Free Markets, Free People


The first post-downgrade business day

The yield on the 10-year note has dropped to 2.44%, down from 2.57% at Friday’s close. I’m thinking this is telling us the economy’s on the way into the toilet, as the standard reaction for a credit downgrade is rising interest rates, to cover the extra risk. The Dow’s long slide, which began on 22 July–and continues with a 250 point loss so far today–is probably telling us the same thing, as earning expectations slide. Since the downgrade was one agency only, and the downgrade only to AA+, economic factors are clearly weighing more on the bonds than the downgrade.  On the other hand, if you’re a gold investor, you’re probably a little happier today, as Gold hit $1,715/oz.

The key takeaway so far today is the continuing decline in yields, which isn’t good news. Thank goodness there’s no economic releases today. I’d hate to see what more bad news would bring.

So, back into recession, it looks like.

One of the more interesting things I’m wondering about, in a horrified kind of way, is what effect the downgrade has on corporate paper.  A number of institutions have investment rules that require they concentrate their investments in AAA-rated securities.  But, one of the general rating rules is that subsidiary corporate and government instruments cannot have a higher rating than their sovereign instruments. So if the US Government doesn’t have a AAA rating, no subsidiary US corporate or government paper should have a AAA rating either.

So, what does this mean for the handful of corporate and government instruments that were rated AAA prior to the downgrade? Do they get downgraded, too?  If so, where do the institutions with a AAA rating requirement go with their money?

I’m not at all sure how this works. As we’ve been saying a lot in the last week or so, we’re in uncharted territory.

END OF DAY WRAP-UP: Well, that could’ve been worse, I suppose.

Dow 10,810.83 -634.76 (-5.55%)
S&P 500 1,119.46 -79.92 (-6.66%)
NASDAQ 2,357,69 -174.72 (-6.90%)
10-Year Yield 2.34% -0.22%
Comex Gold $1,710.20/oz (+3.7%)

I’m not sure how much worse it could’ve been, though.

Dale Franks
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Now he’s done it…

It has become an article of faith in modern economics that the gold standard just isn’t suitable for modern economies.  Since the Great Depression started the movement away from the gold standard, we have moved towards a system of freely convertible fiat currencies whose values are, in the main determined by the ability of central banks to maintain control of inflation.  Any talk of returning to the gold standard, therefore, is derided as some sort of fanatical return to a failed past.

Now, to be sure, there are problems with gold as money. Some of them are perceived problems, others are real.

Ultimately, gold, as a currency, tends to be deflationary. A country’s money supply is limited by the amount of gold on hand. Absent an increase in the amount of gold, any increase in real output must cause prices to decline.

Also, any balance of payments deficit reduces the country’s gold supply. For instance, during the Depression, England had a horrific balance of payments problem. The country was paying out so much money in foreign payments, that it was literally draining all the gold out of Britain.  The only real remedy to this was to massively deflate British prices…in the midst of an already deflationary recession.

Monetary shocks are easily transmitted from one country to another via gold. Since countries who participate in the gold standard have fixed links,  inflation or depression in one country can be quickly transmitted to another.  For instance, the discovery of a large gold mine increases the supply of gold, without affecting real output.  That inflationary effect is quickly felt throughout all the countries who share the standard.

But–and this is a big “but”–the change from a gold standard to freely convertible fiat currencies has solved those old problems by introducing entirely new ones.  Governments and central banks have embarked on massive programs of public indebtedness, the inflationary–and sometimes hyperinflationary–printing of fiat currencies, and the wholesale selling of sovereign debt to foreign countries who may not have, as their primary interest, recouping the money on their investments, but rather the manipulation of an enemy’s economy, should it become necessary.

These problems bring us to Robert Zoellick, the head of the World Bank. In an Op/Ed in the Financial Times addressing our current economic woes, he suggests something that will no doubt be much discussed. In a discussion of how to create a monetary regime to succeed the clearly dying Bretton Woods II paradigm in which we’ve operated since 1971, he suggests, among other things:

This new system is likely to need to involve the dollar, the euro, the yen, the pound and a renminbi that moves towards internationalisation and then an open capital account.

The system should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values. Although textbooks may view gold as the old money, markets are using gold as an alternative monetary asset today.

If I’m not mistaken, the head of the World bank just called for the creation of a new gold standard for international trade.

This should be interesting.

For Informational Purposes Only

I am not an investment advisor.  I’m not a guru.  I’m not qualified to give you any investment advice at all.  I’m just looking around and seeing things, and telling you what I see.  And, in this case, I’ll even tell you what I’m doing.

