Applied Philosophy

In my post The Magical Jet Engine and Global Monetary Disconnect I wrote how dollars printed by a Federal Reserve eager to fight deflation are accumulating into pools outside of economic flow. That was on April 28 2008 when Excess Reserves of Depository Institutions with the Federal Reserve were a meagre $1.737 billion (source St. Louis Fed), today that number stands at $1,560.231 billion. Here is what I wrote, then, about the size of these pools:

So how big are these pools? First there is a little pool of fuel, a small matter of a trillion and a half dollars, called China; followed by a smaller pool, a solitary trillion dollars, called Japan, another trillion is divided by the world: hundreds of billions in the oil-exporting countries of Arabia, seventy billions in Russia, thirty billions in Venezuela, even crumbling Iraq has stash of dollars in its central bank.

Today Total Reserves excluding Gold for China are $3.2 trillion and it has doubled its official gold reserves since that time. Japan is a distant second with $1.2 trillion. Saudi Arabia has $558.7 billion, Russia has $456.5 billion. These four countries alone hold more than $5 trillion in reserves (source St. Louis Fed). US banks hold a trillion and a half with the Federal Reserve and European banks hold about a trillion with the ECB. All added up makes it about $7.5 trillion or fifty-percent of the US GDP.

The US is still printing dollars and exporting them to the world:

The trade deficit in the U.S. widened in January to the largest since October 2008 as imports rose to a record high.

The gap increased 4.3 percent to $52.6 billion, more than forecast, from a revised $50.4 billion in December, the Commerce Department in Washington said today.

—Trade Deficit in U.S. Widens as Imports Hit High, Bloomberg March 9 2012

China on the other hand are starting to export their own dollars:

China had its largest trade deficit since at least 1989 last month as Europe’s sovereign-debt turmoil damped exports and imports rebounded after a weeklong holiday.

The shortfall was $31.5 billion, the customs bureau said yesterday. Imports rose 39.6 percent from a year earlier, after a 15.3 percent slump in January, while exports increased 18.4 percent, the bureau said.

—China Has Biggest Trade Shortfall Since 1989 on Europe Turmoil, Bloomberg March 10 2012

Japan is also exporting its dollars:

Japan’s yen weakened after reported a record current- account deficit, the biggest shortfall since comparable data began in 1985, undermining the currency’s haven status.

—Dollar Reaches 10-Month High as Jobs Gains Dim Outlook for More Fed Easing, Bloomberg March 10 2012

Even Australia, a commodity exporter with a strong currency, is having a trade deficit:

Australia recorded a trade deficit in January, its first in 11 months, as weaker shipments of iron ore and coal contributed to the biggest drop in total exports in almost three years. The local currency fell.

—Australia Records First Trade Deficit in 11 Months on 8% Plunge in Exports, Bloomberg March 9 2012

All this money is going after real physical wealth: natural gas, oil, gold, etc. This in turn is pushing inflation up:

Inflation is back on the European Central Bank’s radar, complicating efforts to bolster growth as the sovereign debt crisis pushes the economy toward recession.

The ECB will lift its 2012 inflation forecast above the 2 percent price-stability threshold today, limiting its ability to cut interest rates further even as it lowers the outlook for growth, economists said.

—ECB’s Inflation Radar Complicates Growth, Bloomberg March 8 2012

High inflation has not stopped the Bank of England:

While inflation eased to a 14-month low of 3.6 percent in January, that’s still above the bank’s 2 percent target. Crude- oil prices have risen about 20 percent in the past six months. The central bank sees inflation slowing to 1.9 percent by the end of this year and 1.8 percent by end-2013.

—King to Face Renewed BOE Policy Maker Rift as Dispute on Inflation Simmers, Bloomberg March 8 2012

Inflation has been above 3.6% for the last 14 months, so inflation has been at least (it was above 5% for two months) 80% above the target. Despite all this inflation the bank has not lifted its centuries low interest rate of 0.5%. In April 2008 the monthly price of gold was $909 (declined to $760 in November) and the Federal Funds Target Rate was 2.25%, today gold is about $1700 and the rate is 0.25%. Somehow I do not believe that the central banks will react to inflation soon and when they finally do they will find that their actions have little effect.

