From: http://www.lemetropolecafe.com/kiki_table.cfm?pid=6369 (As of Nov 26, 2007 this Fekete article appears to have been removed.)

The article, usually without the “Ted Butler Stopped bitching” part is still to be found on the internet at http://www.professorfekete.com/articles%5CAEFCanWeHaveInflationAndDeflation.pdf or http://www.kitco.com/ind/fekete/printerfriendly/sep282007.html or http://oikonomika-blog.blogspot.com/2007/09/antal-fekete-can-we-have-inflation-and.html or http://news.goldseek.com/GoldSeek/1190991990.php ) or http://www.dinl.net/~dinlnet/guestArticle.php5?m=y&id=1912 or http://safehaven.ca/article-8507.htm



Executive Summary [This summary is not in all versions. -FNC]

Very few people understand the „continental drift” that threatens with a fracture of the U.S. (and hence, the world) monetary system. There are two tectonic plates: one, the supply of Federal Reserve notes (FR notes), and the other, the supply of electronic dollars in the form of an inverted pyramid that rests on the supply of FR deposits. The fault line between the two tectonic plates, like San Andreas fault in California, is a worrisome source of unpredictable earthquakes that could cause massive and permanent damage to the U.S. and world economy.

The monetary fault line exists because of the different statutory requirements the Federal Reserve has to meet in order to increase the supply of „high-powered money”:

  1. FR notes must be collateralized by gold or by U.S. Treasury bills and Federal Agency securities. The Federal Reserve does not print FR notes (still less can it air drop them); it gets them from a government official called Federal Reserve Agent against pledging appropriate collateral .

  2. FR deposits may simply be collateralized by the note of the borrower who borrows from any of the FR  banks. Thus the Federal Reserve can increase FR deposits on its own authority, without reference to the government. The banking system then builds its own pyramid of deposits upon the fractional reserve of FR deposits

Thus there is a serious obstacle in the way of increasing the money supply by increasing the volume of FR notes in circulation, giving the lie to Chairman Ben Bernanke’s promise to air drop them from helicopters. The obstacle: falling interest rates. For example, if the T-bill rate dips into negative territory, then the market value of T-bills exceeds their face value and the Federal Reserve „cannot afford” to buy them in the open market. The shortage of eligible collateral will restrict the inflation of FR notes in circulation. By contrast, FR deposits can be created out of the thin air in unlimited quantities at the click of the mouse.

Herein lies the danger of monetary earthquake along the fault line. The outstanding issue of FR notes as of September 20, 2007, was a paltry $760 billion (note that a sizeable fraction is being hoarded by foreigners overseas), see: www.federalreserve.gov/releases , which is less than two tenth of one percent of the notional value of derivatives. Just a drop in the ocean of potential bad debt.

It is possible for the tectonic plate of hand-to-hand money, the FR notes to deflate, while that of electronic dollars to go into hyperinflation. The decoupling has frightening consequences for the financial and economic future of the world.









CAN WE HAVE INFLATION AND DEFLATION ALL AT THE SAME TIME?

Antal E. Fekete
Gold Standard University Live
aefekete@hotmail.com

The curse of electronic dollars

Helicopter Ben has just made a most unpleasant discovery. Earlier he has promised that the Federal Reserve will not stand idly by while the dollar deflates and the economy slides into depression. If need be, he will go as far as having dollars air dropped from helicopters.

Time has come to make good on those promises in August when the subprime crisis erupted. To his chagrin Ben found that electronic dollars, the kind he can create instantaneously at the click of the mouse in unlimited quantities, cannot be air dropped. They just won’t drop.

For electronic dollars to work they have to be able to trickle down through the banking system. The trouble is that when bad debt in the economy reaches critical mass, it will start playing hide-and-seek. All of a sudden banks become suspicious of one another. Is the other guy trying to pass his bad penny on to me? In extremis, one bank may refuse to take an overnight draft from the other and will insist on spot payment. A field day for Brink’s. The clearing house is idled, and armored cars run in both directions up and down Wall Street delivering FR notes and certified checks on FR deposits.

Under such circumstances electronic dollars won’t trickle down. In effect they are frozen. Ultimately, they may be demonetized altogether by the market. How awkward for Helicopter Ben. He would now have to go back to the old-fashioned and cumbersome way of inflating the money supply via the printing press. Literally.

