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Copyright
© 2008
A. E. Fekete
All
rights reserved
…WITH A 36-YEAR LAG
(Part 2 of 2)
Antal E. Fekete
Gold Standard
University
Live
The way to resolve
the credit crisis:
Recapitalize the
banks with gold
Privatizing profits, socializing losses
The 0.7 trillion dollar bailout plan of Treasury Secretary Paulson must
be seen for what it is: a scheme to privatize profits while socializing
losses. The scare tactics with which he was trying to railroad it through
Congress has failed and the world is better for it. The malady has to be
diagnosed properly. I summarize the popular diagnosis in five points.
(1) The bursting of the housing
bubble has led to a surge of defaults and foreclosures which has, in turn,
led to a plunge in the value of mortgage-backed securities ― assets
which are in effect capitalized mortgage payments.
(2) These losses have left many
banks short on capital account. Their problems were compounded by the fact
that as their capital ratios were shrinking, rather than reducing their debt
exposure they aggressively increased it.
(3) “Leveraging” is the
word to describe the deliberate shrinking of capital ratios, i.e., making
smaller capital support a larger amount of risks. Aggressive leveraging was characteristic of the
pre-crisis boom.
(4) When they recovered after the
dizzying ride, banks needed a microscope to read their capital ratios and
they reacted in a predictable way. They were unwilling (unable?) to fulfill their mission to provide the credit that the
national economy needs for its day-to-day operation.
(5) As a defensive measure financial
institutions have been belatedly trying to pay down their debt by selling
assets, including mortgage-backed securities, but as they were doing it
simultaneously, they drove down asset prices. This has damaged their balance sheets
even more. A vicious circle is engaged that some call the “paradox of
de-leveraging.”
Capital destruction
I should hasten to say that I disagree with this popular diagnosis
which puts the cart before the horse. My diagnosis, described in the first
part of this article, identifies the destruction of capital as the cause, and
the credit crisis as the effect.
The
problem goes back to the U.S.
government foolish decision to destabilize the interest-rate structure (and, hence,
bond prices) in 1971. As a consequence, long-term interest rates shot up to
16 percent per annum by the early 1980’s, from where they started their
long descent that still continues.
Falling
interest rates destroy capital as they raise the liquidation-value of debt
contracted earlier at higher rates. By ‘liquidation value’ is
meant the sum that will liquidate the debt, should it be necessary to pay it
off before maturity. In a falling
interest-rate environment it will take a larger
sum to retire the same debt. Why? Because the scheduled stream of
interest payments is now capitalized at a lower
rate of interest and, therefore, it falls short in liquidating the debt.
This
means that, paradoxically, falling interest rates do not alleviate but aggravate the burden of debt. All
observers miss this point as they blithely assume that debt is automatically
refinanced at the lower rate. It is not. Falling interest rates create a
deficiency on capital account since it takes a bigger bite to service
existing debt than originally provided for, and the deficit is made up at the
expense of capital. Over-leveraging is not the cause; it is the effect. What
it shows is that the banks do not pay heed; they persist in error. They
simply ignore shrinking capital ratios. This ultimately causes wholesale
bankruptcies, leading to the vicious downwards spiral.
The
banks should have made provision to compensate for eroding capital as
interest rates were falling. None of them did. None of them understood the
insidious process of capital erosion in the wake of declining interest rates.
They reported losses as profits. Then they were hit by the negative feedback:
capital eroded further. When the truth dawned upon them, it was already too
late.
Interest
rates have been falling for the past 28 years. The liquidation value of
outstanding debt has been increasing by leaps and bounds. It reached the
tipping point in February, 2007 as indicated by the unprecedented jump in the
price of credit-default swaps. It revealed that any further decline in the
rate of interest would plunge bank capital into negative territory. At this
point capital dissipation stops: there is nothing more left to dissipate. For
the banks, this is sudden death.
No
commentator could explain why banks
have all run out of capital at the same time, while making obscene profits.
My explanation is simple. There have been no profits, obscene or otherwise.
The banks were paying out phantom profits in the belief that their capital
accounts were in good shape. They weren’t. The banks were unaware that
the falling interest rate structure has been making inroads on their capital.
