On Wednesday, the Fed’s Beige book was released for July and August. It summarizes reports from the 12 Federal Reserve Districts and pointed to economic activity that continues to stabilize.
Compared to the summary from the Fed’s last report 11 out of 12 regions asserted that economic activity had either stabilized or improved. Even in the 12th region — St. Louis — their read-out pointed to a pace of decline that was moderating.
Almost all regions remarked that among business leader contacts in their territories, the economic activity outlook is now cautiously positive.
The reports underscore what we’ve been reporting here that clunkermania boosted auto showroom traffic and subsequent new car sales in all regions. Several regions confirmed that the program has also resulted in increases or planned increases in automobile-related production. Beyond the auto industry, most regions reported general improvements in manufacturing production.
It also came as no surprise that with labor markets on the mend, 8 of 12 regions report upticks in demand for temporary workers – usually a leading indicator of a return to job growth.
The report that Hong Kong requested the return of its 2 tonnes of gold to be stored in its new vaults and its suggestion that other Asian countries do the same and store their gold with them resulted in a wave of uninformed hype.
Statements like “the move deals a significant blow to London’s historical role as a global hub” (from the aptly named Fool.com) and this weird non-article from a Marvin Clark that is all questions and no answers or opinions are typical of the new breed of gold commentary.
With reported central bank holdings of 30,000t, how can anyone think 2t is “significant”, even if the whole lot had been short sold by whoever they had it “stored” with? As one wit commented, “I moved my BBQ from my mom’s house to my house last week. According to the vague premise of this mysterious ‘logic’, my BBQ must be going up in price soon!” They are in the running for my quote of the year.
I would also note the similarities between the Hong Kong announcement and this report on Dubai: talk of Dubai a “natural choice” for central banks in the region, Dubai to be home to gold backing an ETF. Well, they can’t all be. These attempts at cracking London’s fix (pun intended) on gold trading and settlement occurs with some regularity and is met with a yawn from experienced gold players. Every now and then a country tries to become a “bullion centre”: Shanghai, Thailand, India. They never get off the ground because the rest of the world doesn’t trust them, or trusts them less than London.
Unfortunately, I have noticed an increase in gold commentary from people who have no experience in the gold markets, and it shows. I suppose if no one wants to read your opinion on a leverage stock play, what else are you going to do but write about what is hot, even if you know sweet FA about it.
Editor to Journalist: “hey, gold seems to have passed some magic number, go write something on it for tomorrow’s paper.” Journalist searches for last newspaper article on gold, does a google search and picks up some third hand commentary which misinterpreted “Gold ETFs allowed for EFP transactions” into “Gold ETFs allowed to settle COMEX futures”, and mashes it all together with some clichés and there you have an article for consumption by the general public who believe that the financial journalist knows what they are talking about.
I am thinking of starting an index of commentaries on gold and more specifically, the number by those who have never commented on gold before. I think it would make a very good bubble top indicator to be used along with the “receiving stock tips from a shoe-shine boy” (today to be substituted with taxi drivers I suppose). The number of Kitco forum posts might also be good, particularly the occurrence of the text “to da moon”.
The FRN$, the world’s reserve currency, has no definition and the quantitative easing will fail. After all, what is a dollar? Because there is no definition therefore it is impossible to perform accurate, or even semi-acccurate, calculations of value using this tool. Consequently, other key ratios ought to be used to hone in and focus on value.
While the DOW may continue its rally I highly doubt it will breach 11.5 gold ounces before it resumes its downward destiny and reaching 5-6 ounces sometime this year. Silver will likely continue its upward ascent and return to a more normal ratio with gold around 55. A little bit more difficult to prognosticate is oil but if I were to wager it would not descend too far below 15 on the chart but the probabilities are not particularly clear either way.