Northern Rock and Roll

He had better, and do it double quick. The Northern Rock and Roll fever may spill over across the Atlantic from England to the United States. Northern Rock is a bank headquartered in Newcastle with lots of branches in the Northern Counties. It was a high-flyer using novel ways of financing mortgages through conduits and other SIV’s, instead of using the more traditional methods of building societies through savings. (SIV or Structured Investment Vehicle is euphemism for borrowing short, lending long through securitization). Now a run on the bank has grounded the high-flier. As long queues in front of the doors of branch offices indicate, a world-wide run on banks may be in the offing. Bank runs were thought to be a pathology of the gold standard. In England they haven’t seen the like of it since 1931 when the bag lady of Threadneedle Street went off gold. Surprise, surprise: bank runs are now back in vogue playing havoc on the fiat money world. Depositors want to get their money. Not the electronic variety. They want money they can fold.

There’s the rub. Pity Helicopter Ben. It looked so simple a couple of weeks ago. The promise of an air drop should stem any run. It sufficed to tell people that he could do it. No reason to mistrust the banks since they are backed up by air drops. Now people have different ideas. The air drop is humbug. Can’t be done. Ben is bluffing. As calculated by Alf Field writing in Gear Today, Gone Tomorrow (www.gold-eagle.com, September 6, 2007 [http://www.gold-eagle.com/search.html and appended to this article]) if only ten percent of the notional value of derivatives is bailed out by dropping $500 FR notes the pile, if notes are stacked upon one another, would be nearly 9000 miles high. Helicopter Ben hasn’t reckoned that FR notes do not exist in such quantities. They will have to be printed before they can be dropped. Even if they existed, to drop them all would take years, and by that time the shaky house of cards of FR credit might be blown away. And bailing out just ten percent of the derivatives mess is a conservative estimate. You may have to bail out a lot more than that.

Devolution

What does it all mean? At minimum it means that we can have inflation cum deflation. I am not referring to stagflation. I refer to the seemingly impossible phenomenon that the money supply inflates and deflates at the same time. The miracle would occur through the devolution of money. This is Alf Field’s admirable phrase to describe the “good money is driven out by bad” syndrome a.k.a. Gresham’s Law. Electronic dollars driving out FR notes. The more electronic money is created by Helcopter Ben, the more FR notes will be hoarded by banks and financial institutions while passing along electronic dollars as fast as they can. Most disturbing of all is the fact that FR notes will be hoarded by the people, too. If banks cannot trust one another, why should people trust the banks?

Devolution is the revenge of fiat money on its creator, the government. The money supply will split up tectonically into two parts. One part will continue to inflate at an accelerating pace, but the other will deflate. [Do I believe this?!] Try as it might, the Federal Reserve will not be able to print paper money in the usual denominations fast enough, especially since the demand for FR notes is global. Regardless of statistical figures showing that the global money supply is increasing at an unprecedented rate, the hand-to-hand money supply may well be shrinking as hoarding demand for FR notes becomes voracious. The economy will be starved of hand-to-hand money. Depression follows deflation as night follows day.

Decoupling tectonic plates

Side-by-side of deflation of hand-to-hand money there will be hyperinflation as the stock of electronic money will keep exploding along with the price of assets. You will be in the same boat with the Chinese (and the son of Zeus: Tantalus). You will be put through the tantalising water torture  trillions of dollars floating by, all yours, but which you are not allowed to spend. The two tectonic plates will disconnect: the plate carrying electronic dollars and the plate carrying FR notes, with lots of earthquakes along the fault line. No Herculean effort on the part of the government and the Federal Reserve will be able to reunite them. At first, electronic dollars can be exchanged for FR notes but only against payment of a premium, and then, not at all.

The curse of negative discount rate

If you think this is fantasy, think again. Look at the charts showing the collapse of the yield on T-bills. While it may bounce back, next time around the discount rate may go negative. You say it’s impossible? Why, it routinely happened during the Great Depression of the 1930’s. Negative discount rate means that the T-bill gets an agio, the discount goes into premium even before maturity, and keeps its elevated value after. This perverse behavior is due to the fact that the T-bill is payable in dollars. Yes, the kind you can fold, the kind that is in demand exceeding supply, the kind people and financial institutions hoard, the kind foreigners have been hoarding for decades through thick and thin: FR notes. Thus T-bills are a substitute for the hard-to-come-by FR notes. Mature bills may stay in circulation in the interbank market, in preference to electronic dollar credits*. Why, their supply is limited, isn’t it, while the supply of electronic dollars is unlimited! The beauty of it all is that we have an accurate and omnipresent indicator of the premium that cannot be suppressed like M3: the (negative) T-bill rate. This is an indicator showing how the Federal Reserve is losing the fight against deflation.

