Do We Need Another World War?

Ask the average guy on the street if we need another world war and he might respond with, “We need another world war like I need a hole in the head.”   Yet, there are medical conditions which can be solved by holes in the head, such as cranial swelling, i.e. when your brain gets too big for your skull.

War, according to Carl von Clausewitz, is merely the continuation of politics by other means.  In other words, when talking fails to resolve an issue in need of resolution, military force will accomplish what persuasion couldn’t.

However, winning a war, which, in Clausewitz’ view, means achieving political goals via military means, is easier said than done.  As Machiavelli warned, It ought to be remembered that there is nothing more difficult to take in hand, more perilous to conduct, or more uncertain in its success, than to take the lead in the introduction of a new order of things. Because the innovator has for enemies all those who have done well under the old conditions, and lukewarm defenders in those who may do well under the new.

The end results of WWII are consistent with Machiavelli’s warning.  Nazi Germany, Japan and Italy started the war to, inter alia, create a new world order and they succeeded, in part.  At war’s end, a new world order was created, with the US on top.

Having proved its dominance on the battlefield (leaving aside, for this essay, the stunning success of the Russians against the Germans), and carrying the big stick in the form of Atomic Weapons, the US could talk softly, solving, for a time, international financial conundrums which had proven intractable within the context of the League of Nations.  From this perspective, the “success” of the UN, IMF and World Bank, in contrast to the “failure” of the League of Nations is more a function of US power exercised through the new international institutions than some new-found commitment to cooperation. 

Of course, US dominance of world politics was due not just to military might but to its substantial Gold holdings, undamaged by war capital infrastructure, domestic commodity resources, and sheer economic size.  It seems to me the more recent failures of international financial institutions is more a function of the US resource depletion, gold reserve and capital infrastructure exports, and rapid economic growth of China and other populous nations, than some new found weakness in those institutions. 

Defendants don’t fear the Judge who imposes sentence but the power of the state behind him. 

The last world war was, in a sense, a schoolyard brawl decisively won, and broadcast globally, by the strongest kid, who happened to have the richest parents.        

I ask the opening question from the above perspective.  Do we need another world war to breathe new life and power into current or new international financial institutions- solving problems currently deemed intractable?

Barring a new enlightened faith in the virtues of international cooperation by top policy makers, and given the pressing need to apportion financial losses accruing from, inter alia, unprofitable international investments, the answer may be yes. 

Fasten your seat belts.

Bail-Outs for Screw Ups: Oil and Greece

In the not-to-distant future I wouldn't be surprised to read the following from the IMF: Negotiators over the weekend wrapped up details of the package, involving budget cuts, a freeze in wages and pensions for three years, and oil price increases to address British Petroleum's fiscal and debt problems as a result of the Gulf Oil Spill, along with deep reforms designed to strengthen BP's competitiveness and revive stalled corporate growth.

The above is paraphrased from the IMF's press release announcing the Greek Rescue Package. This, and other press releases, describe the crisis as "economic" when "financial' seems to me more apt (should we describe the oil spill as a "geologic" rather than "drilling" problem?), and proclaim the creation of a, fully funded, mind you, Financial Stability Fund. Greek Banks which failed to see the crisis coming are going to be shielded from the effects thereof.

Imagine if major Greek Banks, instead of investing anywhere from 2-3 times their equity into Greek Government Debt, had invested in safer securities. Just as deep-sea oil drillers have to devise safe (i.e. non-toxic) ways to extract oil, imagining some of the potential problems before they occur, shouldn't banks be devising safe (i.e. non-toxic) ways to extract profits from the seas of finance? If they fail in this task, should they be shielded from the effects of their failure?

One of the essential qualities of capitalist success, agreed upon after decades of careful study is the use of profits as arbiter for continued existence as a financial entity. Implicit in this view is belief that there will always be other competing firms/investors ready and willing to pick up the slack.

I'm pretty sure, just as there are many companies waiting to pick up the business slack caused by BP's error and potential financial distress, so too there are many Greek Banks with stronger balance sheets that would be willing to pick up the slack caused by the major banks' error in crisis forecasting.

