In Gold We Trust
is a special report by Ronald-Peter Stöferle of Erste Group Bank
. It is very comprehensive and well worth a read because it covers across its 65 pages all key factors influencing gold prices, leading to their conclusion that:
“The risk/return profile of gold investments remains excellent. … Our next 12-month target is USD 1,600. We expect the parabolic trend phase to still be ahead of us. At the end of this cycle the price should reach our target of USD 2,300.”
In the section “Paper gold vs. physical gold” (pages 36-37) however I would debate the following statements:
“At the moment physical gold commands a premium of up to 20%.”
In the wholesale physical market the Perth Mint is not seeing anything abnormal. Even in the retail market premiums are back to normal (subscribers to Sharelynx can see this for themselves at the CoinPremiums page). I have asked Ronald-Peter where he is getting this number from but no response as yet.
“According to Paul Mylchreest the London OTC market trades 2,134 tonnes of gold every day. This is 346 times the daily production and close to the global annual production.”
This point is presented as proof of a discrepancy between the physical market and paper gold market. As discussed in this blog post, I don’t see any problem with this rate of turnover. In his report Mylchreest concluded that gold’s 12.7% turnover “is excessive and doesn’t pass the smell test.” My alternatively conclusion is that “the very fact that gold is no one’s liability and cannot be printed means it attracts a disproportionate amount of trading and speculation. … Could not the 12.7% figure be proof of the special monetary nature of gold, proof that it is the King of Currencies?”
“According to Jeff Christian, founder of CPM Group, the trade on the LBMA is based on a leverage factor of 100:1″
Mr Christian has stated that he was talking about COMEX paper trading versus physical COMEX deliveries. There are some who think he is trying to retrospectively cover up his admission. My view is that a 100:1 fractional is ridiculous considering the crucial role London plays in the physical market. London unallocated simply could not function on a 100:1 ratio in my view. Those who accept this number do not appreciate to amount of physical delivery made ex-unallocated accounts by the trade. In any case, Mr Christian actually confirmed the fractional/leverage ratio of bullion banks at around 10:1. See this blog post.
“The volume of gold derivatives is worrisome as well. According to the Bank for International Settlements, the nominal value of all gold derivatives at the end of 2009 amounted to USD 423bn.”
I have often seen the nominal value referred to and while it produces an impressive number the way it is presented is often misleading on two fronts:
1. Common interpretation of these numbers is that the market is short $432bn worth of gold. In fact the nominal value is the summation of both long and short positions, it is not a net figure. If one looks at the BIS figures it can be seen that bought and sold options somewhat net out (although it is not that simple because of differences in dates and strikes).
2. Nominal does not equate to actual value at risk. As per the BIS report: “Nominal or notional amounts outstanding provide a measure of market size and a reference from which contractual payments are determined in derivatives markets. However, such amounts are generally not those truly at risk. The amounts at risk in derivatives contracts are a function of the price level and/or volatility of the financial reference index used in the determination of contract payments, the duration and liquidity of contracts, and the creditworthiness of counterparties.”
They note that “Gross market values provide a more accurate measure of the scale of financial risk transfer taking place in derivatives markets” and if one looks to page six of the report it states that the gross market value of the $432bn nominal figure is actually $48bn.
There is also the issue of what the actual delta-adjusted position (see page 10 of GMFS Hedge Book for an explanation) of the $432bn nominal gold derivatives and real impact on the spot market, but that is getting a bit technical. The point is don’t get over excited by the $423bn figure and assume it means the market is short 10,000 tonnes of gold.
The Mortgage Bankers’ purchase index was released at 7:00 AM EDT, and there was a week to week decrease of 5.9% in the Purchase Index and a week to week increase of 12.6% in the Refinance Index as the housing market continues to show weakness since the second financial stimulus program for home sales came to a close at the end of April, but refinancing remains strong due to low interest rates.
At 8:15 AM EDT, the ADP Employment Report will be released. Investors will be watching this number to get advance notice on the state of the job market in advance of the government’s report on Friday.
At 9:45 AM EDT, the Chicago PMI Index for June will be announced. The consensus index value is 59.7, which is the same as May, but is still well above the break-even level at 50.
At 10:30 AM EDT, the weekly Energy Information Administration Petroleum Status Report will be released, giving investors an update on oil inventories in the United States.
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Trace: Welcome back to the RunToGold Podcast. We have a special guest with us today, Aaron Krowne; he is the founder of ML-implode.com which is the hub in the mortgage lending industry. Welcome, Aaron.
Aaron: Hey Trace. It is good to be back.