I do so, however, with the strong warning that you should not, under any circumstances, use me for an example, or follow my example.  What I do may not be suitable for you at all.  I just want to make that clear.

First let me recap some data points I’ve made in several previous posts:

The Fed has more than doubled the monetary base over the past year. The amount of money that is just sitting there in the economy is incomprehensible.  But, it’s not making any trouble for us in inflationary terms, because it is just sitting there.  It’s what will happen when it does stop just sitting there that is worrisome.

The Federal Budget has spiraled out of control, with the TARP, stimulus, and recession bringing additional massive amounts of debt to bear, and future deficits signifigantly larger than any in recent memory–on top of which, there is now talk of “Stimulus II”.

Despite the happy talk about the economy’s recovery, the fact is that it is still in decline–just a slower rate of decline.  If a recovery doesn’t occur soon, we will run into another leg down in the economy, as households and businesses draw down their cash reserves, hit their credit limits, and slash their spending.  The longer the recession continues, the more people and business that will be forced into bankruptcies, the more foreclosures will rise, etc.  We call things like this “black swan” events.

On the other hand, even if there is a recovery, the Fed will be faced with the task of trying to wring the extra money back out of the economy.  If they are unsuccessful, inflation will rise.  If they are successful, they may spark another recession through tightening, much as they did to cause the second leg of the back-to-back recessions in 1981-1982. A second leg of a recession will undoubtedly result in greater debt and more money funneled into the economy as the government re-imposes monetary and fiscal stimulus again to re-inflate economic activity.  This will both deepen the debt and increase the money supply, making the next round of interest rate tightenings more difficult, unless the economy comes back strongly.

Social Security is now estimated to begin having a negative cash flow in 2019.  In other words, Social Security expenditures will exceed the payroll tax receipts.  We have, until now, been running surpluses in Social Security receipts, but, of course, the government spent that money in the general fund.  There is, therefore, no pot of money saved to make up for the deficit in receipts in 2016.  Benefits will be cut.  Taxes will be increased.  Economic growth will be affected.

I discount the Robert Fisk story that Bruce linked to earlier today as implausible.  As Fabius Maximus points out:

1. Some of these nations have no reason to risk destabilizing the USA.  Esp the Saudi Princes.

2. Some of these nations have no reason to risk destabilizing the global financial system. Esp.  Japan.

3. Many of these nation have leaders who are some combination of cautious, slow, reactive, and incrementalists.

4. Something of this scale would be almost impossible to keep secret 2 days after the first discussions.

5. If multiple Hong Kong banking sources knew it, their fingerprints would be all over the US dollar – as they shorted it to the max.

Having said that, while I believe this particular story is implausible,  it is obvious that a number of countries, China and Russia chief among them, are urging that the dollar be replaced as the world’s reserve currency, or, at the very least, allow some other currency or basket of currencies to be used in addition to the dollar.  If this happens, billions of dollars will be repatriated to the US, drastically lowering the dollar’s foriegn exchange value.  China is already denominating regional trade deals in yuan, and the use of gold has been on the rise as an instrument for international settlements in Asia and Europe.

There are many more data points, but it would be both tedious and depressing to continue.

The bottom line is that the trends outlined above will, in all probability, necessitate dealing with our foreign creditors.  Such dealings may require us to reschedule our debt payments, which will devastate the bond market, make future borrowing far more difficult, and end the notion that treasury notes are “risk-free” investments. If so, we will have become a financial banana republic in which future investment will be given the gimlet eye.  We may also be required to those foreign debts off in some currency or basket of currencies other than dollars, in order to prevent the government from inflating the debt away.

These trends will also probably require devaluing the US dollar by a substantial amount, so that our imports become expensive, while our exports become cheap.  This will allow us to earn the money to pay off our foreign debts, although it will, of course, result in a lower standard of living in the USA.

This the inevitable result of allowing the government–and the voters–to loot the system for 70 years.

So here is what I have done–and this is purely for informational purposes.  I do not recommend it for you, and I urge you to consider that I may be entirely wrong.

Several months ago, I completely pulled all of my investments out of equities, and into some select bond funds with a mix of government and private bonds.  As of today, I have ceased placing any more money in to either equities or bonds.

For the forseeable future, I will be buying gold bullion.  Not gold stocks.  Not Krugerrands.  Not gold depository accounts.  I mean direct bullion purchases of gold bars or rounds.  My personal preference is for APMEX or Pamp Suisse 10g bars, or Scotia Bank 1/4 oz. rounds, since they have the lowest premiums over the spot price, and are small enough to conveniently convert at local jewelry stores, pawn shops, or gold dealers at need.

