Our Version of The Risks of A US Dollar Crash

``The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market. But it could not last forever even if inflation and credit expansion were to go on endlessly. It would then encounter the barriers which prevent the boundless expansion of circulation credit. It would lead to the crack-up boom and the breakdown of the whole monetary system”- Ludwig von Mises Human Action p.555

The prospective shortfall from the frontloading of fiscal deficits has prompted accelerated concerns over a crash of the US dollar.

For some the definition of a US dollar crash is simply a wave of selling of US financial claims from major official creditor nations, i.e. central banks and sovereign wealth funds.

For us, the incentive to drastically and simultaneously unload US assets appears unlikely, because it won’t be to any country’s interest to foment a US dollar crash as this will be equivalent to mutually assured destruction. To quote Luo Ping, a director-general at the China Banking Regulatory Commission who spoke with levity over a recent public engagement, ``“We hate you guys. Once you start issuing $1 trillion-$2 trillion [$1,000bn-$2,000bn] . . .we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.” [emphasis mine]

Moreover, many have been suggesting for the US to massively devalue by running up the printing presses, a step similarly undertaken by then US President Franklin Delano Roosevelt during the Great Depression. This should ostensibly reduce the real value of debt by reducing the currency’s purchasing power.

However, the privilege from “devaluing” translates to lost savings and a significantly lower standard of living and even more poverty. To quote money manager Axel Merk of Merkfund.com, ``Somehow policy makers have it backward. Many of us like our jobs, but not so much that we love to give up half our net worth for the opportunity to go back to work.”

Besides, the basic problem of the US dollar devaluation seems to be, “to devalue against whom or what”?

During the Great Depression, the US dollar was operating on a gold standard platform which allowed for it to devalue. Our paper money system isn’t tied to gold anymore.

I might add that to conduct an arbitrary massive devaluation can be construed also as a form of non tariff protectionism.

Therefore, it would seem rather unlikely for the US or for that matter to any major OECD country or regional economies to perhaps impose on such irresponsible protectionist stance without expecting the same punitive retaliatory measures.

This means, as we have repeatedly pointed out in the past, the likely scenario from unilateralist US dollar devaluation could be the risks of a currency war, which ultimately leads to the disintegration of the present paper money system, and possibly, a world at war.

While many countries appear to be itching towards adopting or gradually espousing non tariff populist protectionist policies such as export restrictions, import quotas, anti dumping duties, non automatic licensing, technical regulation to trade covering health and environment and subsidies to national industries, it is unlikely that governments could veer towards radicalism. Nations which depends on trade, together with the World Trade Organization and multinational companies will possibly lobby to maintain sangfroid temperaments.

Hence, an orderly coordinated devaluation may occur only if done under an international rapprochement similar to the 1985 Plaza Accord. The same multilateral approach can be undertaken when considering global debt restructuring or a reconfiguration of the monetary architecture.

Nonetheless we beg to differ from the conventional expectations of US dollar crash paradigm.

We concur with Brad Setser when he cites that the present dynamics as shifting from reduced significance of external based financing to increasing contribution from domestic savings.

Here is Mr. Setser, ``The overarching assumption behind the stimulus is that a rise in US household savings (linked to the fall in US household wealth) will create a pool of domestic savings that will flow, given the ongoing contraction in private investment, into the Treasury market. The rise in private savings and fall in private investment will allow the US government to borrow more even as the US economy as whole borrows less from the rest of the world. The key to the Treasuries rally in 2008 was the surge in private demand, not the strengthening of official demand. My guess is that the Treasury market will be driven by developments in the US – not developments in China – in 2009.”

This means a US dollar crash will probably occur if private creditors alongside official creditors instigate a run on the US banking system. That will happen only if a surge in inflation or the debt burden becomes intolerable. On the other hand the other possible scenario, as mentioned above, could be a currency war. Of course there maybe other possible scenarios, which at present, escapes our thought for the moment.

Just a short note on equity markets…

``There is an even deeper reason to reject the long run as a guide to future investment policy. The long-run results we can discern in the data of stock market history are not a random set of numbers: each event was the result of a preceding event rather than an independent observation. This is a statement of the highest importance. Any starting conditions we select in the historical data cannot replicate the starting conditions at any other moment because the preceding events in the two cases are never identical. There is no predestined rate of return. There is only an expected return that may not be realised.”- Peter L. Bernstein Insight: The flight of the long run

At the start of the year, we propounded the scenario where 2009 could likely manifest some divergences in the global equity markets.

Despite the continuous decline in the major US equity bellwethers, we seem to be seeing some marginal proof of such transitioning.

Figure 7: stockcharts.com: Emerging Divergences Among Global Equities?

Although pressures from the worsening recession in the US continues to weigh on most Emerging Market bourses, the degree of decline hasn’t been as steep or as deep, based from December 23^rd of 2008, as shown in figure 7.

Probably this could be because most EM bourses fell steeply more than US benchmarks in 2008. As discussed in Black Swan Problem: Not All Markets Are Down in 2008!, In 2008, the US fell 38.49%, Chile lost 22.13%, Brazil 41.22%, Malaysia 39.33%, Thailand 47.56%, Indonesia 50.64% and the Philippines 48.29%.