Over at The Baseline Scenario Simon Johnson asks (of the decision to support too big to fail banks, instead of breaking them up): What is the basis for major policy decisions in the United States? Is it years of careful study, using the concentration of knowledge and expertise for which this country is known and respected around the world?

He suggests a possible (alternative) answer: I would not have a problem with the administration’s top officials saying, “we can’t take on the biggest banks because (a) they are too powerful in general, and (b) they would cut us off from the campaign contributions that we need for November.” This would at least be honest...

Honest, yes. Wise? not in my view.

BP's oil spill is horrific, but a fairly rare occurrence. Finance, at least in its current "liberal" form has a far worse track record. How long would the world tolerate current drilling techniques if such disasters occurred every couple of quarters all around the world? How long would public sector officials feeding from that trough survive?

Those in the public sector need to realize their interests are not aligned with TBTF finance. Can you imagine some BP-financed politician running in Louisiana any time soon?

Public sector monetization of financial sector errors coupled with support of the liberal banking techniques that created the problem will only accelerate currency devaluations in regimes that follow this policy and the brunt of the complaints will fall on the public sector and finance. In layman's terms, bail-outs for financial screw-ups will continue to cause higher prices, and higher prices will only inspire more anger.

Ideally, reward systems like capitalism should favor the prescient over the screw-up. Doing the opposite will likely have undesirable effects for all involved.

To wit; in an interesting irony, while the IMF is engaged in selling its gold it bails-outs the financial screw-ups who make it such a useful asset on a balance sheet.

IMF Power Play: Capital Controls or Failed States?

Coincidences abound these days. GS calls for derivatives clearinghouses, as does the IMF. GS, and in the not too distant future, presumably other TBTF institutions face civil suits enforced by national states from many parties. The IMF declares the debt load of these states the biggest risk to the financial system.

The global financial system and the world economy are slowly regaining their health, thanks in large part to unprecedented interventions by governments, but the sharp rise in government debt during the economic crisis from already elevated levels helped create what the IMF says is the newest threat to the financial system: growing sovereign risk. IMF (April 2010)

2. Yesterday, October 10, the G-7 met and agreed the following plan of action:

• "Take decisive action and use all available tools to support systemically important financial institutions and prevent their failure

3. Today the International Monetary and Financial Committee strongly endorsed the above commitments IMF (Oct. 2008)

On Christmas Day, 800 A.D., Pope Leo III crowned Charlemagne Emperor of the Romans. While scholars' views vary as to the Pope's intent, and Charlemagne's prior knowledge thereof, that the Vatican had thereafter a large effect on national politics in Christendom is without doubt. Concerns about the Vatican's continued influence almost 1000 years later, inter alia, led the framers of the US Declaration of Independence and Constitution to declare their sovereignty from, not only the mother country, but also such supra-national institutions.

Of course, that was then and this is now. The US Government, now hobbled by the debt load, incurred, in part, to support TBTF financial institutions- a policy urged by the IMF 2 years ago- is now being urged, by the same IMF, to reduce sovereign debt risks, which are the "newest threat to the financial system."

As the saying goes, with friends like these...

For decades, admittedly with varying intensity, the IMF has, in general, urged open capital markets- a policy at odds with the IMF's original mandate. Two years ago, the inevitable result of such national sovereignty abdicating policies in the absence of vigorous supra-national regulation brought the world's financial system to the brink of disaster.

With the benefit of hindsight, from one perspective, the IMF could be seen to have loudly urged national governments to "take as much (debt) rope as you'd like," and whispered, "to hang yourselves with."

How times have changed.

The dilemma which, in large part, led to the creation of the IMF- how to have the cake of international capital mobility and eat the cake of national sovereignty (yes, it's a stretch, but go with it), was, according to Louis Pauly, in his Who Elected the Bankers? confronted directly by Bretton Woods negotiators: They could see no way around the fact that states, if they valued economic stability as much as they valued their political independence, would have to maintain the capacity to deploy capital controls.