Inverted pyramid of John Exter

The grand old man of the New York Federal Reserve bank’s gold department, the last Mohican, John Exter [John Exter See also statement below by D R Schoon.] explained the devolution of money (not his term) using the model of an inverted pyramid, delicately balanced on its apex at the bottom consisting of pure gold. The pyramid has many other layers of asset classes graded according to safety, from the safest and least prolific at bottom to the least safe and most prolific asset layer, electronic dollar credits on top. (When Exter developed his model, electronic dollars had not yet been invented; he talked about FR deposits.) In between you find, in decreasing order of safety, as you pass from the lower to the higher layer: silver, FR notes, T-bills, T-bonds, agency paper, other loans and liabilities denominated in dollars. In times of financial crisis people scramble downwards in the pyramid trying to get to the next and nearest safer and less prolific layer underneath. But down there the pyramid gets narrower. There is not enough of the safer and less prolific kind of assets to accommodate all who want to “devolve”. Devolution is also called “flight to safety”.



An example of this occurred on Friday, August 31, 2007, as indicated by the sharp drop in the T-bill rate from 4 to 3%, having been at 5% only a couple of days before. As people were scrambling to move from the higher to the lower layer in the inverted pyramid, they were pushing others below them further downwards. There was a ripple effect in the T-bill market. The extra demand for T-bills made bill prices rise or, what is the same to say, T-bill rates to fall. This was panic that was never reported, still less interpreted. Yet it shows you the shape of things to come. We are going to see unprecedented leaps in the market value of T-bills, regardless of face value! You have been warned: the dollar is not a pushover. Electronic dollars, maybe. But T-bills (if you can fold them) [Well, can you, or can't you?! Is money in my bank account 'foldable'? I guess an individual TreasuryDirect account would be foldable.] and FR notes will have an enormous staying power. Watch for the discount rate on T-bills morphing into a premium rate!

It is interesting to note that gold, the apex of the inverted pyramid, remained relatively unaffected during the turmoil in August. Scrambling originated in the higher layers. Nevertheless, ultimately gold is going to be engulfed by the ripple effect as scrambling cascades downwards. This is inevitable. Every financial crisis in the world, however remote it may look in relation to gold, will ultimately affect gold, perhaps with a substantial lag. The U.S. Government destroyed the gold standard 35 years ago, but it could not get gold out of the system. It was not for want of trying, either, as we all know. Gold remains firmly embedded as the apex of Exter’s inverted pyramid.

Vertical devolution is not the only kind that occurs in the inverted pyramid. There are similar movements that can be described as horizontal. Nathan Narusis of Vancouver, Canada, is doing interesting research on the Exter-pyramid. He noted that in addition to vertical there is also horizontal devolution. Within each horizontal layer of the same safety class there are discernible differences. An example is the difference between gold in bar form and gold in bullion coin form, or silver in bar form and silver in the form of bags of junk silver coins. Franklin Sanders in Tennessee is an expert on horizontal devolution of silver and has a fascinating study how the discount on bags of junk silver coins may go into premium, and vice versa. There may also be differences between FR notes of older issues and FR notes of the most recent vintage. [See note below on Euro serial numbers!!] There are obvious differences between the CD’s of a multinational bank and those of an obscure country bank. The point is that movement of assets horizontally between such pockets within the same safety layer is possible and may be of significance as the crisis unfolds and deepens.

Dousing insolvency with liquidity

In a few days during the month of August central banks of the world added between $300 and 500 billion in new liquidity in an effort to prevent credit markets from seizing up. The trouble is that all this injection of new funds was in the form of electronic credits, boosting mostly the top layer where there was no shortage at all. Acute shortage occurred precisely in the lower layers. This goes to show that, ultimately, central banks are pretty helpless in fighting future crises in an effort to prevent scrambling to escalate into a stampede. They think it is a crisis of scarcity whereas it is in fact a crisis of overabundance.

I feel strongly that this aspect of research on the denouement of the fiat money era has been lost in the endless debates on the barren question whether it will be in the form of deflation or hyperinflation. Chances are that it will be neither, rather, it will be both, simultaneously. There is a little-noticed and little-studied continental drift beween the money supply of electronic dollars and the money supply [of] FR notes. (Continental drift of the geological variety is invisible and can only be studied with the aid of high-precision instruments.) The tectonic plate of electronic dollars will keep inflating at a furious pace, while that of FR notes and T-bills will deflate because of hoarding by financial institutions and the people themselves. The Federal Reserve will be unable to convert electronic dollars into FR notes, as present denominations cannot be printed fast enough physically in times of a crisis. If it comes out with new denominations by adding lots more zero’s to the face value of the FR notes, then the market will treat these the same way as it does treat electronic dollars: with contempt.

