The Goldwatcher

« THE G20, GOLD & THE CASINO CAPITALISM HOUSE OF CARDS

Gold and The Casino Capitalism House of Cards 2

Fools Gold:

‘And I believe it will be said of this age, the first decades of the 21st century, that out of the greatest restructuring of the global economy, perhaps even greater than the industrial revolution, a new world order was created.’  Gordon Brown

The above Gordon Brown quote would not be amiss in the long winded and flowery 3000 word  April 2nd 2009 G20 communiqué posted after the London summit he very successfully organized, hosted and chaired. But it comes from his celebratory 20th June 2007 Mansion House speech as Chancellor of the Exchequer.  It was the week before he took office as British Prime Minister and his tenth and last televised Mansion House speech delivered with near royal pomp, ceremony and pageantry in the ornate London Guildhall medieval banqueting chamber.  The speech opened with a declaration that over the decade he had held office as Chancellor the City of London had risen ‘by their efforts, ingenuity and creativity to become a new world leader.’

In her recently published  new book ‘Fools Gold: How an Ingenious Tribe of Bankers Rewrote the Rules of Finance, Made a Fortune and Survived a Catastrophe’ the Financial Times award winning journalist Gillian Tett tracks the events that ended with current financial crisis. Opening up financial markets in the 1980s ‘big bang’  and the financial de-regulation introduced in the Reagan and Thatcher years also led to developments that contributed greed,  and recklessness and eventually a financial catastrophe.

There was no secret about London being the epicenter of one of the biggest property and debt bubbles in history in 2007 when Gordon Brown made his Mansion House speech . We all knew about it. In the previous article in this series I wrote about Bridgewater Associates Ray Dalio and others warning clients on the imminent dangers of excessive financial leverage.  Urging asset diversification I was writing The Goldwatcher and referenced the comment ‘you had to be blind not to see the bubbles.’ Comment that proved to be on the money when, three months after the Mansion House speech,  the first run on a British bank in centuries started.   How come then was Gordon Brown extolling the wonders of casino capitalism?

A likely answer to this question is he was  in the wrong place at the wrong time. Greatly influenced by former US Federal Reserve Board Chairman Alan Greenspan’s dogma on leaving financial institutions to look after themselves Gordon Brown, the socialist politician, became a champion of free market fundamentalism. He even arranged a Knighthood from the Queen for ‘Sir Alan’ in recognition of their association. But more telling than ideology were the bumper tax windfalls that came to the British Treasury from the mega profits earned by lightly regulated unbridled financial innovators.

Big money for Treasuries in need of ever greater tax revenues won over politicians and policy makers on both sides of the Atlantic and, to a lesser extent, elsewhere.  The casino capitalism affair started decades before the house of cards collapsed. The first fatal embrace could have been  back in 1971 when President Richard Nixon ‘closed the gold window’ - jargon for reneging on America’s commitment  to settle debts with foreign Treasuries in gold if called on to.   With the dollar and other currencies  untethered from gold or any another universal value anchor the door was open for rampant expansion of  debt and eventually casino capitalism.

Even before Nixon closed the gold window the distinguished French Central Banker and intellectual Jacques Rueff homed in on a flaw in the 1944 Bretton Woods arrangements.  Once the dollar, a national currency, gained the dominant role in the international financial system and started usurping the gold’s role as the common denominator,  Rueff argued, capitalism could not be controlled and financial collapse was inevitable. It will be music to the ears of hard money advocates and Rueff’’s many followers that in recent analysis on reforming the international monetary system  Zhou Xiaochuan,  Governor of The People’s Bank of China, has made public his concerns on the re-emergence of conditions similar to those that that led to the breakdown of Bretton Woods and has made the case for a supra-sovereign reserve currency to replace dollar dependancy.

Gold, the G20 and the IMF:

The IMF is the world’s third largest holder of gold ranking only after the U.S. and Germany. It holds 103.4 million ounces (3,217 metric tonnes) valued on its balance sheet at SDR  5.9 billion (about $8.7 billion) on the basis of historical cost and $94.8 billion at current market price on March 31, 2009.  The Second Amendment to the IMF Articles of Agreement in April 1978 eliminated the use of gold as the common denominator of the post-World War II exchange rate system and as the basis of the value of the SDR. It also abolished the official price of gold,  brought to an end the obligatory use of gold in transactions between the IMF and its members and mandated that the IMF avoid managing the gold pice price or establishing a fixed price.
 
The April 2nd G20 communiqué urged prompt action now on the decision taken two years ago by the IMF to sell about 400 tonnes from its gold holdings. The communique also mentioned ecouraging further sales to fund anti poverty initiatives. The further sales are not committed and the 400 tonnes sale has still to be formally ratified by IMF members. Commentators have suggested the US Congress may block the sale but it’s is unlikely they will. President Obama supports it.

The decision to sell the 400 tonnes of gold was taken by the IMF almost two years ago following advice from an IMF advisory panel that included Peoples Bank Of China Governor Zhou Xiaochuan and South African Reserve Bank Governor Tito Mboweni. Provisos were included that the sale should not be undertaken in a way, or over a time frame, that will disrupt the market.