Trace: Gold is at an all time record high right now. I remember last time we chatted on the podcast, we were talking about how housing was going to be going down in terms of gold, and it has. So, what gold price represents is the common stock of nations evaporating, just like how BP has lost a tremendous amount of shareholder value as its threatened with potentially even becoming insolvent and bankrupt. So likewise, the governments are threatened with this similar thing, with gold rising in currency. And so it portends these, as you’re talking about before these cracks in the dike. Can you expand a little bit more on that, these cracks in that dike and what you are doing with this right now?
Aaron: Well first of all I would like to say that your point about the common stock of nations is very apt and I’ve come to think of fiat money as that. The talking heads, the propagandists, tell us that gold is pointless as it stored value as an investment because it doesn’t pay dividends. But what dividend does fiat money pay? By itself it pays nothing, it’s just a question of what you’ve invested in and that’s really more of a speculative exercise these days, than anything that could be credibly called storing value. So, it’s really just a bogus comparison and in that sense gold ranks very strongly and I think the market is starting to see that the store value function is incredibly important to that common stock of nations which is going the way of BP.
Trace: Yeah. In fact I was in New York about a month ago, one of the Meese’s activities and while I was there I met with a couple of the different hedge funds that I work with, and one of them said that the current environment –now this guy runs the biggest Indian hedge fund, you know investment companies over in India, – he said this environment we’re in is a return free risk. Which I thought was a clever play on words which gets right exactly what you are talking about, about how this is just a complete speculative game with these little colored coupons.
Aaron: Exactly and that pertains to your question about cracks in the dike, and what we’re seeing there now at this time. And it really is about that return free risk that is not gone away. That is the condition of the market and the financial markets in general during the financial panic. We’ve seen it time and time again in history, and we are in one of those times now where what predominates is financial panic. And, sure, it can calm things for awhile with government intervention and propaganda. That changes nothing unless the underlining problems, the mass insolvency, the overleveraged character of the most investments out there — I’m not saying it’s actually fixed — which it hasn’t been.
So, about a year ago the stock market started rallying and that makes everybody feel happy, like a big mood ring or something for the financial markets and the economy, and sadly for the society in general, and the national politicians really buy into that and stoke that. So over the past year the zeitgeist has really been about “oh you know things are really recovering and there may be problems but the government is going to take care of them” and whether that’s actually stated or not I think that that’s been the feeling of people in general. At the same time there’s been this unease the job market is not really coming back, the economy still seems very weak in many ways and many metrics are evidence of that. But those underlining problems haven’t been solved and we, and many others in the country, have been writing about that for the past year and pushing articles of that sort of theme and I think now are saying that that’s correct. A year later the pundits are starting to talk about some of these forward looking indicators are now starting to falter.
After the trillions have been spent on stimulus, and some of that, essentially, vapor high is wearing off, there is nothing there. There is no foundation, or the foundation is eroding and the cracks in the dike are continuing to spread. We have run out of silly putty, we are resuming the process that was there before and what we’ve seen with European sovereign debt is just one area where panic set in.
Trace: It’s all fun and games until somebody’s entire lifetime savings goes up and evaporates. And that’s what we are seeing with the pension funds…
Aaron: Right, that’s also the risk for not only European banks but banks around the world in terms of the sovereign debt they hold. That someone being a large chunk of Europe and the rest of the world is at risk of losing their welfare and the sovereign defaults which cover much of Europe.
Trace: I think 39% of BP is owned by British pension funds and another 40% are owned by American pension funds, one of them being in New York who has lost $100 million on the BP investment. But really the New York massive budget problems, they’ve had to borrow money from New York pension funds to make the minimum payments to the pension fund, but that hundred million that they’ve lost in their BP investment that kind of pales in comparison to your specialty, right?
Aaron: Yes, the housing market. Absolutely. That’s one area where we are starting to see those cracks resume their spread, and that is an area where Congress focused a lot of very blatant papering over wallpaper style aid, and they did that with the home buyer tax credits, which are basically… I have heard them being called the home buyer or home sucker tax bribes, but they basically give you cash for buying a house and it essentially alleviates the need to come up with cash, and put cash into the transaction. You’re not supposed to use it as a down payment but you can always move money around so…
Trace: If there’s even a transaction. I’ve heard that there are quite a few prison inmates who have been claiming the tax credit!
Aaron: These programs are always a complete free-for-all, and they invent them out of thin air and they don’t have the resources to administer them and they just want to print money and throw it at the market and try to focus it on a particular sector of the market. In that sense it worked. It did halt the decline in home prices across the country and some markets may be reversed a little. But the evidence has been out there for months, that thought was wearing off, just another vapor high wearing off. And they had to pass a second tax credit when the first one ended and then they could see sales plummeting and now the second one has run out and of course you have the largest drop in new home sales ever in history over a one-month span, I believe.