Genesis of derivatives

Alf Field (op.cit.) is talking about the „seven D’s” of the developing monetary disaster: Deficits, Dollars, Devaluations, Debts, Demographics, Derivatives, and Devolution. Let me add that the root of all evil is the double D, or DD: Delibetare [Deliberate?] Debasement. In 1933 the government of the United States embraced that toxic theory of John Maynard Keynes (who borrowed it from Silvio Gesell). It was put into effect piecemeal over a period of four decades. But what the Constitution and the entire judiciary system of the United States could not prevent, gold could. It was found that gold in the international monetary system was a stubborn stumbling block to the centralization and globalization of credit.

So gold was overthrown by President Nixon on August 15, 1971 by a stroke of the pen, as he reneged on the international gold obligations of the United States. This had the immediate effect that foreign exchange and interest rates were destabilized, and prices of marketable goods embarked upon an endles spiral. In due course derivates markets sprang up where risks inherent in the interest and forex rate variations could be hedged. The trouble with this idea, never investigated by the economic profession, was that these risks, having been artificially created, could only be shifted but could not be absorbed. By contrast, the price risks of agricultural commodities are nature-given and, as such, can be absorbed by the speculators.

The important difference between nature-given [no insiders] and man-made risks is the very cause of the mushrooming proliferation of derivatives markets, at last count half a quadrillion dollars strong (or should I say weak?!) Since the risk involved in the gyration of interest and forex rates can only be shifted but cannot be cushioned, there started an infinite regression as follows.

The risk involved in the variation of long-term interest rates we may call x. The problem of hedging risk x calls for the creation of derivatives X (e.g., futures contracts on T-bonds). But the sellers of X have a new risk y. Hedging y calls for the creation of derivatives Y (e.g., calls, puts, strips, swaps, repos, options on futures). Sellers of Y have a new risk z. The problem of hedging z will necessitate the creation of derivatives Z (with tongue in cheek: futures on options, options on options, etc.) And so on and so forth, ad infinitum.

J’accuse

We have to interpret the new phenomenon, the falling tendency of the T-bill rate accurately. Maybe the financial media will try to put a positive spin on it, for example, that it demonstrates the strength of the dollar. However, I want to issue a warning. Just the opposite is the case. We are witnessing a sea change, tectonic decoupling, a cataclismic decline in the soundness of the international monetary system. The world’s payments system is in an advanced state of disintegration. It is the beginning of a world-wide economic depression, possibly much worse than that of the 1930’s.

We have reached a landmark: that of the breaking up of centralized and globalized credit, the close of the dollar system.

J’accuse said Zola when he assailed the French government for fabricating a case of treason against artillery captain Alfred Dreyfus in 1893. It is now my turn.

J’accuse — the government of the United States under president Roosevelt reneged on the domestic gold obligations of the U.S. in violation of the Constitution, and violated people’s property rights without due process by confiscating gold in 1933

J’accuse — academia has been pussyfooting the government by failing to point out the economic consequences of gold confiscation, namely, the prolonged suppression of interest rates that was ultimately the cause of prolonging depression**

J’accuse — the government of the United States under president Nixon reneged on the international gold obligations of the U.S. thereby globalizing the monetary crisis in 1971

J’accuse — cringing academia failed to point out the consequences of gold demonetization: price spiral of marketable commodities world-wide; roller-coaster ride of long-term interest rates, up to 16 percent per annum and down to 4 percent per annum or lower and back up again; the fact that interest rates may take prices along for the ride

J’accuse — foreign governments accepted Nixon’s breach of faith without demur, apparently because in exchange for their compliance they were given the freedom to inflate their own money supply with abandon on the coattails of dollar inflation

J’accuse — the banks have embraced the regime of irredeemable currency with gusto and greatly profited from it, instead of protesting that under such a regime it was impossible to discharge the bank’s sacred duty to act as the guardian of the savings of the people and the value of the estate of widows and orphans

J’accuse the accounting profession for their compliance in accepting grieviously compromised accounting standards that convert liabilities into assets in the balance sheets of the government and the Federal Reserve.

In the words of Chief Justice Reynolds, in delivering the dissenting minority opinion on the 1935 Supreme Court decision in upholding president Roosevelt’s confiscation of people’s gold:

„Loss of reputation for honorable dealing will bring us unending humiliation. The impending legal and moral chaos is appalling.”

No less appalling, we may add, is the impending financial and economic chaos.