The IMF’s policy on gold is governed by the following principles:

As an undervalued asset held by the IMF, gold provides fundamental strength to its balance sheet. Any mobilization of IMF gold should avoid weakening its overall financial position.

The IMF should continue to hold a relatively large amount of gold among its assets, not only for prudential reasons, but also to meet unforeseen contingencies.

The IMF has a systemic responsibility to avoid causing disruptions to the functioning of the gold market.

Profits from any gold sales should be used whenever feasible to create an investment fund, of which only the income should be used.

The annual sales quota under the Central Bank gold sales agreement for this year is 500 tonnes. The agreement has yet to be renewed beyond September 2009 but ut’s likely it will be  In a strong market a further 400 tons of gold coming onto the market may not be a serious challenge. But in a weak or volatile market, unless the sale is concluded by private treaty between central banks, it could affect prices.

There has been speculation that the 400 tonnes will be bought directly by a central bank.  China’s recent announcement that it had increased its gold reserves by 454 tonnes to 1054 tons ignited gold prices  If indeed China plans to significantly increase its gold holdings this will obviously have sustained long term positive effects on gold prices.  This comment from an article in the South China Morning Post puts a useful perspective on developments:

‘At the end of 2002, the People’s Bank of China (PBOC) was sitting on foreign reserves worth a total of US$286 billion, so gold made up 3.9 per cent of its overall reserves.  Today, after years of massive accumulation, Beijing has foreign reserves worth US$1.954 trillion. With gold at US$910 an ounce, the 1,054 tonnes of gold it now holds are worth US$30.85 billion. That sounds a lot, but it is only 1.6 per cent of overall foreign reserves…..’

China obviously has an interest in a strong gold price and has also announced its intention to diversify its currency reserves. With declining South African production and its increased production China is now the world’s largest producer of gold. But while this suggests China may be looking to substantially increase its gold holdings there also reasons it may not want to hold more than a notional percentage of its reserves in gold. One reason may be it regards gold  as associated with 19th century British and 20th century American economic and political supremacy  and of little relevance now.

More likely to drive the gold price than measured IMF sales are the stability and future purchasing power of the dollar and other fiat currencies, the direction of the global economic contraction, deflationary and inflationary threats, reviving the global economy  and geo-political challenges to security and stability.

The IMF is the only supra national organization mandated to promote international monetary cooperation,  international trade, economic policy aimed at  high levels of employment and income, currency stability, orderly exchange arrangements  and avoidance of competitive devaluations. 185 countries, essentially the world at large, make up its members. Unfortunately the IMF voting structure preserves obsolete privileges stemming from post World War II economic power and 21st century realities have not been accommodated. Reform is in the pipeline but it may take years before it all happens.

By contrast The G20, correctly The Group of Twenty Finance Ministers and Central Bank Governors, is a 21st century body formed in September 1999 in the wake of the Asian currency crisis.  Essentially only a steering group, influential think tank and pressure group  it functions as an efficient organization with members who have the voting power to secure implementation of their proposals.

G20 membership includes the G7 group that has been for decades the world’s effective policy maker. Its members are the large established industrialized nations:  The United Kingdom, Canada, France, Italy, Japan, Germany and the United States. (From time to time the G7 co-opt an additional member and become the G8.)

The G20 include the  G7 countries and the worlds leading emerging economies: China, India, Argentina, Australia, Brazil, Indonesia, Mexico, Russia, Saudi Arabia, South Africa, South Korea and Turkey. With the European Union (EU) also a member  G-20 members account for 85% of global  GDP, 80% of world trade and two-thirds of the world population. The Managing Director of the IMF, the President of the World Bank, the chairs of the World Bank, the IMF and its International Monetary and Financial Committee are ex-oficio members. This comprehensive representation puts the G20 in a position to exert legitimate influence on the management of the global economy.

Results achieved at the G20 Summits:

The key achievement of both G20 summits in November 2008 and April 2009 was keeping the consensus on the need for global co-operation.  When the November G20 meeting was held there was a  real risk of  global financial meltdown . That’s off the agenda now -  for the time being anyway.

An efficient, authoritative, well capitalized and well governed IMF is  essential for global economic stability. The tangible achievements of the April 2009 London Summit were support for trebling the resources of the IMF from $250 billion to $750 billion and a new allocation of $250 Special Drawing Rights (SDRs), the IMF’s quasi currency.   The additional financial fire power the IMF now commands marks an important step in the right direction. Expanding the use of SDRs may be more than a useful boost to liquidity in current troubled conditions and could mark the beginning of a structural change in the global financial system. But, while using the IMF’s quasi currency to expand liquidity is necessary now, it’s a far cry from transforming the IMF into a quasi global central bank.

The April G20 meeting also agreed to supporting exceptional actions to revive global economic growth  including aggressive interest rate cuts, fiscal expansion and ‘unconventional interventions.’ Unfortunately, however,  there was no agreement on a formula for fiscal expansion as proposed by the US and there was no definiton of  essential exit strategies from the exceptional money creation initiatives proposed.  Glossing over the effects of money creation using ‘the full range of monetary policy instruments, including unconventional instruments’ without nailing down exit strategies  leaves the door wide open for another global financial catastrophe.

