We had never commandeered a table, set up our laptop and worked away in the moody lighting amid the pleasant, folksy music.

Today, we resolve to change all that. Today, we Occupy Starbucks!

The unusually high amounts of caffeine in our system may help to explain the figurative hair up our editorial butts this morning, a hair that has to do with Occupations around the world…

We’ve been feverishly posting other people’s articles on our Facebook page, the kind of articles that explain well our view of the Occupy Wall Street movement. We just can’t let this one go, good patrons…All those protesters who know they ought to be mad about something…but who have yet to realize that that something is not Wall Street.

As we’ve been maintaining — along with others with an Austrian understanding of the world — it’s not Wall Street. It’s not “capitalism.” It’s the damned central banks and the nonmarket money whose creation they monopolize.

The central bank’s mandates include “stabilizing prices” and creating full employment. But the powers of the central bank to create new money tend to destabilize economies, create boom-bust cycles, increase joblessness, and destroy the purchasing power of savings.

And really…”stabilizing prices”?

We shot Michael Pento a note for his take on this. His reply:

“The general trend in a productive economy is for a benign level of deflation to exist. A stable price environment or one with slowly falling aggregate prices is optimal for economic growth in that it encourages savings, which are the building blocks of investment and capital formation.

“When an economy is operating under high levels of productivity growth, the supply of goods and services outstrips the supply of money and credit when under a gold or bimetal standard money. Therefore, prices tend to fall over time.”

The central bank rationale is that prices should remain “stable” while incomes rise, along with employment. To this end, they print money and inject it into the economy, mostly by lending it to the government (buying the government’s bonds).

Buying all that debt with the new money puts an extra-market downward pressure on interest rates. This is supposed to make borrowing easier for starting and expanding businesses.

It also spurs consumer spending. Artificially low interest rates tempt consumers while new money erodes the value of saved money.

The free market model, however, tends to keep incomes relatively steady while prices fall. That’s what’s sort of forced to happen with a stable money supply. In fact, incomes — which are just a special form of price — could also fall over time…but as long as general prices fall just a bit faster, the purchasing power of those incomes are still on the up.

Haven’t you noticed this? That life gets better, society gets richer, as goods and services initially thought of luxuries — maybe even science fiction — become commonplace…and cheap?

What makes the free market way better than the central bank’s inflationary habits? It’s been demonstrated repeatedly that printing money does not equal creating wealth. But printing money and injecting excess credit — that beyond what the market would provide — causes misallocations of capital and distortions that lead to bubbles. Then busts.

You see, if all the money everywhere increased exactly the same at once, there would be no distortions…nor would there be any increase in wealth. Just an increase in the amount of money.

But as Murray Rothbard pointed out in The Mystery of Banking, inflation doesn’t work that way.

Inflation is a process, not an “all at once” phenomenon. It’s legally protected counterfeiting that benefits the first recipients of the new money. Those who borrow it first (governments) and collect interest for lending it out after the Feds lend it to them (big commerical banks) benefit.

And thanks to the state-backed legerdemain of fractional reserve lending, the banks themselves can lend out many times the money the Fed deposits with them. The new credit based on the new money causes waves of price inflation, along with not a few credit-fueled bubbles that eventually burst.

This is great work if you can get it. As the financial industry people at the front of the line for the new money will tell you. The rest of us get to watch general prices increase while our wages fall further and further behind.

The free market’s “deflationary” process is lambasted by most modern economists. We’re told that we must fear deflation, both in prices and the money supply…that the central bank is the righteous guardian of inflation and, therefore, of stable prices and economic growth…

While we suppose the Fed could actually inflate the money supply safely, in some safe range as proposed by Milton Friedman….

…We’d just rather let the market handle what gets used as money…and also let it handle how fast those various currencies gets issued or mined.

Down with central banks. Down with their government-backed monopoly on issuing currency which they then use to undermine capital accumulation and swell debt in the economy.