So that that was just pretty much pointless, other than to buy the politicians some time for their expensive fee, and of course now their data is indisputable, that that was not a real organic recovery and now the mainstream analysts, the pundits, have to take notice. So that’s has really characterized the period we are in now, where the mainstream analysts having to wake up to the fact that nothing has really been fixed. The way they put it, is that we’re more able to head into another dip, and it’s actually called a double dip recession.
Trace: So where do you see the real estate prices going then, both the housing and commercial?
Aaron: Well as far as residential I have heard of the risk being as much as another 25% to the downside, maybe more, maybe less in some markets, and that’s fair. If you look at the long-term average inflation adjusted you’ll see that we’re still actually considerably above the long-term trend line, so another 25% or so relative to the peak in 2006 is certainly… we won’t actually get an overshoot, that’s the downside. And when that happens in concert with inflation, so a lot of that decline might only show up inflation-adjusted but it will still be a fair, severe bare market in real estate.
Trace: Which we’ll see when we price it in gold.
Aaron: But when you price it in gold, yeah exactly, it would be plummeting like a stone, like a gold nugget.
Trace: Well this has been very insightful. Thanks for being on the podcast again!
Income, Spending, and Saving All Grow in May
According to the Bureau of Economic Analysis the month of May provided a triplet of economic good news — personal income, spending, and savings all grew. Furthermore, income grew even greater than consumer expenditures and consequently, savings grew as well.
All three measures added similar gains in March of this year.
Personal income has remained fairly stable over the past three months, growing between 0.4% and 0.5%. Over the same period, disposable income has averaged about 0.5% growth. For consumers to be able to spend more on discretionary purchases, their disposable income must of course increase.
Spending has been less stable, recently. In February and March we finally saw spending growth increasing, after the recessionary downward trend of 2009. The first uptick however post-recession had consumers increasing spend without as much additional income, which meant shoppers were relying more on credit to spend and saving less. In April, however, that changed. Spending was constant, while income continued to grow. And in May? We’re now seeing an even better reading: more income growth, but with some additional spending as well.
At 7:45 AM EDT, the weekly ICSC-Goldman Store Sales report will be released, giving an update on the health of the consumer through this analysis of retail sales.
At 8:55 AM EDT, the weekly Redbook report will be released, giving us more information about consumer spending.
At 9:00 AM EDT, the monthly S&P/Case-Shiller home price index report will be released. Given that most economists don’t expect the overall U.S. economy to improve until housing prices end their decline, the market will be watching this number closely.
At 10:00 AM EDT, the monthly report on Consumer Confidence for June will be released. The consensus index level is 63.3, which would be flat compared to May, but much higher than the value in April.
Also at 10:00 AM EDT, the State Street Investor Confidence Index will be released, which looks at changes in the amount of equities held in the portfolios of institutional investors.
At 3:00 PM EDT, the Farm Prices report for May will be released, giving investors and economists an indication of the direction of food prices in the coming months.
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Blog post series, like the vuvuzela, is the new bacon; it works with everything and with John Hempton’s recent excellent series on the economics of default in the Eurozone and Edward’s recent postings on AFOE in which he pulls out some of our old paper abstracts has inspired me to a series in which I try to pin point exactly how demographics and macroeconomics interact and where I believe we need more focus and work.
When it comes to the overall link between demographics and macroeconomics we already have a number of core workhorse models in the form of the life cycle and life course framework where the former deals with consumption and savings decisions as a function of age and the latter deals, broadly, with life time events and their individual and aggregate importance on economic dynamics. The adequate impact on the macro economy from the dynamics of demographics must then be developed as a function of the attempt to do two things; firstly, to continuously develop the life cycle and life course theories themselves and secondly to seek out new ways to apply life cycle and life course theory to existing macroeconomic problems and themes.
In the first series, I will begin with the latter. Overall, I will highlight 6 areas where demographics enter macroeconomic theory and research as an important variable and I will try to offer my view on where to progress further. I will begin with two classics in the form of growth theory and open economy dynamics.
