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The Upside-down World of Currency

Alasdair Macleod wrote . . . . . . . . .

The gap between fiat currency values and that of legal money, which is gold, has widened so that dollars retain only 2% of their pre-1970s value, and for sterling it is as little as 1%. Yet it is commonly averred that currency is money, and gold is irrelevant.

As the product of statist propaganda, this is incorrect. Originally established in Roman law, legally gold is still money and the states’ debauched currencies are not — only a form of credit. As I demonstrate in this article, the major western central banks will be forced to embark on a new round of currency debasement, likely to put an end to the matter.

Central to my thesis is that commercial bank credit will contract sharply in response to rising interest rates and bond yields. This retrenchment is already ending the everything bubble in financial asset values, is beginning to undermine GDP, and given record levels of balance sheet leverage makes a major banking crisis virtually impossible to avoid. Central banks which are already in a parlous state of their own will be tasked with underwriting the entire credit system.

In discharging their responsibilities to the status quo, central banks will end up destroying their own currencies.

So, why do we persist in pricing everything in failing currencies, when that will almost certainly change? When the difference between legal money and declining currencies is finally realised, the public will discard currencies entirely reverting to legal money. That time is being brought forward rapidly by current events.

Why do we impart value to currency and not money?

A question that is not satisfactorily answered today is why is it that an unbacked fiat currency has value as a medium of exchange. Some say that it reflects faith in and the credit standing of the issuer. Others say that by requiring a nation’s subjects to pay taxes and to account for them guarantees its demand. But these replies ignore the consequences of its massive expansion while the state pretends it to be real money. Sometimes, the consequences can seem benign and at others catastrophic. As explanations for the public’s tolerance of repeated failures of currencies, these answers are insufficient.

Let us do a thought experiment to highlight the depth of the problem. We know that over millennia, metallic metals, particularly gold, silver, and copper came to be used as media of exchange. And we also know that the use of their value was broadened through credit in the form of banknotes and bank deposits. The relationships between legal money, that is gold, silver, or copper and credit in its various forms were defined in Roman law in the sixth century. And we also know that this system of money and credit with the value of credit tied to that of money, despite some ups and downs, has served humanity well ever since.

Now let us assume that in the absence of metallic money, in the dawn of economic time a ruler instructed his subjects to use a new currency which he and only he will issue for the public’s use. This would surely be seen as a benefit to everyone, compared with the pre-existing condition of barter. But the question in our minds must be about the durability of the ruler’s new currency. With no precedent, how is the currency to be valued in the context of the ratios between goods and services bought and sold? And how certain can one be about tomorrow’s value in that context? And what happens if the king loses his power, or dies?

Clearly, without a reference to something else, the king’s new currency is a highly risky proposition and sooner or later will simply fail. And even when a new currency has been introduced and linked to an existing form of money, if the tie is then cut the currency will struggle to survive. Without going into the good reasons why this is so, the empirical evidence confirms it. Chinese merchants no longer use Kubla Khan’s paper made out of mulberry leaves, and German citizens no longer use the paper marks of the early 1920s. But they still refer to metallic money.

Yet today, we impart values to paper currencies issued by our governments in defiance of these outcomes. An explanation was provided by the great Austrian economist, Ludwig von Mises in his regression theorem. He reasonably argued that we refer the value of a medium of exchange today to its value to us yesterday. In other words, we know as producers what we will receive today for our product, based on our experience in the immediate past, and in the same way we refer to our currency values as consumers. Similarly, at a previous time, we referred our experience of currency values to our prior experience. In other words, the credibility and value of currencies are based on a regression into the past.

Mises’s regression theory was broadly confirmed by an earlier writer, Jean-Baptiste Say, who in his Treatise on Political Economy observed:

“Custom, therefore, and not the mandate of authority, designates the specific product that shall pass exclusively as money, whether crown pieces or any other commodity whatever.”

Custom is why we still think of currencies as money, even though for the last fifty-one years their link with money was abandoned. The day after President Nixon cut the umbilical cord between gold and the dollar, we all continued using dollars and all the other currencies as if nothing had happened. But this was the last step in a long process of freeing the paper dollar from being backed by gold. The habit of the public in valuing currency by regression had served the US Government well and has continued to do so.

The role of a medium of exchange

Being backed by no more than government fiat, to properly understand the role that currencies have assumed for themselves, we need to make some comments about why a medium of exchange is needed and its characteristics. The basis was laid out by Jean-Baptiste Say, who described the division of labour and the role of a medium of exchange.

Say observed that human productivity depended on specialisation, with producers obtaining their broader consumption through the medium of exchange. The role of money (and associated credit) is to act as a commodity valued on the basis of its use in exchange. Therefore, money is simply the right, or title, to acquire some consumer satisfaction from someone else. Following on from Say’s law, when any economic quantity is exchanged for any other economic quantity, each is termed the value of the other. But when one of the quantities is money, the other quantities are given a price. Price, therefore, is always value expressed in money. For this reason, money has no price, which is confined entirely to the goods and services in an exchange.

So long as currency and associated forms of credit are firmly attached to money such that there are minimal differences between their values, there should be no price for them either, other than a value difference arising from counterparty risk. A further distinction between money and currencies can arise if their users suspect that the link might break down. It was the breakdown in this relationship between gold and the dollar that led to the failure of the Bretton Woods agreement in 1971.

Therefore, in all logic it is legal money that has no price. But does that mean that when its value differs from that of money, does currency have a price? Not necessarily. So long as currency operates as a medium of exchange, it has a value and not a price. We can say that a dollar is valued at 0.0005682 ounces of gold, or gold is valued at 1760 dollars. As a legacy of the dollar’s regression from the days when it was on a gold standard, we still attribute no price to the dollar, but now we attribute a price to gold. To do so is technically incorrect.

Perhaps an argument for this state of affairs is that gold is subject to Gresham’s law, being hoarded rather than spent. It is the medium of exchange of last resort so rarely circulates. Nevertheless, fiat currencies have consistently lost value relative to legal money, which is gold, so much so that the dollar has lost 98% since the suspension of Bretton Woods, and sterling has lost 99%. Over fifty-one years, the process has been so gradual that users of unanchored currencies as their media of exchange have failed to notice it.

This gradual loss of purchasing power relative to gold can continue indefinitely, so long as the conditions that have permitted it to happen remain without causing undue alarm. Furthermore, for lack of a replacement it is highly inconvenient for currency users to consider that their currency might be valueless. They will hang on to the myth of its use value until its debasement can no longer be ignored.

What is the purpose of interest rates?

Despite the accumulating evidence that central bank management of interest rates fails to achieve their desired outcomes, monetary policy committees persist in using interest rates as their primary means of economic intervention. It was the central bankers’ economic guru himself who pointed out that interest rates correlated with the general level of prices and not the rate of price inflation. And Keynes even named it Gibson’s paradox after Arthur Gibson, who wrote about it in Banker’s Magazine in 1923 (it had actually been noted by Thomas Tooke a century before). But because he couldn’t understand why these correlations were the opposite of what he expected, Keynes ignored it and so have his epigonic central bankers ever since.

As was often the case, Keynes was looking through the wrong end of the telescope. The reason interest rates rose and fell with the general price level was that price levels were not driven by interest rates, but interest rates reacted to changes in the general level of prices. Interest rates reflect the loss of purchasing power for money when the quantity of credit increases. With their interests firmly attached to time preference, savers required compensation for the debasement of credit, while borrowers — mainly businesses in production — needed to bid up for credit to pay for higher input costs. Essentially, interest rates changed as a lagging indicator, not a leading one as Keynes and his acolytes to this day still assume.

In a nutshell, that is why Gibson’s paradox is not a paradox but a natural consequence of fluctuations in credit and the foreign exchanges and the public’s valuation of it relative to goods. And the way to smooth out the cyclical consequences for prices is to stop discouraging savers from saving and make them personally responsible for their future security. As demonstrated today by Japan’s relatively low CPI inflation rate, a savings driven economy sees credit stimulation fuelling savings rather than consumption, providing capital for manufacturing improvements instead of raising consumer prices. Keynes’s savings paradox — another fatal error — actually points towards the opposite of economic and price stability.

It is over interest rate management that central banks prove their worthlessness. Even if they had a Damascene conversion, bureaucrats in a government department can never impose decisions that can only be efficiently determined by market forces. It is the same fault exhibited in communist regimes, where the state tries to manage the supply of goods— and we know, unless we have forgotten, the futility of state direction of production. It is exactly the same with monetary policy. Just as the conditions that led the communists to build an iron curtain to prevent their reluctant subjects escaping from authoritarianism, there should be no monetary policy.

Instead, when things don’t go their way, like the communists, bureaucrats double down on their misguided policies suppressing the evidence of their failures. It is something of a miracle that the economic consequences have not been worse. It is testament to the robustness of human action that when officialdom places mountainous hurdles in its path ordinary folk manage to find a way to get on with their lives despite the intervention.

Eventually, the piper must be paid. Misguided interest rate policies led to their suppression to the zero bound, and for the euro, Japanese yen, and Swiss franc, even unnaturally negative deposit rates. Predictably, the distortions of these policies together with central bank credit inflation through quantitative easing are leading to pay-back time.