In fact, the current losses of the US bellwethers seem to match, if not exceed, the losses attained by some of these bourses at their lows.

Nonetheless we seem to be seeing some outperformers: Chile lost only 22.13% during the dramatic meltdown in 2008 but is already slightly up on a year to date basis. We also see Venezuela (growing signs of dictatorships gaining acceptance?) and Colombia among the other Latin American honor roll.

Across the ocean, we have Morocco and last year’s member of the 3 amazing bourses which defied the tide, Tunisia as another hotshot. This, despite the global economic woes affecting their exports and tourism revenues, aside from a sharp slowdown in the national economic growth.

To quote Marion Mühlberger of Deutsche Bank, ``So it looks as though Tunisia cannot decouple completely from the global financial crisis but is unlikely to suffer any major economic or banking crisis”. Probably not in terms of traditional economic metrics but certainly has “decoupled” in terms of financial markets performance in 2008.

Not that we believe that this is anything about “economic recovery”, but from the monetary viewpoint, the potential response stems from the impact from we believe as the liquidity spillover or our “spillage effect” from the collective attempts by central banks and governments to inflate asset markets and the economies. Governments are essentially driving the public to speculate and turbocharge asset inflation.

As we noted above, the losses have vacuumed most of the liquidity generated by global authorities, although last week’s surge in select commodities as oil (+11.82%) and copper (+7.7%) seem to validate our supposition of a prospective spillover. Albeit Gold’s (6%) decline could be indicative of an emerging rotation, or possibly, rebalancing of the Gold-oil ratio which has surged to record levels in favor of gold.

Figure 8: PSE: Sectoral Performances

Finally we seem to see the same signs of divergences even in the Philippine Stock Exchange (figure 8).

Based on sectoral performance on a year to date basis we see commercial industrial (pink-up 15.27%) and the mining sector (green up 11.75%) outperforming the rest of the field- Property blue (-9.47%), banking black (-10.79%), holding red (-1.51%), all maroon (+1.17%) and service orange (+1.34%).

The surge in the commercial industrial has been powered by energy stocks.

The Phisix (-.03% year to date) continues to drift sideways which implies a likely bottoming cycle, despite the October like performance in the US. This seems largely due to the diminished scale of foreign selling activities which may have validated our assessment of the deleterious impact of forcible selling or delevaraging to the local equity market, regardless of fundamentals.

Nonetheless, if we see a continued rise by the present market leaders, then this “inflationary driven” run may start to spread over to the broader market. And people may start to read market prices as “justification” of an economic “recovery” and pile on them; even when this may be due to sublime responses to monetary policies.

However, we will need to be further convinced with technical improvements on some key local and select benchmarks, aside from key commodity prices and similarly progress in domestic market internal activities.

To Nationalize or To Nationalize?

David Leonhardt of New York Times suggests of 2 kinds of government takeover of US banks:

One is premised on ideology-governments can run more institutions more "justly" or "efficiently" than private capitalists.

The second is predicated on short term expediency: government takes over (sheds shareholders, bondholders and management), repackage (segregate assets) and immediately sells back to the public.

And if the path of government action are to be based on public opinion, then the the second option appears as the proximate direction. This supposedly is the optimistic case.

But, as Ludwig von Mises once admonished, interventionism can be addictive, ``It doesn't accomplish its stated ends. Instead it distorts the market. That distortion cries out for a fix. The fix can consist in pulling back and freeing the market or taking further steps toward intervention. The State nearly always chooses the latter course, unless forced to do otherwise. The result is more distortion, leading eventually, by small steps, toward ever more nationalization and its attendant stagnation and bankruptcy."

Despite the denials of key officials, apparently the baby steps are headed towards such direction.

Video: Milton Friedman on Greed

From the Heritage Blog,

Some excerpts from Friedman's terse but awesomely crisp rejoinder on capitalism's "greed"...

``The world runs on individuals pursuing their selfish interest. The great achievements of civilization have not come from government bureaus."

``In the only cases in which the masses have escaped from the kind of grinding poverty you are talking about, the only cases in recorded history are where they have had capitalism and largely free trade. If you wanna know where the masses are worst off is the kind of the society that departs from that. So that the record of history is absolutely crystal clear, that there is no alternative way so far discovered of improving the lot of the ordinary people that can hold the candle to the productive activities that are unleashed via free enterprise."

``And what does reward virtue? You think the communist commissar rewards virtue? Do you think a Hitler rewards virtue? Do you think, excuse me…if you’ll pardon me, American presidents reward virtue? Do they choose their appointees from the basis of the virtues of the people appointed or on the basis of political clout? Is it really true that political self interest is nobler somehow than economic self-interest?"

The Unintended Effects and follies of the Cap and Trade System

The unintended effects from an artificial market to aimed at reducing carbon emissions, this excerpt from Julian Glover of the Guardian (bold highlights mine),

``Set up to price pollution out of existence, carbon trading is pricing it back in. Europe's carbon markets are in collapse.

