million annually for the next five years, according to company filings.
``The upside is that you've now drawn a line on those assets and you know you're not going to lose more than your hedging costs,'' Parker said. ``Unless, of course, your counterparty goes under.''
Still, investors don't have to unwind CDOs. They could hold on until the debt instrument matures if they judge defaults won't be bad enough to prevent them getting their money back, according to Barclays Capital analysts.
Radian, CIT
Companies most frequently referenced in synthetic CDOs include Philadelphia-based Radian Group Inc., the third-largest U.S. mortgage insurer, whose stock fell 68 percent in New York trading this year. Another is CIT Group Inc., an unprofitable commercial lender in New York that dropped 83 percent. The company faces about $2.4 billion in debt repayments by the end of 2008, according to data compiled by Bloomberg.
``We feel very strongly that we have adequate claims-paying capabilities for both our financial-guarantee business and our mortgage-insurer business,'' said Radian spokesman Richard Gillespie.
CIT spokesman Curtis Ritter declined to comment, pointing to the company's statement last week that it will meet funding needs for the next 12 months.
Forecasts for ratings downgrades are ``going to force a lot of activity'' in unwinding CDOs, said Rohan Douglas, former director of global credit derivatives research at Citigroup. He now heads Quantifi Inc., a provider of valuation models for the debt. ``Buy-and-hold investors suddenly find themselves in a situation where they will have to sell these assets.''
To contact the reporters on this story: Abigail Moses in London Amoses5@bloomberg.net; Neil Unmack in London nunmack@bloomberg.net; Shannon D. Harrington in New York at sharrington6@bloomberg.net
House prices to decline 60% everywhere?
My name is Daan de Wit. With me here today is Albert Spits from the Frédéric Bastiat Foundation. We met each other at one of the info-dinners hosted by Willem Middelkoop, author of the bestseller (Dutch only) If The Dollar Falls. Mr. Spits, you are an advisor for pension funds.
I am.
-But you are also clearly interested in the mechanisms behind money.
Exactly.
-And this interest of yours is incorporated into the advice you give. Could you first talk about what your work involves and how much money we're talking about here?
The advisory organization that I work for deals in the millions of euro's, hundreds of millions, and that involves personal advice, actuary, pension administration, and everything associated with that. We're talking about pensions with an average turnover in the hundreds of millions.
-So the advice you give has a fair amount of impact?
Yes.
-Talk a little about your background, as well as your interest in the mechanisms of the financial world, and how you ended up at that dinner with Willem Middelkoop.
Albert Spits: It actually began 25 years ago in 1983. At that time I was still living in New Zealand , where I was studying Pedagogy and Psychology, and because New Zealand was going through some awfully difficult economic times - we were coming out of an economic crisis - I became more interested in the how and the why of the economy, and why it was looking so bad.
I became absorbed in four economic schools of thought. I started with the Keynesian School , which is the one most widely taught at universities in the Western world. I also studied Monetarism - the Monetarism of Milton Friedman - also called the Chicago School . The supply-siders - not so well known in The Netherlands, but more so in the English world, the Anglo-Saxon world - that's the school of Jude Wanniski , who was one of Ronald Reagan's biggest advisors, hence the term ‘Reaganomics'. And the last school that I studied was the Austrian School of economics. Strangely enough that was the school which interested me the most because it came closest to what I call the essence of economics. This school came about in the 19th century and came to the conclusion that the economy worked differently than the Keynesians and the Monetarists would have us believe.
The reason was that the economy was actually controlled from the standpoint of value, not so much from the standpoint of trust like we know now, but from the point of view of value - that there should always be a benchmark for value. But without getting too deep into all that... The reason I found out about this, that was only after 11 years of study, in 1994 (I started in 1983 and actually came to the discovery in 1994), and since then I've been more occupied with the Austrian School and at one time gave a number of lectures on it. At that time I worked at a corporate training agency. I utilized this information in financial training of production managers, department heads, etc.
In 2002, together with Sander Boon and René van Wissen, I founded the Frédéric Bastiat Foundation, and since then we've been engaged with the analysis and research of the economy. My studies of the Austrian School totally preoccupied me... I started in 1993. The book that actually set me on the path was 'The Road to Serfdom' by Friedrich von Hayek. That was a book from 1944 in which he explained that socialism would lead to serfdom. I found that really interesting. After that I read some of his other books, and gradually I came around to Ludwig von Mises, the biggest exponent of the Austrian School in the 20th century. It was tough going to get there because I first had to wade through all these other schools of thought and I was also busy reading articles on the economy - articles from the Financial Times, The Economist, Business Review, etc - which continually led me toward that same Keynesian way of thinking, and that put me on the wrong path for roughly eleven years.
-And you were doing your own research the whole time, never with the intention of for instance writing a book...
No, it was never my goal to write a book. I certainly accumulated a lot of information that I was able to use later on in my lectures, in my articles, etc. Right now I'm working on a publication.
-Eleven years of doing your own research, has that payed off in your work as a consultant for pension funds?
Yes, it really has.
-Have you come to a conclusion after all these years of research?
Yes, I have come to a conclusion, and that conclusion is that the fiat currency system... I'll just explain what the fiat currency system is. The fiat currency system - the system that we have now - is based on trust, trust in paper money, trust in the government. That trust is always temporary. That's why we experience upheavals, revolutions, etc. The more say that you allow a government to have, the more a government is going to abuse it. That's the conclusion that I have drawn from history. Having said that, you can see that a specific monetary standard is necessary, a fixed standard. You can't base everything on trust, because trust will simply be abused - history has taught us that. So you need a specific standard, like the gold standard or the silver standard or a bimetal standard, which means gold and silver together. That means that people will keep their promises. You prevent the government from printing money...
-But that's what's happening now... What to do?
That's right. The credit crisis is now the end point, the final phase of sixty years of credit expansion. And I am specifically not talking about the expansion of the money supply, because those are two different issues. You have credit expansion and you have monetary inflation. Monetary inflation is, in and of itself, printing money. Credit expansion is based on the promise to pay money back. Banks lend money to people hoping that it gets paid back because those banks are obliged to pay back the central bank. The central bank approves the credit that the banks lend to individuals and companies. If people are no longer able to pay it back because they've gotten so deep into debt, then the banking sector can't meet its obligations to the central bank either. That results in bankruptcy. And what we're now seeing - the first signs of this with the credit crisis - is that a few banks have already gone bankrupt. Bear Stearns, Northern Rock…
-But is that caused by the public or by governments?
That's caused by the government. I don't know if the term 'moral hazard' says anything to you. Moral hazard means the longer that things are going well, the more people there are who dare to take risks, the more risks there are being taken. And those risks translate into more credit. We have now generated a huge bubble that since the 1990's has totally exploded, and under normal circumstances this could no longer be paid back. In reality this means that everything needs to be reorganized.
-That also means that by definition the situation cannot be resolved.
Not with this system.
-Yet I'm reading reports that we've seen the worst of this credit crisis...
No, we haven't even seen the beginning of it yet, or at the very least we're just now at the beginning of it. We have a huge problem with hedge funds, which have issued a whole lot of money or credit. The housing market is only now starting to collapse, but soon it will be coupled with huge collapses...
-Are we talking just about America here, or Europe as well?
Europe too. Actually the rest of the world as well - they're coming right along with us. This is the first fiat currency system on a global scale that we've ever had in history. In the past it was localized, regionalized: for example there have been specific countries that did this, while other countries made use of the gold or silver standard. So you had other countries that could then straighten things out again.
-So you could say that it's never been quite as bad as it is now...
It's never been as bad as now. We have a credit bubble of roughly... The Gross World Product is currently 45 trillion dollars. The derivative time bomb heading our way is in upwards of 500 trillion dollars, so there is actually a bubble amounting to more than ten times that which the world produces each year.
-Will that by definition collapse?