Rapidly rising commodity, producer and consumer prices, the consequences of these policy mistakes, are in turn leading to higher time preference discounts. Finally, markets have wrested currency and credit valuations out of central banks’ control, as it slowly dawns on market participants that the whole interest rate game has been an economic fallacy. Foreign creditors are no longer prepared to sit there and accept deposit rates and bond yields which do not compensate them for loss of purchasing power. Time preference is now mauling central bankers and their cherished delusions. They have lost their suppressive control over markets and now we must all face the consequences. Like the fate of the Berlin Wall that had kept Germany’s Ossies penned in, monetary policy control is being demolished.

With purchasing powers for the major currencies now sinking at a more rapid rate than current levels of interest rate and bond yield compensation, the underlying trend for interest rates is now rising and has further to go. Official forecasts that inflation at the CPU level will return to the targeted 2% in a year or two are pie in the sky.

While Nero-like, central bankers fiddle commercial banks are being burned. A consequence of zero and negative rates has been that commercial bank balance sheet leverage increased stratospherically to compensate for suppressed lending margins. Commercial bankers now have an overriding imperative to claw back their credit expansion in the knowledge that in a rising interest rate environment, their unfettered involvement in non-banking financial activities comes at a cost. Losses on financial collateral are mounting, and the provision of liquidity into mainline non-financial sectors faces losses as well. And when you have a balance sheet leverage ratio of assets to equity of over twenty times (as is the case for the large Japanese and Eurozone banks), balance sheet equity is almost certain to be wiped out.

The imperative for action is immediate. Any banker who does not act with the utmost urgency faces the prospect of being overwhelmed by the new interest rate trend. The chart below shows that the broadest measure of US money supply, which is substantially the counterparty of bank credit is already contracting, having declined by $236bn since March.

Contracting bank credit forces up interest rates due to lower credit supply. This is a trend that cannot be bucked, a factor that has little directly to do with prices. By way of confirmation of the new trend, the following quotation is extracted from the Fed’s monthly Senior Loan Officers’ Opinion Survey for October:

“Over the third quarter, significant net shares of banks reported having tightened standards on C&I [commercial and industrial] loans to firms of all sizes. Banks also reported having tightened most queried terms on C&I loans to firms of all sizes over the third quarter. Tightening was most widely reported for premiums charged on riskier loans, costs of credit lines, and spreads of loan rates over the cost of funds. In addition, significant net shares of banks reported having tightened loan covenants to large and middle-market firms, while moderate net shares of banks reported having tightened covenants to small firms. Similarly, a moderate net share of foreign banks reported having tightened standards for C&I loans.

“Major net shares of banks that reported having tightened standards or terms cited a less favourable or more uncertain economic outlook, a reduced tolerance for risk, and the worsening of industry-specific problems as important reasons for doing so. Significant net shares of banks also cited decreased liquidity in the secondary market for C&I loans and less aggressive competition from other banks or nonbank lenders as important reasons for tightening lending standards and terms.”

Similarly, credit is being withdrawn from financial activities. The following chart reflects collapsing credit levels being provided to speculators.

In the same way that the withdrawal of bank credit undermines nominal GDP (because nearly all GDP transactions are settled in bank credit) the withdrawal of bank credit also undermines financial asset values. And just as it is a mistake to think that a contraction of GDP is driven by a decline in economic activity rather than the availability of bank credit, it is a mistake to ignore the role of bank credit in driving financial market valuations.

The statistics are yet to reflect credit contraction in the Eurozone and Japan, which are the most highly leveraged of the major banking systems. This may be partly due to the rapidity with which credit conditions are deteriorating. And we should note that the advanced socialisation of credit in these two regions probably makes senior managements more beholden to their banking authorities, and less entrepreneurial in their big-picture awareness than their American counterparts. Furthermore, the principal reason for continued monetary expansion reflects both the euro-system and the Bank of Japan’s continuing balance sheet expansion, which feed directly into the commercial banking network bolstering their balance sheets. It is likely to be state-demanded credit which overwhelms the Eurozone and Japan’s statistics, masking deteriorating changes in credit supply for commercial demand.

The ECB and BOJ’s monetary policies have been to compromise their respective currencies by their continuing credit expansion, which is why their currencies have lost significant ground against the dollar while US interest rates have been rising. Adding to the tension, the US’s Fed has been jawing up its attack on price inflation, but the recent fall in the dollar on the foreign exchanges strongly suggests a pivot in this policy is in sight.

The dilemma facing central banks is one their own making. Having suppressed interest rates to the zero bound and below, the reversal of this trend is now out of their control. Commercial banks will surely react in the face of this new interest rate trend and seek to contract their balance sheets as rapidly as possible. Students of Austrian business cycle theory will not be surprised at the suddenness of this development. But all GDP transactions, with very limited minor cash exceptions at the retail end of gross output are settled in bank credit. Inevitably the withdrawal of credit will cause nominal GDP to contract significantly, a collapse made more severe in real terms when the decline in a currency’s purchasing power is taken into consideration.

The choice now facing bureaucratic officialdom is simple: does it prioritise rescuing financial markets and the non-financial economy from deflation, or does it ignore the economic consequences of protecting the currency instead? The ECB, BOJ and the Bank of England have decided their duty lies with supporting the economy and financial markets. Perhaps driven in part by central banking consensus, the Fed now appears to be choosing to protect the US economy and its financial markets as well.

The principal policy in the new pivot will be the same: suppress interest rates below their time preference. It is the policy mistake that the bureaucrats always make, and they will double down on their earlier failures. The extent to which they suppress interest rates will be reflected in the loss of purchasing power of their currencies, not in terms of their values against each other, but in their values with respect to energy, commodities, raw materials, foodstuffs, and precious metals. In other words, a new round of higher producer and consumer prices and therefore irresistible pressure for yet higher interest rates will emerge.

The collapse of the everything bubble

The flip side of interest rate trends is the value imparted to assets, both financial and non-financial. It is no accident that the biggest and most widespread global bull market in history has coincided with interest rate suppression to zero and even lower over the last four decades. Equally, a trend of rising interest rates will have the opposite effect.

Unlike bull markets, bear markets are often sudden and shocking, especially where undue speculation has been previously involved. There is no better example than that of the cryptocurrency phenomenon, which has already seen bitcoin fall from a high of $68,000 to $16,000 in twelve months. And in recent days, the collapse of one of the largest crypto-exchanges, FTX, has exposed both hubris and alleged fraud, handmaidens to extreme public speculation, on an unimaginable scale. For any student of the madness of crowds, it would be surprising if the phenomenon of cryptocurrencies actually survives.

Driving this volte-face into bear markets is the decline in bond values. On 20 March 2020, when the Fed reduced its fund rate to zero, the 30-year US Treasury bond yielded 1.18%. Earlier this week the yield stood at 4.06%. That’s a fall in price of over 50%. And time preference suggests that short-term rates, for example over one year, should currently discount a loss of currency’s purchasing power at double current rates, or even more.

For the planners who meddle with interest rates, increases in rates and bond yields on that scale are unimaginable. Monetary policy committees, being government agencies, will think primarily about the effect on government finances. In their nightmares they can envisage tax revenues collapsing, welfare commitments soaring, and borrowing costs mounting. The increased deficit, additional to current shortfalls, would require central banks to accelerate quantitative easing without limitation. To the policy planners, the reasons to bring interest rates both lower and back firmly under control are compelling.

Furthermore, officials believe that a rising stock market is necessary to maintain economic confidence. That also requires the enforcement of a new declining interest rate trend. The argument in favour of a new round of interest rate suppression becomes undeniable. But the effect on fiat currencies will accelerate their loss of purchasing power, undermining confidence in them and leading to yet higher interest rates in the future.

Either way, officialdom loses. And the public will pay the price for meekly going along with these errors.

Managing counterparty risk

Any recovery in financial asset values, such as that currently in play, is bound to be little more than a rally in an ongoing bear market. We must not forget that commercial bankers have to reduce their balance sheets ruthlessly if they are to protect their shareholders. Consequently, as over-leveraged international banks are at a heightened risk of failing in the new interest rate environment, their counterparties face systemic risks increasing sharply. To reduce exposure to these risks, all bankers are duty bound to their shareholders to shrink their obligations to other banks, which means that the estimated $600 trillion of notional over the counter (OTC) derivatives and on the back of it the additional $50 trillion regulated futures exchange derivatives will enter their own secular bear markets. OTC and regulated derivatives are the children of falling interest rates, and with a new trend of rising interest rates their parentage is bound to be tested.

We can now see a further reason why central banks will wish to suppress interest rates and support financial markets. Unless they do so, the risk of widespread market failures between derivative counterparties will threaten to collapse the entire global banking network. And that is in addition to existential risks from customer loan defaults and collapsing collateral values. Central banks will have to stand ready to rescue failing banks and underwrite the entire commercial system.

To avert this risk, they will wish to stabilise markets and prevent further increases in interest rates. And all central banks which have indulged in QE already have mark-to-market losses that have wiped out their own balance sheet equity. We now face the prospect of central banks that by any commercial measure are themselves financially broken, tasked with saving entire commercial banking networks.

When the trend for interest rates was for them to fall under the influence of increasing supplies of credit, the deployment of that credit was substantially directed into financial assets and increasing speculation. For this reason, markets soared while the increase in the general level of producer and consumer prices was considerably less than the expansion of credit suggested should be the case. That is no longer so, with manufacturers facing substantial increases in their input costs. And now, when they need it most, bank credit is being withdrawn.

