September 2, 2011
 
This is the third, and the last, in a series about the function of a Central Bank in the world today. Here is a short re-cap:

In a world of fiat currencies and commonplace government intervention into the economy, which creates distortions and unintended consequences on a continual basis—you need a bank of last resort. This bank needs to be always on the lookout for anything that could bring the whole system down. Under a gold standard, such a bank isn’t necessarily needed since capital requirements are high enough that structural damage to the economy is limited to a sharp but brief fall. But under our current fiat standard which allows for low capital requirements and massive leverage, we need a fire department on the lookout for the next inevitable blaze. (See my article, The Banking System Of The 21st Century, in the Archive Articles.)  

At the root of the US financial crisis was excess leverage. The cure was to recapitalize the banks and require they use less leverage. Europe is facing the same issue now. James Grant of the Interest Rate Observer, an expert in this field, puts leverage ratios at the biggest bank in Germany, Deutsche Bank, at 40 to 1. This is Lehman style leverage ratios. During the years of the gold standard, reserve ratios were more like 4:1, ten times lower.

 

During our financial crisis the banks accumulated too much bad private debt, called sub-prime debt. These debt instruments, eventually deemed “toxic” assets, were fraudulent and not worth what they were represented to be worth. This led to a panic out of banks and other large financial institutions. (See The Elephant in the Room in the archive articles, for further discussion of the causes of the financial crisis.) 
 

Europe's crisis is similar but the suspect debt held in the Euro Zone banks is less private debt than it is sovereign debt. Notes lent out by Ireland, Greece, and other highly indebted nations are now being discounted by the market.  This makes the banks that hold them suspect.  Worse, it is the strong countries like France, and even Germany, who are creditor nations, that hold these countries notes as reserves. This is what "contagion" is all about -- fear that all banks and financial institutions are vulnerable because they hold questionable debt instruments, and are over leveraged to boot. The banks need more capital, which is another way of saying they need to de-leverage their balance sheets. This now includes central banks.

 

This was rarely a problem under the gold standard, since the potential for runs on banks forced them to maintain a high degree of reserves. And those reserves were in gold. Today, while gold is still held by central banks, most commercial banks hold reserves that are paper promises. And those promises are increasingly suspect. In the US, our Treasury, made what amounted to a bridge loan to our banks in the form of TARP, the Troubled Asset Relief Program. The Fed assisted the re-capitalization of banks by buying bills and bonds, thereby injecting new money into the banking system. Over the last few years, banks paid back the money lent them, no tax payer money was lost, the banks are profitable again, and are stronger today than they have been in many decades.

 

Europe needs to follow in America's footsteps and re-capitalize the banking system. But there are two problems with that. First, Europe has no bank of last resort and no treasury. To emulate the US they would have to create from scratch, an international Euro Bank with money printing authority. And they would need a Euro Zone Treasury with a unified policy. This might take years, if even possible. The better, more immediate answer is to ask the US, China, and all other countries, and financial institutions willing to, to make an emergency bridge loan. The Fed is already engaging in large swaps with the ECB, but much more is needed. But that leads to the second problem: while private companies and banks have a history of paying loans back to governments, governments have a history of defaulting. Almost all governments renege outright, devalue their currencies against their creditors, or inflate away the value of their money, rather than pay back debts. Government to government loans cannot be trusted.

 

So here is what I propose. That the US, China, or any other nation or bank willing to loan money to a government or a bank, makes a loan similar to the one made by the Fed and the Treasury to American banks and financial institutions, but on one condition; they puts up gold as collateral. They don’t need to collateralize all or even a large portion of the loan; a 4:1 ratio, with the gold placed in a neutral bank somewhere like Switzerland, and released back to the borrower only when the loan has been discharged, would do.

 

I believe this, along with the other fiscal reforms now being considered, would immediately end the contagion affect going on around the world; and I believe we would see interest rates in suspect countries fall, stock markets rally, and currencies stabilize. That is the power of a real asset versus a paper promise. It is time that gold returns to its age old function as collateral. We have not seen such a move by Central Bankers or the private banking sector in many, many years but, the way things are going, we may be about to.

 

Note: since this article was written, Finland has demanded collateral from Greece for any further loans made; and the following just hit the wires:

 

“Labour Minister Ursula von der Leyen said in the future that money
from the European Union-led rescue fund should only be paid out when
the states receiving the assistance provided collateral.

