Bank Runs

I find the recent Australian Government guarantee of banking deposits (and the Treasury briefing of the leader of the opposition) very interesting. Briefing opposition leaders does not occur very often and I would assume was done because they wanted the opposition leader to know that the problem was serious and not to be used for political point scoring. The problem, then, must have been the real chance of a bank run developing.

Speaking to the Perth Mint's Depository and Shop staff about the reasons why people were buying gold and silver and how they were doing it leads me to believe that Australian banks were seeing the beginnings of a bank run developing. Stories of people not wanting to wait for cheques to clear and going to the bank to withdraw cash so they can get immediate delivery of metal may be reflective of wider cash withdrawals from Australian banks.

This report on ninemsn.com.au certainly would scare your average central banker: "according to Officeworks, the retailer has noticed a 'significant' increase in the sale of personal safes in recent times ... a number of people who feel nervous and consequently are pulling their money out" (see also this report from The Times)

I doubt the cash withdrawals would have posed a significant risk at this time, but I suspect that the banks were seeing abnormally high cash withdrawals and/or a trend developing and wanted the Government to stop it. It is interesting that this was necessary considering that "depositors in authorised deposit‑taking institutions (ADIs) already receive preference in any liquidation" (2 June 2008 press release by Treasurer).

Maturity Crisis in Gold

Excellent blog at Unqualified Reservations about the lease rate.

It should be noted that the primary driver of lease rates has been miner hedging. Have a look at the chart at this blog and then compare to chart of lease rates.

You will see that as miner hedging increased from 1994, lease rates moved from average 0.75% during early 90s to 1.5% during mid 90s to early 00s. They then drop to historically low levels when miners started to de-hedge, all wanting to meet investor calls for full exposure to the gold price.

Doubtful this time miners will be hedging again so this lease spike totally dependent on when central banks regain confidence in bullion banks. Funny how they are prepared to throw fiat money around to any bank that needs it, but not so keen to do the same with gold.

Steve Keen's Oz Debtwatch

http://www.debtdeflation.com/blogs/ subtitled: Analysing Australia’s 45 Year Obsession with Debt, a new addition to blogs I'm following after seeing him on the 7:30 report. Choice quotes:

"As the experience and the memory of the Great Depression receded, academic economics produced a hybrid of Keynes’s macroeconomic ideas grafted on top of Neoclassical microeconomics that they called “the Keynesian-Neoclassical Synthesis”.

Unfortunately, the ideas were incompatible–and over time, wherever there was a conflict, academic economics rejected the Keynesian graft, rather than the underlying Neoclassical microeconomics. After fifty years of this, Keynes’s ideas were completely ejected from the economic mainstream, the Neoclassical belief that the economy is self-correcting became dominant once more, and economists trained in this belief came to dominate Treasuries and Central Banks around the world. They ignored levels of private debt, championed deregulation of finance, and virtually encouraged asset price speculation.

Now we have twice as much debt as caused the Great Depression, and inflation so low that, were it not for unprecented factors (the rise of China, global warming and peak oil), deflation would almost be a certainty.

Having thus unlearnt the real lessons of the Great Depression, the economics profession may yet make us relive it."

"I can be pro-inflation and anti-gold at the same time because I have supreme confidence in the ability of our economic managers to FAIL to cause inflation. So I actually expect deflation in the future, in which case the money price of gold may well fall (though it will surely fall less than other commodities).

However, I could be gazumped by global warming and peak oil, which could cause the inflationary surge that our economic managers will finally realise is needed, but not know how to consciously cause. There is also the slim possibility that truly over the top increases in fiat money could trigger a hyperinflation.

So given those two possibilities, I’m not anti-gold; it depresses me to say that I have actually started considering whether I might put some of my money into gold. But I would still prefer to remain in both bank deposits and my super fund’s so-called cash accounts."

Public interest in private actions

In the complexity of modern commerce it should be recognised that there is no such thing as a "self-regarding" or a private action. ... Every industrial action, however detailed in character, however secretly conducted, has a public import, and necessarily affects the actions and interests of innumerable persons. Indeed it is often precisely in the knowledge of those matters regarded as most private, and most carefully secreted, that the public interest chiefly lies. Yet so firmly rooted in the business mind is the individualistic conception of industry, that any idea of a public development of those important private facts upon which the credit of a particular firm is based, would appear to destroy the very foundation of the commercial fabric.

