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.

Puplava on debt and credit

Financial Sense, 14 July: Jim Puplava notes that there is a US credit contraction underway. Real incomes are falling by 6% per year; bank credit is going down; the quality of loans is worsening.

Consumers appear to loading up their credit cards to maintain living standards, but this is more expensive than mortgages; the Federal Reserve is buying Treasury bonds to keep the interest rates down, hoping to prevent a real estate recession from becoming a depression.

Consequently, Puplava anticipates lower discretionary spending and a cut in interest rates by the end of the year.

Puplava on the coming oil crisis

Jim Puplava's Financial Sense, 14 July (3rd hour transcript): this leads with the coming energy crisis, especially in oil. Puplava's programme features an interview with Basil Gelpke, who has made a documentary on oil called "A Crude Awakening".

Demand is rising, and will continue to do so even if there is a world economic slowdown, because the developing world aspires to Western standards of living; supply is not keeping pace, as exploration and extraction become more difficult and expensive. R&D in alternatives has been inadequate. The crunch could start as early as 2009.

Jim draws two broad conclusions:

1. Prepare to live in a world where energy is much more expensive. There are obvious implications for your transportation and housing.
2. Invest in energy stocks.

Book Review: "China shakes the world" by James Kynge

This is a very well-written book: easy to read, vivid, informative and thoughtful about future trends. James Kynge has spent 19 years in Asia, half of that reporting from China, latterly for the Financial Times. His direct experience may be the most valuable aspect: he gives a sense not only of what the Chinese are doing, but their motivation.

This is an interpretive, sequential and selective summary, and I do suggest you buy the book - US Amazon link here (hard cover), UK Amazon link here (paperback).

It opens with the widely-quoted narrative about moving a steelworks from Dortmund, Germany to the Yangtse delta in China. The Chinese labour much longer and with less regard for health and safety than their European counterparts, shifting the plant in a third of the time originally expected, together with many tons of paperwork (rapid transfer of know-how is a major theme).

The purchase of the works was completed equally quickly, at a time when the Germans suffered high taxes because of reunification, world steel demand was depressed, and South Korea was undercutting their prices. But Kynge notes that had the owners waited until 2004, the recovery in the market would have made the works profitable again, even in Dortmund. A battle lost through failures of nerve and foresight?

The new owner, self-made billionaire Shen Wenrong, had now bought himself a ready-made plant at scrap cost. This got him into production faster, but also with less debt, an advantage which will tell when the next downturn comes - which Shen expects to happen soon.

The Chinese economic reforms that started in 1978 have seen many rags-to-riches stories. The Party hadn't officially sanctioned private enterprise on such a scale, but local officials turned a blind eye for the usual reasons - corruption and ineffective central control are other motifs in this story.

China has leapt from village and farm to city and factory at warp speed. This means that there is a vast pool of eager, cheap labour for its new industry. There is also a great and growing demand for resources, not only for manufacture but also for city construction, road and rail development, and energy production.

The move from handwork to brainwork means education is very valuable - a later chapter gives an example of identity theft merely to secure a college place, which then helps the thief into white-collar work and a far higher standard of living. For the Chinese, elitism is the way to excellence; Kynge writes of a Shanghai school principal's amazement at Britain's assaults on selection in education. Chinese who can afford it are buying the best foreign private schooling - Dulwich College has opened subsidiaries in Thailand and China.

China has a huge population, with a per capita income of slightly over $1,000 a year. Although its people are racing to catch up with our living standards, demographics will impact on the economy: by 2040 one-third will be over 60 years of age. Kyng says, "It may be that China grows old before it is rich." Like Alice and the Red Queen, China has to run just to stay put - the country has to create 24 million new jobs each year, or face the social and political consequences of a stall.

So the pressure is on. Many companies have copied designs and technology e.g. from the Japanese, and then from each other, setting up rival concerns and increasing production to the point where the profit margin disappears. But the result is not bankruptcy - the government has decided that employment is more important than Western-style financial probity. Besides, there's lots of money available for commercial lending: Chinese people save around 40% of their incomes. Since the domestic market is oversupplied, the Chinese look to make a profit from exports, deflating the global market in manufactures.

Intellectual property rights are not a priority in this scramble. The author visits Yiwu, a great market for pirated goods, and when he calls the anti-fakes hotline he gets the runaround.

What about the quality originals? He visits Prato, Italy, to see the ancient textiles centre; it's been hit hard. First, Chinese arrived as cheap immigrant labourers; then Italian firms began to import materials from China; then they started to get the work itself done over there; finally, Chinese firms set up and took over, appropriating pattern books that took centuries to develop.

The tale is the same with silk, in Como, and jewellery, in Chiasso. "In many areas of manufacturing, European companies cannot compete in the longer run - no matter what counter measures they or the EU may take." White collar workers are not safe, either: their work is also migrating to India and China: "...accounting, law, financial and risk management, healthcare, information technology and several other service areas."

