Bank of England investment in US Treasuries; gold

Let's combine the recent mystery about Britain's massive investment in US Treasury securities, with the worldwide asset bubble.

This is Doug Casey speaking to the Agora Financial "Rim of Fire" conference in Vancouver this week, on YouTube (thanks to "Daniel" for alerting me to it).

His view on American bonds? "A triple threat". Why?: (1) interest rates are very low and are going to become very high; (2) credit risk: he says he would not wish to be a lender now, with so much debt everywhere -he refers to a possible "financial credit collapse"; (3) currency risk - he says dollars say "IOU nothing", and compares them to the Argentinian peso 10 years ago.

So, why has the UK invested an extra $112 billion in US-dollar-denominated Treasury bonds, between June '06 and May '07? To dramatise this figure somewhat, let's look at the Forbes list of the richest people in America (Sep 2006): the top 5 billionaires are worth $155 bn between them. Britain is now into America for $167.6 bn. The increase in the last year alone is more than the net worth of Bill Gates and Warren Buffett combined. I wonder (rhetorically) whether they would bet their entire fortunes on US Treasuries?

We already know what Casey thinks about cash held in dollars, and he regards stocks and property as overvalued, too.

So what does he favour? Gold. "It's not just going through the roof, it's going to the moon". He's been a gold bull for the last 7 years. He picks mining stocks, but warns that they are very volatile, even more than Internet stocks. But there are other ways to own gold.

Meanwhile, is there anyone here in the UK who is willing to grill the supposedly independent Bank of England (it wasn't the British Treasury, after all, it seems) about the rationale for its vast punt on "triple risk" US bonds?

Let's finish with Bill Bonner's keynote speech at the same conference, on the difference between the real boom of the Far East and the Ludwig von Mises "crack-up boom" of our inflationary economies:

Futurology

Continuing the argument about sovereign wealth funds, what might this portend for US Treasury securities?

If foreign governments pull the rug out, there could be a run on the dollar on a scale that the US government wouldn't dare correct with proportionately high interest rates, seeing how indebted everyone is. The doomsters are probably right that it could happen, which is why everybody will make sure it doesn't.

And such a fall wouldn't be in the interest of creditor nations who still value the trade surpluses they enjoy with Uncle Sam. Many Chinese light manufacturing industries are working on narrow margins and don't want to see their profits disappear through foreign exchange movements (though their State is sufficiently powerful and ruthless to go that way if it wants to). I suspect that China will continue to develop towards heavier industries and gradually allow the trainer-stitching work to go to even poorer countries like Vietnam. Meanwhile, it's in no hurry to kill the US cow while she's still giving milk.

So here's my bet:

1. For domestic political reasons, the US will not do what is needed to get the economy back on the level. It will continue to borrow but, fearful of its vulnerability to potentially unfriendly foreigners, lean on its friends for more finance.
2. The US Treasury securities held by China will remain much the same, or even gradually increase in dollar terms, but "ally nations" will increase their holdings proportionately faster. There's not much an emotionally or politically vulnerable British PM won't do for a pat on the back at G8 summits, Bilderberg tie-looseners etc. Goodness knows how much of our future has been sacrificed to the last one's ego.
3. Creditor nations will increase their sovereign wealth funds, favouring investments that are involved in the supply lines from their manufacturing concerns to our end purchasers. Marxism has moved on: you have to have control of the means of production, but even more so of the means of distribution.
4. They will also invest in the lines leading towards their industries: energy, industrial metals and infrastructure. I also guess China will explore healthcare, energy-efficiency, food-oriented genetic research and environmental protection. And water. And foreign farmland (Bill Bonner and Marc Faber are really smart). City planning in all its aspects could become really important.
5. If these countries were private investors, we'd be seeing their portfolios alter their balance between bonds and equities, in the direction of higher risk, higher returns. And like good long-term investors, they will get richer. Maybe eventually, as James Kynge says, demographics and healthcare will eat into this wealth, but it's not going to benefit the West much either way.
6. In the US and the UK, our collective concern will be how to handle the social disruption in our own societies; our concern as individuals will be how to save and invest while we still can, and how to set up our own children in relative security.