It is not generally realised yet, but the financial world is in transition between economies being driven by asset inflation and suppressed commodity prices, and a new environment of asset deflation while commodity prices increase. And it is in the valuations of unanchored fiat currencies where this transition will be reflected most.

Physical commodities are set replace paper equivalents

The expansion of derivatives when credit was expanding served to soak up demand for commodities which would otherwise have gone into physical metals and energy. In the case of precious metals, this is admitted by those involved in the expansion of London’s bullion market from the 1980s onwards to have been a deliberate policy to suppress gold as a rival to the dollar.

According to the Bank for International Settlements, at the end of last year gold OTC outstanding swaps and forwards (essentially, the London Bullion Market) stood at the equivalent of 8,968 tonnes of bullion, to which must be added the 1,594 tonnes of paper futures on Comex giving an identified 10,662 tonnes. This is considerably more than the official reserves of the US Treasury, and even its partial replacement with physical bullion will have a major impact on gold values. Silver, which is an extremely tight market, is most of the BIS’s other precious metal statistics content and faces bullion replacement of OTC paper in the order of three billion ounces, to which we must add Comex futures equivalent to a further 700 million ounces.

On the winding down of derivative markets alone, the impact on precious metal values is bound to be substantial. Furthermore, the common mistake made by almost all derivative traders is to not understand that legal money is physical gold and silver — despite what their regulating governments force them to believe. What they call prices for gold and silver are not prices, but values imparted to legal money from depreciating currencies and associated credit.

While it may be hard to grasp this seemingly upside-down concept, it is vital to understand that so-called rising prices for gold and silver are in fact falling values for currencies. Some central banks, predominantly in Asia are taking advantage of this ignorance, which is predominantly displayed in western, Keynesian-driven derivative markets.

Perhaps after a currency hiatus and when market misconceptions are ironed out, we can expect legal money values to behave as they should. If a development which is clearly inflationary emerges, it should drive currency values lower relative to gold. But instead, in today’s markets we see them rise because speculators take the view that currencies relative to gold will benefit from higher interest rates. A pause for thought should expose the fallacy of this approach, where the true relationship between money and currencies is assumed away.

In the wake of the suspension of the Bretton Woods agreement and when the purchasing power of currencies subsequently declined, interest rates and the value of gold rose together. In February 1972, gold was valued at $85, while the Fed funds rate was 3.3%. On 21 January 1980 gold was fixed that morning at $850, and the Fed funds rate was 13.82%. When gold increased nine-fold, the Fed’s fund rate had more than quadrupled. And it required Paul Volcker to raise the funds rate to over 19% twice subsequently to slay the inflation dragon.

In the seventies, the excessive credit-driven speculation that we now witness was absent, along with the accompanying debt leverage in the financial sectors of western economies and in their banking systems. A Volcker-style rise in interest rates today would cause widespread bankruptcies and without doubt crash the entire global banking system. While markets might take us there anyway, as a deliberate act of official policy it can be safely ruled out.

We must therefore conclude that there is another round of currency destruction in the offing. Potentially, it will be far more extensive than anything seen to date. Not only will central-bank currency and QE expansion fund government deficits and attempt to compensate for the contraction of bank credit while supporting financial markets by firmly suppressing interest rates and bond yields, but insolvent central banks will be tasked with underwriting insolvent commercial banks.

At some stage, the inversion of monetary reality, where legal money is priced in fiat, will change. Instead of legal money being priced in fiat, fiat currencies will be priced in legal money. But that will be the death of the fiat swindle.

Source : Goldmoney

Central Banks Are Buying Gold At The Fastest Pace In 55 Years

Alex Kimani wrote . . . . . . . . .

Central banks globally have been accumulating gold reserves at a furious pace last seen 55 years ago when the U.S. dollar was still backed by gold. According to the World Gold Council (WGC), central banks bought a record 399 tonnes of gold worth around $20 billion in the third quarter of 2022, with global demand for the precious metal back to pre-pandemic levels. Retail demand by jewelers and buyers of gold bars and coins was also strong, the WGC said in its latest quarterly report. WGC says that the world’s gold demand amounted to 1,181 tonnes in the September quarter, good for 28% Y/Y growth. WGC says among the largest buyers were the central banks of Turkey, Uzbekistan, Qatar and India, though other central banks also bought a substantial amount of gold but did not publicly report their purchases. The Central Bank of Turkey remains the largest reported gold buyer this year, adding 31 tonnes in Q3 to bring its total gold reserves to 489 tonnes. The Central Bank of Uzbekistan bought another 26 tonnes; the Qatar Central Bank bought 15 tonnes; the Reserve Bank of India added 17 tonnes during the quarter, pushing its gold reserves to 785 tonnes.

Retail buyers of gold bars and coins also surged in Turkey to 46.8 tonnes in the quarter, up more than 300% year-on-year.

These developments are hardly surprising taking into account gold is still considered the pre-eminent safe asset in times of uncertainty or turmoil despite the emergence of cryptocurrencies like bitcoin. Gold is also regarded as an effective inflation hedge, though experts say that this only rings true only over extended timelines measured in decades or even centuries.

Unfortunately, rising interest rates spoiled the party for the gold bulls, with exchange traded funds (ETFs) storing bullion for investors becoming net sellers. Indeed, offloading of bullion by ETFs countered buying by central banks pushed gold prices down 8% in the third quarter. Gold is a non-interest bearing asset, and investors tend to move their money to higher yielding instruments during times of rising interest rates. An overly strong dollar has also not been helping gold (and commodity) prices. Gold prices are down 9.3% YTD and nearly 20% below their March peak of $2,050 per ounce.

Long-term bullish

Luckily for the gold bulls, the long-term gold outlook appears to tilt bullish. Markets are currently primed for the fourth 75-basis point hike in a row, after which the Federal Reserve is expected to signal that it could reduce the size of its rate hikes starting as soon as December.

“We think they hike just to get to the end point. We do think they hike by 75. We think they do open the door to a step down in rate hikes beginning in December. The November meeting isn’t really about November. It’s about December,” Michael Gapen, chief U.S. economist at Bank of America, has told CNBC. Gapen expects the Fed would then raise interest rates by a half percentage point in December.

While inflation in the U.S. has remained stubbornly high, there are growing signs that high interest rates are beginning to slow the economy with the housing market slumping, and some mortgage rates nearly doubling. This calls for the Fed to go easy on its aggressive hikes.

Gold traders appear to agree that the long-term gold trajectory is up.

According to a survey of the bullion industry, gold prices will rebound next year, despite higher interest rates. Traders expect prices to rise to $1,830.50 an ounce by this time next year, nearly 11% above current levels..

“I tend to think that Fed hawkishness is largely now ‘in the price. That said, the scope for a near-term major rebound in gold prices is very limited while rates climb and the US dollar remains strong, “Philip Klapwijk, managing director of Hong Kong-based consultant Precious Metals Insights Ltd, said in an email.

Finay, a weakening dollar is likely to improve the gold outlook. The dollar may finally be losing its luster after a long period of relative strength against other major currencies. The dollar index–a metric that pits the U.S. dollar against six leading currencies–recently fell to multi-month lows. According to Wells Fargo, the dollar’s surge is likely to continue this year as interest rates rise further but Fed rate cuts in 2023 should push the dollar into “cyclical decline.” In other words, the dollar is set to fall in 2023 as the U.S. enters recession and the Fed cuts rates.

Source : Oil Price

Chart: Gold Has Been Out-performing Most Assets in 2022

Source : Bloomberg

Chart: The Gold-to-Silver Ratio Over 200 Years

See large image . . . . . .

Source : Visual Capitalist

Source : Bloomberg

Chart: Global Gold Reserve vs. Global US Treasury in June 2022

Source : Bloomberg

Infographic: The 10 Largest Gold Mines in the World, by Production

See large image . . . . . .

Source : Visual Capitalist

Chart: Total Return in US$ of Selected Government Bonds and Gold Since May 2021

Developed economy government bonds have proved anything but safe.

Source : Gavekal

Russia Moving Closer to a Gold Standard – Official

Russian experts are working on a project to create a two-loop monetary and financial system in the country, Secretary of the Security Council Nikolay Patrushev said on Tuesday, in an interview with Rossiyskaya Gazeta.

He explained that the project involves the provision of the Russian currency with both gold and a range of goods representing a currency value. As a result, the ruble exchange rate would correspond to its real purchasing power parity, he said.

To ensure the sovereignty of any national financial system, it is necessary that its means of payment have intrinsic value and price stability, and is not tied to the dollar, Patrushev said.

Another important condition for Russian economic security is the restructuring of its economy based on modern technologies, he added.

“We are not against a market economy … but … the West allows other countries to be its partner only when it is beneficial for it,” Patrushev stressed, noting that Russia’s development should be based on its internal potential.

On March 25, the Bank of Russia announced a fixed price for buying gold with rubles. It set a price of 5,000 rubles ($59 at the time) for a gram of gold.

The security secretary also stressed that Washington was trying to solve its problems at the expense of the rest of the world, thereby creating a “human-induced global crisis.” And its European allies would be the first to suffer from those actions, Patrushev said.