Von der Leyen believes that the gold reserves and industrial
holdings held by many nations could be used as collateral for loans,
according to information from German public television.”


It begins.

Market Update:
 
I have never considered myself a gold bug. Gold bugs are bullish about gold in bull and bear markets alike. I focus on what is going on in the markets in the here and now, rather than the theoretical future. Don't get me wrong, I am a theorist first and foremost, but I take theory in its literal meaning. After all, most projections about the future, especially those having to do with markets, are a matter of establishing probabilities.
 
Let's say for example that I assign the probability of a recession in the near term as about 35%. A new factor enters the picture tomorrow, the destruction of the Long Beach Harbor in California, which would cripple our ability to import and export for some time to come. That might raise the probability of a recession to well over 50%.
 
I am very aware of all the doom and gloom theories forecasting an "inevitable" recession. However, until I see a trigger that would set these theories into motion, I don't take them seriously. If I do see such a trigger, I assure you, I will be among the first to act.
 
For now I think the stock market is going to move higher, and gold lower, or at least gold prices should remain fairly stable -- depending on Europe. The increasing stock market, together with the growth we are seeing should lead to across the board higher multiples on stocks. And that should include all resource stocks that have lagged the soaring price of commodities. This is why I said last week that the most bullish case for resource stocks is stable commodities prices (like gold and silver) and an increasing stock market.
 
The market as a whole is trading at a lower price to earnings ratio today than it did in 1982 at its low. A good case can be made for a major run in stocks even if growth rates stay around 2%. If PE's go from the present 11 back toward 18, its old recent high, imagine what resource stocks will do. Absolute highs of PE's have been as high as 30 times earnings! A mid ranged PE ratio of 15 to 18 would yield huge gains. With substantially higher earnings yet to be reported and PE ratios expanding in a bull market, you could have the makings of a substantial move in resource stocks. And again, this is in the context of a 2% economy.
 
So I hope we will see a return to economic and monetary stability, over time, with higher world growth rates than expected. This would provide the context for a bull run. That may be too much to hope for, but we know the downside, and it has been well discounted over the last few months. Stocks lost more in the month of August than they have in 30 years. The bear case has been widely advertised, the bull case has not. What most investors are not even considering, is the bull's case that things might actually be getting better, rather than deteriorating. There is a lot of selective evidence to support this view.
 
Speculation of a recession and the need for QE3 are way premature. The Fed, in my opinion, will only move to loosen monetary policy if they see a credible threat of deflation. That was what prompted them to initiate QE2 last year. Remember that just a week before they moved last time, they were talking about their exit policy.
 
My guess is that given the soaring growth in M2, which is probably even shocking to the Fed, the term "exit policy" will be back in the English language just a few months from now. The question is whether or not the Fed will be willing to act in the midst of an election year. Remember the huge increase in the money supply over the last two months is market driven. The Fed hasn't changed its actions or made any accommodations; in fact they are now pretty much out of the market.
 
Even though I am turning more bullish, long term, I still believe that for the near term, we are in a trading range, and I will tend to buy the dips and sell the rips, until proven otherwise. I covered my short position in gold for a tiny profit and repurchased NSU. The $200 drop in gold may have cleaned out the speculators. The low volume in almost all markets tells me that there are less players who want to be in the markets in general. Too much volatility. We now see trends that used to take weeks or months resolved in just days or even hours. Is it any wonder so many are on the sidelines?
 
I also sold out my position in REIT's as the news crossed the wire that the SEC may demand a change of terms of the composition of mortgages REIT's can hold. When the government enters a market, I exit it. I picked up Teck Resources, TCK, a well diversified resource company. I am now sitting at about 25% cash, gold and silver, and 75% resource stocks.
 
The move into TCK was in response to the 200 point plus sell off of the market on the release of the unemployment figures. Two points: the unemployment numbers are lagging indicators. Forward indicators point to increased economic growth at about 1 to 2%. And if you breakdown the unemployment numbers you will find that while government employment fell, private employment increased. The result was a net wash. But to my way of thinking it was a net plus.
 
As the funds closed their books for the month, I close mine with a significant profit in addition to the 100% profit I booked in May. Since I re-entered the market in June...
 
Copper Fox is up 11%, AZK is up 13%, RBY is up 22%, NSU which I jumped out of and back into is up 32% from it's adjusted cost basis, Verde Potash is up 30%, and US Silver is up 52%. Good reports on RBY, AZK., and NSU, helped push these stock higher this week.
 
 
Paul Nathan