Yes, because it's an exponential occurrence. At the time that the options market first began in the 1980's - initially the derivatives market - at that time there were but a few million dollars that were sunk into it worldwide. Now we see that that has grown in the 28 years since to almost 500 trillion dollars. So it's exponential. That also has to do with the desire to take risks - if things are going well for a long period of time, people are going to take more and more risks. But they're not getting corrected by a gold standard that would force you at a given moment to pay back your money to your creditors or to the banks. Debts are getting loaned out anew, in the form of a 'CDO' - a Collateralized Debt Obligation. They get bundled together - mortgages, loans... It gets put back into the market again in the form of financial instruments.
-Yes, at which point it's no longer subject to oversight.
Right, no one is keeping track of it anymore. It's not even known how much credit is currently outstanding. Someone once said - I don't know exactly who it was - 'Money is always scarce, and as soon as it is no longer scarce, it is no longer money'. And that describes this situation quite well. Particularly in the 1990's, we know that people here in The Netherlands took out credit for kitchens, roof dormers, vacations, big cars... All that credit was taken out against the mortgage. Because the value of homes kept rising, it was possible to keep borrowing against it. That has come to an end. In America they have the same problem. People were using their home as a sort of ATM. As long as housing prices kept on rising, that could be easily financed. Now housing prices are no longer rising, they're falling; that began in 2005. The credit crisis, which began in 2007, is a direct result of that.
-There is also the American government, which has been spending money like it's water and dumping it into a black hole in Iraq . It's as if it doesn't matter anymore.
Yes, that' true. Look, they're living off of credit. That's not money. The word "credit" comes from the Latin 'credere' meaning 'to trust'. You trust that you'll be paid back. But what happens if no one gets paid back anymore? What happens when people are in a state of bankruptcy? This is going to result in a contraction of credit once this credit crisis is over. In the past those with the worst credit could get money or mortgages or loans. Now those with the best credit will soon no longer be able to get a loan. We're now seeing the beginning of this contraction, because most banks are now wary of financing real estate projects, for instance. So we're seeing this all around us. This problem is going to express itself at the level of the individual consumer. What we're seeing with the credit crisis is just the beginning of what is to come, and it will probably be resolved in eight to ten years time.
-If possible, could you paint a picture of what the future holds.
The housing market is going to collapse.
-In The Netherlands as well?
In The Netherlands as well. Take a look at history - in Florida in 1925, 1926 the housing market collapsed to twenty percent of its value. If we look at Japan during the 1990's, the real estate market fell by 13%. To say that there will be a collapse of ten to twenty percent is very optimistic. Because we're talking about a deflationary situation, not about monetary deflation. We're talking about credit deflation, i.e. when credit is no longer available. People just plain need credit in order to purchase a home, a mortgage. Nobody can pay for that out of their own pocket. So homes won't be purchased anymore. Not only will it be a buyers market, but it will become a buyers market without any buyers.
-But are we not in a unique situation in The Netherlands because we live in such a densely populated country, where home prices always remain quite high?
Well, take a look at the 1920's. In the 1920's there was a housing shortage in the Netherlands , and in the 1930's that was resolved. A lot of people don't know about the Housing Act homes - the Dutch Housing Act dates back to the beginning of the last century. Because of World War I there weren't many homes and that prolonged the housing shortage into the 1920's. By the 1930's the housing shortage was over.
-But can you translate that into today's terms.
Well I think that the housing shortage that we have now... There is no housing shortage, there is a shortage of affordable housing. And that's only because the value of homes has risen so much. So someone who has €300,000 can easily buy a home. But someone who doesn't have that money or can't get any credit, that person faces a problem, and so has to go looking for a rental, which is harder to find.
-So home prices in The Netherlands are going to decline?
They are going to decline, yes.
-In England there was a cabinet minister photographed with a document, the text of which was so sharp that you could read it on the photo. It was Minister Caroline Flint. On the document it said that ‘‘at best' prices will tumble this year by five to ten percent'. That was in reference to England . It's widely known that home prices in England will most likely fall. What percentage do you expect for The Netherlands , and over how much time?
Well, I think you should figure on a drop of at least sixty percent. I'm working off of ratios. There was a great article in The Economist in 1987 that talked about the ratio of the housing market - average income versus the average price of a home. In 1987 the average income in The Netherlands was not the modal, see, the modal is higher. The Netherlands is one of the few countries that uses modal income, the rest of the world uses average income, which is lower. At that time the average income was 42,000 guilders, which converts to around 20,000 euros, and the average price of a home at that time was 145,000 guilders. So you end up with a ratio of roughly a little more than three. Historically the ratio is between three and four. If you look at the average price of a house and then assume the average income today - that's something like 30,000 euros - then you'd have to calculate the average price of a home at 120,000 euros. But where is it now? It's at 240,000 euros. So in order to get back to the average, it has to drop by 50%.
-You mentioned 60%, how long until then?
In Japan it lasted from 1993 until 2000. So you have to think in terms of a time frame of 6 to 7 years from now.
-But what should you do, you still have to live somewhere?
That's true. For those who are renting: Wait to buy, because an enormous buyers market is on the way. Try to build up a savings. For those who have their own house with a decent mortgage, I would advise putting 10% of that mortgage into gold or silver.
-But not to sell the house and get a rental?
You can sell and rent. But it's a difficult market for sellers right now, and that's when you're still living in it. If you want to sell, then I would get going on it quickly.
-With selling?
With selling.
-Tell me about this 10%. 10% of the mortgage.
-Ten percent of that mortgage...
In gold or in silver. Gold is still at an historic low now. If we look at the ratio between the amount of credit and the amount of gold that's out there, or better put: the amount of monetary instruments - that's money, euros, dollars, etc. - then we can see that gold represents approximately one tenth of that value. Because we're currently heading toward a crisis situation, we're starting to see a flight towards things of value, a flight to gold. So the price of gold is going to have to go ten times higher in order to keep pace with all of the paper money in circulation.
-So even if you get in now, the price is still going to increase tenfold?
Yes, ten times higher. I expect that the price of gold, which is now at 500 euros, will be somewhere between 4500 and 5000 euros in 2016.
-Is it a good idea to buy other precious metals as well?
If you're smart, you'll purchase half in silver and half in gold.
-But your advice is to actually buy it, to physically have it in your house?
Yes, in a place where it can be stored. I wouldn't buy a gold certificate at the bank because banks can fail.
-But if you don't buy it on paper but rather as actual gold, and you store it at the bank, the bank can still shut down.
Right, but not in a separate safe. You would need to have a separate safe at the bank. You could have it stored at a place like Shurguard. That's a kind of big storage shed with safes, you can store it there yourself.
-Or you dig a hole and stick it in the ground...
You can do that too. Or you can procure your own safes, a very good safe, and rivet it into the wall. That way you'll always have it within arm's reach.
-Still it all sounds rather extreme.
It may sound absurd, but if worst comes to worst - and we've experienced it before in the depression and also during the war - then gold and silver are the only currencies that you'll be able to buy food with or that you'll be able to survive off of. For people who have never experienced this it sounds very strange.
-But you've never experienced it either, have you?
No, I haven't. But my parents experienced it, and I heard it from them firsthand. Most people get this secondhand because their parents didn't experience it either, but their grandparents did. That's the problem. You remember what your parents told you, but you don't remember what your grandparents told you.
-Willem Middelkoop says: Monetary systems have collapsed 220 times throughout history. So it's not crazy to think that it might happen one more time. Relocating, moving away from the densely populated Netherlands - does that continue to be an option?
If you're looking for a kind of value-based system, then big cities are not preferable. See, in a big city you're always going to have the problem of riots that could break out, uprisings, revolutions.
-Or if the supermarket isn't stocked anymore...
Right. So then you have to get to the countryside, out of the city. There you could purchase a farm, for example, or you could occupy one. You should live close to farmland anyway, so that in a time of crisis you can provide for food.
-This time of crisis will come after the dollar has collapsed?
When the ATM's are no longer accessible. When the banks close their doors.
-And you consider this situation possible?
It's already happened once.
-Right, in Argentina. But do you have a time frame in mind for when this might happen?
