Paul Brodsky

Today’s Macroeconomic Problems, the Expedient Solution & its Consequences

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Macroeconomic Problems

1) The global banking system is functionally insolvent and will fail without exogenous policy*

• There is one, interconnected global banking system linked by global financial markets and coordination among currency boards and central banks

• In the current banking system model, debts due tomorrow are serviced by newly-incurred debts today (which create deposits)

• Stagnant or declining nominal global asset prices since 2008 have stressed bank balance sheets

o Loan book marks remain at substantial premiums to:

. The present value of their cash flows in real terms

. Liquidation prices at current or higher interest rates

• Central bank easing and asset purchases to date have only tempered the rate of asset price declines

• Current adversity among European banks directly impacts global commerce and finance

*Bank balance sheets can deleverage either via nominal write-downs of assets, (leading to outright failure/insolvency as tangible equity is extinguished), or through nominal increases in system reserves via base money inflation (provided by central banks as they expand their own balance sheets)

2) Governments and private parties are heavily-indebted and this indebtedness is growing exponentially

• In the aggregate, the public and private sectors have “borrowed money into existence” for decades, as fractionally-reserved banks have created unreserved deposits and extended unreserved credit

• In the net, private sector borrowing has stagnated and is prone to contraction

• In response, public sector borrowings have been increased measurably to fill this gap

o Public sector debts and deficits are increasing

o The global economy is rapidly approaching the point where neither the public sector nor the private sector can service debts to the degree required to maintain asset prices, which, in turn, removes incentives to borrow further

o The temporary benefit of growing debt obligations supporting ever-increasing nominal assets prices is now prone to reversal

o Should global bank balance sheets thus contract, so would the global pool of bank deposits

o Contracting bank deposits implies contracting money supplies and attendant deflationary pressures

3) The global economy is threatened because, in real terms, it continues to misallocate capital

• The global relative price spectrum does not reflect true value and therefore is contributing to the general economic and financial malaise

o Wealth and income concentration stemming from the asymmetric rise of asset prices tends to be self-reinforcing, and thus suffocates purchasing power for most economic participants (“the 99%”)

o The more one pays for productive assets, the less one can pay for labor or other productive inputs

• The extension of unreserved bank credit has fed the feedback loop of nominal asset price inflation (i.e. bubbles and subsequent busts)

o Wages and basic input pricing has thus lagged, in relative terms, the robust upward trend of asset pricing

• Over-priced assets have led to capital over-investment in many industries/projects

o Unsupportable by labor inputs or unaffordable at current wage levels

• Most developed economies have morphed into financial economies, which over time have become fragilely dependent on net imports to sustain living standards

• The current propensity of both public and private sectors to channel ever more income towards debt service is threatening the debt-for-debt feedback loop that has maintained the appearance of stability since 2008

o European sovereign issues

o global real estate setbacks

o declining public participation in equity and other leveraged asset markets

The Expedient Solution: Policy-Administered Asset Monetization

1) Re-monetize gold as the asset against which newly-created central bank liabilities (base money) are created

• Gold purchases would serve to promote deleveraging in two manners:

o 1) via base money (bank reserve) creation and,

o 2) by providing the currency proceeds to fiscal agents to retire existing debts

• The threat of waning confidence in the currency unit in response to expanding central bank balance sheets would be arrested by a gold price peg in the aftermath of the base money expansion

• Any future operations to expand the base money stock would require additional purchases of gold at, most likely, higher and higher nominal prices or exchange rates

• A gold peg would thus act both as a deleveraging agent today and a fiscal/monetary policy discipline looking forward

The Consequences (Pros & Cons)

1) The global banking system would be deleveraged via base money (bank reserve) inflation

• Asset monetization is the least painful and most politically expedient option to reverse current conditions in which global bank deposit liabilities are many multiples of reserves (a classic precondition for bank runs)

• Continued central bank purchases of sovereign debts would merely continue to roll and perpetuate the debts, albeit at attractively low interest rates (starkly negative in real terms)

2) Nominal asset (and bank asset collateral) pricing would be supported and perhaps even inflated