The current international set-up is coming apart. Europe is breaking up. The Arab world is changing. China can not keep exporting cheap labour. Japan must wake up from its state of suspended-animation. Australia can not enjoy the “lucky economy” for much long. The world, as we know it, is coming to an end. End by itself is not bad: pregnancy ends with birth, study ends with graduation, life ends with a eulogy. The problem is refusing to knowledge change, prepare for it and manage it when it arrives.

The leaders of China have neither the will nor the ability to guide China into a national economy independent of the US and its global economic empire. They will drive China into the ground and then bow out of history; China will rise again as it has been doing for the last two thousand years (see The Future History of China Today).

Japan is not a fully sovereign nation and until it become one it will not solve its problems. For a people who have never endured foreign occupation in their history until 1945, they turned out to be rather docile clients of the US economic empire. This situation made sense as long as they enjoyed economic prosperity, but since 1990 they have suffered economic stagnation. The solution to their problems is extremely easy, but impossible to implement. The people themselves have neither the drive nor the will for change.

Australia is currently dominating the region with 22.8 million inhabitants, its close neighbour, Indonesia, has 237.5 million. Australia is enjoying economic prosperity, exporting the resources of the country and then re-exporting the dollars for oil and consumer goods. With a persistent current-account deficit since 1976, little wealth remains in Australia. Australia has the obstacles against change of both China and Japan: an inadequate leadership and unwilling people.

The current international set-up looks mighty solid, but inflation is like heat slowly melting the it and turning the world into a boiling liquid.

See also:

• Flow my Dollars the Central Banker Said, on the inflation/deflation debate of 2008.
• The Printing Press is a Harsh Mistress, once you start printing you can never stop.
• Stock Valuation and Interest Rate, the valuation of the stock market is inversely proportional to the interest rate.
• Zimbabwe’s Monetary Policy, an example of monetary policy in hyperinflation.

God is dead

Fred

Fred is dead

God

—The Benny Hill Show, circa 1985

I remembered this joke when I heard the latest remarks by Warren Buffet about investing in gold. I clocked Buffet the first time I read his Wikipedia page way back in 2006, I realised then that he is a financial creature and not an economy investor (I described him as ‘odious’ in December 2008). The general public were quite taken with the sage but mistrust started when he stood up to defend the financial sector in 2008. Dislike came from seeing how much he was cosy with the Obama administration and China. Today a lot of people are turning away in disgust as he disparages gold buying.

The real problem is not Buffet but the gold enthusiasts who advertise gold as an investment: gold is not an investment. With friends like these gold is an easy target for a viper like Buffet. Gold is physical wealth that functions as money, it is not an investment. I would buy gold because I know that fiat money will lose all exchange value in the market sooner or later, but I would not buy it as an investment, because gold is not an investment (I said it three times now).

If gold is money then what are dollars? The dollar is a Federal Reserve Note, i.e. a zero-interest rate debt security that never mature, Treasury notes on the other hand pay interest and mature in less then a year. Some people who advocate gold say that there have been 10 years of growth, but in reality there has not been any growth. An ounce of gold ten years ago is still just an ounce, it did not germinate and produce a hundred ounces nor did it get pregnant and produce an ouncelet. What has happened in the last ten years is that the dollar lost value:

The Dollar Priced in Gold (Feb 98 - Jan 12)

(source The World Bank, Graph made with LibreOffice. Image created with GIMP)

This is the correct graph that reflects reality instead of illusions. You can not in invest in gold, but you can profit from a falling dollar to make real money. First you have to adjust the way you carry your accounts: all accounts have to be in gold instead of dollars and profit measured in gold and not dollars. Success means increasing the weight of gold owned and not the amount of dollars. A typical account book would look like this:

Example of accounting with Gold instead of Dollars

(Table made with LibreOffice. Image created with GIMP)

I personally would carry silver apart and other bullion with gold. I take into account the physical premium when converting dollars to gold so the price of dollars is set lower than the market rate. Receivables are any promise to deliver physical gold at a later date or on demand. I do not add a haircut on receivables to account for counter-party risk, but that can easily be done; it might be also useful to separate receivables according to risk. Other assets, stock or real estate, can be added in the same way. The bottom line is in gold, growth can only happen by increasing the bottom line.