Since all banks have been working with microscopic capital ratios as a result
of 28 years of capital erosion, the failure of one single bank would trigger
the ‘domino-effect’ on the rest.
Why gold?
This puts the role of gold into high relief. Had gold been retained as
a component of bank capital, credit-default swaps would have never been
invented. Gold is unique among financial assets in that it has no
corresponding liability in the balance sheet of others. Gold is the only financial asset that will survive any consolidation
of bank balance sheets, in
contrast with paper assets that are subject to annihilation (e.g., when the
bank is consolidated with its counterparty holding the liability side of that
asset). Suppose we consolidate the balance sheets of the global banking
system. Then all assets will be wiped out with
the sole exception of gold. But since the global banking system as it is
presently constituted has no gold assets, under any consolidation the banks
will be denuded of assets while note and deposit liabilities to the public
remain. This is why the regime of irredeemable currency is susceptible to
collapse that could be violent, taking place with lightening speed. It can
also be seen that trying to save banks from collapsing through consolidation,
mergers, takeovers, and shotgun marriages is pouring oil on the fire: it
accelerates the meltdown of bank capital, rather than retarding it.
Implosion of the derivatives monster
My thesis also explains the explosive growth of the derivatives
markets. First round insurance against decline in the value of bonds in the
banks’ portfolio can be had by selling bond futures. Those writing
first-round insurance need to cover their assumed risk in the form of
second-round insurance, they do so by selling call or buying put options on
bond futures. But those writing second-round insurance also need to cover
their risk: they do it in the derivatives market by purchasing credit-default
swaps. The point is that an infinite chain of credit-default swaps is being
built on every bond in the banks’ portfolio, as shown by the
derivatives monster’s more than doubling in size every other year, already
having reached the size of one half
quadrillion dollars and still counting.
Why
is the derivative monster so dangerous? Because it is subject to implosion
that could destroy an inordinate amount of bank assets. If the derivatives
tower is consolidated, then its value collapses to zero as claims are wiped
out by counter-claims. It is possible that this implosion has already
started, but the banks (and their supervisory agencies) keep the lid on this
information to avoid a world-wide panic. The earth quakes badly under the
foundations of the Derivatives Tower of Babel. Its toppling may be imminent.
If gold had been retained as a component of the bank capital structure, then
there would have been no derivatives monster to fret about.
Those
who explain the proliferation of derivatives by the popularity of “dry
swaps”, that is to say, swaps created for the sole purpose of
speculative profits they promise in view of their ultra-low price-to-reward
ratio, are wrong. All those credit-default swaps were purchased by actual
insurers insuring actual risks going with bond ownership, in trying to hedge
their own risks.
Recapitalizing banks with gold
The credit crisis could be
solved through the recapitalization of banks with gold. The Treasury should pledge to
match subscriptions of new private capital, in gold, at the ratio of two to
one. This means that two gold shares of capital stock subscribed by the
private sector (individuals, firms, and institutions) shall invite one share
of capital stock subscribed by the Treasury. Gold subscribed by the private
sector should be constitutionally guaranteed against capital levy and
confiscation.
There
is no better use to which Treasury gold can be put which has been foolishly
idled for the past 36 years. What is needed is the mobilization of gold
hoarded by the Treasury, as well as of gold hoarded by the private sector.
The trouble is that much of the privately owned gold is in hiding and
won’t surface for reasons of lack of confidence in the monetary system.
But as soon as there is a market for the shares of the recapitalized banks,
private gold can be coaxed out of hiding and made to participate actively in
the great task of rebuilding world credit.
Capital
stock of the recapitalized banks would pay dividend, in gold, at the rate of
one tenth of one percent per annum to stockholders, exempt of all taxes. This
would make it possible, even for people of modest means, to acquire gold
earning a safe return in gold. The maliciously false propaganda of the past
decades that gold is a sterile asset in that it earns no interest is easy to
refute. Gold has been lent and borrowed at interest (facetiously called the
‘lease rate’) without interruption, in spite of its so-called
‘demonetization’ by the government. In fact, the gold rate of
interest is the benchmark on which all other interest rates are still based,
after adding a risk-premium reflecting the risk that the monetary unit may
lose its gold exchange value.
