The gold price is now down 17% YTD and clearly questions are being asked about the viability of the gold bull market.  Even more worrying should be the FY 2012 financial numbers for the big miners.  Using the Bloomberg function FA, you can get a quick look at the financial numbers in a basic form.

The Free Cash Flow numbers for 2012 for the other top producers were:

Newmont………..-838.00

GoldCorp……….-511.00

Kinross………….-623.00

Agnico Eagle……250.45

Yamana………..-379.94

The average gold price for the sales of produced gold in 2012 was approximately $1650 per oz.  You don’t have to be a rocket scientist to understand that if the gold price is at $1400, as it is currently, then each of these miners are going to be producing at a loss.  Last year we wrote a blog, Gold and Silver Mining: A Post Mortem, which highlighted the increasing costs which were crushing margins.

Well, those margins are negative now and, even if gold stays at the current price, the margins are likely going to get more negative. Some inputs like oil have fallen as well which will help, but most are increasing as inflation pressures remain.  These companies are mining finite assets – they are not cyclical firms managing their business at the bad point in the business cycle looking to survive until the economy brightens.  Mining all your reserves at a loss is clearly a rather fatalistic and bad business plan.

We have seen hundreds of mining executives over the years.  They are a fantastic group of people working in often atrocious, dangerous conditions. Despite the numerous ‘unforeseen’ disasters in the whole mining process from discovery to production, they remain incredibly optimistic about their own project.  No one expects their project to be delayed or nationalised. No one expects to pay $8 billion for an asset 3 years ago and write down $6 billion already.  Most have not appreciated how much bull markets make geniuses out of idiots – not that they are idiots – but that they might be well served to be more pessimistic. To expect massive overruns on budgets and permitting times. To expect huge problems with First Nations minority groups or complex metallurgical problems. This is the norm in the mining business and not freak one-off problems.

In the late 1990s, when the nominal gold price was much lower, costs were much lower as well, and arguably margins were slim-to-negative then too. The decision taken at that time was to hedge forward production to lock in a profitable margin, no matter how wafer-thin that was.  They were helped by the high interest rates of the day. With Fed Funds at 6-7%, the forward contango price curve of gold prices was severely steeper than today. Today, the 3 year gold forward price is only 2% or $25 per oz higher than spot.  If hedging was an incredibly bad move 10-13 years ago with a steep contango, then it is a dead cert way to the poor house today, locking in a 100% guaranteed loss. Of course your bankers might insist on it for new finance etc, but doesn’t mean it’s smart.

Is there a Plan B? Mining company CEOs need to face up to reality.

Costs are greater than revenue at $1400 per oz gold. No matter how much we might delude ourselves that cash costs are $800 per oz and  all-in costs are $1200 per oz: they are not. If they were we would see free cash flow.

Do not even think about hedging the gold price at these current levels. It is locking in a loss, one that will probably grow over time;  it is akin to slavery.

As ridiculous it might sound , I believe that the only solution, apart from praying that the gold price goes immediately to $2000 per oz is to wind down production.  Others might suggest warehousing gold to restrict supply coming on to the market. Whether intentionally or not, production will start to drop as smaller mining companies will fold. There are allegedly 1000 mining companies on the TSX index with less than $200k in the treasury.  The most power that the big mining companies have in order to try and survive this debacle is to reduce production in any feasible way and stop supplying the physical market.  This should not only be done but should be shouted from the roof tops.   We need to hear words to the effect of: “We cannot produce gold profitably at these levels so we are stopping and saving our prize reserves for another cycle”.

It may not work in stopping this current rigged market rout but it has to be a better idea than hedging your way to self-inflicted penury.  The at  least the mining industry could hold its head up high and be in the driving seat, rather than getting mugged off by the market manipulators.

Crises are not often seen or predicted prior to the event. Despite the world now full of “experts” who fully predicted the 2007-08 crisis and hundreds of books on the matter, there were very few real visionaries. Most if not all of them were much maligned at the time and often dismissed as crackpots.

This recent article on Seeking Alpha shows the current state of play with the so-called black swan funds declining in AUM rapidly. The VIX volatility index tells the same story. Plain sailing ahead, no crisis in sight. Bernanke, Draghi et al have it all worked out and will protect you no matter what.

I do like the real definition of a black swan event.   It is a risk so small as to be inestimable. It is not the risk of dying when your main and reserve parachute fail to open as you fall to the ground, it is the risk of dying when you are playing golf when a parachutist lands on you after his two parachutes have failed.

I expect to be maligned and dismissed as a crackpot for this forecast. The imminent (less than 2 years) arrival of very high inflation whether it be described as hyperinflation, only the history books will tell us later and with it the investor reaction to demand an inflationary premium on fixed income assets.  The potential for an interest rate rise so catastrophic it will bring the house down.

The ability of rates to rise will depend on the central banks buying power. While sovereign base rates will remain anchored at the zero bound, anyone who can remember the 1994 bond market debacle will remember how steep the money market curve can get when there is a true duration shed. In extremis there are two basic stages to an inflationary scare in bond markets.

1. A very steep curve if the central bank remains static.
2. A much shorter curve as the market for long dated paper stops trading.

So when you wake and you pull up the US bond curve on your Bloomberg and it only goes out to 5 years you know you are in trouble, no matter how well they have rescaled the graph.

For all the deflationists, can we just agree that at some stage of money printing through balance sheet expansion, that cannot ever be reduced, we can create inflation. The fact that it hasn’t happened yet is not a good argument. Anyone who has played the children’s game “Buckaroo” will grasp this. (The game involves gradually adding weights to a spring loaded donkey before it bucks and everything falls off, the proverbial binary tipping point). If we increase the monetary base by another $20 trillion dollars hyperinflation will no doubt result. This is the current state of play and projected expansion.

In Japan last week the latest entry roared into the money printing arena and the Nikkei continued its dizzy ascent, now up 50% in the last 6 months while the yen currency weakened almost to the psychological 100 level. Money printing and inflation are extremely good for stocks and the Nikkei could continue benefit exponentially. What seemed to receive much less attention was the 3 point sell-off in 10 year JGBs.

Did someone finally say “ Hey, if you are trying to do everything you can to get at least 2% inflation which could potentially overshoot dramatically, I’m not sure these 10 year bonds at 0.315% are that good value!!!!”

While less dramatic in point terms than the percentage change in yield, as illustrated below, I think we can agree it’s rather concerning to have a 3 point move in a day when the last 2 years range is only 5 points. At the minimum, these are not good for the short gamma trader’s trousers.

Now let’s take a look at inflation. Here is a chart of the official US CPI levels versus original unbastardised CPI levels (Shadow Statistics data) which reflect the level of inflation we all actually experience.

Or a more tongue-in-cheek James Bond Index that we created recently, the cost of going to see a James Bond movie, arguably provides a very similar experience over the years.

Inflation has been overly debated but the general consensus being that everyone thinks their inflation rate is much closer to Shadow Statistics number than the official CPI. Clearly when a tremendous amount of government liabilities are index-linked, the more cynical of you might argue that making sure official inflation numbers are as low as possible serves a real purpose. Of course there must be some people who might believe the low official inflation number just as there are people who believe in Father Christmas.

As financial repression currently forces savers to hand over their hard earned cash at negative real interest rates, it also has allowed borrowers to finance themselves at very low rates. Sovereigns, corporates and individuals are merrily enjoying the cheapest financing in history with no obvious concerns that rates will ever not be abnormally low.

If variable mortgage rates go to 2007 levels, it is arguably that most homeowners will be unable to pay.

If companies have to finance at those levels, it is arguably that most will be unable to run a profitable business.

If governments have to finance at those levels, clearly the default template is in play.

Clearly we/they (the powers that be) need to keep rates low to avoid that unthinkable scenario.  How do they achieve this?

1. Reduce the need to issue new debt by reducing the deficits. Hmmm. More chance of being killed on that golf course by the parachutist???
2. Have the central bank buy all the new net issuance so no floating supply to spill over looking for a home. Not exactly a long term game plan but ever so marginally better than putting your head in a sandy bucket.
3. Impose controls on domestic sales of bonds, require minimum holding percentages, forbid short sales and all the usual tricks of the financial repression trade.
4. Keep denying that inflation is ever greater than 2% constantly reminding yourself of that famous Woody Allen infidelity sketch. Deny, deny, deny and deny again…

In these days of increased regulation, I have had to do a couple of finance exams recently and I noticed one of the questions was about the perceived risks in finance.

