By Ajay Shah, on February 26th, 2010
Financial stability, regulatory coordination, financial reforms
So far, in India, regulatory coordination was based on the HLCC. This has not been a particularly good experience. The HLCC was not statutory and there was no defined mechanism through which decisions would be obtained. Many inter-regulatory difficulties simply languished. One peculiar aspect of the HLCC was that it was chaired by the RBI governor, while RBI was at the centre of many inter-regulatory disputes. It was awkward, having one of the competing views on a question being the chair.
On these questions, the Raghuram Rajan report had said:
A Financial Sector Oversight Agency (FSOA) should be set up by statute. The FSOA’s focus will be both macro-prudential as well as supervisory; the FSOA will develop periodic assessments of macroeconomic risks, risk concentrations, as well as risk exposures in the economy; it will monitor the functioning of large, systemically important, financial conglomerates; anticipating potential risks, it will initiate balanced supervisory action by the concerned regulators to address those risks; it will address and defuse inter-regulatory conflicts, and look out for the build-up of systemic risks.
The FSOA should be comprised of chiefs of the regulatory bodies (with a chair, typically the senior-most regulator, appointed from amongst them by the government), and should also include the Finance Secretary as a permanent invitee. The FSOA should have a permanent secretariat comprised of staff including those on deputation from the various regulators. There should be a prescribed minimum frequency of meetings of the FSOA. All issues of regulatory co-ordination, and supervision of systemically important financial conglomerates and financial institutions will be taken up by the FSOA.
The discussions of the FSOA with the management of systemically important institutions will be principles-based, and ts will initiatete the process of gradually implementing more principles-based regulation throughout the system. It will be important that the FSOA add value by substituting for some existing processes instead of adding another layer, while bringing collective regulatory views to bear. It is not our intent that the FSOA be a super-regulator displacing existing regulators. Instead it provides needed coordination and fills gaps that current structures have proved inadequate for.
In addition, there is merit in setting up a Working Group on Financial Sector Reforms with the Finance Minister as the Chairman. The main focus of this working group would be to monitor progress on financial sector reforms (such as the proposals of the Patil, Parekh, Mistry, and this committee), and to initiate needed action. The working group’s membership would include the regulators, as well as ministries on as-needed basis. The working group would be supported by a secretariat inside the Finance Ministry.
There was a contrasting view. After the global financial crisis, we got a strong campaign by RBI, based on the proposition of financial stability. It was claimed that now that financial stability is important, the original role and structure of RBI (as envisaged in the 1934 legislation) is the right one, so all reform proposals should now be shelved. Suggestions were made that the financial stability function should be handed over to RBI, which could ultimately lead to RBI becoming the super-regulator of finance, with the power to give instructions to other regulators such as SEBI based on financial stability considerations. Every bureaucracy likes to stave off change, and to grow its turf, so the arguments put forward by RBI were less than persuasive given its self-interest.
I have been skeptical about the idea of placing financial stability functions at RBI, for a few reasons:
- Crisis management involves utilisation of taxpayer resources, which can only be authorised by the treasury. Indeed, if a banking regulator is given a stability function, he will be inclined to cover up for the failures of banking supervision by utilisation of taxpayer money.
There is a similar problem when a banking regulator who is also a central bank is inclined to cover up for the failures of banking supervision by giving `short-term liquidity support’. This problem is already with us in India. We should not make matters worse.
- The essence of financial stability thinking is to break out of India’s silo system, and look at the overall financial system. The inhabitants of any one silo in India are likely to be ill equipped to think about the overall financial system.
- Financial stability thinking repeatedly involves asking any one regulatory agency to question its existing way of thinking. If an existing agency doing a lot of financial regulation is asked to do financial stability, this will not come about. Worse, there is the danger of `regulatory capture’ where every regulatory agency tends to adopt the world view and maximisation of its firms. If RBI is asked to do financial stability work, we run the risk that these new levers of power will be used to favour banks at the expense of other kinds of financial firms.
- It is hard to obtain sensible notions of transparency and accountability in the nascent field of financial stability. There is much merit in a principal-agent problem approach in designing the block diagrams of government. When a clear document can be written down specifying a job that has to be done, then it is better for government to contract that out to an external agency, since the clarity of mandate makes possible accountability. But for the things where a clear contract cannot be written down, contracting-out to an external agency is hard, and it is better to in-source these functions.
- New work that we initiate in India should not interfere with our long term goals of establishing a proper central bank.
I am quite comfortable with the two interesting models out there. In the US, there are many financial regulators, and stability functions are being placed in a council of regulators. That makes sense. And in the UK, the Bank of England does no financial regulation, and it has been asked to do stability work. That also makes sense since the BoE takes an outsiders view of the work of the FSA. The staff quality of the Bank of England also encourages confidence that this will be in a technically sound way, without being imbued with an ideology of hostility to finance. In an Indian setting, both approaches make sense. Either all financial regulation is removed from RBI, a high quality central bank is created with staff quality matching that of the BoE, and this is tasked with the financial stability function. Or, we go for a council of regulators.
