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Helicopter Ben has just made a most unpleasant
discovery. Earlier he has promised that the Federal Reserve will not stand
idly by while the dollar deflates and the economy slides into depression. If
need be, he will go as far as having dollars air dropped from helicopters.
Time has come to make good on those promises in
August when the subprime crisis erupted. To his
chagrin Ben found that electronic dollars, the kind he can create
instantaneously at the click of the mouse in unlimited quantities, cannot be
air dropped. They just won’t drop.
For electronic dollars to work they have to be able
to trickle down through the banking system. The trouble is that when bad debt
in the economy reaches critical mass, it will start playing hide-and-seek. All
of a sudden banks become suspicious of one another. Is the other guy trying
to pass his bad penny on to me? In extremis, one bank may refuse to
take an overnight draft from the other and will insist on spot payment. A
field day for Brink’s. The clearing house is idled, and armored cars run in both directions up and down Wall
Street delivering FR notes and certified checks on FR deposits.
Under such circumstances electronic dollars
won’t trickle down. In effect they are frozen. Ultimately, they may be
demonetized altogether by the market. How awkward for Helicopter Ben. He
would now have to go back to the old-fashioned and cumbersome way of
inflating the money supply via the printing press. Literally.
Northern
Rock and Roll
He had better, and do it
double quick. The Northern Rock and Roll fever may spill over across the
Atlantic from England to
the United States.
Northern Rock is a bank headquartered in Newcastle with lots of branches in the
Northern Counties. It was a high-flyer using novel ways of financing
mortgages through conduits and other SIV’s,
instead of using the more traditional methods of building societies through
savings. (SIV or Structured Investment Vehicle is euphemism for borrowing
short, lending long through securitization). Now a run on the bank has
grounded the high-flier. As long queues in front of the doors of branch offices
indicate, a world-wide run on banks may be in the offing. Bank runs were
thought to be a pathology of the gold standard. In England they
haven’t seen the like of it since 1931 when the bag lady of Threadneedle
Street went off gold. Surprise, surprise: bank
runs are now back in vogue playing havoc on the fiat
money world. Depositors want to get their money. Not the electronic variety. They
want money they can fold.
There’s the rub. Pity Helicopter Ben. It
looked so simple a couple of weeks ago. The promise of an air drop should
stem any run. It sufficed to tell people that he could do it. No reason to
mistrust the banks since they are backed up by air drops. Now people have
different ideas. The air drop is humbug. Can’t be done. Ben is
bluffing. As calculated by Alf Field writing in Gear Today, Gone Tomorrow (www.gold-eagle.com, September 6,
2007) if only ten percent of the notional value of derivatives is bailed out
by dropping $500 FR notes the pile, if notes are stacked upon one another,
would be nearly 9000
miles high. Helicopter Ben hasn’t reckoned that
FR notes do not exist in such quantities. They will have to be printed before
they can be dropped. Even if they existed, to drop them all would take years,
and by that time the shaky house of cards of FR credit might be blown away. And
bailing out just ten percent of the derivatives mess is a conservative
estimate. You may have to bail out a lot more than that.
Devolution
What does it all mean? At minimum it means that we
can have inflation cum deflation. I am not referring to stagflation. I
refer to the seemingly impossible phenomenon that the money supply inflates
and deflates at the same time. The miracle would occur through the devolution
of money. This is Alf Field’s admirable phrase to describe the
„good money is driven out by bad” syndrome a.k.a. Gresham’s Law. Electronic
dollars driving out FR notes. The more electronic money is created by Helcopter Ben, the more FR notes will be hoarded by banks
and financial institutions while passing along electronic dollars as fast as
they can. Most disturbing of all is the fact that FR notes will be hoarded by
the people, too. If banks cannot trust one another, why should people trust
the banks?
Devolution is the revenge of fiat money on its
creator, the government. The money supply will split up tectonically into two
parts. One part will continue to inflate at an accelerating pace, but the
other will deflate. Try as it might, the Federal Reserve will not be able to
print paper money in the usual denominations fast enough, especially since
the demand for FR notes is global. Regardless of statistical figures showing
that the global money supply is increasing at an unprecedented rate, the
hand-to-hand money supply may well be shrinking as hoarding demand for FR
notes becomes voracious. The economy will be starved of hand-to-hand money. Depression
follows deflation as night follows day.