We're now in a period of time in which things can change very quickly. I think that starting in 2012 we'll have to take into account the possiblity that banks or the banking sector could shut down. Then you're really dependent on the government, the government will step right in of course. At that point you'll be dependent on the government for your income, just like we saw right after the Second World War.
-Why 2012?
I've done my own research into the demographic situation: At that point we will have had the biggest bubble - the baby boomers that spent the most. The peak of the baby boom was somewhere between 1958 and 1962. That is the wave that is now heading in the direction of retirement age. By 2012 this largest wave will already be in decline. That also means that stock markets in the West will collapse. That has implications for businesses that are dependent on consumption, because consumption will naturally decrease. Then we'll probably find ourselves in a heavily deflationary situation. On the one hand prices will fall because businesses will still have to provide goods to the public. On the other hand monetary inflation, which the government attends to, will increase. Raw materials and vital necessities will then become more expensive.
-How does this insight affect your work as an advisor to pension funds, and how does it affect your personal situation?
I've already hedged my own capital by putting 10% of it into gold. I've already transferred my pension into raw materials and raw material shares. I sold my house in 2002, and I've been renting since then. As far as pension funds go, we're currently advising that a minumum of 10% of pension assets be put into gold.
-Is 10% enough?
Ten percent is the foundation - you still have the raw materials as well. That's another story, that's above and beyond precious metals. That's also something that I've done some research into: At a certain point gold and silver are going to decouple from raw materials and become monetary metals. Right now they are still seen as raw materials, but soon they will be considered monetary metals. That's the money that we'll be left with when the mountain of paper money collapses.
-OK, so that's your advice. But how does this information sit with the pension funds, these rather extreme ideas?
There are already a few pension funds that have come around to it. Unfortunately I can't name names without their approval. Obviously they don't want to broadcast it. But we're working on it. I think that it will most likely be a few years before a number of them are on board. As far as the bigger pension funds like ABP and PGGM go, we don't advise them.
-ABP is heavily invested in the U.S. dollar, is it not?
That's correct.
-Are they not running a huge risk?
Yes, they are running a risk, PGGM as well. They're very deep into stocks. That makes sense because they are really big pension funds. These are the great hulking supertankers of the pension fund world, so they're difficult to budge. If they were to put 10% of their assets into gold, the gold market would explode right now. So that's not advisable. But I do believe that they are going to have to make a shift in their entire way of thinking.
-How does it look for all the employees of ABP? Are they not in danger because of all this?
They are, and that's why I'm also advising them to invest in gold and silver so as to secure their personal assets. So that they are not solely dependent upon their pension and the government, but have instead secured their assets themselves a little bit.
-If I could ask another personal question - have you purchased a boat, or some land in Paraguay, like president Bush?
No, all my assets are liquid. That is to say: Gold, silver, as well as savings in the bank. You see, I'm waiting until everything collapses, and then I'll go ahead and buy something. To give an example: Recently I heard in the news that you can buy a single family home in Miami, Florida - right now - for 45,000 dollars. Four or five years ago, just before the collapse, those houses went for between 150,000 and 200,000 dollars. That's just an example...
-But is that an investment then?
Well, not an investment, it can also serve as a place to live. And with your retirement pension you can live anywhere you want.
-But is America really a smart place to live?
Personally America wouldn't be my choice, I'm just using it as an example.
-Why not?
Because in America you still have the same problems as here, especially if you live in the big city - riots and uprisings.
-But wouldn't you have even more issues in America because of the possible accumulation of harsh legislation?
That's true, it's definitely not my land of choice these days, with the Patriot Acts... Personal freedoms are being heavily restricted. And that's going to start getting worse soon because people tend toward extreme measures in a crisis situation. That's within the government, but the people will ask for it as well. We saw this in the 1930's with the election of Adolph Hitler: When people find themselves in extreme circumstances, they want extreme people in power. They want someone who will start solving things right away.
-I spoke with Willem Middelkoop about departing for another country. He made mention of some specific places that would be good to go to. He said: When it is warm, then...
South America is a nice example. I know some folks who live there and they also say that the climate is great. The problem with Brazil* is that there is an awful lot of crime - I wouldn't be so quick to recommend that country. Though Australia would be good. I myself have lived in New Zealand , that could be an option. Again, these are countries that are involved in the credit crisis, they have also built up a huge amount of debt.
* Also read the interview: DeepJournal interviews an expatriate who did what Willem Middelkoop is advising.
-What are you going to do?
At the moment I'm thinking things over. I think I'll go with an early retirement. And then I'll be thinking more about South America.
As long as things are going fine, then it's okay. But if you find yourself in a situation in which you need to find a way out, if you can buy a piece of land for not too much money, a place where you can grow your own vegetables and have alternative sources of energy like wind and solar on your own property... Then you'll be less dependent than you would be if you lived in a big city and were dependent on someone else for your energy, for your shopping, for your garbage pick-up, etc. In the countryside you're less dependent.
-Is there still time to get there if things go wrong?
If you have money! Most people who are in debt have few options. That's why I also advise people: Try to conserve your assets now. You don't need to worry about increasing your assets; conserving your assets is good enough. The money that you have from your house or from your investments can serve as an escape route.
-But at that point is there still really time? Won't everyone be standing in line, or stuck in a traffic jam?
By that time they very well could. But also by that time there will be a lot of people who can no longer get away. They'll have to put up with it. If you're in the middle of a credit crisis and the value of your home has dropped by 60%, then your alternatives have dried up.
-Credit crisis, food crisis - Middelkoop's new book is called The Permanent Oil Crisis. What does this situation say about us and our leaders?
Firstly I accuse the central banks, because they are the most responsible for creating this system. The Dutch Central Bank, the Federal Reserve, the European Central Bank - they are the ones that have actually created this situation thanks to their fiat currency system. Since the introduction of the euro, monetary inflation has been exceeded 10% per year.
A lot of people don't know it, but monetary inflation is the real, true inflation. The CPI , the Consumer Price Index, which we see as inflation, published by the Central Bureau for Statistics, is a manipulated index. There is a specific portfolio, and a weighting of commodities is done. And substitutions are made. For example if steak becomes too expensive, then it gets replaced with a substitute, like pork chops. But it's no longer the same thing that's getting weighted. That's also why you end up with some very distorted figures.
-What does the Central Bureau of Statistics say the inflation is?
At this moment the CBS is saying that it's heading in the direction of 3%.
-But in reality everything is getting 10% more expensive each year.
Yes. Currency devaluation actually. Now people are saying, ‘Yeah but I didn't really see that because I've been able to find cheap stuff'. That's because China is exporting deflation, goods are very cheap. It used to be that those goods were all made here in Europe or in America . Now they are being made in East Asia, in particular in China, where salaries are approximately one tenth of ours. Everyone knows that 80% of an industry's costs is payroll. That 80% in China is one tenth of ours. In China the value of what they produce is just 28% of the value of what we can produce in the West. That's also why China could export cheap products to us whereby the price index of China 's industrial production dropped. That has put an awful lot of pressure on the CPI.
A currency devaluation of 10% means that your euro is worth 10% less each year. I asked for the data from the Dutch Central Bank, the M1 and the M3 data. The M1 data was pretty impressive. (I always use M1 as monetary inflation, the M1 is the growth in the money supply plus money on deposit). It has risen 499% since 1982. That's a gigantic increase. Compared to the worth of a euro and/or guilder back in 1982, today it's worth about 17 or 18 cents. Not even a fifth of the original value is left.
-That's front page news, but I'm not reading it...
That's right.
-What is your scenario for the future?
What I see is that…
What do you think the future holds? Can you sketch out a scenario for the future?
What I see is inflation and deflation occurring at the same time. I'll explain this. Inflation is monetary inflation, it just keeps growing. Because as long as we maintain trust in the currency - the euro, the dollar, the pound, the yen, etc. - the government is going to keep printing money, and the central banks will too. But at the same time there is deflation in the stock market, deflation in the housing market, deflation in commodities - not so much in raw materials, but in say industrial production.