1. Credit risk
2. Settlement risk
3. Liquidity risk
4. Market risk
5. Operational risk

As the black swan funds bleed premium into the volatility abyss, I couldn’t help thinking that maybe we have all become overly focused on all the risks above apart from actual market price risk. Is the chance of a rapid 5%+ back up in rates really zero?

The endgame would not really surprise anyone. We have massive debts with not enough growth to repay them.  We are having a huge money printing attempt to promote growth and inflate debts away, artificially holding interest rates down.  Some markets soar on the new liquidity. Eventually we reach a tipping point where capital at 0 percent becomes scarce and rates sky rocket higher.  During this huge period of market volatility, there will be large wealth transfers as failures, confiscations and asset price changes occur.

But strangely we all hope that this is not the case but secretly we know it is the most likely.

Let’s just have another look at that JGB chart.

The ECB has threatened to withdraw ELA from the Central Bank of Cyprus on Monday if a deal has not been reached. If this is the case, and the required two thirds of the ECB board vote to stop Cyprus’s ELA, then other eurozone banks will be ordered to cease the transfer of reserves to Cyprus, and not to recognize any reserves received from Cyprus as euros. Cyprus, at this point, will be the first country to leave the EMU.

Cyprus is a miniscule 0.2% of eurozone GDP and, in absolute terms, the numbers do not look too scary (in the context of this crisis – however, on any ‘normal’ scale they are still truly ginormous amounts of money). According to BIS data, as of the Q3 last year, European banks had €31 billion of exposure to Cyprus; most of the major eurozone countries individually have less than €2 billion exposure each. Even Germany’s exposure is under €8 billion.

However, it is the contagion effects that will be difficult to gauge, whatever the outcome to the crisis. If the levy on deposits is restricted to uninsured depositors, then this would not preclude the flight of uninsured deposits – nominally those over €100,000 – in other eurozone countries. Narrow money would likely collapse, catastrophic for economic growth, and TARGET2 imbalances – that record the theoretical debtor/creditor status of each country in the eurozone – will grow much larger, with Germany becoming a significantly bigger creditor than it already is, and the periphery countries the corresponding debtors. These imbalances, it must be remembered, are no longer theoretical if the EMU breaks up.

One likely solution for the Cypriot banking crisis is the creation of a Scandinavian style good bank-bad bank, the good bank containing mainly the insured deposits, those under €100,000, and the bad bank containing almost everything else. The good bank can hopefully operate as a normal, well-capitalized entity, and the bad bank is recapitalized with whatever Cyprus can conjure up, perhaps government-guaranteed natural gas bonds, promising a share in some of the future profits from this source.

We have often read that what is happening in Cyprus, and what will probably have to happen, is unprecedented. This is not the case. One of the more recent examples, aside from the Sweden and Norway instances, of this resolution was the Bradford and Bingley building society in the UK in 2008. B&B suffered from wholesale deposit flight, thus the regulator deemed it necessary to withdraw the building society’s status as a deposit taker. All depositors were protected, however, with this part of the business being separated from the mortgage book, personal loan book, etc. The latter assets and liabilities were taken in to public ownership, given government guarantees, and wound down over time. Most people in the UK have probably forgotten about the rescue of Bradford and Bingley, but this is precisely because it worked.

However, the parallels with Cyprus are obviously inexact. The whole banking sector in Cyprus is in need of bailout, and the banking sector in aggregate is many times bigger in relation to GDP than in the UK. Furthermore, the composition of liabilities in Cypriot banks are different, heavily skewed towards deposits, and large chunks of these are of dubious provenance, mainly Russian. Nevertheless, there are many extant templates for how this sort of fix might operate.

The Icelandic solution has also been mooted as a template for Cyprus. Iceland, too, had a banking system that was too big to save. With no institution like the ECB breathing down its neck, and coercing it to assume the debts of its broken banks (as it did with Ireland), Iceland cleaved off the bad assets from the good assets, told foreign creditors – including many depositors from the UK – to go hang, introduced capital controls to prevent flight of money, supported the poor, and implemented only very reduced austerity measures. As a result, Iceland took a sharp hit to growth up front, but now is back on the path to sustainable growth. Iceland took the view that the banks were not sacrosanct, and deemed it unfair to bail-in taxpayers to rescue them. As Olafur Grimsson, Iceland’s President, put it at Davos, “Why do they [the Western democracies] consider the banks to be the Holy Churches of the modern economy?” We couldn’t agree more.

However, one thing Iceland was able to do to help rekindle the fires of growth was allow a 50% devaluation of its currency, something Cyprus will be unable to do as long as it remains in the euro. It may be beneficial, in fact, for Cyprus to leave the euro and follow the Icelandic path. This would probably be the case for Greece too. Departing Europe, defaulting on debt, and devaluing the (new, post-euro) currency is quite possibly the shortest route to a return to prosperity. However, the political elite in both countries will do their utmost to prevent this happening, thus drawing out the pain.

As long as capital controls remain in place in Cyprus, this will prevent a bank run as soon as the extended bank holiday comes to an end. Yet bank runs, like bank-splits, are nothing new either. We have seen one in the UK as recently as Northern Rock in 2007. Going back further in time, to 1720, the Bank of England itself faced a run. The Bank had reneged on a promise to absorb bonds of the South Sea Company at a certain price. A run was imminent, so the Bank managed to organize its confidantes at the front of the line. They were paid off, as slowly as possible, in sixpence coins. The same confidantes then went to another door at the Bank and paid the cash back in, again slowly counted. It was then again paid out. This process was enough to prevent a run until the holiday period, beginning on Michaelmas. By the time the Bank reopened, confidence had returned and a run was averted. Thus history shows that the authorities will stop at no measure to achieve their ends.

We wait apprehensively for the outcome in Cyprus. A few things, however, are highly likely. Capital controls will be put in place, uninsured depositors will take a haircut, and nominal GDP will collapse. Contagion effects of at least some magnitude will occur, with deposit flight in the periphery countries causing narrow money to contract, and thus growth in the eurozone will struggle to retain any, frankly non-existent, momentum. Moreover, financial imbalances between the core and periphery countries will increase, after recently showing some signs of improvement.

Whatever is decided – and as we write this a bailout solution within the EU framework is apparently hours away – will likely not be the best solution for Cyprus as a whole and, if they do remain in the EMU, there will be no concomitant currency devaluation to help regain competitiveness quickly.

Once again, the question of the survival of the euro has come into view. That the catalyst has been a seemingly innocuous country such as Cyprus does not fill one with confidence given the much larger, and much less tractable, problems Europe will eventually have to deal with. It looks like there will be plenty more horses heading to the glue factory.

The Window Tax was introduced under William III in 1696. At the time, windows were a luxury, and it was likely the number of windows in a property would be in proportion to the size of the property and thus to the wealth of the owner. It was this seen as a progressive tax and a prototype to income tax, introduced 146 years later by William Pitt the Younger. Nevertheless, the tax was unpopular, and avoidable if windows were bricked up, as many were (and one can still see many examples of windows that were bricked up for this reason in London today). Indeed, the term ‘Daylight Robbery’ is thought to have its provenance in this era. The Window Tax lasted 156 years until 1851.

As Brad Pitt in the movie Joe Black would say, the only guarantees are death and taxes. There is nothing new in monarchs and governments finding novel and ridiculous ways to tax their populace to fund their overspending. Likewise the serfs will continue to change their habits to reduce their tax liabilities. Anyone who believes that there is anything substantially different from the proposed Mansion Tax to that of a window tax is likely so deluded that they should be a top parliamentary candidate for the next election.

“I contend that for a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle.” – Winston Churchill.

As the old adage goes, “How do you get rich?”. The answer: “spend less than you earn and invest wisely”.

Unfortunately the UK like most developed countries is taking the other path, spending more than we “earn” in tax revenue and heading towards de facto bankruptcy (although as we know, with the printing presses always at the ready, this would never happen in name).

Source: McKinsey

The media is full of talk of the austerity measures being taken to address our growing indebtedness, By now it should be evident – even for a politician – we are not actually cutting spending at all in net terms. We are merely hoping and praying that growth can return to sky high pre-crisis levels to improve the government debt to GDP ratio. As an old colleague used to say, the chance of this happening are “slim to none and slim just left the building”.

We are, in fact, focusing most of our efforts on the taxation side of the government costs-and-revenues ledger; this is the main discussion point of this article.

Politicians and the futility of over taxation

“A liberal is someone who feels a great debt to his fellow man, which debt he proposes to pay off with your money.”- G.Gordon Liddy.