I wonder what that would look like on a protest placard.

It’s The Central Banks, You Dumb Kids was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

What is a bank? According to a helpful little essay on banks for students at ThinkQuest helpfully titled “What is a Bank?”, a bank is a financial organization in which people deposit their money. A bank is a business. According to the aforementioned essay, “each bank tries to make THEIR bank look better than all of the other banks by offering services that some other banks might not have.” That is to say, banks compete in a market. This is true, conceptually at least, and also true to some extent in reality, although numerous banking laws seriously alter the market and the competition. But it is the pure idea we are after here, and in the pure idea, a bank is a business that competes in a market.

I won’t analyze every “central bank” in the world. I don’t have to because their setup is more or less the same everywhere. I’ll use the Federal Reserve System (the Fed) to represent all of them.

Historically, the Fed and other “central banks” came to be called “central banks” for several reasons. First, they are financial organizations. Second, they hold deposits of other banks and governments. Third, their assets are largely financial assets. Fourth, they make advances or loans to other banks on collateral. Fifth, the government has made them to be at the heart or center of the banking industry and the monetary system. Sixth, government power is itself centralized or national. All of these statements are factual.

Now, this is an imposing array of reasons why “central banks” are called “central banks.” But the most important of these reasons is the fifth reason, which is that the government has used its power to make the “central bank” central. And because the government has used its power to create the “central bank” and make it central, we know that the “central bank” is not a free market institution.

This is the main ground upon which I challenge the notion that a “central bank” is a bank. The concept of “central bank” fails to distinguish a free market business and a bureau created by government power. The term “central bank” undermines this distinction between free market and government. Indeed, it erases it altogether.

The Fed is not a business. It has powers that no ordinary bank has. It has privileges that no ordinary banks have. It doesn’t compete with other banks. The government created the Fed. The government gave it power to create fiat money. The government can alter the Fed’s organization and powers at any time. The Fed’s so-called independence from the government is mythological. It is that of a dog on a long leash. The only independence the Fed has is from the public.

Let’s go back for a moment to the essay on banks that I just cited, because it displays this erasing of any distinction between the free market and government. After defining the term “bank,” it lists the kinds of banks. Quite suddenly, it introduces the term “central bank” in the same breath as ordinary banks that have national or state charters. It says, “There are different kinds of banks. There are national banks, state banks and central banks. The Federal Reserve Bank is the United States government’s central bank. The Bank of England is England’s central bank.”

Suddenly, what this essay told us earlier disappears. We were told that a bank was a business that competed with other banks. But now we are told that the Fed “decides how much money is in circulation” and that it “may tell the [ordinary] banks to charge more interest or keep more money in ‘reserve.’”

Obviously, if the “central bank” has such powers, it gets them from the government. Just as obviously, the “central bank” is not a business and not in competition with other banks if it exercises these and other powers over ordinary banks.

Furthermore, distinctions between monies that ordinary free market banks deal in and the fiat money that central banks produce are completely glossed over and erased.

This essay is representative of the usual thought in the field of economics. Banks are businesses. But then, all of a sudden, there is another so-called “bank” that has an array of powers that business banks do not have. This “bank” is actually a government bureau. Its fiat money is made into legal tender by the government. The government states that it stands behind this money. This “bank” has powers to control and organize the ordinary banks into a cartel.

The facts I’ve pointed out are widely recognized. There is a Wikipedia article titled “Central Bank” that confirms this:

“A central bank, reserve bank or monetary authority is a public institution that usually issues the currency, regulates the money supply and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries. In contrast to a commercial bank, a central bank possesses a monopoly on printing the national currency, which usually serves as the nation’s legal tender.”

This too makes it very clear that a “central bank” is not a bank, but a powerful Monetary Authority and Fiat Money Administration.

However, the same Wikipedia article almost immediately contradicts itself when it states: “Central banks in most developed nations are independent in that they operate under rules designed to render them free from political interference.”