Decoupling
tectonic plates
Side-by-side of deflation of hand-to-hand money
there will be hyperinflation as the stock of electronic money will keep
exploding along with the price of assets. You will be in the same boat with
the Chinese (and the son of Zeus: Tantalus). You will be put through the
tantalising water torture trillions of
dollars floating by, all yours, but which you are not allowed to spend. The
two tectonic plates will disconnect: the plate carrying electronic dollars
and the plate carrying FR notes, with lots of earthquakes along the fault
line. No Herculean effort on the part of the government and the Federal
Reserve will be able to reunite them. At first, electronic dollars can be
exchanged for FR notes but only against payment of a premium, and then, not
at all.
The curse
of negative discount rate
If you think this is fantasy, think again. Look at
the charts showing the collapse of the yield on T-bills. While it may bounce
back, next time around the discount rate may go negative. You
say it’s impossible? Why, it routinely happened during the Great Depression
of the 1930’s. Negative discount rate means that the T-bill gets an agio, the discount goes into premium even before
maturity, and keeps its elevated value after. This perverse behavior is due to the fact that the T-bill is payable in
dollars. Yes, the kind you can fold, the kind that is in demand exceeding
supply, the kind people and financial institutions hoard, the kind foreigners
have been hoarding for decades through thick and thin: FR notes. Thus T-bills
are a substitute for the hard-to-come-by FR notes. Mature bills may stay in
circulation in the interbank market, in preference
to electronic dollar credits*. Why, their supply is limited, isn’t it,
while the supply of electronic dollars is unlimited! The beauty of it all is
that we have an accurate and omnipresent indicator of the premium that cannot
be suppressed like M3: the (negative) T-bill rate. This is an indicator
showing how the Federal Reserve is losing the fight against deflation.
Inverted
pyramid of John Exter
The grand old man of the New York Federal Reserve
bank’s gold department, the last Mohican, John Exter
explained the devolution of money (not his term) using the model of an
inverted pyramid, delicately balanced on its apex at the bottom consisting of
pure gold. The pyramid has many other layers of asset classes graded
according to safety, from the safest and least prolific at bottom to the
least safe and most prolific asset layer, electronic dollar credits on top. (When
Exter developed his model, electronic dollars had
not yet been invented; he talked about FR deposits.) In between you find, in
decreasing order of safety, as you pass from the lower to the higher layer:
silver, FR notes, T-bills, T-bonds, agency paper, other loans and liabilities
denominated in dollars. In times of financial crisis people scramble
downwards in the pyramid trying to get to the next and nearest safer and less
prolific layer underneath. But down there the pyramid gets narrower. There is
not enough of the safer and less prolific kind of assets to accommodate all
who want to „devolve”. Devolution is also called „flight to
safety”.
An example of this occurred on Friday, August 31,
2007, as indicated by the sharp drop in the T-bill rate from 4 to 3%, having
been at 5% only a couple of days before. As people were scrambling to move
from the higher to the lower layer in the inverted pyramid, they were pushing
others below them further downwards. There was a ripple effect in the T-bill
market. The extra demand for T-bills made bill prices rise or, what is the
same to say, T-bill rates to fall. This was panic that was never reported,
still less interpreted. Yet it shows you the shape of things to come. We are
going to see unprecedented leaps in the market value of T-bills, regardless
of face value! You have been warned: the dollar is not a pushover. Electronic
dollars, maybe. But T-bills (if you can fold them) and FR notes will
have an enormous staying power. Watch for the discount rate on T-bills
morphing into a premium rate!
It is interesting to note that gold, the apex of the
inverted pyramid, remained relatively unaffected during the turmoil in
August. Scrambling originated in the higher layers. Nevertheless, ultimately
gold is going to be engulfed by the ripple effect as scrambling cascades
downwards. This is inevitable. Every financial crisis in the world, however
remote it may look in relation to gold, will ultimately affect gold, perhaps
with a substantial lag. The U.S. Government destroyed the gold standard 35
years ago, but it could not get gold out of the system. It was not for
want of trying, either, as we all know. Gold remains firmly embedded as the
apex of Exter’s inverted pyramid.