``Yet the hiss of escaping gas is almost inaudible. There's no big news headline, nothing sensational for TV viewers to watch; no queues outside banks or missing Texan showmen. You can't see or hear a market for a pollutant tumble. But at stake is what was supposed to be a central lever in the world's effort to turn back climate change. Intended to price fossil fuels out of the market, the system is instead turning them into the rational economic choice.

``That there exists something called carbon trading is about all that most people know. A few know, too, that Europe has created carbon exchanges, and traders who buy and sell. Few but the professionals, however, know that this market is now failing in its purpose: to edge up the cost of emitting CO2.

``The theory sounded fine in the boom years, back when Nicholas Stern described climate change as "the biggest market failure in history" - a market failure to which carbon trading was meant to be a market solution. Instead, it's bolstering the business case for fossil fuels.

``Understanding why is easy. A year ago European governments allocated a limited number of carbon emission permits to their big polluters. Businesses that reduce pollution are allowed to sell spare permits to ones that need more. As demand outstrips this capped supply, and the price of permits rises, an incentive grows to invest in green energy. Why buy costly permits to keep a coal plant running when you can put the cash into clean power instead?

``All this only works as the carbon price lifts. As with 1924 Château Lafite or Damian Hirst's diamond skulls, scarcity and speculation create the value. If permits are cheap, and everyone has lots, the green incentive crashes into reverse. As recession slashes output, companies pile up permits they don't need and sell them on. The price falls, and anyone who wants to pollute can afford to do so. The result is a system that does nothing at all for climate change but a lot for the bottom lines of mega-polluters such as the steelmaker Corus: industrial assistance in camouflage.”

No this isn't a market failure but a false/pretentious market that was meant to fail.

Why? Some arguments from Vincent Gioia (bold highlight mine),

``They argue that emissions trading does little to solve pollution problems overall, as groups that do not pollute sell their conservation to the highest bidder, not the worst offender...

``Another problem as The Financial Times noted in an article on cap and trade systems "Carbon markets create a muddle" and "...leave much room for unverifiable manipulation". The paper actually conducted an in-depth study of the carbon credit business and made some very revealing findings". Their investigation found:

■ "Widespread instances of people and organisations buying worthless credits that do not yield any reductions in carbon emissions.
■ Industrial companies profiting from doing very little – or from gaining carbon credits on the basis of efficiency gains from which they have already benefited substantially.
■ Brokers providing services of questionable or no value.
■ A shortage of verification, making it difficult for buyers to assess the true value of carbon credits.
■ Companies and individuals being charged over the odds for the private purchase of European Union carbon permits that have plummeted in value because they do not result in emissions cuts...

``There is also the issues of what do those selling carbon credits do the reduce carbon dioxide emissions and are proponents of the idea merely using the global warming fanatics to line their pockets and do so-called environmentalists scam the system for political advantage...

Zimbabwe's Hyperinflation

Interesting Hyperinflation data...from Economist Steve Hanke of Forbes and Cato.org

According to Mr. Hanke, ``Zimbabwe failed to break Hungary’s 1946 world record for hyperinflation. That said, Zimbabwe did race past Yugoslavia in October 2008. In consequence, Zimbabwe can now lay claim to second place in the world hyperinflation record books."

Highest Monthly Inflation Rates in History
Country	Month with highest inflation rate	Highest monthly inflation rate	Equivalent daily inflation rate	Time required for prices to double
Hungary	July 1946	1.30 x 1016%	195%	15.6 hours
Zimbabwe	Mid-November 2008 (latest measurable)	79,600,000,000%	98.0%	24.7 hours
Yugoslavia	January 1994	313,000,000%	64.6%	1.4 days
Germany	October 1923	29,500%	20.9%	3.7 days
Greece	November 1944	11,300%	17.1%	4.5 days
China	May 1949	4,210%	13.4%	5.6 days

More from Mr. Hanke, ``Zimbabwe is the first country in the 21st century to hyperinflate. In February 2007, Zimbabwe’s inflation rate topped 50% per month, the minimum rate required to qualify as a hyperinflation (50% per month is equal to a 12,875% per year). Since then, inflation has soared."

Well as of November 14th, this was how Zimbabwe's inflation rate fared

Monthly inflation rate=79,600,000,000.00%

Annual Inflation Rate=89,700,000,000,000,000,000,000%

The magic of the printing press.

Fiscal Stimulus Debate: Oops, We’re Using The Wrong Keynes!

Given today’s worsening financial and economic crisis, the debate on the viability of the fiscal stimulus (government spending) patterned after John Maynard Keynes theories continues to rage.

courtesy of American.com

But, unfortunately, both proponents (including uber-Keynesians) and detractors have been citing the "wrong" theories of “rock star” economist JM Keynes. That’s according to Professor Rizzo who wrote, ``we should pay attention to his mature ideas rather than to the textbook versions of what he said, some of which reflect Keynes’s earlier thinking.”

So what were the thoughts of the “matured” Keynes?

Again Professor Rizzo (all bold highlights mine), ``Keynes did not think that public works expenditure was very effective in countering existing or impending recessions. He believed that it was difficult to get the timing right.