In the event, capital controls fell out of favor and thus capital sovereignty in the largest states was greatly diminished but the costs associated with supporting the banks profiting the most from the open environment have been shouldered by these same states. This seems, borrowing a term for yesterday's post, asymmetric.

Why should the state pay for what it cannot control?

Why, if the IMF supported the use of all available tools to restore financial stability but 18 months ago, does its most recent report highlight the risks of growing sovereign debt, but not the risks of private sector financial institutions whose failure to pilot the open capital market seas successfully played such a large role in the "risky" debt growth?

Louis Pauly asked, "Who Elected the Bankers?" If the IMF is taking its cue from Pope Leo III and playing for power with TBTF institutions, we have an answer. The IMF didn't Elect the Bankers, It Crowned Them.

Coincidences abound these days. GS calls for derivatives clearinghouses, as does the IMF. GS, and in the not too distant future, presumably other TBTF institutions face civil suits enforced by national states from many parties. The IMF declares the debt load of these states the biggest risk to the financial system.

The question of who is in control begs an answer. If the states aim to retain sovereignty, they will be forced to use the tool of capital controls. Indeed, in the current battle with GS, the US may find, if capital controls aren't imposed, that GS leaves a shell company to bear the brunt of any penalties. More broadly, if the national states don't impose control, they may soon find themselves, like Greece, California or New York, overly indebted entities with no power to solve their own problems, and thus waiting for hand-outs from the new supra-national institutions they created.

Let the games commence!

The Price of Gold Backed FX Reserves

While perusing the IMF's data set of Central Bank reserves I did a bit of calculating.  The graph below depicts the calculated $ price at which aggregated Central Bank FX reserves could be backed (100%, 35%, and 65%) by their holdings since 1980.

Currently, the IMF figures that Central Banks have 970M oz. of gold and $8,463B worth of FX reserves.  100% cover equates to a price of $8,720. 

Alternatively, they could just buy more.

China, TBTF, and dancin' with the gal that brung ya'

QUESTIONER: Changing the part of the world and going to China. Yesterday I read a statement from Mr. Strauss-Kahn about the yuan, the currency, being definitely undervalued. I wanted to know if you had anything to articulate on this or to comment. Thank you.

MS. ATKINSON (IMF): We have said a number of times that the yuan appears to us to be substantially undervalued. We've also said that what's important is to think about the rebalancing of China's economy. More broadly it's important that the Chinese themselves are interested in boosting domestic demand and private consumption, and exchange rate movements would be just a part of that. It's also of course important to think about global rebalancing, and that means that deficit countries as well as surplus countries need to make some adjustments. IMF Press Briefing 3/18/2010

Perhaps because of my rebellious nature, I've always been attracted to the counter-trend trade. Back in my days as a Hedge Fund trader, I learned about the "max pain" (there are more colorful descriptions) trade. When the market is positioned for a currency price rise, IF (timing is everything, here) you can catch the changing winds of news, you can make a killing (or at least avoid getting caught in the slaughter). In Sorosian jargon, this is the bet against the false premise.

As James Chanos has been arguing: We’re all looking at -- one of the most obvious, obvious trades of the world right now is that the RMB, the Yuan is undervalued. Mr. Geithner, I think, is in Beijing tonight talking about whether or not China is a currency manipulator. Everyone is assuming China needs to peg its currency higher to avoid the export deflation going on.

Well, Chinese exports aren’t the problem here. And what if it turns out that by having to nationalize lots and lots of real estate, bad debts, the RMB is devalued?

These days, the mother of all "max pain" trades would be an RMB decline.  How likely might such an event be?

Let me preface my view (with which, and $4.50, you can get a coffee at Starbucks) with my more general sense that China is in the midst of an amazing transformation which has many more years to run. I wouldn't bet against China in the long term (or at least until demographics catch up to them).