Firstly, I need to say that I am not an expert on growth theory and this represents somewhat of a problem since growth theory although somewhat out of vogue at the moment has grown to become an extremely diverse field with a wide number of different schools and discourses. For the purpose here it will suffice to note that most economists today still use some form of the classic production function framework which has its roots in the work by Charles Cobb and Paul Douglas in 1928 and was popularized in 1958 by Solow’s famous article. This is what it looks like;
Where Y is output, K is physical capital, A is the illusive residual or more specifically technology/production function, L is the size of the labour force and H is a measure of human capital. Now, I certainly won’t do any math at this point and it is important to note that the functional form may take many exotic forms (which are not necessarily Cobb-Douglas), but just to give you one example the following is a Cobb-Douglas production function which incorporates human capital as above (here with constant returns to scale);
The key point I want to emphasize here is simply that we have output as a function of some input and that we would like to account for and explain the dynamics and behaviour of this input. How might we imbue this model with reasonable characteristics that reflect demographic dynamics? As it turns out, we already have some pretty solid frameworks to deal with this questions and we can see this by looking at the inputs one at a time.
The evolution of capital (K) – In most traditional models the evolution of capital is simply expressed as the fraction of income save minus any depreciation of the capital stock in the last period and here of course we have several workhorse models to show demographic dynamics that are all wrapped up in the form of the life cycle hypothesis of savings and consumption. Usually and since most of these models are constructed on the basis of Walrasian microfoundations, we have some form of intertemporal optimization problem ticking away in the background which assumes an OLG (overlapping generations) form. The classic model here is the Diamond model who is based on Diamond (1965) which is the father of all OLG models, but over time a plethora of different OLG models have been developed with differing degree of analytical complexity.
The basic problem here though remains the concept of the steady state which means that we must construct model such as to allow the change of capital through time (or its derivative with time) to be 0 in the long run. Please note here that this condition is not imposed on the basis of empirical behaviour but on the basis of (mathematical) analytical tractability. So, apart from the uncertainty surrounding exactly what this ”long run” is it also locks in the analysis and assumes away a large part of the important aspects of even basic life cycle behavior. Specifically, the idea that once reaching a steady state any change in the savings/consumption rate will one have transitory effect and that the economy will automatically (and always) converge to the same growth rate/state as before is a problem. Essentially, the whole idea of a steady state whether be it in the form of an exogenous or endogenous growth theory framework is a huge problem since it is evident that such a thing does not exist. And even if we could establish over a very long run horizon that such an average/constant path is a good approximation we would be ironing out all the interesting and important questions in the process.
The evolution of human capital (H) – The adoption of human capital into the growth theory framework is famously due to a paper by Mankiw, Romer and Weil in 1992 in which human capital is proxied by rates of schooling and thus the perspective becomes one of the quality of human capital and to the extent that the formation of human capital also includes the evolution of the population (or perhaps working age population) we can say that this is a direct way in which demographics enter the framework. Again, we might simply ask here; to what extent does the aggregate quality of human capital in an economy depend on the age structure of its population and here I am not only talking about the level of education but much more broadly about the idea of innovative capacity as a function of population structure.
The evolution of technology (A) – Technology and productivity are famously assumed exogenous in the Neo-Classical tradition while New Growth theory as it was developed in the 1980s and 1990s emphasised the need to specifically account for the evolution of technology. Today, I would venture the claim that there is a consensus that productivity and technology is a function of what we could call, broadly, institutional quality which encompass almost anything imaginable from basic property rights to the level of entrepreneurship. Indeed, a large part of research is still devoted to pinning down exactly which determinants that are most important here both across countries and through time. Now, I would argue that, in the context of standard growth theory, this is where the scope for the study of the effect of population dynamics is largest. Thus I don’t think it is unreasonable to expect the level and evolution of productivity growth and technological development to be a function of the current population structure but also its velocity which is a function of e.g. migration (new inputs?), future working age size etc. Also, this is also where human capital and the evolution of technology is joined at the hip through the idea of innovative capacity and readiness.
As you might have inferred from the exposition above, I have some difficulties with growth theory. I can admire the framework for its internal logic and I can see why it is an important part of a macroeconomist’s toolkit, but I also think that growth theory (as I describe it above) has outlived itself. In this sense, most of the questions that we have as economists when it comes to the evolution of growth and welfare of our economies both individually and through their interaction is not addressed by growth theory. Especially the effect of an ongoing and ruthless process of ageing is completely impossible to analyse in the standard framework. Naturally, I am also being a bit unfair here since the kind of growth theory I am describing above is also too simple to give adequate credit to where the field is today. For example in relation to demographics, I am grossly overlooking important strides in the development of OLG models which have been perfected continuously so that we today have a very large battery of very complex models. But also more generally, growth theory is being used today to produce a lot of useful research. As I say, it remains a key tool in our toolbox.