``In the first place, he preferred that such investments be made without deficits. But if they were to be made as “loan expenditure”—that is, through a deficit in the portion of the government’s budget allocated to long-term expenditures like infrastructure—the expenditure should be covered by a surplus in the portion of the budget allocated to ordinary expenses like transfer payments, or through a special fund accumulated in prosperous times for just such purposes. If a deficit were incurred, the investments should be “self-liquidating,” that is they should repay their costs over the long run. Thus his strong, but not rigid, preference was against deficit-financed public works.

``The more fundamental reasons for his preference against deficit-financed public works, however, emerge from the theoretical framework he built in his masterwork General Theory of Employment, Interest and Money (1936). As economists Bradley Bateman and Allan Meltzer stress, Keynes was convinced that avoiding depressions required the maintenance of a high level of investor confidence. He believed that (in general and not just during slumps) confidence tended to be too low. This low confidence was due to radical uncertainty generated by speculation inherent in financial markets, especially the stock exchange. This speculation could give rise to unsustainable asset bubbles. The ever-present threat of such speculative activity creates instability in the expectation of investment returns. As a result, investment spending will fluctuate unpredictably. This in turn creates further instability of investor expectations.

``In Keynes’s view, the financial uncertainty generated by such speculation was an unnecessary social burden. It tended to keep long-term interest rates above where they would lead to full employment. The task of good economic management is to reduce this uncertainty burden and lower long-term interest rates through a kind of “socialization of investment.” The state in one way or another (Keynes is not entirely clear on this) should undertake large investments with no thought of speculative gains or advantage. The long-term social return on capital should be its only guide. And it should do this reliably, as part of a well thought-out plan, and on a permanent basis. Stabilization is to be achieved not by temporary and discretionary policies, but by permanent changes. Stimulus follows stability, not vice versa.

Read the rest here

Some observations:

The matured Keynes admits he does not “think that public works expenditure was very effective in countering existing or impending recessions”

Goes to show how interventionists have been using Keynes inappropriately for intellectual cover.

Finally, don’t be slaves of defunct immature economist!

(Hat Tip: Café Hayek)

How Math Models Can Lead To Disaster

The crash of Wall Street had been aggravated by people looking for rationales to confirm their beliefs. And there was no better source of inspiration than one modeled after a seemingly impervious mathematical formula.

An article from Wired.com on “Recipe for Disaster: The Formula That Killed Wall Street” by Felix Salmon, gives a splendid narrative.

Some excerpts (all bold highlights mine),

``For five years, Li's formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels.

``His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored….

``It was a brilliant simplification of an intractable problem. And Li didn't just radically dumb down the difficulty of working out correlations; he decided not to even bother trying to map and calculate all the nearly infinite relationships between the various loans that made up a pool. What happens when the number of pool members increases or when you mix negative correlations with positive ones? Never mind all that, he said. The only thing that matters is the final correlation number—one clean, simple, all-sufficient figure that sums up everything.

``The effect on the securitization market was electric. Armed with Li's formula, Wall Street's quants saw a new world of possibilities. And the first thing they did was start creating a huge number of brand-new triple-A securities. Using Li's copula approach meant that ratings agencies like Moody's—or anybody wanting to model the risk of a tranche—no longer needed to puzzle over the underlying securities. All they needed was that correlation number, and out would come a rating telling them how safe or risky the tranche was…

``As a result, just about anything could be bundled and turned into a triple-A bond—corporate bonds, bank loans, mortgage-backed securities, whatever you liked.

``In the world of finance, too many quants see only the numbers before them and forget about the concrete reality the figures are supposed to represent. They think they can model just a few years' worth of data and come up with probabilities for things that may happen only once every 10,000 years. Then people invest on the basis of those probabilities, without stopping to wonder whether the numbers make any sense at all.

``As Li himself said of his own model: "The most dangerous part is when people believe everything coming out of it."

Some observations:

One. This is another example of people how people (including the majority of experts and professionals) fall prey to cognitive biases, such as the confirmation bias, in order to buttress their beliefs.

Two. This also shows of people’s penchant to trustingly espouse mathematical models to address the concerns of social structures especially in markets.

The illustrious Friedrich A. Hayek (1899–1992) in his Nobel Prize speech The Pretence of Knowledge warned of this, ``A theory of essentially complex phenomena must refer to a large number of particular facts; and to derive a prediction from it, or to test it, we have to ascertain all these particular facts. Once we succeeded in this there should be no particular difficulty about deriving testable predictions — with the help of modern computers it should be easy enough to insert these data into the appropriate blanks of the theoretical formulae and to derive a prediction. The real difficulty, to the solution of which science has little to contribute, and which is sometimes indeed insoluble, consists in the ascertainment of the particular facts.”

For pundits, math models elicit intellectual attraction of a system that can be deliberately controlled. However, the sad reality is that they hardly capture all variables required out of the complexity of the environment. And over reliance thereof may lead to disastrous consequences, similar to the LTCM fiasco.

And this applies not only to Wall Street but to the general economics or even to the environment.