Place your bets

The Dow Jones Industrial Average closed yesterday at 13,785.07. Where will it go? Please see the survey on the right.

Here's an idea: the doomsters may be correct in their analysis, but wrong in their prognosis. If sovereign wealth funds continue to grow, we may see a new type of massive institutional investor, one that has no plans to retire or die. So ownership of American, British and other Western countries' businesses will shift to the East.

Initially, this will seem to make little difference, except that the markets may become better-supported against falls and may trend upwards, long-term (in currency terms; I'm not so sure about inflation-adjusted terms). But the dividends on foreign-owned shares will not accrue to the host countries, and so the US and UK will bleed from two wounds: trade deficits and accelerating loss of investment income.

If small businesses are eaten by big businesses, and big businesses have been taken over by sovereign wealth funds of other nations, the result for us may be not only economic impoverishment, but a form of slavery, since we will have lost control of our means of production. All we will have left is our labour, and in world terms, you and I are grossly overpaid. There is an developing Eastern middle class that can and will do everything better, faster, harder and cheaper than you. Many of them speak better English than the English.

Look at the businesses these sovereign wealth funds are going for. China: $3 bn for a 9.9% stake in giant US hedge fund Blackstone in May this year, and now (with Singapore) 10% of Barclays Bank (UK); Qatar: Sainsbury's (UK supermarket chain). These investments involve commercial property, finance and retail distribution. I've recently relayed James Kynge's statement that Chinese manufacturing only gets them 15% of the end price; now they're after the other 85%. I shouldn't be surprised if we start to see acquisitions in marketing and advertising firms, too.

What to do? I think:

• Work hard and earn as much as you can, while you can.
• Look after your health. Better not to get sick in the first place, than hope for "healthcare" to put Humpty Dumpty back together.
• Live simply and well within your means. Do you need a car? One that size?
• Pay off debts as fast as possible.
• Save and invest.

And if you have time and don't mind potential official surveillance and bullying, give your politicans earache about their incompetence, which is on a scale that to some might seem almost treacherous.

They are the masters now - or will be soon

The BBC Ten o' Clock News last night featured an article about China's purchase of a share in Barclays Bank. I have posted a video of part of Chris Mayer's speech at Vancouver (see below), where he discusses "sovereign wealth funds".

China, India and Japan have enormous surpluses of money from their trade. They have bought US Treasury securities (bonds, i.e. loans to the US), but this is a thing governments do to park money that they might need back in year or two, when the trading balance has altered. Since the US/UK (etc) trade deficits are long-running, these eastern countries can now start thinking like young private investors, in which case equities become attractive - offering income from dividends AND the potential for capital growth.

These countries are turning our debt into their ownership, like an old Punch cartoon where a plumber took his customer's house in payment for his work.

This issue is big.

Prohibition: Uncle Sam beat Eliot Ness

Don Boudreaux, of Cafe Hayek fame (see blogroll), writes that Prohibition ended, not because of popular demand, but because the US government was running short of tax money in the Depression.

It's an interesting theory. I have long thought that the UK government is more hooked on cigarettes than the smokers. If they really wanted to ban smoking, they'd start by cutting the tax, so as to wean themselves off financial dependence. But how would they replace the lost revenue?

Familar themes, and a sales pitch (not mine!)

This is NOT a recommendation, but you may be interested in the general trend of thinking it reveals: The Daily Reckoning features a sales spiel for a newsletter from Tim Price, which passes on pessimistic comment on the near future of the markets, and indicates four areas for investment:

"Portfolio insurance"
Infrastructure (e.g. roads, railways)
Gold
Oil

We are seeing these themes crop up again and again among the contrarians. Though I'm not quite sure what is meant by the first - unless it's futures and options, which make me nervous.