Yet, the basic growth theoretical setup remains flawed in key a number of un-salvagable ways. Concretely, specifying a production function and specifying the underlying inputs as differential equations through whose solution we reach a steady state equilibrium is not, in my opinion, the way to go. Thus and in an intuitive sense I feel much more at home, for example, in the company of evolutionary growth theorists  whose argument and methodology is more agile. In summary then and as I try my utmost not to become a hostage of the notion of a steady state I will simply make the following observations in the context of what we macroeconomists consider the main inputs to growth where the ”age” is simply an unspecified collection/function of variables that pertains to fertility, age structure, mortality etc (and of course a whole slew of other factors, but for the sake of argument let us keep it monocausal here).
Where age in the context of the capital stock relates to the size and evolution of the capital stock as well as savings and investment dynamics, in the context of human capital it may be argued to enter directly, but may also affect the quality of human capital. Finally, I think that the impact of demographics on innovation and especially the idea of velocity of innovation and innovative capacity represents an area which is not well understood. In general though and short of letting some variant of demographics enter directly, I think an important research program would be to examine the effect from demographics on the inputs to growth which we traditionally operate with. Especially, the process unprecedented process of ageing is a completely new phenomenon here in the context of traditional growth theoretical analysis.
Open Economy Dynamics
An enduring feature of macroeconomics is that the entities we study are not black boxes but interdependent entities who interact in very complex ways in the global economy. This statement was true 40-50 years ago and today it is almost a cliché. In fact, for non-macroeconomists it must seem very strange that we still distinguish so strongly between closed and open economy analysis as the use of studying the former must surely be almost nill. I would agree with this statement but simply note that important things do actually happen when we go from a closed to an open economy and the way this transition is operationalised is important in itself.
Now, I could write a lot about this (in fact, I have penned a whole thesis about it), but I will only cover the essentials. What you need to know upfront are two things. The first is that the economic theory used to handle the effect of age structure/demographics on open economy dynamics is again the life cycle framework and, in most cases, we still have a OLG representative agent model taking care of the microfoundations. Secondly, it is important to be aware of the concrete specifics of the transition from a closed to an open economy. Luckily, this can be handled by some very simple algebra from macroeconomics 1-0-1.
The whole point is to find an expression for savings, so for the closed economy we have;
By definition every unit of output has to equal a unit of income, and national income in any given period can either be saved or consumed. This means that national income can either be put aside for saving or consumed through government (G) or private consumption (C). In this way, we define national saving in any given period as;
This is a fundamental result in basic macroeconomics and what is equally fundamental is why this changes in one key aspect when we move into an open economy setting. We then have;
With (x-m) equal to the trade balance and by doing the same exercise above we get;
In this context and remembering that the life cycle hypothesis tries to map consumption and saving as a function of age, the transition from a closed to an open economy becomes crucial in order to see how demographics may affect open economy dynamics. As such, allow me to quote the following passage of my thesis which I find myself coming back to when thinking about this topic;
The best way to think about this  is to imagine that savings and investment are in a race governed and controlled, as it were, by the transition in age structure that occurs as a result of the demographic transition. Initially, as the transition sets in with a decline in mortality and where fertility only follows with a lag, investment demand outruns the supply of savings and the economy is running an external deficit. Steadily however, the supply of saving catches up with investment demand which itself begins to decline and thus the external balance moves into a surplus. Finally, the pace of savings accumulation is replaced by outright decumulation (dissaving) and the external balance moves into deficit as savings decline faster than domestic investment demand
This is stylized of course, but especially the idea of the race between savings and investment is a very helpful metaphor. Consider then a closed economy; in such a setting there can be no race as described above since savings and investment will be tied together at all points in time, but in an open economy savings and investment dynamics are exactly what provokes relations between economies and more specifically, the fact that the economies have different preferences for savings and investment at different points in time. This gives a very strong foundation for thinking about how demographics affect open economy dynamics.
Concretely, and in order to tie the argument up on the underlying theory capital flows occur precisely because economies have different intertemporal preferences for consumption and saving and since this intertemporal preference itself is a function of age (through the life cycle/OLG framework) demographics become a driving force for international capital flows.
This as it were is also where the fun begins since exactly how this process should be understood both from the point of view of the individual economy, but also in a global context remains, for all intent and purposes, an unresolved question. Surely, we have studies that use basic life cycle frameworks to simulate capital flows between economies and they do have some intuitive appeal and explanatory power, but they are hampered by, in my opinion, by an inadequate understanding of the life cycle thesis and how exactly it manifests itself. As I noted in the beginning, part of all this also requires a continuous development of the life cycle hypothesis itself and here this becomes important. Personally, I have cast my eyes on two areas of research where I believe that the influence of demographics on open economy dynamics is important.