Nick Clegg, Vince Cable and Ed Balls et al, I ask you to please put your coats on and start walking down that long passageway opposite which seems like a million miles long. When you get to the end please take a right turn and walk for another million miles. At the end you will find a door, open it and pass through. You have finally arrived in the REAL world.

In the real world, most people are going about their daily lives trying to provide for their families, paying the mortgage, the gas bill, for the food on the table and a modicum of leisure consumption, made possible by receiving a wage in exchange for services provided. Butcher, baker or candlestick maker you struggle to get that wage. Obviously this line of reasoning falls down somewhat when you possibly include many government workers who not actually having held down a genuine, private sector job, are entirely unversed in the matter of having to deliver on time, to a tight budget, in a competitive market place and have little concept of how razor sharp the boundary is between taxable success and tort-racked failure. (Hat tip to Sean Corrigan at Diapason Commodities.)

For most the wage received is already after income tax and national insurance tax. The paltry remainder is then taxed through any multitude of ways in indirect taxes, on consumption of food, beer, driving or fuel. On the investment income or capital gains of any business you run, you pay tax, and then finally you pay death duties. Take your pick.
• Working: Income tax, national insurance, business rates, corporation tax
• Investing: Capital gains tax, dividend tax, unearned income tax
• Living: Council Tax, stamp duty, landfill tax
• Travelling: Air passenger duty, fuel tax, vehicle tax, toll taxes, customs duty
• Consumption: VAT, betting and gambling, alcohol tax, tobacco tax, insurance premium tax, climate levies
• Dying: Inheritance tax
Paying taxes has never been popular of course but in most countries there is, or at least was, a general consensus that we were paying for the services that the country provided us. Healthcare, a police force, an army, and infrastructure, all come to mind. We don’t need to go further than that to start the discussion.

So most people justifiably feel that they are getting short changed on the deal, paying more and more tax and receiving less and less in return. Some might feel they are getting short changed and subsidizing some of the less efficient areas of the public sector. (They might have a point, see charts below.) No wonder there is a tendency to ‘avoid’ tax.

Source: Centre for Policy Studies

A negative effective tax rate means that you receive more than you pay and the percentage reflects the amount, ie -20% means that you receive 20% more income from the government than you pay in tax. As we can see, the proportion of households with negative effective tax rates has risen steeply in recent years.

Source: Centre for Policy Studies

There used to be a clear divide between legally ‘avoiding’ tax and illegally ‘evading’ tax. This seems to have become blurred and that anyone who tries to avoid paying tax in whatever way stands the risk of being named and shamed by HMRC. (Apparently HMRC, after thoroughly investigating the comedian Jimmy Carr’s legal offshore structure and realising that they were unlikely to be successful in court, leaked it to the media. Most legal tax avoidance schemes like the Employee Benefit Trusts or the Enterprise Zone investments were all given tax-free status in the past for reasons that seemed relevant at the time. If they no longer fit in with the ex post “moral tax code” that is applied today, change the law – but not retrospectively – and move on.

There are two basic concepts in tax collection: the optimal amount an individual can be taxed, and the optimal amount a populace, in aggregate, can be taxed.

The Laffer Curve

The Laffer Curve is a very simple construct that demonstrates the relationship between possible rates of taxation and the resulting levels of government revenue. In basic terms it suggests that no tax revenue will be collected if the tax rate is 0% and 100% (if people could choose whether to work or not) and that theoretically there must be at least one rate where tax revenue would be a non-zero maximum, based on the rational choices of individual tax payers.

The Total Tax Potential

The chart above shows us that the total tax as a percentage of GDP only varies for the most part between 33-38% irrespective of the “low” or “high” tax regime of the current governments. So it is clear, from a macro perspective, that it is difficult to extract more than 38% from the economy even with quite punitive tax rates.

Clearly tax collection is a very slippery customer for the very simple reason that people change their habits with changing tax rates and with the resulting change of residual spending money.

In the following chart, we can see the breakdown of how much tax in the UK is collected in each category. About one third of total government receipts come from income tax, with National Insurance Contributions the second single biggest contributor.

Robin Hood

On the subject of raising tax revenue to reduce the deficit, it is a good time to ask if that is what we really want.

How much are we focusing on a sensible tax policy to generate growth and revenue and how much are we using the tax system for more sinister aims?

In Ayn Rand’s famous novel, “Atlas Shrugged”, (Mr Clegg, please order a copy), the most despised person after the government is Robin Hood. The hero of English folk-lore; how could that be? In the novel, Robin Hood is not thought of as robbing the idle, evil rich to feed the deserving poor. He is robbing the productive wealth and job-providing rich to feed the non-productive government largesse and the non-productive benefit-entitled poor.

“…He [Robin Hood] is held to be the first man who assumed a halo of virtue by practising charity with wealth which he did not own, by giving away goods which he had not produced, by making others pay for the luxury of his pity. He is the man who became the symbol of the idea that need , not achievement, is the source of rights, that we don’t have to produce, only to want, that the earned does not belong to us, but the unearned does….”

Left wing politicians have used the banner “tax the rich more to give to the needy poor” as a vote winner for decades. It has great popularity with the masses – of course the rich should pay more, it stands to reason.

“A government which robs Peter to pay Paul can always depend on the support of Paul” – George Bernard Shaw

But is this really what we want to have, do we really want to tax the rich even more when they are the employers and wealth creators of economic growth?
So a better question might be this:

“Do you think that the rich should be taxed more than the poor?” YES, of, course.

“If that means they can’t expand their businesses and employ you, is it still a resounding YES?”

Let’s return to the Mansion Tax and challenge its Robin Hood-esque proposal. Everyone knows that one should take into account the annual “upkeep” of a property in considering a purchase. Service costs or land maintenance costs – they all go into the equation. A large country house with 3 acres of land may cost substantially less to run than one with 100 acres.

We can view the proposed Mansion Tax as just another upkeep cost and ask what would be the most obvious and realistic assumption if a 1% tax was applied on all property over £2million.

• All property marginally above £2million threshold would no doubt drop below it as has happened with any binary cut off
• All property reasonably above the threshold would have to factor in the new “carrying cost”, assuming people purchase property on affordability whether it be £200k or £3million (even Russian oligarchs can be price sensitive)
• The new tax collected from disposable income would have to be offset against what it would have been spent on otherwise, and the tax collected in somewhere else

Business assets often trade at 10x cash flow. So if you reverse that logic as an asset charge, a 10% drop in property prices is a distinct probability, although unlikely to be linear. If property prices drop 10%, all stamp duty collected on purchases in the future will drop by 10% and as people will have to find the disposable income to pay the 1%, they will have less money to be taxed elsewhere. Go back to the chart on total tax potential, earlier. There is an empirical limit to how much a government can extract taxes from an economy.

A totally unrealistic fairy tale assumption would be:

• It costs virtually nothing to administer and collect this new Mansion Tax.
• All property prices remain at the same levels or rise
• The 1% tax is paid for by the unlimited disposable income that the home owner has
You may laugh, but there are undoubtedly some deluded fools in the government who really believe this. In Blackadder Goes Fourth, the classic BBC comedy, the hapless Baldrick asks what was wrong with the grand plan for averting WW1. Captain Blackadder replies, “Ah the plan, Baldrick . . . . . . . . . . it was total b****cks”.
So let’s admit it, it’s unlikely it will collect much tax, indeed, it could even be a net cost. It is a pure Robin Hood rich-bashing tax in a vain attempt to get more votes.

Benjamin Disraeli, the great 19th century British Prime Minister, once said, “Statesmen think of the next generation, politicians think only of the next election”. I don’t see many statesmen from where I am sitting.

A bail-in takes place before a bankruptcy, and involves losses being imposed on bondholders, something that has rarely taken place throughout the GFC and euro crisis. In fact taxpayers (the government) have consistently bailed-out the private sector in full. The Cypriot bank rescue is no exception, except this time there is a bail-in and ironically again not of bondholders but of the depositors first. This is a direct contravention to the usual legal claims on the capital structure.

So there you have it – on Friday 14^th March Cyprus became the 5^th country to receive an EU bail-out (in), except this one was a bail-in but one with a significant and severe twist of fate. The Cypriot government in Nicosia is scheduled to vote on a EU bail-out plan which calls to extract a “tax” on bank depositors (savers) some €5.8 billion: 6.75 per cent for anyone with less than €100,000 in a Cypriot bank account, 9.9 per cent for anyone with more than that.

This is an unprecedented assault on individual property rights and every individual in the developed world should take notice, and far from stabilising the eurozone, the bail-out likely heightens contagion risk across the EU.