Trying to convert a 1kg bar on short notice would be…inconvenient.  Even 1oz. Krugerrands might be hard to convert as the value of each single coin is now over $1000.

I have no interest in paying a premium for “collectible” coins.  I have no interest in purchasing a depository account, where my gold holdings have to be reported to the government. In fact, prior to this month, I had no real interest in gold either.  Indeed, if you bought gold at any time from 1979 to 2001, by march of 2001, you would have lost money–perhaps quite a lot of money, depending on when you bought it.   However, in the current circumstances, let’s just say that my interest is now…heightened substantially.

Whether your interest should be heightened…well, I couldn’t say.

D-Day plus 65 years

Yesterday evening I thought about what was occurring at the same time 65 years before in Europe. Young paratroopers of the 82nd and 101st Airborne Divisions as well as the British 6th Airborne Divison and 1st Canadian Parachute Battalion were headed in for night combat jumps with the mission of securing key bridges and road junctions and setting up blocking positions to prevent German reinforcements from reaching the beaches of Normandy. Of the 17,000 US airborne troops engaged in operation Overlord, 1,003 were KIA, 2,657 were WIA and 4,490 were declared MIA.

At the same time, off that coast, the largest amphibious assault fleet the world had ever seen, drawn from 8 allied navies (6,939 vessels: 1,213 warships, 4,126 transport vessels (landing ships and landing craft), and 736 ancillary craft and 864 merchant vessels), began gathering. 19 and 20 year old young men, who to that point had never seen a shot fired in anger nor fired one themselves, would get their baptism in war on Omaha, Gold, Utah,  Swordand Juno beaches. In all 160,000 allied troops would land that day.

Eisenhower meets with US Co. E, 502nd Parachute Infantry Regiment (Strike), photo taken at Greenham Common Airfield in England about 8:30 p.m. on June 5, 1944.

Eisenhower meets with US Co. E, 502nd Parachute Infantry Regiment (Strike), photo taken at Greenham Common Airfield in England about 8:30 p.m. on June 5, 1944.

At Pointe du Hoc, the US 2nd Ranger Battalion assaulted the massive concrete gun emplacements that commanded the beach landing sites. They had to scale 100 foot cliffs under enemy automatic gunfire to reach them. When they did, the found out the guns had been moved further inland. They pressed their assault, found them and destroyed them and then defended the location for two days until relieved. The operation cost them 60% casualties. Of the 225 rangers who began the operation, only 90 were still able to fight at its end.

On Omaha beach, the US 1st and 29th Infantry Divisions landed opposite the veteran German 352nd Infantry Division. They had sited their defensive positions well and built concrete emplacements which were all but immune from bombardment. The initial assault waves of tanks, infantry and engineers took heavy casualties. Of the 16 tanks that landed upon the shores of Omaha Beach only 2 survived the landing. The official record stated that “within 10 minutes of the ramps being lowered, [the leading] company had become inert, leaderless and almost incapable of action. Every officer and sergeant had been killed or wounded [...] It had become a struggle for survival and rescue”. Only a few gaps were blown in the beach obstacles, resulting in problems for subsequent landings.

Leaders considered abandoning Omaha, but the troops that had landed refused to stay trapped in a killing zone. In many cases, led by members of the 5th Ranger Battalion which had been mistakenly landed there, they formed ad hoc groups and infantrymen infiltrated the beach defenses and destroyed them, eventually opening the way for all. Of the 50,000 soldiers that landed, 5,000 became casualties of bloody Omaha.

Canadian forces landed at Juno. The first wave suffered 50% casualties in the ferocious fighting. The Canadians had to fight their way over a sea wall which they successfully did. The 6th Canadian Armoured Regiment (1st Hussars) and The Queen’s Own Rifles of Canada achieved their 6 June objectives, when they drove over 15 kilometres (9 mi) inland. In fact, they were the only group to reach their D-Day objectives.

By the end of D-Day, 15,000 Canadians had been successfully landed, and the 3rd Canadian Infantry Division had penetrated further into France than any other Allied force, despite having faced strong resistance at the water’s edge and later counterattacks on the beachhead by elements of the German 21st and 12th SS Hitlerjugend Panzer divisions on June 7 and June 8.

The Brits landed at Sword and Gold beaches. At Gold the 50th (Northumbrian) Infantry Division landed with heavy casualties, but overcame the obstacles and drove about 10 kilometers off the beach.

Led by amphibious tanks of the 13th and 18th Hussars, the landings on Sword went rather well with elements of the 8th Infantry Brigade driving 8 kilometers off the beach.

