Wednesday, December 28, 2016

Some thoughts on current monetary crisis

This is an old article (23 Feb 2012), but was posted in the wrong place.

Money basically means a transactional unit that can be used for buying stuff. What this transaction unit can be is pretty open.

Most commonly money is the national currency. This currency has a force of law behind it, and everybody is expected to accept it for a monetary transaction. The force of law accords the currency with very high liquidity. These days all currencies in the world are paper currencies. Such currencies do not really have any value apart from its government controlled value. I say controlled, because ultimately the market place decides what value it has. The government can just guide the market to arrive at a given value. The government can increase/decrease the pool of currency, which will in effect reduce/increase the value of the currency. Or it can change the Reserve Requirement for the banks to change the value of the currency.

Reserve Requirement creates a multiplier effect. Say a bank gets 100$ from a customer and CRR is 10%. So the bank is free to loan out 90$. This is obviously paid to another person, who will save it in the bank. So bank will get it back. Again the bank will loan out 81$, which is 90% of 90$. If you take this to conclusion bank will finally have all the 100$ as reserve and it would have given 900$ as loan to other people. So in effect the base currency has expanded 10 times.

One thing to remember with currencies, they are based on faith, and tend to lose value when people lose trust in the government. So any monetary crisis will trigger political changes.

Money can be other items as well, for example gold and silver. Gold is supposed to be a commodity, but it does not behave like a commodity. It's price does not depend on the production and consumption (where recovery would be prohibitively expensive), as both are way too small. World Wide annual Production is around 1.5% of the total stock, so the price does not depend on the production. Consumption of gold is just around 10% of the production, ie .15%. So we can see that it is not a normal commodity.

Silver shares some characteristics, but the consumption of silver has increased a lot, it is now nearly 80% of the production. So although the stocks are still increasing, the price does have a small dependency on production and consumption.

These commodities which are used like currencies have some associated transactional costs, eg taxes and profit margins of dealers. The higher the transactional cost the lower the liquidity. Gold generally has a higher liquidity compared to silver. In India the taxes for silver are higher and generally dealers will charge a bigger margin for silver than gold.

So what does gold behave like? Lets look at a different concept now.

What is Saving? When you produce something, you use it to buy things that you consume. If you produce more than you consume, the difference is called credit. If you consume more than you produce the difference is called debit. If you have credit you can save it so that you can consume the credit later, or invest it in the hope that you can get more credit than you invested at some future time. If you have debit you have to take on a debt to pay for your consumption, and pay for excess consumption later along with some extra interest.

We might think that putting the money (or credit) in bank is saving. But its not. It is investment. You are giving your money to the bank to lend it out and hopefully make a profit and then give you interest on your credit.

So if putting your money in bank is not saving, then what saving is? Lets say you consume 1 Kg of rice every week. And with your monthly income you save enough to buy 4 Kgs of Rice more than what you would need this month. If you do buy the 4Kg Rice you are saving your excess production, for consuming it next month. So buying any commodity in excess of your consumption can be construed as saving. Saving is basically deferred consumption.

Rice is fine for saving your credit for maybe a year or two, but then you have to also think about storage costs, and the possibility of loss because of the damage. If you wanted to save your credit for a longer time, with minimal storage costs, you could buy a commodity that survives longer. Gold is exactly suited for this task. Infact this is the only significant use of gold, even when it is used as jewelry, it is just a store of value. Gold also tends to have a more stable value over time when compared to other commodities, because it is not like a commodity.

Gold does not act like a commodity so its value also cannot be evaluated in the same way as a commodity. We will look at the factors that affect its value now. Remember we are not considering the price in terms of a currency, but the value in terms of other commodities. This value can be potentially different for different individuals, depending on what they generally consume, or what they want their savings for. But in general the value tends to be similar.

First the factors that affect a commodity.
1) Amount of Production - Over Production of the commodity will tend to reduce its price.
2) Cost of production - This fixes the minimum price.
3) Consumption - More consumption will increase price.

The above three factors apply to a commodity, but Gold is not like a commodity, so lets see what factors affects its value. Its value depends on value of other things rather than its own production and consumption.

1) Technology - Automation allows production to become cheaper. This depresses the value of the products in real terms, and consequently in terms of Gold. This happens because Technology has so far not affected the value of gold much.

2) Prosperity - Technology increases productivity which increases earning of people. While simultaneously making the basic necessities cheaper. The two together creates a lot of saving potential. The higher saving potential should lead to more storage in gold, but since gold quantity stays nearly same, the value of gold should increase, in comparison of other stuff.

3) Population - As number of people increase, there are more people that would want to store their excess production as gold for rainy day scenarios. Increasing the value of gold. This is traded off with increase of value of other commodities, because more people means more value of the commodities. So Population would probably not have any special effect on the value of gold.