Why bother holding a bank account when your government can expropriate your savings? Far from containing a bank run in Cyprus it will exacerbate it, absent capital controls, and likely begin significant depositor flights across the European periphery.

These events I believe signify one of the most alarming developments in the Eurozone crisis and by dint the global economy since the financial crisis began.

Cypriot Disputes and Levies

For a sovereign entity so small, Cyprus is a country that has had more than its fair share of international controversy and disputes. Cyprus has a long and convoluted history with the British, Turks and Greeks, whose tensions have wreaked havoc across Europe over two World Wars. This weekend marked yet another period of disquiet in the history of this troubled island.

Cyprus is reeling from an oversized and ailing banking system.  Technically bankrupt, domestic banks stand at €126.4 billion in size, or over 7 times the size of the economy.  Without a bail-in, depositors would be wiped out and Cyprus would undergo economic collapse, bringing along with it all the attendant social misery and deprivation of a depression.

Ironically Cyprus is no stranger to levies.  The British extracted taxes in the 19^th century to cover the compensation they owed to the Ottoman Sultanate, who had conceded the island to the British.

In 1878, under the Cyprus Convention, the Cyprus became a protectorate of the British in a secret agreement between the United Kingdom and Ottoman Empire. The Greek Cypriots believed the British would eventually help Cyprus unite with mother Greece, just as with the other Ionian Islands. The indigenous Cypriots believed it their natural right to reunite the island with Greece; after all the very first census showed the population was comprised of 74% Greeks and 24% Turks.

Fast forward half a century and most of us over the age of 40 refer to the Cyprus dispute as that of the conflict between the Republic of Cyprus, and Turkey, over Turkish-occupied North Cyprus. My knowledge of the origins of the Cyprus dispute is a little sketchy but as I understand it, the dispute originally was born out of the Cypriots’ desire for self-determination away from the British Crown, which had unlawfully declared itself the constitutional ruler after Greece failed to fulfil its WWI obligations to invade Bulgaria; in return the Republic of Turkey recognized British rule of the island.

Eventually this colonial dispute became an ethnic one between Greek and Turkish islanders and their respective mother countries. In 1974 Turkey invaded Northern Cyprus and declared unilateral independence, as well as itself a sovereign entity – the Turkish Republic of Northern Cyprus – but has never received UN and international recognition. There has been a UN no-go zone buffering North and South ever since.

Another irony of the day was that in return for the British protectorate the Ottoman Empire received military support against Russia in Asia. As I will cover later Russia has been integral to the demise and now the future well-being of Cyprus. Another legacy dispute that has compounded the Cypriot collapse was their adherence to Enosis. This refers to ‘the union’, literally speaking, of the Greek-Cypriot population to incorporate the island of Cyprus into Greece.  Observance of this tradition led the Cypriot banks to misguidedly purchase vast amounts of Greek sovereign debt before and during the euro crisis. Cyprus became a casualty of the Greek’s very own bailout restructuring. Oh the irony again.

Creditor Structure

Bank depositors by now will have realised that bank deposit guarantees are not worth the paper they are written on and the legal precedent to label this confiscation of assets as a ‘stability levy’ or tax has no doubt been framed as such so as to circumvent EU deposit guarantee law, which this levy clearly violates. This is stealing – period.

Every saver in Italy, Spain, Portugal, but not limited to these countries, as it potentially applies to any saver in northern Europe and the UK, are at risk of a confiscation of their hard-earned money.  We will likely see depositor flight from the periphery to the supposedly more robust surplus countries – principally Germany. This is despite the very large outstanding Target2 balances owed Germany by the periphery, but don’t expect the man in the street to be aware of this fact.  This is unfortunate as some progress was being made in the reduction of Target2 imbalances as deposits in the periphery showed renewed signs of growth.

The Troika has run roughshod over the rule of law. By calling for a universal bail-in of depositors (the securest part of bank capital ladder) before extracting money from shareholders, junior and subordinated bondholders, the EU bureaucrats and IMF have unilaterally ripped up the legal framework for property rights. This is a truly worrying and frightening progression – actually regression – in economic freedom.

At Hinde Capital, we have no issue with uninsured depositors contributing to the bail-out of a banking system, even as unpalatable and clearly undesirable as this would seem.

Unfortunately bank depositors (savers) have long been under the misguided impression that they are potentially immune from a bank collapse, with the State providing a safety net in the form of deposit guarantees up to a declared sum.  I would argue that individuals, partly due to government propaganda in the good times, have long since forgotten – or indeed have never understood – that once you deposit your money into a bank, you give up your right to ownership, ie, It’s a LOAN! An asset which is lent out multiple times as is the agreed practice under fractional reserve banking, clearly has a risk of no return, albeit a seemingly a low risk when confidence and trust is high in the economic system.

In truth the correct order of claims on the creditor structure in this ‘bankruptcy’ proceeding has been largely ignored as the Cypriot banks have such a small sliver of equity and debt, and have an unusually large depositor base.  It is the involvement of the depositor base that turns this whole debacle into a plot of immense political intrigue and, indeed, even conspiracy.

Cyprus-sia ‘Tax’ Haven

It has been long known that Cyprus has held a vast sum of deposits from Russian lenders, and because of that Russia has been its biggest direct foreign investor. Low corporate tax rates, sub 10%, were the attraction, with Russians transferring their money into companies based in Cyprus. Some of this was then reinvested back in Russia.  According to Der Spiegel:

An internal study by the German foreign intelligence agency, the Bundesnachrichtendienst (BND), says banks in Cyprus hold $26 billion (€20.33 billion) in deposits by Russian investors. According to the BND, most of this money has been illegally moved abroad to evade Russian tax authorities. By Cypriot standards it’s a tremendous sum given that the island’s entire annual GDP amounts to €17 billion.

The Cypriot government on Monday denied the money-laundering accusation. A government spokesman said SPIEGEL was trying to besmirch the reputation Cyprus has as an international investment location. The country had effective money-laundering rules and adhered to EU law, the spokesman said.

Indeed, Russians aren’t the only ones who sought the refuge of this once tax safe-haven, and consequently other European countries were not keen to be seen to be using their own tax payers’ money to afford a bail-out for ‘tax dodgers’ and money laundered in Cypriot banks by Russian KGB, mafia and their own citizens. So you could call the tax on uninsured depositors actually a levy on money laundering – call it a 10% haircut for washing your dirty linen. I bet any good money launderer worth his salt would take that cut.

Conspiracy Talk

The question is why have the small savers been penalised? This is the point in the plan which makes the EU bureaucrats look so dysfunctional or at best dishonest – I meant to phrase it that way round. By penalising small depositors, mostly local Cypriots, they, as I have stated, undermined the universally agreed EU depositor guarantee that currently stands at €100,000. The talk is that the Cypriot government who took a line of credit of some €2.5 billion from Russia in 2011, and having utilised it fully, wanted to appease the ‘motherland’.  So they have agreed not to levy the full tax on deposits above €100,000. By doing this they hope for further assistance from Russia. I suspect they will offer support as Russian banks have loaned in excess of $40 billion to Cypriot companies of Russian origin (according to financial reports).

The Private Sector Initiative (PSI) on depositors is a victory for the ‘northern league’ of Europe, for now at least.  With a German election year in full swing Merkel needed to satiate German taxpayers by no longer exposing their euros to the profligacy of the periphery. Yes, a victory in round one for Merkel and the CDU, but ‘ding ding’, here comes round two: I bet the Cypriots pull a few punches by pushing back on the levy on small depositors. ‘Ding, ding’ – round 3 – I say Merkel gets knocked off her feet as depositors flee the periphery and then (eventually) Mario has to step in and decide whether to cite ‘irreversibility’ status as a clause to stem a banking sector collapse in Europe, and provide unlimited monetary support, but without the conditionality clause of austerity. I say ‘eventually’ as Mario had repeatedly slapped the EU finance ministers, and Schauble particularly, for advocating a haircut on bank deposits. So he could really make Germany sweat by holding back on a re-load of its big bazookas’ – long-term LTROs and OMTs.

In the interim the national central bank (NCB), in this case Cyprus is no doubt utilising the ELA (Emergency Liquidity Assistance) to supply the Cypriot banks with sufficient funds to remain liquid in the event of insolvency and failure.  This is at the risk of the NCB concerned and outside the ECB’s refinancing operational framework.  It is completely opaque and in truth it will appear as a Target 2 ledger or on the ECB asset side as ‘Other assets’.