Now we can do three different things: the first is to do nothing. This will result ultimately in a lower bottom line as the value of the Federal Reserve notes go to zero. The second option is to convert all dollars to gold, this will leave us without any legal tender and in case of an emergency we will have to buy dollars at a loss. The third option is to invest in dollars to increase the bottom line.

How do you invest in dollars? Easy all we have to do is to apply the old rule of buying low and selling high. We buy dollars when the price is low (translated: sell gold when the price is up) and sell them when the price is high (translated: buy gold when the price is down). You have to be nimble to take advantage of declines (gold price spikes) and spikes (gold price declines), but a careful trader without using margin can probably grow his gold every year.

Earning gold through the future markets is nearly impossible (a single contract is 100 oz. and taking delivery is very difficult). Having a retail shop is great, you would buy bullion by weight and sell it marked up; a shop requires independent means of living (so you would not eat your capital if people stop buying) and a culture of buying gem-less jewellery. Most people can increase their gold by earning dollars and buying bullion from the government mint (some private mints give good prices for bulk buying).

See also:

• Human Freedom Rests on Gold Redeemable Money (PDF) by Howard Buffet, congressman and father of Warren.
  
• The S&P 500 went DOWN 13% in 2010, the stock market measured in gold.
• Will the Fed ever Get Paid Back, why the dollar is going down.
• Will the Real Gold Standard Please Stand Up, relationship between silver and gold.
• The Difference between Past and Future Labour, why gold is money.
• High Treason in Zimbabwe, specifications for a new gold coin.

The Problem

Apple said in its annual results filing that its cash and investments – worth $81.6 billion at that stage – earned just 0.77 percent in the fiscal year ended September 24, 2011. That was a hair above the 0.75 percent return earned the previous year and down from 1.43 percent in fiscal 2009 and 3.44 percent in 2008.

—One area where Apple lags: Its low returns on cash

Apple Inc. does not pay dividends, profits that are not re-invested are accumulated as cash (probably in short-term high-quality notes). With the success of the iPad coming after the iPhone and the iPod, coupled with the high margin that Apple has on each device and the stream of income from the iTunes web-shop the corporation has built a cash-stash of almost a hundred billion dollars.

Big shareholders do not want the cash paid out to them, if the whole amount would be paid in one go the market capitalisation of the company would be reduced by a similar amount overnight and the share price would decline accordingly. If the money is to be paid in instalments, then the income stream can be capitalised; this at first would boost the share price, but as payments are made the net present value of the income stream and the net value of the company would decline, eventually a hundred billion paid would reduce the capitalisation by a hundred billion.

Both big shareholders (funds managing money) and the management would not like to see a declining share price, they have no use for the money and would only lose part of it to taxes, so Apple keeps the money. The problem, as the quote above demonstrate, is the low interest earned on the cash-stash. Shareholders want to earn higher return, than 0.75%, on their money so they demand that Apple either invest it or return it to them.

The Solution

The solution is simple: Apple Inc. should set up a bank-holding company, iBank, with about a third of its stash. Banks, even the timid Federally insured commercial banks, can leverage their equity many multiples to increase their earnings, helped by the Federal Deposit Insurance Corporation and the Federal Reserve System backing. The following graph shows the average yearly leverage (total assets/total equity) for banks in the US:

Leverage for All Insured U.S. Commercial Banks

(Graph from St. Louis Fed).

Leverage did decline from above ten times equity to about nine times equity after the financial crisis of 2008. As a new bank with no sub-prime assets on its book iBank can easily leverage a third of a hundred billion ten times to a third of a trillion. This will make it one of the top ten banks by assets:

Top 10 bank holding companies as of 31 Dec 2011 with iBank shown

(source National Information Center, table made with LibreOffice. Image created with GIMP).

Banks are very profitable with some earning 20% return on equity. We will take the average return on equity for insured banks in the US in the last few years:

Return on Equity for All Insured U.S. Commercial Banks

(Graph from St. Louis Fed).