________________________

*An object lesson in negative T-bill rate is being presented as I write this on Thursday, September 20, 2007. The 30-day silver lease rate has gone to minus 0.1 percent. I wish analyst Ted Butler stopped bitching about manipulation [More Fekete on this here or here or here .] and instead of telling fairy tales about raptors and dinosaurs explain to us what the negative silver lease rate means. My own explanation is panic short covering in silver. Normally the price of silver moves in tandem with that of gold. In case the rising price of silver lags substantially behind that of gold, negative lease rate may develop, indicating that silver is delivered faster by the lessees than the lessors are willing or able to take (for example, if the lessors expected the leases will be rolled over). Under these circumstances the lessor is happy to leave the silver with the lessee even after the lease expired. This seems to explode the myth about an acute shortage of silver, so ardently spread by Butler. The rising price of silver that may well follow the panic short-covering has nothing to do with shortages. Just the opposite.

Concerning the case of a negative T-bill rate, the pinching shoe is on the other foot. Here we do have a shortage, namely, a physical shortage of FR notes in which the bill is supposed to be paid. But since the borrower is the government, there is no presumption of a default, so the mature T-bill is monetized by the market to alleviate the shortage.

** The causal connection between gold confiscation and the prolonging of the Great Depression should be clear. Gold must be seen as the main competitor of bonds. Once the competitor is forcibly removed, bond prices start rising or, what is the same to say, interest rates start falling. Linkage between falling interest rates and falling prices did the rest.

September 24, 2007

Copyright © 2007

A. E. Fekete

All rights reserved

From http://elainemeinelsupkis.typepad.com/money_matters/2008/06/free-trade-in-f.html This makes Fekete's notion that “There may also be differences between FR notes of older issues and FR notes of the most recent vintage.” more imaginable!!

Germans have a long group memory about banking woes. The average German is becoming nervous about the relative value of paper money and are taking measures that are frankly, hopeless, in an attempt at protecting themselves and their savings.


Support for euro in doubt as Germans reject Latin bloc notes
By Ambrose Evans-Pritchard, The Telegraph:

Ordinary Germans have begun to reject euro bank notes with serial numbers from Italy, Spain, Greece and Portugal, raising concerns that public support for monetary union may be waning in the eurozone's anchor country.
X-factor: German bank customers are favouring notes that start with the distinctive ‘X’ serial numbers, which show they have come from Berlin
Germany's Handelsblatt newspaper says bankers have detected a curious pattern where customers are withdrawing cash directly from branches, screening the notes to determine the origin of issue. They ask for paper from the southern states to be exchanged for German notes.


The German public is a canary in the mine. The bird is trying to fly out of the Cave of Death because they realize that the financial system is shaky, at best. They have been buying up things that can survive inflation and this is across the planet: anyone with savings is hoarding.











From http://www.gold-eagle.com/editorials_05/field090607.html



GEAR TODAY, GONE TOMORROW

Alf Field

"Gear Today, Gone Tomorrow" is an old saying in the market place, referring to the propensity for over-leveraged entities to implode. The continuing crisis in the global banking and credit markets has caused the clock to tick past midnight. What was "Today" has become "Yesterday" and what was "Tomorrow" is now "Today".

In April 2005 I published an article entitled "The Seven D's of the Developing Disaster". The article suggested that most of the major problems facing the USA and the rest of the world commenced with the letter "D". The first six D's were the problem areas and the seventh "D", "Devolution", is what investors will do when a financial crisis erupts. The following are the problem areas:

  1. DEFICITS (US Current account and Federal Budget deficits.)

  2. DOLLAR (US) - a greatly over-valued currency requiring correction.

  3. DEVALUATIONS (COMPETITIVE) - by countries such as Japan that keep creating their local currencies in huge quantities in order to prevent their local currencies from appreciating against the US Dollar;

  4. DEBT - of all descriptions, that has been growing exponentially;

  5. DEMOGRAPHICS - refers to the Baby Boomer generation that are now starting to retire and expect to receive pension and social security benefits from the Government. The Government unfunded liabilities for these benefits are estimated to be between $40 Trillion and $80 Trillion.

  6. DERIVATIVES - potentially the biggest problem; the BIS estimated a notional value of $410 Trillion of outstanding derivatives at 31 December 2006. The current figure will certainly be much bigger.

Two additional problems have since emerged, also starting with D's:
DWELLINGS - the problems in the housing and sub-prime credit markets in the USA.
DESTRUCTION - the ongoing wars in Iraq and Afghanistan which are ringing up increasing costs with no end in sight.

The thesis is that when a financial crisis hits the system as a result of problems in one or more (or all) of the above categories, to the point where the system itself is threatened with collapse, then the Fed will "throw money at the problem" using the electronic liquidity creator available to authorities today. Governments would also bail out sectors that were suffering excessive financial pain and threatening bankruptcy.

