Alasdair Macleod: Finance and Economics

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The trouble with cash

Alasdair Macleod
14 May 2015
When interest rates are zero and it costs a bank to look after your money it becomes an unattractive asset.
Banks in some jurisdictions (such as Switzerland, Denmark and Sweden) are even charging customers
interest on cash and deposits. And if you go to your bank and withdraw large amounts in the form of folding
notes to avoid these charges you will be lucky if you are not treated as a sort of pariah. For the moment, at
least, these problems do not extend to sound money, in other words gold.
There are two distinct issues involved with government-issued currency: zero-to-negative interest rates,
which all but eliminate any interest turn on deposits for the banks, and a systemic issue that arises if too
many people withdraw their money from the banking system. The problems with the latter would become
significant if enough people decide to effectively opt out of holding money in the banks.
Conversion of bank deposits into physical cash increases reserve ratios, restricting the banks ability to create
credit. However, while the banks are contractually obliged to supply physical cash to anyone who wants it, a
drawdown on bank deposits is a bad thing from a central banks point of view. A desire for physical cash is,
therefore, discouraged. Instead, if the option of owning physical cash was removed and there was only
electronic money, deposits would simply be transferred from one bank to another and any imbalances
between the banks resolved through the money markets, with or without the assistance of a central bank. The
destabilising effects of bank runs would be eliminated entirely.
In the current financial climate demand for cash does not originate so much from loss of confidence in
banks, with some notable exceptions such as in Greece. Instead it is a consequence of ultra-low or even
negative interest rates. The desire for cash is therefore an unintended consequence of central banks
attempting to inject confidence into the economy. The rights of ordinary individuals to turn deposits into
http://www.financeandeconomics.org/[5/16/2015 10:22:42 AM]
physical cash are therefore resisted by central banks, which are focused instead on managing zero interest
rate policies and supressing any side effects.
Central banks can take this logic one step further. Monetary policy is primarily intended to foster investor
confidence, so any tendency for investors to liquidate investments is, therefore, to be discouraged. However,
with financial markets getting progressively more expensive central bankers will suspect the relative
attraction of cash balances are increasing. And because banks are making cash deposits more costly, this is
bound to increase demand for physical notes.
Monetary policy has now become like a pressure cooker with a defective safety-valve. Central bankers
realise it and investors are slowly beginning to as well. Add into this mix a faltering global economy, a fact
that is becoming impossible to ignore, and a dash-for-cash becomes a serious potential risk to both monetary
policy and the banking system.
There is an obvious alternative to cash, and that is to buy physical gold. This does not constitute a run on the
banking system, because a buyer of gold uses electronic money that transfers to the seller. The problem with
physical gold is a separate issue: it challenges the raison dtre of the banking system and of government
currencies as well.
This is why we can still buy gold instead of encashing our deposits, for the moment at least. It can only be a
matter of time before people realise that with the cash option closing this is the only way to escape an
increasingly dysfunctional financial system.
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14 May, 2015 Articles cash, cash deposits, central bank, gold 1 Comment
Controlling copper and silver prices

Alasdair Macleod
Print
7 May 2015
There is an unwarranted assumption that market prices are always right, and represent fair value. In the
case of commodities, particularly metals, this is not necessarily true, because regulated financial markets
make it too easy for government agencies and large banks to game the system.
Take the case of a country like China, which is the largest consumer of copper. Does it passively buy its
copper through the market? No. Instead it strikes a price with a supplier, such as a Zambian copper mine,
based on the London market price, bypassing the market entirely. If China plays no part in setting the
reference price in London, the Zambians can be satisfied the price is fair; but if China or her agents
suppressed the price of copper in the market before the price is set, the Zambians would be right to be upset.
Now, we do not know if China or her agents drive the copper price down, by placing a relatively small paper
order so that the large off-market physical deal is priced favourably, but it is obviously in her interest to do
so. Another metal where this could apply is silver.
We need to bear in mind three things about China and silver. She is the worlds largest industrial user, she is
almost certainly the worlds largest refiner, and the government owns all the refineries. China imports large
quantities of dor 1 and also base metal ores containing silver. So how she goes about this business is highly
relevant to the silver price, and the following is an example of how it works.
In the case of foreign silver mines a qualified agent assesses the silver content of concentrates or dor on site
and agrees a payment figure with the mine manager. Two further considerations then arise: the mine manager
will want payment upfront because he has wages and other costs to meet; and the agent will look for the
most cost-effective refining option. The first consideration is addressed by getting a bullion bank to advance
the money against delivery of the concentrates or dor when refined, and the second will often involve a
government-subsidised Chinese refiner.
There now exists a relationship between the Chinese government and the bullion bank, because the former
has to deliver refined silver to the latter, or it must alternatively provide paper cover as may be subsequently
agreed between them. As owner of the refining industry, Chinas interest is primarily strategic rather than
profitability. Whether it is to subsidise the solar cell industry, or to build a strategic stockpile matters not; the
temptation to suppress the price is the point.
The problem with price suppression is that it only works when buyers stand aside. But as we saw in the 30
months following October 2008 when the silver price ran up from under $9 to nearly $50, when buyers step
in huge price moves can occur relatively quickly.
To the extent such price suppression does occur, todays commodities must be under-priced, just as bond and
stock prices have become overpriced through central banks and other government agencies interfering with
the markets. In any event investor opinion is bearish for commodities and bullish for the US dollar.
Therefore, in a general market correction of valuation extremes commodities should recover strongly, how
strongly will depend on whether or not prices have been artificially suppressed in the way described in this
article.
Deflationists should take note: when markets crack, after initial confusion the prices of key commodities
such as silver could rise more strongly than imaginable if they have been artificially suppressed, making
them the only game in town.
A dor bar is a semi-pure alloy of gold and silver, usually created at the site of a mine. It is then
transported to a refinery for further purification.
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7 May, 2015 Articles China, copper, dore, silver, zambia
Why deflation is unlikely

