Authored by Alasdair Macleod via Substack,
This year is likely to see wealth destruction on a massive scale. The reason this is not widely anticipated in financial markets is due to a mistaken belief that interest rates are at their peak and will decline over the year. The reason interest rates will rise is due to the colossal mountain of government debt to be financed and the restriction of commercial bank credit for non-financial businesses, forcing borrowing rates up and guaranteeing an economic slump.
This article summarises the economic outlook, the consequences for government finances, the fragility of the banking system, and the prospects for financial asset values. All these factors are inter-related to combine in undermining the value of fiat currencies in a widespread flight from credit.
Only direct ownership of gold, which remains legal money despite five decades of US and state-educated economists’ propaganda that it is not, protects citizens from the mounting threat of a collapse in the value of credit.
Introduction
Henceforth, my detailed economic and geopolitical analyses will migrate to my newsletter on Substack.
I will continue to write a summary introduction for Goldmoney’s readers on Thursdays. My market reports for Goldmoney will be published on Fridays as normal.
Accordingly, this is an opportunity to summarise the economic and geopolitical challenges ahead for all Goldmoney readers and how they affect credit and legal money, which always has been and still is gold. There is little doubt now that many of the problems about which I have been warning readers of this column over the years are coming home to roost, and 2024 could go down in history as a year of enormous economic, political, and social change.
Growing instability in the American, European, and Japanese banking systems has encouraged me to emphasise the distinction between money and credit, a topic which is poorly understood even among economists and bankers. Yet growing financial instability is all about the value placed on credit, characterised by obligations which bear a risk of default. And almost the entire Western economic establishment and even its critics mistakenly think that currency is money, having replaced gold. It is an error leading to dangerous misconceptions.
Protecting personal wealth increasingly depends on understanding the distinction between the two, because hoarding real money without counterparty risk is the refuge from an increasingly likely economic crisis, currently facing what we used to call the advanced economies. The economic distinction is no longer appropriate: China is more advanced in terms of consumer goods production than the old school, and India is rapidly catching up. Even the Third World is rapidly evolving. And after multi-decades of socialism, Peronism, and dictatorships Argentina is leading the way back to free markets, a smaller state, and stabilising her currency.
Our governments dare not follow this unexpected change of direction. The legacy of rapid economic development in the nineteenth century and the wealth created have been squandered. Under the accumulating burdens of various socialist delusions, westerners still think someone else owes them a living and that their governments are morally right to rob the rich to keep them in idleness. You can’t blame them for this indolent attitude when the political class thrives on promoting it. But it is our decline and our fall.
The world is bifurcating into two halves — the declining woke old and the dynamic new. While we in the west are declining at an increasing pace, under the influence of our supposed enemies the rest of the world welcomes an escape from our hegemony. Absorbed in our own delusions, our establishments and their media barely recognise this development. And the defeat that looms in Ukraine over Russia and a worsening situation in Palestine hardly disturbs our complacency.
So violent are our economic prospects becoming and the wealth destruction that will follow that we could end up being rescued from our follies by our former empires and spheres of influence. After all, measured by population and GDP we westerners are now in a decreasing minority. Led by the Asian hegemons, the Middle East, Africa, and Latin America will still be there trading with each other and anyone else who can pay for their goods while we go to hell in a handcart. And crucially, Russia, China, members of the Gulf Cooperation Council, and assorted others do understand that gold is money and currencies are merely unbacked credit.
Indebted nations owing dollars could even begin to welcome the collapse of the dollar because it would wipe out their obligations. It would wipe out American hegemony. This was definitely an attraction for supporters of the gold-backed BRICS trade settlement currency which failed to make the agenda in Johannesburg last August.
This is the background we are dealing with for the new year. In our misplaced belief in the fiat dollar and allied currencies, we are rotting from the head down while the rest of the world is rising like a fabled phoenix.
The economic outlook
Investment research echoed by western media has a common theme which runs like this: “The economic outlook is for a mild recession, which will permit interest rates to decline, taking pressure off the financial system.”