Vertical devolution is not the only kind that occurs
in the inverted pyramid. There are similar movements that can be described as
horizontal. Nathan Narusis of Vancouver, Canada,
is doing interesting research on the Exter-pyramid.
He noted that in addition to vertical there is also horizontal devolution. Within
each horizontal layer of the same safety class there are discernible
differences. An example is the difference between gold in bar form and gold
in bullion coin form, or silver in bar form and silver in the form of bags of
junk silver coins. Franklin Sanders in Tennessee
is an expert on horizontal devolution of silver and has a fascinating study
how the discount on bags of junk silver coins may go into premium, and vice
versa. There may also be differences between FR notes of older issues and
FR notes of the most recent vintage. There are obvious differences between the
CD’s of a multinational bank and those of an obscure country bank. The
point is that movement of assets horizontally between such pockets within the
same safety layer is possible and may be of significance as the crisis
unfolds and deepens.
Dousing
insolvency with liquidity
In a few days during the month of August central
banks of the world added between $300 and 500 billion in new liquidity in an
effort to prevent credit markets from seizing up. The trouble is that all
this injection of new funds was in the form of electronic credits, boosting
mostly the top layer where there was no shortage at all. Acute shortage
occurred precisely in the lower layers. This goes to show that, ultimately,
central banks are pretty helpless in fighting future crises in an effort to
prevent scrambling to escalate into a stampede. They think it is a crisis of
scarcity whereas it is in fact a crisis of overabundance.
I feel strongly that this aspect of research on the denouement
of the fiat money era has been lost in the endless debates on the barren
question whether it will be in the form of deflation or hyperinflation. Chances
are that it will be neither, rather, it will be both, simultaneously. There
is a little-noticed and little-studied continental drift beween
the money supply of electronic dollars and the money supply FR notes. (Continental drift of the geological variety is
invisible and can only be studied with the aid of high-precision
instruments.) The tectonic plate of electronic dollars will keep inflating at
a furious pace, while that of FR notes and T-bills will deflate because of
hoarding by financial institutions and the people themselves. The Federal
Reserve will be unable to convert electronic dollars into FR notes, as
present denominations cannot be printed fast enough physically in times of a
crisis. If it comes out with new denominations by adding lots more
zero’s to the face value of the FR notes, then the market will treat
these the same way as it does treat electronic dollars: with contempt.
Genesis of
derivatives
Alf Field (op.cit.)
is talking about the „seven D’s” of the developing monetary
disaster: Deficits, Dollars, Devaluations, Debts, Demographics, Derivatives,
and Devolution. Let me add that the root of all evil is the double D, or DD: Delibetare Debasement. In 1933 the government of the United States
embraced that toxic theory of John Maynard Keynes (who borrowed it from Silvio Gesell). It was put into
effect piecemeal over a period of four decades. But what the Constitution and
the entire judiciary system of the United States could not prevent,
gold could. It was found that gold in the international monetary system was a
stubborn stumbling block to the centralization and globalization of credit.
So gold was overthrown by President Nixon on August
15, 1971 by a stroke of the pen, as he reneged on the international gold
obligations of the United
States. This had the immediate effect that
foreign exchange and interest rates were destabilized, and prices of
marketable goods embarked upon an endles spiral. In
due course derivates markets sprang up where risks inherent in the interest
and forex rate variations could be hedged. The
trouble with this idea, never investigated by the economic profession, was
that these risks, having been artificially created, could only be shifted but
could not be absorbed. By contrast, the price risks of agricultural
commodities are nature-given and, as such, can be absorbed by the
speculators.
The important difference between nature-given and
man-made risks is the very cause of the mushrooming proliferation of
derivatives markets, at last count half a quadrillion dollars strong (or
should I say weak?!) Since the risk involved in the gyration of interest and forex rates can only be shifted but cannot be cushioned,
there started an infinite regression as follows.
The risk involved in the variation of long-term
interest rates we may call x. The problem of hedging risk x
calls for the creation of derivatives X (e.g., futures contracts on
T-bonds). But the sellers of X have a new risk y. Hedging y
calls for the creation of derivatives Y (e.g., calls, puts, strips,
swaps, repos, options on futures). Sellers of Y
have a new risk z. The problem of hedging z will necessitate
the creation of derivatives Z (with tongue in cheek: futures on
options, options on options, etc.) And so on and so forth, ad infinitum.