For now the Cypriot banks are now on holiday, forcibly closed for business until at least Thursday at time of writing, so depositors cannot withdraw their money. Likewise, ATMs have been deactivated and electronic wire transfers suspended. They will be opened once the Cypriot parliament has ratified (or not) the deposit levy and other terms of the bail-in. It could well be that the terms change yet to protect small savers as they should have been all along. Either way, the psychological damage has been exacted across European populations.

Contagion Risk

Those who think there is little risk of a levy being imposed on other periphery members are missing the point. The seeds of doubt have been planted. As a saver facing zero yields on deposits and a potential haircut, why keep your savings in a bank? Sure it is convenient for electronic transactions, but individuals can adapt easily. As one of my more amusing colleagues put it, “mattresses now hold a 10 per cent premium”.

Talk of ‘exceptional’ circumstances and a ‘one-off’ are true but only because Germany and the Troika would never succeed in enforcing such illegal measures on Italy and Spain without risking social unrest and a collapse of the euro. The Cypriots have more leverage than they realise. The Russians don’t need a failure as it could mean Russian bank risk. Moreover, Target 2 imbalances likely ensure that the ECB would not cut off the ELA and risk a euro currency break-up.

Conclusion

What this should reaffirm to you all is how the handling of the crisis has only succeeded in heightening the risks associated with this current monetary order.  The excessive amounts of debt have continued to grow and are clearly not sustainable. Policymakers have resorted to draconian methods of expropriating private sector assets (households, pension funds and corporates) either by excessive explicit ‘taxation’ and/or stealth taxation administered by a policy of negative real rates to help reduce the fixed real burden of debts.

It also reinforces our long-held views that when push comes to shove policymakers (the State) will escalate oppressive tactics against their electorate in a bid to maintain their status quo and that of their fiat currency system.

Of most importance is the adherence to retrospective changes of law and different rules for different people and countries. Insolvencies are generally well-defined in law. First equity, then subordinated debt, then deposits and senior bonds together, take the hit in that order.  The creditor structure has been up-ended and more than merely tweaked over the last few years.  I suspect with levels of ignorance high amongst populations they haven’t quite woken up to the reality that the state is not in fact here for your protection as it once was and that we all need to take on self-reliance and a heightened sense of responsibility for ourselves. Some notable rule changes of late are subtle but growing in number:

1. The ECB, holders of Athens-law and foreign law Greek debt all received different treatment
2. The Dutch didn’t restructure SNS Reaal paper, they confiscated it
3. The Irish banned lawsuits against the ultimate wind-down of Anglo Irish
4. Portuguese private pensions were confiscated

The list is long but you get the idea.  Rule-changes are getting ‘regressively’ more creative and sinister. As a friend  pointed out to me this as if the “football referee has gone from being a quasi-neutral arbiter, to pulling off his black shirt to reveal a Manchester United one underneath and awarding himself a series of penalties.”

The bail-out should have been a legal bail-in whereby equity is wiped out, and all bank debt is written down. Then unsecured (uninsured) depositors ie above €100,000 should have taken a double digit hit. By doing this EU finance ministers and lawmakers would have been respecting the creditor hierarchy while adhering and honouring the rule of law. The retrospective change of law is what should alarm us all. The insidious and subtle nature of this encroachment on our civil rights sets an ominous precedent and those who glibly mock libertarians for their ‘rants’ are no doubt those same people who thought PIIGS really do fly.

The bail-in announcement for the Cypriot banks late Friday night was one of those events when we all look back and think that was the beginning of the end of the real global financial crisis. This should leave any individual in Europe under no illusion that the political elite will enact whatever it deems fit to protect their positions in the name of the euro and their own positions of power.

It is very clear that markets and investors underestimate the reality that debt restructurings are very necessary but won’t necessarily be enacted which leaves only more private sector wealth transfers (confiscation) and likely circumvention of the underlying problem of sovereign insolvency by central bank deficit financing.

So much for EMU solidarity…comrades.

P.S.

Market risk will be most exposed in positions of heightened risk taking – short term buy yen crosses, sell Nikkei, sell Nasdaq as margin debt is very high and buy USD and UST.  Gold as well – with no creditors – is designed for such occasions. But gold has been going down, hasn’t it?  Not quite.

Who Said Gold is Going Down?

Let’s look at two simple charts, one of gold denominated in sterling and one in yen.  Depending on where you are domiciled and hence exchange your domestic currency for gold will determine the extent to the value of your gold holdings.

Personally domiciled in UK, alongside many of our investors, we have exited sterling for gold and right now are enjoying all the protection that gold historically affords an individual when confronted with a currency that is being serially debased.  Similarly with Japan’s escalation of monetisation of their structural fiscal deficits which has led to a significant fall in the value of yen on a trade weighted basis, Japanese gold owners have received a significant rise in the value of their gold holdings too.  So gold has not gone down in value unless you own it in dollar terms!

Gold in GBP

Gold in Yen

Gold is doing exactly what it should be:  holding its value against currencies being actively debased.  The dollar – as reserve currency – will likely be the last currency to be debased, in what is likely to the closing stages of the fiat currency system and the dollar paper standard.  Gold at that point will also be strongly appreciating against the USD, while the other major paper currencies will likely already be dust.

 
Humans seem to have a propensity to forget cataclysmic events quite quickly. The longer the passage of time from a major event, the lower the probability people tend to think of it happening again. Think of people stocking up on food after a hurricane, then as time passes on people’s propensity to stock food diminishes. Or the fall in air travel immediately after a plane disaster. This is known as recency bias, where events that have happened most recently are deemed to be most likely; and, the corollary, events that happened a long time ago are judged much less likely.
 
This makes no sense, whether it be earthquakes or a financial crisis. The likelihood of an earthquake happening in a known unstable zone is far less one month after a major earthquake than it is ten years later. If the root cause is the level of instability, then any passage of time only increases the probability of the coming crisis, rather than diminishing it.
 
In the case of the global financial markets – which should reflect the concerns of worldwide investors – it would seem that we are following the same time-conditioned path. As we are now five years on from the last crisis, there is a growing belief there is a diminishing chance of a new one happening anytime soon. This is dangerous thinking.
 
In the case of the individual’s ‘financial crisis index’, it appears fairly straightforward to predict using the following standard variables:
 
• total income expected currently, and in the future;
• total debt currently, and in the future;
• (emergency) savings as insurance firepower.
 
Depending on the change in the variables coupled with the ability and rate at which to service the debt, this will give us a very good idea of our own financial crisis possibility. Let’s call it the “F-point”.
 
Is it really any different in the real world? Let’s have a quick look at the world’s biggest economies.
 
Nominal growth (which includes inflation) took a hit after the financial crisis. Apart from the US, which will see modest growth in GDP based on recent trends, and China, which continues to grow, nominal growth – that is a country’s income – looks set to be poor. Real growth will struggle to be positive.
 

 
Meanwhile the total public and private sector debt of most of the world’s major economies is colossal, and in many cases continues to rise at an astonishing rate.
 

 
While private debt growth has stalled in many economies, the slack has been taken up by the public sector. To support this process of public re-leveraging, central banks continue to accumulate government debt at an amazing pace.
 
Although year-on-year growth in G4 central bank balance sheet expansion has gone down lately, it is still about 8%, and has not been negative for over 3 years. On current projections, the weighted average central bank balance sheet will be nearing 25% of GDP in 5 years or so. This has to be paid back somehow? But how, and with what?
 

So, the $64 trillion question is: is the financial stability of the world economy increasing or decreasing?
 
The basic observation from where I’m sitting is that we are getting more and more into debt with less and less growth to service it and pay it off. There is a clear F-point becoming more likely with the passage of time. In 2007, the world had emergency firepower of 5% central bank rates that could be cut, and trillions of dollars of bonds yet to be purchased to back stop the system. What do we have today? Far, far less options.
 

 
Currently many investors are questioning their exposure to gold, whether they bought it 10 years ago, 5 years ago or 6 months ago. At the same time they are congratulating themselves on their equity returns, or their property gains after the resurgence in many housing markets. (In the UK, the ability to get multi-million pound mortgages has only recently returned to pre-Lehman availability.)
 
Over the years gold has demonstrated a zero and often inverse correlation to equities especially during crises. So it is often the case that in the short-term if you are making stellar returns in equities, your gold investments might suffer.
 
Nevertheless, it would appear that the world’s central banks do not hold the same concerns as regular investors on their exposure to gold, as their net buying clearly implies:
 

 
What do they know about the future of the currency system and the next financial crisis?
 
Is it safe?
 