The confidence expressed in our economic condition appears to be supported by backward facing statistics. We extrapolate our forecasts from the past, relying on economic models for interpretation. But it is plainly obvious to anyone who is aware of the true economic conditions that non-financial businesses are struggling badly. Bankruptcies in American and European jurisdictions are hitting new highs. Having unexpectedly soared, mortgage expense is leading to personal distress and reducing consumer spending. Small and medium sized enterprises are facing cash flow difficulties at the same time as banks are withdrawing credit facilities. Larger corporations face radical restructuring to deal with their excess debt.
Yet official statistics do not reflect these difficulties.
The current expansion in US and European GDPs relies entirely on excess government spending. We know that the US Government’s budget deficit is probably running at about $3 trillion in the current fiscal year, including interest on its debt. That $3 trillion represents excess government spending being injected almost entirely into the GDP economy. This debasement of the currency amounts to over 10% of nominal GDP, inflating it accordingly. To the extent that nominal GDP does not increase by this amount reflects an underlying contraction of private sector transactions, ex-government.
The next question to address is the consequence of this debasement on the purchasing power of the dollar. Macroeconomists forecasting consumer price inflation currently believe it will decline in the current year to perhaps an average of 3% or even lower. However, after an indefinable time lag currency debasement will almost certainly lead towards a significantly higher than expected CPI figure. The timing difference between currency debasement and its consequence for the general level of prices makes a mockery of the concept of an inflation-adjusted real GDP. This Cantillon effect partly explains why the US economy appeared to resist fears of a recession in fiscal 2023. It was the net result of an indefinable prior debasement, the extra spending from the then $2 trillion budget deficit, and the contraction of private sector activity. These factors are yet to fully catch up with the current situation.
In the same vein, in 2024 the GDP outturn will suggest that the US economy is extraordinarily robust by continuing to grow both nominally and in inflation-adjusted terms. Perhaps the best way to illustrate the falsity of the GDP statistic as a measure of economic activity is to imagine if it had existed to quantify Germany’s economy in the early 1920s. Nominal GDP would have been soaring, while the CPI inflation adjustment lagged, only until the final few months when the paper-mark collapsed in 1923. Yet, at the same time acute poverty by any measure had been growing, and personal wealth completely wiped out.
Today, the US economy faces similar dynamics with the dollar being as fiat as the paper mark, and to think otherwise is delusional. Once this line of reasoning is adopted, it becomes clear that talk of recession is misleading. It is a concept which arose from Keynesianism as a justification for state intervention. Instead, we must consider changes in the levels of economic activity and the long-term legacy of the expansion of non-productive debt. Ignoring the evidence in favour of corrupted macroeconomic statistics not only misleads us all but encourages further destructive monetary and fiscal policies.
You cannot get away from the consequences of budget deficits being currency debasement. Furthermore, anticipation that a recession leads to lower consumption and therefore declining prices makes the fatal mistake of not understanding that production declines first, restricting product supply. The idea that a recession offsets currency debasement with respect to the general price level is simply untrue. We face the naked consequences of currency debasement together with changes in the balance of personal savings and cash retained relative to consumption, and the value imparted to the currency on the foreign exchanges.
Once the enormous distortions of covid had worked out of the system, the drawdown on US savings and the increase in consumer credit have not been significant. If it had, we would expect the purchasing power of the dollar to decline more than it has. For now, the greatest additional risk to the dilution of the dollar’s purchasing power comes from changes in foreigners’ collective valuation of the dollar, to which they are dangerously overexposed. For the moment, they exhibit a complacent attitude, broadly retaining their exposure without adding to it.
It has been changing, particularly when anti-dollar sentiment followed US sanctions against Russia at the start of her “special military operation” in Ukraine. While we in the NATO camp might feel it was justified, the refusal to honour Russian-held dollars is a default by the US Government. It is no different from a common debtor refusing to honour obligations to its creditors, a point which is understood by every nation not allied to the Americans. It is hardly surprising that those at the centre of this maelstrom are reducing their dollar reserves in favour of gold.