But, although in the game of commerce a single firm which played its hand openly while others kept theirs well concealed might suffer failure, it is quite evident that the whole community interested in the game would gain immensely if all the hands were on the table. Many, if not most, of the great disasters of modern commercial societies are attributable precisely to the fact that the credit of great business firms, which is pre-eminently an affair of public interest, is regarded as purely private before the crash.

The Evolution of Modern Capitalism: A Study of Machine Production by John A Hobson, published 1906

Deflation or Inflation?

Two scenarios are receiving increasing attention in assessments of the US economic outlook – inflation and deflation. Some assessments favour a combination of both – such as a severe deflation followed by inflation, or hyperinflation. Others feel that successive development of alternating deflationary and inflationary periods of increasing intensity is more likely, leading ultimately to a collapse of confidence in the US economy.

With the inflationary scenario, the rise in total US debt becomes so extreme that the level of interest rate required to attract ever higher international capital inflows seriously damages GNP growth. Faced with this dilemma, the Federal Reserve will have no choice but to relax its policies (as it is currently doing), and expand money supply with ultimately inflationary consequences. The interest rate reductions will debase the currency by allowing the real value of debt to be inflated away, a collapse in support for the USD abroad, and together with a retreat into gold by many USD holders.

With the deflationary scenario, proponents see similarities between the 1930s and the current situation. In their scenario, the debt explosion becomes too large to be serviced in many parts of the economy. Asset liquidation becomes endemic, forcing prices down, creating debt deflation in a vicious downward spiral with continuing attrition of debt collateral. Personal incomes and consumer confidence plunge, causing a contraction in spending. As faith in the USD evaporates, there is a flight into gold and other safe haven currencies.

The position of the USD as the major international reserve currency is pivotal to the unfolding of either scenario. The prospect of currency debasement through a monetary reflation by the Federal Reserve would undoubtedly provoke a flight from the dollar by foreign investors. Such a flight would cause a quick reversal of Federal Reserve policy and a surge in domestic interest rates, in an attempt to maintain investor confidence. This move would eventually undermine the corporate sector by raising debt servicing costs in an economy in recession, thereby ultimately triggering a credit collapse with consequent deflationary effects.

It is not possible to prove or disprove these theories and scenarios. Nonetheless, it is sufficient to note that the US has been on a track of increasing financial instability for 40 years and that inflation has been checked only by periodic credit crunches which have triggered debt crises, followed by another round of monetary stimulus.

Nevertheless, the evidence now accumulating in the financial and banking sectors suggests that the outcome is more likely to be a deflationary depression. There is no evidence of new developments in the US economy at this time that might transform international disinterest in the USD. Consequently, the US deficit will have to be internally funded in the future – unless the authorities choose some unforeseen strategy such a mobilising US gold reserves into gold swaps. The question is, however, whether internal funding is a practical option under the circumstances?

The old remedy of inflating out of this predicament by issuing cheaper and cheaper money into the banking system simply will not work this time. The reason is simple – the country is already awash with too many debtors.

Corporations, individual, and the Federal government are already suffering from a gigantic surfeit of debt, from the highest debt total to GNP levels in recent US history. The Federal Reserve can no longer make the inverted debt pyramid grow because the debtors in it are too illiquid – they are unable to go further into debt – no matter how attractive the authorities make interest rates. The lever of expansionary money has been pulled once too often. The next phase will be the rapid descent of investors down the inverted debt pyramid from illiquid assets such as property into quality money – including gold – at the inverted apex. This phase will be prompted by a collapse in confidence in the dollar – triggered possibly by the collapse of a major bank, the stock market, and/or the bond market.

In any case, as it is made clear above, the situation now emerging has all the hallmarks of an insoluble dilemma for the US authorities. Against the background of the global capital crunch, the decline of foreign savings to fund the increasing deficit, the growing global economic contraction, the deflationary or inflationary scenarios are both insoluble. There are no solutions that do not involve a dramatic transformation of the USD in international financial markets, and its role as the reserve currency. Both scenarios ultimately lead to a flight to quality money and liquidity, out of the USD and into gold and other currencies.

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Unfortunately I cannot take credit for the insightful words above. They were written by my former boss - Michael Kile. What is shocking is that they were written in February 1991, one chapter in a 40 page document titled "The case for gold in the 1990s", published by the Perth Mint.

