Paper Money On Path To Return To Intrinsic Value - ZERO

Voltaire (1694-1778) once said, ``Paper money eventually returns to its intrinsic value ---- zero."

No matter how you look at it...

From Price levels...

source (Robert Sahr, Oregon State, HT: Jeff Tucker)

Or inversely translated into the currency's purchasing power...

(Source AIER)

Paper money based on the US dollar system is indeed headed towards ZERO

Source AIER

As Thomas Paine(1737–1809) an English pamphleteer, revolutionary, radical, and classical liberal once wrote, ``Paper money is like dram-drinking, it relieves for a moment by deceitful sensation, but gradually diminishes the natural heat, and leaves the body worse than it found it. Were not this the case, and could money be made of paper at pleasure, every sovereign in Europe would be as rich as he pleased. But the truth is, that it is a bubble and the attempt vanity. Nature has provided the proper materials for money: gold and silver, and any attempt of ours to rival her is ridiculous…."

Effects Of Inflationary Policies Surface In Currency Markets

``America’s policy is pushing China towards developing an alternative financial system. For the past two decades China’s entry into the global economy rested on making cheap labour available to multi-nationals and pegging the renminbi to the dollar. The dollar peg allowed China to leverage the US financial system for its international needs, while domestic finance remained state-controlled to redistribute prosperity from the coast to interior provinces. This dual approach has worked remarkably well. China could have its cake and eat it too. Of course, the global credit bubble was what allowed China’s dual approach to be effective; its inefficiency was masked by bubble-generated global demand. China is aware that it must become independent from the dollar at some point. Its recent decision to turn Shanghai into a financial centre by 2020 reflects China’s anxiety over relying on the dollar system. The year 2020 seems remote, and the US will not pay attention to something so distant. However, if global stagflation takes hold, as I expect it to, it will force China to accelerate its reforms to float its currency and create a single, independent and market-based financial system. When that happens, the dollar will collapse.”- Andy Xie If China loses faith the dollar will collapse

This episode of the stock markets in a fierce rebound has brought about exhortations of “greenshoots” and “prospective” economic recovery, which we have described as the reflexivity theory at work.

And as we have repeatedly been saying, the unparalleled scale of concerted and collaborative global central bank actions will ultimately be transmitted to the currency markets which subsequently will pose as the underlying current to financial market actions.

Figure 3: stockcharts.com: Falling US Dollar And Rising Stocks, Commodities and Treasury Yields

As governments continue to distort the market pricing process by providing subsidies, guarantees, fiscal spending and other interventionist measures, the pressures accrued from the imbalances will ultimately be vented on the world’s currency market which risks a cataclysmic collapse in the present monetary system.

Let me reiterate, this grandest experiment of the unbacked paper-digital money system has been 38 years old. If one would treasure the lessons of history, ALL paper money had been extinguished out of the propensity of the rulers to inflate or destroy the currency-mostly for political survival or wars, see our previous discussion Government Guarantees And the US Dollar Standard.

So those fervently praying for governments to “print money” as a way out of the present predicament or to “avoid a Japan” have been putting undue faith on a system which had temporarily weaved “short term” magic before, but at the cost of building a riskier economic and financial structure based on the exponential growth in systemic leverage and moral hazard, which only leads to worsening cyclical bubbles or worst a collapse in the world’s monetary architecture.

Yet policies that serve to uphold the economically unsustainable borrow, speculate and spend policies will ultimately meet its comeuppance. You can dream of printing away the economic crisis similar to Zimbabwe. But that dream we know only turned into a real life nightmare.

Yet, today’s global policy directions reflect on the very essence of why paper money has failed.

The present “boom” appears to be manifesting inflation as getting some “traction”.

As figure 3 shows, the Euro-weighted US dollar index (USD) has broken below its 200-day moving averages, which signals a regression to its long term bear market.

Some will interpret today’s phenomenon as the revival of risk appetite or the reawakening of the “animal spirits” especially when seen with rising yields of the long term US treasuries (TNX).