In May the DOW to gold ratio was 9.32, S&P 500 to gold ratio was 0.97, gold to silver ratio was 66.4 and gold to oil ratio was 16.2. I concluded,
There appears to be (1) a strong uptrend for gold, (2) a fairly decent bear market rally for equities that is running out of upward pressure, (3) a resurgent oil, (4) insane accounting sorcery that is rending any remaining confidence from the financial statements of corporations, (5) insolvent banks being sustained only through government bailout, (6) massive job losses with (6) continued bankruptcies which (7) detonate financial weapons of mass destruction.
Around the end of July I warned of the coming market crash. At the time the DOW to gold ratio was 9.5 ounces and the S&P 500 to gold ratio was 1.05.
CURRENT RATIOS
The DOW to gold ratio is 9.49 and S&P 500 to gold ratio is 1.03.
Despite the S&P 500 rocketing up over 10% in FRN$ during the past 4 months when priced in gold, a definable currency, there is no material change. In other words, despite the proclamation of recovery and green shoots, which are really only red roots, the market has not been fooled. The rising equities are really just a function of an evaporating fiat currency. Where does the top line come from when 40% of working age Californians are unemployed? California is just a portent for the other states.
The resurgent oil price, with the gold to oil ratio at 13.95, seems to be the most difficult to explain. Because of the slowing economic picture, empty ports, empty trucks, empty railroads and empty stores the demand for oil seems to have slowed considerably. Natural gas stockpiles may soon exceed capacity. Why the oil price, in gold, has continued rising is probably the result of it being extremely cheap compared to historical norms. Even with the 12.5% gain in gold it still has a significant ways to go before it reaches much more normal territory.
Perhaps the market is beginning to take the Peak Oil Theory seriously? But we understand the importance between gold, oil and our stomach. Perhaps Nate Hagen understated the magnitude of the recent IEA report when he wrote, “the initial language in this year’s Executive Summary is of an urgent nature.” The Independent reported, “The IEA estimates that the decline in oil production in existing fields is now running at 6.7 per cent a year compared to the 3.7 per cent decline it had estimated in 2007, which it now acknowledges to be wrong.”
GOLD AND SILVER
Silver’s movement seems to amplify gold’s. The current gold to silver ratio is 60.2 and declining quickly.
Physical gold is on the move as both the Arabs and the Chinese are moving physical gold bullion bars out of London to the Middle East and Hong Kong. As MarketWatch reported, “Hong Kong is pulling all its physical gold holdings from depositories in London, transferring them to a high-security depository newly built at the city’s airport”. The timing with the CME clearing of OTC gold derivatives is particularly interesting.
Additionally, Barrick Gold “will issue $3 billion in stock to eliminate all of its fixed-price gold hedges and a portion of its floating hedges, taking a $5.6 billion hit to third-quarter earnings, the world’s top gold miner said on Tuesday.”
Dr. Greenspan testified before Congress in 1998, “Nor can private counterparties restrict supplies of gold, another commodity whose derivatives are often traded over-the-counter, where central banks stand ready to lease gold in increasing quantities should the price rise.”
Central banks carry gold in the vault and gold out on loan to the bullion banks as the same line item and in effect report cash and accounts receivables as the same thing. As Bill Murphy of GATA has observed, “They cannot get this gold back. They say they lent it; when you lend something out you expect to get it back.” Is the gold cartel retreating in the face of a coming tsunami of physical demand?
PROGNOSTICATION
The DOW to gold ratio is fairly above the 200dma while the gold to oil ratio and gold to silver ratio are significantly below. A relative price is the current price divided by the X day moving average. For example, the 200 day relative price would be the current price divided by the 200dma.
In FRN$ the DOW is at a 200 day relative price of 1.14x, gold is at 1.05x, silver is at 1.26x and oil is at 1.29x. Based on seasonal trends gold and silver will be strengthening, with the strongest months in September and November, while oil just finished the usual August surge and will be weak the rest of the year with the weakest month in October.