This debate had simmered for some time. In the budget speech today, the Finance Minister announced the decision taken by government on how this should be handled:
37. The financial crisis of 2008-09 has fundamentally changed the structure of banking and financial markets the world over. With a view to strengthen and institutionalise the mechanism for maintaining financial stability, Government has decided to setup an apex-level Financial Stability and Development Council. Without prejudice to the autonomy of regulators, this Council would monitor macro prudential supervision of the economy, including the functioning of large financial conglomerates, and address inter-regulatory coordination issues. It will also focus on financial literacy and financial inclusion.
This seems to be some kind of fusion between the Raghuram Rajan proposals of the FSOA and the Working Group on Financial Sector Reforms. More details are awaited from DEA on how they want to play this.
Financial Sector Legislative Reforms Commission
The four major committee reports on Indian finance — Patil, Mistry, Rajan and Aziz — have all emphasised a comprehensive overhaul of outdated laws. The laws of 1934, 1952, 1956, etc. are quite out of touch with the India of today. And this job is complicated by the fact that one amendment to the laws at a time does not cut it. You might like to see my article in Pragati magazine in August 2009, where I argue that changing the laws is the essence of financial reform in India today.
In today’s budget speech, the FM said:
101. Most of our legislations governing the financial sector are very old. Large number of amendments to these Acts made at different points of time has also increased ambiguity and complexity. The Government proposes to set up a Financial Sector Legislative Reforms Commission to rewrite and clean up the financial sector laws to bring them in line with the requirements of the sector.
Large complex IT-intensive projects
Stepping away from new laws, economic reform in India is critically about big and complex IT systems. These present unique challenges of public administration, when compared with the traditional ways of working of government in India. A new process manual is required through which these big complex IT-intensive projects can be rolled out and run.
In today’s budget speech, the FM said:
104. An effective tax administration and financial governance system calls for creation of IT projects which are reliable, secure and efficient. IT projects like Tax Information Network, New Pension Scheme, National Treasury Management Agency, Expenditure Information Network, Goods and Service Tax, are in different stages of roll out. To look into various technological and systemic issues, I propose to set up a Technology Advisory Group for Unique Projects under the Chairmanship of Shri Nandan Nilekani.
Co-contribution for unorganised sector in NPS
There is an increasing sense that a government should help grow the participation of the informal sector in a defined-contribution individual account pension system by having co-contribution. In today’s budget speech, the FM said:
90. To encourage the people from the unorganised sector to voluntarily save for their retirement and to lower the cost of operations of the New Pension Scheme (NPS) for such subscribers, Government will contribute Rs.1,000 per year to each NPS account opened in the year 2010-11. This initiative, “Swavalamban” will be available for persons who join NPS, with a minimum contribution of Rs.1,000 and a maximum contribution of Rs.12,000 per annum during the financial year 2010-11. The scheme will be available for another three years. Accordingly, I am making an allocation of Rs.100 crore for the year 2010-11. It will benefit about 10 lakh NPS subscribers of the unorganised sector. The scheme will be managed by the interim Pension Fund Regulatory and Development Authority.
91. I also appeal to the State Governments to contribute a similar amount to the scheme and participate in providing social security to the vulnerable sections of the society.
A coherent vision for pension reforms is not yet in place: right alongside this, the government talks about a National Social Security Fund for unorganised sector workers with Rs.1000 crore.
Entry barriers in banking
One of the key mistakes in Indian banking has been the entry barriers: until recently, the rules inhibited placement of ATMs, placement of branches, new private banks, branches by foreign banks, money market mutual funds. There has been some progress on placement of ATMs and branches in recent months. A next step was announced in the budget speech:
38. The Indian banking system has emerged unscathed from the crisis. We need to ensure that the banking system grows in size and sophistication to meet the needs of a modern economy. Besides, there is a need to extend the geographic coverage of banks and improve access to banking services. In this context, I am happy to inform the Honourable Members that the RBI is considering giving some additional banking licenses to private sector players. Non Banking Financial Companies could also be considered, if they meet the RBI’s eligibility criteria.
A coherent vision for banking policy is not yet in place: right alongside this, the government promises to put Rs.16,500 crore or roughly 0.3% of GDP to increase the equity capital of PSU banks.
By Bron Suchecki, on January 11th, 2010
Two interesting quotes caught my eye in a recent Andy Smith note:
“We cannot stop terrorism or defeat the ideologies of violent extremism when hundreds of millions of young people see a future with no jobs, no hope, and no way ever to catch up to the developed world” Hillary Clinton, Remarks to the Center for Global Development at the Peterson Institute for International Economics
For a moment there I thought she was talking about the US – “when millions of young Americans see a future with no jobs, no hope, and no way ever to catch up to the Baby Boomers”. Generational class warfare anyone?
“could seriously disrupt bond markets if it triggered concerns about creditworthiness or inflation because of concerns with government incentives to inflate debt away” Bank for International Settlements in invitation to top central bankers and financiers for a meeting in Basel
This doesn’t need any further comment for readers of this blog, suffice to say I find it interesting that the BIS acknowledges that inflating debt away is an option.