By examining a classic monetary equation which became the foundation of Milton Friedman’s monetarism and central bank monetary policy we can see why there is potential for much more money printing.

MV = PT

M= money supply

V = velocity of money/ circulation

P = prices of goods and services/ price level

T = quantity of goods and services/ transactions or output

Irving Fisher termed this the quantity theory of money, and is often credited with this economic identity, but it was in fact the mathematician and astronomer Simon Newcomb who introduced this simple relationship; the equation of exchange, when he ventured into a new field of expertise with his book Principles of Political Economy (1885). Fisher’s belief is upheld by central bankers today:

“we find nothing to interfere with the truth of the quantity theory that variations in money (M) produce normally proportional changes in prices”

MV = PT simply put means the amount of money spent (MV) is always equal to the price of all things bought (PT) in an economy over any given period of time. If MV is the quantity of money (M) multiplied by the number of times that money is used during any given period (V); and if PT represents the price (P) of each product multiplied by the quantity purchased or volume traded (T) then this must equal the value of everything produced and sold in an economy during a given period of time.

If we look again at the definition of nominal GDP – the sum of all the goods and services produced, counted in their quantity (the ‘real GDP’), and then multiplied by their prices (the ‘price index’ or ‘deflator’). Clearly this is the same as PT. Therefore MV = PT = Nominal GDP.

Market Monetarism Misdiagnosis (M3)

A new strain of monetarism called market monetarism argues that because velocity is unpredictable, the Fed should manipulate the money supply so as to offset fluctuations in velocity and maintain a fixed rate of growth in the level of aggregate demand. Successfully doing so, they maintain, would considerably mitigate demand-side macroeconomic fluctuations.

The two decades prior to the financial crisis of 2008 was known by economists as ‘the Great Moderation’, an acknowledgement of a period of low inflation and relatively stable growth, with only two relatively mild recessions.

Furthermore, this stable period was attributed to the success of the Federal Reserve Bank (and many of the other world’s central banks) adopting an inflation target. They decided on a preferred inflation rate and steered the economy towards it, adjusting interest rates lower when inflation fell below target and higher when inflation exceeded the target.

Then in 2008 the severest recession since the Great Depression undermined economists’ faith in the ability of central banks to respond to crises as they were seemingly unable to prevent this major crisis. The search for alternative ways to conduct monetary policy began. Inflation targeting was supposed to make the demand-side fiscal policy less relevant or even obsolete, as after all, both monetary and fiscal policy affect the same variable, total nominal spending (aggregate demand).

However the slump in nominal spending has had demonstrative effects as both public and private sector debt burdens have risen. Since both households and governments ability to service their debt depends upon their nominal incomes and revenues, a new monetary solution is being advocated that in encompasses the impact of fiscal policy. The solution that has risen to prominence is Nominal GDP level Targeting (NGDPLT).

NGDPLT was the hottest idea in monetary blogs over the last few years but has now migrated from the academic cloudscape to implementation. Central bank monetary policy setting across the G7 is adopting de facto or actual NGDPLT. It was the Danish economist Lars Christensen of Danske Bank who coined the phrase ‘Market Monetarist’ in his working paper Market Monetarism – The Second Monetarist Counter-revolution. In it he refers to this economic school as the first to be born out of the blogosphere and in the abstract he defines the school as such:

“Market Monetarism shares many of the views of traditional monetarism but unlike traditional monetarism Market Monetarism is sceptical about the usefulness of monetary aggregates as policy instruments and as an indicator for the monetary policy stance. Instead, Market Monetarists recommend using market pricing to evaluate the stance of monetary policy and as a policy instrument. Contrary to traditional monetarists — who recommend a rule for money supply growth –

Market Monetarists recommend targeting the Nominal GDP (NGDP) level. The view of the leading Market Monetarists is that the Great Recession was not caused by a banking crisis but rather by excessively tight monetary policy. This is the so–called Monetary Disorder view of the Great Recession.”

Proponents of NGDPLT believe it is better than inflation targeting, which to date has been used explicitly or implicitly by most central banks as a means of stabilising inflation and growth. Critics of inflation targeting centres around the belief that such a target provides too little flexibility to stabilise growth and/or employment in the event of an external economic shock.

The lead protagonist is arguably Scott Sumner, Professor of economics at Bentley University who adopted the motif of Market Monetarism having written extensively in his blog The Money Illusion to promote NGDPLT.

Sumner outlines nominal income or NGDPLT for the US in an article Re-targeting the Fed in National Affairs, Issue Fall 2011, and applies it to the UK in The Case for NGDP Targeting – Lessons from the Great Recession in a publication by the Adam Smith Institute in 2011.

NGDP and NGDPLT explained

Nominal GDP (NGDP) is the sum of all the goods and services produced, counted in their quantity (the ‘real GDP’), and then multiplied by their prices (the ‘price index’ or ‘deflator’). So NGDP combines a ‘real’ variable – one that measures something being actually produced and a ‘nominal’ variable, one which considers prices and not actual production.

Simply put NGDP is the sum or value of all spending in the economy, measured in US dollars, in the case of the US or Sterling, in the case of the UK etc; as you and I use them. It is the GDP figure that has not been adjusted for inflation. For example if nominal GDP is 8% and inflation has been 4%, the real GDP has increased 4% (NGDP minus inflation).

NGDP Level targeting is where a central bank determines a path along which NGDP would grow, and uses its monetary policy tools to affect that end; either conventional or unconventional if at the zero bound. In practice the central bank, say the Fed, would adopt an annual rate of nominal income growth of 4 to 5%, and commit to return to that trend line when spending falls short or overshoots. So if the target is 5% and NGDP comes in at only 4% one year, they would aim for 6% the next year.

In most developed countries inflation has been preferred at 2% and long term growth potential at 2 to 3% and monetary policy would react, as it does now, easing when NGDP growth was expected to be too slow and tighten when it was too fast. So if NGDP fell below the target growth rate in any one year then the central bank would seek to make up for that in subsequent years.

What one will see is that in any one year the components of NGDP will vary. If trend target growth is a 5% NGDP, in years where real GDP is 1% then the central bank will alter monetary policy to achieve 4% inflation or such inflation that is required over a number years to regain this trend path of 5%. This as we discuss later is one the main criticisms of NGDPLT – that excessive growth in money supply could lead to higher inflation than is stable for long term sustainable output (employment).

Advocates of NGDPLT believe its overriding virtue is that it can address the dual concerns of macroeconomic policy by combining both employment and inflation into a single metric. It provides a way to address both inflation and output (employment) stability, without placing the central bank in the confusing situation of having to aim at two separate targets which require opposite action to achieve them.

A Flaw in Nominal GDP Level Targeting

In our latest HindeSight Investor Letter – “The Central Bank Revolution I – Well ‘Nominally’ So” we explored the arguments for and against NGDPLT in some depth. We wanted to highlight one flaw here, which is the potential implementation of NGDPLT.

The single biggest problem for a NGDPLT is what is the start date from which to project a trend path for NGDP. If one recalls NGDP Level targeting is where a central bank determines a path along which NGDP would grow, and using its monetary policy tools to affect that end; either conventional or unconventional if at the zero bound.

Christina Romer, professor at the University of California, Berkeley in a NY Times article making the case for NGDPLT explained how it would work:

“The Fed would start from some normal year — like 2007 — and say that nominal G.D.P. should have grown at 4 1/2 percent annually since then, and should keep growing at that pace. Because of the recession and the unusually low inflation in 2009 and 2010, nominal G.D.P. today is about 10 percent below that path. Adopting nominal G.D.P. targeting commits the Fed to eliminating this gap. HOW would this help to heal the economy? Like the Volcker money target, it would be a powerful communication tool. By pledging to do whatever it takes to return nominal G.D.P. to its pre-crisis trajectory, the Fed could improve confidence and expectations of future growth.”

The key phrase here is – “is some normal year – like 2007”

We nearly choked on our morning Weetabix when reading this comment. This encapsulates to us how market monetarists have totally misunderstood that we have witnessed a super credit cycle that culminated in a blow-off bubble in 2007. Now this is hardly a year that we would term ‘normal.’

Normal is brushing your teeth before you go to bed, normal is filling your car with petrol because that is what provides the essential ingredient to propel it; normal is not gunning your car at 200 mph down the motorway so you won’t be late for a speeding offence, which would be somewhat analogous to starting the economy again at some excessive price rate of the likes we witnessed in 2007. This graph below illustrates beautifully how far we are away from Romer’s concept of norm:

Our next graph illustrates that if we started with 1994 when the FOMC signalled base rate changes then one could argue that late 90s and early 2000s were over-trending and 4.5% is the correct growth rate. This fits with our understanding of credit induced NGDP. We would emphasise that this suggests the Fed should do nothing more as it is at the target level, finally.