How can a bureau that is established by the government and possesses extraordinary powers be independent and free from political interference? The “central bank” embodies political interference!

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And to the extent that a Monetary Authority such as the Fed has been granted powers that it can exercise free of political interference, how can such an institution be held accountable? How can it operate without being responsible to the government and, indirectly, to the people?

“Central bank” independence is to a large extent a myth, that is, in the essence of the institution and in those activities in which it is not mythical, it is an unaccountable power.

It may seem as if I am splitting hairs, but what I see is that the common explanations of central banking confuse banking as might occur in free markets with so-called banking as executed by a “central bank” that is empowered by government. They are two entirely different kinds of operations. A thoughtful or questioning reader is bound to feel a degree of discomfort when he encounters these explanations that blur important distinctions.

A “central bank” is a government department. It is a government bureau. It is the government’s fiat money bureau. The “central bank” is the government’s money-printing machinery or money-printing organization or money-printing bureau or money-printing agency. As contrasted with monies produced in a free market, the Fed’s money is state-produced “money.” In the sense of comparing the Fed’s money to free-market money, it is counterfeit. It is held up by the force of government law and power. It is imposed on the public.

A more accurate term for the Fed might be the “Fiat Money Administration.” Perhaps the term “Monetary Authority” would be more accurate. It would be more accurate if the latter were the official name. In the U.S. Constitution, at least, it is clear that there is no power to create a Monetary Authority, and if there were such a power, it could not possibly be delegated in such a way as to make that Monetary Authority independent.

The “central bank” is not a real bank. Everything about it is permeated with government power. At the heart of the financial and monetary system of a nation that is supposed to be an exemplar of free markets is a government money-bureau.

Regards,

Michael S. Rozeff

Michael S. Rozeff is a retired professor of finance living in East Amherst, New York. He is the author of the free e-book Essays on American Empire: Liberty vs. Domination and the free e-book The U.S. Constitution and Money: Corruption and Decline.

Central Banks Aren’t Banks was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

The present system must end, it will end, it will now certainly end badly. And probably soon. As it is inevitable it doesn’t matter what I wish. To wish that this would not happen would be as sensible as to wish that the present summer would not end, and that the days would not get shorter. I don’t wish it and I don’t fear it. The system must go. Good riddance.

What I do fear, however, are the political consequences and the societal fall-out from the crisis, and I particularly fear the responses it will provoke from governments and state officials.

Of course, the fiat money crisis is not a natural catastrophe. It is entirely man-made. It is the direct consequence of political decisions and political action.

In particular, it is the inevitable consequence of the decision to abandon a gold-based monetary system, a system of essentially inflexible and apolitical money, and to replace it with entirely elastic and constantly expanding paper money. This paper money leads to accumulation of imbalances, to capital misallocations, and to resource mis-pricings. Those must lead, over time, to economic disintegration of banks.

It is the direct consequence of the erroneous belief that low interest rates and additional credit are good regardless of whether they are the outcome of true saving and capital accumulation, or simply the outcome of fiat money creation.

There is the unspoken belief that after all my research on the topic I must have some good policy advice up my sleeves. Often people ask me, so what should be done? If what central bankers and politicians are doing presently is, as you say in your book, counterproductive, what should they do instead? What is the solution?

There is an assumption that one cannot simply predict some unpleasant outcome in the field of economics and not offer at least a bit of hope that things may turn out differently. Suggesting the possibility of a way out that would spare us all the painful consequences of past actions, of decades of misguided policy, of cheap credit and limitless money.

I suspect that since I speak so little about specific policy reforms leads people to believe that I don’t care about where we are going, or I might even look forward to the disaster.

What should be done

There is only one possible way out. Stop the printing of money and the artificial suppression of interest rates. Return to hard money. Allow interest rates and market prices to again reflect the true extent of voluntary savings, and to thus allow the liquidation of the accumulated imbalances from previous money expansion.