PS – unfortunately Andy Smith’s stuff is not publically released, because I rank him as the top precious metals analyst.
By Claus Vistesen, on November 27th, 2009
The excellent research edifice at the Bank of International Settlements have conjured up one of those papers which needed to be written (by Claudio Borio and Piti Disyatat) on the back of the myriad of different monetary policy responses we have observed in the contex of the economic crisis. The abstract and conclusion look as follows;
(my emphasis throughout)
The recent global financial crisis has led central banks to rely heavily on “unconventional” monetary policies. This alternative approach to policy has generated much discussion and a heated and at times confusing debate. The debate has been complicated by the use of different definitions and conflicting views of the mechanisms at work. This paper sets out a framework for classifying and thinking about such policies, highlighting how they can be viewed within the overall context of monetary policy implementation. The framework clarifies the differences among the various forms of unconventional monetary policy, provides a systematic characterisation of the wide range of central bank responses to the crisis, helps to underscore the channels of transmission, and identifies some of the main policy challenges. In the process, the paper also addresses a number of contentious analytical issues, notably the role of bank reserves and their inflationary consequences.
(…)
In the wake of the current financial crisis, monetary policy will probably never be the same again. Central banks have been forced to review their implementation frameworks and to try out policies that, only a few years back, were not on their radar screens. They have been operating in unchartered waters, outside their “comfort zone”. In the process, unconventional monetary policies have become the focus of much discussion and heated debate. In this paper, we have provided a unified framework to think about and classify unconventional monetary policies, considered the analytical issues they raise, with particular reference to the transmission mechanism, and briefly assessed some of the key policy challenges.
We have stressed several analytical points.
First, unconventional monetary policies fall under the broader category of balance sheet policy, whereby the central bank uses its balance sheet to affect asset prices and financial conditions beyond the short-term interest rate. Thus, they are not unconventional in their essence, with foreign exchange intervention being a very familiar form of such policies.
Second, balance sheet policies can be decoupled from interest rate policies. This reflects the fact that the level of the short-term interest rate can be set independently of the amount of bank reserves in the system. Third, the main channel through which balance sheet policy operates is by altering the composition of private sector balance sheets, exchanging claims that are imperfect substitutes for each other. By altering the risk profile of private portfolios, such as through the purchase of less liquid or risky assets or by being prepared to lend at more attractive terms than the markets, the central bank can reduce yields and ease financing constraints.
Fourth, because of this, in our view the outsized role often attributed to banks’ excess reserves in discussions of balance sheet policy is not warranted. Since excess reserves are very close substitutes with short-term claims on the central bank or the government, what the central bank buys and the credit it extends are more important than how these operations are financed. Finally, balance sheet policy should be the considered in the broader context of the consolidated public sector balance sheet. Importantly, central banks have a monopoly over interest rate policy, but not over balance sheet policy.
While we have not examined in depth the effectiveness of balance sheet policies, it would be hard to deny that they have helped to stabilise conditions and cushion the fall in aggregate demand. There is evidence that central bank purchases of government bonds have lowered their yields, although they seem to be subject to “diminishing returns”, once the surprise factor wears off. And policies targeting interbank markets or private sector securities have been successful in narrowing risk spreads and supporting borrowing activity there.
At the same time, balance sheet policies raise a number of challenges for central banks. As central banks move away from the simplicity and well-rehearsed routine of interest rate policy, they face much trickier calibration and communication issues. As they substitute for private sector intermediation, they may favour some borrowers over others, tilting the level playing field, and could risk making the private sector unduly dependent on public support. As they purchase government debt, they come under pressure to coordinate with the public sector debt management operations. And as their balance sheets expand and they take on more financial risks, central banks risk seeing their operational independence and anti-inflation credentials come under threat in the longer term. As a result, questions about coordination, operational independence and division of responsibilities with the government loom large. These costs suggest that unconventional monetary policies should best be seen as special tools for special circumstances. The costs also point to the need for appropriate governance arrangements, designed to limit the risk that the central bank anti-inflation priorities are undermined in the medium term. And they put a premium on early exits, as soon as economic conditions permit.
I have only scanned the paper and thus not really given it the attention it probably deserves, but one of the things I found most interesting, (especially in the light of the my recent inquiry into the matter with respect to the ECB), is that while I agree that exit strategies is first and foremost a communication exercise they will also become a concrete operational challenge.
More generally, the discussion on the transmission channel from unconventional monetary policy as split into two between the signalling channel and the broad portfolio channel (operational/market channel) is interesting and provides a good framework through which to understand the current initiatives by monetary policy makers. The paper also pulls out the classic, as it were, about how the Fed and the ECB differs in their response because the former has focused extensively on the non-bank sector (asset backed securities and government bonds) whereas the latter has mainly focused on the the banking sector (i.e. through fixed-rate full-allotment refinancing operations with maturities of up to 12 months).