The resulting massive creation of new liquidity would destroy or vastly reduce the purchasing power of currencies as we know them today. The situation that might eventually emerge could be described as: "Hyper-Stagflation". The financial and banking crisis would lead investors to:

7. DEVOLUTION

This was described in "The Seven D's of the Developing Disaster" in the following terms:

Dictionary definitions of the word DEVOLUTION include the following:

  1. A passing down or descent through successive stages of time or a process.

  2. Transference, as of rights or qualities, to a successor.

  3. Delegation of authority or duties to a subordinate or substitute.

  4. A transfer of powers from a central government to local units.

"It is the first definition that is applicable here. Imagine an inverted pyramid of various investment asset classes where the least secure (and most prolific assets) are in the very wide top layers. The inverted pyramid then narrows down through layers of increasingly more secure asset classes to the small point at the base which consists of the most secure (and least prolific) assets. This is an idea propagated years ago by John Exter.

The theory is that in times of financial crisis investors will cause their investments to devolve downwards (hence DEVOLUTION) through the different asset class layers in the inverted pyramid as they search for greater security. DEVOLUTION is thus a movement by investors out of riskier, speculative asset classes into more secure ones. This is what can be expected in the months and years ahead as the creation of electronic US Dollar credits gathers momentum and faith is lost in the US Dollar.

The assets in the most secure category at the tip of the inverted pyramid are gold and silver bullion, assets that have performed the function of protecting wealth throughout the ages. In the layer above the precious metals lie the companies that mine and hold large deposits of gold and silver. The least secure assets in the envisioned environment, which form the broad layers at the top of the inverted investment pyramid, will be the electronic US Dollar credits and assets or loans that are repayable in US dollars."

There is ample evidence that investors are already moving their capital down through the inverted pyramid. Initially the move has been out of the "toxic waste" and lesser quality bonds at the top of the pyramid into bonds with more security, especially Government Bonds and Treasury Bills. Those who feel uncomfortable holding long dated Government paper have been moving into 90-Day US Treasury Bills.

Data updated to 31 August 2007.

What can only be described as a panic surge over the past 3 weeks drove the US Treasury Bill rate down to 3%, and it was around 4% on Friday 31 August, 2007. The 10 Year US Treasury Bond yield also dropped, from 4.85 to 4.50, during the last 3 weeks of August. The extent to which the Treasury Bond and Treasury Bill rates are below the Fed Funds Target Rate is indicative of the level of concern behind the credit market's façade. This is evidence that investors are moving assets down the inverted pyramid and that the process of seeking ever more secure asset classes for investments is underway.

One must assume that there is a lot more bad news to come, news that the greater body of investors is not yet aware of, but which is of sufficient concern to people close to the banking and credit markets that they are scurrying for cover and moving into secure Treasury assets. It took a massive amount of money to move the T Bond and T Bill rates down to the extent that they fell over the past few weeks, funds presumably coming from sophisticated investors. [What is being said here?]

There is likely to be a lot more bad news to come from the real estate sector. Increasing numbers of mortgages are to be reset at higher rates over the coming 12 months, almost certainly leading to escalating foreclosures and lower home prices. It is a self-feeding downward spiral that reduces personal balance sheets and removes the method of using homes as ATM's to obtain cash to fund consumption spending.

Alex Weber, President of the German Bundesbank and a member of the Governing Council of the European Central Bank, in a speech to Central Bankers at the Jackson Hole meeting last weekend, said that the only difference between a classic banking crisis and the turmoil under way in the markets is that the institutions most affected at the moment are conduit and investment vehicles raising funds in the commercial bond markets, rather than regulated banks. Most of the conduits, however, are owned by banks.

When someone of Mr Weber's stature admits publicly that there is a crisis, we can surely believe that there is a crisis and that it is probably more serious than anyone is currently admitting. Possibly this is because no one knows where the losses will settle. We should expect a string of unhappy announcements and bankruptcies to emerge over the coming weeks and months.

There is potential for considerable debt liquidation and de-leveraging in the credit markets in the months ahead. There is a possibility that the crisis may become severe enough to threaten a collapse of the existing financial system. If that happens, the choice will be to: (i) allow the credit contraction to continue and accept a decade long depression, or: (ii) pump in massive amounts of liquidity and bail out the institutions that could bring down the entire edifice if they collapse.

Past history suggests that politicians will probably (almost certainly?) choose option (ii) and massively inject liquidity into the system, bailing out major banks and players on the way. The only problem is that on this occasion the amount of new liquidity that will be created will dwarf existing money supplies in countries around the world. This in turn will massively ignite the inflationary fires and those investors who have sought "security" in Treasury Bonds and Bills will start to fear the erosion of purchasing power of their capital.

The next phase in the cycle will be a search for asset classes that can maintain their purchasing power. The search for "stores of value", (generally real tangible assets that are not someone else's liability), will then commence. This desire for "stores of value" will cause those investors seeking greater security to move even further down the inverted pyramid, eventually reaching gold and silver at the lower point of the triangle.