But because we had a four-decade long period of unprecedented fiat money creation globally, these imbalances are now so big that the necessary liquidation would be very painful. The political class — which got us into this mess in the first place — would never deem it acceptable.

The overstretched banking industry, the overextended asset markets, insolvent governments are all screaming for a cleansing liquidation and recalibration. A crisis has now become unavoidable.

But politicians still think that the power of the state is unlimited, that what they don’t find acceptable will simply not be allowed to occur. Only in the realm of politics is reality optional…somehow reality can simply be made to conform to the wishes of the political elite.

Of course, policy cannot create a new reality. What policy does at the moment is try to postpone the inevitable correction ever further. “Not on my watch” is the modus operandi. This will make the final crisis even worse.

I quoted Ludwig von Mises on this on a couple of occasions but I will do it again. In his magnum opus of 1949, Human Action, the grand master of Austrian School economics said:

“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.”

The endgame will be “a final and total catastrophe of the currency system”, and “later” may indeed be soon. Remember, we have been postponing the liquidation for decades and happily piled new debt and new imbalances on top of the old debt and the old imbalances. By not stopping the printing of money and the accumulation of debt and capital misallocations (and by adding to them instead) the policy establishment is making sure that the final crisis will only be worse.

This is why I consider it pointless to come up with policy recommendations. What would be the purpose of presenting a detailed plan of converting to a gold standard, which is what should be done? Mainstream economists, politicians and central bankers will either ridicule or ignore it. They still believe that the answer to all these money-induced imbalances is — more money! They are hell-bent on creating a total currency catastrophe. And they will get it.

A whiff of Weimar Germany

A touch of Weimar? (Chart Greenburger)

Let’s just take a casual look at the events of the past month: While I was hiking in the Dolomites or relaxing in Tuscany, the destroyers of paper money did not rest. The ECB completed a U-turn of embarrassing proportions and switched from exit strategy to buying more PIIGS-bonds funded by the printing press — a policy that continues to this day and that will not end!

And Dartmouth College Professor and ex-Bank of England money-debaser David Blanchflower argues for more quantitative easing from the Fed. When asked how much, the good professor showed his generous side: $ 1 trillion or $ 2 trillion…just print until things look better. We will show this economy who is boss!

British pundit Ambrose Evans-Pritchard argues that real monetary stimulus hasn’t even been tried yet. He recommends some globally co-ordinated monetary blitz — what if all central banks opened their monetary floodgates simultaneously? Surely, that is going to buy us a nice recovery.

If you thought that this lunacy is being greeted with derision, as it should, think again. As I write this, the Swiss government has declared that international cooperation in monetary debasement is a splendid idea — and has just pegged the Swiss franc, formerly the gold-rimmed version of paper money, to the PIIGS. Congratulations!

Make no mistake: They will all get what they are asking for. But to expect anyone who sees the writing on the wall to engage with a policy establishment beholden to the myth that prosperity and jobs can be had through constant monetary manipulation, through artificially low rates, money printing and asset bubbles — that is asking a bit too much. And let’s face it: it is not as if any of them would even want to listen to what I have to say. I put my case out there — it is for others to decide what to do with it.

Here is another, less well-known quote from the great man, Mises:

“Political ideas that have dominated the public mind for decades cannot be refuted through rational arguments. They must run their course in life and cannot collapse otherwise than in great catastrophes…”

We are approaching such a catastrophe with full force. Rather than coming up with a monetary reform (and there is only one true reform: a return to gold) that will certainly be rejected by the powers that be, I think the most sensible thing one can try and do is to protect oneself, one’s family and one’s wealth as best as one can from the ensuing fall-out.

My recommendation has been and still is to reduce exposure to banks and to governments – the two grotesquely bloated entities that have for decades benefited from their privilege to be unconstrained paper money producers and who are now close to OD’-ing on that privilege. Hold gold (and maybe silver) instead of paper money, bank deposits and fixed income securities. Real assets, not paper assets.