Foreign creditors’ loss of faith in the dollar for now is confined to relatively few nations, but it forms the background to prospective US debt funding. While offshore financial centres are prone to continue to accumulate dollars and underlying debt, national central banks and sovereign wealth funds are likely to quietly liquidate positions in US Treasuries and Agency bonds, a trend already reflected in China’s and Japan’s position. As the marginal buyers of US Treasuries, declining foreign appetite for funding the US Government’s budget deficit plus maturing debt together totalling over $10 trillion is bound to drive dollar bond yields higher.
Domestic conditions also indicate that the interest rate outlook is not for lower levels. Being overleveraged in their balance sheet relationships of assets-to-equity, risk-averse commercial banks are reducing their exposure to non-financial borrowers, forcing up their costs of borrowing. Far from the Keynesian’s benign analysis justifying an outlook for lower interest rates, they miss the point. 2024 is not about their textbook recession, it is about the difficulties of refinancing excessive quantities of unproductive debt.
For now, the US Treasury is in a sweet spot, with money funds reducing their deposits at the Fed in favour of Treasury bills yielding 5.4%, and the commercial banking system shifting its combined balance sheet into short-term government debt as well. But this is a one-off adjustment into short-term liquidity which has its limits. And we can then expect funding difficulties to emerge with respect to longer-dated debt.
Meanwhile, the US Government’s debt demands are starving the productive private sector of credit. The consequences are to be found in yet more bankruptcies for want of cash flow and overdraft facilities, and the failure of corporations of all sizes which took advantage of zero interest rate policies for financial engineering purposes. These otherwise stable businesses, even with utility characteristics, will likely follow Silicon Valley Bank into oblivion which similarly believed interest rates would never rise again.
The consequences for government finances
In our western welfare states, there is a common expectation that governments will intervene in order to rescue the economy from the consequences of an economic downturn. They go beyond mandated welfare commitments, being seen as having a democratic duty to intervene and support industries, irrespective of the downturn’s magnitude.
The extent to which these commitments arise will determine the magnitude of additional spending to which governments will be committed. America faces a presidential election this year without a debt ceiling. In a rerun of President Hoover’s failed interventions in the wake of the 1929—1932 Wall Street crash and the associated banking collapse, President Biden has the latitude to increase unfunded support as much as is necessary.
Essentially, this downturn is driven by an emerging debt crisis as described above, which will be worsened by attempts to stop the rot. When one accepts that western capital markets face an immense debt crisis it becomes clear that interest rates are bound to continue rising because lenders are becoming increasingly risk averse in order to avoid their own bankruptcies. The economic consequences for government finances will lead to unexpected increases in mandated welfare obligations, declines in tax revenues, calls to bail out indebted businesses and a further escalation of government debt.
All this costs governments, costs which they must recover through taxes and currency debasement. The government’s funding is either through taxing private sector actors who can ill afford to pay the taxes demanded (and being thrown out of work will be paying less anyway), or through higher prices the consequence of currency debasement. The outlook being for higher, not lower prices, the markets will require higher interest rates to compensate.
In short, major western governments are ensnared in debt traps. And as debt comes due, they end up refinancing it at higher interest costs, never reducing the rate of interest rate cost accumulation. The table below shows the current debt to GDP ratios for some major economies.
Some of these ratios have declined dramatically in the last decade, with Greece being the obvious example. Declining ratios follow from a combination of balanced budgets and economic expansion. Following the Napoleonic Wars, Britain was in a similar debt to GDP position to Greece today, with her ratio estimated by the Bank of England to be 184% in 1816. Without the mandated expense of a welfare state, it was able to control government spending, keeping it low as a portion of total economic activity. Furthermore, by operating a gold standard successfully, the cost of borrowing also remained low. But even then, it took almost a century to reduce the ratio to 28% in 1913.
On the eve of a severe economic downturn debt reduction can be ruled out. Ratios will be rising as further debt accumulates and GDP increases at a lower pace. But the real killer is high interest rates. And any attempt by the Fed to keep them suppressed would simply lead to weakening of the dollar on the foreign exchanges and pressure on the general level of prices to rise even further.