Just above gold and silver (and their mining shares) in the inverted pyramid are the other precious metals, such as platinum, and the base metals group. As an example of the scarcity of metals relative to the anticipated new liquidity injections, copper has an annual world production of 18m tonnes or 40 billion lbs. At the current price of around $3.40 per lb, the proceeds of all the copper mined throughout the world in one year would amount to less than $140 billion.

In just a couple of days in the middle of August, Central Banks around the world injected a total variously estimated to be between $300 and $500 billion of new liquidity into the credit markets. Taking the lower figure of $300 billion, the new liquidity injected in just a couple of days would have been sufficient to buy the world's entire annual copper production for TWO years! That is how scarce copper is relative to the inflow of liquidity that we have just witnessed. As this financial crisis develops, the liquidity injections will become massively larger than anything seen to date.

There seems to be an ETF for just about everything these days, but I cannot find an ETF for copper. If anyone knows about a copper or base metals ETF, please email the details to me.

Virtually all the copper produced these days is consumed by industry. Copper stocks at the LME amount to 140,000 tonnes, just 3 days of consumption at current rates. Any purchases of copper for "store of value" investment purposes will probably push the copper price much higher. Increased input costs as the inflation surges will also add upward pressure to the copper price.

The small quantity of available copper stocks means that only a limited amount of investment capital can be funnelled into copper for "store of value" purposes. This makes copper a less than ideal "store of value" medium. Most other metals, including silver, are in the same boat due to strong industrial demand and low above-ground stock levels.

Gold is a different animal. Virtually all the gold ever mined is still available in some form or another. The large chunk of the UK's gold reserves that Gordon Brown sold some years ago at $255 went to someone. The ex-UK gold (less a little that is around necks and fingers) is probably still available to the market at a price. The same applies to other Central Bank sales. The gold that has been sold in recent years did not just "vaporise". It is still held by someone. Some or all of that gold may emerge in the marketplace at much higher gold prices.

Thus while silver and copper may have larger percentage price increases than gold as a result of "store of value" buying, gold will still be the prime target for large investors looking to put very big sums of money into a "store of value" investment. That is why gold is at the point of the inverted pyramid, being the most secure investment asset.

Hedge Funds: Geared Monsters

To fully appreciate the problems that could emerge in Derivatives, it is necessary to examine how Hedge Funds operate. This is not an easy thing to determine as most Hedge Funds are very secretive about their investment processes. Some Hedge fund managers will not allow their management companies to float on the stock exchange because this would require them to disclose their modus operandi. The managers claim proprietary knowledge that they do not wish to reveal to competitors. The other side of the coin is that they do not show investors what risks they are being exposed to.

We can construct a hypothetical Hedge Fund to see what kind of animal it is. We will assume a very simple structure, but it explains the system. Hedge Fund managers typically charge an administration fee of 2% per annum of investor's capital plus an incentive fee of 20% of profits realised.

Assume that our hypothetical manager raises $1,000 million from investors, promising a superior return. The manager invests the capital in, say, Australian Government Bonds at 6% return. After deducting the 2% admin fee, profits would amount to 4%, of which the manager is entitled to 20%. That leaves a grand 3.2% for the investors. Obviously that model will not excite investors. So the return must be "juiced up" by using leverage.

Using the $1.0 billion of Australian Govt Bonds as security, the manager borrows say $5.0 billion in Japan at 1% and invests the money into more Aussie Bonds at 6%. That is a profit of 5% x 5 = 25% plus the 4% on the original capital = 29% return. That is more like the profit that Hedge Fund investors are looking for! The manager takes home $20 million in admin fees and $58 million in incentive fees (20% of $290m). Not a bad reward.

There are several risks in this hypothetical structure. If the Japanese Yen declines against the US$, the fund makes a currency profit but if the Yen appreciates against the US$, there would be a loss. Solution: buy some cover against the Yen rising against the Dollar. There is also a currency risk in the Aussie dollar/US$ exchange rate. The Aussie rises and the Fund makes a profit but a decline in the A$ could cause losses. Solution: buy some cover against the Aussie dollar declining. These are currency derivatives that would typically be arranged with banks or other counter-parties.

A further risk is that the Aussie Bonds might decline if there is an increase in interest rates. Solution: buy some cover against Aussie interest rates rising. With all these risks covered, albeit at a cost that will reduce the return to investors, the manager can put up the "Gone Fishing" sign and just wait for the money to roll in.