J’accuse
We have to interpret the new phenomenon, the falling
tendency of the T-bill rate accurately. Maybe the financial media will try to
put a positive spin on it, for example, that it demonstrates the strength of
the dollar. However, I want to issue a warning. Just the opposite is the
case. We are witnessing a sea change, tectonic decoupling, a
cataclismic decline in the soundness of the
international monetary system. The world’s payments system is in an
advanced state of disintegration. It is the beginning of a world-wide
economic depression, possibly much worse than that of the 1930’s.
We have reached a landmark: that of the breaking up
of centralized and globalized credit, the close of
the dollar system.
J’accuse said Zola when
he assailed the French government for fabricating a case of treason against
artillery captain Alfred Dreyfus in 1893. It is now my turn.
J’accuse — the government
of the United States under
president Roosevelt reneged on the domestic gold obligations of the U.S. in
violation of the Constitution, and violated people’s property rights
without due process by confiscating gold in 1933
J’accuse — academia has
been pussyfooting the government by failing to point out the economic
consequences of gold confiscation, namely, the prolonged suppression of
interest rates that was ultimately the cause of prolonging depression**
J’accuse — the government
of the United States under
president Nixon reneged on the international gold obligations of the U.S. thereby
globalizing the monetary crisis in 1971
J’accuse — cringing
academia failed to point out the consequences of gold demonetization: price
spiral of marketable commodities world-wide; roller-coaster ride of long-term
interest rates, up to 16 percent per annum and down to 4 percent per annum or
lower and back up again; the fact that interest rates may take prices along
for the ride
J’accuse — foreign
governments accepted Nixon’s breach of faith without demur, apparently
because in exchange for their compliance they were given the freedom to
inflate their own money supply with abandon on the coattails of dollar
inflation
J’accuse — the banks have
embraced the regime of irredeemable currency with gusto and greatly profited
from it, instead of protesting that under such a regime it was impossible to
discharge the bank’s sacred duty to act as the guardian of the savings
of the people and the value of the estate of widows and orphans
J’accuse the accounting
profession for their compliance in accepting grieviously
compromised accounting standards that convert liabilities into assets in the
balance sheets of the government and the Federal Reserve.
In the words of Chief Justice Reynolds, in
delivering the dissenting minority opinion on the 1935 Supreme Court decision
in upholding president Roosevelt’s confiscation of people’s gold:
„Loss of reputation for honorable
dealing will bring us unending humiliation. The impending legal and moral
chaos is appalling.”
No less appalling, we may add, is the impending
financial and economic chaos.
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*An object lesson in negative T-bill rate is being
presented as I write this on Thursday, September 20, 2007. The 30-day silver
lease rate has gone to minus 0.1 percent. I wish analyst Ted Butler stopped
bitching about manipulation and instead of telling fairy tales about raptors
and dinosaurs explain to us what the negative silver lease rate means. My own
explanation is panic short covering in silver. Normally the price of silver
moves in tandem with that of gold. In case the rising price of silver lags
substantially behind that of gold, negative lease rate may develop,
indicating that silver is delivered faster by the lessees than the lessors are willing or able to take (for example, if the lessors expected the leases will be rolled over). Under
these circumstances the lessor is happy to leave
the silver with the lessee even after the lease expired. This seems to
explode the myth about an acute shortage of silver, so ardently spread by Butler. The rising
price of silver that may well follow the panic short-covering has nothing to
do with shortages. Just the opposite.
Concerning the case of a negative T-bill rate, the
pinching shoe is on the other foot. Here we do have a shortage, namely, a
physical shortage of FR notes in which the bill is supposed to be paid. But
since the borrower is the government, there is no presumption of a default,
so the mature T-bill is monetized by the market to alleviate the shortage.
** The causal connection between gold confiscation
and the prolonging of the Great Depression should be clear. Gold must be seen
as the main competitor of bonds. Once the competitor is forcibly removed,
bond prices start rising or, what is the same to say, interest rates start
falling. Linkage between falling interest rates and falling prices did the
rest.
Antal E. Fekete
Gold Standard University
aefekete@hotmail.com
Copyright © 2007, Antal
E. Fekete
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