The funding situation is similar to that which faced the UK in the 1970s. Sterling was over-owned by foreigners who were sensitive to the deteriorating economic conditions under the socialist government. Sterling fell from 2.6 dollars to the pound in 1972 to 1.06 in March 1985. Funding dislocation drove gilt coupons to 15 ½% in October 1976.
Furthermore, an IMF loan was required to rescue UK government finances in January 1976. But as a creature of the US Government and its dollar, it is impossible for the IMF to come to the rescue of the US Government. The debt problem will either be solved by the US Government taking remedial action which is politically impossible, or the dollar’s purchasing power must collapse.
The fragility of the banking system
A further colossal difficulty looming for the US Government as well as its European and Japanese allies is banking systems rotten from the central banks down to the entire commercial banking network. Thanks to a previous combination of interest rate suppression and quantitative easing, all the major central banks have substantial losses, which properly accounted for, wipes out their balance sheet equity many times over.
It is a relatively simple matter to recapitalise a central bank. The central bank makes a loan to its shareholder (the government) recording it as an asset. A balancing entry is made on the liability side not as a deposit, but as equity. In most jurisdictions, legislative confirmation can be rapidly obtained. The Fed and the Bank of Japan can be expected to recapitalise themselves this way. The Bank of England has losses on its portfolio specifically underwritten by the UK’s Treasury and will not be required to recapitalise itself, losses simply being added to the national debt.
The problem facing the euro system of the ECB and its national central banks who are its shareholders creates additional difficulties. Theoretically, the ECB can recapitalise itself in the manner described above. But legislative confirmation will almost certainly be required in multiple jurisdictions, not just to recapitalise the ECB but individual national central banks as well. Additional questions over the TARGET2 imbalances are bound to be raised, particularly in Berlin given that the Bundesbank is owed over €1 trillion from other central banks through the TARGET2 system. Unless these thorny issues are resolved, the entire euro system and the currency itself risks collapse.
Another legacy of zero and negative interest rates is that slender credit margins encouraged commercial banks to leverage their balance sheets higher in order to protect bottom line profits. Consequently, they now face capital losses on bonds and higher funding costs than the income from bond coupons. And now that bankers are increasingly aware of the deterioration in business conditions, they are desperate to reduce lending risk. Inevitably, loan losses will mount over the course of this year threatening the equity of all thinly capitalised banking networks, spreading systemic risk globally. In the US, it is estimated that the collapse in commercial real estate values alone will wipe out over half total bank equity.
Even if interest rates and bond yields don’t fall slightly, there are other Silicon Valley Banks likely to fail. Rising interest rates increase the risks facing the entire banking system. Central banks with their respective government treasury departments will be faced with having to ensure that no banks fail. Inevitably, it will mean yet more credit expansion of base money, further undermining currencies’ purchasing power and leading to yet higher interest rates in time.
The consequences for financial asset values
Obviously, higher interest rates lead to higher bond yields, undermining bond values. And the yield on bonds is one of the most important determinants of equity values, the other being prospective earnings.
Clearly, faced with an economic downturn coupled with a developing banking crisis and the contraction of bank credit, equities should be declining on earnings prospects. But the S&P 500 Index has been hitting new highs, despite the rise in bond yields over the last three years. However, the valuation disconnection with bond yields has become extreme as shown in the chart below.
The negative correlation (the 30-year UST yield is inverted) is usually tight. The previous overvaluation for the S&P was the dot-com bubble in 2000. Today, the overvaluation is even more extreme. This suggests that the slightest disappointment over the interest rate outlook could crash the equity market.
This matters particularly for foreigners invested in US equities, which according to the US Treasury amounts to over $14 trillion at risk of a bear market.
Bond yields are already rising again, with the 10-year Treasury Note’s yield having risen from 3.75% to 4.16% — obviously not enough to undermine equities yet. But with a combination of the supply and demand issues described above and Middle Eastern troubles potentially escalating, the chances that yields are going no lower before tracking higher are mounting.