However, other countries which have similarly transformed have hit speeds bumps in the process. Rapid growth creates a financial environment that begs (usually temporary) over-extension.  In China's case, their history of modern financial corporate governance is quite short (on that score, we, in the US still have more than a few kinks to work out). The burned hand, as they say, teaches best (or will after the stove is touched a few more times).

For the past few months China has been trying to slow the economy down, in particular the property market, probably in search of the elusive soft landing.  I've never been much of a believer in the "soft-landing" thesis. There are too many unknowns in a huge economy so policy inevitably over-shoots (or never uncovers the excesses at all). At some point, a threshold will be reached and we'll find out just how sound Chinese property (et alia) lending has been.

My guess is, as almost always tends to be the case, there will be a big difference between viable credit levels of an economy growing at 8% (or, according to the latest data more than 11%) and one growing at 1-2%.

Given that the Chinese banking system totals upwards of $11.5T in assets, even a small "hair-cut" means a couple $100Bil.  

China is now a key piece of our increasingly interconnected global economy. It certainly qualifies, in a more profound sense than the largest US banks, as Too Big To Fail.  We may even find that China's economy has grown sufficiently to ensure that when China sneezes, the rest of the world gets a cold.

In the event of a speed bump, support, in one form or another, will certainly be forthcoming and that support will not be predicated on how the IMF or other nations wish China to develop but on the infrastructure already in place in the same way that TBTF banks were given support based on their infrastructure in place (i.e. continued prop. trading, continued derivatives, etc.) and not on the proposed models envisioned in reform plans.

In times of crisis, ya' gotta dance with the gal that brung ya'.

China is an export driven economy (net exports were 8.9% of 2009 GDP), and the best way to goose such an economy is by letting the currency slide. Moreover, China has been the recipient of substantial capital inflows (the cumulative current account surplus only accounts for roughly 65% of the growth in FX reserves over the past 15 years- just to give a flavor and sense of magnitude). During a crisis, these flows will tend to reverse (or minimally, stop flowing in).

In other words, I wouldn't be surprised to see a not insignificant RMB decline in the medium term, as palliative to a domestic credit problem, before it resumes its more general uptrend against the US$.

I leave for future essays questions of the impact of China's first "speed bump" as a maturing, and huge world power on the international financial architecture (and the impact of a necessary increase in China's current account surplus on the US). Suffice it to write that if such an event occurs (and it will sooner or later) I suspect many known, but currently politically intractable flaws in the regulatory arena (or lack thereof) will come into sharp focus. But they will have to wait.

To repeat, in times of crisis, ya' gotta dance with the gal that brung ya'.

And from a broader perspective, the gal that brung us all to the dance is the gal of monetary stimulus to fix all that ails us.  I'm not, at the moment, arguing for a rethink of this policy, just observing.

The Big School and Convertibility Lost

As described in The Partnership: The Making of Goldman Sachs: Coyne [CEO of J. Aron] learned that the central banks of many nations kept their currency reserves in gold bars stored in the vaults of the Bank of England in London or the New York Federal Reserve Bank. Taken together, all this great wealth of nations had what Coyne saw as one fascinating characteristic: It earned zero return. It just sat in the vaults. But Coyne knew that the time value of money always figured into any futures contract...so he called on the central bankers in one country after another and made what appeared to be a generous and innovative offer: "Lend me your sterile bars of gold bullion and I'll pay you a fee of one half of one percent every year!"

Why then was this forbid? Why but to awe,
Why but to keep ye low and ignorant,
His worshippers; he knows that in the day
Ye Eate thereof, your Eyes that seem so cleere,
Yet are but dim, shall perfetly be then
Op'nd and cleerd, and ye shall be as Gods
Milton: Paradise Lost

There are, it may seem to a new student of economics, more schools of thought in the field than stars in the sky. I sometimes wonder if David Bohm, author of, inter alia, The Qualitative Infinity of Nature, might have felt more comfortable as an Economist than a Physicist. While the physical sciences, according to Thomas Kuhn, exhibit totalitarian tendencies with violent revolutions, Economics is far more democratic, tolerating, albeit not without disputes, multiple coincident schools of thought.