Alasdair Macleod
30 April 2015
Financial markets are becoming aware that the US economy is stalling, so investors increasingly take the
view that with demand likely to stagnate or even fall, prices for goods and services will soften. This is
already threatening to be the situation in a number of other advanced nations, with negative interest rates to
combat it becoming commonplace. For this reason, gold and silver priced in dollars are expected by many
traders to drift lower.
Putting the prices of precious metals to one side for a moment, there are some serious issues with this
analysis. Let us assume for a moment that the US economy does stall; the text-books tell us supply and
demand for goods and services will rebalance at lower prices. This was what effectively happened in the
wake of the Lehman Crisis, when energy, metals and precious metal prices all fell sharply and large
discounts for manufactured capital goods became available. This does not mean that second time round (and
a sliding US economy could create the sort of financial strains that make Lehman look like a walk in the
park), the same thing will happen again. Indeed, for next time the central banks already have a plan to
contain the situation based on their experience in the Lehman Crisis. It involves the rapid expansion of
money, which to the Federal Reserve System (Fed) at least has been proven on recent experience to have
little or no inflationary consequences whatever.
We therefore know something we did not know in the wake of August 2008, when the imminent collapse of
the global banking system drove everyone to increase their cash balances. This time we know that last times
guarantees of $13 trillion, or whatever sum you care to think of, will yet again be provided by the Fed,
backed by hard cash on demand. Forget bail-ins; they are for dealing with one-off bank insolvencies, not a
wider systemic crisis.
Of course its tempting to think that a new financial and economic crisis will drive us towards selling
anything we can for cash. However, this has not necessarily been the experience of previous monetary
inflations: after printing money fails to raise the animal spirits, the consensus often expects a fall in prices,
only for the opposite to happen. This was certainly the case in Germany and Austria after the First World
War, when economic burdens from the combined destruction of infrastructure and wealth, the loss of
productive lives, the end of military spending and the burden of reparations were all expected to overwhelm
their respective economies. The result was people briefly preferred to hold onto their savings rather than
spend. How wrong they were.
The political situation then was very different from that of today, but there was an important economic
similarity. The rapid acceleration of growth in money supply failed to stimulate the Germanic economies in
the preceding seven years. Its the same today. The mistake is the one identified by Frederik Bastiat nearly
200 years ago with his fallacy of the broken window. We see the dynamics of a failing economy and draw
our conclusions from that observation alone. We disregard the previous monetary inflation, and we have yet
to see the more rapid expansion of money and credit to come. This is why we do not anticipate the growing
certainty that the purchasing power of money will fall and not increase, embarking on the same value-path as
the German mark and Austrian crown in 1920-23.
If a financial crisis is to be averted, the best we can hope for is an economy moving sideways rather than
expanding. But there are dangers to this hope, partly from markets that are dangerously over-valued, and
partly from the limitations on further private sector debt creation. In short, we are living with a situation that
is highly vulnerable to an exogenous shock.
Meanwhile, the prices of gold and silver reflect the deflationary view to the exclusion of the likely outcome.
There is no doubt that many dealers believe that gold and silver are merely commodities, otherwise they
would be chasing their prices upwards in a dash for cash. Future historians should be puzzled. Perhaps
someone will write a history with a snappy title, such as Extraordinary Popular Delusions and the Madness
of Crowds.[i]
[i] Already written by Charles Mackay and published in 1851. Updates will doubtless be required.
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30 April, 2015 Articles deflation, gold price, lehman crisis, silver
Gold, the SDR and BRICS