1 – Global Imbalances
This represents an enduring feature of the global economic system and while everyone can agree that they need to be resolved some way or the other I think that the proper understanding of demographics shows us that they are essentially structural. Especially on the side of surplus economies I have argued (both in my thesis and in genera) why we cannot suddenly expect economies such as Germany and Japan to do their part and crucially, why we should expect more economies to venture down the same path as they are also ageing rapidly. Importantly, this provides a concrete theoretical spin to the question everyone seems to be asking at the moment of who exactly is going to run the deficits? The pessimistic answer here is no-one and herein lies the rub.
2 – Export dependency
This one is essentially the concrete theoretical proposition used to make the argument above on global imbalances. Ageing leads to a decline in domestic demand and in a closed economy there is really not a lot you can do; savings/investment will fall and consumption will be lacklustre since there is no underlying dynamic to feed it other than dissaving. However, in an open economy you can fight this through claims on other economies or put in another way, you can save more than merited by domestic demand and thus you can invest your savings abroad. Note here that technically this is exactly what e.g. Germany and Japan are doing in the sense that their excess savings have to be matched by excess borrowing/investment demand elsewhere.
I am still developing these two areas, but there are plenty of meat on this topic I think. One crucial task is to develop the life cycle hypothesis on the basis of observed behavior of economies as they age and another is to.
Stay tuned for the next post in this series which looks at the influence from demographics on asset prices, demand, and return and composition of consumption. Suggestions and comments on potential omissions on my part are welcome.
 - Most often operationalized through an OLG framework.
 – Evolutionary Growth goes back to this one “Nelson, R.R., Winter, S.G., 1982. An Evolutionary Theory of Economic Change. Harvard University Press, Cambridge, MA” and is a must read I think. The work by Jan Fagerberg is a good place to begin as well as for a more modern exposition.
 – I.e. demographics and savings and investment behavior in an open vs closed economy
In late 2008 Australia nearly had a full blown bank run. The Australian newspaper’s edited extract from the book “Shitstorm” details the run and is well worth a read:
“It was a silent run, unnoticed by the media. Across the country, at least tens and possibly hundreds of thousands of depositors were withdrawing their funds. Left unchecked, there would soon be queues in the street with police managing crowd control … It’s a long time since Australia has had a serious run on a financial institution, but it’s all about confidence, and you cannot allow an impression to develop generally in the public that there is any risk.”
The article states that there are “60 storerooms across the country with an average of about $35 million in each” plus “the Reserve Bank has its own cash stash … understood to be in the region of $4 billion to $5 bn”. This gives us a total of say $7b. Over an estimated adult (15y+) population of 17.8m that works out at only $400 per person.
The article also notes that “households pulled about $5.5bn out of their banks in the 10 weeks between US financial house Lehman Brothers going broke … and the beginning of December … a year later, only $1.5bn had been put back.”
So there is still $4b of what I would call “fear” money out there. Now guess how long people will continue to hold this cash if faced with increased inflation while observing a strong AUD gold price? Would they not consider gold a better store of wealth in such circumstances?
Putting the $4b in perspective, it equals 87 tonnes of gold. Perth Mint refines on average say 6t per week. Now as the article says, the cash was withdrawn over 10 weeks, so you would not see instant conversion into gold. But then consider you would have at that time additional people who weren’t freaked out last time starting to withdraw cash out of the banks.
Faced with that sort of local demand, the Perth Mint would be able to draw additional metal out of London, but either way in such a high/hyper inflationary environment I can see Australia’s gold production being locked out of international markets for at least 3-4 months. Sorry India, sorry COMEX, we are all out.
At 8:30 AM EDT, the monthly Personal Income and Outlays report for May will be released. The consensus for Personal Income is an increase of 0.5% over the previous month, which would be the fourth month of gains in a row. The consensus for Consumer Spending is an increase of 0.2% after there was no change last month, and the consensus Core PCE price index change is an increase of 0.1%.
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Richard Posner’s recent book, ‘The Crisis of Capitalist Democracy’, is mainly about the global financial crisis, how it came about in the US, the lessons that the author thinks we should have learned from it and what governments should do to prevent similar crises in future. According to this distinguished author the crisis came about because of lax regulation; we have learned from it that the financial system is inherently fragile and that Keynes is still relevant; and the way to avoid similar crises in future is to introduce regulatory reform in the financial sector.