The coming monetary meltdown will wipe out vast amounts of paper wealth, and it will facilitate one of the largest transfers of real wealth in human history. Many people will lose a lot.

Sadly, it will be mainly those who produce more than they consume and who save the difference — and then save it in the form of cash, bank deposits and bonds.

All paper money collapses decimate the middle class. No, I certainly don’t wish for this but the chance of this being avoided is practically zero.

Short of the century — coming soon!

As always, some will win, and there is no shame in trying to be among them. Apart from the rise in the gold price and certain other commodities, I think that there is another money-making (no pun intended!) opportunity: fixed income markets will soon be the short of the century.

Those out there who think the world will be just like Japan for the next twenty years are wrong, in my view. Japan’s present state is not stable and it doesn’t constitute an endgame. It is collapse in super-slow-motion.

The ongoing fiscal deterioration and the mind-boggling accumulation of public debt mean that the ultimate endgame there will be inflation and paper money collapse, too. And I doubt that the U.S. and Europe will manage to stretch this out for quite as long as Japan has.

But here is what I fear.

I am very concerned about the political fall-out from the crisis. Although it will ultimately mark the end of state paper money, of politically controlled interest rates, and government-manipulated asset markets, don’t expect the state to leave the economic stage without a fight.

For the immediate future at least, I expect more interference with markets, more regulation, more confiscation via taxation, capital controls and curtailment of property rights and individual freedom. In a crisis, many will demand more government and more state action, not more freedom and markets.

When I spoke to a libertarian audience in Vulcano I was speaking to friends, to like-minded people. People who, like me, value personal freedom and free markets. I sensed that they, too, would have loved me to give them a bit more of an uplifting message.

Many of these libertarians believe that what they are involved in is simply a battle of ideas, and that they can, if they try hard enough, convince others of the benefits of a free society and of capitalism. I don’t think that this is entirely wrong. But I fear that many of them underestimate the opposing forces that the present crisis may unleash.

In the meantime, the debasement of paper money continues.

Regards,

Detlev Schlechter

Why Policy Advise Is Futile And What You Should Do Instead was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Up until Monday, we’ve seen the end of the super cycle in fiat money as a process that could take years to unfold. The piecemeal nationalisation of certain industries…the assumption of private sector liabilities on the public sector balance sheet…the abrogation of contract in the form of defaulted mortgages that are not foreclosed on…and higher-and-higher public debt-to-GDP ratios were all signs that the government everywhere was sucking the life out of the economy to preserve the status quo, and turning dozens of firms and institutions into zombies with no real productive economic future.

But Monday is the day that sent a bit of a chill down your editor’s spine. And it’s not because the €750 billion bailout package by the ECB caused a frisson here in St. Kilda. Granted, it did wonders everywhere else. The S&P 500 was up 4.4% in New York. Local stocks rallied. And most impressively, the spread between 10-year Greek debt and equivalent German bunds shrunk by a massive 570 basis points.

And if you’re a speculator — and especially a high-yield bond hunter — why not get on the gravy train? If the ECB is going to print money to buy public and private sector debts to “ensure depth and liquidity” in certain markets, it’s not a trend you want to fight. If the central banks are going to splurge on assets to support debt markets, bond yields will fall and asset prices will rise. For now.

But we reckon it is not for long. This really is Act V of the fiscal welfare state, in which monetary policy becomes the shameless handmaiden of fiscal policy in order to sustain an unsustainable kind of riskless society with massive benefits for everyone paid for by a few. That is an unaffordable illusion, the shattering of which leads to lower standards of living — a fact many in Europe find politically unacceptable (even if the fiscal facts speak for themselves).

