At the recent LBMA Conference here in Singapore, the head of macro strategy and FX research at Standard Chartered Bank indicated that 26% of globally tradable bonds now have negative yields.
Our financial system has become fundamentally unstable
At a time when global debts are 20% of world GDP higher than during the 2008 crisis these negative yields are a big warning sign that something is terribly amiss with our financial system. There is simply too much debt which has been artificially made too cheap for too long and it is routinely financed by printing new currency (debt monetization).
The US Monetary base for example has been expanded by a staggering 450% since the 2008 crisis while federal debts have doubled to nearly 20 trillion in 8 short years. Looking forward the enormous unfunded liabilities, which are mandatory future expenditures, will ensure that these debt levels become much worse.
Japan has even greater debt levels and has monetized enormous amounts of currency as part of their Abenomics policy of ultra-cheap money. Meanwhile Mario Draghi at the Europe Central Bank is monetizing debt and spearheading negative interest rates, having set the ECB rate at negative 0.4%.
When central banks monetize debt and impose these artificially low and/or negative interest rates for long periods of time, they create massive imbalances in the economy, ensuring that an eventual re-adjustment will occur. The more extreme the interventions, the more painful the re-adjustment will be.
since 2008, USD Base Currency increased by 450% to 3.6 trillion USD
while Federal debt increased 110% to nearly 20 trillion USD
while Monetized Debt held by the FED increased 590% to 2.8 trillion USD
Hyperinflation, Germany’s painful re-adjustment from excessive debt monetization
Throughout history, over-indebted governments often created currency well in excess of real economic growth and eventually had to pay a high price for it. The German Reichsmark was such an example:
To finance the massive costs of World War I, Germany suspended it’s currency gold backing in 1914 and turned on the printing presses to monetize it’s ballooning debt. The German government would pay creditors with a constant flow of newly printed money. This money gradually seeped into the economy and went into people's cash holdings.
This monetized currency was also referred to as the “Papiermark” (Papermark). By the end of the war, the amount of currency in circulation had increased by over 400%, and debts had skyrocketed.
Initially despite the debt monetization, prices for real goods (such as food and coal) rose relatively slowly because most people did not spend but rather saved most of their excess currency as they were afraid of what tomorrow may bring.
It all started to go haywire when people started spending more of their saved currency causing prices of everyday goods to increase. Soon, too much currency chased after a limited number of goods. It started a self-reinforcing cycle of higher prices, prompting more people to panic and buy any physical goods which in turn caused prices to rise at an even faster rate.
Sellers also became reluctant to sell their produce, believing that prices would increase soon and asked for even higher prices. At its peak, prices of ordinary goods would be many times higher in the evening compared to the morning causing people to spend their currency as fast as they could on anything available before their daily wages became worthless.
With the collapse of the currency also went many of the lifetime plans of average citizens. Widows dependent on insurance found themselves destitute. Savings became worthless and people who had worked a lifetime found that their pensions would not buy even a cup of coffee.
"My father was a lawyer," says Walter Levy, a German-born oil consultant in New York, "and he had taken out an insurance policy in 1903, and every month he had made the payments faithfully. It was a 20-year policy, and when it came due, he cashed it in and bought a single loaf of bread.
The few Winners of Germany’s hyperinflation
Eventually after years of debt monetization a new gold backed currency (The Goldmark) restored price stability to the traumatized financial system.
By this time, lenders and creditors had lost nearly everything while holders of gold and ex-debtors (those who had paid off their debt in worthless Papiermark) emerged very well from the financial carnage.
A borrower who would have taken a German mortgage of 1,000,000 Papiermarks in 1918 for example, which was the equivalent of 9,218 oz of gold (worth 11,523,000 USD today) could have paid if off for just 0. 00000008 oz of gold (worth 0.0001 USD today) by November 1923.
Similarly gold owners did very well as a troy oz of gold would have been worth over a trillion Reichmarks by 1923 as the following official revaluation chart shows:
The Revaluation Table of 1925 was used to re-value debts after the Goldmark (being about 0.0115 oz of gold) was issued.
Note that Papiermarks refer to Reichsmarks (same thing) after 1914 when the gold backing was removed.
Unstable financial systems collapse slowly then suddenly
A key lesson from Germany’s hyperinflation was that although debt monetization was a pre-requisite for the eventual hyperinflation, it was only when a critical number of people started to spend this excess currency that a self-reinforcing cycle of ever increasing prices destroyed the currency.
Just like water pressure behind a dam, debt monetization built up over the years but was largely neutralized by savers who kept the newly printed currency from becoming actual demand for real goods. Savers were the figurative concrete walls of the dam that held the pressure back.
Ironically, the additional saved currency made their owners feel richer (the money illusion phaenomenon), causing them to increase their spending which eventually led to higher prices. As prices started rising people were gripped with fear of escalating prices and even more people started buying goods pushing prices higher faster.
Once the fear of higher prices had set in, the figurative dam breach was a certainty and an unstoppable flood of demand was let loose to hyper inflate prices of real goods. Savers who were too slow or unable to react were ruined.
Hence systemic events such as hyperinflation or massive banks failures require:
- Imbalances that were built over years to set the conditions necessary to destabilize a financial system
- A trigger in the form of a critical mass of people to set off a self-reinforcing trend
Imbalances can be built over decades without having much effects. However, the pent-up energy can be released in a very short period of time once triggered and those who are too slow to react will incur substantial or total losses.
Imbalances, Uncertainties and Triggers
The ECB’s negative interest rates, the Bank of Japan’s money printing bonanza and the United States’ endless fiscal debt spiral and cheap money policies have created enormous financial imbalances. When 26% percent of global bond yields are negative, the message is very clear (for those that care to look): We are due for a massive systemic adjustment.
Our debt imbalances have been built over the last 25 years and every time a painful re-adjustment came due (particularly the 1998 and 2008 crises), central banks postponed the adjustment through even more debt and liquidity issuance; ultimately creating a larger powder keg.
We are now waiting for a catalyst to spark it all, a misguided trade war or a mishandled bank collapse might be all that is needed for the system to go critical. In such a scenario, physical gold and silver carefully stored outside our over-leveraged banking system can become a cheap insurance for your wealth.
As William White – Chairman of the OECD Economic Development & Review Committee - put it during the LBMA conference after illustrating how irrational behaviours and false beliefs have skewed our traditional risk/return metrics, “Good luck, you might just need it.”
By Gregor Gregersen