Of late, however, one school of economic thought has become increasingly dominant in policy making circles. The Big School holds that the larger a financial institution becomes the more protected it should be, and vice versa, the smaller a financial entity is, the less protection it should receive.

As an example of this (somewhat) facetious claim, consider the views of JPM's David Lowman: Like all loans, mortgage contracts are based on a promise to repay money borrowed. Importantly, there is no provision in the mortgage contract, express or implied, that the lender will restore equity or reduce the repayment amount if the value of the collateral – be it a home, a car or a stock market investment – depreciates. If we re-write the mortgage contract retroactively to restore equity to any mortgage borrower because the value of his or her home declined, what responsible lender will take the equity risk of financing mortgages in the future? What responsible regulator would want lenders to take such risk?

In other words, the same bank (there were, of course, others) whose inability to meet its contractual obligations a few years ago was such that it needed loans from, and preferential swapping of toxic for performing securities with, the Fed, equity support from the Treasury, and a release from the onerous task of marking securities to market, NOW thinks contracts, regulations and agreements are sacrosanct.

I wonder if the issue up for debate was deriviatives regulation or marking toxic assets to market, would any person from a bank end a paragraph with "what responsible regulator would want lenders to take such risks?"

Big School Rules.

In a Jonathon Demme film appropriately (for our purposes) titled "Stop Making Sense", the Talking Heads' David Byrne asked, "Well, how did I get here?"

The Big School took its cue from Kuhn and engaged not in democratic debate, but totalitarian revolt. They appropriated Walter Bagehot's views on the Central Bank's Lender of Last Resort facility in times of crisis but perverted them in the process. Instead of the outline presented in Lombard Street of "very large loans at very high rates" which, in modern times, became, "lend freely at a high rate", the Big School preaches the doctrine of "lending freely (to the banks) at a very low rate" thereby relieving the Central Bank of its responsibility to enforce prudence.

I may, however, be wrong in assuming the Big School appropriated their "lend freely (to the banks) at a very low rate" doctrine from Bagehot (they may simply have thought "lots of free money would sure be nice"), because this implies a reading thereof. If they had read Lombard Street they would have found these lines of concern about big banks, and management practices obscured from review:

The second misgiving, which many calm observers more and more feel as to our largest joint stock banks, fastens itself on their government. Is that government sufficient to lend well and keep safe so many millions?

All that the best board of directors can really accomplish [in the largest joint-stock banks] is to form a good decision on the points which the manager presents to them, and perhaps on a few others which one or two zealous members of their body may select for discussion

There is no more unsafe government for a bank than that of an eager and active manager, subject only to the supervision of a numerous board of directors, even though that board be excellent, for the manager may easily glide into dangerous and insecure transactions, nor can the board effectually check him.

Our great joint stock banks are imprudent in so carefully concealing the details of their government, and in secluding those details from the risk of discussion. The answer, no doubt, will be, “Let well alone; as you have admitted, there hardly ever before was so great a success as these banks of ours; what more do you or can you want?” I can only say that I want further to confirm this great success and to make it secure for the future. At present there is at least the possibility of a great reaction. Supposing that, owing to defects in its government, one even of the greater London joint stock banks failed, there would be an instant suspicion of the whole system. One terra incognita being seen to be faulty, every other terra incognita would be suspected. If the real government of these banks had for years been known, and if the subsisting banks had been known not to be ruled by the bad mode of government which had ruined the bank that had fallen, then the ruin of that bank would not be hurtful. The other banks would be seen to be exempt from the cause which had destroyed it. But at present the ruin of one of these great banks would greatly impair the credit of all. Scarcely any one knows the precise government of any one; in no case has that government been described on authority; and the fall of one by grave misgovernment would be taken to show that the others might as easily be misgoverned also. And a tardy disclosure even of an admirable constitution would not much help the surviving banks: as it was extracted by necessity, it would be received with suspicion. A sceptical world would say, “Of course they say they are all perfect now; it would not do for them to say anything else”.