Again, it is difficult to argue with the underlying argument here in the sense that it is clearly borne out in the data. The problem with the ECB, as I have argued before, is the extent to which banking finance is indirectly funding the purchase of government bonds and thus what happens to sovereign spreads in the Eurozone when the refinancing offers taper off into 2010. That is a subject for a different entry. For now, I leave you with this instructive paper from the BIS; it is well worth a look.
By Trace Mayer, on October 29th, 2009
The recent gold bull upleg is in the midst of a predictable slight correction and consolidation. When that finishes it is highly probable, based on seasonality and technicals, that the next part of the upleg will commence. The Federal Reserve and Washington are only making matters worse through their extremely damaging policies.
GOLD PARTY BARELY STARTED
Back on 9 September 2009 I wrote:
200 day relative price of gold is at 1.08x … Based on seasonal trends gold and silver will be strengthening, with the strongest months in September and November
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
Back then the price of gold was $996 and the 200dma was about $920. Today gold’s price is about $1,030 with a 200dma of about $950. While the probability for a profitable trade is not nearly as high as it would be should the price relative to the 200dma be significantly below the 200dma there is still room for the price to run as we enter winter. The October intermission is likely coming to a close.
OCTOBER INTERMISSION
Dr. Greenspan testified in 1998 that, ”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.”
One of the key reasons to keep the price of gold suppressed through central bank gold leasing is to keep interest rates low. This will be particularly helpful for the $182,000,000,000,000 of certificates of confiscation that will be sold during the week of 26-29 October 2009. Another reason is that NYMEX November options expired 27 October 2009.
PHYSICAL PREMIUMS RAISED
The physical coin dealers are fairly wise to the machinations of Wall Street. When the paper price of bullion falls precipitously then the dealers often raise the premiums.
For example, a reader asked me a few weeks ago when would be a good time to buy gold American Eagles. I suggested after the next drop and if lucky then he may be able to acquire them around $1,025 spot but the premium would likely increase. He reported his shopping to me a couple days ago after the recent drop in price and informed me the premium had been raised from $37.95 to $41.95 per coin.
SILVER BACKWARDATION
On 12 September 2009 I observed that “the London SIFO, the Silver Forward Mid Rates, have been trending towards backwardation.” It is interesting to observe the continuing trend and brief entry of silver in backwardation in the LBMA on 9 October 2009. It seems like the physical silver market is getting a little tight.
 QUANTITATIVE EASING
The big issue is whether the Federal Reserve will be able to, as Ben Bernanke said on 8 October 2009 in The Federal Reserve’s Balance Sheet: An Update, ‘tighten the stance of monetary policy and eventually return our balance sheet to a more normal configuration?’ Back in March 2009 when Bernanke started this lunacy I asserted that The Federal Reserve Will Fail With Quantitative Easing.
Bernanke asserts:
Although the Federal Reserve’s approach also entails substantial increases in bank liquidity, it is motivated less by the desire to increase the liabilities of the Federal Reserve than by the need to address dysfunction in specific credit markets through the types of programs I have discussed. For lack of a better term, I have called this approach “credit easing.
What Bernanke is trying to do is get capital to take on additional risk by moving up the liquidity pyramid. But The Great Credit Contraction has begun. While there may be differences in the velocity at which capital moves down the liquidity pyramid the overall direction has not changed. Washington and the Federal Reserve are tiny actors compared to the total size of the market.
Their policies are aimed and designed to grant special privilege to banks like JP Morgan and Goldman Sachs. Through government assistance the banks are able to move their capital down the liquidity pyramid. In effect, they have privatized the gains and socialized the losses. While there may be a case for a rise in the FRN$ in the short term the ultimate destiny is known: the fiat currency graveyard.
EXACERBATING THE GREATER DEPRESSION
As Murray Rothbard observed on page 18 of his 1963 America’s Great Depression:
It is true that credit contraction may overcompensate, and, while contraction proceeds, it may cause interest rates to be higher than free-market levels, and investment lower than in the free market. But since contraction causes no positive malinvestments, it will not lead to any painful period of depression and adjustment.
Mr. Rothbard continues the observation that government policy can hobble the adjustment process by: “(1) Prevent or delay liquidation, (2) Inflate further, (3) Keep wage rates up, (4) Keep prices up, (5) Stimulate consumption and discourage saving and (6) Subsidize unemployment.”
In the present case, mark-to-market rules, like FAS 157, are not implemented, delayed, ignored or willfully violated. The financial markets are now undergirded by fair-value lying standards. For example, Section 132 of the Emergency Economic Stabilization Act of 2008 is titled “Authority to Suspend Mark-To-Market Accounting” and restates the SEC’s authority to suspend the application of FAS 157.
The Austrian definition of inflation is an increase in the money supply. The Adjusted Monetary Base, the very lowest layer of power money, shows a tremendous increase over the past year. The effects are most likely masked by the tremendous slowing in the velocity of money.