Chris Mayer at Vancouver, on China

"Daniel" has responded to an earlier post re rail revival, to say that Chris Mayer's speech at the Agora Financial symposium in Vancouver has now been put on YouTube. Here it is, with my thanks to Daniel:

Plunge Protection Team trying to keep precious metals low

An extraordinary (to me) comment by Michael Misunas, responding to Michael Panzner's post in Seeking Alpha today - do read it. He says that the US Government's "Plunge Protection Team" has not only punted huge sums into derivatives to support the stockmarket each time it falls significantly, but has recently been rigging the market against gold and silver.

Assuming that you can't buck the market forever, it looks like an opportunity to buy precious metals.

More on US Treasury bonds

Another concise overview by David Galland in today's Daily Reckoning Australia. Part of it goes like this:

Make no mistake, we are in uncharted water; it is unprecedented that the claims represented by the fiat currency of one government - that of the U.S. - have been accumulated in such massive quantities for the reserves of other governments. And we're not just talking China but virtually the world. And the world is getting nervous.

To quote Thai Finance Minister Chalongphob Sussangkarn in his recent address to the annual meeting of the Asian Development Bank in Kyoto:

"Should the financial markets lose confidence in the U.S. dollar, huge capital outflows from the U.S. could lead to a rapid depreciation of the U.S. dollar, and thus dramatic appreciation of other currencies."

This is why I am theorising that the UK's massively increased support for US Treasuries may be an emergency measure by the British Government. Though it has been pointed out to me that this money may have also come from hedge funds and conventional funds - the Treasury stats don't say that the purchases are official.

Another country that has significantly increased its US bond holdings is Brazil (145% up, from $33.3 bn to $81.6 bn). Maybe that's to do with its increasing oil exports. According to the US government's Energy Information Administration, Brazilian production is projected to rise long-term.

Coming back to the Treasury bond stats: of those who previously held at least 1% of total foreign-held US Treasury debt, the top five reductions are:

Caribbean Banking Centres
Mexico
Korea
France
Switzerland

The top three in this list account for almost $50 bn of the total $72 bn that foreigners withdrew. I thought the conspiracy theorists believed Caribbean Banking Centres were part of the US government's secret plan for supporting the dollar? Perhaps somebody would kindly pay for me to go on a "fact-finding mission" to the Caribbean. Please.

UK, US Treasury securities, and blogs (continued)

Well, I've got some sort of response from Iain Dale's commentators, starting with an ad hominem accusation of being emotionally needy (scared, more like!).

Here's my main argument, however inexpertly expressed:

Over the last 12 months, 10 countries have reduced their loans to the US by a combined total of $72 billion; we've increased our commitment by $112 billion, moving us from 10th place to 3rd place in the list of America's creditors. And our own finances aren't that good, either.

America is in hock to foreigners to the tune of 2.18 trillion dollars and rising. Effectively, they're running up a very big credit card bill to maintain domestic living standards. The US Comptroller General has very recently commented that this indebtedness could be used against the US by unfriendly foreign powers.

Our greatly increased support for America's finances is at the cost of some risk to ourselves, because if the borrowing spree continues unabated, we may find we get repaid in dollars that are worth far less than they are today. Can we afford to keep bailing out a spendthrift?

The borrowing is a powerful economic stimulus to China which, despite its relative poverty, is the second biggest creditor to the US. By sending the money back to America in the form of loans (purchase of US Treasury bonds), they avoid having their own currency appreciate. So their wage rates remain fantastically low and they continue to take business and jobs from the West - us included. Think of the transfer of the Swan Hunter shipyard to south India, or the purchase of Rover by China (don't tell me they're desperate to create long-term employment in Birmingham, when the average per capita wage in China is less than £1,000 per year). We're seeing a shift from higher-paid industrial work to lower-paid service jobs - perhaps the economic profile and geographical distribution of the readership of this blog means that it isn't obvious to them. China and others are hoovering up world resources in the dash to industrialise, right down to our iron manhole covers. James Kynge's "China shakes the world" is easy to read and very enlightening about what's going on.