• As nominal bank reserves grow, the illusion of returning strength to bank balance sheets would be perpetuated

• The propensity for privileged speculators to place their “risk-on” bets would likely increase

3) Public and private sector debts from the prior extension of unreserved bank credit would, at the margin, be paid down with the base money creation stemming from central bank asset purchases

• Public debts in particular could be paid down in the event fiscal agents were to sell official gold holdings to their respective central bank (central bank purchases of gold then would be, in the net, debt-extinguishing and thus, deleveraging)

4) Wages and consumables pricing would rise in asset-price terms, which would arrest and begin to reverse the political consequences of several decades of wealth and income redistribution to the top “1%”

• An easy political posture to take for those who choose to promote it

5) Asset prices would decline relative to current and future expectations of consumption expenses which, in turn, would lead to lower living standards than currently anticipated by those asset holders

• A necessary evil; however, the loss of future purchasing power as assets are sold to fund future consumption is already “baked in the cake”

• This loss of perceived value can either be crystallized and recognized today so the real economy can begin to rebalance and establish a foundation for growth, or, in the alternative, be suspended — a slow and time-consuming “death by a thousand cuts” malaise (e.g. Japan’s lost decade[s])

6) Rising relative and nominal wages would support debt-servicing capacity going forward

• Would promote debt pay-downs at par, which better ensures banking system solvency

• Would raise wages relative to debt, a powerful political palliative

7) Banks, being agnostic to measures of consumer-type price inflation, would most likely see the nominal pricing of their current pool of assets rise, which would eventually restore their solvency because the nominal valuations of their liabilities are generally fixed

• The value of the currency unit is a common denominator to both sides of bank’s balance sheet

o Real losses/gains on one side of the balance sheet are simultaneously and proportionately offset with real losses/gains on the other side

• However, this would not hold for nominal losses (insolvency would result if a bank were to go into a negative equity position should the variable nominal valuation of its assets decline as the nominal valuation of its liabilities remains constant)

8) Deleveraged government balance sheets would have less impact on private asset values and marketplace pricing

• The political dimension could review and renew optimal levels of participation and capital market intervention

9) No overall meaningful impact on the general price level (but, as implied above, there would likely be a migration f value, in real terms, from leveraged assets to unleveraged goods, services and assets)

• Stable to higher nominal asset prices would require even higher nominal wage and consumable pricing looking forward

Conclusion

Asset monetization (and in, particular, gold monetization) would solve many more problems than it would create. The negatives would merely recognize the balance sheet damage already done and beginning to be manifest (first, in the private sector and now, increasingly in the public sector).

Mechanically, policy-administered asset monetization would be quite simple. Using the US as an example, the Fed would purchase Treasury’s gold at a large and specified premium to its current spot valuation. The higher the price, the more base money would be created and the more public debt would be extinguished. An eight-to-tenfold increase in the gold price via this mechanism would fully-reserve all existing US dollar-denominated bank deposits (a full deleveraging of the banking system). An appropriate multiple of today’s spot price could fully-extinguish the public debt if desired.

In terms of the relative price spectrum, a speculative 50% increase in the US median home price would be most-welcomed to the US banking system (and certainly to mortgage holders). Clearly, such an operation would be a subsidy to leveraged asset holders and banks. Would this be another form of perpetuating moral hazard? Superficially, it would be easy to conclude so; however, we think this conclusion would be incomplete. Such a “subsidy” is already embedded and institutionalized in the system. The key distinction would be that the system will have been reset to promote fairness and efficiency going forward. Given today’s circumstances, that should be a universal, non-partisan goal.

Rolling unfunded debts and debating in the political sphere over the merits and risks of unfunded growth or policy-administered national austerity programs is a futile endeavor. The math suggests strongly neither can work. We are convinced policy-administered asset monetization would stop the global financial system from seizing, restore sorely needed economic balance, and reset commercial incentives so that real growth can once again gain traction.

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Copyright © 2012 · Lee Quaintance and Paul Brodsky of QB Asset Management

Published by kind permission of the authors.

No part of this document may be reproduced in any way without the written consent of QB Asset Management Company, LLC.

 

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