-But monetary inflation means currency devaluation, and this deflation in commodities and houses, etc...
Yes, in capital. So you have inflation of expenditures and deflation of capital.
-So you see your wealth diminish - home prices drop.
Yes, the price of homes drops, stock prices drop, securities drop. At the same time we see inflation of the main vital necessities.
-Which we are already seeing.
Which we're now seeing, yes, that's going on now. In the 90's we experienced disinflation, which means that prices for industrial goods, etc., went down. Then in early 2000 price inflation started to slowly creep up again. What we now have is stagflation - stagnation versus inflation. And where we'll soon find ourselves is hyperinflation. At that point governments will be grasping for ways to manipulate the interest rate and the growth in the money supply. We are already seeing this unfold now, for the growth in the money supply has risen from roughly 7 to 8% in the last ten years to 10% now.
-Hyperinflation makes me think of those photos from the 1930's where you see people going to buy a loaf of bread with a cartful of money. But of course that's not going to happen now.
Well that depends.
-How do you see hyperinflation playing out today.
What we're seeing is that the 10% growth rate in the money supply is simply going to persist. So we'll get hyperinflation á la the 1970's, which we have also experienced. In the 70's prices rose sharply, by 10%, and wages rose as well. We'll see much more unrest, discontent among workers. People want higher wages in order to compensate for the higher prices, but employers can't meet that demand and they lay people off instead. So you actually end up with unemployment, massive unemployment. I think that in the next few years The Netherlands can count on more than a million unemployed workers [on a total population of 16,5 million].
-But then those people will need to receive unemployment benefits...
That's right. And that gets financed by way of monetary inflation.
-So more money gets printed as a result?
Yes
-Also here in The Netherlands?
Yes, here as well. Most people are probably unaware of this: In Frankfurt we have a central bank, the European Central Bank, but any bank in the eurozone can print its own money.
-So if the government needs more money for unemployment benefits, are they going to get that from the Dutch Central Bank?
Yes, the Dutch Central Bank is responsible for the printing of money.
-But printing additional money - they could do that anytime they wanted, couldn't they?
Yes, of course, and they do. What we see is that our leaders - I'm talking mainly about politicians - they are often ignorant people, uninformed about the real economy. A number of them may well be economists, but those are economists trained in the Keynesian school, they've never had training in the Austrian school. They think about the economy the way John Maynard Keynes did, who wrote his book in 1936. Since World War II we've plunged headlong into Keynesian economics. On the one hand that means that - as Keynes says - you can manipulate the economy, you can raise or lower the interest rate, you should print money as it becomes necessary, that the government has to provide you with financing, and that you have to be able to go into debt. That was his official position: if things aren't going well, then go into debt.
-As an investment?
As an investment, yes, exactly. 'It will turn out okay, because that investment will pay itself off soon enough. Once things are going well again, then you have to pay it off'. The problem was that most governments never bothered with that part. They went into debt, but they never paid it off. Look, Keynes' idea was that if you go into debt, you have to pay it off in good time. It was never his intention to say, 'We've gone into debt, and as long as everything's okay we'll go deeper into debt'.
-So politicians didn't have that sense of responsibility?
Exactly. That has been completely done away with over the course of decades.
-But then is the Austrian School really the great savior?
The Austrian School is an adherent of the gold standard . It functioned well for more than a century, it was introduced at the beginning of the 19th century. It wasn't a standard that was imposed by the government, it was a de facto standard that everyone complied with. The only thing the government had to do was produce gold and silver coins. In The Netherlands we had for instance the silver guilder and the silver rijksdaalder. The English had the sovereign, the French had the gold francs - the Louis d'Ors, and the Germans had the goldmark. These coins were minted and people viewed them as legal tender, as well as a way to save money. This system was able to manifest itself for an entire century, and it went very well, for there were precious few wars fought, and international trade grew so explosively that it was greater in 1909 than it was in 1964. There's a lot of talk about globalization these days, but globalization was actually already well underway in the 19th century.
-But the creation of money that completely abandons this, also is responsible for cr…
Destroying wealth.
-Not creating it?
No, destroyed, that's an imaginary value.
-But with that so-called imaginary value someone can build an actual house.
Yes that's true, that's credit. That's credit that isn't backed by anything of real value.
-But there is still real value to such a house or building... America is full of magnificent...
Full of magnificent houses. There are also about 14.5 million of them that are currently uninhabited. This is actually a destruction of capital. Those people can't afford to live in those homes because the value of the homes has risen so explosively. That is imaginary value, but money is still borrowed against this imaginary value. If you take for instance a rise in value of 100%, that 100% is all air, and then people take out a loan for 200,000 euros, while the house is actually worth 100,000 euros. So the value of that 100,000 euros is imaginary. People can't pay that, and so they move out of their house, but the bank or the financial institution can't get rid of it either by selling it for 200,000 euros to someone else. That's also why we're seeing the collapse of the housing market, and that's been going on not only in the last few years, but over the course of the last century. The problem originated in 1909 when the gold standard was abandoned. Two countries were responsible for this: France and Germany. They sensed that war with each other was in the offing, and so both Germany and France abandoned the gold standard by ceasing to pay their government officials in gold coins, and instead paying them with paper money.
-Right, whereby one is still under the impression that it's being backed by the government: 'It will turn out alright'.
Yes, 'It will turn out okay'. This paper money then went into circulation, and the gold was used as backing for the weapons industry, at which point an arms race started first between France and Germany, followed later on by all other Western countries.
From 1914-1918 the gold standard was abandoned en masse because countries began to wage war. After 1918 the gold standard was not reinstituted, though a de facto gold standard came into being, and that's something else. In countries such as Germany, France and America , day-to-day needs were no longer paid for in gold and silver, but instead with paper, because people assumed that it was backed by the central bank. Then in the 1920's an enormous amount of money was created. Money was created in America and England , in The Netherlands and in Germany , whereby a huge bubble arose in the economy in the 1920's, when there was a high rate of production of cars, radios, airplanes and trains - you name it. So there was a huge boom in the economy. This came to an end in 1929. It was at that time that the first blow came, because the value of stocks and homes was also so high, such that the value reverted back to the actual value, because people couldn't pay for that either. The 1930's are the result of all this.
In 1933 Roosevelt was the first to abandon the de facto gold standard. All Americans were required to surrender their gold, which was stored at Fort Knox . They got 20 dollars for each ounce of gold, 31 grams. Once everyone had surrendered their gold, it was revalued to 35 dollars, so people had already been made 15 dollars per ounce poorer by the government. It was only in 1975 that Americans were once again permitted to purchase gold - most people don't know that. In 1971 an awful lot of money was spent on the Vietnam War. It cost billions, and it also cost a whole lot of Fort Knox 's gold, which was traded on London 's Bullion Market.
In 1966 [French President] de Gaulle began to demand gold in place of dollars, and then America had to sell gold right away. That lasted five years. At that time America was for the most part actually without gold, and then Nixon abandoned the international gold standard. That was in effect the end of the Bretton-Woods system, which had been in vogue since 1944.
-Regarding the weapons industry... It has ultimately been able to pilfer a lot of value.
Yes.
-Are there other areas as well in which value – value that in our eyes is disappearing - ends up surfacing somewhere else? Or does it really disappear?
Value never disappears, imaginary value certainly does, but never real value. What we are now seeing are bubbles, and those are exaggerated values. We've had a bubble in the stock market which exploded in 2000. We now have a bubble in the housing market, which is now in the process of exploding. We are now also seeing a bubble in raw materials, among them oil, gas, uranium, base metals, and others. And also with rice, with soybeans - of course this is becoming a huge bubble as well. But bubbles have a tendency to last a long time; the stock bubble has lasted about 20 years, 18 to 20 years. The housing bubble too. So the bubble in raw materials is going to last something like 20 years. That began sometime in 1997 or 1998, so we can safely say that it will stick around until 2015, 2017, and then it will collapse. That bubble is also going to move automatically into the monetary metals, which are gold and silver. But before that happens it's important to know what stage a bubble is in.