Nassim Taleb: Banking System is Designed to Blow Up

From Bloomberg:

Banking with Ponzi characteristics...
People can invest in real thing...
You can't trust bankers
Hat tip infectious greed

Video: Crisis of Credit Visualized

Nice presentation of the credit crisis. HT: Justin Ptak Mises Blog

The Crisis of Credit Visualized from Jonathan Jarvis on Vimeo.

Do Governments View Rising Gold Prices As An Ally Against Deflation?

``One day the price of gold will be higher than the Dow Jones.”-Dr. Marc Faber

As gold nears its all time high see figure 7, public awareness in gold seems to be snowballing.

Figure 7: World Gold Council: Two Remaining Currencies Where Gold Has Yet To Establish Record High

There are only two major currencies wherein gold trades below its record high; one is the US dollar and the other is the Japanese Yen.

The chart above courtesy of the World Gold Council was last updated February 13^th. But as of last Friday’s close, Gold in US dollar terms was seen nearly leveling on its previous high at 1,004.

When gold rises across all currencies, this is symptomatic of a systemic monetary disorder than just mere inflation. There appears to be an accelerating realization that paper currencies issued and guaranteed by the global governments are becoming less sacrosanct, or people have been exhibiting diminished “faith” on the present financial architecture or this has been reflective of paper money’s “race to the bottom” or the effect of the collective efforts by governments to debauch or even destroy their currencies.

Nonetheless, a recent article at the Financial Times had this unusual observation; it noted that rising gold prices seem to be operating under the auspices of governments.

This from Mr. Steve Ellis of RAB Gold Strategy at the FT.com,

``Speaking to central bankers, this is the first time I can recall them actually favouring a high gold price. Normally they see high gold prices as a lack of trust in the financial system (not to mention their ability as central bankers). Alan Greenspan, the former Fed chairman, for example used to target a gold price of around $400 to $500 an ounce.

``Recently, the central bankers have become more enamoured of higher gold prices as it would suggest that their attempts to stave off deflation were starting to work.

``Central bankers in favour of higher gold prices? Things really have changed.”

Gold’s moniker, the “barbaric metal” had been contrived by interventionists because it functioned as rabid nemesis to elastic currency or the ability of authorities to inflate the system to appease the political gods.

Thus, could central bankers truly see gold as an ally against their campaign deflation?

Three reasons why we think this is possible.

Inflation Expectations Needs To Be Reshaped

One, for central bankers, it’s all about signaling channels. This is usually known as the managing of inflation expectations, where the central bank communicates to the markets their policy intentions as to project stability.

In a recent speech, US Federal Reserve chair Ben Bernanke said, ``increased clarity about the FOMC’s views regarding longer-term inflation should help to better stabilize the public’s inflation expectations, thus contributing to keeping actual inflation from rising too high or falling too low.”

You see central bankers believe that inflation can function like a light switch that can be turned on or off, or like a genie that be called in and out of his lamp.

Unfortunately, this is an academic and bureaucratic delusion. In as much as authorities failed to predict the catastrophic consequences of a bursting bubble, they’ve nonetheless equally botched any attempt to rein its deflationary reaction. So they are now hoping that by unduly taking on the inflation risk, they can manage to steer it successfully once the crisis pasts. But like the recent activities, the inflation genie will most likely elude them, until the next crisis surfaces.

Yet by pushing and maintaining interest rates at near zero levels, and the policy shift to adopt the tactical measures of “quantitative easing”, most major central banks (US, Swiss, UK, Japan) appear to be communicating their desire to reignite inflation as means to restore the credit flow.

However, this hasn’t been the entire truth, as we have repeatedly pointed out- the colossal debt structures of the bursting bubble economies require governments to inflate away the real debt levels.

In addition, government’s use of the fiscal medicine to deal with national or domestic economic malaise serves as a parallel approach to stoke inflation in the economy regardless of how ineffectual such efforts are.

Nevertheless, we have almost every government in the world today rehabilitating their domestic economies by instituting inflationary policies. Thus, if gold’s rise should signify as resurgent “inflation” then governments are likely to reticently “cheer” on it.

Enhancement of the Balance Sheet of the US Federal Reserve

Two, if the aim of the US Federal Reserve is to enhance its balance sheet, a revaluation of gold reserves might be necessary.

Using the “backing theory”, which means that the currency’s worth is determined by the underlying assets and liabilities of the issuing agency (wikipedia.org), the Federal Reserve’s attempt to debase its currency is done by absorbing more toxic assets to its balance sheet.

According to Philipp Bagus and Markus H. Schiml, ``Since the crisis broke out, the Fed has continuously weakened the quality of the dollar by weakening its balance sheet. In fact, the assets the Federal Reserve holds have deteriorated tremendously. These assets back the liability side of the balance sheet, which mainly represents the monetary base of the dollar. The assets of the Fed, thereby, hold up the value of the dollar. At the end of the day, it is these assets that the Fed can use to defend the dollar's value externally and internally. Thus, for example, it could sell its foreign exchange reserves to buy back dollars, reducing the amount of dollars outstanding. From the point of view of the buyer of the foreign exchange reserves, this transaction is a de facto redemption.” (bold highlight mine)

Hence, under the backing theory, it isn’t just quantitative easing (printing of money) that determines the currency value but also the qualitative aspects (or what it buys for the asset side of its balance sheet).

