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Western Europe and US: pay the debt or deflate the currency

Date: 20 Aug 2011 19:55

Market and political events and publications in the recent two weeks led me to the following thoughts about the future of Western Europe (WE) and US:

  1. GDP growth in WE and US after the 2nd World War was caused by

    • Growth in productivity
    • Growth in population
    • Growth in internal and external debt

  2. All these sources of growth are exhausted now and can no longer drive the growth
    • Innovation is slowed down, especially in WE. Also, current innovations are problematic
      • while industrial innovations of the 20th century created workplaces and built middle class…
      • …technology innovations of the 21st century kill work places, leads to more uneven distribution of wealth and requires more government spending to support poor citizens who used to high standard of living

    • Birth rates are decreasing. Immigration slowed down and probably doesn't compensate for the decreased birth rates
    • Debt of all economic groups is close to unsustainable point or is already above it
      • Governments: US and many WE countries has debt at >50% of GDP
      • Private: mortgage and credit card debt is unbearable for many consumers
      • Business: after in 1970s Michael Milken showed borrowers and investors that high yield debt is profitable, businesses started a debt raising cycle with intensive facilitation from PE funds. This continued for 30-40 years, and now finally almost every western company has debt level which is optimal but no longer extendable.

  3. In the situation with no GDP growth prospects and a pressure to de-lever governments has two strategic choices:
    • Pay down the debt by decreasing government spending. It's a very tough political decision after ~60 years of the growth in government expenditures
    • Print more money

  4. All other options are short term, unsustainable and will lead to bigger declines in government spending in the future then they could be if deleveraging is started now. These options can be:
    • Borrow more money
    • Move debt payments to the future by restructuring the debt
    • Give money to problematic countries like Greece to avoid defaults now. This will save Greece and similar, but will require actions described above for the countries who pay for it.

Below are two charts showing debt levels and GDP growth.

Government debt, % of GDP (2010) vs. Real GDP growth (2008)

Government debt, % of GDP (2010) vs. Real GDP growth (2008) counties with Gov. Debt/GDP <50%


GDP growth data is from 2008 as in 2009-2010 GDP growth numbers were unrepresentative of the counties' growth potentials

Below are three publications and facts that are in line with the above views. What investments decisions do all these thoughts lead to?
  • Invest in equities and debt of EMs with low government debt levels. Don't hedge currency risk vs. USD or EUR
  • Invest in gold as return to hard commodity money is inevitable
1) Forty Years of Paper Money
Fiat currencies always end with hyperinflation and economic collapse.

WSJ, 15 Aug 2011

Forty years ago today, U.S. President Richard Nixon closed the gold window and ushered in, for the first time in human history, a global system of unconstrained paper money under full control of the state.

It is not that prior to August 15, 1971, there was a gold standard. Far from it. Most countries had severed any direct link between their currencies and gold many years earlier. U.S. citizens were still prohibited by their own government from even holding gold privately. Nevertheless, a tenuous link to gold still existed. Under new monetary arrangements after World War II, the dollar had become the global reserve currency and central banks around the world received a guarantee from the U.S. that they could exchange their dollar reserves for gold at a fixed price. But on this day in 1971, the United States defaulted on this promise and thereby removed the last impediment to the unconstrained production of fiat money. After the "Nixon shock," money everywhere became pure paper money—or, increasingly, electronic money—that could be created by privileged money producers—banks and central banks—practically without limit.

The global paper standard has lasted 40 years but evidence is accumulating daily that its endgame is now fast approaching. The world economy is caught in a deepening financial crisis caused by excessive levels of debt, severe asset price bubbles and overextended banks—all imbalances that are the direct consequence of four decades of unprecedented fiat money creation, of artificially low interest rates and of "lender-of-last-resort" central banking. Monetary policy today—whether by the U.S. Federal Reserve, the ECB or the Bank of Japan—is not much more than an increasingly desperate attempt to postpone via super-low interest rates and periodic debt monetization the painful but unavoidable liquidation of these imbalances. This will not only ultimately prove futile, but will lead to a
complete currency catastrophe if pursued further.

Full paper money systems had existed before 1971, but only in individual countries, never on a global scale. The Chinese invented paper, ink and printing, and were the first to experiment with complete paper money systems a thousand years ago. The reason for introducing state paper money then was the same as later in Western societies: to fund growing state expenditure, usually for the purpose of waging war. Complete paper money systems are always creations of the state, never the outcome of private initiative or the free market. All paper money systems in history have, after some time, experienced growing financial instabilities, economic volatility, and an accelerating decline in money's purchasing power. All of them ultimately failed. Either the monetary authorities returned to commodity money before total collapse occurred, or they failed to do so, which then led to hyperinflation, with grave consequences for society.

Nixon closed the gold window
Associated Press Nixon closed the gold window in 1971.

In its early history, the U.S. itself had already had these very same experiences with its own paper-money systems. The continentals, introduced to fund the Revolutionary War, led to rising inflation, and continentals finally became worthless. The greenback, introduced to fund the Civil War, also led to rising inflation—but this time a return to a gold standard was achieved before the currency collapsed. The return to unrestricted paper money 40 years ago was also in no small part motivated by wartime expenses, this time for the Vietnam War.

Most of today's macroeconomists see surprisingly little wrong with the present system of fully elastic money. This is surprising for two reasons: First, there is the universally dismal historical record of paper money systems. Second, paper money systems are inherently incompatible with capitalism. In a state paper money system, the banking system is de-facto cartelized and the banks' funding conditions and certain interest rates are determined administratively by a state agency—the central bank. The constant expansion of bank reserves constitutes an ongoing subsidy to the banks, which encourages further money creation through fractional-reserve banking. Credit growth in such an economy is no longer driven by the extent of saving in the economy but the result of central bank policy and the banks' willingness to expand their balance sheets. The continuous injection of fiat money puts downward pressure on interest rates and systematically encourages debt accumulation and investment that is funded by money printing, not by saving.