There was also an important omission in the G20 report on calls for a supra sovereign currency initiated by China and supported by Russia and others. On the day the meeting ended Russian President Medvidev  said in public  the communique does not properly reflect discussions on the subject and he has since then been advancing the case for a super sovereign currency.

 

Gold and the Supra sovereign currency issue:

Note: The article on Zhou Xiaochuan’s speech mentioned refers to a super sovereign currency. This appears to be a translation error. He is obviously referring to a supra sovereign currency

As noted above The G20 communiqué ignored the call for a global supra sovereign currency outlined Zhou Xiaochuan, Governor of China’s central bank . In  a March 26th speech on Reforming the International Monetary System he raised this question   ‘The outbreak of the current crisis and its spillover in the world have confronted us with a long-existing but still unanswered question, i.e., what kind of international reserve currency do we need to secure global financial stability and facilitate world economic growth, which was one of the purposes for establishing the IMF?’  Zhou went on to develop the argument that ‘A supra-sovereign reserve currency not only eliminates the inherent risks of credit-based sovereign currency, but also makes it possible to manage global liquidity. A supra-sovereign reserve currency managed by a global institution could be used to both create and control the global liquidity. And when a country’s currency is no longer used as the yardstick for global trade and as the benchmark for other currencies, the exchange rate policy of the country would be far more effective in adjusting economic imbalances. This will significantly reduce the risks of a future crisis and enhance crisis management capability.” The following are the subjects he explores in support of his argument:

The outbreak of the crisis and its spillover to the entire world reflect the inherent vulnerabilities and systemic risks in the existing international monetary system;
The desirable goal of reforming the international monetary system, therefore, is to create an international reserve currency that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies;
The reform should be guided by a grand vision and begin with specific deliverables. It should be a gradual process that yields win-win results for all;
Entrusting part of the member countries’ reserve to the centralized management of the IMF will not only enhance the international community’s ability to address the crisis and maintain the stability of the international monetary and financial system, but also significantly strengthen the role of the SDR;

Zhou concludes his proposals ‘lay a foundation for increasing SDR allocation to gradually replace existing reserve currencies with the SDR.’

In a similar vein to the comment made on the property and debt bubbles in 1997 that a blind man could see them a blind man will see that China has a plan for ‘replacing the dollar as the dominant world currency and creating ‘an international reserve currency that is disconnected from individual nations and is able to remain stable in the long run’.

Beyond drawing attention in this article to the G20 having left comment on this issue out of their communiqué,  without fully reviewing the dollar standard and current international monetary arrangements,  further snippets of information will only be confusing. Chapter 5 of The Goldwatcher ‘The Dollar Standard and the Deficit without Tears’ is associated with the question ‘Is the dollar again America’s currency and everyone else’s problem?’ Chapters that follow also have information readers will find useful when taking a view on outcomes for the dollar and for gold.

Uncharted waters keep gold on the agenda:

G20 communiqués sound reassuring but wide ranging commitments need careful analysis. Globalisation will be challenged as all economies won’t benefit at the same pace, labour and capital will be affected in different ways and the G20 consensus may not last. It has been noted that the crisis has already led to contempt for policy makers, regulators, the financial establishment and the financial system itself. Members may not remain sufficiently unified to stay the course for a smooth transition from near chaos to prosperity - or even a steady shift from sliding towards an economic depression to managing a long recession. 

The message in the wake of the failure of socialism and the bankruptcy of capitalism from the distinguished 92 year old socialist historian Eric Hobsbawm is ‘None of the world’s governments, central banks or international financial institutions know how to resolve the crisis’ and ‘are all like a blind man trying to get out of a maze by tapping the walls with different kinds of sticks in the hope of finding the way out.’ To address the crisis Hobsbawm expects a major shift away from free market dogma towards public action.  A far bigger shift than Governments have envisaged. His conclusions are open to question but there is no doubt the global economy is in uncharted waters.
 

Zhou Xiaochuan’s call for currency reform quoted above leave little doubt that the dollar’s tenure as the global currency the US can print to order is being challenged. And, if policy makers and central banks don’t fully understand the challenges, noble as their intentions may be, we are all in a room with an elephant. OK if we know what the elephant is going to do. Likely to be crushed if we don’t. And no scope for wandering round tapping sticks on the wall to find the way out.

Of course, if we are going to experience the great new world order Gordon Brown forecast we won’t want gold and, remember,  Gordon Brown sold half Britain’s gold in the late 1990s at the lowest price recorded for decades. But, on the other hand, if we expect some disruptions in the role of paper money we will keep owning some gold high on the agenda as insurance against the perils of uncharted waters, what Zhou calls ‘ the inherent vulnerabilities and systemic risks in the existing international monetary system and what Ray Dalio identifies as the likelyhood of countries with excessive debt denominated in their domestic curencies inflating the debt away.