Japan, America's greatest creditor, also buys US bonds to keep excess money out of its own system, so its interest rates are low, so the yen stays low and protects its well-established export markets. Also, a lot of money powering the world's stockmarkets is cheap money borrowed from Japan and invested elsewhere - the so-called "carry trade". All right if it goes on forever - but it can't. You cannot live for the rest of your life on borrowed money.

If currencies were responsibly managed, the trade deficit would cause the US to start to run short of cash, US wages would go down and exports back up, and trade would eventually (if painfully) come back into balance. But the Americans - and others, including ourselves again - respond by increasing the money supply (mostly through bank lending - up another 13% this year on both sides the Atlantic), which leads to price inflation, hence the rise in house prices and the stock markets. But borrowed money has to be repaid someday and then the tide will go out - but this time, we'll be left without much industrial capacity.

There's a fear that to prevent a 3os-style Depression, governments will print money even faster, but this leads to hyperinflation and eventually no one wants the currency at all (cf. Germany in 1923). So we could well have both a slump and high inflation. It may sound dull and technical, but then money is boring - until you haven't got any.

An American Congressional committee recently grilled the chairman of the Federal Reserve (like our Bank of England) and at least one Congressman admitted he realized he didn't understand inflation; the only one who seemed to was Ron Paul, who said that if we can make a living by printing money, we should all quit our jobs and do that. Most of Ron Paul's own investments are in gold and silver; the world's richest investor, Warren Buffett, has been sitting on many billions of dollars of cash for a long time and has recently disclosed that he's hedged by buying into a foreign currency, to protect against financial loss from a falling dollar.

If the value of the dollar (and possibly the pound) starts to collapse through overproduction, we really will notice - it's not just going to be bargain fares to Disneyworld. Americans - rich, expert ones, who manage big funds - are sounding the warnings loudly, clearly and angrily.

The collapse hasn't happened yet, partly because the dollar is the world's standard trading currency. This is changing; already, Iran is demanding payment from Japan in yen, not US dollars. When more countries start to impose similar conditions, the demand for the dollar will drop significantly, and so will its exchange value. China is beginning to de-link from the dollar, in favour of a wider basket of currencies; meanwhile, it's widened the range within which its currency (the renminbi, or Chinese yuan) can move against the dollar. They're not in hurry to appreciate their money, for reasons of international industrial market share; but that's the way the pressure is building.

Although our economy is much smaller than America's, we have (to some extent) similar problems ourselves. Yet here we are, lending money to our bigger cousin. I don't think we can sub him indefinitely, and I don't think we have begun to address the question of our own economic future. Without that, there'll be lots more hoodies to hug.

Michael Panzner relays the alarm

Michael Panzner's latest post discusses a warning from David M. Walker, the nation's chief accountant, about America's vulnerability to potentially unfriendly foreign creditors. This confirms me in my feeling that the recent purchases by the UK of US Treasury securities is extremely significant (see recent posts on Bearwatch).

I have attempted to elicit interest in various quarters, including Iain Dale's influential political blog ("Tuesday open thread", 24 July) but so far I seem to be speaking to the profoundly deaf. Today I submitted the following comment to Iain's Diary, but without much hope of a response - as I have said in an email to Michael Panzner today, the Brits add apathy to financial ignorance:

Okay, one last Cassandra-like call and then I'll admit defeat:

Does it really not matter to your sophisticated political readership that the UK (presumably the Treasury under Gordon Brown) has recently purchased an absolutely massive amount of American Treasury securities, most of it in the last nine months, which quite probably will lose us many billions of pounds through currency depreciation? We have gone in one wild leap from 10th largest holder of American debt, to third place.

