The
Path to Monetary Collapse by By Alasdair Macleod
, Goldmoney | May 25, 2020
Few mainstream
commentators understand the seriousness of the economic
and monetary situation. from a V-shaped rapid return to
normality towards a more prolonged recovery phase.
The fact that a liquidity crisis
developed in US money markets five months before the virus
hit America has been forgotten. Only a rising gold price
stands testament to a deeper crisis, comprised of contracting
bank credit while central banks are trying to rescue the
economy, fund government deficits and keep the market bubble
inflated.
The next problem is a crisis
in the banks, wholly unexpected by investors and depositors.
At a time when lending risk is soaring off the charts, their
financial condition is more fragile than before the Lehman
crisis. Failures in European G-SIBs in the next month or
two are almost impossible to avoid, leading to a full-blown
monetary and credit crisis which promises to undermine asset
values, government financing and fiat currencies themselves.
We can now discern the path
leading to the destruction of fiat currencies and take reasonably
guesses as to timing.
How central banks view the current
situation.
The financial world is bemused: what is
it to make of the economic effects of the coronavirus? The
official answer, it seems, is on the lines of don’t panic.
The earliest fears of millions of deaths have subsided and
in the light of experience, a more rational approach of
easing lockdown rules is now being implemented in a number
of badly hit jurisdictions. Whether this evolving policy
is right will be proved in due course. But the motivation
is moving from saving lives to restricting the economic
damage.
While I am a critic of the inflationist
policies of central banks, it is always valuable to look
at monetary policy from a central banker’s point of view.
Last Friday, Andrew Bailey, the new Governor of the Bank
of England, gave an interview to Chris Giles of the Financial
Times, where he spoke frankly and reasonably freely about
the challenges the Bank faced in common with other major
central banks.
Regarding inflation, from his comments it
is clear Bailey defines it as changes in the general level
of prices, which is hardly surprising, since central banks
are mandated to target it. He believes that the rate of
price inflation will fall towards zero, citing recent moves
in the oil price as a major factor, though the oil price
has since recovered. This gives him room to use monetary
policy to its greatest extent.
His view was that monetary policy would
minimise what he called “scarring”. This is the new buzzword
for economists who generally dismiss the economic effects
of the current crisis as being temporary, as in when it
heals the only evidence left will be a scar. In other words,
some overindebted businesses will fail and others would
be victims to changes in consumer patterns once normality
returns. Therefore, the working assumption is that once
the coronavirus crisis is behind us the economy would broadly
return to normal, and while he didn’t specifically say it,
he expectats is a V-shaped recovery, possibly with a moderate
time element to it.
The bank is undertaking a £200bn programme
of quantitative easing, which amounts to two-thirds of Britain’s
expected funding requirement relating to the coronavirus,
in order to satisfy the following policy objectives:
To stabilise financial
markets, buying £50-60bn of gilts every month, in common
with actions of other central banks in their markets.
This suggests the economy is expected to be on the way
to recovery by late-July.
To reassure the market
that extra government debt would be absorbed and to smooth
the profile of overall government borrowing. This will
enable the bank to keep gilt yields low, and those of
corporate bonds as well.
To meet economic objectives.
In other words, pursue a Keynesian policy to return to
full employment.
To address counterfactual
issues that can be expected to arise if the Bank did not
do QE. Presumably, other than disrupted markets Bailey
was referring to fears of deflation in the absence of
monetary stimulus.
If Bailey is right and QE of £200bn will
see the British economy through the crisis, then that £200bn
will be an addition of a little more than 10% to the national
debt. The addition to February’s M3 money supply is 6.8%,
which is hardly a problem. But there will be trouble if
he is wrong, glitches that could arise from one or more
of three sources. If other central banks, principally the
Fed, dilute their currencies by a larger amount proportionately,
the effect on commodity prices, particularly agricultural
products, could be to drive them up in sterling terms, helping
to undermine sterling’s purchasing power for life’s essentials.
Secondly, 28% of gilts in issue are owned by foreigners,
who, needing the money in their own currencies, are likely
to turn sellers. The third threat is of systemic failure,
requiring extra expenditure to rescue one or more major
banks and to manage the fall-out.
There is little doubt that Bailey’s thinking
is shared by his counterparts in the other major central
banks. Besides the threats listed above, the mistake is
to simply assume the economy is an entity that does not
change materially over time. While seeming an innocuous
mistake, it leads to the belief that there is a normality
to which to return. Bailey dismisses the problem by saying
some businesses won’t survive, and others might have to
change. But he is clearly banking on a return to normal,
when there is no such thing. It is the proper function of
economic, monetary and credit analysis to divine the benefits
and threats that make the future different from the present.