The outlook for gold
Clearly, the risks facing credit valuations are growing and a systemic crisis threatening the entire banking system looks increasingly likely. An expansion of central bank base money through new rounds of QE in an attempt to prevent falling financial asset values from triggering systemic events looks inevitable. The problem is common to the jurisdictions of all the major western currencies: dollar, euro, yen, and sterling.
The deployment of central bank credit in an attempt to secure the entire financial system will simply undermine the purchasing power of these currencies even more, risking yet higher interest rates and bond yields. Inevitably, this valuation crisis will destabilise currency relationships as enormous quantities of credit flees from one perceived risk to a lesser one. But it is here that an understanding is required of the difference between legal money, that is gold bullion and coin where there is no counterparty risk, and fiat-based credit which imparts values to all economic assets.
It is credit, including fiat currencies, which is at risk. Gold has broadly maintained its purchasing power over millennia, even though as explained by Gresham’s law it rarely circulates. It’s not generally realised what this means, but the chart below of major currencies valued in gold illustrates the decline of currencies since President Nixon suspended the Bretton Woods Agreement in 1971.
Note the log scale, which records the percentage loss. In US dollars, the loss is 98.3%, and that is on top of the decline from $20.67 to the ounce which was the rate before 1934. Including that devaluation of the dollar, it has lost 99%. In sterling, the post 1971 decline is over 99%. Longer term it has been even worse, bearing in mind that one pound was exchangeable for a sovereign coin, which is currently valued at £390.
The euro comprised of national currencies before 2000 has declined by 98.7%, and the yen 96%. The lack of awareness that the purchasing power of fiat currencies has declined so much encourages investors to believe that their investments and property are the best hedges against inflation, without realising the true extent of currency value destruction.
The conventional approach to wealth preservation is governed by government diktat. The state makes the regulations and educates the compliance officers, now required to be appointed by every financial institution. Any investment manager advising or managing on a discretionary basis who promotes gold has difficulty justifying the case because gold is not a regulated investment. Accordingly, after decades of increasing regulatory intervention, gold is estimated to be represented by less than one percent by value in the estimated $150 trillion equivalent of global investment portfolios.
Before regulatory intervention by governments, as a base case it was generally reckoned that a balanced portfolio should have exposure to gold or related investments of 10%. At current prices, taking average portfolio exposure to just 2% requires the purchase of 23,300 tonnes, or a mixture of mining stocks and bullion to that value.
While it is true to say that the value of gold measured by its purchasing power has been remarkably stable over millennia, it is likely to rise spectacularly in the event of a general credit crisis, because the scale of liquidity to accommodate portfolio adjustment doesn’t exist.
I have been increasingly asked whether governments will deal with the gold question by confiscating and prohibiting ownership of it by their citizens. The first point to note is that by his executive order President Roosevelt did not confiscate gold, only requiring gold and gold notes to be submitted in return for $20.67 dollars per ounce. If Biden or Trump tried that line again, a question arises over the rate of exchange: will it be at the official rate of $42.22, or the market rate?
While there is no knowing the bounds of political stupidity in purely economic terms, we can assume that any move to banning gold ownership would require the agreement at G7 level at the least, which might be difficult to get. And the signal sent to other nations and central banks is likely to drive gold higher and the dollar down. Indeed, instead of putting off Westerners from owning gold, if they think this course of action is a strong possibility they would probably accumulate as much gold as they can.
And finally, the likelihood that a gold backed BRICS currency will make the agenda this year is high, with Russia the rotating chairman and over 200 meetings planned in Russia for existing and prospective members. Russia herself would gain significant advantages from reintroducing the gold standard dropped by Khrushchev in 1961. While the merits already appear to be appreciated at the highest levels in the Russian government, in the face of collapsing credit values in the western alliance Russia, China, and most of the Middle East will have little option to protect their credit markets by anchoring them to gold.
To summarise, we face a strong possibility that a combination of excessive debt, rising not falling interest rates, an extremely fragile banking system and a collapse in financial asset values are in prospect for this year. In these circumstances, only those prescient enough to possess real money, which is gold bullion and coin, will emerge with at least some of their wealth intact.
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Tyler Durden
Fri, 01/26/2024 – 17:00