4) Perception - When people see gold as an investment, it does not match up. It does not produce anything. It forever stays what it was. This can cause the price of gold to reduce substantially, as people don't think of gold as a good "Investment".

5) Paper Gold - When there are instruments that are not gold but are considered as good an "investment" as gold, the price can be substantially reduced. Currently there is nearly as much "paper gold" as there is physical gold. This might not look much, until you realize that most of the physical gold is with people that hoard it away, while most of the paper gold is used only for trading. The transaction ratio is more than 20 times physical. A large part of this transaction might be just plain investment in nature, and not really a proxy for physical gold. So the depression may not be exactly 20 times.

If we look at the value of gold with respect to other things and not in respect of currency, we see that the gold has not risen in value since 1970. Before that it may have even dropped in value, since 1930s. So for the last 80 years gold has been relatively stable, while technology has improved phenomenally. Productivity and prosperity have gone up phenomenally. Why is it that gold has not gone up anywhere near where it should. The reason is paper gold and perception in much of the western world has changed a lot. Actually the increase in the value of gold during the last decade could be attributed to the rise in eastern economies, which perceive gold to be valuable.

Now we have some basic facts that will help us look at the current monetary crisis. Some more terms will be added as we go. I will split the remaining into several components of the crisis. Any one of them could trigger loss of faith.

A) American Ballooning Deficit and USD's Reserve Status
B) OTC derivatives bubble and the Banking system.
C) European Sovereign Debt Crisis.

A) American Ballooning Deficit and USD's Reserve Status

America is suffering from exponentially exploding Deficit for at least 10 years. For the last 3 years the Deficit has crossed the point of no return. Some facts about the Deficit crisis.

1) Budget Deficit has reached more than a Trillion Dollars per year, which is around 10% of the total GDP now. Compare this with the growth rate of <3% and the nominal inflation at 3%.

2) American Total external Debt has crossed the GDP, and growing at 10% every year.

3) American Total Debt has crossed 2 times the GDP. Total Debt is in excess of 50Trillions.

4) US doubled their monetary base between 2008 and 2009. This will cause a devaluation of USD to half, when the money hits the market via the multiplier effect. Further Money Printing has not stopped and in fact will increase a lot, if the money does not enter the market.

Such dire straits mean that US will not be ever able to pay back the trillions of Treasury Debt that it has issued to other nations for transaction purposes.

Much of US's problem is related to USD's Reserve Status. Reserve Status means that other countries need USDs for their transactions. This has forced other countries to collect more and more USDs. China being the major holder of T-Bills. This has been propping up the American Economy for the last 20 years. They have been slowly moving away from producing anything tangible, and are mostly using the Reserve Status for their livelihood. Their prosperity is linked with the Reserve Status of USD.

Other countries need the USD for any transactions. If a country (like China) produces
surplus stuff it will get more USDs. The USDs being a Paper Currency does not automatically increase the value of Chinese currency, and provides no braking. Similarly USD's can be printed without restriction so it does not stop America from consuming so much by depressing their currency.

Now most countries (including China) understand that the money they have in T-Bills is not going to ever be worth anything. This is the reason why Countries in Asia are doing Currency Swap agreements. Currency Swap agreements allow a country to trade without using USDs. There are now several such Swap agreements. China and Russia are at the forefront of these agreements. Even India has got into some of these. All big economies of Asia, China, Japan, Russia, India are into it.

These currency swap agreements are a big problem for the Reserve Status of USD.

The main reason why USD is the reserve currency, is because all major oil producing countries trade only in USD. Iraq had tried to get out of USD, and had started trading in Euro. This is what had forced USA to attack Iraq. It was not the oil. It was the loss of Reserve Status. If America had not done anything, other countries would also have followed suit. We have the same situation now with Iran selling its oil in other currencies, including Yuan (Remnibi). If US does not do anything about it the OPEC countries will also follow suit. OPEC countries also know that USD is worthless in the long run. They are just very afraid of American retaliation. I would think that this hatred encourages these countries to sponsor Terrorism.

Some people think that Iraq attack was for the oil or for creating expenses for their defense industries. This may be partially true. But the fact is that the war had cost america a lot of money, and the budget deficit it caused is irreparable. The govt would not have made the war if it was not a matter of life and death for America.

In any case there is a very high possibility of America attacking Iran. After that we can expect Oil prices to increase a lot. It is still a matter of life and death for them.

Now we have seen that USDs Reserve Status is under attack. And it is going to lose the status in the very near future. Now the question arises what will take its place. There are several options.
1) Yuan
2) Euro
3) SDR
4) Gold Standard
5) Gold (RPG)

1) Yuan is currently a tightly controlled currency. The Chinese govt will have to loosen its control over the currency before any other country will consider it as the reserve currency. Although several small countries are considering it, but more important are the bigger economies. They will not accept it. One of the reason is also the communist govt there. Even if they do accept it, we will get into the same situation, but with China at the helm instead of USA. Who will feel safe in this situation? China will do worse things with its agencies compared to what USA did with CIA.