A read of Lombard Street would not have led to the Big School's conclusion that the Lender of Last Resort should, in times of crisis, lend only to the banks, and even insolvent ones.

Bagehot advised differently: A panic, in a word, is a species of neuralgia, and according to the rules of science you must not starve it. The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to “this man and that man,” whenever the security is good. In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them.

In other words, Bagehot argued the Central Bank's responsibility was to "the market", not the banks.

Further, he argued: the majority to be protected, are the “sound” people, the people who have good security to offer. He also speaks to the issue of unsound people, perhaps using a bit of wishful thinking: No advances indeed need be made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business. That in a panic the bank, or banks, holding the ultimate reserve should refuse bad bills or bad securities will not make the panic really worse; the “unsound” people are a feeble minority, and they are afraid even to look frightened for fear their unsoundness may be detected;

While the fraction of business which is unsound today is likely larger than in Bagehot's England, I suspect most is sound. Unfortunately, the unsound elements, while small in practical classification (derivatives, mortgage backed securities, etc.) are huge in terms of currency relative to the whole economy.

Big School means Big Problems

Why, I wonder, did the other schools of thought so meekly submit to the Big School's totalitarian revolution? Perhaps the question might better be phrased, what problem(s) deemed intractable by most other schools of thought did the Big School solve.

My best guess; one of the problems the Big School solved is Triffin's Dilemma. Alternatively, a previous (temporary) "solution" of Triffin's Dilemma, the London Gold Pool, was brought back to life, a la Frankenstein's monster which begat Big School thinking.

Triffin's Dilemma states that when a national money is used as an international medium of exchange and international reserve there will be trade-offs between the national and global effects of the reserve currency issuer's monetary policy. Moreover, the reserve currency issuer nation would soon find that it had to run increasing current account deficits to provide liquidity to the rest of the world. This, in turn, would erode confidence in reserve currency convertibility, eventually leading to international currency instability and potentially a break down in world trade.

Robert Triffin forecast the breakdown of the Bretton Woods system based on this dilemma. Of late, his work has been cited by the PBOC.

Issuing countries of reserve currencies are constantly confronted with the dilemma between achieving their domestic monetary policy goals and meeting other countries´ demand for reserve currencies. On the one hand,the monetary authorities cannot simply focus on domestic goals without carrying out their international responsibilities on the other hand,they cannot pursue different domestic and international objectives at the same time. They may either fail to adequately meet the demand of a growing global economy for liquidity as they try to ease inflation pressures at home, or create excess liquidity in the global markets by overly stimulating domestic demand. The Triffin Dilemma, i.e., the issuing countries of reserve currencies cannot maintain the value of the reserve currencies while providing liquidity to the world, still exists. Zhou Xiaochuan: hairman, Monetary Policy Committee of the People's Bank of China

Triffin, in the late 50s, called for the creation of a new global currency to act as international reserve, along the lines of Keynes' Bancor, or the IMF's SDR (deliberations for the creation of which were informed of his concerns), which, in my view, invites a whole new set of problems, but may still, barring a significantly large, in economic terms, country usurping the US$'s role, e.g. China (which invites similar problems, and leads to the US' loss of the exorbitant privilege), prove the best solution. A "free banking" system of competing moneys is another option.

As the US, not entirely without globally altruistic justification, did not want the Bancor in 1960 any more than it wanted it in 1945, the dilemma of convertibility fears was managed by illusion by way of intervention. The London Gold Pool was established in 1961 to keep the "market price" of Gold at $35 and thus reduce the incentive to demand promised convertibility from the Fed.

This worked until French demands for Gold were not satisfied. The cartel failed to maintain prices within the target and within a few years Nixon's closing of the Gold window ended US$-Gold convertibility.

I'll spare you the details of the 70s inflation and early 80s newfound stability. Suffice it to write that US$ reserves were accepted as semi-convertible- if not to Gold at a fixed price, at least to Gold and a basket of commodities with limited (until recently) fluctuations at new, higher prices.