The
tax-exempt feature of dividends has great merits to recommend it, especially
if no other exemptions across the economic landscape are granted. You could
look at it as society’s protection of widows and orphans, and other
members of society who are unable to fend for themselves in a competitive
environment, to live in dignity away from the hurly-burly of the investment
world.
What
is the use of recapitalizing banks with irredeemable promises to pay? It has
been tried for the past 36 years; it doesn’t work.
No chain is stronger than its weakest link
The newly recapitalized banks must offer their old assets for sale to
the public, in exchange for the gold shares of capital stock, through
competitive auctions. In this way the true value of the old paper assets can
be determined, and whatever can be salvaged will be salvaged. The market for
bank assets, presently frozen, would be made liquid once more. If a bank
wants to retain a part of its old assets in the balance sheet, it must bid
for it in the same way as if it were buying from another bank through
competitive auction. If an asset cannot be disposed of in this way, then it
must be written off. Any delay in validating bank assets through the sieve of
competitive auction will only prolong and deepen the crisis.
The
‘securitization’ of bank assets was an idiotic strategy motivated
by the fraudulent idea that in lumping sub-prime assets together with valid
assets would somehow impart value to the former, and the marketability of the
product would be enhanced. This, of course, is just a ploy to cheat the
buyer. It is like trying to make a chain containing a weak link stronger by
adding any number of strong links. The weak link must be replaced with a
strong one. No chain can be stronger than its weakest link.
The
re-liquefying of bank assets is a first order of business in the present
runaway global credit crisis. We are past the point that the wild-fire can be
localized. Mobilization of gold is the only way.
Save the pension funds!
This crisis is a warning, possibly the last one, that the
recapitalization of banks with gold cannot be further postponed without
risking the total collapse of the financial system. If there was some hope
that the Treasury might have a contingency plan to mobilize gold in case of a
crisis such as this, the Paulson bailout plan has dispelled it. When the
moment for the ‘break-the-glass’ rescue plan has arrived, what
did we find behind the broken glass? More irredeemable promises to pay, to
augment bank capital. All chaff, no grain.
Global
credit collapse would bring enormous hardship in its train for ordinary
people who have worked hard and saved hard through a lifetime only to see the
fruits of their efforts going up in smoke. The result could be total social
chaos and lawlessness. At risk are all the insurance companies, pension funds,
money market funds. Also at risk is the taxing power of the government, as a
prostrate economy won’t be able to bear the tax burden, but will spawn
a grey economy that finds ways to evade taxes. The rejection by the U.S.
House of Representatives of Paulson’s bailout plan can be viewed as a
taxpayer revolt. Is it the first, with more to come?
Close of Keynes’ and Friedman’s system
Understandably, it will be hard for policy-makers, academia and media,
and the accountants’ profession to admit that they have been wrong all
along about gold and its essential role in the economic bloodstream and in
accounting. They have fallen victim to the charm of John Maynard Keynes, the
prankster who invented the idea that gold was a barbarous relic, and the gold
standard was a ‘contractionist fetter’
upon the world economy. Now we have proof that the blame for the contraction
should be assigned, not to the use but to the misuse of gold. The debt collapse is the burial ground for
Keynesianism.
After
Keynes was gone, policy-makers, academia and media, and the
accountants’ profession fell under the spell of another visionary and
adventurer talking with a forked tongue, Milton Friedman. He was fond of
posing as a free-market man, but in promoting irredeemable currency he did
more than anybody, save Keynes, to destroy the free market. Friedman promoted
the spurious idea that gold is superfluous in the international monetary
system as floating foreign exchanges rates can mimic the operation of the
gold standard and will balance the trade accounts. But as the record shows, Friedmanite nostrums have ruined the dollar, as well as
the once flourishing and peerless American productive apparatus.
Politicians,
academia and media, and the accountants’ profession must swallow their
pride and get the confession off their chests that their prognostication,
policies, and advice about gold have been in error. If they fail to do this,
and continue to block the way of gold to make a return to the economic
bloodstream, then their responsibility for the suffering caused by the credit
collapse in this country and in the world will be total. They will be shown
as doctrinaire wreckers of human cooperation under the system of division of labor, who muzzled their critics and usurped unlimited
power, while paving the way to a world disaster akin to that of the Bolshevik
revolution.