Again from Mssrs Bagus and Schiml, ``Despite of all these efforts, credit markets still have not returned to normal. What will the Fed do next? Interest rates are already practically at zero. However, the dollar still has value that can be exploited to keep the experiment going. Bernanke's new tool is the so-called quantitative easing. Quantitative easing is when a central bank with interest rates already near zero continues to buy assets, thus injecting reserves into the banking system. In fact, quantitative easing is a subsection of qualitative easing. Qualitative easing can be defined as the sum of the policies that weaken the quality of a currency.”

Simply said, as the Federal Reserve increasingly digests poor quality of assets into its balance sheet, this effectively reduces its equity ratio from which would eventually translate to its insolvency.

Hence, this would leave the US Federal Reserve with only two options, according to Mssrs Bagus and Schiml, ``Only two things can save the Fed at this point. One is a bailout by the federal government. This recapitalization could be financed by taxes or by monetizing government debt in another blow to the value of the currency.”

``The other possibility is concealed in the hidden reserves of the Fed's gold position, which is only valued at $42.44 per troy ounce on the balance sheet. A revaluation of the gold reserves would boost the equity ratio of the Fed.”

High gold prices would eventually be required for gold to be revalued to enhance the balance sheet of the US Federal Reserve.

End To Gold Manipulation?

Lastly, the surging gold prices suggest an end to possible gold manipulation.

It has been long contended by groups like the GATA that central bank gold reserves has been unofficially “sold”, through lease, swaps and derivatives to the markets, hence gold stashed in the central bank books have simply been accounting entries.

Mr. Robert Blumen of Mises.org cites a report from where a broker endorsed the suspicion of gold manipulation; says Mr. Blumen, ``The major conclusion of the report is that the western central banks have sold a larger fraction of their gold reserves than they acknowledge in their official statements. The gold has entered the market through derivatives such as leases, swaps, the writing of call options against the gold. The sale of the gold is obscured in the central banks books through the representation of leased, swapped, and otherwise encumbered, aggregated together with actual physical gold held in vaults as a single asset on their books. An estimated 10,000-15,000 tons of gold has entered the market since 1996 (compared to an official number of 2,000-3,000) through these mechanisms, according to the report. The purpose of these covert gold sales is part of a larger effort to disable the functioning of inflation indicators, which operate to limit central bank credit expansion.”

Gold’s recent rise has been primarily investment demand driven, see figure 8.

Figure 8: gold.org: Surging Investment Demand

The implication of which is a shift in the public’s outlook of gold as merely a “commodity” (jewelry, and industrial usage) towards gold’s restitution as “store of value” function or as “money”.

The greater the investment demand, the stronger the bullmarket for gold.

If the estimated number of 10,000 to 15,000 tons, is anywhere close to being accurate, then this translates to 40-50% of world central bank gold reserves of 29,697.1 tonnes (gold.org as of December 2008) as having been “shorted”.

Therefore, “short” positions in a rampaging gold bullmarket will extrapolate to additional national balance sheet losses. This implies that world governments, whom are net short positions, will likely be net buyers in the near future.

Although I haven’t been totally convinced about the “gold manipulation theory”, I am, however, open to it, in the understanding of the political nature of central banking. Central bankers don’t want competition or interference from gold, thus, the odds that price controls may have attempted in the past.

The implication is that the bullmarket in gold will possibly be accelerating once governments’ covers open short positions. And if we see $100 dollar a day moves, perhaps this theory might be validated.

And since the gold market is an iota or about 6% or $5 trillion (165,000 tonnes of above ground gold) relative to the overall financial markets, this suggests that a bullmarket market will likewise spillover to important key commodities as silver, copper and oil.

Moreover, any panic into gold will likewise see a panic to own producers, which functions as proxy to gold by virtue of reserves.

For now, central bankers would likely to be “sleeping with the enemy”.

Central And Eastern Europe’s “Sudden Stop” Fuels US Dollar Rally

``Big government reforms, bailouts, stimulus, and “change" in general create negative expectations of the future along with a great deal of uncertainty. This leads to inaction and fear — the preconditions for a crash in the stock market. All it needs now is the appropriate trigger.” Mark Thornton, Unhinged

Except for some currencies such as the Norwegian Krone, British Pound or the Swiss Franc, the US dollar surged against almost every major currency including those in Asia…the Philippine Peso included. (Be reminded this has nothing do with remittances)

Since the forex market is a huge liquid market, with daily turnover of nearly $ 4 trillion dollars, this means there has been an intense wave of ex-US dollar liquidation. And to see such a coordinated move suggests that the global financial system could be faced with renewed dislocations in a disturbing scale. So the likely suspects could be either major bank/s in distress, or a country or some countries could be at a verge of default.

