"I cannot think
of anything which would more surely lead to a danger of all-round deflation
than the collapse of international monetary confidence."
- Roy Jenkins, then British chancellor, debate
on the London Gold Pool, 18 March 1968
SUMMER'S FIRST U.S. debt downgrade came after Washington failed to fix
the debt ceiling one way or the other. Three months later, and Washington
just failed again.
Yet that first downgrade also saw 10-year Treasury yields
fall to 3.0% as US debt prices rose. And today, with a second downgrade
nailed on, that yield is already down below 2.0%.
What gives? Why is the financial world piling into US debt
– driving its price higher – even as the security of that very
debt risks being de-rated further below the magic risk-free AAA mark?
"Most risk and return models in finance start off
with an asset that is defined as risk free," explains
an NYU professor. "The expected returns on risky
investments are then measured relative to the risk-free rate." The loss
of "risk free" as a concept thus plays hell with Wall Street's
investment confidence, let alone its models.
Pricing stock-market options using the Black Scholes
equation, for instance, starts by assuming that "it is possible to
borrow and lend cash at a known constant risk-free interest rate."
Remove the "risk free rate", and things fall apart faster than Long
Term Capital Management, the hedge fund built on Black-Scholes' model, which
collapsed when the world changed but the equation didn't.
More urgently, messing with the concept of "risk free
rate" also plays havoc with the insurance and banking businesses.
"A reduction in the risk-free rate increases lending profitability by
reducing funding costs and increasing the surplus the monopolistic bank
extracts from borrowers," the
IMF explains. "Insurance contract cash flows...are
discounted using a locked-in discount rate determined at inception
consultants PwC, "[calculated as] the risk-free rate
plus liquidity premium."
So no risk-free rate, no baseline for banks or insurers,
those multi-trillion-dollar industries pervading pretty much every deal,
order and purchase you can think of today outside the black economy. But even
cash-only gangsters aren't free of the crisis hitting the financial world's only other competitor for the role of
"risk-free" reference point. Because in Eurozone bonds, the very
denomination itself is now in question.
"Reintroducing the national currency would require
essentially all contracts – including those governing wages, bank
deposits, bonds, mortgages, taxes, and most everything else – to be
redenominated in the domestic currency," warned economics professor Barry
Eichengreen of Eurozone break-up
in 2010. The currency historian thought this hurdle was "insurmountable";
no member state would quit the Euro because the procedural obstacles were too
"Exit is effectively impossible." But in
reality? It will be a real mess – a big, ugly, deflationary mess in
which lending collapses and trading grinds to a halt.
Irony guarantees that we get the word "crisis"
from the Greek, of course, via the Romans. Transliterated with a
"k", it means "decision, judgement, event, issue,
turning-point of a disease" according to the Shorter Oxford Dictionary – and that monetary madness which
is the Euro has certainly reached one fork in the road or another.
The Esperanto Experiment clearly
can't go on, won't go on, as it is. Whatever replaces or mutates it, one
immediate horror is not knowing whose contracts with whom might be about to
lose a surer foundation than the very ink in which they're written. Not just
inside the Eurozone; around one-third of UK banks' lending is owed across the
Channel. London-based asset managers are also "reducing their Eurozone
exposures," says eFinancialNews, "for fear of
capital controls freezing Euros and other assets held" inside the
"When the wall is lifted, the Euros might be new
Drachma or new Pesetas or new Lira – you don't know what they'll
be," the website quotes Alan Brown, chief investment officer at Schroders. But no matter the flood of non-Eurozone money
getting (and staying) out of the Eurozone, there's more money pouring in, as
Eurozone institutions pull back their money from outside. Over the 12 months
to September, says ECB data, net portfolio inflows to the 17 member states
hit €335 billion – more than 10 times the volume over the previous
year, and "all the more significant" says Reuters
"[because of] ample evidence that overseas investors have been exiting
"As Eurozone banks and other Eurozone entities lose
access to funding markets abroad, they are forced, at least partly, to sell
foreign assets," the newswire quotes Morgan Stanley. "This creates
the rather counterintuitive result that stress in funding markets abroad
induce repatriation flows that support rather than hurt the Euro."
Witness peripheral Europe outside the Eurozone, for
example. What used to be called the "New EU" states risk being
drained of capital as banks in core-member countries liquidate assets to
hoard money closer to home or are told
to stop new lending by their domestic regulators. That means the
local currency falls (see the Polish
Zloty for instance). Hence the crisis-defying strength of the
Euro on the currency market. Less bothered by 2011's money crisis than
Lehman's collapse in 2008 or the first Greek deficit crisis of early 2010,
the Euro's strength is no less bizarre than US Treasury debt rising in value
as Washington's credit rating is cut. But that's deflation for you – a
dash for cash that sells first, asks questions later, and holds
currency...the very stuff called into crisis...above everything else.
Thus Roy Jenkins' unwitting paradox of 43 years ago,
quoted up top, still holds true. It is hard to imagine a more deflationary
event than the collapse of confidence in the monetary system. "Feelings
are reasons too," as Glyn Davies wrote in his History of Money, and short
term, currency and near-cash Treasury debt look the only refuge from the
system beneath them. As the US and Eurozone crises roll on, however, crushing
Dollar-dependent and Euro-denominated asset prices worldwide, it's
unsurprising to find demand to own physical gold and silver bullion surging
worldwide, not least as the precious metals join the
indiscriminate price fall.
Gold and silver's zero-yield is plainly risk free. Their
value isn't denominated in any one currency or system. If this first blush of
crisis turns red with anger, escaping all currency risk-free could become
very much more popular still. Three-thousand years of monetary use will
likely stand out as the 10-year Euro experiment and 40 years of Dollar
dependency unwind together.