In one (presumably easily accepted) respect, Big School banks that created and kept markets going in multiple new ($ based) investment vehicles helped sustain the sense of convertibility so long as those markets were trading.  Markets to spend one's $s, even if one never shops there, engender a sense of stability.

Also coincident with this new found stability was the beginning of a business deal between J. Aron (purchased by Goldman Sachs in 1981) and Central Banks around the world. As described in The Partnership: The Making of Goldman Sachs: Coyne [CEO of J. Aron] learned that the central banks of many nations kept their currency reserves in gold bars stored in the vaults of the Bank of England in London or the New York Federal Reserve Bank. Taken together, all this great wealth of nations had what Coyne saw as one fascinating characteristic: It earned zero return. It just sat in the vaults. But Coyne knew that the time value of money always figured into any futures contract...so he called on the central bankers in one country after another and made what appeared to be a generous and innovative offer: "Lend me your sterile bars of gold bullion and I'll pay you a fee of one half of one percent every year!" (pg. 258)

The book goes on to detail that J. Aron was actually making 8% on the deal with no money down, "it produced a nearly infinite rate of return." The book suggests they pulled a fast one on the central banks.

What Coyne may not have known was that at least some governments may well have done the deal for nothing. J. Aron offered to do what the London Gold Pool had done, and was willing to take the risk itself- a risk passed on in the merger to GS.  An added benefit, assuming the deal worked as described, no gold had to actually be sold on the market, paper gold would suffice.

GS was not alone in this game. By the mid to late 80s when I was at Chase (now JPM), our Gold desk (fortunately positioned right behind the options desk where I worked) was playing the same game. Paper gold flooded the market.

One of the reasons I began working with GATA a decade ago was my observation (shared by them) of Gold's stubborn reluctance to rise in price despite the rapidly increasing external US$ reserves. If Gold was, as Triffin asserted, undervalued in the early 60s, surely, I thought, it was a steal in 2000 at $275.

Global US$ reserves have done nothing but rise since, at an increasing pace.

In 1978, Triffin and Mundell were warning of a sudden collapse of the US$ due to the growth of those reserves. Back then they wrote in astonishment of US$ reserves in the few hundreds of billions. Now, such reserves are measured in the trillions.

Without concrete data I can only speculate as to the extent of Central Bank gold leasing, or its effect on the price. In the past few years, the price of Gold has risen above $1000. Interestingly the price broke above the early 1980s high of $800 when problems began appearing in large US banks. The mid 2008 dollar squeeze in international markets capped its advance at that time, only to bring the US banking system to the brink of disaster.

How causal the coincidence proves to be remains a mystery. What seems certain is that, if Central Bank gold leasing is a policy aimed at extending the life of the US$ as global reserve currency, the banks so engaged cannot be allowed to fail, or the game is over.

Thus, I wonder how much effect, if any, the Gold leasing practices of the big NY banks had on the decision to make them too big to fail.

Have we dodged Triffin's dilemma by trying to maintain the illusion of convertibility only to invite a banking collapse worse than Bagehot's worse nightmare?

How will the US respond if an economy as large as China's needs a boost in international liquidity?  How large might an IMF rescue package need to be to keep China from suffering a disastrous contraction?  Would the US, as is its wont, allow the current account to widen further to ensure China repaid the IMF?

What if Japan needs IMF support?

How far off might such events be?

Big Questions for the Big School

The Tyranny of Financial Technicians (and its demise)

The people always have some champion whom they set over them and nurse into greatness. This and no other is the root from which a tyrant springs; when he first appears he is a protector. Plato - The Republic

One of the earliest civilizations of which we still have record, Ancient Egypt, was, in a sense, run as a Technocracy (rule by technical experts). Technicians of that period were revered as priests and studied not money or credit, but time. Their worship of the sun set them apart from other cultures which used the more frequent lunar cycles to track time. By tracking the sun's movement in the sky the priest-technician forecast the coming of the Nile flood on which Egyptian food production was based.

These days the reverence accorded the ancient priests of time seems silly. Children with a few years of school can explain how the earth's revolution around the sun, and the earth's axial tilt leads to seasonal change. The basic secrets of the temple of time can be known by any who wish.