Consider that I had only to remove a few sentences (which included giveaway dates and figures) for it to read as if it was written in 2008. It is worth re-reading it with the understanding that the analysis is 17 years old and realise that during those 17 years the US got away with "the old remedy of inflating out of this predicament by issuing cheaper and cheaper money".

The question is: will the US get away with it this time, or will Mr Kile be finally correct that the old remedy "simply will not work this time"?

The 1974 Liquidity Squeeze in Australia

Googling for background on the Banking Act for a future blog, I found a paper titled "A History of Last-Resort Lending and Other Support for Troubled Financial Institutions in Australia" (http://www.rba.gov.au/rdp/RDP2001-07.pdf).

I had an unnerving déjà vu experience when reading Section 10 (except the bank run part, maybe that is next). Below are some extracts.

"Section 10 The 1970s

Following the comparative calm of the 1950s and 1960s, the growth of non-bank financial institutions fuelled a property boom in the early 1970s. The 1974 liquidity squeeze brought the boom to an abrupt end. The failure of a number of property financiers precipitated runs on building societies in several states, particularly South Australia and Queensland. Building societies in Queensland also experienced difficulties in 1976 and 1977. Weakness in the property market brought down the Bank of Adelaide later in the decade. The Reserve Bank provided some liquidity support in each of these cases, although it did not lend directly to non-banks.

10.1 The 1974 Liquidity Squeeze

Following a boom in lending by banks and non-bank financial institutions, the Reserve Bank tightened monetary policy in 1973. This was accompanied by a drain in liquidity resulting from a deterioration of the balance of payments and a government budget surplus. As interest rates soared, property prices began to collapse triggering the failure of several property development companies.

On 30 September 1974, the property financier Cambridge Credit went into liquidation. The failure of two other substantial property developers (Home Units Australia in July and Mainline Corporation in August) preceded Cambridge Credit’s closure. While those failures prompted sharp falls in the share prices of other property developers, finance companies and banks, Cambridge Credit’s failure saw public nervousness spread directly to other financial intermediaries. The following day, runs developed on building societies in NSW, Victoria, Queensland and South Australia. While the runs in NSW and Victoria were comparatively small, the runs in Queensland and South Australia were far more severe.

...

Although the Hindmarsh Building Society in South Australia was financially sound, it was subject to the most severe run. The run, based on rumours the society had lent to failed property companies, continued, little affected by the Acting Treasurer’s statement. The run exhausted the society’s cash reserves. The National Australia Bank lent the society cash until the National also ran low. On 3 October, the South Australian Premier, Don Dunstan, addressed customers queuing outside the Hindmarsh’s offices, assuring them that their funds were safe. The run subsided the next day."

For "youngsters" like me (I was only 5 years old when this liquidity squeeze occurred) I would also recommend reading "Appendix A: Financial Disturbances in Australia – A Chronology". Runs happen. Interesting question is whether the public these days would be comforted by a statement by a politician that all is OK. Maybe they will be, is there any proof that society has gotten any smarter? If anything one could argue they have gotten stupider and more greedy and are just as invested in keeping the system going so will want to believe there isn't any fundamental problem with the system. Coming soon to a theater near you: The F-Files: I Want to Believe in Fiat Currencies.

I also found some other interesting comments about legal tender gold backed notes in the paper:

“High-powered money consists of those forms of money that are directly exchangeable for real goods (i.e. commodity money, such as gold coin, and instruments declared to be legal tender). While, up until 1910 the notes issued by banks and backed by gold were also highly liquid, the fact that their widespread acceptance relied on public confidence in the banks that issued those notes indicated that they were one step removed from high-powered money.”

“In 1910, the Federal Government’s legal-tender note issue was introduced. Initially, it was required that the government’s gold reserve cover one-quarter of the value of notes issued up to £7 million. For any note issuance above £7 million, one-for-one backing was required. In 1914, however, the gold reserve provision was relaxed so that the required gold reserve was one-quarter of the value of notes on issue regardless of the size of the total note issue.”

“The bank [Commonwealth Bank] was required to maintain a minimum gold reserve of 25 per cent of the notes on issue (although the required gold reserve was reduced to 15 per cent in June 1931). Although Australia went off the gold standard at the end of 1929, it was not until the introduction of new banking legislation in 1945 that the gold reserve requirement was completely abandoned.”

I like the term "high-powered money". I wonder if this is some defined academic term or just made up by the authors? History lesson for today - get hold of some high-powered money!