The potential downside from this crazy investment (I think it has already lost the equivalent of the first year's interest) worry me less than the implication, which is that the US is using its "special relationship" with the UK to defer (for a short time) the end-stage of a US debt-fuelled global inflationary spiral, with the prospect of a deep economic depression and possibly a wealth-destroying hyperinflation. The problems this would give us make the current floods seem a minor inconvenience.

Or is it that everybody here knows already, and is merely filling the time in the rattling tumbrils with political chit-chat and mutual insult? Is it aristocratic insouciance, or financial ignorance? Surely not the latter, when Americans are discussing their economic problems so openly and extensively.

The rewards of "honest money" and interest-free lending

Some things are so simple that it takes a while to understand them. For me until now, one was the question of how anybody could lend money and not expect interest - for centuries, usury was forbidden under both Christian religious and civil law. In France, interest was illegal until after the Revolution in 1789 - see here.

And then the penny dropped, so to speak. If the supply of money is fixed, and the economy gradually becomes more larger and more efficient, then money gradually becomes more valuable, as The Mogambo Guru explains here. So if real GDP grows at the rate we seem to expect (on average, about 2% per year), then with a fixed money supply, a depositor would earn 2% in real terms, as would a lender. All you would need is adequate security for the return of capital.

Banks would have to cover their running expenses (I believe Swiss banks already do charge depositors for holding their cash really safely), but this would be need to be in the form of explicit costs, which might therefore be better restrained. Borrowers would have no reason to keep switching loans; in fact, the need to charge arrangement fees would act as an incentive to remain loyal to the existing creditor.

But it looks to me like it would mean the end of fractional reserve banking, inflation and periodic banking crises, not to mention the permanent and pervasive importance of money lenders.

Would that really be so bad? If so, then "if you can't beat 'em, join 'em" - would you and other like-minded readers care to join forces with me and start another bank? It seems to be the only game in town.

More on UK purchases of US Treasury securities

I have sent the following email to George Osborne, the shadow Chancellor:

"Please find attached a document from the US Treasury website, detailing major foreign holdings of US Treasury securities (web address top left of document). I emailed this document to the Daily Mail newsdesk yesterday, in the fervent hope that somebody might take an interest.

Between June 2006 and May 2007, the UK has leapt from being the 10th largest foreign holder of American debt to 3rd place (behind Japan and China, both of whom, although increasing in dollar terms, have actually reduced their overall share of foreign commitment to the US).

We have contributed an extra $112.1 billion, i.e. around 55% of the $205 billion total increase in investment by foreigners over that 12 month period. To put it another way, 10 countries have reduced their holdings in dollar terms, by a combined total of $72 billion; we have covered these withdrawals and added another $40 bn.

For comparison purposes, the UK's increase in US Treasury securities is equivalent to some 50% of the £104 billion budget for the NHS for next year (http://www.timesonline.co.uk/tol/comment/columnists/article2039584.ece)

The effect for the UK has been to more than triple its exposure to US Treasury instruments, at a time when the dollar is dropping - and some predict it will fall much further. The potential loss of our national wealth easily matches (and will quite possibly dwarf) that from the sale by Gordon Brown of much of our gold reserves some years ago."

News: huge investment by UK in US Treasury securities

Never mind the conspiracy theorists and the rumoured use of "Caribbean Banking centres" to buy US Treasury bonds; look at this document from the US Treasury, dated 17 July 2007. It shows that in the last 12 months, holdings by foreigners increased by 10.37%, but the UK's holdings shot up over 202% in the same period, from $55.5 billion to $167.6 billion. And the dollar has dropped against the pound at the same time. Can our little island afford such generosity?

Open secrets about banks, credit and inflation

There are things about money that are well-known to some, but not known and understood by all.