2) Euro is a very good currency. But the European Union Members are currently under fire because of their past spending habits. Using the Euro will again cause similar issues as the current USD. But in this case the whole of the Euro will be the beneficiary. It will kind of force everybody to join the EU, and start using Euro internally. Bad for weaker economies that cannot devalue against it. Current crisis is causing the ECB to print money just like US, and driving it to make it cheaper. The same is happening for all currencies of developed countries.

3) SDR is a paper currency based on a basket of currencies. The SDR will float against all other currencies. This would be a good idea except that its not a natural solution. It's biases will depend a lot on who defines it. China does not want SDR because it knows that the western economics will load the dice against them. It is the strongest economy now, but won't get the treatment it should under the regime.

4) Gold Standard is often recommended by people as a future replacement for currency for internal use. If (and its a big if) all countries started using gold as a standard, then we will have this situation. Infact most countries before the 20th century were on either silver or gold standard.

It worked well earlier because Technology growth was slow, so the rate at which the value of gold increased was quite slow. This changed in the beginning of 20th century.

When a country goes on a gold standard it fixes the price of the currency on a fixed amount of gold. The fix is such that the currency is higher valued than the gold amount. This makes people use the currency in preference of gold. With time due to technological innovations, commodities become cheaper compared to gold. But the prices quoted for commodities does not reduce, as retailers would prefer to keep the balance. Slowly the Currency becomes devalued compared to gold. Now people prefer to keep gold instead of the currency. This results in a crisis, and the fix needs to be fixed again. Actually gold does not appreciate as much as it should and the currency does not depreciate as much as it should due to the existence of the fix. Since 20th century the fix has become unworkable due to speed of technological growth.

The World Reserve Currency USD was on a Gold standard till 1971, it had kept the price of gold low artificially. When that fix was broken, the gold appreciated immediately to several times. It reached its peak in 1980. After this gold price was somehow controlled to prevent loss of faith in USDs. The manipulation was very successful till 2001, when it was brought to near production costs, and it reached near the price of gold in 1975. Since then it has been steadily growing, possibly due to the introduction of Euros which uses gold as a prominent reserve. Part of the reason for the gold price depreciation was the monumental increase in paper gold instruments.

Basically Gold Standard cannot be implemented in this century within any country.

5) Gold RPG is a natural Reserve mechanism. Reference Point Gold means that all currencies are indexed based on their gold prices. The higher the price of gold in a currency the lesser its value. This allows every country to trade in their individual currencies and its perceived stability. If some country produces much more, they will start collecting a lot of currency, then they will buy goods particularly gold with these. When more gold enters the country, the price of gold will drop in their currency, causing their currency to become stronger. Buying will become cheaper but selling will become more difficult for the country applying a sort of brake to the excess production. The reverse will happen for import surplus countries.

This scheme is workable and doesn't suffer the defects of Gold Standard, as it does not fix the value of currencies, but it floats against currencies, and provides only a reference point.

Regardless of which route the world goes, all the paper instruments that are marked in USD will go down with it. Including gold instruments. This will force a revaluation of Gold.

B) OTC derivatives bubble and the Banking system.
In good times plenty of credit is created. This credit is deposited in banks. Banks due to the multiplier effect are able to lend out the money to people. In most countries the Reserve Requirement is too low. Since the banks want to make more money, and don't want money sitting in their banks, they have every incentive to lend it out. This easy money results in loans that are not good. Eventually some of the loans go bad, and the bank loses money on it.

When Debt goes beyond a threshold, there is no chance that money will be returned to the banks. The threshold depends on the percentage of money people save, the interest rate, and the ratio of existing credit to debt. The system does not crash at this point. The system crashes when the bad debt extinguishes the reserve with the bank.

One might think that the crash of 2008 was due to housing bubble, and they would be right. But the housing loans were involved in what is called OTC Derivatives.

The OTC bubble was less than 700Trillion dollars at the time of the last collapse, with a lot more value. Now it has crossed 700Trillions with a lot less value.

The OTC Derivatives bubble has not yet abated, even after the crash because the US government shoved the problem under the rug by printing money and feeding it to the banks. This bubble is due for another collapse, which will get another large infusion. Eventually the people will realize that things are not going to improve and the system will collapse. Lots of large western banks will go down. Much of the paper instruments will become trash. Banks in eastern economies will also suffer if they have much exposure to such instruments.

The problem cannot be delayed for very long. I would think 3 years is the tops, with very high chance that the collapse happens much sooner.