The same thought process can be applied to analysis of UK NGDP. The next graph shows a NGDP growth level of 5% by which the BoE could signal its intentions. It is clear that prior to 2008 the UK NGDP was running ahead of this pathway. One can see the gap that now exists – this is the output gap that policymakers like to refer to, and why market monetarists advocate that NGDP should rise by more than 5% to get back to its original trend path.

Anthony J. Evans of Kaleidic Economics illustrates that using a 4.5% NGDP target level extrapolated from 1997 shows the boom up to 2007 was significantly above trend. So depending on what target level one uses determines if you are back at trend levels, or undershooting. And if you want to get back to a 2007 projection M will have to rise considerably, and no doubt P will do too. So what is the correct growth rate required to get back to trend levels?

Again, one can see it all depends on a start point that is totally arbitrary.

UK 4.5% Target Level – Are we at the trend growth rate already?

Evans has a keen sense of humour when his observation on an extrapolated 2007 trajectory for NGDPL targets:

“But by this logic we should believe that since Usain Bolt can run the 100 metres in under 10 seconds, he could run 600 metres in under a minute.”

Market Monetarists have overlooked credit, in the same way the US Federal reserve did away with collating data on M3 credit supply. This oversight and misdiagnosis renders NGDPLT as a non-starter.

The great Monetarist Milton Friedman who persistently argued that the main reason still to have an independent central bank was that over the medium and longer term monetary forces influence only monetary variables. Other real, ie supply-side, factors determine long-term growth. So are Market Monetarists really now telling us that faster and higher inflation will generate sustainable long-term growth rates and faster to boot? Really…

In our latest HindeSight Investor Letter – The Central Bank Revolution I (Well ‘Nominally’ So) – we explore and counter this new wave of economics called Market Monetarism, which advocates NGDPLT and which appears to be revolutionising central bank monetary policy.

The UK has usually had a strong services surplus, helping to offset a long-standing deficit in goods. However, the goods trade deficit has been on a long-term decline, and recently the services surplus has shown signs of rolling over. Furthermore, the income balance – the income earned on UK-owned foreign assets, which has historically been in surplus – is showing signs of a permanent lurch downwards. A recent news story about the energy company Iberdrola – domiciled in Spain, a country with its own severe economic problems – extracting a £900m dividend from UK subsidiary Scottish Power is emblematic of the problem.
 
This is not good for the UK. If a 25% cut in the currency – virtually all of whose effects have now passed through – was not enough to revive the external sector, it is clear another devaluation will be required. We are seeing the seeds of this now. The Bank of England minutes released on Tuesday showed a shift in outlook, with Governor King being joined by two other MPC members in a vote for a fresh injection of bond-buying money.
 
GBPUSD subsequently sold off sharply and, over the last month, GBP has sold off against all G10 currencies, except Japan’s (which has been aggressively encouraging the devaluation of its own currency).
 

 
However, as we can see in the chart below of trade-weighted sterling, the recent move down has been insignificant from a longer-term perspective, and it is likely much more will need to be done. A “creative” and “innovative” central banker such as Mark Carney – the incoming Governor at the Bank of England with no ties to the ‘old guard’ – is quite possibly just the man to accomplish the task. Nominal GDP targeting, discussed in a recent HindeSight Letter is just one of the ideas in play to justify easier monetary policy and thus a weaker currency.
 

 
Due to its manifold and profound problems, the UK is only a little further along the road to economic catatonia than other developed nations, who will soon also have to devalue as aggressively as the UK. However, one currency is acting precisely as it should in such an environment: gold. Gold, for a sterling investor, is up slightly since the beginning of 2013, despite declining 5.5% against the dollar and the euro. Indeed, gold in pounds has risen 117%* since the Lehman crisis, when the last, failed, devaluation of sterling took place.
 

 
* We feel we should add, this being a Hinde Capital blog after all, that an investment in the sterling share class of Hinde Gold Fund over the same period (October 1st 2008 to January 31st 2013) would have returned 151% (23.7% annualized).
 

“The Checklist Manifesto – How to get things right”, is a masterful book for its narrative and practical application. Written by Atul Gawande, an acclaimed surgeon based in the US, he takes us on a journey of how the simple checklist helps individuals deal with immensely complex situations, where risks can be calculated and often lives protected – skyscraper construction, medicine and investment banking.

First introduced into the US Air Force to assist pilots, the humble checklist in all its simplicity has helped generations of pilots navigate the complexity of flying modern aeroplanes. Gawande himself has introduced the concept into operating theatres and hospitals around the world with astounding success.

At Hinde Capital we have embraced such a concept almost naturally in an attempt to codify both our objective and subjective observations of the market place. Our hope is to eliminate behavioural biases that can lead to a misdiagnosis of events before an investment decision.

It has long been our contention that central bankers have misdiagnosed the dynamics of the global economy, particularly in this last decade. Right up until the implosion of equity markets in 2007 and 2008 Bernanke said there was no housing bubble, that inflation was benign, even though almost every asset price from equities to gold was trending in a succession of levitating new highs. When considering how to guide a system as complex as the global economy with so many independent countries and decision makers, we often wonder what type of checklist a modern central bank was actually employing. The crucial ingredient, though, is not only a checklist but the correct checklist.

Central Bank Checklist Manifesto

In a hospital one of the most basic but effective checklists deployed since the 1960s as introduced by nurses was a vital signs chart – every few hours or so nurses would check the following:

• Pulse
• Blood pressure
• Temperature
• Respiration

Likewise a central bank observes certain vital signs to observe the state of the economy – their patient. To have an understanding of what the ‘vital signs’ checklist is for the Fed, let’s look at their duties as outlined in their manifesto ‘The Federal Reserve System – Purposes & Functions.’

The Federal Reserve’s duties fall into four general areas:

• conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates

• supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers

• maintaining the stability of the financial system and containing systemic risk that may arise in financial markets

• providing financial services to depository institutions, the US government, and foreign official institutions, including playing a major role in operating the nation’s payments system

Let’s focus on the first point. The Fed’s objectives include economic growth in line with the economy’s potential to expand; a high level of employment; stable prices (that is, stability in the purchasing power of the dollar); and moderate long-term interest rates. So their vital signs checklist may go something like this:

• Growth
• Employment
• Inflation
• Interest rates

Alan Blinder, a former Fed governor and Vice Chairman (1994-96) wrote an insightful working paper called ‘Monetary Policy Today: Sixteen Questions and about Twelve Answers’. These questions in many ways are a checklist questioning parts of the Fed manifesto. Blinder himself resigned as Vice Chairman under Greenspan as he was in disagreement with his diagnosis of the US and global economy.

Central banks have tried to be omnipotent in guiding economic behaviour rather like a surgeon accustomed to holding centre stage in his ‘operatic’ theatre. The central banker can’t enforce his will on agents in the economy because it does not allow for human beings subjective preferences on how to spend and live. Using a policy of market expectations to direct human action, based on assumption of some rational expectation, has been proven to be flawed. Besides which, who leads? The market place or the central bank? – the dog or the dog’s tail?

The great US humourist of the Depression era, Will Rogers once famously said, “There have been three great inventions since the beginning of time: fire, the wheel, and central banking”.  His comment, laced with no small amount of irony, may have well been uttered today.

Central Bank CAnniBALism

Central banks are the devil. They are like drug dealers except they administer regular doses of supposedly legally prescribed barbiturates to their addicts. The ‘easy money’ or ‘credit’ they create is an opiate, and like all addictions there is a payback for the addicts, one exacted only in loss of health, misery, and death.

Our reliance on ‘easy money’ as facilitated by credit has become terminal.  Like drug users we continue to attempt to find a heightened state of nirvana. We continue to hark for the utopian days prior to the eruption of the post-2008 crisis, even though our well-being was fallacious and based on an illusion of wealth paid for by credit – a creditopia. The abuse of credit is what defined the Great Financial crisis and one that still defines our economic system and one which will define a much worse crisis to come.

Central bankers have begun a concerted effort to fight the global debt problem which has been stifling growth as tax revenues merely serve to finance debt servicing rather than addressing the repayment of principal outstanding. Omnipotent governors, Bernanke, Carney, Draghi, Svensson and Iwata or Kuroda (either are likely to replace Shirakawa at the BoJ) are to take a far more aggressive and activist role in pursuing a new framework for growth and inflation by seeking an alternative way to conduct monetary policy. It’s called Nominal GDP Level targeting (NGDPLT) and it is in our opinion as significant a moment as Volcker’s appointment to the Federal Reserve governorship in 1978.