As a new bank iBank can easily achieve 8% return on equity. Apple should deposit one third of its cash-stash with the new bank. The total earnings would be: 8% for third of the money and at least 0.75% for the deposited third. The total earnings from two-thirds of the cash-stash would be 3.8 times the money earned on the whole cash-stash in 2011. The last third can be returned to the shareholders.

The Prestige

iBank would solve the cash-stash problem by doing three things simultaneously: pay dividends, increase earnings and lift the share price. Once you own a bank, however, the limits to what you can do are as high as the central bank funding you get. For example Apple can leverage its design and retail knowledge (both in store and on the web) into making new banking processes, then license its patented methods to others. Just imagine walking to a hip iBank branch where everyone carries an iPad and uses an iMac.

Apple can use iBank as both a sandbox for developing enterprise products and an early adopter. Payment with iPhone and other monetary products will have one of the ten largest banks in America as a guaranteed partner. A native app will let customers access their accounts with an iPhone or an iPad.

The History

This is neither a joke nor an absurd idea. This is a serious idea based on historical evidence: Rockefeller turned his oil money to the Chase Manhattan Bank. The Harriman rail road fortune was turned into Brown Brothers Harriman & Co..

You might object, dear reader, that those were generational shifts; probably the sons of industrial barons growing up surrounded by accountants and advisers found finance a more suitable environment than industry, but many industrial families remained in industry and did not make the transformation into finance; what characterised those two families were huge profits made thanks to a monopoly. Rockefeller had a monopoly in the oil business and Harriman consolidated the railway business in the north-east. After obtaining a high return for many years and amassing huge liquid profits (i.e. cash) they moved to finance.

Apple has amassed the cash-stash thanks to high-margins on its ground-breaking devices; sooner or later the margins will decline and Apple will withdraw from the competitive market, concentrating on exclusive products. As Bill Gross said (quoted in my last post) the best way to make profits today is to “use money to make money”. Companies are driven to finance by three factors: high profits, lack of investments, low return on cash. Of course the great facilitator is the financial modern economy with a central bank willing to lend to banks at rates lower than the market. I will give two modern examples of corporations that used their industrial base to wade into the sea of finance; one was an ultimate failure that went bankrupt (due to bad management over decades) and the other is still one of the largest and most profitable US corporations.

The first is GM—the original company and not the Frankenstein monster that walks the earth today—which had GMAC (founded in 1919) which, in 2008, provided financing to 75% of the 6,450 GM dealers (source Ally Financial) it also engaged in insurance, online banking, mortgage operations, and commercial finance. GM made so much profit from lending people money to buy its cars that the joke was that “GM was a bank that happened to make cars” (source Seven reasons GM is headed to bankruptcy). In 2006 GM sold 51% of GMAC when it needed cash (when you fall on your luck the first to go is the most profitable part). Today GMAC is a bank-holding company called Ally Financial and it is majority (73.8%) owned by the government.

The second is GE which has a financial services unit called GE Capital which provides commercial and consumer financing. When the crisis hit in 2008 the chief officers of GE repeated in the media that they would not lose their AAA rating, they did in March of 2009. Today GE is rated AA by Standard and Poors and Aa2 or Aa3 by Moody (source: What’s the Deal with GE?). The downgrade did not hurt them badly as their industrial units benefited from the increased spending. The share of GE Capital revenues to total revenues fell from a third in 2010 to about 28% for Q4 2011 (source GE 2011 fourth quarter performance PDF and Annual Report 2010 PDF).

See also:

• Bagehot on Money a 5-part series discussing Bagehot’s book on money markets and banking.