Enter Greed. Some new investments yielding say 8% are offered to the manager. The investments are rated triple A, so the manager exchanges the Aussie Bonds for the new investments, boosting the return to a margin of 7% x 5 = 35% plus 4% = 39%, less the cost of protections purchased.

Things go wrong. The banks become concerned about the quality of the security that they are holding because of turmoil in the credit markets. At the same time 25% of the investors ask for their money back. The manager finds that there is little or no market for the securities that he is holding. In unwinding the transactions the fund takes a bath on both the Yen and Aussie currencies and has a loss on selling the assets. The manager claims against the derivative products that he has purchased in order to recover the fund's losses. The question now is whether the Fund's counter-parties can or will honour their Derivative obligations.

Derivatives are created by private treaty and there is generally no market in these OTC products. There is no Clearing House and there are no financial guarantees. The ability of the loser in these products to meet their commitments depends on the strength of their balance sheets. Invariably the risks are arbitraged from the originating contract maker to many other participants, possibly other Hedge Funds specialising in these products.

Thus one domino falling in the system can trigger an ongoing collapse as the loss is passed around. Derivatives have grown from a notional $50 Trillion 8 years ago to $410 Trillion at 31 December 2006. That figure has probably mushroomed to at least $450 Trillion now, and possibly much more. This is a trembling house of cards and the potential source of major trouble.

It is easy to visualise how these ultra highly geared Hedge Fund vehicles (some are said to operate at 10x1 and even 50x1 gearing), operating across currencies and across interest rate spectrums, can run into serious problems. It will come as no surprise if we hear of many more bankruptcies in the Hedge Fund area. An exodus of investors from Hedge Funds will cause a further serious unwinding of leverage with unknown consequences. It will be "Geared Today, Gone Tomorrow" with a vengeance.

What is most concerning is the level of new liquidity that will be created to bail out banks who have been big lenders to the Hedge Funds. While individual Hedge Funds may be allowed to go to the wall, banking bankruptcies have the potential to bring down the financial system. They can be expected to be bailed out.

If we assume that the bail out is for just 10% of the notional total of Derivatives, that would amount to a huge $45 Trillion. This is a massive injection of new liquidity relative to present world money supply. The destruction of purchasing power of currencies will be equally large and the move down the inverted pyramid into "Stores of Value" will become a stampede.

It is difficult to conceive exactly how big this amount of $45 Trillion is. Even $1 Trillion is a mind boggling sum. If there were $1,000 bank notes in existence, (I think $500 may be the biggest note) it would require 1,000 bank notes to make a million dollars. A pile making up the million dollars would, at a guess, be perhaps 6 inches (15cm) high.

If the pile of $1,000 notes was extended up to $1 Trillion, how high would the pile of bank notes be? The answer is 150 kilometres, or nearly 100 miles. The height would double if $500 notes were used in place of the non-existent $1,000 notes. That is just $1.0 Trillion. Imagine 45 stacks of notes each 100 miles high and you get some concept of what may happen - and that is on the relatively conservative assumption that only 10% of the existing Derivatives are bailed out.

These are potentially very frightening times that we are contemplating. It is appropriate to move assets down the inverted pyramid and to have, at the very least, an insurance position in "Store of Value" assets.



Alf Field

6 September 2007

Comments to: ajfield@attglobal.net

Disclosure and Disclaimer Statement: In the interest of full disclosure, the author advises that he is not a disinterested party in that he has personal investments in base metal mining shares including Zinifex and Mincor ment. The author's objective in writing this article is to interest potential investors in this subject to the point where they are encouraged to conduct their own further diligent research. Neither the information nor the opinions expressed should be construed as a solicitation to buy or sell any stock, currency or commodity. Investors are recommended to obtain the advice of a qualified investment advisor before entering into any transactions. The author has neither been paid nor received any other inducement to write this article.





"John Exter, like Hyman Minsky, will someday be remembered as someone who knew long beforehand what was going to happen to the US economy. Exter never wrote a book and I was fortunate to have discovered a rare interview with Exter by Franklin Sanders which is included in my book Survive The Crisis And Prosper In The Process, see www.survivethecrisis.com,

Professor Fekete said that Exter ceased being a Keynesian when as Vice-President of the Federal Reserve Bank of New York, Exter had personally witnessed the wholesale loss of America’s gold—in one year alone, 1958, as Exter watched US gold reserves fell 10 %.

I was surprised and heartened to learn that Professor Fekete knew Exter personally and that Exter is still alive and finally witness to the unraveling of an economy based on, as Exter called it, IOU-nothing money. An unraveling he had predicted a half a century before."

..

Darryl Robert Schoon http://www.drschoon.com/ Quote from http://www.drschoon.com/articles%5CProfAEFeketeAndBuckysWorldGame.pdf