While the White House is discussing a possible default by Russia, the situation is such that “it’s time for them to declare their own default,” Patrushev said, pointing out that the US’ external debt has exceeded $30 trillion.

Source : RT

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Gold-backed ruble could be a game-changer (INTERVIEW) . . . . .

Edging Towards a Gold Standard

Alasdair Macleod wrote . . . . . . . . .

Commentators are trying to make sense of Russian moves. However, there is a back story which differs from much of the speculation, which this article addresses.

The Russians have not put the rouble on some sort of gold standard. Instead, they have repeated the Nixon/Kissinger strategy which created the petrodollar in 1973 by getting the Saudis to agree to accept only dollars for oil. This time, nations deemed by Russia to be unfriendly will be forced to buy roubles – roughly 2 trillion by the EU alone based on last year’s natural gas and oil imports from Russia — driving up the exchange rate. The rouble has now doubled against the dollar from its low point of RUB 150 to RUB 75 yesterday in just over three weeks. The Russian Central Bank will soon be able to normalise the domestic economy by reducing interest rates and removing exchange controls

The Russians and Chinese will be acutely aware that Western currencies, particularly the yen and euro, are likely to be undermined by recent developments. The financial war, which has always been in the background, is emerging into plain sight and becoming a battlefield between fiat currencies, and it is full on.

The winner by default is almost certainly gold, now the only reliable reserve asset for those not aligned with Russia’s “unfriendlies”. But it is still a long way from backing any currency.

Putin is losing the battle for Ukraine

President Putin is embattled. His army as let him down — it turns out that his generals lack the necessary leadership qualities, the squaddies are suffering from lack of food, fuel, and are suffering from frostbite. It is reported that one brigade commander, Colonel Yuri Medvedev, was deliberately run down by one of his own men in a tank, a measure of the chaos at the front line. And Putin is not the first national leader to have misplaced his confidence in military forces.

Conventional wisdom (from Carl von Clausewitz, no less) suggested Putin might win the battle for Ukraine but would be unable to hold the territory. That requires the willingness of the population to accept defeat, and a lesson the Soviets had learned in Afghanistan, with the same experience repeated by America and the UK. But Putin has not even won the battle and word from the Kremlin is of accepting a face-saving fall-back position, perhaps taking Donetsk and the coast of the Sea of Azov to join it up with Crimea.

There was little doubt that if Putin came under pressure militarily, he would probably step up the commodity and financial war. This he has now done by insisting on payments in roubles. The mistake made in the West was to believe that Russia must sell commodities, and even though sanctions harm the West greatly, the strategy is to put maximum pressure on the Russian economy for a quick resolution. It is obviously flawed because Russia can still trade with China, India, and other significant economies. And thanks to rising commodity prices the Russian economy is not in the bad place the West beleived either.

Besides nations representing 84% of the world’s population standing aside from the Western alliance’s sanctions and with some like India sorely tempted to buy discounted Russian oil, we would profit from paying attention to some very basic factors. Russia can certainly afford to sell oil at significant discounts to market prices, and there are buyers willing to break the American-led embargoes. The non-Western world is no longer automatically on-side with American hegemony; that is a rotting hulk which the Americans are desperately trying to keep afloat. Observing this, the Kremlin seems relaxed and has said that it is willing to accept currencies from its friends, but Western enemies (the “unfriendlies”) would have to pay for oil in roubles or, it has also been suggested, in gold.

On 23 March the Kremlin drew up a list of these unfriendly countries, which includes the 27 EU members, Switzerland, Norway, the United States, the United Kingdom, Canada, Australia, New Zealand, Japan, and South Korea.

Payment in roubles is easy to understand. We can assume that all oil and natural gas long-term supply contracts with the unfriendlies have force majeure clauses, because that is normal practice. In the light of sanctions, the Russians are entitled to claim different payment terms. And it is this that the Russians are relying upon for insisting on payment in roubles.

Germany, for example, would have to buy roubles on the foreign exchanges to pay for her gas. Buying roubles supports the currency, and this was the tactic that created the petrodollar in 1973 when Nixon and Kissinger persuaded the Saudis to take nothing else but dollars for oil. It was that single move which more than anything confirmed the dollar as the world’s international and reserve currency in the aftermath of the temporary suspension of the Bretton Woods Agreement. That’s not quite the objective here; it is to not only underwrite the rouble, but to drive it higher relative to other currencies. The immediate effect has been clear, as the chart from Trading Economics below shows.

Having halved in value against the dollar on 7 March, all the rouble’s fall has been recovered. And that’s even before Germany et al buy roubles on the foreign exchanges to pay for Russian energy.

The gold issue is more complex. The West has banned not only Russian transactions settling in their currencies but also from settling in gold. The assumption is that gold is the only liquid asset Russia has left to trade with. But just as ahead of the end of the cold war Western intelligence completely misread the Soviet economy, it could be making a mistake again. This time, intel seems to be misled by full-on Keynesian macro analysis, suggesting the Russian economy is vulnerable when it is inherently stronger in a currency shoot-out than even the dollar. There is no need for Russia to sell any gold at all.

The Russian economy has a broadly non-interventionist government, a flat rate of income tax of 13%, and a government debt of 20% of GDP. There are flaws in the Russian economy, particularly in the lack of respect for property rights and the pervasive problem of the Russian Mafia. But in many respects, Russia’s economy is like that of the US before 1916, when the highest income tax rate was 15%.

An important difference is that the Russian government gets substantial revenues from energy and commodity exports, taking its income up to over 40% of GDP. While export volumes of energy and other commodities are being hit by sanctions, their prices have risen substantially. But it remains to be seen what form of money or currency for future payments will be used for over $550bn equivalent of exports, while $297bn of imports will be substantially reduced by sanctions, widening Russia’s trade surplus considerably. Euros, yen, dollars, and sterling are ruled out, worthless in the hands of the Central Bank. That leaves Chinese renminbi, Indian rupees, weakening Turkish lira and that’s about it. It’s hardly surprising that Russia is prepared to accept gold. Putin’s view on the subject is shown in Figure 1 of stills taken from a Tik Tok video released last weekend.

Furthermore, Russia’s official reserves are only a small part of the story. Simon Hunt of Simon Hunt Strategic Services, who I have found to be consistently well informed in these matters, is convinced based on his information that Russia’s gold reserves are significantly higher than reported — he thinks 12,000 tonnes is closer to the mark.

The payment choice for those on Russia’s unfriendly list, if we rule out gold, is effectively of only one — buy roubles to pay for Russian energy. By sanctioning the world’s largest energy exporter, the effect on energy prices in dollars is likely to drive them far higher yet. Additionally, market liquidity for roubles is likely to be restricted, and the likelihood of a bear squeeze on any shorts is therefore high. The question is how high?

Last year, the EU imported 155 billion cubic meters of natural gas from Russia, valued at about $180bn at current volatile prices. Oil exports from Russia to the EU were about 2.3 million barrels per day, worth an additional $105bn for a combined total of $285bn, which at the current exchange rate of RUB 75.5 is RUB 2.15 trillion. EU Gas consumption is likely to fall as spring approaches, but payments in roubles will still drive the exchange rate significantly higher. And attempts to obtain alternative sources of LNG will take time, be insufficient, and serve to drive natural gas prices from other suppliers even higher.

For now, we should dismiss ideas over payments to the Russians in gold. The Russian gold story, initially at least, is a domestic issue. Though it might spill over into international markets.

On 25 March, Russia’s central bank announced it will buy gold from credit institutions at a fixed rate of 5,000 roubles per gramme starting this week and through to 30 June.[i] The press release stated that it will enable “a stable supply of gold and smooth functioning of the gold mining industry.” In other words, it allows banks to continue to lend money to gold mining and related activities, particularly for financing new gold mining developments. Meanwhile, the state will continue to accumulate bullion which, as discussed above, it has no need to spend on imports.

When the RCB’s announcement was made the rouble was considerably weaker and the price offered by the central bank was about 20% below the market price. But that has now changed. Based on last night’s exchange rate of 75.5 roubles to the dollar (30 March) and with gold at $1935, the price offered by the central bank is at a premium of 7.2% to the market. Whether this opens the situation up to arbitrage from overseas bullion markets is an intriguing question. And we can assume that Russian banks will find ways of acquiring and deploying the dollars to do so through their offshore facilities, until, under the cover of a strong rouble, the RCB removes exchange controls.

There is nothing in the RCB’s statement to prevent a Russian bank sourcing gold from, say, Dubai, to sell to the central bank. Guidance notes to which we cannot be privy may address this issue but let us assume this arbitrage will be permitted, because it might be difficult to stop. And if Russia does have undeclared bullion reserves more than those allegedly held by the US Treasury, then given that the real war is essentially financial, it is in Russia’s interest to see the gold price rise in dollars.

Not only would Eurozone banks be scrambling to obtain roubles, but the entire Western banking system, which takes the short side of derivative transactions in gold will find itself in increasing difficulties. Normally, bullion banks rely on central banks and the Bank for International Settlements to backstop the market with physical liquidity through leases and swaps. But the unfortunate message from the West to every central bank not on Russia’s unfriendly list is that London’s or New York’s respect for ownership rights to their nation’s gold cannot be relied upon. Not only will lease and swap liquidity dry up, but it is likely that requests will be made for earmarked gold in these centres to be repatriated.