Issues of credit
By definition, central bankers do not fully
understand credit cycles, otherwise they would have done
something to fix their disruptive nature long ago. Instead,
they believe in business cycles, which central bankers view
as disrupting monetary policy, thereby muddling cause with
effect. Conveniently for state organisations, central banks
place the blame for irrational behaviour on the private
sector. The banks, so obviously the cause of credit cycles,
are seen to be merely responding to changing business conditions
and must be discouraged, in their own interests, from making
the situation worse at a time of periodic crisis.
But central bankers play their part in credit
instability by encouraging banks to extend credit to stimulate
the economy in the first place. That fact alone makes it
nearly impossible for them to accept the consequences of
their monetary policies. Central bankers like Andrew Bailey
not only look at bank credit through the wrong end of the
telescope, but they do not see a credit crisis in the making.
This amounts to an ignorance that explains why they believe
that the coronavirus is simply a one-off hit, and after
a short period of time, everything can return to normal,
so long as the recovery is properly managed.
Their simplistic approach does not explain
the liquidity stresses in the US banking system that surfaced
last September, long before the virus had infected anyone.
It does not explain why the Fed was forced to abandon its
attempt to reduce its balance sheet, over five months before
the first virus casualty occurred in the US. It ignores
the consequences of the tariff war between America and China,
which collapsed international trade by the beginning of
2019. Central bankers have been blind to evidence that the
world was already tipping into a recession, and that commercial
banks were, and still are, dangerously leveraged in the
face of escalating loan risk.
The bureaucrats in central banks and banking
regulatory bodies believe they have insulated commercial
banks from the extreme risks of over-lending. Since the
Lehman crisis, rules and compliance measures have been put
in place designed to reduce these systemic risks, and periodic
stress tests have been run from time to time to establish
the level of existing risk. Unfortunately, stress testing
appears to be designed not to expose systemic weakness but
to confirm it no longer exists.
A new paper by Dean Buckner and Kevin Dowd
has examined the current position of UK banks, which is
instructive in the wider sense about the relationship between
central banks, regulators and commercial banks.[ii] It concludes
that “the core metrics of the Big Five UK banks have deteriorated
sharply since the New Year, and even more since the end
of 2006, i.e., the eve of the Global Financial Crisis.”
It goes on to say,
“The BoE’s ‘Great Capital Rebuild’ narrative
about a strongly recapitalised UK banking system is little
more than an elaborate, and occasionally shambolic, window
dressing exercise. The BoE focused most of its efforts on
making the banking system appear strong by boosting banks’
regulatory capital ratios instead of ensuring that the banking
system became strong through a sufficiently large increase
in actual capital meaningfully measured. The result is that
the UK banking system enters the downturn in a worryingly
fragile state and avoidably so.”
The authors did not spring this on Britain’s
central bankers and regulators all of a sudden. For almost
a decade, Professor Dowd has written and co-authored papers
warning of the inadequacy of official attempts to strengthen
the resilience of the banking system to systemic shocks.
And now, a weaker banking system is tasked with supporting
the non-financial economy, where lending risk is soaring
off the charts.
It is not just the UK banking system that’s
in trouble. While the Buckner & Dowd paper confines
itself to UK banks and there are differences in the detail,
we know that banking regulation is standardised across borders,
and the motivation for stress tests to see no evil is common
to other major central banks. A central point, missed by
most observers, is that the markets are telling us there
is a banking crisis already, with bank share prices significantly
lower than book values.
The authors go further, pointing out that
the relationship that matters most is between total assets
and market capitalisation, the true forward-looking value
independently placed on a bank in the markets instead of
a static accounting figure for shareholders’ capital in
the balance sheet. In the case of Barclays Bank its assets
relative to market capitalisation gives a leverage for shareholders
of 62 times at a time of increasing lending risk. Put another
way, additional loss provisions of only 1.6% of the balance
sheet asset total wipes out the bank’s market capitalisation.
Major Eurozone banks are in a similar or worse condition,
as shown in Table 1, of all UK and European designated and
listed global systemically important banks (G-SIBs). The
G-SIBs are meant to have extra capital buffers to lessen
the likelihood of a repeat of the Lehman crisis.
Clearly, it is virtually impossible to see
some of these highly leveraged banks surviving today’s deteriorating
loan conditions, nor is it possible to imagine that if one
or more of them fail how they will not take down other banks.
As well as believing their own wise monkeys,
Andrew Bailey and Christine Lagarde should be praying on
their knees that the recovery will be V-shaped and rapid,
because the banking system might not even survive that,
let alone anything worse. But the outlook is significantly
worse because of the pre-existing slide into global recession.