This upleg in gold and silver will have significant strength because of the long period of consolidation just like in 2004 and 2006 which provided the foundation for the uplegs in 2005 and 2007 that took gold from $400 to $700 and $650 to $1,000, respectively. If the current upleg is similar to the previous two then the 200 day relative prices for gold and silver at the top of this upleg would be about 1.5x and 1.7x, respectively.
This puts $1,300 gold and $25 silver within range without greatly exceeding previous trading norms and would result in a gold to silver ratio of 52 which would be about average for the past few years excluding the panic of 2008 where silver went into backwardation for nine weeks. If the DOW retreats to 6 ounces then that would be about 7,800 and a gold to oil ratio of about 12 would mean $110 barrel oil. While we could see both the USD Index and gold rise at the same time, because of their respective places in the liquidity pyramid, I think it is more probable than not that the USD Index will retreat below the 75 level.
CONCLUSION
Given the shakiness of the FDIC, the routine bank failure Friday and counter-party risk from OTC derivatives, financial weapons of mass destruction, it still makes sense to establish an alternative and eventual substitute monetary system for your ordinary daily and business transactions. While the OTC derivatives were latent they have now become financially lethal.
To immunize and protect yourself and your capital I recommend either buying gold, silver or platinum and taking possession of the physical bullion or using a trusted third-party storage service like GoldMoney which allows for physical delivery at anytime. By all means, stay away from the problematic GLD or SLV ETFs if you are seeking safety.
The markets are not fooled by the red roots being touted as green shoots. The technicals, fundamentals and seasonality are merging and consequently the ratios are materially changing. The Great Credit Contraction is grinding on and capital is seeking the safest and most liquid assets. Gold and silver have been preparing for the next upleg for over a year and laid a strong foundation for a massive run which has likely just started.
Humanity’s gold lust has been dormant for nearly a century and when it awakens it will be extremely vehement and go viral. Those who own gold know of what I speak. The yellow metal seems to call out to the inner conscience and resonate with our DNA. Our cash balances ought to be denominated in gold to avoid unnecessary risk from barbarous relics like fiat currency and fractional reserve banking. Think of how few people have held physical gold in their hand; let alone owned it. This fact is perhaps the most bullish aspect of this upleg. Consequently, this gold party has barely started.
DISCLOSURES: Long physical gold, silver and platinum with no position in the DOW, S&P 500, Barrick or the problematic GLD or SLV ETFs.
“Human flourishing is fundamentally a self-directed activity. … Flourishing does not consist in the mere possession and use of goods that might be necessary for a flourishing life. Rather, human flourishing consists in a person developing the skills, habits, judgements and virtues that will, in most cases, achieve the needed goods. The goods must, in a central way, be made one’s own”: Douglas Rasmussen and Douglas Den Uyl, “Norms of Liberty”, 2005: 86.
Is there a readable book about the neurology of human flourishing? The only book that I am aware of that comes close is “Iconoclast”, by Gregory Berns. This book discusses things that have probably happened at a neurological level when famous people have achieved extraordinary things. The brain functions and processes that Berns writes about, however, seem to me to be relevant to the character development and flourishing of all humans.
What are the factors most likely to prevent individuals from achieving according to their potential? Anyone writing a list from the top of their head would be likely to include such things as: getting one’s thinking stuck in a rut; being constrained by fear of the unknown or fear of ridicule; social environments that reward conformity rather than individuality; and lack of skills in social networking. Gregory Berns discusses these factors.
Points made by Berns include the following:
In order to think creatively and imagine new possibilities it is necessary to break out of the cycle of experience-dependent categorization. We need novel experiences in order to see things differently.
Constraints associated with conditioned fear responses can be inhibited through cognitive reappraisal (re-interpretation of information). For example, fear of uncertainty or ambiguity can be inhibited if the situation is viewed as an opportunity to gain additional knowledge by experimenting.
People have a strong tendency to follow the herd in order to avoid activating their fear systems. But one dissenter is typically enough to break the herd effect.
