The Bennett Newsletter
Money - The forgotten factor
While it is obvious that the credit crunch was a crisis about the availability of money, no one seems to be talking about how the crisis affecting bank capital impacts upon money and the real economy.
I want to review money creation though leveraged lending and stress again that it is a source of instability which needs more attention. At present the debate is about other kinds of regulation and the insanity of monstrous bonuses.
Instability
Larry Summers, the former Republican treasury Secretary, reminded us that the recent crisis resulted from financial instability and “hundreds of thousands of middle class families who had nothing to do with the financial sector losing their jobs”.
Moreover, the crisis was “disturbingly familiar”. He ticked off: the Latin America debt crisis of the early 80’s , the 1987 stock market crash, the Savings and Loan debacle of the late 1980’s, the Mexican crash of 1994, the Asian financial crisis of 1997, the Dotcom bubble, collapse of LTCM 2000, Enron collapse, and the present crisis.
The Obama-Summers-Geithner proposed solution will raise capital requirements, eliminate the present system whereby institutions choose who regulates them, impose stronger standards, establish resolution authority to ensure no institution is too big to fail, and improve consumer protection. But it many not be enough.
Some gains
The global political and monetary authorities have acted quickly to halt the crisis. To stop panic, most governments have guaranteed deposits, rescued many collapsing institutions, made massive liquidity injections, pump-primed the economy with infrastructure investments, and (often) introduced zero interest rates (ZIRP). The authorities have acted now without deciding how they will repay their outlays.
Zero interest rate policies are risky. Keynes warned of possible liquidity traps when increasing liquidity will not stimulate the economy. Economists were skeptical about this theory until Japan fell into it in the 1990’s. All Japan’s efforts failed to stimulate growth: the most visible consequence was to incur massive state debt.
Another risk of ZIRP is that private losses have been replaced with more public debt. That debt is now so high that ZIRP is ensconced because states could not service their debt at higher rates. Japan could not service its debt, which is double GDP, without a fiscal crisis, massive capital inflows and increased deflation.
ZIRP encourages a search for yield. The dollar and sterling have joined the yen in a global carry trade: investors search out niches where yields are higher. This will bring more bubbles, more demand for gold, and more reckless leverage (possibly on margin in the futures markets).
US low interest rates are holding the world to ransom. It is a brave country that raises rates when there is a flood of cheap dollars waiting to pounce on carry- trade opportunities. States are unwilling to start paying down their debt and this is increasing distortions.
Ballooning Debt
New Zealand is borrowing hundreds of millions of dollars weekly to provide government services. According to Treasury, net sovereign debt was NZ$15.5 b in 2009, but it will almost double next year to $27.3 b, and double again 2010-2012 to $51.9b, and then grow to $62b in 2013. This is an almost fourfold growth in 4 years, and this is the middle projection of the forecast: it could be worse. As it is, New Zealand will be issuing $54 b of bonds between 2008and2013. [http://www.treasury.govt.nz/budget/forecasts/befu2009/befu09-pt2of6.pdf]
The UK is in a deep debt hole. According to the Centre of Policy Studies “The Hidden Bombshell”, (a new book) the UK’s net liabilities are ₤2,200 b, three times official figures, and equivalent to ₤85,600 per household.
The Confederation of British Industry uses the books data to demand the Government slash the budget to boost investor confidence.
Households not guilty
Spencer Dale (Bank of England Chief Economist) has corrected some misapprehensions about current realities. He denies the accepted view that current problems are a payback for past excesses, especially the idea that Households were seduced by easy credit and rising assets, leading to a debt-fueled spending boom.
There was no consumer boom! Consumer spending in the UK recently had the same increase as average over 40 years! Nor did household expenditure increase its share of national income.
That destroys one myth. It is true that household debt, as a proportion of income, increased from 100% to 165% over 1997-2007, but there was a matching increase in finanancial assets. Debt increased by one trillion pounds but assets increased by ₤750m.
Older households trading down were winners; younger households either buying in or trading -up, accumulated massive debt. The money borrowed by the young ended up in older households bank accounts. The debt of one part of the population was matched by saving in another. There was no change in aggregate wealth.
Asset prices have fallen (houses by 15%) but the debt remains. Moreover, the crisis has caused households to spend less. Employment has fallen. Consumption has fallen sharply for 5 quarters for the first time since 1955, when records began.
Spencer Dale’s paper is significant because the consumer emerges as blameless for the crisis: I therefore assume it was the behaviour of the banks that was responsible. Let us look at money creation.
{http://www.bankofengland.co.uk/publications/speeches/2009/speech403.pdf}
Money creation
Money is essentially the net debts of the banking systems (including deposits). It increases when banks increase their balance sheet by making loans. In the past banks were restrained by regulatory capital ratios. But they escaped this constraint in the 1990’s as securitisation allowed banks to sell the risks of their mortgage holdings. This reduced the capital needed to advance mortgages.
Securitisation led to leverage, profits and a strong incentive to print money. Capital adequacy addressed only the bank’s asset risks: but securitisation allowed banks to transfer the risk, so new mortgage lending boomed. House prices advanced due to easy mortgage finance and ever increasing house prices led to even more money creation. The 2007-2008 crash stopped the music and lending dried up.