To delay the day of reckoning, the ECB is offering European banks nearly unlimited amounts of cash for three and six month borrowing periods. You can imagine those banks — proud owners of heaps of sovereign debt from Greece, Spain, Italy, Ireland, and Portugal — are happy to sell that stuff to the ECB and borrow some short-term cash to lever up into an equity rebound. More privatised profits and socialised losses that favour the financial industry.

And why wouldn’t you play that game if you were playing with other people’s money? We’ll get to WHOSE money in just a moment.

The immediate question you might have is, “Will this work?” It depends on what you mean by “work”. By throwing wads of cash at stressed banks, the ECB alleviates the immediate threat in the market that bond yields spike and a liquidity crisis sets in. But enabling debt-laded countries to take on more debt hardly seems like a long term solution to the problem of living above your national means.

“You cannot make any nation that is unable to service its accumulated debts more creditworthy by extending more credit!” said Jeremy Batstone-Carr, analyst at Charles Stanley in today’s Wall Street Journal. “If the EU lends Greece money, the loan will increase that country’s public sector debt. The interest on the additional loan, whatever it eventually proves to be, will increase the public sector deficit. Total debt-servicing costs will rise, raising the burden on public sector cash flows. At some point in the future, the loan will have to be paid back.”

EU policy makers hope that by extending more credit now to sovereign governments, bond investors will just, you know, back off! It’s amazing to read how officials blame derivatives and a “wolf pack” of speculators for the crisis. As if it was the speculators who ran up huge debt-to-GDP ratios. As if the solution was to ban credit default swaps and remove the one market pricing mechanism which alerts investors to rising sovereign credit risk.

Incidentally, this is a minor trading point…but worth thinking about…who is on the other side of all the credit default swaps underwritten on European debt? Remember it was AIG that collected premia by writing default insurance against sub-prime mortgage backed securities and collateralized debt obligations. Goldman, among others, bought that insurance.

If you were a handy speculator right now, you’d find out who sold default insurance on Greek and Spanish debt. And then you might consider shorting the daylights out of them.

Of course maybe the ECB really has solved the problem by throwing a wall of fake money at it. But we reckon yesterday’s action gives you fair warning about what’s ahead and a bit of time to do something about it. A massive monetisation of debt and an increase in public sector liabilities has now been set in motion. The euro itself will soon, again, become a target of speculators once the next major tranche of sovereign debt must be rolled over and there’s no one but the ECB there to buy it.

How long can Europe pay its bills and creditors with money that doesn’t exist?

But the buried item in yesterday’s news reveals that the U.S. dollar might be on the hook too. The Fed re-opened its swap lines with major banks around the world. This means the Fed will be expanding its balance sheet again…and sending a flood of dollars out into the world to shore up banks that need them. The Fed had closed the swap line with the ECB in February, when everything was just fine.

To the barricades, dollar standard! But this really could be a kind of last stand for the dollar as the world’s reserve currency. Unbeknownst to the American taxpayer, the Bernanke Fed has now thrown the dollar once more into the breach of a liquidity and solvency crisis. It may not survive.

That’s what you should watch for, then: the expansion of the Fed’s balance sheet. It will be hard to keep your eyes on that target with so many green numbers on so many shares and indices. The ECB has invited the entire financial world to speculate on the house. The ECB’s monetisation — with the Fed’s cash — is going to lead to a quick reflation of some markets; that’s for sure.

The biggest inflation, though, could come in precious metals. In fact, as a hedge against the central bank monetisation strategy, precious metals are about the only sensible speculation in a market which has essentially been reduced to total speculation by the distortion of values from the flood of money.

Things that can’t be printed by a central bank and aren’t anybody else’s obligation to pay might be the best investments for the rest of this year. And beyond?

The Welfare State has met its great funding crisis with a fraud. And the fraud is going to cost a lot of people a lot of money. If you’re in markets now, be aware that markets no longer bear any relation to underlying risk or reality. It’s never been more dangerous. And given the last few years, that’s saying something.