• In the USA (and the UK, I understand), notes and coins represent only 3% of all money; the rest is, in effect, various types of IOU.
• Most money is simply created out of nothing, by private banks, as bookkeeping entries.
• Banks lend out money, and also charge interest.
• Since the banks haven't created enough money to cover the interest, they demand it from the borrowers.
• If the total amount of money in the economy stays the same, and banks always charge enough interest to make a profit, then someday banks will own all the money in the world.
• So banks create and lend even more money. Some of this new money is to provide for the interest they have charged on earlier loans.
• Therefore, banks have caused inflation, and as long as they create new money, they will create more inflation.

This is so simple, but so hard to believe. It's like standing up from a game of Monopoly to find that you've been playing for real. And when you read others who explain the money system in these terms, you get the same emotional sequence:

1. amused, complacent toleration
2. a growing sense of unease
3. dawning, half-incredulous understanding
4. appalled outrage

So it is with one of the latest of these explainers, Ellen Hodgson Brown. But there is a world of difference between diagnosis and prescription. Here is hers, and halfway into here is a riposte from Richard Daughty, aka The Mogambo Guru.
Please note that Daughty is not contradicting the diagnosis, only the proposed solution. He is permanently at stage (4) in the above sequence.
Now, what do we do about it? Daughty's usual response "We're freakin' doomed!" reflects his pessimism about attempts to save the system as a whole, but is generally accompanied by recommendations for individual financial survival, namely, investment in commodities such as gold, silver and oil, merely to protect against end-stage inflation.

Michael Panzner on financial liquidity and asset prices

Writing in Seeking Alpha yesterday, Michael Panzner (author of Financial Armageddon - my review here) comments on an article by Yale economics professor Robert J Schiller, which discusses the notion and possible consequences of excess "liquidity" in the world economy. For Panzner's own website promoting his very bearish view on the American economy, see here.

Peter Schiff on US monetary policy

Peter Schiff's latest commentary (today in Forex Street) pours scorn on the Treasury Secretary's professed commitment to a strong dollar, and points out that Ben Bernanke's reasons for a stronger Chinese yuan (renminbi) also imply higher interest rates AND higher consumer prices in the US.

Schiff concludes with the same recommendations as in his book, Crash Proof (my review here): buy gold (he's selling Australian Perth Mint Certificates through a dedicated website) and selected foreign (i.e. non-US) equities.

Fragility of the stockmarket

Ben Steverman in Business Week (20 July) gives reasons to worry about the US stockmarket, one of them being the amount of borrowed money powering it, which is something Richard Daughty also comments on (see link in previous post). A credit contraction could trigger a collapse in stock prices.

My comment: this might sound like a reason to hold cash, but the hyper-inflation scenario espoused by some is predicated on what they expect will be the response of the government to the threat of a depression.

The Mogambo Guru agrees with Jim Puplava

Richard Daughty submits another gonzo rant to GoldSeek, coming to the same conclusion as Jim Puplava at Financial Sense: buy gold, silver and oil.

Puplava on inflation, commodities

Financial Sense, July 14: Jim Puplava discusses inflation figures and the management of our perceptions of inflation.

The effects of expanding the money supply must, he feels, eventually spill over from assets to consumer prices. He sees three scenarios:

1. A credit contraction, leading to recession.
2. An inadequate credit expansion, resulting in consumer price inflation.
3. A change in public perception of inflation. If people expect their money to become progressively worthless, they will eventually try to get rid of it as fast as possible, in exchange for tangible things.

Conclusions:

• Cut unnecessary living expenses, shop smarter.
• Avoid bonds.
• Because there is no sign of (1) or (2) above happening, we are heading for a US hyperinflationary depression, perhaps starting around the same time as the oil crisis, i.e. 2009. So invest in tangibles: gold, silver, oil.

By the way - some thought-provoking replies to listeners:

• Puplava agrees that Israel may be sitting on a valuable oil field!
• He says creditor nations in Asia may have a deflationary depression, while ours will be inflationary.
• He notes that Iran now demands payment from Japan in yen, not US dollars.