The lesson is banks must be held to capital ratio regulations and not avoid them by securitisation or other scheme that the banks dream up. The present reforms do not address this problem.
Demise of the USD
The world system is still reeling from the effects of the Greater Depression. It effects and consequences are still not obvious, but increasingly it seems that 2008 will mark the beginning of the demise of the US Dollar.
The landscape is changing and obviously the depreciating dollar is under pressure as an unsatisfactory trading and reserve currency. But my main purpose is to substantiate the dollar’s demise in three particulars: about London replacing New York as the world’s financial centre; a “plot” to introduce a gold-backed currency, and China’s building rival commodity exchanges. .
These are not entirely new: London has been the centre while the US dollar has been the currency of choice, especially for the LIBOR (London Interbank offered Rate). London is the centre for secured securities, while New York remains the centre for capital securities. The dollar will be important in the foreseeable future as a hedge as money creation erodes the value of other currencies.
Gold standard in oil trade?
Robert Fisk broke a story in the Independent last week:
“In the most profound financial change in recent Middle East history, Gulf Arabs are planning – along with China, Russia, Japan and France – to end dollar dealings for oil, moving instead to a basket of currencies including the Japanese yen and Chinese Yuan, the euro, gold and a new, unified currency planned for nations in the Gulf Co-operation Council, including Saudi Arabia, Abu Dhabi, Kuwait and Qatar.
Secret meetings have been held by finance ministers and central bank governors in Russia, China, brazil and Japan.”
Fisk says the meetings could explain the rise of gold. More importantly, the meetings augur an extraordinary transition from dollar markets in nine years. Fisk is adamant that “the current deadline for the currency transition is 2018”.
Brazil and India have shown previous interest in non-dollar oil payments, but China is aggressive. Former Chinese Envoy to the Middle East, Sun Bigan, has warned of divisions between China and the US over Middle East oil, saying “Bilateral quarrels and clashes are unavoidable”. This almost implies a future economic US-China war over oil. There are other signs of a struggle with China making long term deals with Iran, Brazil, Venezuela, Sudan, and Libya.
Iran at present deals in the Euro; Sadam Hussein proposed to use the Euro but was invaded shortly after his announcement.
China and Commodity futures
China is issuing an enormous challenge to US hegemony by positioning its futures markets to be major players in setting world prices for metal, energy and food commodities. China feels it will be less at the mercy of world markets, and American speculators, if it lets the world know what it thinks commodities are worth.
New Zealanders will appreciate China’s concern with being a price-taker. China is the second biggest oil importer but uses New York Mercantile Exchange’s contracts which tend to set the global price. The Shanghai Future’s Exchange plans to muscle in and try to set prices too.
China will have its work cut out to rival New York, Chicago and London which set benchmark rates for most commodities, but it may gain a role because it is a major customer wanting a fair price. Suppliers to China will also welcome exchange indications: this would mean less guesswork about China’s buying habits. A beefed-up commodity exchange is another indicator of a growing super-power acquiring the instruments of autonomous authority.
London judged top financial centre
American power since 1945 has rested as much on financial power as military for in both areas it can impose its will and cow uncooperative entities with awesome sanctions.
According to the World Economic Forum, the largest economies took a tremendous hit in the Crisis. The Forum’s Financial Development Report places the UK over the US. Its success was not complete; the Forum criticized its financial stability. It examined exchange rate stability, the management of debt both public and private, and the problem of real estate bubbles. Britain came 37th in the category. Britain trailed Thailand, Poland and Brazil in economic volatility.
The Forum is really indicating a major change in the world order. An official said: “The UK and US may still show leadership in the rankings, but their significant drops in score showing increasing weakness and imply their leadership may be in jeopardy”.
Dollar Spurned
The US dollar is being spurned as central banks are holding alternative currency reserves in records quantities. According to Bloomberg, central banks placed 63% of their new reserves into euro and yen in the April to June quarter. This is the highest percentage ever. It reflects the perception that the Obama administration’s rhetoric about a strong dollar is a smokescreen for a gradual devaluation designed to increase American competitiveness.
Banks, business and traders alike are aware that the dollar has lost over 10% on a trade-weighted basis in the last six months. This is despite the Japanese and Swiss, for example, trying desperately to depreciate their currency and the pound losing almost any attraction.
The dollar is unattractive because of record low-interest rates, budget blowouts and rapidly escalating debt. Ben Bernanke has also indicated that interest rates will not rise soon. The markets also respect the views of major traders like Barclays Capital and Standard Chartered which predict further declines, partly because of the poor performance of the US economy.
Another aspect of the dollars demise is the importance of non-western creditors; the biggest of which are (in order) China, Japan, Russia, India, Taiwan and South Korea.
China
The Governor of the Chinese central bank rattled markets a year ago when he recommended reforming the global monetary system by ending the dollar’s reserve status. But there is no quick fix. China could increase its holdings of Self Drawing Rights, but these are not a true currency. It may have increased its exposure to the euro, yen and gold. But is has retained massive US reserves and if it moves a large amount out, it could provoke a massive dollar depreciation, thereby damaging its remaining reserve wealth.
Nevertheless, the status quo is unsatisfactory. A currency which is depreciating rapidly is unsuitable for a reserve or trading currency. Its status is shot.
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