The G-SIB bankers’ problem is managing the risk they already
have to contend with and not the additional risk the central
banks now wish them to bear.
Looking ahead, with increasing certainty
we can expect a European and British banking crisis. There
is no material reason for it not to happen. The Keynesian
debt machine has ploughed on regardless since the Lehman
crisis and roughly doubled the debt problems that led to
it. The evidence from the Bucknall & Dowd paper is that
the banking system, in the UK at least and by extrapolation
in Europe and almost certainly elsewhere, is less fit to
deal with a crisis on the Lehman scale, let alone the larger
one ahead of us. And on top of all that the coronavirus
has shut down the global economy. The best possible outcome
is that governments and non-financial private sectors emerge
with substantially more debt.
Given these factors, it is nearly impossible
to argue convincingly that a banking crisis will not emerge
very soon, perhaps in as little as a month or two. A banking
and systemic crisis will raise the costs for central banks
and their governments considerably, not just because they
will have to fund bail-outs, but they will also have to
cover the associated fallout, such as the inevitable evaporation
of interbank credit in the financial sector and of bank
credit from non-financial borrowers.
We now know with the greatest certainty
what the policy response will be: a further acceleration
of base money inflation. In the UK’s case, the estimated
cost of £300bn to the exchequer of the coronavirus will
turn out to be an appetiser not just for a main course but
for the full-blown banquet. And what applies to the UK will
apply to the other major advanced nations which lack the
genuine savers to fund it all.
The golden canary
At the time of writing few if any headline-writers
in the media have pointed out the dangers to the global
banking system from the coronavirus shutdown and the contraction
of bank credit. Equity markets have rallied strongly in
recent weeks and bond yields have remained low. As forward
indicators, these financial markets communicate an ethereal
stability. The only sign that black swans, a common sight
nowadays, are peddling furiously while appearing calm above
the surface is in the gold price. Measured in US dollars,
while it is yet to conquer the highs seen at the time of
the last Eurozone banking crisis, it appears to be on its
way to doing so. The chart below shows how the gold price
has over the last twenty months.
In August 2018, it first became clear that
America’s tariff war against China was disrupting international
trade, which coincided with the gold price setting off on
its current bullish run. More recently, gold markets and
their derivatives faced unprecedented stresses as bullion
banks running short positions have been wrongfooted by changes
in monetary policy responding to the coronavirus. So far,
gold has been doing what one would expect: discounting increasing
rates of future monetary expansion.
But it also acts as a warning of troubles
to come. The shock it has yet to discount is the rising
systemic risk from bank failures. Barring successful intervention
to suppress it, a sharply rising gold price must be the
logical outcome from an increasingly certain banking crisis,
as people flee bank deposits in favour of physical bullion
held outside the banking system.
In previous fiat currency inflations, there
has always been a cash alternative to bank deposits. A bank
run created increased preferences for cash. At the least,
prices of goods did not rise as a direct consequence of
systemic crises, and it is worth noting that increased cash
hoarding tends, if anything, to lead to falling prices.
That can no longer be the case. Retail banks everywhere
have been instructed to discourage the disbursement of even
relatively small amounts of cash, making it virtually impossible
for a depositor to encash all but the smallest deposits.
Unless a depositor already has an account with a bank he
is confident is safe, he has no alternative but to spend
the deposit and give someone else the headache of being
a creditor in a failing banking system.
Financial assets are also likely to be unsafe
beyond the very short term, and the restriction of bank
and mortgage credit in these conditions makes residential
and commercial property a bad bet as well. Our frightened
depositor is left scrabbling for alternatives to money in
the bank, and therefore as a measure of how the crisis unfolds,
the gold price is likely to be the most reliable indicator.
For this reason, a gold price rising sharply
will not be welcomed by the major central banks, who will
rightly fear it is an indicator of declining confidence
in the monetary system. Central banks in emerging economies
have a different problem, seeing the dollar upon which they
depend failing. Undoubtedly, this has encouraged many central
banks in this category to build gold reserves as a dollar
substitute, at least until the way to a new currency regime
can be seen.
The path to fiat obscurity
With the knowledge that the situation is
considerably more serious than just a temporary COVID-19
interruption, we can be certain of a lethal combination
of mounting bad debts and bankers desperate to contain escalating
lending risks. The situation invokes the ghost of Irving
Fisher, who was credited with describing the destructive
workings of a debt-deflationary spiral driving the economy
inexorably into a depression. Central banks will do everything
they can to avoid a debt-driven depression, but it is likely
to prove an insurmountable task. With a high degree of certainty,
the result will be bank failures and bank rescues. And with
commercial bankers fearful of their own bankruptcies, they
will be poor transmitters of raw base money into the non-financial
economy.