Regards,
Dan Denning
Daily Reckoning Australia
Whiskey & Gunpowder

May 13, 2010

Debt to Break the Back of the Welfare State was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Just like poor Pip Dickens’ Great Expectations, central banks keep inheriting unwelcome bequests.

Today’s “legacy assets” are toxic derivatives; a decade ago it was gold reserves. Both are proving hard to shrug off, but for very different reasons. Both legacies also come thanks to previous central-bank history; the fossils remain only too livid today.

And 10 years from now, if not sooner, just how welcome will the current central bank must-have become – freshly printed government debt, bought with money that doesn’t exist until the central bank wills it?

Seeking first to defend against inflation and war, the West’s central banks built up huge reserves of the ultimate hard money –gold bullion– during the early-to-mid 20th century. Long before the turn of the millennium, however, these hoards grew to look quaint and expensive. Unyielding and relatively useless to industry, gold simply sat there, down in the vaults, costing money to store but returning no interest.

Who needed crisis-proof gold when Western Europe (if not the Balkans or Mid-East) was enjoying its first generation of peace-time in history? And who needed fine gold when the Nasdaq index of tech stocks was priced for 20% annual earnings growth over the next decade and more?

In short, who needed gold when we’d got Alan Greenspan, as the New York Times asked in May 1999. “The argument against retaining gold is that its day is past,” wrote Floyd Norris with uncanny timing, just two days before Gordon Brown’s Treasury announced its ham-fisted sale of half the UK’s gold bullion hoard.

“Once it was useful as a hedge against inflation that would hold its value when paper currencies did not. Now financial markets have their own sophisticated ways, using exotic derivative securities, to hedge against inflation.”

You could butter your toast with the irony. But it wouldn’t taste sweet or provide much nutrition. Whereas a further glance back at history might.

“With huge gold stocks available for sale, [governments] may discourage excessive price increases but naturally do nothing to prevent sharp decreases,” reported an investment piece for Medical Economics published in October 1977. (Our thanks to the author for finding and faxing it to BullionVault this week.)

“The government specter [over the gold market] can’t be expected to disappear quickly,” F.D.Williams continued, some 32 years ago. “Gold will continue to be part of many national reserves for a long time. The stocks are so large, they can’t all be dumped at once.”

Compare and contrast with today’s unwanted bequest – those toxic derivatives the US Treasury chooses to call “legacy assets” as if it played no role at all in producing them. Unlike state-hoarded gold, it only encouraged their creation; it didn’t want to look after the damn things. And quite unlike the market for state-hoarded gold, a ready stock of willing mortgage-bond buyers also looks unlikely to gather.

“The PPIP, which was beset by multiple delays as regulators tried to figure out the best means of removing many of the troubled assets from banks’ books,” as CNN reports, “is still not up and fully running yet.” It’s not been for lack of incentives. The $2 trillion Public-Private Investment Partnership, announced to much fanfare in March, offers huge leverage – entirely at tax-payer expense – plus some or other hold-to-maturity value to risk-cushioned investors, albeit as yet unknown. Private investment groups can use up to $1 of non-recourse loans, plus another dollar of Treasury finance, for every $1 they spend on taking toxic housing derivatives off the banks’ busted balance-sheets. Yet as a report published this week by the Congressional Oversight Panel put it:

“Whether the PPIP will jump start the market for troubled securities remains to be seen. It is also unclear whether the change in accounting rules that permit banks to carry assets at higher valuations will inhibit banks’ willingness to sell. Similarly, it is unclear whether wariness of political risks will inhibit the willingness of potential buyers to purchase these assets.”