Central an dEastern Europe’s “Sudden Stop”

With no major spike in the major indicators which we monitor, such as the Libor-OIS, TED Spread, EURIBOR 3 month, Hong Kong Hibor, BBA LIBOR 3 months and 3 MO LIBOR - OIS SPREAD, the epicenter of last week’s pressure appears to emanate from the Central and Eastern European (CEE) region.

Regional credit spreads and Credit Default Swap (CDS) prices soared, as credit ratings agency the Moody’s issued a warning last week of the possibility of credit ratings downgrades in the region’s debt amidst a deteriorating global economic environment, See figure 1.

Figure 1: Danske Bank: CEE Under Pressure

According to the Danske Bank, ``Credit spreads have had a hard time during the week – especially for banks. The investment grade CDS index, iTraxx Europe, currently trades at 174bp up from 154bp last Friday. The high yield index iTraxx Crossover currently trades at 1085bp up from 1070bp last week. The senior financial index has also widened considerably and now trades at 152bp. As long as sovereign CDS prices are under pressure CDSs on senior bank debt are also likely to suffer as the two are heavily interlinked due to the various state guarantees on bank debt.”

The turbulence affected every financial market in the region; the CEE currencies crumbled, regional bond markets sovereign spreads widened, and regional equity markets tanked see figure 2.

Figure 2: Danske Bank: Emerging Europe currencies slump, Euro bonds

All these resemble what is known as the “sudden stop” or capital stampeding out of the region.

Somehow the CEE crisis approximates what had happened in Asia 12 years ago or what was labeled as the 1997 Asian Financial Crisis.

Central and Eastern European Crisis A Shadow of the Asian Financial Crisis?

So what ails the CEE?

As in all bubble cycles, the common denominator have always been unsustainable debt. And unmanageable debt acquired by the banking system and Eastern European households during the boom days had been manifested through burgeoning current account or external deficits. And these deficits had been balanced or offset by a flux in capital flows, mostly bank loans see figure 3.

Figure 3: Emerging Europe Crisis versus the Asian Crisis

The Bank of International Settlements (BIS) makes a comparison between the present developments in Emerging Europe with of Asia 12 years ago.

From the BIS, ``The crisis was preceded by rapid growth in credit to the private sector, with a significant share of loans denominated in foreign currency. East Asian economies also recorded large current account deficits, mainly induced by the private sector. These deficits were financed by strong debt inflows, which reversed sharply following the crisis. A further similarity lies in exchange rate policies. Prior to the crisis, East Asian economies had fixed nominal exchange rates (in their case against the US dollar). Moreover, the economies relied heavily on a single foreign creditor – Japanese banks. Emerging European countries currently show a similar level of dependence on a few European banking system creditors. For example, claims by Austrian-owned banks are equivalent to 20% of annual GDP in the Czech Republic, Hungary and Slovakia, while claims of Swedish-owned banks on the Baltic states are equivalent to 90% of their combined GDP. An adverse shock to one or more of these foreign banks could result in them withdrawing funds from emerging European countries.”

So the emerging similarities seen in both crises have been strong debt inflows, fixed nominal exchange rates and the concentration of source financing.

As the above chart shows, FDIs (red line) and Bank loans/Debt (blue line) composed most of the inflows in Emerging Europe (left window) whereas the Asian crisis bubble (right window) was almost entirely financed by debt from bank loans.

According to BIS, one marked difference for the strong capital flows in Emerging Europe had been due to the “strengthening in GDP growth and policy frameworks due to closer EU integration.” Plainly put, the integration of many of these countries into the Eurozone facilitated capital flows movement in the region, which may have abetted the bubble formation.

Moreover, another important difference was that Asian debt was principally channeled into the corporate sector while the liabilities in Emerging Europe have been foreign currency related.

Like the recent debacle in Iceland, Emerging Europe’s households incurred vast mortgage liabilities through their banking system in unhedged foreign currency contracts (mostly in Euro and Swiss Francs), which was meant to take advantage of low interest rates while neglectfully assuming the currency risk. In short, Emerging European households engaged in the currency arbitrages or otherwise known as the CARRY TRADE.

So when the sharp downturn in economic growth occurred, these capital starved economies failed to attract external capital, hence, the net effect was a drastic adjustment in their currencies which prompted for a capital flight.

Households which took on massive doses of foreign currency liabilities or loans saw their debts balloon as their domestic currency depreciated.

And it is not just in the households, but foreign investors too which incurred substantial exposure through local currency instruments. Morgan Stanley estimates Turkey, Hungary, Poland and Czech having non-resident exposures to equities and bonds at 30%, 18%, 17% and 10%, respectively.

Thus, the sharp gyrations in the currency markets have accentuated the pressures on the underlying foreign currency mismatches in the region’s financial system.

Another source of distinction has been the degree of exposure of the Emerging Europe’s debt to the European banking system. As noted by the BIS above, the Asian crisis further undermined Japan’s banking system, which provided the most of the loans, at the time when its domestic economy had been enduring the first leg of its decade long recession. On the hand, over 90% of the distribution of loans $1.64 trillion loans held by Emerging Europe have been scattered between the European and Swedish banks.