Alasdair Macleod
23 April 2015
Last Monday there was a meeting in Washington hosted by the Official Monetary and Financial Institutions
Forum (OMFIF) to discuss the future relationship, if any, of gold with the Special Drawing Rights[1] (SDR).
Also on the agenda was the inclusion of the Chinese renminbi, which seems certain to be included in the
SDR basket in this years revision, assuming that the United States doesnt try to block it.
This is not the first time the subject has come up. OMFIFs chairman, Lord Desai wrote a paper about it
after the last Washington meeting on gold and the SDR exactly four years ago. The inclusion of the renminbi
in the SDR was rejected in 2010 because of inadequate liquidity and is due to be reconsidered this year.
Desai pointed out in his paper that there are difficulties when it comes to including gold, because (and I think
this is what he was trying to say) none of the SDRs paper constituents are convertible into gold, but golds
inclusion in the SDR would make them convertible through the back door. However, Desai seemed keen to
re-examine the case for gold.
It should be pointed out that if gold is included in SDRs the arrangement cannot be long-lasting so long as
the major central banks insist on printing money as an economic cure-all. However, Chinas position with
respect to gold and her own currency could be a different matter.
The Chinese government has almost certainly accumulated large amounts of gold yet to be included in her
reserves, and she has also encouraged her own citizens to own gold as well. We can therefore be certain that
China sees a monetary role for gold while at the same time she is pushing for the renminbi to be included in
the SDR basket. There is no doubt, if you read the IMF papers from the last SDR review in 2010 that the
renminbi does now fulfil the criteria for inclusion today. So the question then is will the advanced nations,
which dominate the IMFs membership, permit the renminbis inclusion, and will the US, which has dragged
its heels on giving China and the other BRICS nations a greater shareholding in the IMF, relent and permit
these reforms, which were accepted by the other members back in 2010?
The Americans blocking of reform signals her desire to preserve the dollars hegemony; but given she lost
out spectacularly over the creation of the Asian Infrastructure Investment Bank, IMF reform could become
the next serious threat to the dollars dominance. And if America does not back down over the IMF and the
SDR, she will have no fall-back position; China on the other hand still has some aces up her sleeve.
One of them is gold, and another is her role in a rival organisation established by the BRICS. The New
Development Bank (NDB) is in the final stages of being set up, driven by frustration at Americas attempts
to protect the dollars role and to keep the IMF as an exclusive club for advanced nations. Instead, the NDB
could easily issue its own version of the SDR with the gold lining Desai referred to in his original paper.
The reason this would work is very simple. The BRICS members, unencumbered by the cost burden of
modern welfare states could exercise the monetary restraint required to tie their currencies to gold, perhaps
running a Bretton-Woods-style[2] gold-exchange arrangement between member central banks to stabilise
their currencies.
However, the NDB would almost certainly want to see the gold price considerably higher if it is to play any
part in a new rival to the SDR. Other BRICS members would be encouraged to make sure they have
sufficient gold on board by selling US dollar reserves to buy gold, ahead of any decision to go ahead with a
new super-currency.
It would appear the era of the dollars global domination as a reserve currency is coming to an end, and the
stage is now being set for gold to be officially accepted as the ultimate reserve money once again, this time
by the next generation of advanced nations.
[1] The SDR is an international reserve asset, created by the IMF in 1969 to supplement its member
countries official reserves. Its value is based on a basket of four key international currencies, and SDRs can
be exchanged for freely usable currencies. As of March 17, 2015, 204 billion SDRs were created and
allocated to members (equivalent to about $280 billion).

[2] A now defunct system of monetary management that established the rules for commercial and financial
relations among the worlds major industrial states. In 1971, the United States unilaterally terminated
convertibility of the US dollar to gold, effectively bringing the Bretton Woods system to an end and rendering
the dollar a fiat currency; many fixed currencies (such as the pound sterling, for example), also became freefloating at the same time.
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23 April, 2015 Articles BRICS, China, gold, IMF, OMFIF, SDR 3 Comments
The over-valued dollar

Alasdair Macleod
16 April 2015
There are two connected reasons usually cited for the current dollar strength: the US economy is performing
better than all the others, leading towards relatively higher US dollar interest rates, and that this is triggering
a scramble for dollars by foreign corporations with uncovered USD liabilities. There is growing evidence that
the first of these reasons is no longer true, in which case the pressure to buy dollars should lessen
considerably.
In coming to this conclusion we must be careful not to limit our thinking to the dollar rate against other
currencies. They are arguably in an even worse position, with active Quantitative Easing in both Japan and
the Eurozone failing to resuscitate industrial life, while the UK is in the middle of a heated election
campaign. Instead we should think primarily in terms of the dollars purchasing power for goods and
services, and here the market is already skewed to one side: the public prefers to hold dollars and reduce debt
rather than spend freely, because everyone knows that prices of consumer goods are not rising and, so the
logic goes, inflation is dead and buried.