Funnily enough, as the US authorities struggle to sell toxic debt, Western Europe’s Central Bank Gold Agreement has also stalled in 2009. This comes, however, despite prices and private-investor demand both holding near record levels. First signed ten years ago this September, back when no one at the New York Times, Economist, Financial Times or big central banks could see a use for the metal (simply owning this secure, liquid store of value is use enough, by the way), the CBGA capped annual gold sales and made them plain in advance for the coming five years. It aimed to avoid a repeat of May 1999, when the UK Treasury’s announcement drove prices down to what then proved their floor. In contrast to Washington’s PPIP, however, central-bank gold sales weren’t arranged in the hope of achieving maximum price, but merely curbing a rush for the exits instead. And as it is, they needn’t have bothered.

Gold prices have since risen three-fold and more against all major currencies, even while the 16 signatories to date sold almost one-fifth of their hoard in aggregate. Thus gold’s weighting in their reserves portfolio has doubled regardless, rising as gold outperformed all other assets from the start of this decade.

Hence the dramatic slowdown in central bank gold sales since the financial crisis began in August ’07. Because it’s tough selling gold when its use becomes so clear, so present. Here in the fifth and last year of 2004′s renewed CBGA, “Net central banks sales likely to be in the order of 140 tonnes this year, down from 246 tonnes in 2008,” reckons London market-maker Scotia Mocatta. Yet the annual ceiling for CBGA sales currently stands at 500 tonnes!

The new agreement – just signed and due to commence on Sept. 27th – tips its hat to the facts, reducing that limit by one fifth. But who’s left to sell any way? Just as in the gold mining sector worldwide, the “easy metal” has already gone from West Europe’s vaults, pretty much emptying Spain, the UK and those excess Swiss holdings which maintained the Franc’s 100% gold-backing until the turn of this century. The two largest holders, Germany and Italy, continue to face down political calls for “mobilization”, refusing to yield one ounce so far despite signing all three agreements. France, the third largest owner, has pretty much sold the 600 tonnes from its hoard announced when it joined the central-bankers’ Cash4Gold party in 2005. That leaves only the International Monetary Fund’s 400-tonne sale, hardly enough by itself to meet the next half-decade’s 2,000-tonne limit.

Back at the Federal Reserve, meantime, tomorrow’s central-bank legacy – of freshly printed Treasury bonds bought with magic money from nowhere – continues to swell. Yes, the Fed’s stockpile of T-bonds may be smaller today than it was back in August ’07 before the Great Inevitable broke, thanks to record Wall Street demand for the safety of Washington’s debt. And yes, the Fed isn’t quite collecting new bonds from the Treasury door directly, waiting instead a few days or so before picking them up (as Brian Benton, Chris Martenson and others have found) from those primary dealers who do bid at auction, rather than out-and-out monetizing the debt for all to see with its newly created cash.

And sure, private-sector demand for Treasuries continues to look so strong right now – what with overnight rates at 0%, plus the ongoing collapse of house prices, world trade and jobs creation – that the Fed says it will stop financing Uncle Sam’s spending in, umm, October rather than in September as previously stated.

But hoarding gold looked rather more sensible amidst the violence and misery of the mid-20th century, and no one at the Fed or Treasury guessed two years ago that they’d be offering leverage incentives to try and revive the market in mortgage-backed derivatives. When the global economy gets off the floor…or risk assets become more attractive to private investment…or China and Japan find they really don’t have any space left for US debt in their central-bank vaults, the market into which the Fed will want to sell its Treasury hoard will look very different to the market from which it’s currently buying.

Whether a decade from now, in 2010, or perhaps this fall – when the $300 billion of quantitative easing ear-marked for Treasuries is spent – trying to quit the Fed’s newest “legacy asset” could prove tougher even than finding ready buyers for today’s toxic junk. And given the soaring interest rates and potential US bankruptcy that in turn might trigger, spurred by whatever’s added to the Treasury’s $11.7 trillion of debt between now and then, perhaps buying gold will look a smart move to the Western world’s central bankers once more.

Regards,
Adrian Ash
BullionVault

August 18, 2009

Gold Will No Longer Be a Toxic Derivative to Central Banks was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.