From these obstacles to monetary planning,
we can tentatively sketch a path towards future events,
some of which that are likely to run concurrently, including
the following:
The first G-SIB failure
will initially trigger widespread liquidations of bank-issued
bonds and flights of large uninsured deposits from the
riskier banks. Capital flight creates funding difficulties
for vulnerable banks, and wholesale money markets will
seize up. Attempts to proceed with bail-ins, which have
been enacted into law by most if not all G20 nations will
only make the situation worse. Bail-ins were designed
to shift the cost of bank rescues to the private sector
instead of governments, which is the case with bail-outs.
Therefore, as banks fail there will be added penalties
for bond holders and large depositors.
Market capitalisations of listed banks
will take another lurch downwards, pushing price to book
ratios substantially lower. Governments, sovereign wealth
funds and central banks are likely to mount emergency support
operations for the shares of the G-SIBs and all other listed
banks at risk in an attempt to calm markets.
After an initial panic, the determination
of the authorities to support the banks may buy a brief
period of stability. As lockdown restrictions are abandoned,
we can expect a partial recovery in the wider economy, fuelled
by essential maintenance and catch-up activities that have
been put on hold by lockdowns. At this point, everyone heaves
sighs of relief in the hope that the worst is over.
Following a temporary period of relief,
high levels of unemployment and consumer caution are likely
to restrict further economic recovery. Real assets held
as bank collateral will continue to fall in value, renewing
pressure on lending banks. It will become increasingly obvious
that global and local economies are not returning to normal
with the ending of the virus. Following an anaemic recovery
from the easing of lockdowns, it will be apparent that central
bank attempts to use a broken banking system to funnel credit
to the non-financial economy is failing. Small and medium
size enterprises, which typically contribute a Pareto 80%
of all economic activity is unlikely to obtain the financial
support more easily accessed by big business.
Residential property prices will fall,
in many cases heavily, as a consequence of lack of demand,
risk aversion among buyers and lack of affordable mortgage
finance upon which prices are marginally based. Commercial
property values will also decline, driven by falling retail
and office demand. Both sectors are important loan collateral
for the banks, adding to systemic woes.
Seeing deteriorating economic conditions,
central bankers with an eye to the immediate effects on
the consumer price index will be encouraged to double down
on monetary inflation, principally to support financial
markets. They will see it as the only way to keep their
governments out of a trap comprised of a combination of
rapidly rising debt and the cost of financing it.
Inevitably, government bond prices will
begin to reflect the heightened levels of government deficits
and the consequences of inflationary funding. Central banks
will find they are the only significant buyers of government
and corporate debt. Their resistance to raising interest
rates will then be undermined by market reality.
The general public will be more concerned
with rising food prices, energy, and others of life’s essentials,
a process which has already started. Throughout history,
it has been the economic and social destruction wreaked
by the rising prices of these basics that has led to price
controls and loss of public confidence in government money.
At this point, the public is likely to finally realise that
it is the currency that is losing its utility, and that
it must be discarded as quickly as it is obtained.
Timing
Following a banking crisis, deteriorating
economic and monetary conditions are likely to evolve more
rapidly than circumstances might suggest. Information, global
communications and the interconnectedness of markets all suggest
it. The evolution of cryptocurrencies, such as bitcoin, has
made millennial generations more aware of monetary debasement
than their parents. But most importantly, by cutting off holding
cash as an escape from bank deposits, an attempt by a population
to move deposits out of banks will result in the immediate
purchase of non-monetary goods. Cash has been regulated out
of this function and the reservoir effect of it delaying the
price consequences of a crisis no longer exists.
Governments and central banks can be expected
to cooperate with each other to stop their currencies collapsing,
but ultimately it is a matter for the general public. While
inflations have persisted for considerable periods, the final
collapse, when the public realises what is happening to money,
in the past has typically taken between six months and a year.
The German inflation 97 years ago started before the First
World War, but its catastrophic phase can be identified as
starting in May 1923 and ending the following November. John
Law’s monetary collapse, the closest parallel to that of today,
ran from approximately February 1720 to the following September.
In the run up to its collapse, Law’s Mississippi
experiment depended increasingly on money-printing to support
financial asset values. The same inflationary policies apply
today. The end point of Law’s inflationary stimulation is
lining up to be identical with our neo-Keynesian experiment,
and on that basis alone is increasingly likely to come to
a rapid conclusion.