C) European Sovereign Debt Crisis.
European Sovereign Debt Crisis is not really a very big problem, but it might act as a trigger which could result in the collapse of banks. The problem is not really that PIIGS nations can default, this happens and is actually better for the countries involved. eg Ireland, Iceland. There are several other countries. The problem really is trying to paper over the problem with printed money. That will cause hyperinflation ala Zimbabwe. ECB has not been trying to print the money, but is being forced to print, to show that it is concerned about the fate of individual European countries.

Greece is going to default, and so are some of the other PIIGS countries. When Greece defaults the ECB will make sure to pay the banks enough money so they don't collapse due to their exposure. This might be done for Portugal also. But eventually this scheme will fail.

Conclusions and Actions
We have established the following major points above.
1) USD is in real danger of losing its reserve status value.
2) Western banks are on the verge of collapse, and actually depend on continued USD strength for their survival.
3) Gold value is probably quite a bit lower than what it should be.

Lets see what each of these points mean for us.

1) USD is in real danger of losing its reserve status value.
When USD loses its reserve status, there is a lot of USD in several countries, that will be forced into US. Consequently there will be lot more USDs than required. Also the USG has been printing a lot of it. These problems together will likely cause USDs to drastically lose purchasing power, and there will be hyperinflation in USD terms. This will be very problematic for US Citizens or people living inside US. Most will lose their livelihoods. US also does not have much production of real goods and mostly it imports things. This will make it very difficult for people their to survive. It is possible that there will be large scale rioting and arson.

It is imperative for American people to invest their worth in physical goods and properties. Lack of real production means that food will be very difficult to get. People should store food for at least a year or have means to get out of the country. People should also think about personal protection because if they have the means to survive they will be good targets for arson.

2) Western banks are on the verge of collapse
This is very much tied to the USD strength, as the major banks of the world and their OTC bubble has been held together by huge printing of USDs. This means that people should get their money out of bank instruments and into physical objects or stocks of companies that produce physical things. Depending on the health of their countries financial condition and production status they may have to take other precautions. eg India is mildly in deficit but it can feed its population. So food will not be a problem. Money in any bank that is either western or private bank that may have a lot of exposure may be dangerous places to store money. Public banks maybe safer as govt is likely to save them.

3) Gold value is probably quite a bit lower than what it should be.
Lets try to evaluate what the factor of depression is.
First thing to understand is that the value of gold (or indeed any object) depends on the flow, and not on the actual physical amounts. This means that the gold trading is a very good estimation of how much the value should be.
At present times physical to paper gold is 1:20. This would mean that gold should be 20 times the present value.
But this is not real because much of the trading would not be actually a proxy for actual gold. Lets say that factor is 4. So the real markup is now 5 times.
Another factor is perception. At present perception in much of the world is not very positive for gold this is another cause for gold value being less. Of course this factor will not turn over night, and will take some time maybe years to achieve full potential. This maybe a factor of 2-3.

So if we take it into consideration, the price of gold will jump around 5 times around the time when all gold paper becomes worthless. Of course there will be jump in silver too, but the magnitude maybe smaller.

Due to massive jump in value, perception will also increase. So the value is likely to go 7-8 times and then will possibly still go further up over the next months/years.

The above does not take into consideration the possibility that RPG may become the future international trade mechanism. If RPG gets incorporated into international dealings, then gold will become a preferred form of reserve, and all central banks will try to obtain some of it. This will increase the flow and might add another factor of two for the duration when banks are striving to obtain it. This might take some time maybe a few years.

It would be a good idea to convert as much as possible into gold, because in the near future its not only going to be a great store of value, but it will probably beat most investments.

It will probably beat real estate hands down.

Further reading: This is a blog dedicated to the concept of FreeGold RPG. It clarified the concept of money and gold in my mind. Do note that the Factor of 4, that I speculated about, is my own. The blog people do not believe that any such factor exists, and they do know a lot more about gold trading than me. That is my fudge factor to make the numbers look realistic :-). This is a repository of articles on present financial situation. Articles vary a lot in quality, but you do get a lot of information, if you pick properly.


  1. Thanks for this.

    You may want to give this a read

    and also have a peek at my comment there. Cheers!

  2. I only have a couple of quibbles (and they are quibbles)
    "In any case there is a very high possibility of America attacking Iran."

    Not likely with Trump, as he will be (rightly) advised that attacking Iran is a very bad idea (all we can do is bomb them, and they will retaliate by hitting Israel with many, many ballistic conventional missiles).

    "It worked well earlier because Technology growth was slow, so the rate at which the value of gold increased was quite slow. This changed in the beginning of 20th century."

    Growth was actually quite strong (as noted in the Grant Williams piece noted on Roacheforqe's site). The wealth of nations is the productive capacity of the people, the unit of account/SOV simply adjusts to reflect that. Precious metal standards allow for greater growth, as it prevents excessive financialization/government debt parasitization.