The European Central Bank (ECB) led by Mario Draghi has decided to cut its main lending rate to 0.05% from the current 0.15%. It has also decided to cut the deposit rate to –0.2%. European banks need to maintain a certain portion of their deposits with the ECB as a reserve. This is a regulatory requirement. But banks maintain excess reserves with the ECB, over and above the regulatory requirement. This is because they do not see enough profitable lending opportunities. As of July 2014, the banks needed to maintain reserves of €104.43 billion with the ECB. Banks had excess reserves of € 109.85 billion over and above these reserves. The ECB was paying a negative interest rate of –0.1% on these reserves. Now it will pay them –0.2% on these reserves. This means that banks will have to pay the ECB for maintaining reserves with it, instead of being paid for it. These rate cuts have taken the financial markets by surprise. When the ECB had last cut interest rates in June earlier this year, it had indicated that would go no further than what it had at that point of time. Nevertheless it has. So what has prompted this ECB decision? In August 2014, inflation in the euro zone (countries which use euro as their currency) dropped to a fresh five year low 0.3%. In fact, in several countries prices have been falling. From March to July 2014, prices fell by –1.5% in Belgium, –0.4% in France, –1.6% in Italy and –1% in Spain. In an environment of falling prices, people tend to postpone their purchases in the hope of getting a better deal in the future. This, in turn, impacts business revenues and economic growth. Falling business and economic growth leads to an increase in unemployment. And this has an impact on purchasing power of people. Those unemployed are not in a position to purchase beyond the most basic goods and services. And those currently employed also face the fear of being unemployed and postpone their purchases. The rate of unemployment in the euro zone stood at 11.5% in July 2014. This has improved marginally from July 2013, when it was at 11.9%. The highest unemployment was recorded in Greece (27.2 % in May 2014) and Spain (24.5 %). Hence, the ECB has cut interest rates in the hope that at lower interest rates, people will borrow and banks will lend. Once this happens, people will borrow and spend money, and that will lead to some economic growth. But is that likely the case? The numbers clearly prove otherwise. In June 2014, the ECB decided for the first time that it would charge banks for maintaining excess reserves with it. In April 2014, the excess reserves of banks with the ECB had stood at € 91.6 billion. The hope was that banks would withdraw their excess reserves from the ECB and lend that money. The excess reserves have since increased to € 109.85 billion. What does this tell us? Banks would rather maintain excess reserves with the ECB and pay money for doing the same, rather than lend that money. The ECB had cut the interest rate on excess deposits to 0% in July 2012. Hence, the negative interest rate on excess deposits has been around two years, without having had much impact. In fact, the loans made to companies operating in the euro zone is currently shrinking at 2.3%. Also, banks always have the option of maintaining their excess reserves in their own vaults than depositing it with the ECB. They can always exercise that option and still not lend. Interestingly, in July 2012, the central bank of Denmark had taken interest rates into the negative territory. The lending by Danish banks fell after this move. The Draghi led ECB has also decided to crank up its printing press and buy bonds, though it refused to give out the scale of the operation. The ECB plan, like has been the case with other Western central banks, is to print money and pump that money into the financial system by buying bonds. This method of operating has been named “quantitative easing” by the experts. The Federal Reserve of United States, the Bank of England and the Bank of Japan have operated in this way in the past. The hope as always is to ensure that with so much money floating around in the financial system, banks will be forced to lend and this, in turn, will rekindle economic growth. The ECB has plans of printing money and buying covered bonds issued by banks as well as asset backed securities(ABS). Covered bonds are long-term bonds which are “secured,” or “covered,” by some specific assets of the bank like home loans or mortgages. The ABS are essentially bonds which have been created by “securitizing” loans of various kinds. The size of the ABS market in Europe is too small, feel experts, for these purchases to have much of an impact. Nick Kounis, an economistat ABN Amro told the Economist that “the likely size of possible purchases would be €100 billion to € 150 billion.” This is too small to make any difference. Bonds covered by home loans and worth buying could amount to another € 500 billion. Further, the buying of ABS is unlikely to begin at once. As Ambrose Evans-Pritchard of The Telegraph put it on his blog “Buying may not begin in earnest until early next year since the ABS market is not ready.” All this makes Evans-Pritchard conclude that “this would be a form of “QE lite” but it would be trivial compared with the huge operations of the Bank of Japan and the US Federal Reserve, together worth €120bn a month at their peak.” If the ECB has to launch a serious form of quantitative easing it needs to be buying government bonds. But any such move is likely to be opposed by the Bundesbank, the German central bank. As the Economist put it “such an intervention would be bitterly opposed by the Bundesbank on the grounds that it would redistribute fiscal risks among the 18 member states that belong to the euro.”