In modern times, the secrets of the temple of money, however, despite demystification attempts by William Greider, et alios, are still considered secret. Financial Technicians are revered perhaps as much as were the Time Technicians of old. Just as the Pharaohs of Egypt thought twice about confronting his priests our rulers think twice about confronting ours.

The Passover season just passed commemorates, from one perspective, the freedom gained from the ancient technocracy of Egypt, who, in the story, weren't as prescient in their forecasting as they professed. In that light, the timing of this op-ed, taking a modern technocrat to task for his lack of prescience, was perfect.

In modern times, internet connectivity makes the secrets of the temple of money far more open than was the case in ancient times. The big secret of the temple of money is that there is no secret. Men like Blankfein, Paulson, Rubin, Dimon, Greenspan, Bernanke, and (perhaps especially) Geithner, are not possessed of intellect and wisdom not found in many thousands of others. Moreover, their judgments, even granting solid "market sense" might be detrimental to the people and corporations that make up the nation (and whose actions are the ultimate determinants of the market).

Louis Brandeis, in his Other People's Money: and how the bankers use it, speaks to this issue:  Prominent in the banker-director mind is always this thought: "What will be the probable effect of our action upon the market value of the company's stock and bonds, or indeed, generally upon stock exchange values?" The stock market is so much a part of the investment-banker's life, that he cannot help being affected by this consideration, however disinterested he may be. The stock market is sensitive. Facts are often misinterpreted "by the street" or by investors. And with the best of intentions, directors susceptible to such influences are led to unwise decisions in the effort to prevent misinterpretations. Thus, expenditures necessary for maintenance, or for the ultimate good of a property are often deferred by banker-directors, because of the belief that the making of them now would (by showing smaller net earnings), create a bad, and even false impression on the market. Dividends are paid which should not be, because of the effect which it is believed reduction or suspension would have upon the market value of the company's securities. To exercise a sound judgment in the affairs of business is, at best, a delicate operation. And no man can successfully perform that function whose mind is diverted, however, innocently, from the study of, "what is best in the long run for the company of which I am director?"

Like the Ancient Egyptians waiting for the flood, a critical mass of modern people, many of whom dream of a comfortable retirement, are willing to revere those who promise market prices supportive of their financial expectations, and ignore those who don't. The market concerns of the investment banker described by Brandeis have increasingly became a major factor on policy.

As one example, consider the changed IMF perspective of capital flows (and its analog in the 2008-09 US Financial Rescue package) detailed by Raymond Mikesell, who attended the Bretton Woods Conference: Both White and Keynes believed that the IMF's assistance to members should not finance capital flight. However, the IMF has not maintained this position. The IMF's loans in response to the financial crises in the East Asian countries during the 1990s were primarily for the purpose of helping members restore confidence in their securities markets and currencies, rather than for financing imports. Moreover, according to a recent statement by Secretary of the Treasury Lawrence E. Summers, emergency loans to countries facing currency crises should be the principal lending function of the IMF (Kahn 1999).

Ultimately the Tyranny of Financial Technicians is the Tyranny of the Markets. Admittedly, I've employed hyperbole to make my point. The object of people's fascination varies over time. Following WWII, the people revered war heroes and elected Eisenhower and Kennedy. Their Treasury Secretaries did not come from Wall St. (or even close) and finance was but one of many technical skills deemed useful, and not the most popular.

In all likelihood, the modern fascination with our Technocracy will fade when the promises are seen to be empty. And empty they will prove to be so long as finance is primarily concerned with the markets and not the real sector on which they are based.

** Late addition:  In further support of the Investment-Banking mind driving policy thesis, consider the following argument in favor of EU and IMF support for Greece, granted at below market rates:  Jean-Claude Juncker, the Luxembourg prime minister and eurogroup president, said he hoped the agreement would calm the markets and help to avert the crisis facing Greece and the single currency. "This is the step of clarification the markets are waiting for," he said. "It shows there is money behind this."