In short, Russia appears to be initiating a squeeze on gold derivatives in Western capital markets by exploiting diminishing faith in Western institutions and their cavalier treatment of foreign property rights. By forcing the unfriendlies into buying roubles, the RCB will shortly be able to reduce interest rates back to previous policy levels and remove exchange controls. At the same time, the inflation problems faced by the West will be ameliorated by a strong rouble.

It ties in with the politics for Putin’s survival. Together with the economic benefits of an improving exchange rate for the rouble and the relatively minor inconvenience of not being able to buy imports from the West (alternatives from China and India will still be available) Putin can retreat from his disastrous Ukrainian campaign. Senior figures in the Russian army will be disciplined, imprisoned, or disappear accused of incompetence and misleading Putin into thinking his “special operation” would be quickly achieved. Putin will absolve himself of any blame and dissenters can expect even greater clampdowns on protests.

Russia’s moves are likely to have been thought out in advance. The move to support the rouble is evidence it is so, giving the central bank the opportunity to reverse the interest rate hike to 20% to protect the rouble. Foreign exchange controls on Russians can shortly be lifted. Almost certainly the consequences for Western currencies were discussed. The conclusion would surely have been that higher energy and other Russian commodity prices would persist, driving Western price inflation higher and for longer than discounted in financial markets. Western economies face soaring interest rates and a slump. And depending on their central bank’s actions, Japan and the Eurozone with negative interest rates are almost certainly most vulnerable to a financial, currency, and economic crisis.

The impact of Russia’s new policy of only accepting roubles was, perhaps, the inevitable consequence of the West’s policies of self-immolation. From Russia’s failure in Ukraine, Putin appears to have had little option but to go on the offensive and escalate the financial, or commodity-currency war to cover his retreat. We can only speculate about the effect of a strong rouble on the international gold price, but if Russian banks can indeed buy bullion from non-Russian sources to sell to the RCB, it would mark a very aggressive move in the ongoing financial war.

China’s position

China will be learning unpalatable lessens about its ambition to invade Taiwan, and Taiwan will be encouraged mightily by Ukraine’s success at repelling an unwelcome invader. A 100-mile channel is an enormous obstacle for a Chinese invasion that Russia didn’t have to navigate before Ukrainian locals exploited defensive tactics to repel the invader. There can now be little doubt of the outcome if China tried the same tactics against Taiwan. President Xi would be sensible not to make the same mistake as Putin and tone down the anti-Taiwan rhetoric and try the softer approach of friendly relations and economic integration to reunite Chinese interests.

That has been a costless lesson for China, but another consideration is the continuing relationship with Russia. The earlier Chinese description of it made sense: “We are not allies, but we are partners”. What this means is that China would abstain rather than support Russia in the various supranational forums where the world’s leaders gather. But she would continue to trade with Russia as normal, even engaging in currency swaps to facilitate it.

More recently, a small crack has appeared in this relationship, with China concerned that US and EU sanctions might be extended to Chinese entities in joint ventures with Russian businesses linked to sanctioned oligarchs and Putin supporters. The highest profile example has been the suspension of a joint project to build a petrochemical plant in Russia involving Sinopec, because of the involvement of Gennady Timchenko, a close ally of Putin. But according to a report from Nikkei Asia, Sinopec has confirmed it will continue to buy Russian crude oil and gas.

As always with its geopolitics, we can expect China to play its hand with great care. China was prepared for the consequences of US monetary policy in March 2020 when the Fed reduced its funds rate to zero and instituted quantitative easing of $120bn every month. By its actions it judged these moves to be very inflationary, and began stockpiling commodities ahead of dollar price rises, including energy and grains to project its own people. The yuan has risen against the dollar by about 11%, which with moderate credit policies has kept annualised domestic price inflation subdued to about 1% currently, while consumer price inflation in the West is soaring out of control.

China is not therefore in the weak financial position of Russia’s “unfriendlies”; the highly indebted governments whose finances and economies are likely to be destabilised by rising energy prices and interest rates. But it does have a potential economic crisis on its hands in the form of a collapsing property market. In February, its response was to ease the credit restrictions imposed following the initial pandemic recovery in 2021, which had included attempts to deleverage the property sector.

Property aside, we can assume that China will not want to destabilise the West by her own actions. The West is doing that very effectively without China’s assistance. But having demonstrated an understanding of why the West is sliding into an inflation crisis of its own making China will be keen not to make the same mistakes. Her partnership with Russia, as joint leaders in the Shanghai Cooperation Organisation, is central to detaching herself from what its Maoist economists forecast as the inevitable collapse of imperial capitalism. Having set itself up in the image of that imperialism, it must now become independent from it to avoid the same fate.

Gold’s wider role in China, Russia, and the SCO

Gold has always been central to China’s fallback position. I estimated that before permitting its own people to buy gold in 2002, the state had acquired as much as 20,000 tonnes. Subsequently, through the Shanghai Gold Exchange the Chinese public has taken delivery of a further 20,000 tonnes, mainly through imports from outside China. No gold escapes China, and the Chinese government is likely to have added to its hoard over the last twenty years. The government maintains a monopoly on refining and has stimulated the mining industry to become the largest national producer. Together with its understanding of the West’s inflationary policies the evidence is clear: China is prepared for a world of sound money with gold replacing the dollar’s hegemony, and it now dominates the world’s physical market with that in mind.

These plans are shared with Russia, and the members, dialog partners and associates of the Shanghai Cooperation Organisation — almost all of which have been accumulating gold reserves. Mine output from these countries is estimated by the US Geological Survey at 830 tonnes, 27% of the global total.

The move away from pure fiat was confirmed recently by some half-baked plans for the Eurasian Economic Union and China to escape from Western fiat by setting up a new currency for cross-border trade backed partly by commodities, including gold.

The extent of “off balance sheet” bullion is a critical issue, because at some stage they are likely to be declared. In this context, the Russian position is important, because if Simon Hunt, quoted above, is correct Russia could have more gold than the US’s 8,130 tonnes, which it is widely thought to overstate the latter’s true position. Furthermore, Western central banks routinely lease and swap their gold reserves, leading to double counting, which almost certainly reduces their actual position in aggregate. And if fiat currencies continue to decline we could find that the two ringmasters for the SCO have more monetary gold than all the other central banks put together — something like 30,000-40,000 tonnes for Chinese and Russian governments, compared with perhaps less than 20,000 tonnes for Russia’s adversaries (officially ,the unfriendlies own about 24,000 tonnes, but we can assume that at least 5,000 of that is double counted or does not exist due to leasing and swaps).

The endgame for the yen and the euro

Without doubt, the terrible twins in the major fiat currencies are the yen and the euro. They share much in common: negative interest rates, major commercial banks highly leveraged with asset to equity ratios averaging over twenty times, and central bank balance sheets overloaded with bonds which are collapsing in value. They now face rising interest rates spiralling beyond their control, the consequences of the ECB and Bank of Japan being trapped under the zero bound and being in denial over falling purchasing power for their currencies.

Consequently, we are seeing capital flight, which has accelerated dramatically this month for the yen, but in truth follows on from relative weakness for both currencies since the middle of 2021 when global bond yields began rising. Statistically, we can therefore link the collapse of both currencies on the foreign exchanges with rising bond yields. And given that rising interest rates and bond yields are in their early stages, there is considerable currency weakness yet to come.

Japan and its yen

The Bank of Japan has publicly stated it would buy an unlimited amount of 10-year Japanese Government Bonds at a 0.25% yield to contain the bond sell-off. A higher yield would be more than embarrassing for the BOJ, already requiring a recapitalisation, presumably with its heavily indebted government stumping up the money.

As avid Keynesians, the BOJ is following similar policies to that of John Law in 1720’s France. Law issued fresh livres which he used to prop up the Mississippi venture by buying shares in the market. The bubble popped, the venture survived, but the livre was destroyed.

Today, the BOJ is issuing yen to prop up the Japanese government bond market. As the issuer of the currency, the BOJ is by any yardstick bankrupt and in desperate need of new capital. Since it commenced QE in 2000, it has accumulated so much government and corporate debt, and even equities bundled into ETFs, that the falling value of the BOJ’s holdings makes its liabilities significantly greater than its assets, currently to the tune of about ¥4 trillion ($3.3bn).

Ignoring the cynic’s definition of madness, the BOJ is doubling down on its commitment, announcing on Monday further unlimited purchases of 10-year JGBs at a fixed yield of 0.25%. In other words, it is supporting bond prices from falling further, echoing Mario Draghi’s “whatever it takes” and confirming its John Law policy. Last Tuesday’s Summary of Opinions at the Monetary Policy Meeting on March 17 and 18 had this gem:

“Heightened geopolitical risks due to the situation surrounding Ukraine have caused price rises of energy and other items, and this will push down domestic demand while raising the CPI. Under the circumstances, it is necessary to improve labour market conditions and provide stronger support for wage increases, and therefore it is increasingly important that the bank persistently continue with the current monetary easing.”

No, this is not satire. In other words, the BOJ’s deposit rate will remain negative. And the following was added from Government Representatives at the same meeting:

“The budget for fiscal 2022 aims to realise a new form of capitalism through a virtual circle of growth and distribution and the government has been making efforts to swiftly obtain the Diet’s approval.”