Many will recall Volcker’s moment was to engineer a swift monetary contraction and deceleration of the money velocity to try and reign in excessively high inflation and stabilise growth. It worked. Today we are witnessing an ‘Inverse Volcker’ moment, whereby the opposite is likely true.

The question remains are they all still ‘inflation nutters’ as Mervyn King, the BoE Governor glibly referred to those central bankers who focussed solely on inflation targets to the potential detriment of stable growth, employment and exchange rates.

Are central bankers merely expanding the boundaries of monetary largesse by focusing on a broader mandate and merely evolving the singular variable approach of inflation targeting, or have they finally found a solution to eradicating boom-bust business cycles? This is a question we need to answer as we are currently witnessing a Central Bank Revolution which could portend severe consequences for prices in our economies, and all the attendant misery that comes with very high inflation.

Nominal GDP Level targeting advocates believe they have a plausible case for a change of mandate by central banks and one which is being gradually adopted, but we believe that like central banks they have misdiagnosed the cause of the crisis by failing to examine the impact of credit creation in our global economy. Money matters, but credit matters more.

In our latest HindeSight Investor Letter – The Central Bank Revolution I (Well ‘Nominally’ So) – we explore and counter this new wave of economics called Market Monetarism, which advocates NGDPLT and which appears to be revolutionising central bank monetary policy.

 
Government bonds and interest-rate swaps, expressing the rates governments can borrow at and the rates banks lend to one another at, are also at or near all-time lows.  Being so close to zero, how much lower can they realistically go?
 

 
Whether it be corporate or sovereign, you are being given the chance to invest at a 300-year low in yields in most fixed-income markets.  In the desperate search for income, you will enjoy an after-inflation guaranteed loss on maturity.  Furthermore, with the very real possibility of a bond collapse, especially if the Fed jumps the gun and tries to raise rates too quickly – as happened in 1994 – you could lose 40% of your principal.
 
Equities also look overvalued to offer any chance of delivering a long-term return.
 

 
The weekly market comment from the well-known mutual fund manager, John Hussman, tells us that present market conditions in equities now match six other historical occurrences:  August 1929, November 1972, August 1987, March 2000, May 2007 and January 2011.  All of which were particularly inauspicious times for investing in stocks, and certainly not times to be “rotating” full pelt into them.
 
Moreover, as Hussman frequently reminds us, we cannot all just rotate into equities, because someone must sell them and either stay in cash or exchange this cash for bonds or another asset.  There is always someone who has to hold each equity or bond or unit of cash – as for every seller there is a buyer – it just depends at what price the exchange takes place.  Now, many investors are moving into equities at a price which implies they have very low odds of ultimately generating a positive real return.
 
Of course it would be hard to imagine that we could really have a return to growth when we have a debt mountain that keeps growing in almost every country.  The US debt ceiling, for example, will soon have to be raised again.
 

 
And how is cash likely to fare in the coming years? From the Zeal Intelligence Newsletter:
 
“The inimitable Peter Schiff, the hard core contrarian and elite fund manager, discussed the results of an inflation study done by his firm Euro Pacific Capital.  His hard data found the Bureau of Labor Statistics’ calculation methodologies for the CPI seriously flawed.  Euro Pacific’s researchers built their own basket of 20 goods and services in the CPI.  They found that it only increased 5% faster than the CPI itself from 1970 to 1980.  The CPI was honest then.  But between 2002 and 2012, the prices of this same basket soared 61% faster than the CPI! Schiff believes the true inflation rate in the US is 7% to 9%, and heading higher.”
 
Indeed, our tongue-in-cheek James Bond Index arrives at the same 7% rate.
 
The fact is we all know that inflation is NOT what the government would like us to believe, and whether it is 5, 7 or 10% depends on your lifestyle – but it is not 2%.
 
Obviously with inflation at 5-10% – and looking like it could go yet higher if monetary velocity picks up –  holding cash is a difficult investment-choice right now.  In fact we would argue cash is not king: cash is dangerous.
 
How about gold?  Well, sentiment has very quickly changed against it.  Last week there were at least five bearish articles on gold.  Leading the pack was Credit Suisse’s, Gold: The Beginning of the End of an Era from Credit Suisse.  There was also a tempering of bullishness from Citi in a note, Gold Schizophrenia.
 
So bonds and equities worldwide are in nosebleed territory.  And gold, apparently, has “peaked”.  As the oil/gold ratio is at 17 and gold/copper is 4.4 – close to their long-term averages – we would then, according to this thought process, have to say that all commodities have “peaked”.
 
But holding cash is going to cost you 5-10% a year in purchasing power.  So I think I might be right in suggesting this is the worst time in history to invest, and certainly the riskiest I have known in 30 years.
 
Dylan Grice, until recently of SocGen, introduced the so-called “cockroach” portfolio that would “survive” the nuclear war.  This is also known as the permanent portfolio, and it is something we have written about before as well.
 
The basic premise is a portfolio consisting of 25% gold, 25% equities,25% bonds and 25% cash.  However, while I still very much advocate this type of portfolio, the discussion above would lead me to be cautious.  Indeed, given the egregiously low yields, I would eliminate the bond constituent altogether and instead aim for: 33% cash, 33% well-picked equities, and 33% gold.  (After doing that I would buy some short-dated put options (ie downside protection) on the equities, and keep rolling them as I see fit.)
 
Why raise the gold portion?  Of course I might have some bias, as I have every year since 2001, but I feel I need to hold a high percentage of gold, ie 30% or so, in my portfolio until circumstances dictate that it is expensive relative to the monetary base and other assets and/or the global economy has reduced its debt burdens.
 
On that note, gold currently is out of favour.  The Hulbert Gold Sentiment Indicator, which tracks the bullishness of gold newsletter writers, has turned down to 6%, near its recent lows.  Furthermore, the Daily Sentiment Indicator (DSI, charts below), which tracks the sentiment of traders in gold futures, is also bobbing around a low level.  Of course, as a long-in-the-tooth trader, I prefer to see lots of bearish investors if I am bullish: no one makes money in the herd for long.
 
To illustrate gold’s recent falling out of favour, the chart below shows the net long speculator positions in gold futures (according to the CFTC) are falling and are low compared to the last 3 years.
 

 
And the DSI confirms this lack of enthusiasm for gold:
 

 
While I do not usually comment on other’s work on gold, I couldn’t help thinking that Credit Suisse (CS) were particularly one-sided.  I have never seen a serious analysis of gold being rich or cheap without a comparison to the monetary base – given the latter’s explosion in recent years gold is undeniably cheap on this basis.
 
However, there was no mention of Chinese GDP per capita growing at 13% a year for the last 11 years in the CS note, roughly the same growth rate as gold, with China now the largest producer and importer of gold.  Is China GDP per capita going to stop here, at $2,500, with US GDP per capita at $35,000?
 

 
Another important point in this discussion about gold is its production.  Gold stocks, as shown in the chart below of GDX, have gone nowhere for six years.  This is because of the simple fact they do not make any money at the current gold price.  Their margins are wafer thin if they exist at all.  Projects are being delayed everywhere due to too high capex.  It doesn’t take a rocket scientist to realise that this will lead to a huge production fall off very soon.  Indeed, the Canadian bank, National Bank Financial, put out a report detailing just that last week: The Gold Production Cliff.
 

 
It’s rare for a commodity that is unprofitable to mine at $1,650 dollars an ounce to continue to be mined at that price.  Producers will close production down and wait.
 
Finally, I’d mention that gold now has the hallmarks of promising price action.  Our Trend Intensity Index, in the chart below, is very low, meaning gold is ‘trend ready’, ie poised for a break out in price.  Although gold’s performance has been lacklustre of late, given the negative sentiment and the seeming belief that we are returning to some sort of normality in global growth, I am surprised gold is not lower.  I believe this shows gold is well supported, and I expect the break-out in price to be higher.
 

 
My view of the future is not good.  I see an indebtedness worldwide that is only being addressed by money printing.  I see growth only being ‘achieved’ by yet more debt.  The lies about inflation are a disgrace.  Levels of complacency in asset markets and policymakers’ ability to deal with crises abound like 2007.
 
I cannot think of not owning a significant portion of gold in my portfolio.  It would go against all that I have learnt in 30 years, and all that I will worry about for the next 30 years.