Some others will adduce market activities especially by the performances of the global stock markets (DJW) alongside rising commodity prices (oil broke above $55 and is now $58!) to prospective global economic recovery.

We hope both of these arguments are right because this will be the ideal “goldilocks” scenario.

From our end, we understand this “goldilocks” scenario as toothfairy economics simply because of the “the marginal utility of real goods and services divided by the marginal utility (mostly for portfolio and transactions purposes) of government liabilities” or inflation as defined by Professor John Hussman in our previous discussion Expect A Different Inflationary Environment.

In short, when more paper money is produced than real goods we essentially get inflation.

But think of it, if present trends will persist and inflation is indeed gaining traction, then rising commodities will essentially squeeze purchasing power of consumers and raise the cost of production for producers.

Meanwhile, rising interest rates will jeopardize or even defeat programs instituted by governments to ease debtor angst, especially in the crisis affected nations.

Aside, rising interest will translate to higher cost of maintaining or servicing debt for the government and the private sector.

So governments seem trapped in a fix; on one hand by allowing markets to function this will translate to the much dreaded (but needed) deflation, which policymakers won’t accept.

On the other hand, policies to pump money in the system will mean more inflation which essentially will undermine most of the programs that have been put in place to mend the dislocations brought upon by the present crisis.

More proof of inflation driving the currency markets in Asia which seems being transmitted to the stock markets? See figure 4.

Figure 4: Bloomberg: Bloomberg-JP Morgan Asia Dollar Index (yellow), MSCI AC ASIA PACIFIC (green)

When Asian Markets are on a rebound as shown by the Bloomberg’s MSCI ASIA PACIFIC [MXAP:IND-green], the Asian currency benchmark Bloomberg-JP Morgan Asia Dollar Index [ADXY:IND-yellow] goes positive-meaning regional currencies appreciate against the US dollar.

There appears to be a strong correlation between the activities in the stock markets and the region’s currency values possibly influenced by portfolio flows, relative economic growth, relative inflation and or yield differential expectations.

But I would like to remind you that currency markets aren’t free markets (no markets are actually free) and are subjected to repeated government manipulations directly (direct market operations) or indirectly (domestic inflationary policies).

Yes, today’s fiat paper money currency standard is a monopoly supplied by governments.

This makes currencies values vulnerable to political interferences which may induce short term aberrations where arguably market prices do not manifest efficiency.

Nevertheless, while imbalances can be deferred for sometime, in due course they get to be exposed by the natural forces of the market.

And applied to the Philippine Peso, in contrast to mainstream and popular predictions, we argued in 2009: Phisix and Peso Will Advance!, that the Peso like the Phisix will defy bearish projections, which had mostly been anchored on remittances and exports, made by mainstream experts who remain afflicted with rear view looking, ivory tower ensconced-laboratory based economic theories and an obsession with self-importance.

The Philippine Peso has been marginally up on a year to date basis with Friday’s close at Php 47.25 and quite distant yet to the Php 50-52 level predicted by the consensus of “experts”.

And based on the above premises, we expect the Peso to similarly reflect gains in the Phisix. In my view, the Peso will possibly appreciate towards the Php 45-46 level or better by the yearend.

And as a final word today’s boom in contrast to the 2003-2007 cycle which basically lasted more than 4 years maybe swifter, steeper and shorter.

Ron Paul: We Have No Understanding of How Capitalism Is Supposed to Work

Testing the Banking System’s Resilience: Deposit Insurance Coverage

Previously the conventional thinking was that the banking system signified as the ultimate bulwark of money. While people basically trusted banks because of their faith over governments (implied guarantees), many fail to realize that such government authored cartelized system, which centered on the powers emanating from central banks, are not foolproof and are likewise subject to incompetence or abuse-whose constant manipulations of the market can be equally disruptive-and thus, lead to a loss of faith or specifically a RUN.