Important social networking skills include promoting familiarity with the goods you are selling (because familiarity defines what people like) and establishing a reputation for being trustworthy.
Do we need a neurologist to tell us such things? Probably not, but it is good to know that there is neurological evidence supporting at least some of the claims made by personal development practitioners.
There is a fair amount of discussion in the book relating to wisdom and knowledge, courage, humanity and justice, but I don’t think there is much discussion of temperance or transcendence. One could hardly have expected all the human virtues to be discussed in the book, however, because Greg Burns did not actually set out to write a book about the neurology of human flourishing.
“No-one seems to be able to give a clear answer due to the sorry state of knowledge about PM’s in Australia but seeing as you work for the Mint, are an accountant, and want to make this site a source of information for Australian gold investing, are you able to make some comment about the capital gains treatment of gold bullion in Australia? Are there any precedent cases in tax law? In particular, is the conversion of unallocated to allocated considered a capital gains event? I know that you are not able to give investment advice but perhaps you could give some hypothetical situations or similar.”
Before I start, let me say that my comments below are general in nature and do not take into account the specific taxation circumstances of each reader. Readers should not rely on what I say and should seek their own independent advice on the taxation implications relevant to their own circumstances before making any investment decision.
The only publicly available information on the tax treatment of precious metals in Australia I know of is that contained in the Product Disclosure Statement (PDS) for our ASX listed product, Perth Mint Gold (PMG). This product is structured as a right to receive gold, so is different to unallocated or allocated, but it does give some pointers as to the likely treatment of physical bullion.
Note that the PMG PDS advice assumes an Australian resident individual taxpayer who acquires PMGs and holds them on capital account, in other words the frequency of your trading would not constitute carrying on a business of trading or dealing in gold.
Firstly, gold is a Capital Gains Tax (CGT) asset. Some gold investors seem to think that gold is a special asset to which the normal tax rules don’t apply. Sorry, it is just like any other real asset, like property. It is taxable.
The PMG PDS advice notes that gold does not earn any income and that it is held with the intention of selling it for a capital gain. This affects the treatment of the costs incurred in acquiring and storing gold. Below is a summary of the tax issues for PMG:
* Sale of PMG on ASX [same as sale of gold]: Disposal of PMG is a taxable CGT event. 50% Discount may be available if PMG held for more than 12 months.
* Physical Settlement [same as unallocated conversion to physical]: No CGT event. Costs of acquisition and exercise of PMG become part of cost base of the gold.
* PMG Management Fee [same as storage fee]: Not deductible in the year in which it is incurred. Forms part of the cost base of the PMG. Can be utilised to reduce any capital gain on the disposal or cancellation of the PMG. Does not form part of the reduced costs base of the PMG and so cannot increase any capital loss on disposal or cancellation of a PMG. Not a cost of acquiring or exercising the PMG. Will not become part of the cost base of any physical gold a Holder acquires through exercising the PMG.
I think the sale of gold and storage fees advice for PMG would apply to physical gold. I am not so sure about the unallocated to allocated conversion because the exact advice on Physical Settlement refers to the option nature of PMG: “Under section 134-1 of the 1997 Tax Act, any gain or loss on the exercise of an option is disregarded and any payment made to acquire the option, plus any payment made to exercise the option, will become part of the cost base of the asset acquired on exercise of the option. Therefore, no CGT will arise if the Holder completes an Exercise Notice requesting physical delivery of gold bullion.”
I think it would be important in any unallocated to allocated (or unallocated collection) transaction to ensure that you are only invoiced for fabrication and storage/delivery and that it is not processed as a sale of unallocated, purchase of allocated. Common sense interpretation is that conversion of unallocated to physical is merely a change in form and as you do not give up the gold in exchange for cash, there is no CGT event. But since when does tax law make any sense? Always best to get specific advice from a tax expert.