In July 2012, Mario Draghi, president of the European Central Bank (ECB) had said that “the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” Yesterday, the ECB cut its deposit rate to – 0.1%. European banks need to maintain a certain portion of their deposits with the ECB as a reserve. This is a regulatory requirement. But banks maintain excess reserves with the ECB, over and above the regulatory requirement. This is because they do not see enough profitable lending opportunities. In April 2014, the European banks had excess reserves amounting to € 91.6 billion. This was over and above the reserve of €103.6 billion that they needed to maintain as per regulatory requirement. The ECB currently pays no interest on the excess reserves of banks. With effect from June 11, 2014, it will pay an interest of – 0.1% on the excess reserves. What this means is that the ECB will charge the banks for any excess reserve that they maintain with it. This has been done to ensure that the banks do not maintain any excess reserves with the ECB and go out and lend that money instead. The lending to the private sector in Europe has been declining at the rate of 1.8%. Over and above this, the economic growth in the Euro Zone (18 countries in Europe which use Euro as their currency) has been very slow. During the period of January to March 2014, the economic growth was at a minuscule 0.2%. The Eurzo Zone managed to avoid an economic contraction primarily due to a strong performance by the German economy. What this means is that economies of certain countries in Europe are contracting. Economies of Italy, Holland and Portugal contracted during January-March 2014. The economy of France did not grow at all. What makes the situation worse is the latest inflation number. In May 2014, the inflation in the Euro Zone fell to 0.5%. It was at 0.7% in April 2014. This is well below the ECB’s target inflation of 2%. If inflation keeps falling, the Euro Zone will soon be experiencing a deflationary scenario in which prices will keep falling. In such a scenario people will postpone consumption in the hope of getting a better deal in the days to come. And this will further impact economic growth. Due to these factors the Draghi led ECB has decided to cut the deposit rate to – 0.1%. The hope is that banks will withdraw their excess reserves from the ECB and lend that money. But how good are the chances of something like that happening? The ECB had cut the interest rate on excess deposits to 0% in July 2012. Its been around two years since then and as mentioned earlier the lending to the private sector in Europe has been going down at the rate of 1.8%. Also, banks always have the option of maintaining their excess reserves in their own vaults than depositing it with the ECB. They can always exercise that option and still not lend. Interestingly, in July 2012, the central bank of Denmark had taken interest rates into the negative territory. The lending by Danish banks fell after this move. Banks will go slow on lending unless they feel that their lending will turn out to be profitable. And that is something the ECB or for that matter any central bank, cannot do much about. So, that brings us back to the question of why did the ECB take interest rates into the negative territory? The only possible answer seems to be that ECB wants to weaken the euro against other currencies. The euro has appreciated against the yen since October 2012. In October 2012, one euro was worth around 100 yen. Currently, one euro is worth around 140 yen. This has happened because of the massive money printing carried out by by the Bank of Japan, the Japanese central bank, since early 2013. Germany is the export powerhouse of Europe and competes directly with Japan in many hi-tech sectors. Nevertheless, despite the euro appreciating against the yen, the Eurozone as a whole has been running a trade surplus i.e. its exports have been greater than its imports. In February 2013, the Eurozone ran a trade surplus of €13.6 billion. This is primarily because a collapse in demand in many Eurozone countries has led to a significant cut down in imports. Also, with a collapse in internal demand businesses have been forced to look for external growth. Now with the ECB looking to cheapen the euro, it will lead to German exports becoming more competitive than they were in the past and this in turn will push up the trade surplus of the Eurozone further. Whether this will benefit countries in the Eurozone other than Germany, remains to be seen. In a press conference yesterday, Mario Draghi said “We think this is a significant package…Are we finished? The answer is no. If required, we will act swiftly with further monetary policy easing. The Governing Council is unanimous in its commitment to using unconventional instruments within its mandate should it become necessary to further address risks of prolonged low inflation ” Speculation is rife that the Draghi led ECB will soon enter the full blown quantitative easing territory and print money to buy bonds, something that the Federal Reserve of the United States and the Bank of Japan have been doing for a while now. But it may not be so easy to initiate quantitative easing in the Eurozone, given that 18 countries of the Eurozone will have to support the decision. But as Guntram B. Wolff, director of Bruegel, a research organization in Brussels told The New York Times “The conventional measures are all done…What remains is quantitative easing.” In short, the era of “easy money” will continue.