European workers cost too much: pay, healthcare, unions. And their governments are too expensive: Chinese state expenditure as a percentage of GDP is less than 50% of German levels. But European countries are democracies, so tough economic action is politically difficult; whereas in China, it was possible for them to lay off 25 million workers in state-owned enterprises in 1997-2002, and 120 million migrant workers receive no welfare at all.

To the USA: Rockford, Illinois, the centre for machine tools. The Chinese government is overwhelmingly composed of engineering graduates, and they want Western tools, blueprints and know-how. They bought Ingersoll Production Systems and used the firm to try to acquire Ingersoll Milling Machine, which has key technologies for rockets, nuclear power stations and stealth bombers. The US government and its intelligence services were quite unaware, until tipped off by locals. Now, American machinists who used to earn $16/17 per hour are working in retail for $7 per hour, with no pension.

Eric Anderberg of Dial Machine tells the author how the world is not flat, but tilted against America: China has an undervalued currency, little welfare for workers, no labour unions, cheap credit from the state banking system, loan defaults without consequences, VAT rebates available to exporters but not US companies, lax environmental emission controls, intellectual property theft and little enforcement of IPR rights, state-subsidised input costs such as electricity and water. And then US bureaucracy and legislation adds some 20% to American business costs.

Kynge learns all this at the local annual Chamber of Commerce dinner, where Al Frink, the US President’s manufacturing “czar”, is to speak. The dismayed audience then hears Frink talk in favour of outsourcing. The author notes that what hurts Anderberg suits the big US corporations, who earn 25% of their profits from foreign subsidiaries; for example, IPR theft saves on overseas R&D. Anderberg remarks that “Lenin said that America would tear itself apart from the inside through greed.”

Kynge turns back to a coal mining area in China, to illustrate her difficulties. Industrialisation is creating health-wrecking air and water pollution. There is a shortage of usable land, and the deserts are advancing. China is gobbling up resources and commodities, especially oil. There are environmental limits to growth: using the measure of a “green GDP”, i.e. economic growth minus resource depletion and environmental degradation, Shaanxi province has made virtually no progress in the last 20 years. Besides, China’s vast population can never have a standard of living like present-day America – the world does not have the resources.

The pressures are breaking down the bonds of mutual trust and obligation. Identity theft; bogus police; cash-stuffed envelopes for journalists; corrupt and immune officials; sexual infidelity; lethal, fake baby milk powder; HIV-infected blood plasma. And from the West's standpoint, there is an image of political oppression, unfair terms of trade, supposed worker exploitation.

So China has a brand image problem that affects its foreign trade. But if China can crack this, she will enjoy another great leap forward. For the worst exploitation of its workers is not by the Chinese themselves: "... all of the work done in China - the sourcing, manufacturing, transportation and export - rarely qualifies for a return of more than 10 or 15 per cent from a product's sales revenue." Most of the money is being made in advertising, marketing and sales., and when the foreign consumer no longer thinks it uncool to buy openly from the Chinese, the latter will reap much greater benefit from their labour. (Perhaps there are some questions to be asked about the markups and fees of Western middlemen.) We shall have to see how the Olympics changes perceptions. Meanwhile, established brands are being used as the marketing wrapper for Chinese work, e.g. Lenovo's purchase of IBM.

Doubts about China are not merely a matter of perception. The country is trying to move to a capitalist economy, but retain centralized Party control. So when companies get stockmarket listing, typically they float less than a third of share capital, keeping ultimate control for their own management. There are lax disclosure rules and company figures have not infrequently been falsified. The "big four" banks are State-owned, run by Party officials and burdened by bad debt. Kynge guesses it could cost up to $500 billion to clean up the financial system. There is also corruption - he gives as an example oil wells in Shaanxi, developed by private investors and then arbitrarily confiscated by local officials, who may well have benefited personally; but appeals to the local courts are pointless, since the judges are appointed and paid by the same officials. There is some hope: in March 2003, the national Constitution was amended to give private property the same status (in principle) as Party property - but government accountability is still in its infancy.

The author concludes with a chapter on China's relations with outsiders, which are coloured by the events of the nineteenth and twentieth centuries. The desire for economic progress is sometimes in conflict with impulses of national pride, power and prestige. Now that she is becoming mighty, China is choosing her own friends, and is in uneasy relationships with neighbours such as Taiwan and Japan. As America's balance of trade worsens, China may have more than one reason to give more weight to its own need for economic development than to harmonious foreign relations.

Why commodities are the future

Martin Hutchinson, writing in PrudentBear yesterday, explains why he thinks commodities are in a long-term bull market: the developing world wants the "white goods" and other consumer durables that we already have and take for granted.

Peter Schiff - corrosive effects of debt

Peter Schiff has revamped his site, and is generally increasing his media profile.

His economic commentary reports that the US has sent an official to China to ask them to buy into mortgage-backed securities! (The man will deserve a medal if he succeeds.) But it's not only subprime loans that are risky - Schiff says that many home valuations were inflated for mortgage purposes, and foreclosures realize less than half such values.