In an effort to stimulate consumption and discourage savings that will result in keeping prices and wages high the Obama administration has unveiled a $1 trillion stimulus package. The Geithner toxic asset plan will only serve to hasten the destruction of wealth from the economy as the system evaporates.
The Federal minimum wage rose in July 2009. Unemployment will be subsidized by extending benefits for 13 weeks and delaying the income tax payments. Legacy industries, like the auto industry, are receiving bailout money to keep wage rates up and people employed doing nothing all day long because of the huge over capacity of automobiles. With Cash-For-Clunkers automobiles which have value are destroyed to reduce supply of alternative goods to new cars made by Government Motors. This is a prime example of what Washington DC is: A giant wealth destruction machine.
Therefore, like heroin to cure a hangover the quantitative easing from the Federal Reserve and the lunatic policies from Washington are not improving the situation for average people but instead exacerbating the greater depression. Now is the time to Raze The Fed and while doing the spring cleaning who needs Washington?
CONCLUSION
The current correction and consolidation of gold appears to be within trend and expected based on the seasonality. November is the strongest month and this recent correction on low volume is laying a strong foundation for a large move upwards.
The Federal Reserve’s quantitative easing programs have not been helping the situation but instead exacerbating the greater depression. All in an effort to save the inefficient, barbarous and archaic relics of a fiat currency and fractional reserve banking system that is destined for extinction and replacement. The Crash of 2008 was just the start of The Great Credit Contraction and it will last for decades.
DISCLOSURES: Long physical gold and silver and no position the problematic SLV or GLD ETFs.
By Claus Vistesen, on October 27th, 2009
Sorry for the hiatus, but I am preparing a large note on the ECB, whether it is conducting QE or not, what QE at the ECB is, and finally what the prospects of an exit strategy is. This has taken most of my time the last week. I will be posting this report shortly. Meanwhile, I will leave you with the following fresh report from the FT about the earnings derived from the ECB’s open market operations (emphasis is mine) which is naturally, although not directly, related to my analysis;
The European Central Bank has made up to €1bn in extra profits from crisis-related emergency lending, but its caution on unconventional policy measures has curbed potential earnings, analysts estimate. Extra liquidity pumped into the eurozone banking system since the collapse of Lehman Brothers last year has probably generated an extra €900m ($1.5bn, £780m) in profits so far, according to calculations by Goldman Sachs.
Some €300m of the total has been generated since June, when the ECB provided €442bn in one-year loans in its biggest liquidity providing operation. The extra profits are on top of the sums that the ECB normally makes on its market operations. Although the interest rate currently charged by the ECB – 1 per cent – was the lowest in its 11-year history, revenues “remain juicy because of the quantity of liquidity that banks keep hoarding”, said Natacha Valla, European economist at Goldman Sachs in Paris.
From last October the ECB has been meeting, in full, eurozone banks’ demand for liquidity. Ms Valla argued, however, that by sticking largely to using policy instruments already in its armoury the ECB had forgone potentially far higher margins.
Profits on the ECB’s programme to buy €60bn in covered bonds – low risk assets issued by banks and backed by public sector loans and mortgages – could be dwarfed by those on schemes launched by other central banks, which have involved higher risk. The Financial Times reported last month that the US Federal Reserve had made a $14bn profit on its crisis loan programmes, with its purchases of commercial paper among its most lucrative operations.
Instead, the ECB has created arbitrage opportunities for eurozone banks, which have used liquidity provided by the central bank to buy large amounts of government bonds, including from some of the smaller eurozone countries and riskier assets. These, in turn, can be used as collateral to raise fresh funds from the ECB. Eurozone banks’ holdings of euro-denominated government bonds have increased by more than €200bn since last year.
By Bron Suchecki, on September 14th, 2009
Yesterday I was dismissive of the recall of Hong Kong’s gold as significant, but it is another bit of evidence of a shift in central bank attitudes towards gold. Far more significant indicators include (see this MineWeb article):
* China’s announcement that it had moved 454 tonnes of gold into its reserves since 2003
* Central Bank Gold Agreement (CBGA) quota being reduced from 500t to 400t a year
* Russia’s Prime Minister stating that it should hold 10% of its reserve assets in gold
It points to a renewed appreciation of the role of gold in turbulent times. Recalls of gold like Hong Kong may also indicate a reassessment of counterparty risk. Moves to return gold are eminently sensible, of course: what is the point of a country having its gold out of its immediate physical control if everything goes to hell. That is really the whole point of having gold reserves. In a time of war (not that I’m suggesting that is where we are heading) you ain’t going to be able to buy guns or food from another country with your funny paper money.
Some have claimed that repatriation of gold by other central bankers following Hong Kong’s lead will translate into higher gold prices. However, this depends on the extent to which that gold is actually sitting in a vault somewhere or has been lent out to bullion banks. If the former, then obviously there is no effect on the price – the gold is just changing location. If the latter, then it could be potentially explosive if Frank Veneroso’s estimates of leased gold of between 10,000 and 16,000 tonnes are correct.