The belief among mainstream economists and central bankers today is obviously that they fully understand and can correctly anticipate the consequences of their monetary manipulations. The effects of money injections appear to them to be simply stronger growth and higher inflation, both neatly captured by the set of macro-statistics that modern economists follow so slavishly. All that central banks have to do, then, is target the right balance between the two. A display of such intellectual hubris was given by Federal Reserve Chairman Ben Bernanke when he explained the Fed's policy of quantitative easing to the U.S. public in an op-ed last November. Extolling the advantages of artificially depressed interest rates and propped up asset prices courtesy of the Fed's printing press, Chairman Bernanke promised that, "lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion."

One wonders why we even need markets, if the Fed chairman and his committee know where mortgage rates, corporate borrowing rates and stock prices should be, how much debt U.S. households and corporations should carry, and what the "correct" funding cost for the government is.

Forty years of persistent monetary interventionism have left the economy addicted to cheap credit and continuous asset inflation. Forty years of monetary expansionism have led to distorted prices, misdirected economic activity and unsustainable debt levels. Since Lehman Brothers we know that the accumulated imbalances have become so momentous that a market-driven liquidation of them is deemed politically unacceptable. Credit correction, debt deflation and liquidation—as much as the market is craving them to cleanse the economy of its dislocations—will not be allowed under any circumstances.

The central banks are now boxed in. There is no exit strategy.Low interest rates and further credit growth must be sustained at all cost, and as the private sector becomes reluctant to participate, the state is increasingly the "borrower of last resort" to the central bank's "lender of last resort." The Fed will engage in QE3, then in QE4. After mortgage-backed securities and Treasuries, it will be corporate bonds, auto loans and credit card debt that will also end up on the central bank's balance sheet—and, of course, more Treasurys. The ECB will continue to accumulate the ever-growing debt of European sovereigns. But when the public realizes that the mirage of solvency is only being maintained by ever-faster money creation, the confidence in the state's paper money will evaporate quickly.

Historically, all paper money systems ended either in complete collapse or a timely return to hard commodity money.

Forty years after the start of the present paper money episode, we are facing the same choice.

Mr. Schlichter's book, "Paper Money Collapse—The Folly of Elastic Money and the Coming Monetary Breakdown," will be published by John Wiley & Sons next month.

2) Asian Currencies Get New Respect Amid Turmoil
WSJ, 15 Aug 2011

Asian Currency Index
Associated Press Nixon closed the gold window in 1971.

3) Hedge fund to bet against west

THE FINANCIAL TIMES, Posted: Saturday, Aug 06, 2011 at 0223 hrs IST
By Sam Jones, Hedge Fund Correspondent

Lee Robinson, the outspoken founder of London hedge fund Trafalgar Asset Managers and former senior Tudor Investment Corporation trader, is preparing the launch of a hedge fund to profit from the devaluation and collapse of western economies.

Mr Robinson has already begun marketing his Altana Sovereign Diversity Fund to investors. The fund is positioned to take advantage of the devaluation of the dollar and “stealth defaults” of developed countries, reflecting Mr Robinson’s long-held bearish views on the prospects for the global economy.

Marketing materials for the fund seen by the Financial Times identify France, Germany, Italy, Spain, the UK and the US as countries that it will be positioned against.

The fund is designed to “profit from the global secular wealth shift from debtor to saver nations”, the presentation says.

Based on the increase in the quantity of paper money, wealth may fall 30-60 per cent. This trend would likely take generations to reverse,” it adds.

Mr Robinson quotes economist John Maynard Keynes on the frontispiece of the confidential presentation, which has been discreetly distributed to potential investors: “By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.

A prototype version of the strategy has returned 3 per cent since inception in October, before fees.

As well as taking long-term positions against western economies, the fund will take advantage of short-term currency trends and invest opportunistically in a range of financial instruments to “enhance returns”.

Altana’s launch has already had its fair share of attention.

Mr Robinson’s decision to set up a new hedge fund firm precipitated a dispute between himself and his former partners at Trafalgar, Theo Phanos and Goldman Sachs.

Via its Petershill investment fund, Goldman owns a 20 per cent stake in Trafalgar that has dropped in value following Mr Robinson’s decision to step back from the firm, which specialised in trading around European corporate events such as mergers and bankruptcies.

Trafalgar’s flagship Catalyst fund, which Mr Robinson managed, was pushed into liquidation by its directors because of his departure.

Negotiations are understood to be under way over the possibility of Goldman taking a successor stake in Altana.

Mr Robinson has nevertheless pressed ahead with his fundraising drive and has invested more than $25m himself.

He has also been on a hiring spree.

Altana has recruited Ian Gunner, the former head of foreign exchange research at BNY Mellon, to be a fund manager and Antony Lingard, a senior banker at UBS’s prime brokerage division, to be chief operating officer.

Mr Robinson was unavailable for comment.


Here is the information about the fund from its official page:


To profit from the appreciation of currencies of stronger sovereign credits and to protect investors’ wealth from the stealth defaults of debtor nations.


Invest in diversified portfolio of short-dated sovereign credit instruments, whose currencies are expected to strengthen against the US$ and other traditional reserve currencies (£,€,Y). Favoured currencies to reflect relative strength in public finances, the domestic financial system and the balance of payments.

Avoid nations at risk of default/restructuring.

Enhance returns by taking advantage of short-term currency trends to actively trade around the long-term positions of the portfolio and investing in other instruments such as gold.

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