-But I wonder whether or not certain groups are - we were just talking about the weapons industry which has benefited from the elimination of the gold standard - whether there are certain industries that time and time again benefit from things that to our eyes are collapsing, but which perhaps make others very happy.
[Spits interpreted my question other than I had intended it. I was curious as to his view regarding the idea that the current crises are interpreted positively by some parties, and why that might be].
I think that people who have money in savings or who have gold and silver can simply wait until everything has returned to its actual value before buying. I'm also advising people not to buy a house - don't buy a house, and if you do buy a house, then you should simply hedge your investment, should you have the money to do so. You should really just keep renting. It's actually cheaper to rent than to buy an average home now. Look, most people look at the interest rate deduction, but that's only part of the story, because there are other issues like the ratable rental value, property taxes, sewer taxes, and everything that goes along with that. All those maintenance costs have to be figured in. Then you see how renting is actually not so expensive.
I am.
-But you are also clearly interested in the mechanisms behind money.
Exactly.
-And this interest of yours is incorporated into the advice you give. Could you first talk about what your work involves and how much money we're talking about here?
The advisory organization that I work for deals in the millions of euro's, hundreds of millions, and that involves personal advice, actuary, pension administration, and everything associated with that. We're talking about pensions with an average turnover in the hundreds of millions.
-So the advice you give has a fair amount of impact?
Yes.
-Talk a little about your background, as well as your interest in the mechanisms of the financial world, and how you ended up at that dinner with Willem Middelkoop.
Albert Spits: It actually began 25 years ago in 1983. At that time I was still living in New Zealand , where I was studying Pedagogy and Psychology, and because New Zealand was going through some awfully difficult economic times - we were coming out of an economic crisis - I became more interested in the how and the why of the economy, and why it was looking so bad.
I became absorbed in four economic schools of thought. I started with the Keynesian School , which is the one most widely taught at universities in the Western world. I also studied Monetarism - the Monetarism of Milton Friedman - also called the Chicago School . The supply-siders - not so well known in The Netherlands, but more so in the English world, the Anglo-Saxon world - that's the school of Jude Wanniski , who was one of Ronald Reagan's biggest advisors, hence the term ‘Reaganomics'. And the last school that I studied was the Austrian School of economics. Strangely enough that was the school which interested me the most because it came closest to what I call the essence of economics. This school came about in the 19th century and came to the conclusion that the economy worked differently than the Keynesians and the Monetarists would have us believe.
The reason was that the economy was actually controlled from the standpoint of value, not so much from the standpoint of trust like we know now, but from the point of view of value - that there should always be a benchmark for value. But without getting too deep into all that... The reason I found out about this, that was only after 11 years of study, in 1994 (I started in 1983 and actually came to the discovery in 1994), and since then I've been more occupied with the Austrian School and at one time gave a number of lectures on it. At that time I worked at a corporate training agency. I utilized this information in financial training of production managers, department heads, etc.
In 2002, together with Sander Boon and René van Wissen, I founded the Frédéric Bastiat Foundation, and since then we've been engaged with the analysis and research of the economy. My studies of the Austrian School totally preoccupied me... I started in 1993. The book that actually set me on the path was 'The Road to Serfdom' by Friedrich von Hayek. That was a book from 1944 in which he explained that socialism would lead to serfdom. I found that really interesting. After that I read some of his other books, and gradually I came around to Ludwig von Mises, the biggest exponent of the Austrian School in the 20th century. It was tough going to get there because I first had to wade through all these other schools of thought and I was also busy reading articles on the economy - articles from the Financial Times, The Economist, Business Review, etc - which continually led me toward that same Keynesian way of thinking, and that put me on the wrong path for roughly eleven years.
-And you were doing your own research the whole time, never with the intention of for instance writing a book...
No, it was never my goal to write a book. I certainly accumulated a lot of information that I was able to use later on in my lectures, in my articles, etc. Right now I'm working on a publication.
-Eleven years of doing your own research, has that payed off in your work as a consultant for pension funds?
Yes, it really has.
-Have you come to a conclusion after all these years of research?
Yes, I have come to a conclusion, and that conclusion is that the fiat currency system... I'll just explain what the fiat currency system is. The fiat currency system - the system that we have now - is based on trust, trust in paper money, trust in the government. That trust is always temporary. That's why we experience upheavals, revolutions, etc. The more say that you allow a government to have, the more a government is going to abuse it. That's the conclusion that I have drawn from history. Having said that, you can see that a specific monetary standard is necessary, a fixed standard. You can't base everything on trust, because trust will simply be abused - history has taught us that. So you need a specific standard, like the gold standard or the silver standard or a bimetal standard, which means gold and silver together. That means that people will keep their promises. You prevent the government from printing money...
-But that's what's happening now... What to do?
That's right. The credit crisis is now the end point, the final phase of sixty years of credit expansion. And I am specifically not talking about the expansion of the money supply, because those are two different issues. You have credit expansion and you have monetary inflation. Monetary inflation is, in and of itself, printing money. Credit expansion is based on the promise to pay money back. Banks lend money to people hoping that it gets paid back because those banks are obliged to pay back the central bank. The central bank approves the credit that the banks lend to individuals and companies. If people are no longer able to pay it back because they've gotten so deep into debt, then the banking sector can't meet its obligations to the central bank either. That results in bankruptcy. And what we're now seeing - the first signs of this with the credit crisis - is that a few banks have already gone bankrupt. Bear Stearns, Northern Rock…
-But is that caused by the public or by governments?
That's caused by the government. I don't know if the term 'moral hazard' says anything to you. Moral hazard means the longer that things are going well, the more people there are who dare to take risks, the more risks there are being taken. And those risks translate into more credit. We have now generated a huge bubble that since the 1990's has totally exploded, and under normal circumstances this could no longer be paid back. In reality this means that everything needs to be reorganized.
-That also means that by definition the situation cannot be resolved.
Not with this system.
-Yet I'm reading reports that we've seen the worst of this credit crisis...
No, we haven't even seen the beginning of it yet, or at the very least we're just now at the beginning of it. We have a huge problem with hedge funds, which have issued a whole lot of money or credit. The housing market is only now starting to collapse, but soon it will be coupled with huge collapses...
-Are we talking just about America here, or Europe as well?
Europe too. Actually the rest of the world as well - they're coming right along with us. This is the first fiat currency system on a global scale that we've ever had in history. In the past it was localized, regionalized: for example there have been specific countries that did this, while other countries made use of the gold or silver standard. So you had other countries that could then straighten things out again.
-So you could say that it's never been quite as bad as it is now...
It's never been as bad as now. We have a credit bubble of roughly... The Gross World Product is currently 45 trillion dollars. The derivative time bomb heading our way is in upwards of 500 trillion dollars, so there is actually a bubble amounting to more than ten times that which the world produces each year.
-Will that by definition collapse?
Yes, because it's an exponential occurrence. At the time that the options market first began in the 1980's - initially the derivatives market - at that time there were but a few million dollars that were sunk into it worldwide. Now we see that that has grown in the 28 years since to almost 500 trillion dollars. So it's exponential. That also has to do with the desire to take risks - if things are going well for a long period of time, people are going to take more and more risks. But they're not getting corrected by a gold standard that would force you at a given moment to pay back your money to your creditors or to the banks. Debts are getting loaned out anew, in the form of a 'CDO' - a Collateralized Debt Obligation. They get bundled together - mortgages, loans... It gets put back into the market again in the form of financial instruments.
-Yes, at which point it's no longer subject to oversight.
Right, no one is keeping track of it anymore. It's not even known how much credit is currently outstanding. Someone once said - I don't know exactly who it was - 'Money is always scarce, and as soon as it is no longer scarce, it is no longer money'. And that describes this situation quite well. Particularly in the 1990's, we know that people here in The Netherlands took out credit for kitchens, roof dormers, vacations, big cars... All that credit was taken out against the mortgage. Because the value of homes kept rising, it was possible to keep borrowing against it. That has come to an end. In America they have the same problem. People were using their home as a sort of ATM. As long as housing prices kept on rising, that could be easily financed. Now housing prices are no longer rising, they're falling; that began in 2005. The credit crisis, which began in 2007, is a direct result of that.