Turning to government debt, he says Treasury bonds will be hollowed out by a gradual devaluation of the dollar (by maybe 50% over the medium term), plus soaring interest rates. Further ahead, he sticks to his Crash Proof prediction of hyperinflation.

Future opportunities in the subprime market

Following on from the last post, I feel Mr Schultz could well be right, though the timing is important. There are going to be many people with an impaired credit history after this debacle, who want to have another go at owning their own home; and presumably houses will become more reasonably-priced, too. A specialist lender could get good returns from servicing carefully-selected customers, in much the same way that after a natural disaster, fresh insurance companies enter the market on a better footing, while the outfits that were already committed are still struggling.

As Wavy Gravy said at Woodstock, “There’s always a little bit of heaven in a disaster area.” Though of course, I'm sure he didn't mean it in quite that way.

Update

Having written that last bit, what do I read (in Saturday's Free New Mexican) but that some of the hippies who set up communes in New Mexico eventually became realtors!

US subprime fallout

Credit rating agencies seem on the brink of downgrading CDOs, according to last week's New York Times; GE has dumped its subprime portfolio, accepting $160 million losses; the Wall Street Journal reports on the exposure of mutual funds to subprime lending; Fannie Mae and Freddie Mac are getting choosier; official guidance is being issued to brokers; borrowers are starting to sue lenders; the dollar is dropping against the Euro, in advance of expected bad figures on consumer spending and borrowing; builders are quitting, going to law or offering special financing deals.

Among loan arrangers, 15,000 of 500,000 jobs (3%) have gone; Guardian Loan Company has escaped collapse by the skin of its teeth, because eager new firms were squeezing it out of the niche market and back towards standard mortgages - but like General MacArthur, chief executive Stuart Schultz promises a return: "If I were a rich man, I would buy the largest subprime business in the country, because it will be back."

US mortgage difficulties to continue next year

There are now forecasts that mortgage defaults and foreclosures will continue into 2008; comparisons are being made with similar drops in the early 1980s and 1990s. Peter Schiff reminds us that the biggest losers will be the lenders, but to the individual mortgageholder that won't seem comforting.

US house price bubble has been deflating for some time

Tim Iacono in Seeking Alpha (July 5) reexamines the housing market to check underlying trends at different price levels, and finds certain sectors have been dropping for some time. As in the UK, the overall average has been skewed by way the high end has held up; a more detailed examination suggests the decline for ordinary houseowners is well under way.

UK housing market also a bubble

The conventional view is that house prices are still rising in the UK. Merryn Somerset Webb, editor of Moneyweek, begs to differ (25 June) and the index to which she refers is here; Michael Hampton (Financial Sense, July 5) is also pessimistic.

For those who want to know what prices houses have actually fetched, see Nethouseprices.com, which gives much other useful information.

Marc Faber on the world bubble and his own investments

I have already referred today to Faber's interview on Minesite.com and would like to pull out one or two strands:

Faber thinks "...all real estate markets around the world are in cuckoo land and that they will all correct at some stage meaningfully even if you print money".

Asked whether he has real estate himself, he says, "I own properties in Asia, in New Zealand and in Vietnam in particular and in Thailand, and Indonesia and some in Switzerland; but ... I never borrow money to buy my properties, I pay cash ... I also own gold, and I also own some shares of course, I’m just diversified; but in general, I am very liquid at the present time... I’m holding a lot of cash at all times."

Re precious metals and inflation: "I tell you, the US has no other option but to print money. And they’ll go down like the Roman Empire in a huge hyperinflation. " He is bullish on silver and gold (especially gold), though he notes the danger that in a crisis, the government may simply expropriate investors' holdings of precious metals, as has happened in the US before.

Faber also notes that the expansion in the money supply in the West is not matched by increases in GDP, which is why we have speculative bubbles and a stalled standard of living: "...in the 50s and 60s and 70s if you increased your debt in the United States by $1 you got essentially also a dollar's worth of GDP growth. Now in the last 5 years, total credit market debt in the US has grown by $13 trillion but GDP by just $2.3 trillion." By contrast, in the East, living standards have risen: "I moved to Hong Kong in 1973. When I came, Taiwan, South Korea were very, very poor countries, as well as Singapore was like a dump at that time. Today, Singapore is the richest country in the world and, you see that the standards of living of people, has over the last 30 years, improved very dramatically in these countries. Whereas in Switzerland I go there, back, a few times a year I don’t see any meaningful improvements in the standard of living."

I think I have to speak personally now. What worries me, since I'm not rich and live in a large ex-industrial city, is not how to profit from the crash, as Peter Schiff advises, but what my life is going to be like when my neighbours and their children are strapped for cash, unemployed (or in Mcjobs) and increasingly resentful. Shouldn't we get our noses out of the financial press and start to become concerned about the social cost of the folly and cynicism of our banks and governments?