I would point out that central banks can’t just recall gold mid-lease, they have to wait till it’s maturity. Consider also that the leases will have been made over varying terms, from a few months to a few years, and all at different points in time. This means that all of the central bank leases will mature over a number of years. What the term to maturity of this global lease book is, is hard to say. I’ll have a stab at most of it being 1 to 2 year leases, but am prepared to stand corrected.
So not all of Mr Veneroso’s leases will be recalled immediately, or to be more accurate, declined to be rolled. Plus not all central banks will decline to roll their leases (although that may change depending on how bad things get).
Also, don’t fall into the trap of assuming that all of this leased gold has to be bought back from the market to repay the gold loans. This sort of simplistic analysis is based on an ignorant view that “leasing = bad”. The reality is a bit more complex. To explain, I am going to have to be a hypocrite and be simplistic myself. There are three things someone can do with borrowed gold:
1) Manufacture it into jewellery, coins or bars. Sell these for cash. Use cash to buy replacement gold. Hopefully have left over cash = profit. Repeat many times.
2) Sell the gold. Use the cash to build a mine. Extract the gold from the ground. Repay your gold loan. Hopefully have left over gold. Sell this for cash = profit.
3) Sell the gold. Invest the cash to earn interest. Hopefully gold price drops. Use part of your cash to buy gold. Repay your gold loan. Left over cash = profit.
All of the above are ultimately promises to repay gold, but not all of these have the same risk profile. I’ve ranked them in terms of risk and the first two are materially different to the third. In the first two the gold loan is backed by gold, either in inventory or below the ground.
In the current gold market, one would have to consider the risk of failure low for the coin/bar business – everyone wants the stuff – and I’m sure that central banks, through bullion banks, would not consider these leases high risk and necessitating recall. For jewellery, the increasing gold price equals less sales, so we could expect some business failures, so while these leases are backed by physical it would have to be considered at some risk.
For miners it is a bit more risky. Sure they have it in the ground, but lets not forget Bre-X or Sons of Gwalia. As long as any hedging is modest and loan maturities tied to production, these would also be considered lower risk by central banks.
In the case of the first two it ultimately comes down to the extent that the lease is secured: the first two are not risk free – business ventures do not always turn out as expected. To the extent that they are not secured in some way, central banks would have to be nervous, but not as much as our third category.
In the case of the short sellers, the gold is gone and only cash is left. To the extent that a miner has excessively hedged (did I hear someone say Barrick?), then they are also in this category. The crux of the issue is to what extent have the short sellers put up collateral and more importantly, have the ability to put up more (or the willingness to put up more)?
This collateral issue I will discuss in my next post. My point for the moment is to not get awe struck by the 16,000t figure (or whatever other figure is bandied about) and think it is all going to have to be bought back, and now, and therefore the gold price is going to the moon.
If central bank reassessment of counterparty risk results in requests for leases to be repaid, then it will occur over a number of years as those leases mature. This will manifest itself as a steady stream of short covers, not as a big bang, and be a source of solid “base” demand for gold for a number of years. 
By Ajay Shah, on August 26th, 2009
The Bank of Israel has become the first central bank worldwide to raise interest rates.
A few weeks ago, I wrote an elongated blog post titled Does unconventional monetary policy and unusual fiscal policy presage an upsurge in inflation?. This was partly motivated by the concerns of the time (this was in mid-June) about the exit strategy of central bankers. I had argued that inflation targeting gave the right framework for all three phases: the sharp drop in the policy rate, the shift to quantitative easing when the short rate fell to zero, and the eventual rise of interest rates. It is not surprising that the first mover on the exit process is an inflation targeting central bank.
A Taylor rule with an inflation coefficient of 1.5 and an output coefficient of 0.5 gives us a rough approximation to the thinking of inflation targeting central banks. The puzzle then lies in forecasting the extent to which inflation will exceed the target and forecasting the extent to which output will be below the target. These two forecasts are hard to make. But as I said in the above article:
As the financial system comes back to life, as the money multiplier comes back to normal values, the intellectual framework of inflation targeting will shape the responses of the central banks. There will obviously be some mistakes in forecasting inflation, given that the parameter estimates in our models are driven by normal times. But one can expect an average error of zero in the sequencing through which unconventional monetary policy is withdrawn. And when mistakes are made, when de jure inflation targeting is in place, the bond market will know that these are mistakes of execution and not a change in strategy.
By Dan McLaughlin, on March 6th, 2009
“The Audacity of Hope” is a catchy phrase with important implications. It is good to hope, to look forward boldly in anticipation of better times, to have a positive outlook that is open to opportunity. But, just as it is not a good idea to run around in the dark with a sharp butcher knife, it is also not a good idea to boldly pursue policies with blinders on, while wielding dangerous economic weapons.
The “war on poverty” has been a miserable failure, in spite of the trillions of taxpayer dollars spent over the last 4 decades. The “war on drugs” is another expensive failure on all fronts. Central planning in American education has resulted in a very expensive system that is failing our children. Ask any supporter of the welfare state, however, and the ongoing failures of government programs result only from not throwing enough money at them. It doesn’t matter what miserable results from whichever government program, the only proposed solution to the problems is more money stolen from taxpayers.