And the final beach, Utah, saw the 23,000 troops of the US 4th Infantry Division land. Through a navigation error they landed on the western most part of the beach. That happened to be the most lightly defended as well. Taking full advantage of the situation, the division fought their way off the beach and through the German defenses linking up with the 502nd and 506th Parachute Infantry Regiments of the 101st Airborne Division which had dropped in the night before and secured the inland side of the beach exits.

The liberation of Europe had begun. But it was costly. Of the total 10,000 casualties suffered that day on the beaches by the allies, the US had 6,603 of which 1,465 were killed in action. The Canadians suffered 1,074 casualties (359 KIA) and the British had 2,700.

Men who had never set foot on the continent of Europe before died trying to liberate it that day. Today most of them lie in quiet graveyards near where they fell, the only piece of land ever claimed, as Colin Powell said, was enough to lay them to rest. 65 years ago, as the guns boomed, the shells exploded and desperate and courageous men made life and death decisions on the bloody sands of Normandy beaches, the fate of the world literally hinged on their success.

I think it is important, on this day to remember that. It is also just as important to remember that had the rest of the world taken the threat posed by the evil of Nazi Germany seriously earlier than they did, the possibility exists that such a fateful landing would never have been necessary.

But it was. And to those who made it, liberated Europe and destroyed the evil that was Nazi Germany, they have my undying respect and deserve to have what they did -and why they did it – remembered by all for eternity.


Money? Or Receipts?

Recently, while listening to the Opie and Anthony show, I heard an interview with Loius CK, the comedian.  And he said something that struck me as quite profound.  And quite true.

Back in olden times–i.e., prior to the 1930s–our paper money wasn’t actually money, as such.  Instead, it was a receipt for the real money–gold, or silver–that we had stored in the bank.  And the amount of gold we had determined how many of those receipts we could get.  The gold or silver we held had an intrinsic value, and the paper currency we carried was simply a representation of that intrinsic value.

Then, in the 1930s, we simply got rid of the metal, and kept the receipts.  Ever since then, the paper money we carry around with us has no intrinsic value.  And the value of that receipt is worth whatever the government says it’s worth.  It is a medium of exchange, and nothing more.

You may have $1,000,000 in the bank.  And if the government says that it’s only worth a cup of coffee in exchange, then that’s exactly what it’s worth.  It doesn’t matter if acquiring that million bucks was the work of a lifetime.  The government can, if it wishes or is unwise, reduce the stored value of your life’s work to a trip to Starbucks.

Just something to think about.

Another Troubling Sign

What if the Treasury held a bond auction and nobody came?  After today, that’s not a rhetorical question.

Weak demand at a Treasury bond auction touched off worries in the stock market Thursday about the government’s ability to raise funds to fight the recession.

The government had to pay greater interest than expected in a sale of 30-year Treasurys. That is worrisome to traders because it could signal that it will become harder for Washington to finance its ambitious economic recovery plans. The higher interest rates also could push up costs for borrowing in areas like mortgages.

We are moving closer to what I warned about in March, after the UK had a failed auction of 15-year gilts.  Apparently, the Chinese didn’t turn out in force today.  They did however, continue talking about a new reserve currency–one that isn’t the US Dollar.  And apparently they’ve been doing more than talking about it.

As we learned last week, the Chinese–who haven’t announced anything about their gold holdings since 2003–casually dropped an announcement that they’d nearly doubled their gold holdings from 19 million to 34 million ounces.  Moreover, this gold, which had previously been kept for foreign trade in an account at the State Administration of Foreign Exchange, has now been transferred to the bank of China, as part the country’s monetary reserves.

I don’t think they’re all that keen on lending us money any more.

This is important because it indicates the extent to which gold is being rehabilitated as a monetary reserve asset, not only by the Chinese monetary authorities but by central bankers around the world. It has been clear that gold was being restored as a more important part of the world’s financial system, with rising investment demand over the past nine years. The Chinese government’s decision to say that this gold belongs in its monetary reserves emphasizes that monetary authorities also are looking at gold with greater interest than they have since the 1960s.

There’s a new reserve currency in town, and it’s yellow and shiny.  What it isn’t is green with pictures of dead presidents on it.  Maybe the Fed’s doubling of M2 the monetary base over the last eight months was a bit…intemperate.

So, the key take-aways here:

1) Higher interest rates possible as auctions fail to find bidders at lower yields.

2)  Billions and billions of dollars floating around, with no place to go but back home.  “Wouldn’t you like to wear $3,000 suits and smoke $75 cigars?  I know I would.”

But, we probably shouldn’t worry. As Glenn Reynolds says, “The country is in the best of hands.”