BCA Research: Credit Markets Remain Jittery

The continuing tremors in the banking system, as indicated by the intensified stress in the credit markets (see BCA Research chart above), which has fundamentally emanated from the bubble bust in the US, has rippled almost internationally and has most importantly began to raise questions about the sanctity and integrity of the current operating monetary platform-the Paper money standard.

As the system remains besieged from its self-inflicted ordeal, it is everyone’s task to ensure of the security of their deposits via the institutionalized deposit insurance coverage or a safety net (guarantee) provided by government institutions to depositors in order to promote financial stability.

From the Economist

According to the Economist, ``AS BANKS tumble like skittles, customers across the world are eyeing their cash nervously. Savings are protected in around 100 countries, with varying degrees of generosity. Those spooked by a run on a bank in Hong Kong this month may have been particularly nervous because only HK$100,000 ($12,860) of their cash is protected, including interest. Ireland has recently extended its limit from €20,000 ($29,337) to €100,000, to reassure savers. In America the first $100,000 is guaranteed for each depositor at each bank, while Britain's savers are limited to £35,000 ($64,650) in one institution, although an increase is expected soon. It is not only a matter of how much is protected, of course, but also of how quickly and easily the savers would get it back.” (highlight mine)

Of course, the other alternative is to own precious metals.

Reverse Coupling, Inflation From The Core and Current Account Deficits

``Only as you do know yourself can your brain serve you as a sharp and efficient tool. Know your own failings, passions and prejudices so you can separate them from what you see.” -Bernard Baruch (1870-1965), Financer, Speculator Statesman and Presidential Adviser

Finger pointing on policymaking is easy to do. Yet many analysts seem to forget that the global monetary regime functions under the US dollar standard system which runs on the fractional banking reserve system platform, whose underlying principle basically stems from leverage (reserves as a fraction of deposits).

Because the logistical agencies of the US monetary system have presently been undergoing severe deleveraging pressure, this has been spilling over into the real economy and equally reflected in the underlying asset prices which is likewise being felt worldwide see figure 5.

Figure 5: The Economist: Sinking Global Equity Markets

The Economist cites Standard & Poor’s estimates of the losses for the month June as having wiped out $3 trillion in global capitalization, mostly due to the horrific 10% losses in emerging markets.

And as we have been saying along-it’s all not about oil but a combination of factors from the softening economic growth, deteriorating profit outlook, rising interest rates and higher incidences of consumer goods inflation.

“Reverse Coupling”

Thus given these aggravating circumstances, the US Federal Reserves policies have been designed to keep interest rates at negative real levels considering the staggering amount of leverage built onto the financial system under the abovementioned environment.

And as we discussed last week in Global Financial Markets: US Sneezes, World Catches Cold!, this evidently could be the continuing policy thrust since authorities have in their radar screen the magnified view of heightened systemic deflationary risk. Apparently the central bank of central banks the Bank of International Settlements (BIS), have echoed the same risk and sees “inflation is a more immediate threat than deflation” (The Economist).

Hence, the Bernanke-Paulson tandem appear to be banking on a lower dollar and lever its economy through exports by turbocharging the economic growth to emerging markets via the transmission mechanism of US dollar linked monetary regimes and the expansion of the current account deficit. Essentially lower US interest rates have been stimulating emerging markets.

This excerpt from the commentary of Fred Bergsten, director of the Peterson Institute for International Economics at the Financial Times appears to corroborate our view,

``The improved US trade performance of the past two years is due partly to the substantial, if lagged, restoration of the country’s price competitiveness as the dollar declined by a trade-weighted average of 25-30 per cent since early 2002, reversing most of its excessive run-up during the previous seven years that produced unsustainable current account deficits exceeding 6 per cent of GDP. Equally important, however, is the continued robust growth of the world economy. Every percentage point by which the rest of the world expands domestic demand faster than internal growth in the US produces gains of about $50bn (€32bn, £25bn) for the US external balance. Weighted by US exports, foreign growth exceeded US growth by about 2 percentage points in 2007 and will do so by an average of about 1.5 points this year and next as decoupling persists. Taken together, these currency and comparative growth factors have already improved the real US trade balance, and hence GDP, by almost $150bn since 2006, with gains of another $150bn or so likely through 2009. (The nominal US trade and current account deficits will not improve as much because of the sharp rise in the price of oil imports.)