In the real world, if a private business or association is not successful, it either changes the way it does business and serves people or it takes a one way trip to the business graveyard. Bankruptcy and failure ensure that bad ideas or inefficient, unproductive systems don’t keep sapping life from the productive sectors of society. That is the way that society progresses and economies advance.
Not so with government. It seems that the bigger the failure, the more support it gets. We have been victims of expensive stimulus plans for some time now. Remember the cure-all about a year ago? If only the wise politicians could take enough money from taxpayers to redistribute to taxpayers, they could jump-start the economy. Not enough. More billions prop up banks and failing businesses. Between the Federal Reserve Bank, FDIC and the multiple stimulus spending plans, the toll is now in the multiple trillions of dollars.
With all of the smart people purportedly hanging out in Washington DC, you would think that they might realize that, if you take a dollar from Joe and give it to Frank, and a dollar from Frank and give it to Joe, you really haven’t stimulated either. Worse yet, if you take a two dollars from Frank, give one to Joe and keep one to feed the beast, you have actually de-stimulated and made the whole economy less productive.
Stimulation is the fundamental reason that this country and the world are in their present sad state of affairs. Central banks try to stimulate economic performance at the beginning of an economic boom by pumping counterfeit money into the economy and lowering interest rates below the market rates. That stimulation only distorts the real economic incentives. The inflation devalues the dollar and creates bubble economies, where certain sectors inflate at a quick pace, giving the illusion of rapid real growth. In the present case, artificially low interest, specific homeowner incentives, government subsidized mortgages and ownership programs, and requirements for banks to offer loans to risky borrowers combined for the deadly combination that exploded into the current meltdown.
Those same smart people in our nation’s capital choose to ignore the obvious, and instead, throw trillions of dollars of good money after bad. Instead of fixing the core problem, they play political games for fun and profit. It is hard to believe that hundreds of the most well connected and powerful people in the country can be so willfully ignorant. That is, hopefully, the case, however, because if it isn’t, it means that, instead, they are willfully malicious. They consciously hurt the people they pretend to help.
Audacity, in the positive sense, means boldness or daring. It is a characteristic of effective leaders.
There is, on the other hand, an old saw among seasoned airplane pilots: “There are old pilots and there are bold pilots, but there are no old bold pilots.” Audacity is sometimes the precursor to disaster, because it substitutes cockiness for clear thinking, and throws caution to the wind. In this time of crisis, our leaders have thrown caution to the wind. They are flailing in the dark so they can say they are doing something. They are prescribing poison as the antidote for poison. They don’t think about the ramifications and, instead, rely on knee jerk reactions, which will ultimately multiply the problems they themselves have created.
Wouldn’t it be refreshing if our politicians would have the audacity to actually think for a change?
By Dan McLaughlin, on February 18th, 2009
A recent Forbes article listed the ten “tallest cities”, those with the most buildings over 700 feet tall. The current record holder for tallest building is the Burj Dubai in the Arab Emirates, at 2684 feet, scheduled to open this fall. It is more than 1000 feet taller than the previous record holder, the Taipei 101 in Taiwan. There are plans to build a couple of skyscrapers over 3000 feet tall.
The article brings to mind a concept introduced in 1999 by Andrew Lawrence, called the “Skyscraper Index”. The index highlights a fairly strong correlation between new world record buildings and the onset of recession. While correlation isn’t causation, and tall buildings certainly don’t cause economic downturns, it is quite interesting and can help to shed some light on the workings of business cycles.
Business cycles can be more aptly described as banking or monetary cycles. They arise in conjunction with inflationary credit bubbles, the responsibility for which lies with the central banks and the fractional reserve banking system. The relative regularity of the bubbles is linked to the fact that the actions taken to mitigate the deflationary effects of an economic downturn, when the bubble bursts, actually plant the seeds for the next bubble.
The root of the matter is that central bankers use incentives to spur rapid economic growth. The interest rate is artificially reduced to below the market rates and the market is flooded with money. Fractional reserve banks greatly leverage the money supply, and it expands like an accordion. The banks use deposited money to make loans, and the leverage of fractional reserves transforms a billion dollars of new reserves into ten billion dollars of new money, created out of thin air.
When interest rates are artificially lowered, business ventures that might not make sense under normal conditions suddenly look profitable. The beginning of the bubble is actually the end of the previous bubble, so costs look favorable. The prior shakeout means that there are lots of resources available at cheap prices. Business really does look good, and entrepreneurs make rational decisions to start projects which look profitable. The money entering the system makes it appear that business is booming for everyone. High spirits and lots of cash stoke the fires for bigger and bigger projects. At times like this, record breaking skyscrapers start to materialize. The thesis of the Skyscraper Index is that when world record building projects get rolling, it is likely that the end of the bubble is near.