A virtuous circle of growth? It seems like intensified intervention. Meanwhile, Japan’s major banks with asset to equity ratios of over twenty times are too highly geared to survive rising interest rates without a bank credit crisis threatening to take them down. It is hardly surprising that international capital is fleeing the yen, realising that it will be sacrificed by the BOJ in the vain hope that it can continue to maintain bond prices far above where they should be.

The euro system and its euro

The euro system and the euro share similar characteristics to the BOJ and the yen: interest rates trapped under the zero bound, Eurozone G-SIBs with asset to equity ratios of over 20 times and market realities forcing interest rates and bond yields higher. Furthermore, Eurozone banks are heavily exposed to Russian and Ukrainian debt due to their geographic proximity.

There are two additional problems for the Eurosystem not faced by the BOJ and the yen. The ECB’s shareholders are the national central banks in the euro system, which in turn have balance sheet liabilities more than their assets. The structure of the euro system means that in recapitalising itself the ECB does not have a government to which it can issue credit and receive equity capital in return, the normal way in which a central bank would refinance its balance sheet by turning credit into equity. Instead, it will have to refinance itself through the national central banks which being insolvent themselves in turn would have to refinance themselves through their governments.

The second problem is a further complication. The euro system’s TARGET2 settlement system reflects enormous imbalances which complicates resolving a funding crisis. For example, on the last figures (end-February), Germany’s Bundesbank was owed €1,150 billion through TARGET2, while Italy owed €568 billion. It would be in the interests of a recapitalisation for the Italian government to want its central bank to write off this amount, while the Bundesbank is already in negative equity without writing off TARGET2 balances. Germany’s politicians might demand the balances owed to the Bundesbank be secured. This problem is not insoluble perhaps, but one can see that political and public wrangling over these imbalances will only serve to draw attention to the fragility of the whole system and undermine public trust in the currency.

With Germany’s CPI now rising at 7.6% and Spain’s at 9.8%, negative deposit rates are wildly inappropriate. When the system breaks it can be expected to be sudden, violent and a shock to those in thrall to the euro system.


For decades, a showdown between an Asian partnership and hegemonic America has been building. We can date this back to 1983, when China began to accumulate physical gold having appointed the Peoples’ Bank for the purpose. That act was the first indication that China felt the need to protect itself from others as it ventured into capitalism. China has navigated itself through increasing American assertion of its hegemony and attempts to destabilise Hong Kong. It has faced obstacles to its lucrative export trade through tariffs. It has been cut off from Western markets for its advanced technology. China has resented having to use the dollar.

After Russia’s ill-advised invasion of Ukraine, it now appears that the invisible war over global financial resources and control is intensifying. The fuse has been lit and events are taking over. The destabilisation of the yen and the euro are now as certain as can be. While the yen is the victim of John Law-like market-rigging policies and likely to go the same way as France’s livre, perhaps the greater danger is for the euro. The contradictions in its set-up, and the destruction of Germany’s sound money principals in favour of the inflationism of the PIGS was always going to be finite. The ECB has got itself into a ridiculous position, and no amount of conjuring and cajoling of financial institutions can resolve the ECB’s own insolvency and that of all its shareholders.

History shows that there are two groups involved in a currency collapse. International holders take fright and sell for other currencies and assets they believe to be more secure. They drive the exchange rate lower. The second group is the public in a nation, those who use the currency for transactions. If they lose confidence in it, the currency can rapidly descend into worthlessness as ordinary people accelerate its disposal for anything tangible in a final crack-up boom.

In the past, an alternative currency was always the sounder one, one backed by and exchangeable for gold coin. That is so long ago that we in the West have mostly forgotten the difference between money, that is gold and silver, and unbacked fiat currencies. The great unknown has been how much abuse of money and credit it would take for the public to relearn the difference. Cryptocurrencies have alerted us, but they are not a widely accepted medium of exchange and don’t have the legal standing of gold and gold substitutes.

War is to be our wake-up call — financial rather than physical in character. Western central banks and their governments have been fiddling the books, telling us that currency debasement is good for us. That debasement has accelerated in recent years. But by upping the anti against Russia with sanctions that end up undermining the purchasing power of all the West’s major currencies, our leaders have called an end to the reign of fiat.

Source : Gold Money

The Failure of Fiat Currencies and the Implications for Gold and Silver

Alasdair Macleod wrote . . . . . . . . .

What is money?

To understand why all fiat currency systems fail, we must start by understanding what money is, and how it differs from other forms of currency and credit. These are long-standing relationships which transcend our times and have their origin in Roman law and the practice of medieval merchants who evolved a lex mercatoria, which extended money’s legal status to instruments that evolved out of money, such as bills of exchange, cheques, and other securities for money. And while as circulating media, historically currencies have been almost indistinguishable from money proper, in the last century issuers of currencies split them off from money so that they have become pure fiat.

At the end of the day, what constitutes money has always been determined by its users as the means of exchanging their production for consumption in an economy based on the division of labour. Money is the bridge between the two, and while over the millennia different media of exchange have come and gone, only metallic money has survived to be trusted. These are principally gold, silver, and copper. Today the term usually refers to gold, which is still in government reserves, as the only asset with no counterparty risk. Silver, which as a monetary asset declined in importance as money after Germany moved to a gold standard following the Franco-Prussian war, remains a monetary metal, though with a gold to silver ratio currently over 70 times, it is not priced as such.

For historical reasons, the world’s monetary system evolved based on English law. Britain, or more accurately England and Wales, still respects Roman, or natural law with respect to money. To this day, gold sovereign coins are legal tender. Strictly speaking, metallic gold and silver are themselves credit, representing yet-to-be-spent production. But uniquely, they are no one’s liability, unlike banknotes and bank deposits. Metallic money therefore has this exceptional status, and that fact alone means that it tends not to circulate, in accordance with Gresham’s Law, so long as lesser forms of credit are available.

Money shares with its currency and credit substitutes a unique position in criminal law. If a thief steals money, he can be apprehended and charged with theft along with any accomplices. But if he passes the money on to another party who receives it in good faith and is not aware that it is stolen, the original owner has no recourse against the innocent receiver, or against anyone else who subsequently comes into possession of the money. It is quite unlike any other form of property, which despite passing into innocent hands, remains the property of the original owner.

In law, cryptocurrencies and the mooted central bank digital currencies are not money, money-substitutes, or currencies. Given that a previous owner of stolen bitcoin sold on to a buyer unaware it was criminally obtained can subsequently claim it, there is no clear title without full provenance. In accordance with property law, the United States has ruled that cryptocurrencies are property, reclaimable as stolen items, differentiating cryptocurrencies from money and currency proper. And we can expect similar rulings in other jurisdictions to exclude cryptocurrencies from the legal status as money, whereas the position of CBDCs in this regard has yet to be clarified. We can therefore nail to the floor any claims that bitcoin or any other cryptocurrency can possibly have the legal status required of money.

Under a proper gold standard, currency in the form of banknotes in public circulation was freely exchangeable for gold coin. So long as they were freely exchangeable, banknotes took on the exchange value of gold, allowing for the credit standing of the issuer. One of the issues Sir Isaac Newton considered as Master of the Royal Mint was to what degree of backing a currency required to retain credibility as a gold substitute. He concluded that that level should be 40%, though Ludwig von Mises, the Austrian economist who was as sound a sound money economist as it was possible to be appeared to be less prescriptive on the subject.

The effect of a working gold standard is to ensure that money of the people’s choice is properly represented in the monetary system. Both currency and credit become bound to its virtues. The general level of prices will fluctuate influenced by changes in the quantity of currency and credit in circulation, but the discipline of the limits of credit and currency creation brings prices back to a norm.

This discipline is disliked by governments who believe that money is the responsibility of a government acting in the interests of the people, and not of the people themselves. This was expressed in Georg Knapp’s State Theory of Money, published in 1905 and became Germany’s justification for paying for armaments by inflationary means ahead of the First World War, and continuing to use currency debasement as the principal means of government finance until the paper mark collapsed in 1923.

Through an evolutionary process, modern governments first eroded then took away from the public for itself the determination of what constitutes money. The removal of all discipline of the gold standard has allowed governments to inflate the quantities of currency and credit as a means of transferring the public wealth to itself. As a broad representation of this dilution, Figure 1 shows the growth of broad dollar currency since the last vestige of a gold standard under the Bretton Woods Agreement was suspended by President Nixon in August 1971.

From that date, currency and bank credit have increased from $685 billion to $21.84 trillion, that is thirty-two times. And this excludes an unknown increase in the quantity of dollars not in the US financial system, commonly referred to as Eurodollars, which perhaps account for several trillion more. Gold priced in fiat dollars has risen from $35 when Bretton Woods was suspended, to $1970 currently. A better way of expressing this debasement of the dollar is to say that priced in gold, the dollar has lost 98.3% of its purchasing power (see Figure 4 later in this article).

While it is a mistake to think of the relationship between the quantity of currency and credit in circulation and the purchasing power of the dollar as linear (as monetarists claim), not only has the rate of debasement accelerated in recent years, but it has become impossible for the destruction of purchasing power to be stopped. That would require governments reneging on mandated welfare commitments and for them to stand back from economic intervention. It would require them to accept that the economy is not the government’s business, but that of those who produce goods and services for the benefit of others. The state’s economic role would have to be minimised.