``The Organisation for Economic Co-operation and Development’s new Economic Outlook projects that more than 80 per cent of all US growth in 2008-09 will derive from continued strengthening of its external position. Exports have been climbing at an annual rate of about 8 per cent, at least six times as fast as imports. Unless domestic demand takes an unexpected further fall in the quarters ahead, reverse coupling of the global economy will thus have prevented the US recession that was so widely predicted and feared.”

So what you have is the US trying to utilize emerging markets to cushion its economic decline hoping that the global inflationary process from emerging markets would keep the US-UK deflationary forces at bay. However, the unexpected repercussion of this exercise is the risk of emerging markets to overheat and exacerbate the “inflation” in commodity prices particularly of food and energy.

An example, if you think record levels of oil prices have climbed enough to “destroy demand” in emerging markets, it’s definitely not showing yet. Car sales in June remained robust in India (+8%) Brazil (+30%), Korea (+9.2%), New Zealand (+5.5%) and Australia (+1.4%).

Inflation From The Core

If markets have been reappraising financial assets through policy actions shouldn’t it be the US that needs to be penalized more for its influential grip over other economies?

Yes, if you ask Doug Noland in his Credit Bubble Bulletin (highilight), ``I find it rather incredible that U.S. and European policymakers are increasingly pointing blame and calling upon their emerging economy cohorts to aggressively combat inflation. With the U.S. today stuck with intractable $700bn Current Account Deficits and European Credit systems still churning out double-digit Credit growth, the Periphery is not the root cause of today’s escalating global inflationary pressures. The global Credit system has run amuck, a process that evolved from years of Credit and speculative excess generated by, and tolerated at, the Core. It is today unreasonable to expect the Chinese or Asians generally to bring their booming economies to their respective knees to fight global inflation anymore than we can expect the Fed to tighten the economic screws to the point of balancing our Current Account and punishing the destabilizing speculators.

``Today’s inflationary dynamics have been developing for decades. Only discipline and stability at the Core of the global financial system would have stemmed the strong inflationary bias of contemporary fiat “money” and Credit. But the Core was instead egregiously undisciplined and unstable, setting the stage for the type of runaway inflation we are now experiencing. The Core came to love and rationalize asset inflation and consumption. The Periphery was forced along for the ride and happy to oblige.”

Of course, to a lesser degree the US dollar linked monetary regimes in emerging markets should bear some of these responsibilities for tolerating the US policy induced global inflationary environment.

Emerging Market Turmoil: From Carry Trade To Current Account Deficits?

On the other hand, perhaps the turmoil in today’s marketplace exceptionally seen in some emerging markets could be as a result of the shifting focus of the markets as the distortions from the carry trade in the face of heightened risk aversion fades while the market prices on the state of current account balances as suggested by The Economist see figure 6.

Figure 6: Economist: Current Account Balances Reshaping Asset Pricing In Emerging Markets?

From the Economist, ``ACCORDING to economic textbooks, the currencies of economies with large current-account deficits should depreciate relative to those of countries with surpluses. This will stimulate their exports and curb imports, thereby helping to slim the trade gaps…Increased concern about current-account deficits is also causing investors to discriminate much more between emerging markets. A popular argument in recent years has been that developing economies are less risky because, unlike a decade ago, they are no longer dependent on foreign capital. It is true that emerging economies are forecast to have a combined current-account surplus of more than $800 billion this year, but this is more than accounted for by China, Russia and the Gulf oil exporters. In fact over half of the 25 biggest emerging economies now have deficits. South Korea is running a deficit after a decade of surpluses. Brazil has also moved back into the red, despite record high prices for its commodity exports. Others such as India, South Africa and Turkey have had external deficits for many years.”