-There is also the American government, which has been spending money like it's water and dumping it into a black hole in Iraq . It's as if it doesn't matter anymore.
Yes, that' true. Look, they're living off of credit. That's not money. The word "credit" comes from the Latin 'credere' meaning 'to trust'. You trust that you'll be paid back. But what happens if no one gets paid back anymore? What happens when people are in a state of bankruptcy? This is going to result in a contraction of credit once this credit crisis is over. In the past those with the worst credit could get money or mortgages or loans. Now those with the best credit will soon no longer be able to get a loan. We're now seeing the beginning of this contraction, because most banks are now wary of financing real estate projects, for instance. So we're seeing this all around us. This problem is going to express itself at the level of the individual consumer. What we're seeing with the credit crisis is just the beginning of what is to come, and it will probably be resolved in eight to ten years time.
-If possible, could you paint a picture of what the future holds.
The housing market is going to collapse.
-In The Netherlands as well?
In The Netherlands as well. Take a look at history - in Florida in 1925, 1926 the housing market collapsed to twenty percent of its value. If we look at Japan during the 1990's, the real estate market fell by 13%. To say that there will be a collapse of ten to twenty percent is very optimistic. Because we're talking about a deflationary situation, not about monetary deflation. We're talking about credit deflation, i.e. when credit is no longer available. People just plain need credit in order to purchase a home, a mortgage. Nobody can pay for that out of their own pocket. So homes won't be purchased anymore. Not only will it be a buyers market, but it will become a buyers market without any buyers.
-But are we not in a unique situation in The Netherlands because we live in such a densely populated country, where home prices always remain quite high?
Well, take a look at the 1920's. In the 1920's there was a housing shortage in the Netherlands , and in the 1930's that was resolved. A lot of people don't know about the Housing Act homes - the Dutch Housing Act dates back to the beginning of the last century. Because of World War I there weren't many homes and that prolonged the housing shortage into the 1920's. By the 1930's the housing shortage was over.
-But can you translate that into today's terms.
Well I think that the housing shortage that we have now... There is no housing shortage, there is a shortage of affordable housing. And that's only because the value of homes has risen so much. So someone who has €300,000 can easily buy a home. But someone who doesn't have that money or can't get any credit, that person faces a problem, and so has to go looking for a rental, which is harder to find.
-So home prices in The Netherlands are going to decline?
They are going to decline, yes.
-In England there was a cabinet minister photographed with a document, the text of which was so sharp that you could read it on the photo. It was Minister Caroline Flint. On the document it said that ‘‘at best' prices will tumble this year by five to ten percent'. That was in reference to England . It's widely known that home prices in England will most likely fall. What percentage do you expect for The Netherlands , and over how much time?
Well, I think you should figure on a drop of at least sixty percent. I'm working off of ratios. There was a great article in The Economist in 1987 that talked about the ratio of the housing market - average income versus the average price of a home. In 1987 the average income in The Netherlands was not the modal, see, the modal is higher. The Netherlands is one of the few countries that uses modal income, the rest of the world uses average income, which is lower. At that time the average income was 42,000 guilders, which converts to around 20,000 euros, and the average price of a home at that time was 145,000 guilders. So you end up with a ratio of roughly a little more than three. Historically the ratio is between three and four. If you look at the average price of a house and then assume the average income today - that's something like 30,000 euros - then you'd have to calculate the average price of a home at 120,000 euros. But where is it now? It's at 240,000 euros. So in order to get back to the average, it has to drop by 50%.
-You mentioned 60%, how long until then?
In Japan it lasted from 1993 until 2000. So you have to think in terms of a time frame of 6 to 7 years from now.
-But what should you do, you still have to live somewhere?
That's true. For those who are renting: Wait to buy, because an enormous buyers market is on the way. Try to build up a savings. For those who have their own house with a decent mortgage, I would advise putting 10% of that mortgage into gold or silver.
-But not to sell the house and get a rental?
You can sell and rent. But it's a difficult market for sellers right now, and that's when you're still living in it. If you want to sell, then I would get going on it quickly.
-With selling?
With selling.
-Tell me about this 10%. 10% of the mortgage.
-Ten percent of that mortgage...
In gold or in silver. Gold is still at an historic low now. If we look at the ratio between the amount of credit and the amount of gold that's out there, or better put: the amount of monetary instruments - that's money, euros, dollars, etc. - then we can see that gold represents approximately one tenth of that value. Because we're currently heading toward a crisis situation, we're starting to see a flight towards things of value, a flight to gold. So the price of gold is going to have to go ten times higher in order to keep pace with all of the paper money in circulation.
-So even if you get in now, the price is still going to increase tenfold?
Yes, ten times higher. I expect that the price of gold, which is now at 500 euros, will be somewhere between 4500 and 5000 euros in 2016.
-Is it a good idea to buy other precious metals as well?
If you're smart, you'll purchase half in silver and half in gold.
-But your advice is to actually buy it, to physically have it in your house?
Yes, in a place where it can be stored. I wouldn't buy a gold certificate at the bank because banks can fail.
-But if you don't buy it on paper but rather as actual gold, and you store it at the bank, the bank can still shut down.
Right, but not in a separate safe. You would need to have a separate safe at the bank. You could have it stored at a place like Shurguard. That's a kind of big storage shed with safes, you can store it there yourself.
-Or you dig a hole and stick it in the ground...
You can do that too. Or you can procure your own safes, a very good safe, and rivet it into the wall. That way you'll always have it within arm's reach.
-Still it all sounds rather extreme.
It may sound absurd, but if worst comes to worst - and we've experienced it before in the depression and also during the war - then gold and silver are the only currencies that you'll be able to buy food with or that you'll be able to survive off of. For people who have never experienced this it sounds very strange.
-But you've never experienced it either, have you?
No, I haven't. But my parents experienced it, and I heard it from them firsthand. Most people get this secondhand because their parents didn't experience it either, but their grandparents did. That's the problem. You remember what your parents told you, but you don't remember what your grandparents told you.
-Willem Middelkoop says: Monetary systems have collapsed 220 times throughout history. So it's not crazy to think that it might happen one more time. Relocating, moving away from the densely populated Netherlands - does that continue to be an option?
If you're looking for a kind of value-based system, then big cities are not preferable. See, in a big city you're always going to have the problem of riots that could break out, uprisings, revolutions.
-Or if the supermarket isn't stocked anymore...
Right. So then you have to get to the countryside, out of the city. There you could purchase a farm, for example, or you could occupy one. You should live close to farmland anyway, so that in a time of crisis you can provide for food.
-This time of crisis will come after the dollar has collapsed?
When the ATM's are no longer accessible. When the banks close their doors.
-And you consider this situation possible?
It's already happened once.
-Right, in Argentina. But do you have a time frame in mind for when this might happen?
We're now in a period of time in which things can change very quickly. I think that starting in 2012 we'll have to take into account the possiblity that banks or the banking sector could shut down. Then you're really dependent on the government, the government will step right in of course. At that point you'll be dependent on the government for your income, just like we saw right after the Second World War.
-Why 2012?
I've done my own research into the demographic situation: At that point we will have had the biggest bubble - the baby boomers that spent the most. The peak of the baby boom was somewhere between 1958 and 1962. That is the wave that is now heading in the direction of retirement age. By 2012 this largest wave will already be in decline. That also means that stock markets in the West will collapse. That has implications for businesses that are dependent on consumption, because consumption will naturally decrease. Then we'll probably find ourselves in a heavily deflationary situation. On the one hand prices will fall because businesses will still have to provide goods to the public. On the other hand monetary inflation, which the government attends to, will increase. Raw materials and vital necessities will then become more expensive.
-How does this insight affect your work as an advisor to pension funds, and how does it affect your personal situation?