This is not just a capitalistic plea. It has been confirmed as true countless times through history. Capitalistic nations always do better at creating personal wealth than socialistic ones. This is why the Berlin Wall was demolished by angry crowds, finally driven to do so by the failure of communism relative to capitalism just a stone’s throw away. The relative performance of Hong Kong compared with China when Mao Zedong was starving his masses on some sort of revolutionary whim, also showed how the same ethnicity performed under socialism compared with free markets.

The relationship between fiat currency and its purchasing power

One can see from the increase in the quantity of US dollar M3 currency and credit and the fall in the purchasing power measured against gold that the government’s monetary statistic does not square with the market. Part of the reason is that government statistics do not capture all the credit in an economy (only bank credit issued by licenced banks is recorded), dollars created outside the system such as Eurodollars are additional, and market prices fluctuate.

Monetarists make little or no allowance for these factors, claiming that the purchasing power of a currency is inversely proportional to its quantity. While there is much truth in this statement, it is only suited for a proper gold-backed currency, when one community’s relative valuations between currency and goods are brought into line with the those of its neighbours through arbitrage, neutralising any subjectivity of valuation.

The classical representation of the monetary theory of prices does not apply in conditions whereby faith in an unbacked currency is paramount in deciding its utility. A population which loses faith in its government’s currency can reject it entirely despite changes in its circulating quantity. This is what wipes out all fiat currencies eventually, ensuring that if a currency is to survive it must eventually return to a credible gold exchange standard.

The weakness of a fiat currency was famously demonstrated in Europe in the 1920s when the Austrian crown and German paper mark were destroyed. Following the Second World War, the Japanese military yen suffered the same fate in Hong Kong, and Germany’s mark for a second time in the mid 1940s. More recently, the Zimbabwean dollar and Venezuelan bolivar have sunk to their value as wastepaper — and they are not the only ones.

Ultimately it is the public which always determines the use value of a circulating medium. Figure 2 below, of the oil price measured in goldgrams, dollars, pounds, and euros shows that between 1950 and 1974 a gold standard even in the incomplete form that existed under the Bretton Woods Agreement coincided with price stability.

It took just a few years from the ending of Bretton Woods for the consequences of the loss of a gold anchor to materialise. Until then, oil suppliers, principally Saudi Arabia and other OPEC members, had faith in the dollar and other currencies. It was only when they realised the implications of being paid in pure fiat that they insisted on compensation for currency debasement. That they were free to raise oil prices was the condition upon which the Saudis and the rest of OPEC accepted payment solely in US dollars.

In the post-war years between 1950 and 1970, US broad money grew by 167%, yet the dollar price of oil was unchanged for all that time. Similar price stability was shown in other commodities, clearly demonstrating that the quantity of currency and credit in circulation was not the sole determinant of the dollar’s purchasing power.

The role of bank credit

While the relationship between bank credit and the sum of the quantity of currency and bank reserves varies, the larger quantity by far is the quantity of bank credit. The behaviour of the banking cohort therefore has the largest impact on the overall quantity of credit in the economy.

Under the British gold standard of the nineteenth century, the fluctuations in the willingness of banks to lend resulted in periodic booms and slumps, so it is worthwhile examining this phenomenon, which has become the excuse for state intervention in financial markets and ultimately the abandonment of gold standards entirely.

Banks are dealers in credit, lending at a higher rate of interest than they pay to depositors. They do not deploy their own money, except in a general balance sheet sense. A bank’s own capital is the basis upon which a bank can expand its credit.

The process of credit creation is widely misunderstood but is essentially simple. If a bank agrees to lend money to a borrowing customer, the loan appears as an asset on the bank’s balance sheet. Through the process of double entry bookkeeping, this loan must immediately have a balancing entry, crediting the borrower’s current account. The customer is informed that the loan is agreed, and he can draw down the funds credited to his current account from that moment.

No other bank, nor any other source of funding is involved. With merely two ledger entries the bank’s balance sheet has expanded by the amount of the loan. For a banker, the ability to create bank credit in this way is, so long as the lending is prudent, an extremely profitable business. The amount of credit outstanding can be many multiples of the bank’s own capital. So, if a bank’s ratio of balance sheet assets to equity is eight times, and the gross margin between lending and deposits is 3%, then that becomes a gross return of 24% on the bank’s own equity.

The restriction on a bank’s balance sheet leverage comes from two considerations. There is lending risk itself, which will vary with economic conditions, and depositor risk, which is the depositors’ collective faith in the bank’s financial condition. Depositor risk, which can lead to depositors withdrawing their credit in the bank in favour of currency or a deposit with another bank, can in turn originate from a bank offering an interest rate below that of other banks, or alternatively depositors concerned about the soundness of the bank itself. It is the combination of lending and depositor risk that determines a banker’s view on the maximum level of profits that can be safely earned by dealing in credit.

An expansion in the quantity of credit in an economy stimulates economic activity because businesses are tricked into thinking that the extra money available is due to improved trading conditions. Furthermore, the apparent improvement in trading conditions encourages bankers to increase lending even further. A virtuous cycle of lending and apparent economic improvement gets under way as the banking cohort takes its average balance sheet assets to equity ratio from, say, five to eight times, to perhaps ten or twelve. Competition for credit business then persuades banks to cut their margins to attract new business customers. Customers end up borrowing for borrowing’s sake, initiating investment projects which would not normally be profitable.

Even under a gold standard lending exuberance begins to drive up prices. Businesses find that their costs begin to rise, eating into their profits. Keeping a close eye on lending risk, bankers are acutely aware of deteriorating profit prospects for their borrowers and therefore of an increasing lending risk. They then try to reduce their asset to equity ratios. As a cohort whose members are driven by the same considerations, banks begin to withdraw credit from the economy, reversing the earlier stimulus and the economy enters a slump.

This is a simplistic description of a regular cycle of fluctuating bank credit, which historically varied approximately every ten years or so, but could fluctuate between seven and twelve. Figure 3 illustrates how these fluctuations were reflected in the inflation rate in nineteenth century Britain following the introduction of the sovereign gold coin until just before the First World War.

Besides illustrating the regularity of the consequences of a cycle of bank credit expansion and contraction marked by the inflationary consequences, Figure 3 shows there is no correlation between the rate of price inflation and wholesale borrowing costs. In other words, modern central bank monetary policies which use interest rates to control inflation are misconstrued. The effect was known and named Gibson’s paradox by Keynes. But because there was no explanation for it in Keynesian economics, it has been ignored ever since. Believing that Gibson’s paradox could be ignored is central to central bank policies aimed at taming the cycle of price inflation.

The interests of central banks

Notionally, central banks’ primary interest is to intervene in the economy to promote maximum employment consistent with moderate price inflation, targeted at 2% measured by the consumer price index. It is a policy aimed at stimulating the economy but not overstimulating it. We shall return to the fallacies involved in a moment.

In the second half of the nineteenth century, central bank intervention started with the Bank of England assuming for itself the role of lender of last resort in the interests of ensuring economically destabilising bank crises were prevented. Intervention in the form of buying commercial bank credit stopped there, with no further interest rate manipulation or economic intervention.

The last true slump in America was in 1920-21. As it had always done in the past the government ignored it in the sense that no intervention or economic stimulus were provided, and the recovery was rapid. It was following that slump that the problems started in the form of a new federal banking system led by Benjamin Strong who firmly believed in monetary stimulation. The Roaring Twenties followed on a sea of expanding credit, which led to a stock market boom — a financial bubble. But it was little more than an exaggerated cycle of bank credit expansion, which when it ended collapsed Wall Street with stock prices falling 89% measured by the Dow Jones Industrial Index. Coupled with the boom in agricultural production exaggerated by mechanisation, the depression that followed was particularly hard on the large agricultural sector, undermining agriculture prices worldwide until the Second World War.

It is a fact ignored by inflationists that first President Herbert Hoover, and then Franklin Roosevelt extended the depression to the longest on record by trying to stop it. They supported prices, which meant products went unsold. And at the very beginning, by enacting the Smoot Hawley Tariff Act they collapsed not only domestic demand but all domestic production that relied on imported raw materials and semi-manufactured products.

These disastrous policies were supported by a new breed of economist epitomised by Keynes, who believed that capitalism was flawed and required government intervention. But proto-Keynesian attempts to stimulate the American economy out of the depression continually failed. As late as 1940, eleven years after the Wall Street Crash, US unemployment was still as high as 15%. What the economists in the Keynesian camp ignored was the true cause of the Wall Street crash and the subsequent depression, rooted in the credit inflation which drove the Roaring Twenties. As we saw in Figure 3, it was no more than the turning of the long-established repeating cycle of bank credit, this time fuelled additionally by Benjamin Strong’s inflationary credit expansion as Chairman of the new Fed. The cause of the depression was not private enterprise, but government intervention.