To be fair, Posner condemns some of the knee jerk responses of governments introducing tighter financial regulation and acknowledges that he is not entirely happy with his own suggestions for regulatory reform. He views the only ambitious proposal that he discussed sympathetically – the separation of commercial banking from other forms of financial intermediation – as ‘fraught with problems’ (p.362).
It is arguable that the global financial crisis was a crisis of capitalism. A milder financial crisis might still have occurred if central banks had not previously acted in ways that led major financial institutions to expect that they would be bailed out if their excessive risk-taking resulted in major losses. It is even possible to entertain the idea (as I did here) that the financial crisis has highlighted a fundamental problem in that laws governing the financial system currently permit financial intermediaries to make promises that they can’t always keep. But why view this economic crisis as a crisis of democracy?
The title of the book arises from Posner’s view that while the American political system can react promptly and effectively to an emergency, it ‘tends to be ineffectual’ in dealing with longer term challenges:
‘The financial collapse and the ensuing depression (as I insist we must call it) have both underscored and amplified grave problems of American public finance that will not yield to the populist solutions that command political and public support. The problems include the enormous public debt created by the decline of tax revenues in the depression, the enormous expenses incurred by government in fighting the depression, and the boost the depression has given to expanding the government’s role in the economy. These developments, interacting with a seeming inability of government to cut existing spending programs (however foolish), to insist that costly new programs be funded, to limit the growth of entitlement programs, or to raise taxes, constitute the crisis of American-style capitalist democracy’ (p.387-8).
Unfortunately, the quoted passage appears in the final paragraph in the book rather than the introduction. There is not much discussion in this book about this supposed weakness of the US democratic system. The author implies that it is largely a problem of political culture. Republicans favour low taxes but they have been reluctant to reduce government spending. Democrats favour high levels of government spending but they have been reluctant to raise taxes. As a result:
‘From the standpoint of economic policy we have only one party, and it is the party of profligacy’ (p.384).
As a person living in a democratic country in which a large part of the electorate has come to equate responsible economic management with budget surpluses and minimal public debt (to the dismay of some left wing economists who would like to see more public sector investment) I find it difficult to take seriously the idea that the current political culture in the United States involves a crisis of capitalist democracy. I am confident that before too long Americans will insist that their governments balance their books in order to avoid the problems currently being experienced in Greece and other European countries.
However, the picture might look a lot different from within the US. Before a change in political culture can occur in the US it will be necessary for a lot more Americans to become concerned about the future implications of current fiscal policies. Richard Posner claims that he has no idea how to solve the problem of America’s political culture (p.385) but I think he is contributing to the solution by merely raising awareness of the problem.
On 18th June, the President signed an ordinance that would settle the recent spat between SEBI and IRDA over unit linked insurance plans (”ULIPs”). The ordinance makes it clear that ULIPs cannot be regulated by SEBI and places them within the jurisdiction of IRDA. The ordinance also tries to prevent further disputes by setting up a joint committee to address future conflicts. But this is not all there is to the matter. The ordinance also amends 4 major acts of parliament governing financial markets in the country (the RBI Act, the Insurance Act, the Securities Contract Regulation Act and the SEBI Act) with minimal consultation. The language of the ordinance also raises a wide range of questions about regulatory arbitrage, misselling, what issues the joint committee would actually consider, the very effectiveness of the proposed solutions, good governance and the structure of financial sector regulation. This is not a small list.
Looking at these matters in turn, the ordinance raises serious concerns about regulatory arbitrage. Today, ULIPs act as ‘endowment policies’ where the premium paid by the insured on a what is nominally a life insurance contract is invested in the stock market. Under these contracts, if the insured dies before the maturity of the policy, there is an insurance payout. After a fixed period or maturity, the investments in the stock market are liquidated and returned to the insured minus charges. Under these conditions, insurance companies cover the risk of premature death for only a short period of time (between entering into a contract and maturity). As such, the insurance component of these policies (the money which the insurance company must keep with itself to meet its contingent liability) is very low. The rest of the money can easily be invested and payouts depend upon the stock market.
Mutual funds are similar in all aspects to ULIPs except for the small component of insurance that an ULIP carries. However, mutual funds must comply with tough regulations imposed by SEBI and are severly limited in the forms of fees they can charge. Financial firms faced with the choice of registering as a mutual fund and complying with SEBIs regulatory framework or providing a small component of insurance in their product structures, registering as a ULIP, and charging open-ended fees, will rationally choose the latter.