There is no doubt that many were examining their careers this Labor Day. Some were just thankful to have a job. Many were reflecting on changes they’d like to make. And still others have already made those changes and are just now headed into new careers. Over the weekend I read an article by Tony Kindelspire in the Longmont Times-Call about three individuals who have made those changes and currently reaping the benefits.
Eric Olinger, 36, of Longmont, CO had worked in lumber and hardware for most of his life. After being let go several times, Eric decided to take charge and find a recession proof job. His research pointed him at the nursing field. He entered nursing school at a community college and has just recently become a certified nursing assistant. He plans to continue his schooling and move further up the medical profession ladder. Eric bets, “People are still going to need medical care no matter what.”
Joseph Vogel, 52, of Aurora, CO was a certified master technician in the automobile industry. After losing his job at Ford, Vogel also decided to go back to community college to become a radiology technician. “Trying to go back to school at an older age is tough,” he says, “but you can do it. It’s frightening, it’s scary, it’s literally life changing, but you can do it.” This past Tuesday, Vogel cleared a final certification test. His new job awaits at the University of Colorado Hospital.
Laura Woods, of Hygiene, CO has been a real estate broker for the last several years. Her career in real estate wasn’t unsuccessful, but in a round about way taught her that what she really wanted to do was teach. Woods just landed and has started as a full-time fourth grade teacher. When asked if she has any advice for others looking for work or considering a change, Wood says, “Go for it. You only go around the block once, and you’re not going to know what you truly love unless you try different things.”
When I began to reflect on these three individual I thought, how did these folks get the job they wanted even amidst all the gloomsters out there claiming there are no jobs to be had?
There is nothing I dislike more than reading a self-help book that turns out to be filled with re-warmed platitudes and stale ideas. That is definitely not the case with “Get the Job You Want, Even When No One’s Hiring”. Ford R. Myers gets straight to real time solutions, with a step by step approach that gets the job done. Finding yourself unemployed is not a pleasurable circumstance in the best economic times. In today’s environment it can be downright terrifying.
From new graduates to those displaced later in their careers, this book is the best tool in your job search arsenal. So buy it, read it, do the exercises, regain your confidence and get out there, armed with a realistic strategic plan to do what needs to be done to “Get the Job You Want When No One’s Hiring”.
If you were searching for meaningful work on this Labor Day, I truly wish you Good News and Good Fortune.
“I have been acquiring Perth Mint silver and gold in the depository scheme and am concerned about confiscation issues in the long term. Probably it will not happen, but again given the mindlessness of recent policy decisions there is no reason why the Australian government could not just decide to tax the gains at a punitive level – ‘because people are making unfair gains from it’ or some other vacuous reason. Seems to me the main risk is not holding bullion, but also the ‘privacy risk’ if you want to call it that, that the government knows that you’ve got it and can therefore either tax it highly or confiscate it. Are you able to make comment about how best to acquire completely private gold and silver (ie no record of the sale therefore no one knows you’ve got it and therefore can’t confiscate it), in quantities of up to 100 oz?”
The scenario you suggest is certainly probable in any country. In an environment where other assets have declined and gold is $5000, the politics of envy may come into play. Classic example of this is the Luxury Car Tax introduced in Australia in 1986. While one can expect that a populist “gold profits tax” would get support, I think it is an open question as to whether it will go down well in Western Australia considering the high profile of gold mining in this state.
As I discuss in Australian Gold Confiscation, secessionism would be “in play” in such an environment. A “gold profits tax” could be considered as an Eastern States Federalist tax grab on Western Australia’s wealth, and could provide yet another reason to secede.
As to Government knowledge of your gold, note that the law only requires Australian bullion dealers to record your identity for purchases above $5000, not report them (unless you give cause for the bullion dealer to believe it is a suspicious transaction).
Therefore for the Government to confiscate, it will first need to personally visit each bullion dealer and go through their sale records. This gives you a bit of time between announcement of confiscation and a knock on your door. It is possible that the data collection will happen in advance of an announcement, but it is likely that rumors would circulate quickly.