After
the close of Marx’ system, the close of Keynes’ and
Friedman’s system is inevitable. But the wounds they have caused would
take a long, long time to heal.
The
mission of Gold Standard University Live is to do the research that academia
refused or was forbidden to do: find out the consequences of ousting gold
from the monetary system by the U.S. government, following its 1971 default
on the Treasury’s gold obligations. Unfortunately our sponsor, Mr. Eric
Sprott of Sprott Asset
Management, Inc., has withdrawn his financial support saying that our
“results do not justify the expenditure”. I am forced to
terminate the sessions. Our last activity will be a panel discussion on the
present credit crisis to be held in Canberra, Australia, on
November 15, 2008, under the title: The
chickens of 1933 and 1971 are coming home to roost and take out bank capital.
I invite you to come and contribute to the success of Gold Standard
University Live with your questions and comments. At any rate, the sessions
will be taped and the DVD’s made available to the public, along with
the conference proceedings.
Calendar of events
New York City, October 16, 2008
Committee for Monetary Research
and Education, Inc., Annual Fall Dinner.
Professor Fekete is an invited speaker. The
title of his talk is:
The Mechanism of Capital
Destruction.
Inquiries: cmre@bellsouth.net
Santa Clara, California,
November 3, 2008
Santa Clara University, hosted by the Civil Society
Institute
Professor Fekete is the invited speaker. The
title of his talk is:
Monetary Reform: Gold and Bills of Exchange.
Inquiries: ffoldvary@scu.edu
San Francisco, California,
November 4, 2008
Economic Club of San
Francisco
Professor Fekete is the invited speaker. The
title of his talk is:
The Revisionist Theory and
History of the Great Depression ― Can It Happen Again?
Inquiries: ifkbischoff@yahoo.com
Canberra, Australia,
November 11-14, 2008
Gold Standard
University Live, Session Five. (This is the last session of GSUL since our sponsor,
Mr. Eric Sprott of Sprott
Asset Management, Inc., has withdrawn his support saying that in his opinion
the results do not justify the expenditure. Come along and judge for
yourself.) This 4-day seminar is a Primer
on the Gold Basis ― Trading Tool for Gold Investors, Marketing Tool for
Gold Miners, and Early Warning System for Everybody Else.
Inquiries: feketeaustralia@yahoo.com
Canberra, Australia,
November 15, 2008
Panel Discussions: The chickens of 1933 and 1971
are coming home to roost and take out bank capital.
Inquiries: feketeaustralia@yahoo.com
Reference
Is Our Accounting System Flawed? ― It may be insensitive to capital
destruction
www.professorfekete.com May 23, 2008.
Antal E. Fekete
Professor, Intermountain Institute of Science and Applied Mathematics,
Missoula, MT 59806, U.S.A.
Gold
Standard University
aefekete@hotmail.com
DISCLAIMER AND CONFLICTS
DISCLAIMER
AND CONFLICTS
THE PUBLICATION OF THIS LETTER IS FOR YOUR INFORMATION AND AMUSEMENT ONLY.
THE AUTHOR IS NOT SOLICITING ANY ACTION BASED UPON IT, NOR IS HE SUGGESTING THAT
IT REPRESENTS, UNDER ANY CIRCUMSTANCES, A RECOMMENDATION TO BUY OR SELL ANY
SECURITY. THE CONTENT OF THIS LETTER IS DERIVED FROM INFORMATION AND SOURCES
BELIEVED TO BE RELIABLE, BUT THE AUTHOR MAKES NO REPRESENTATION THAT IT IS
COMPLETE OR ERROR-FREE, AND IT SHOULD NOT BE RELIED UPON AS SUCH. IT IS TO BE
TAKEN AS THE AUTHORS OPINION AS SHAPED BY HIS EXPERIENCE, RATHER THAN A
STATEMENT OF FACTS. THE AUTHOR MAY HAVE INVESTMENT POSITIONS, LONG OR SHORT,
IN ANY SECURITIES MENTIONED, WHICH MAY BE CHANGED AT ANY TIME FOR ANY REASON.
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