Second, as many others have commented, the ordinance does not address misselling. (See recent articles by Monika Halan, Deepak Shenoy and Jayant Thakur). The ordinance does not include any provisions to deal with misselling. The ordinance also does not address IRDAs lack of enforcement capabilities vis a vis SEBI. The ordinance does active harm and removes provisions that previously protected investors. By amending the Securities Contract Regulation Act, insurance instruments are now not considered securities for the purposes of the Act. Section 27 A and B were one of the few statutes in the country addressing misselling. These two sections gave investors in collective investment schemes and mutual funds limited investment protection, namely rights to income under collective investment scheme. These small provisions will now not apply to insurance products, weakening investor protection for the time being.
Third, the provisions of the ordinance raise concerns about what matters the joint committee would actually consider. The dispute settlement mechanism in the ordinance specifies the securities which can be referred to the joint committee. We wonder: could the ULIP controversy have been the first matter submitted to the joint committee? In any case, since new types of securities are constantly being developed by financial firms, the joint committee would need frequent legislative interventions to be operable. For example, the joint committee in its current form, does not include the Forwards Markets Commission (FMC). If a product were to be launched which consisted of a hybrid of steel futures and steel companies futures (not an absurd proposition to the extent that steel prices play a significant role in the profits of the steel industry), the FMC would not be allowed to approach the joint committee as the Commission is not a recognised regulator under the ordinance.
To take up a different example, the joint committee is also limited in its jurisdiction to “hybrid” or “composite” instruments. Certainly many disputes could arise between regulators that do not involve an underlying hybrid or composite instrument. An instrument governed by one regulator that has a negative effect on the market regulated by another regulator, as with the regulatory arbitrage hypothesis suggested above, could not be referred to the joint committee. Neither could issues which bring instability to multiple markets, unless, of course the underlying instrument is hybrid or composite.
Fourth, the structure of the joint committee points to problems of institutional design. The ordinance is largely silent about the procedures the joint committee would follow. This is not simply a technical matter. How would differences of opinion in the board be settled? By majority vote? Consensus? Would there be staffing? Who would be responsible for expenses? No doubt, to a significant extent disputes would be settled by reference to soft norms and existing hierarchies in government. The culture of deference by IAS officers to other IAS officers of a senior class provides one example. The unlikely possibility of agency regulators going against the deeply held preferences of a strong finance minister provide another. Yet these are not simply mundane questions and impact, materially, how extensively the committee could study and resolve matters before it.
Fifth, the process by which the ordinance was passed is worrisome. As suggested by the Economic Times, regulators were not consulted on a ordinance that amends 4 major acts of parliament. What does this say for consultativeness and democratic process? What does this say for the legitimacy of the proposed solution? Is the failure to consult and rush to promulgate this solution reflected in the drafting and policy flaws of the instrument suggested above?
Sixth, the ULIP dispute has been presented as a contest between SEBI and IRDA. Implicitly, one regulator had to win, and the other, lose. This is misleading. One scenario would have each regulator govern the portion of ULIPs which fall within their domain. IRDA would govern the insurance component of these instruments and SEBI would govern the investment component. Some might suggest that this would lead to too much complexity. Yet, we are more used to dealing with complexity than we realize. A person driving a vehicle who causes damage to property could be liable for damages under rules of the Motor Vehicle Act, tort law and possibly the Indian Penal Code. That the net zone of freedom of action in driving a car would be limited to the conjunction of the areas prescribed by these laws seems hardly remarkable. The government would never declare that all motor vehicle drivers are immune from civil or criminal laws. The more complex the transaction, the more regulation might apply. Financial firms are as well-equipped as any actor in society to handle this complexity.
Another scenario would involve crafting a mechanism for joint regulation of ULIPs. As Monika Halan suggests, this proposal has precedent in the arrangements between the banking and capital markets regulators and could lead to the harmonisation of regulation to the benefit of investors and the marketplace.
Yet another scenario would involve actively fostering or allowing some measure of regulatory competition. The heightened regulation of ULIPs as a result of this controversy is itself a salutary case in point. We do not suggest that the government allow this issue to fester but feel confident that serious scholars and practitioners of administrative law and institutional design could develop interesting ways of promoting regulatory competition given time and a mandate.
Hurried solutions lead to poor law with implications that will be felt by investors and markets down the line. Ordinances are intended for use when Parliament is out of session and the President perceives a need for immediate legislation. Ordinances may be amended. The conflict between SEBI and IRDA is also only one small piece of a larger problem of financial sector legislation that is fragmented, at times duplicative and at times inadequate. We can only hope that Parliament revisits this matter in a more thorough fashion, either independently or through the efforts of the proposed Financial Sector Legislative Reforms Commission proposed in the Finance Ministers budget speech of 2010-11.