In any case, those looking to take possession of physical gold should always consider the privacy implications. The risk here is a thief getting hold of the records of a bullion dealer or courier company. One needs to weigh up the convenience and cost of a telephone or Internet sale (which will leave records) versus a cash and carry purchase from your local bullion dealer.
The only way to protect yourself against this risk is to establish a relationship with your local bullion dealer and buy in cash under the relevant reporting/recording limit ($5000 in Australia). There is nothing illegal about buying a little gold with each pay packet, and most bullion dealers would understand that you are a prudent saver and not a drug dealer. But doing twenty $4990 transactions twenty days in a row would be considered a suspicious transaction and reportable.
For those whose personal circumstances mean the risk of theft is greater than privacy/confiscation considerations and thus choose to store their gold in a facility, just a word of warning not to get tricky with your identification. It needs to be clear to the facility operator who is the beneficial holder of the gold, otherwise you may have trouble establishing title to it (or being impersonated) in the future.
For example, even if there were no account identification requirements for bullion, the Perth Mint Depository would still want photo identification as an additional security measure. It is really the only way we can ensure that the person standing at our doors to collect your metal is you.
By way of example, a couple of years ago we had a call from a person who gave us an account number and account name and wanted to sell. However, he did not have the password, nor was he a signatory, so we could not take his instruction or reveal any details of the account. He gave us details, like purchase dates and amounts, that did correlate exactly with the account, but we couldn’t confirm or deny any of that – because he was not identified on the account. He became extremely agitated, but to no avail.
It turned out that he had the account opened in the name of a company by a broker/agent of his and they were the nominee directors and signatories. This privacy mechanism may have sounded good at the time, and maybe he had some other agreement with the broker to ensure they could not abscond with his metal. However, whatever structure he put in place, he had not considered the scenario where his broker was arrested and put in jail!
Not being keen contact his broker in jail, there was no way for him to get the broker to give us an instruction. He therefore had to wait, unsure if the broker had cleaned out his account. There is a happy ending to the story, as the broker did eventually get out of jail (but it was some months) and put in the sale instruction for him. In some cases, privacy may be too much of a good thing.
The first section of the first chapter in The Great Credit Contraction addresses the conflicting definitions of money and currency. If one does not have a correct understanding of money and currency then they will have flawed conclusions regarding inflation or deflation. This will lead to inaccuracies when performing mental calculations of value and result in poorly allocated capital.
WHAT IS MONEY
The terms money, money substitutes, illusions and currency are often used interchangeably. Since they do not mean the same thing this misuse can be confusing. Even many of the leading experts in this subject have difficulty agreeing on definitions. The conflation of these terms causes great problems in understanding monetary science. Therefore, we will separate and distinguish each.
EXPERTS DO NOT AGREE
MONEY
Money must have intrinsic value by being a tangible asset. This is because when A gives B the pizza, the pizza has intrinsic value. For the transaction to be extinguished, A must receive from B an asset with intrinsic value. If B exchanges a 1oz. American Silver Eagle $1 coin for the pizza, then at the time of the transaction, a pizza and a silver coin would exchange hands. Value would be exchanged for value at the time of settlement, and the transaction would be extinguished.
MONEY SUBSTITUTE
A money substitute, on the other hand, is a negotiable instrument that promises the payment of money. An example would be a silver certificate that reads: ”This certifies that there have/has been deposited in the Treasury of the United States of America (number) silver dollar(s) payable to the bearer on demand.”
Chartalism, the State theory of money, asserts the government gives money or currency its value. This theory completely opposes basic economic law. In reality, the backing of government-issued money substitutes with bullion gives the currency value.
If A exchanged the pizza with B for a silver certificate, then the transaction would be settled but not extinguished until A passed on the silver certificate for value. While A holds the silver certificate, its value could change and it could become worthless. This happened on June 24, 1968 when the Treasury of the United States of America declared it would no longer honor redemption of silver certificates.