Half way through the interview, I ask him where does he see the price of gold reaching in the days to come. “Well, I don’t see gold’s trajectory being typical of what you’d expect to see in a bull market….And I expect that physical gold will be repriced somewhere around $55,000 per ounce in today’s purchasing power. I have to add that purchasing power part because it will likely be concurrent with currency devaluation,” he replies. Meet FOFOA, an anonymous blogger whose writings on fofoa.blogspot.com have taken the world by storm over the last few years. In a rare interview he talks to Vivek Kaul on paper money, the fall of the dollar, the coming hyperinflation and the rise of “physical” gold. The world is printing a lot paper money to solve the economic problems. But that doesn’t seem to be happening. What are your views on that? Paper money being printed to solve the problems… this was *always* on the cards. It doesn’t surprise me, nor does it anger me, because I understand that it was always to be expected. The monetary and financial system we’ve been living with—immersed in like fish in water—for the past 90 years uses the obligations of counterparties as its foundation. These obligations are noted on paper. In describing the specific obligations these papers represent, we use well-known words like dollars, euro, yen, rupees and yuan. But what do these purely symbolic words really mean? What are these paper obligations really worth in the physical world? Ultimately, after 90 years, we have arrived at our inevitable destination: the intractable problem of an unimaginably intertwined, interconnected Gordian knot of purely symbolic obligations. A Gordian knot is like an unsolvable puzzle. It cannot be untangled. The only solution comes from “thinking outside the box.” You’ve got to cut the knot to untangle it. So the endgame was always going to be debasing these purely symbolic units. Anyone who expected anything else simply fooled themselves into believing the rules wouldn’t be changed. Do you see the paper money continuing in the days to come? Yes, of course! Paper money, or today’s equivalent which is electronic currency, is the most efficient primary medium of exchange ever used in all of human history. To see this you only need to abandon the idea of accumulating these symbolic units for your future financial security. They aren’t meant for that! They are great for trading in the here-and-now, not for storing for the unknown future. To paraphrase Silvio Gesell, an economist in favor of symbolic currency almost a century ago, “All the physical assets of the world are at the disposal of those who wish to save, so why should they make their savings in the form of money? Money was not made to be saved!” In hindsight, this statement is true whether money is a hard commodity like gold or silver, or a symbolic word like dollar, euro or rupee. In both cases, saving in “money” leads to monetary tension between the debtors and the savers. When money was a hard commodity, this tension was sometimes even released through bloodshed, like the French Revolution. So no, I don’t think we’re swinging back to a hard currency this time. Do you see the world going back to the gold standard? No, of course not! “The gold standard” means different things depending on which period you are talking about. But in all cases it used gold to denominate credit, the economy’s primary medium of exchange. Today we have a really efficient and ultimately flexible currency. Bank runs like the 1930s are a thing of the past. But that’s not to say that gold will not play a central role in the future. It will! The signs of it already happening are everywhere! Gold is not going to replace our primary medium of exchange which is paper or electronic units with those names I mentioned above. Instead, physical gold will replace paper obligations as the reserves—or store of value—within the system. Physical gold in unambiguous ownership has no counterparty. This is a much more resilient foundation than the tangled web of obligations we have today. Can you give an example? If you’d like to see this change in action, go to the ECB (European Central Bank) website and look at the Eurosystem’s balance sheet. On the asset side gold is on line 1 and obligations from counterparties are below it. Additionally, they adjust all their assets to the market price every three months. I have a chart of these MTM (marked to market) adjustments on my blog. Over the last decade you can see gold rising from around 30% of total reserves to over 60% while paper obligations have fallen from 70% to less than 40%. I expect this to continue until gold is more than 90% of the reserves behind the euro. Where do you see all this money printing heading to? Will the world see hyperinflation? Yes, this will end. I am pretty well known for predicting dollar hyperinflation. As controversial as that prediction is, I think it is a fairly certain and obvious end. I don’t like to guess at the timing because there are so many factors to consider and I’m no supercomputer, but ever since I started following this stuff I’ve always said it is overdue in the same way an earthquake can be overdue. As for other currencies, I don’t know. Perhaps yes for the UK pound and the yen, but I don’t know about the rupee. The important things to watch are the balance of trade and the government’s control over the printing press. If you’re running a trade deficit and your government can (and will) print, then you are a candidate for hyperinflation. In that context what price do you see gold going to? Well, I don’t see gold’s trajectory being typical of what you’d expect to see in a bull market. Instead it will be a reset of sorts, kind of like an overnight revaluation of a currency. I’m sure some of your readers have experienced a bank holiday followed by a devaluation. This will be similar. And I expect that gold will be repriced somewhere around $55,000 per ounce in today’s purchasing power. I have to add that purchasing power part because it will likely be concurrent with currency devaluation. So, in rupee terms, I guess that’s about Rs3.2 million per ounce at today’s exchange rate. The price of gold has been rather flat lately. What are the reasons for the same? Where do you see the price of gold going over the next couple of years? “The price of gold” is an interesting turn of phrase because I use it often to express “all things goldish” in the gold market. In today’s market, “gold” is very loosely defined. What passes for “gold” in the financial market is mostly the paper obligations of counterparties. These include forward sales, futures contracts, swaps, options and unallocated accounts. I often use the abbreviation “$PoG” to refer to the going dollar price for this loose financial “gold”. The LBMA (London Bullion Market Association) recently released a survey of the total daily trading volume of unallocated (paper) gold. That