I've already hedged my own capital by putting 10% of it into gold. I've already transferred my pension into raw materials and raw material shares. I sold my house in 2002, and I've been renting since then. As far as pension funds go, we're currently advising that a minumum of 10% of pension assets be put into gold.
-Is 10% enough?
Ten percent is the foundation - you still have the raw materials as well. That's another story, that's above and beyond precious metals. That's also something that I've done some research into: At a certain point gold and silver are going to decouple from raw materials and become monetary metals. Right now they are still seen as raw materials, but soon they will be considered monetary metals. That's the money that we'll be left with when the mountain of paper money collapses.
-OK, so that's your advice. But how does this information sit with the pension funds, these rather extreme ideas?
There are already a few pension funds that have come around to it. Unfortunately I can't name names without their approval. Obviously they don't want to broadcast it. But we're working on it. I think that it will most likely be a few years before a number of them are on board. As far as the bigger pension funds like ABP and PGGM go, we don't advise them.
-ABP is heavily invested in the U.S. dollar, is it not?
That's correct.
-Are they not running a huge risk?
Yes, they are running a risk, PGGM as well. They're very deep into stocks. That makes sense because they are really big pension funds. These are the great hulking supertankers of the pension fund world, so they're difficult to budge. If they were to put 10% of their assets into gold, the gold market would explode right now. So that's not advisable. But I do believe that they are going to have to make a shift in their entire way of thinking.
-How does it look for all the employees of ABP? Are they not in danger because of all this?
They are, and that's why I'm also advising them to invest in gold and silver so as to secure their personal assets. So that they are not solely dependent upon their pension and the government, but have instead secured their assets themselves a little bit.
-If I could ask another personal question - have you purchased a boat, or some land in Paraguay, like president Bush?
No, all my assets are liquid. That is to say: Gold, silver, as well as savings in the bank. You see, I'm waiting until everything collapses, and then I'll go ahead and buy something. To give an example: Recently I heard in the news that you can buy a single family home in Miami, Florida - right now - for 45,000 dollars. Four or five years ago, just before the collapse, those houses went for between 150,000 and 200,000 dollars. That's just an example...
-But is that an investment then?
Well, not an investment, it can also serve as a place to live. And with your retirement pension you can live anywhere you want.
-But is America really a smart place to live?
Personally America wouldn't be my choice, I'm just using it as an example.
-Why not?
Because in America you still have the same problems as here, especially if you live in the big city - riots and uprisings.
-But wouldn't you have even more issues in America because of the possible accumulation of harsh legislation?
That's true, it's definitely not my land of choice these days, with the Patriot Acts... Personal freedoms are being heavily restricted. And that's going to start getting worse soon because people tend toward extreme measures in a crisis situation. That's within the government, but the people will ask for it as well. We saw this in the 1930's with the election of Adolph Hitler: When people find themselves in extreme circumstances, they want extreme people in power. They want someone who will start solving things right away.
-I spoke with Willem Middelkoop about departing for another country. He made mention of some specific places that would be good to go to. He said: When it is warm, then...
South America is a nice example. I know some folks who live there and they also say that the climate is great. The problem with Brazil* is that there is an awful lot of crime - I wouldn't be so quick to recommend that country. Though Australia would be good. I myself have lived in New Zealand , that could be an option. Again, these are countries that are involved in the credit crisis, they have also built up a huge amount of debt.
* Also read the interview: DeepJournal interviews an expatriate who did what Willem Middelkoop is advising.
-What are you going to do?
At the moment I'm thinking things over. I think I'll go with an early retirement. And then I'll be thinking more about South America.
As long as things are going fine, then it's okay. But if you find yourself in a situation in which you need to find a way out, if you can buy a piece of land for not too much money, a place where you can grow your own vegetables and have alternative sources of energy like wind and solar on your own property... Then you'll be less dependent than you would be if you lived in a big city and were dependent on someone else for your energy, for your shopping, for your garbage pick-up, etc. In the countryside you're less dependent.
-Is there still time to get there if things go wrong?
If you have money! Most people who are in debt have few options. That's why I also advise people: Try to conserve your assets now. You don't need to worry about increasing your assets; conserving your assets is good enough. The money that you have from your house or from your investments can serve as an escape route.
-But at that point is there still really time? Won't everyone be standing in line, or stuck in a traffic jam?
By that time they very well could. But also by that time there will be a lot of people who can no longer get away. They'll have to put up with it. If you're in the middle of a credit crisis and the value of your home has dropped by 60%, then your alternatives have dried up.
-Credit crisis, food crisis - Middelkoop's new book is called The Permanent Oil Crisis. What does this situation say about us and our leaders?
Firstly I accuse the central banks, because they are the most responsible for creating this system. The Dutch Central Bank, the Federal Reserve, the European Central Bank - they are the ones that have actually created this situation thanks to their fiat currency system. Since the introduction of the euro, monetary inflation has been exceeded 10% per year.
A lot of people don't know it, but monetary inflation is the real, true inflation. The CPI , the Consumer Price Index, which we see as inflation, published by the Central Bureau for Statistics, is a manipulated index. There is a specific portfolio, and a weighting of commodities is done. And substitutions are made. For example if steak becomes too expensive, then it gets replaced with a substitute, like pork chops. But it's no longer the same thing that's getting weighted. That's also why you end up with some very distorted figures.
-What does the Central Bureau of Statistics say the inflation is?
At this moment the CBS is saying that it's heading in the direction of 3%.
-But in reality everything is getting 10% more expensive each year.
Yes. Currency devaluation actually. Now people are saying, ‘Yeah but I didn't really see that because I've been able to find cheap stuff'. That's because China is exporting deflation, goods are very cheap. It used to be that those goods were all made here in Europe or in America . Now they are being made in East Asia, in particular in China, where salaries are approximately one tenth of ours. Everyone knows that 80% of an industry's costs is payroll. That 80% in China is one tenth of ours. In China the value of what they produce is just 28% of the value of what we can produce in the West. That's also why China could export cheap products to us whereby the price index of China 's industrial production dropped. That has put an awful lot of pressure on the CPI.
A currency devaluation of 10% means that your euro is worth 10% less each year. I asked for the data from the Dutch Central Bank, the M1 and the M3 data. The M1 data was pretty impressive. (I always use M1 as monetary inflation, the M1 is the growth in the money supply plus money on deposit). It has risen 499% since 1982. That's a gigantic increase. Compared to the worth of a euro and/or guilder back in 1982, today it's worth about 17 or 18 cents. Not even a fifth of the original value is left.
-That's front page news, but I'm not reading it...
That's right.
-What is your scenario for the future?
What I see is that…
What do you think the future holds? Can you sketch out a scenario for the future?
What I see is inflation and deflation occurring at the same time. I'll explain this. Inflation is monetary inflation, it just keeps growing. Because as long as we maintain trust in the currency - the euro, the dollar, the pound, the yen, etc. - the government is going to keep printing money, and the central banks will too. But at the same time there is deflation in the stock market, deflation in the housing market, deflation in commodities - not so much in raw materials, but in say industrial production.
-But monetary inflation means currency devaluation, and this deflation in commodities and houses, etc...
Yes, in capital. So you have inflation of expenditures and deflation of capital.
-So you see your wealth diminish - home prices drop.
Yes, the price of homes drops, stock prices drop, securities drop. At the same time we see inflation of the main vital necessities.
-Which we are already seeing.
Which we're now seeing, yes, that's going on now. In the 90's we experienced disinflation, which means that prices for industrial goods, etc., went down. Then in early 2000 price inflation started to slowly creep up again. What we now have is stagflation - stagnation versus inflation. And where we'll soon find ourselves is hyperinflation. At that point governments will be grasping for ways to manipulate the interest rate and the growth in the money supply. We are already seeing this unfold now, for the growth in the money supply has risen from roughly 7 to 8% in the last ten years to 10% now.
-Hyperinflation makes me think of those photos from the 1930's where you see people going to buy a loaf of bread with a cartful of money. But of course that's not going to happen now.