While some of the performances in emerging markets appear to affirm such theory, it hasn’t been linear. For instance, the Philippines have severely underperformed South Africa and Turkey both of which have had deficits even during the heydays of the markets.

The Philippines isn’t about to turn into a current account deficit yet though. Current account surplus is expected to narrow to $4.2 billion from $6.9 billion (Reuters) despite the expected broadening of the trade deficit to about $11 billion-highest in 9 years on higher fuel and rice imports and weaker exports. So the recent underperformance of the Philippine asset class does not tally will or could be fully explained by this theory.

Thus, if we read by the activities in the market, such expectations are likely to be wrong (we will turn steeply into a deficit) or the market is inaccurately priced (market is wrong).

For the Philippine setting my conjecture is that the recent bear market has been exacerbated by internecine politicking see Philippine Politics: The Nationalist Hysteria Over Energy Issues.

Risk Of A US Dollar Crisis: Benign or The Austrian Endgame?

``The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”-Ludwig von Mises, Human Action, The Monetary or Circulation Credit Theory of the Trade Cycle

As a final thought, many people ignore the risks of a US dollar crisis.

Crisis happens because they are an unexpected. It is a black swan or statistical fat tail. The US housing crisis was a much anticipated outcome yet many got caught owing to the belief that they would be able to get out on time. They never expected a buyer’s boycott.

Another, the repercussions from the US housing bust was largely unforeseen. Nobody saw that the investment grade AAA papers would lose sizably in value. Nobody predicted the extent of the contagion from the mortgage bust which would lead to a seizure of global credit markets.

Today, the US dollar continues to fall. The conventional expectation is that the declining trend of the dollar will be orderly. The culmination of the US dollar crisis is presumed to be a benign “overshoot” of the currency’s valuation which would fall low enough to attract enough foreign buyers and reverse the decline. We hope this is the right scenario.

However, the Austrian school’s endgame outcome is different. The risk from a US dollar crisis probably suggests of the collapse of the global currency standard and the end of the US dollar as the world’s de facto foreign exchange reserve. It also suggests that the world may experience a bout of hyperinflation, as the entire chain structure of paper money collapses. To quote Anthony Mueller, The End of Dollar Supremacy, ``Losing trust does not mean that there must be a ready substitute. On the contrary: when distrust will emerge towards the US dollar this would affect the attitude towards all paper currencies. In the final stages of the currency crisis, the dollar will most likely devalue not so much against the euro and the yen, but all of these currencies and most of the rest will devalue drastically against gold.”

Yet the common denominator of countries that experienced hyperinflation had war related expenditures, protectionist walls and uncompromising leadership which pursued onerous welfare policies that eventually resulted to a lose of faith in the country’s currency. These ingredients have been not absent from today’s landscape. The difference is at least we remain globalized.

I came across a sober article from a blogger Steve Waldman who suggests that today’s commodity boom could be seen as “a run on central banks”.

To quote Mr. Waldman (highlight mine) ``Capital devoted to precautionary storage would be better employed building new enterprises, laying a foundation for tomorrow's prosperity. But claims on future money are only promises, easily broken or devalued. A run on central banks, a flight from financial assets to stored goods, sacrifices the hope of future abundance for certain present scarcity. Governments can shut futures exchanges, confiscate gold, ban "hoarding, profiteering, and price-gouging". People will hoard anyway if they don't believe in the paper. People are losing faith in financial assets for good reason. Rather than organizing productive economies, the machinery of finance has recently functioned as an anesthetic, masking the pain while resources were mismanaged and stolen. We need a solid financial system, but confidence cannot be imposed or legislated. It will have to be earned. There has to be a plan. Earnest promises to do better soon won't suffice. Nor will yet another drink from the punch bowl.

Since the pillar of the world’s Paper money standard depends solely on faith on the credibility of the issuer of money, all it needs to topple the entire system is to lose such binding faith. I hope we don’t lose it.