The composition of the Federal Reserve’s treasuries’ holdings that I discussed ten months ago (see Fed Holdings: Short vs. Long Term Securties) is now at the center of the Fed’s monetary policy:

The Federal Open Market Committee concluded its September 21, 2011 Meeting at about 2:15PM EDT by announcing the implementation of Operation Twist. This is a plan to purchase $400 billion of bonds with maturities of 6 to 30 years and selling bonds with maturities less than 3 years, thereby extending the average maturity of the Fed’s own portfolio

—History of Federal Open Market Committee actions, Wikipedia

This how the Fed’s holdings were split in January 2007:

Federal Reserve treasuries holdings January 2007: short-term in blue, long-term in red

Four years, nine months and one financial crisis later it looks like this:

Federal Reserve treasuries holdings September 2011: short-term in blue, long-term in red

Operation Twist is the implementation of the Fed’s promise to keep interest rates low until 2013. Investors do not want stable low rates, they want declining rates. Short term rates are already at zero, so longer term rates have to decline to satisfy the financial world. Interest rates have been declining since their highs 30 years (see Liquidating the Debt of the United States) and as long as they keep declining the financial structure built after Nixon closed the gold window will survive; when they start rising that structure will die and so will the fiat dollar with it.

Twisting might have once worked, but that was back in 1961 when the dollar was linked to gold. Extending the average maturity of the treasuries today means that while investors roll over their bills at higher rates, as the dollar starts to lose the remaining one percent of value it still has, the Fed will be stuck with long dated treasuries. A positive feedback loop descending all the way to zero dollar value.

If you want to make your own graphs you can use this FRED graph to get you started.

After posting in my last blog post the following graph showing the composition of the Federal Reserve’s Treasuries holdings:

The Fed's Treasury securities composition

I returned to the excellent St. Louis Fed: Economic Research website to further examine the data and produce a more concise graph. I grouped the six data series into two lines; the first (in red) shows the total face value of securities maturing from 1 year to over 10 years, so Notes and Bonds. The second (in blue) shows the total face value of securities maturing in less than a year, so Bills (maturities refer to the remaining time to maturity and not the maturity of the security at issue).

Federal Reserve treasuries holdings: short-term in blue and long-term in red.

At the start of 2007 short term securities formed the majority of the Fed’s holdings:

Federal Reserve treasuries holdings January 2007: short-term in blue, long-term in red

After almost four years, at the end of 2010, short-term Treasury debt declined to less than a tenth of the Fed’s holdings:

Federal Reserve treasuries holdings December 2010: short-term in blue, long-term in red

If you want to adapt these graphs you can use this FRED graph to get you going.

In a preliminary report released Tuesday, the U.S. Federal Reserve said it will turn over $46.1 billion to the federal government. That money comes from income the central bank received mostly from its investments in U.S. Treasury bonds and mortgage-related securities.

The Federal Reserve also made money from loans to banks and other firms.

The bank’s profits follow an unprecedented amount of spending in emergency investments.  At the end of 2009, the bank was holding more than $1.5 trillion in U.S. government debt and mortgage-related assets.

After paying operating costs, the Federal Reserve turns over all profits to the U.S. Treasury.  It returned $34.6 billion in 2007.

—US Federal Reserve Makes Record Profits in 2009 [my emphasis]

In September 2009 the Fed’s balance sheet was $2,144 billion, while in June 2007 it was $869 billion (source). Thus the profit-to-assets ratio is:

click to view

Record profits, indeed! Record low profits that it is.

The first shows the decline of treasuries held by the Federal Reserve Banks, while their credit has doubled:

This has a serious implication on the soundness of the dollar. The second graph shows the dependence of the US on imported goods and services:

That would is not a problem by itself, but taken in conjunction with the next graph that shows the increase in federal debt held by foreigners:

The conclusion must be ominous.

The last graph shows the death of the last profitable sector in the US, namely the financial sector:

Is it possible to have a fiat currency that does not end in hyperinflation? In this post I will try to explain why the answer is a resolute No.

Irresponsible governments who print prodigious amounts of paper to fund expenses beyond their ability to carry the debt are certainly going to end with hyperinflation, as is the case in Zimbabwe for example. The belief is that governments that have monetary experts at the helm and a strong economy that can service the debt-No economy can pay off the debt of the government and prosper at the same time unless the payments are colonial profits-then the currency can live on without the danger of hyperinflation; that belief is completely false.

To begin let us look at a time when the gold standard was in effect, so by comparison we can better understand fiat money. Here is the balance sheet of the Bank of England Issue Department at the end of 1869 (see Bagehot on Money):
Read the rest of this entry »