The use of a money substitute introduces risk to A in the transaction with B because A relinquishes value when he tenders the pizza to B but does not receive an asset with intrinsic value in exchange at settlement. Instead, A must use the instrument in another transaction to receive value.
ILLUSIONS
An illusion is a negotiable that promises nothing and has no intrinsic value. It is like a silver certificate that promises the bearer no silver. It has value only because individuals are willing to bear the payment risk and other risks of the illusion. The bearer usually tolerates the risks because their cost is lower than the value placed on the utility derived from the service the currency provides to the market participants.
CONCLUSION
In conclusion, currency is primarily used to settle transactions. When money, such as gold, silver or platinum, is used to settle a transaction, then the transaction is extinguished. However, if either illusions or money substitutes are used, then the transaction is not extinguished and one or more parties to the contract are left to bear the risk of extinguishing the transaction. This risk often leads to errors in accurately assessing the value and utility from the underlying consideration in determining the price for the transaction. This is one of the largest risks with using fiat currency. As the illusions evaporate during The Great Credit Contraction, here is a free sample, it will be real tangible assets the remain and increase in purchasing power.
There seems to be increasing skepticism these days about the worth of democracy. The following quote from a post by John Humphreys on the “Thoughts on Freedom” blog provides a good example of what I mean:
“Democracy has become a new faith. Simply saying the word supposedly makes an argument stronger, as though there is some inherent morality in two wolves and a sheep voting on what to have for dinner. Democracy has it’s uses — it allows you to change government without any killing and it puts downward pressure on corruption. But I doubt that it leads to better policy, and indeed I think it has a built-in bias towards ever more totalitarian policy controlled by special interest groups …”
In my view Humphreys is wrong. There is an inherent morality in democracy when it is perceived appropriately as a system in which all members of the polity have equal potential to influence the construction and operation of the political order. The problem is that it is often seen to be legitimate for some groups to use democratic politics as a means to obtain benefits at the expense of others. Such attitudes should be denounced as immoral for the same reason that the attitude that the market economy exists to enable some people to benefit through opportunistic exploitation of others is widely denounced as immoral. As James Buchanan has emphasised, the viability of a market economy and a democratic political system both depend on norms of mutual respect and reciprocity.
The political system in most democratic countries does not have huge problems in dealing with blatant attempts by some people to benefit at the expense of others. Democratic politics can be effective in dealing with corruption (as John Humphreys acknowledges). It is worth noting, however, that corruption often goes undetected for long periods where dedicated institutional arrangements do not exist to detect it.
I think that democratic politics are also reasonably effective in dealing with unsubtle attempts at vote buying, for example where a governing party promises additional benefits to residents of marginal seats in a desperate attempt to hold onto or win office. Parties initiating such tactics risk being perceived by voters as acting unfairly – and hence unworthy of being elected to government.
It is much more difficult for voters to deal appropriately with complex issues such as those involved in trade protectionism. A recent policy brief prepared for the Lowy Institute by Bill Carmichael, Saul Eslake and Mark Thirlwell describes the nature of the problem as follows:
“Most of us have a limited understanding of what is at issue in decisions about protection. Our response to the prospect of opening domestic markets is influenced by the information available to us about the domestic consequences. In the absence of public information about the economy-wide gains at issue for the community as a whole, and in view of the more visible costs to prospective losers, the latter have naturally found support at home. As a result, governments have had difficulty mobilising a domestic commitment to open domestic markets to international competition” (“Message to the G20: defeating protectionism begins at home” p 7-8).
The solution advocated by the authors is “a domestic discipline on national decision-making that promotes wide domestic awareness of its economy-wide costs.” Rather than attempt to summarise the proposals here I recommend that people should read them in the context in which they are presented in the paper.