Doom Mongering: Will Eastern Europe Collapse the World?

Nonetheless this has been the key source of pessimism in media, especially by doom mongers whom have alleged that the failure to salvage East Europe will either lead to a worldwide economic catastrophe or to the disintegration of the Euro, as major European economies as Germany and France may opt NOT to bailout the crisis affected union members or union members whose banking system are heavily exposed to Eastern Europe of which may lead to cross defaults and culminate with a collapse in the monetary union.

In addition, they further assert that due to the huge extent of financing requirements, the IMF would deplete its funds and may be compelled to sell its gold hoard in order to raise cash. And to prim their narrative, they’ve made use of the historical parallelism to bolster their views or as possible precedent; the Austrian bank collapse in 1931 triggered a chain reaction which ushered in an economic crisis in Europe during the Great Depression years.

We are no experts in the Euro zone and Emerging Europe markets, but what we understand is that these doomsayers appear to be inherently biased against the Euro (on its very existence, even prior to these crisis), or alternatively, have been staunch defenders of the US dollar as-the-world’s-international-currency-standard, and have used the recent opportunities to promote their agenda.

Moreover, these doom mongers appear to be interventionists who peddle fear to advocate increased government presence and interference, which ironically has been the primary cause of the present predicament.

Be reminded that the fiat paper money system exists on the basis of trust by the public on the issuing government. Conversely, a lost of faith or trust, for whatever reason, may indeed undermine the existence of a monetary framework, such as the US dollar or the Euro. Thus rising gold prices are emblematic of these monetary disorders and we can’t disregard any of these assertions.

Although, for us, the claims of the tragic collapse from the ongoing CEE crisis could be discerned as somewhat superfluous.

One, the argument looks like a fallacy of composition- as defined by wikipedia.org-something is true of the whole from the fact that it is true of some part of the whole (or even of every proper part).

Figure 4: BIS: Foreign Liabilities Varies Across EM Regions

The CEE debt problem has been interpreted as something with homogeneous like dynamics, where the assumption is that every country appears to be suffering from the same degree of difficulties even when the economic structures (leverage, deficits etc.) are different.

They even apply the same logic to the rest of the world including Asia, where, as can be seen in Figure 4, have different scale of foreign liabilities exposure.

Two, because a large part of the Emerging Europe’s banking system is owned by European banks (see Figure 5) some have alleged that European governments have been indiscriminately pressuring their domestic banks with exposures to Eastern Europe to abruptly reduce or pullback their exposure to these countries, such as Greek banks in Balkans. There may be some cases, but a wholesale withdrawal would seem unlikely.

Figure 5 BIS: Foreign Bank Ownership in Emerging Markets

Yet according to the BIS, ``a large part of most emerging European banking systems is foreign owned. These banking groups appear to be financially strong currently, as reflected in standard –albeit backward-looking – measures of financial strength such as capital adequacy ratios and profitability. The foreign subsidiaries should have better risk management techniques in place, more geographically dispersed assets and, in principle, good supervision (from the home country on the consolidated entity).” [bold highlight mine]

Three, emerging markets have been reckoned as “more inferior and risk prone” asset class compared to the securitized instruments sold by the US.

As the Europe.view in the Economist magazine aptly remarked, ``Foreign-currency borrowing by east European households was seriously unwise. But it does not compare with the wild selling of sub-prime mortgages in America that turned balance sheets there to toxic waste. It may be necessary to restructure some of these loans, or convert them into local currency (perhaps with statutory intervention). That will hurt bank profits. But it will not mean American-style write-offs. Bank lending to foreign companies based in eastern Europe is still a good business.”

Divergences Even Among Emerging Markets?

While it could be true that some European banks could be heavily levered compared to their US counterparts and has significant exposure to the CEE region- where the latter seem to be encountering an Asian Crisis like unraveling due to outsized external deficits, large internal leverage and foreign currency mismatches in their liabilities- it is unclear that the deterioration in the financial and economic environment would result to an outright disintegration of the Euro monetary union or trigger an October 2008 like contagion across the globe.

Figure 6 Danske Bank: EM Stock markets

The fact that EM stockmarkets have been performing divergently as shown in figure 6, where LATAM (blue), Asia (apple green), CIS (Commonwealth of Independent States-gray) appear to be recovering, while the CEE (red) and MSCI (dark green) index are down, hardly implies of a contagion at work yet.

Moreover, as we earlier noted, credit spreads of major indicators haven’t seen renewed stress and seems to remain placid despite the recent CEE ruckus.

Thus from our standpoint the present strength of the US dollar encapsulates the ongoing Emerging Market phenomenon called the “sudden stop” or capital “flight” (resident capital) or “exodus” (non-resident capital) from the region, which has siphoned off the availability and accessibility of the US dollar in the global financial system which has probably led to the steep rally in the US dollar almost across-the-board.

We believe that 2009 will be a year of divergence as concerted policy induced liquidity measures will likely have dissimilar impact to all nations depending on the economic, financial markets, and political structures aside from the policy responses to the recent crisis and recession.

Even among Emerging Markets such divergences will likely be elaborate.