The problem is that real resources are limited in the short term. More money pouring into the system does not make any more steel, concrete or lumber available. It does not make more people available to do the work. As the market heats up, the limitation on real resources becomes apparent and costs of production are bid up far beyond expectations. It turns out that entrepreneurs have been fooled. Projects that once looked like big winners now become losers.
The downhill side of the bubble occurs when businesses and individuals can’t pay and the loans go bad. The accordion of fractional reserve banking starts to contract as the leverage is reversed. A billion dollars in bad loans will cause a contraction of 10 billion dollars, as money made from nothing disappears into the ether from whence it came.
As the bust progresses, the real productive resources are still there. Skyscraper owners may go bankrupt but deflation should make prices come down. Productive assets, or overpriced homes in the present case, should become more affordable and realistically priced. If that was allowed to happen, the efficient entrepreneurs would take over productive assets and prospective homeowners would finally be able to afford the homes that they were responsible enough to avoid when they were overpriced.
The reaction among politicians today is to flood the market with “stimulus” to prevent prices from falling and to prop up failed banks and businesses. Aside from the glaring moral hazard of supporting failing businesses and irresponsible homeowners at the expense of those who were responsible, the actions prevent the adjustment that is needed for the economy to become productive again. Skyscraper owners are bailed out, while Average Joe drowns.
Eventually, we may wake up to the reality that the present banking system is the problem. Real banking reform may make the bailout mentality obsolete. It is probably not a good idea to hold your breath waiting, though. Big banks and skyscraper owners with political clout have become addicted to bailouts.
By Cheryl Grey, on October 21st, 2008
On the surface it seems simple enough. The Federal Open Market Committee (FOMC) of the Federal Reserve adjusts interest rates to manage both inflation and the economy. When inflation rises, the FOMC raises rates, which limits the money supply, raises the cost of credit and slows economic expansion to a manageable level. When inflation falls, the FOMC lowers interest rates, which (in theory, at least) floods the markets with money, lowers the cost of credit and encourages economic expansion beyond its current level. Central banks from Sweden to Australia follow this model, which has been standard practice for the past decade and more.
So if it’s that simple, why can’t central bankers agree amongst themselves? Why was it that, as recently as August, when the Bank of England’s Monetary Policy Committee held its scheduled meeting, seven members voted for no rate change, one voted for a hike and one voted for a cut?
The Taylor Model
The model generally used to determine the Federal funds rate was first proposed by John Taylor in 1992. This model utilizes a mathematical formula to balance inflation against the optimal rate of economic growth for each nation, with the sum of that equation indicating the proper interest rate necessary to achieve that balance. Because the rates of inflation and growth change over time, the interest rate must change in harmony to accomplish its goals.
However, according to a new school of thought, the Taylor model might be causing the very problems it’s attempting to correct.
One variable the Taylor model seems to miss is outside or unexpected shocks to the economy. Granted that any model flies out the window when the entire financial framework is rocking—you just grab whatever’s closest and hang on. But surely we can do better than ignore the pressures leaning on the markets and causing those shocks?
Of Fractals and Finance
Dr. Charles Ivie, a retired NASA analyst with a keen interest in the mathematics of chaos theory, verbally rubbed his chin when asked that question.
“The trajectory of a rocket is determined by Newton’s laws and by celestial mechanics and is completely deterministic,” he wrote in an email exchange. “Market behavior is more like that of an infinitely branching tree. …The actions of the individual players are multidimensionally recursive. By this I mean that individual investors react to a multitude of events and data elements to make their decisions. And these decisions are not always based on objective reality.”
He’s a rocket scientist; he should know.
Perhaps it’s no coincidence that, since the concepts of fractals and chaos theory have gone mainstream, central bankers have started to wonder if the Heisenberg uncertainty principle might not apply to national-level interest rates. If the very act of observing a phenomenon alters it, do we really know enough to jump in?
“In the case of economics,” Dr. Ivie wrote, “investors don’t just observe, they participate so the alteration of the process is compounded. It is this fact that suggests that economic behavior is mathematically chaotic.”
The new school of thought among central bankers, as suggested by an analyst at Danske Bank, could be called the non-activist school. More concerned with structural-level determinants, such as the switch from hydrocarbons to wind or solar energy and the effect that change will have on their nation’s financial foundation, this non-activist school has less time for short-term variables such as the rate of inflation or economic growth. (Of course, it’s also true that much of the financial distress of the Great Depression was caused by the Federal Reserve’s inaction, meaning they’re damned if they do and damned if they don’t.)
According to this school of thought, the current trembling in our global financial system has its roots in loose monetary policy during and after the 2001 recession. It can be argued that lowering interest rates now not only may not help the situation, it also carries the potential to make it much worse. If the global marketplace is not understood well enough to be quantified—if such an action is even possible—then the more the system is tampered with, the more likely it is that an unknown variable will kick in, resulting in unintended and unwanted complications or an even bigger shock to the system. And the biggest variable of all, human nature and the power of emotions, is harder to calculate than the path of the rockets we sent to the moon.
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