Well that depends.
-How do you see hyperinflation playing out today.
What we're seeing is that the 10% growth rate in the money supply is simply going to persist. So we'll get hyperinflation á la the 1970's, which we have also experienced. In the 70's prices rose sharply, by 10%, and wages rose as well. We'll see much more unrest, discontent among workers. People want higher wages in order to compensate for the higher prices, but employers can't meet that demand and they lay people off instead. So you actually end up with unemployment, massive unemployment. I think that in the next few years The Netherlands can count on more than a million unemployed workers [on a total population of 16,5 million].
-But then those people will need to receive unemployment benefits...
That's right. And that gets financed by way of monetary inflation.
-So more money gets printed as a result?
Yes
-Also here in The Netherlands?
Yes, here as well. Most people are probably unaware of this: In Frankfurt we have a central bank, the European Central Bank, but any bank in the eurozone can print its own money.
-So if the government needs more money for unemployment benefits, are they going to get that from the Dutch Central Bank?
Yes, the Dutch Central Bank is responsible for the printing of money.
-But printing additional money - they could do that anytime they wanted, couldn't they?
Yes, of course, and they do. What we see is that our leaders - I'm talking mainly about politicians - they are often ignorant people, uninformed about the real economy. A number of them may well be economists, but those are economists trained in the Keynesian school, they've never had training in the Austrian school. They think about the economy the way John Maynard Keynes did, who wrote his book in 1936. Since World War II we've plunged headlong into Keynesian economics. On the one hand that means that - as Keynes says - you can manipulate the economy, you can raise or lower the interest rate, you should print money as it becomes necessary, that the government has to provide you with financing, and that you have to be able to go into debt. That was his official position: if things aren't going well, then go into debt.
-As an investment?
As an investment, yes, exactly. 'It will turn out okay, because that investment will pay itself off soon enough. Once things are going well again, then you have to pay it off'. The problem was that most governments never bothered with that part. They went into debt, but they never paid it off. Look, Keynes' idea was that if you go into debt, you have to pay it off in good time. It was never his intention to say, 'We've gone into debt, and as long as everything's okay we'll go deeper into debt'.
-So politicians didn't have that sense of responsibility?
Exactly. That has been completely done away with over the course of decades.
-But then is the Austrian School really the great savior?
The Austrian School is an adherent of the gold standard . It functioned well for more than a century, it was introduced at the beginning of the 19th century. It wasn't a standard that was imposed by the government, it was a de facto standard that everyone complied with. The only thing the government had to do was produce gold and silver coins. In The Netherlands we had for instance the silver guilder and the silver rijksdaalder. The English had the sovereign, the French had the gold francs - the Louis d'Ors, and the Germans had the goldmark. These coins were minted and people viewed them as legal tender, as well as a way to save money. This system was able to manifest itself for an entire century, and it went very well, for there were precious few wars fought, and international trade grew so explosively that it was greater in 1909 than it was in 1964. There's a lot of talk about globalization these days, but globalization was actually already well underway in the 19th century.
-But the creation of money that completely abandons this, also is responsible for cr…
Destroying wealth.
-Not creating it?
No, destroyed, that's an imaginary value.
-But with that so-called imaginary value someone can build an actual house.
Yes that's true, that's credit. That's credit that isn't backed by anything of real value.
-But there is still real value to such a house or building... America is full of magnificent...
Full of magnificent houses. There are also about 14.5 million of them that are currently uninhabited. This is actually a destruction of capital. Those people can't afford to live in those homes because the value of the homes has risen so explosively. That is imaginary value, but money is still borrowed against this imaginary value. If you take for instance a rise in value of 100%, that 100% is all air, and then people take out a loan for 200,000 euros, while the house is actually worth 100,000 euros. So the value of that 100,000 euros is imaginary. People can't pay that, and so they move out of their house, but the bank or the financial institution can't get rid of it either by selling it for 200,000 euros to someone else. That's also why we're seeing the collapse of the housing market, and that's been going on not only in the last few years, but over the course of the last century. The problem originated in 1909 when the gold standard was abandoned. Two countries were responsible for this: France and Germany. They sensed that war with each other was in the offing, and so both Germany and France abandoned the gold standard by ceasing to pay their government officials in gold coins, and instead paying them with paper money.
-Right, whereby one is still under the impression that it's being backed by the government: 'It will turn out alright'.
Yes, 'It will turn out okay'. This paper money then went into circulation, and the gold was used as backing for the weapons industry, at which point an arms race started first between France and Germany, followed later on by all other Western countries.
From 1914-1918 the gold standard was abandoned en masse because countries began to wage war. After 1918 the gold standard was not reinstituted, though a de facto gold standard came into being, and that's something else. In countries such as Germany, France and America , day-to-day needs were no longer paid for in gold and silver, but instead with paper, because people assumed that it was backed by the central bank. Then in the 1920's an enormous amount of money was created. Money was created in America and England , in The Netherlands and in Germany , whereby a huge bubble arose in the economy in the 1920's, when there was a high rate of production of cars, radios, airplanes and trains - you name it. So there was a huge boom in the economy. This came to an end in 1929. It was at that time that the first blow came, because the value of stocks and homes was also so high, such that the value reverted back to the actual value, because people couldn't pay for that either. The 1930's are the result of all this.
In 1933 Roosevelt was the first to abandon the de facto gold standard. All Americans were required to surrender their gold, which was stored at Fort Knox . They got 20 dollars for each ounce of gold, 31 grams. Once everyone had surrendered their gold, it was revalued to 35 dollars, so people had already been made 15 dollars per ounce poorer by the government. It was only in 1975 that Americans were once again permitted to purchase gold - most people don't know that. In 1971 an awful lot of money was spent on the Vietnam War. It cost billions, and it also cost a whole lot of Fort Knox 's gold, which was traded on London 's Bullion Market.
In 1966 [French President] de Gaulle began to demand gold in place of dollars, and then America had to sell gold right away. That lasted five years. At that time America was for the most part actually without gold, and then Nixon abandoned the international gold standard. That was in effect the end of the Bretton-Woods system, which had been in vogue since 1944.
-Regarding the weapons industry... It has ultimately been able to pilfer a lot of value.
Yes.
-Are there other areas as well in which value – value that in our eyes is disappearing - ends up surfacing somewhere else? Or does it really disappear?
Value never disappears, imaginary value certainly does, but never real value. What we are now seeing are bubbles, and those are exaggerated values. We've had a bubble in the stock market which exploded in 2000. We now have a bubble in the housing market, which is now in the process of exploding. We are now also seeing a bubble in raw materials, among them oil, gas, uranium, base metals, and others. And also with rice, with soybeans - of course this is becoming a huge bubble as well. But bubbles have a tendency to last a long time; the stock bubble has lasted about 20 years, 18 to 20 years. The housing bubble too. So the bubble in raw materials is going to last something like 20 years. That began sometime in 1997 or 1998, so we can safely say that it will stick around until 2015, 2017, and then it will collapse. That bubble is also going to move automatically into the monetary metals, which are gold and silver. But before that happens it's important to know what stage a bubble is in.
-But I wonder whether or not certain groups are - we were just talking about the weapons industry which has benefited from the elimination of the gold standard - whether there are certain industries that time and time again benefit from things that to our eyes are collapsing, but which perhaps make others very happy.
[Spits interpreted my question other than I had intended it. I was curious as to his view regarding the idea that the current crises are interpreted positively by some parties, and why that might be].
I think that people who have money in savings or who have gold and silver can simply wait until everything has returned to its actual value before buying. I'm also advising people not to buy a house - don't buy a house, and if you do buy a house, then you should simply hedge your investment, should you have the money to do so. You should really just keep renting. It's actually cheaper to rent than to buy an average home now. Look, most people look at the interest rate deduction, but that's only part of the story, because there are other issues like the ratable rental value, property taxes, sewer taxes, and everything that goes along with that. All those maintenance costs have to be figured in. Then you see how renting is actually not so expensive.
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