It is still misread by the establishment to this day, with universities pushing Keynesianism to the exclusion of classic economics and common sense. Additionally, the statistics which have become a religion for policymakers and everyone else are corrupted by state interests. Soon after wages and pensions were indexed in 1980, government statisticians at the Bureau of Labor Statistics began working on how to reduce the impact on consumer prices. An independent estimate of US consumer inflation put it at well over 15% recently, when the official rate was 8%.[i]

Particularly egregious is the state’s insistence that a target of 2% inflation for consumer prices stimulates demand, when the transfer of wealth suffered by savers, the low paid and pensioners deprived of their inflation compensation at the hands of the BLS is glossed over. So is the benefit to the government, the banks, and their favoured borrowers from this wealth transfer.

The problem we now face in this fiat money environment is not only that monetary policy has become corrupted by the state’s self-interest, but that no one in charge of it appears to understand money and credit. Technically, they may be very well qualified. But it is now over fifty years since money was suspended from the monetary system. Not only have policymakers ignored indicators such as Gibson’s paradox. Not only do they believe their own statistics. And not only do they think that debasing the currency is a good thing, but we find that monetary policy committees would have us believe that money has nothing to do with rising prices.

All this is facilitated by presenting inflation as rising prices, when in fact it is declining purchasing power. Figure 4 shows how purchasing power of currencies should be read.

Only now, it seems, we are aware that inflation of prices is not transient. Referring to Figure 1, the M3 broad money supply measure has almost tripled since Lehman failed, so there’s plenty of fuel driving a lower purchasing power for the dollar yet. And as discussed above, it is not just quantities of currency and credit we should be watching, but changes in consumer behaviour and whether consumers tend to dispose of currency liquidity in favour of goods.

The indications are that this is likely to happen, accelerated by sanctions against Russia, and the threat that they will bring in a new currency era, undermining the dollar’s global status. Alerted to higher prices in the coming months, there is no doubt that there is an increased level of consumer stockpiling, which put another way is the disposal of personal liquidity before it buys less.

So far, the phases of currency evolution have been marked by the end of the Bretton Woods Agreement in 1971. The start of the petrodollar era in 1973 led to a second phase, the financialisation of the global economy. And finally, from now the return to a commodity standard brought about by sanctions against Russia is driving prices in the Western alliance’s currencies higher, which means their purchasing power is falling anew.

The faux pas over Russia

With respect to the evolution of money and credit, this brings us up to date with current events. Before Russia invaded Ukraine and the Western alliance imposed sanctions on Russia, we were already seeing prices soaring, fuelled by the expansion of currency and credit in recent years. Monetary planners blamed supply chain problems and covid dislocations, both of which they believed would right themselves over time. But the extent of these price rises had already exceeded their expectations, and the sanctions against Russia have made the situation even worse.

While America might feel some comfort that the security of its energy supplies is unaffected, that is not the case for Europe. In recent years Europe has been closing its fossil fuel production and Germany’s zeal to go green has even extended to decommissioning nuclear plants. It seems that going fossil-free is only within national borders, increasing reliance on imported oil, gas, and coal. In Europe’s case, the largest source of these imports by far is Russia.

Russia has responded by the Russian central bank announcing that it is prepared to buy gold from domestic credit institutions, first at a fixed price or 5,000 roubles per gramme, and then when the rouble unexpectedly strengthened at a price to be agreed on a case-by-case basis. The signal is clear: the Russian central bank understands that gold plays an important role in price stability. At the same time, the Kremlin announced that it would only sell oil and gas to unfriendly nations (i.e. those imposing sanctions) in return for payments in roubles.

The latter announcement was targeted primarily at EU nations and amounts to an offer at reasonable prices in roubles, or for them to bid up for supplies in euros or dollars from elsewhere. While the price of oil shot up and has since retreated by a third, natural gas prices are still close to their all-time highs. Despite the northern hemisphere emerging from spring the cost of energy seems set to continue to rise. The effect on the Eurozone economies is little short of catastrophic.

While the rouble has now recovered all the fall following the sanctions announcement, the euro is becoming a disaster. The ECB still has a negative deposit rate and enormous losses on its extensive bond portfolio from rapidly rising yields. The national central banks, which are its shareholders also have losses which in nearly all cases wipes out their equity (balance sheet equity being defined as the difference between a bank’s assets and its liabilities — a difference which should always be positive). Furthermore, these central banks as the NCB’s shareholders make a recapitalisation of the whole euro system a complex event, likely to question faith in the euro system.

As if that was not enough, the large commercial banks are extremely highly leveraged, averaging over 20 times with Credit Agricole about 30 times. The whole system is riddled with bad and doubtful debts, many of which are concealed within the TARGET2 cross-border settlement system. We cannot believe any banking statistics. Unlike the US, Eurozone banks have used the repo markets as a source of zero cost liquidity, driving the market size to over €10 trillion. The sheer size of this market, plus the reliance on bond investment for a significant proportion of commercial bank assets means that an increase in interest rates into positive territory risks destabilising the whole system.

The ECB is sitting on interest rates to stop them rising and stands ready to buy yet more members’ government bonds to stop yields rising even more. But even Germany, which is the most conservative of the member states, faces enormous price pressures, with producer prices of industrial products officially increasing by 25.9% in the year to March, 68% for energy, and 21% for intermediate goods.

There can be no doubt that markets will apply increasing pressure for substantial rises in Eurozone bond yields, made significantly worse by US sanctions policies against Russia. As an importer of commodities and raw materials Japan is similarly afflicted. Both currencies are illustrated in Figure 5.

The yen appears to be in the most immediate danger with its collapse accelerating in recent weeks, but as both the Bank of Japan and the ECB continue to resist rising bond yields, their currencies will suffer even more. The Bank of Japan has been indulging in quantitative easing since 2000 and has accumulated substantial quantities of government and corporate bonds and even equities in ETFs. Already, the BOJ is in negative equity due to falling bond prices. To prevent its balance sheet from deteriorating even further, it has drawn a line in the sand: the yield on the 10-year JGB will not be permitted to rise above 0.25%. With commodity and energy prices soaring, it appears to be only a matter of time before the BOJ is forced to give way, triggering a banking crisis in its highly leveraged commercial banking sector which like the Eurozone has asset to equity ratios exceeding 20 times.

It would appear therefore that the emerging order of events with respect to currency crises is the yen collapses followed in short order by the euro. The shock to the US banking system must be obvious. That the US banks are considerably less geared than their Japanese and euro system counterparts will not save them from global systemic risk contamination.

Furthermore, with its large holdings of US Treasuries and agency debt, current plans to run them off simply exposes the Fed to losses, which will almost certainly require its recapitalisation. The yield on the US 10-year Treasury Bond is soaring and given the consequences of sanctions on global commodity prices, it has much further to go.

The end of the financial regime for currencies

From London’s big bang in the mid-eighties, the major currencies, particularly the US dollar and sterling became increasingly financialised. It occurred at a time when production of consumer goods migrated to Asia, particularly China. The entire focus of bank lending and loan collateral moved towards financial assets and away from production. And as interest rates declined, in general terms these assets improved in value, offering greater security to lenders, and reinforcing the trend.

This is now changing, with interest rates set to rise significantly, bursting a financial bubble which has been inflating for decades. While bond yields have started to rise, there is further for them to go, undermining not just the collateral position, but government finances as well. And further rises in bond yields will turn equity markets into bear markets, potentially rivalling the 1929-1932 performance of the Dow Jones Industrial Index.

That being the case, the collapse already underway in the yen and the euro will begin to undermine the dollar, not on the foreign exchanges, but in terms of its purchasing power. We can be reasonably certain that the Fed’s mandate will give preference to supporting asset prices over stabilising the currency, until it is too late.

China and Russia appear to be deliberately isolating themselves from this fate for their own currencies by increasing the importance of commodities. It was noticeable how China began to aggressively accumulate commodities, including grain stocks, almost immediately after the Fed cut its funds rate to zero and instituted QE at $120 billion per month in March 2020. This sent a signal that the Chinese leadership were and still are fully aware of the inflationary implications of US monetary policy. Today China has stockpiled well over half the world’s maize, rice, wheat and soybean stocks, securing basics foodstuffs for 20% of the world’s population. As a subsequent development, the war in Ukraine has ensured that global grain supplies this year will be short, and sanctions against Russia have effectively cut off her exports from the unfriendly nations. Together with fertiliser shortages for the same reasons, not only will the world’s crop yields fall below last year’s, but grain prices are sure to be bid up against the poorer nations.

Russia has effectively tied the rouble to energy prices by insisting roubles are used for payment, principally by the EU. Russia’s other two large markets are China and India, from which she is accepting yuan and rupees respectively. Putting sales to India to one side, Russia is not only commoditising the rouble, but her largest trading partner not just for energy but for all her other commodity exports is China. And China is following similar monetary policies.

There are good reasons for it. The Western alliance is undermining their own currencies, of that there can be no question. Financial asset values will collapse as interest rates rise. Contrastingly, not only is Russia’s trade surplus increasing, but the central bank has begun to ease interest rates and exchange controls and will continue to liberate her economy against a background of a strong currency. The era of the commodity backed currency is arriving to replace the financialised.

And lastly, we should refer to Figure 2, of the price of oil in goldgrams. The link to commodity prices is gold. It is time to abandon financial assets for their supposed investment returns and take a stake in the new commoditised currencies. Gold is the link. Business of all sorts, not just mining enterprises which accumulate cash surpluses, would be well advised to question whether they should retain deposits in the banks, or alternatively, gain the protection of possessing some gold bullion vaulted independently from the banking system.

Source : Gold Money