Such unanimity is always dangerous and the mainstream fails to notice that far from an inflationless
recovery, the US economy appears to be stalling badly. This is hardly surprising since private sector credit is
still tight. Depending whose figures you use, total US debt is estimated to be in the region of $57 trillion, an
increase of about $4 trillion since the banking crisis in 2008. However, government and state debt held by the
public has risen by $6.7 trillion and large corporations have borrowed a further $2.3 trillion to buy back
shares. Meanwhile financial debt, which includes asset backed securitisations of consumer debt, has fallen by
about $4 trillion, while consumer debt directly held has declined slightly. These rough figures suggest that
credit for households and smaller businesses remains constrained.
Since mid-2014 markets have undergone a sea-change, with the dollar strengthening sharply against the
other major currencies and the oil price collapsing along with a number of key industrial commodities. The
Baltic Dry Index, a measure of shipping demand, has recently fallen to the lowest level ever recorded.
Admittedly there is a glut of ore carriers helping to drive shipping rates down, but there can be no doubt that
trade volumes are down as well; and there has also been hard evidence with Chinas imports and exports
having declined sharply.
Common sense says that from the middle of 2014 the world ex-America entered the early stages of an
economic slump. Common sense obviously took time to catch up with the U S, and it is only in the last
month or so that mainstream economists have begun to cautiously down-grade their GDP forecasts. It is now
impossible to ignore the confirmations which are coming thick and fast. This week alone has seen inventories
stuck on the shelves, small business optimism declining and the National Association of Credit Managers
reporting serious financial stress; and that was only Monday and Tuesday. This is the background against
which we must assess future dollar-denominated prices.
Conventional wisdom would have us believe that an economic slump leads to an increased demand for cash
as businesses are forced to pay down their debt: this is essentially the Irving Fisher debt-deflation theory
from the 1930s. It is for this reason that modern central banks exist and they stand ready to create as much
money as may be required to prevent this happening. Let us assume they succeed. We then have to consider
another factor, and that is the progress of monetary hyperinflation, for this becomes the underlying condition
driving dollar prices.
Central banks can nearly always debauch their currencies with impunity. People automatically think that
money is stable and do not generally draw the conclusion that a rise in the level of prices is connected to an
expansion in the quantity of money or credit. While they often admit that money buys less today than it did
thirty or forty years ago, and they are aware of the consumer price index trend, they may fail to appreciate
that money can and does change its purchasing power from day to day. The result is they attach changes in
prices not to money but to factors affecting individual goods.
There are several factors that affect prices, one of which is an increase in the quantity of money when that
new money is spent on the goods being considered. Obviously, if the new money is not spent on consumer
goods, but hoarded or spent on something else, an increase in the quantity of money will not lead to higher
prices for items in a consumer price index. But more importantly, prices are inherently subjective, which is
why we cannot forecast tomorrows prices. If you find this hard to accept, just look at the average stock
traders record: if he is very good he might have a 10% edge, but even then he cannot tell you tomorrows
stock prices.
Subjectivity of prices is the consequence of changing preferences for money relative to individual goods. In
the current economic climate with its restricted credit people are understandably cautious about spending,
which means their preference for money is relatively high. But not everyone shares the same preferences,
and they are likely to be different across different classes of goods as well, with commodities and raw
material prices behaving differently from the prices of finished goods, even though they are linked.
So far price rises due to monetary inflation have been generally restricted to financial markets and associated
activities. Early speculators have done very well, with todays buyers being forced to pay considerably
higher prices for the same investments. Despite this obvious phenomenon, speculators do not usually
understand it is the swing in preference from money towards financial instruments that is behind the rise in
prices.
But what if this relative preference starts to swing in favour of commodities? The swing in preference has
meant the price of oil in dollars has already risen 25% in recent weeks, or alternatively, we can say the
purchasing power of the dollar has fallen by that amount. Copper, the commodity that should be collapsing
as we go into a slump, has also risen, this time by 15% over the last two months.
Commodity traders who look at the charts will tell you that these are normal corrections in a bear market for
the commodities involved. But how can this be, when we are entering a deflationary slump? The answer is
simple: there has been a change of preferences with respect to oil, where buyers value oil more than dollars,
and also for copper. This should not be confused with an increased desire to own oil and copper; rather it is
a reduced desire to hold dollars relative to these two commodities.
If the idea the dollar is weakening spreads from selected but economically important commodities it could
begin to alter the balance of preferences more generally, for which almost everyone is ill-prepared. How long
the process takes we cannot know until it happens; but if the general public realises it is the dollars
purchasing power going down instead of goods prices rising, it will be very difficult to stop its purchasing
power from collapsing entirely.
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17 April, 2015 Articles central banks, dollar, irving fisher, quantitative easing, US
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The trouble with cash

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