The thought that I would like to leave you with here is that there is scope for policy outcomes in democracies to be improved if more intellectual effort is put into constructive efforts of the kind presented in the Lowry paper.
Jayanth Varma is astounded that some corporate treasurers think that their derivatives positions should not be backed by collateral. I am too. On a related track, there is news today that RBI is pushing banks to report interest rate swap transactions through CCIL. This is in the right direction.
The futures clearing corporation as the role model
The role model here is the futures clearing corporation, e.g. NSCC. Futures clearing corporations are designed to enable safe trading between strangers, which makes possible the nice efficiencies of the anonymous electronic market. In doing this, futures clearing corporations demand the identical collateral from all customers. There is no question of NSCC exempting SBI from collateral requirements because SBI is para-statal. It is through such toughness on collateral requirements that NSCC has built up a 13-year track record, of surviving quite some market turbulence, as central counterparty.
More generally, the `recipe’ of how clearing corporations work has fared well in the last 100 years, barring a few failures which are really about operational risk, corporate governance, malpractice etc. If someone is serious about running a clearing corporation properly, it can be made to work. All that one has to do is to ensure sound ownership and governance in the exchange business.
Rule of law
I have a disagreement with the mechanism adopted by RBI, on the issue of rule of law. If the story is accurate, RBI officials met a few banks and asked them to do something different. If we respect the concept of rule of law, then it is better to run through the full set of steps:
Put out a draft rule change for comments.
Genuinely, substantively, listen to the commends. Consider it possible you may be mistaken.
Put out a modified rule on the website, after which everyone should be obeying it regardless of whether there has been a meeting with RBI officials or not.
Rule changes should be appealable at an SAT.
This is a better process flow, one that expresses the goal of having rule of law. SEBI is the most advanced financial regulator in India today, in having developed the closest approximation to this process.
A real problem with corporations and OTC derivatives in India
I am not a legal expert, but in my understanding, at present, if two corporations enter into an OTC derivative against each other, this is not enforceable. Enforceability is limited to the class of transactions where one of the two counterparties is a bank.
This is reminiscent of 1970s vintage rules of the game in exchanges. Here, exchanges forced the public order flow to only go to market makers. Public orders could not match against each other. Or to say it differently, public orders could not compete with the quotes posted by the market maker. This was a way to rig the rules of the game so as to favour the market makers.
In similar fashion, the existing rules with banks and OTC derivatives in India (if I have understood them correctly) are a way to prop up the profitability of banks at the expense of customers of banks. This is anti-competitive. It helps ensure that the inter-bank OTC market is a rigged game, one that favours banks at the expense of corporate customers. It is one more reason why exchange-traded derivatives are so important in India. It is only on the NSE screen that, for the first time in India’s history, we are getting a genuine, competitive, transparent market for the currency or interest rate futures.
These kinds of efforts at rigging the game, in the context of corporations and OTC derivatives, help increase the chances that India will be a pioneer by world standards on the shift of the currency and bond markets to the exchange platform. In terms of the ratio of the size of the OTC currency forward to the size of the exchange-traded currency futures, India is already one of the remarkable places in the globe.
Where corporations are different
While futures clearing corporations should give no quarter to corporate customers as far as collateral requirements are concerned, I think there is a case for having bigger position limits for corporate hedgers.
There is a genuine tension here. If small position limits are used, this reduces the usefulness of the derivatives market for society, because the most important customers of hedging (corporations) are blocked from using it. If special rules are applied for corporate hedgers, there will inevitably be certain shades of gray on what gets done. Yet, when regulators swing over to the other direction and blindly force tiny position limits, it imposes a cost on society. There is a bias towards such over-reaction given that regulators have a different personal perspective on the risk and return from a rational rule set, when compared with the welfare gains to society.
I think the real answer lies in more principles based regulation. For physically settled contracts, there should be no dislocation in the delivery process and for cash settled contracts there should be no artificial distortion of the market price. An excessive attempt at writing down rules does not get the job done.
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