survey revealed a trading flow of such magnitude that it compares to every ounce of gold that has ever been mined in all of history changing hands in just three months, or about 250 times faster than gold miners are actually pulling metal out of the ground. Equally stunning were the net sales during the survey period. The rate at which the banking system created “paper gold” was 11 times faster than real gold was being mined. What is the point you are trying to make? The point is that gold is being used by the global money market as a hard currency. But it is being treated by the marketplace as both a commodity that gets consumed and also as a fiat currency that can be credited at will. It is neither, and gold’s global traders are in for a rude awakening when they find out that ounce-denominated credits will not be exchangeable for a price anywhere near a physical ounce of gold in extremis—ironically failing at the very stage where they were expected to perform. So what are you predicting? But don’t get me wrong. It is not a short squeeze that I am predicting. In a short squeeze, the paper price runs up until it draws out enough real supply to cover all of the paper. But this paper will not be covered by physical gold in the end. It will be cash settled, and it will be cash settled at a price much lower than the price of a real ounce of gold, like a check written by an overstretched counterparty. It is a tough job to make my case for the future of the $PoG in just a few paragraphs. The $PoG will fall and then some short time later we will find that the market has changed out of necessity into a physical-only market at a much higher price. If you were holding paper you will be sad. If you were holding the real thing you’ll be very happy Why is the gold price so flat these days? Today’s surprisingly stabilized $PoG tells me that someone is throwing money into the fire to delay the inevitable. Where do I see the $PoG going over the next couple of years? Maybe to $500 or less, but you won’t be able to get any physical at that price. I think that today’s price of $1,575 is still a fantastic bargain for physical gold. Franklin Roosevelt had confiscated all the gold that Americans had in 1933. Do you see something similar happening in the days to come? Not at all! The purpose of the confiscation was to stop the bank run epidemic at that time. There’s no need to do it again. The dollar is no longer defined as a fixed weight of gold, so the reason for the last confiscation—and subsequent devaluation—no longer exists. Gold that’s still in the ground is a different story, however. Gold mines will likely be considered strategically important national assets after the revaluation, and will therefore fall under tight government control. The irony of the entire situation is that a currency like “dollar” which is being printed big time has become the safe haven. How safe do you think is the safe haven? Indeed, everyone seems to be piling into the dollar. Especially on the short end of the curve, helping drive interest rates ridiculously low. The dollar is as safe as a bomb shelter that’s rigged to blow up once everyone is “safely” inside. You can go check it out if you want to (sure, from the outside it might look like shelter), but you don’t want to be in there when it blows up. You’ve got to realize that it is both economically and politically undesirable for any currency to appreciate against its peer currencies due to its use as a safe haven. Remember the Swiss franc? As soon as it started rising due to safe haven use they started printing it back down. The dollar is no different except that it’s got a whole world full of paper obligations denominated in it. So when it blows, the fireworks will be something to behold. What will change the confidence that people have in the dollar? Will there be some catastrophic event? That’s the $55,000 question. It is impossible to predict the exact pin that will pop the bubble in a world full of pins, but I have an idea that it will be one of two things. I think the two most likely proximate triggers to a catastrophic loss of confidence are a major failure in the London gold market, or the U.S. government’s response to an unexpected budget crisis due to consumer price inflation. Most people who expect a catastrophic loss of confidence in the dollar seem to think it will begin in the financial markets, like a stock market crash or a Treasury auction failure or something like that. But I think it is more likely to come from where, as I like to say, the rubber meets the road. And here I’m talking about what connects the monetary world to the physical world: prices. I think these “worlds” are connected in two ways. The first is the general price level of goods and services and the second is the price of gold. If one of these two connections is broken by a failure to deliver the real-world items at the financial-system prices, then we suddenly have a real problem with the monetary side. So I think it will be a relatively quick and catastrophic event, but maybe not as dramatic as a major stock market crash. It will be confusing to most of the pundits as to what it really means, so it will take a little while for reality to sink in. The Romans debased the denarius by almost 100% over a period of 500 years. The dollar on the other hand has lost more than 95% of its purchasing power since the Federal Reserve of United States was established in 1913, nearly 100 years back. Do you think the Federal Reserve has been responsible for the dollar losing almost all of its purchasing power in hundred years? Yes, inflation was a lot slower in Roman times because it entailed the physical melting and reissuing of coins of a certain face value with less metal content than previous issues. This was a physical process so it occurred on a much longer time scale. The dollar, on the other hand, has lost nearly 97% of its purchasing power in roughly a hundred years. Do I think the Federal Reserve is responsible for this? Well, given that the lending/borrowing dynamic causes expansion of the money supply, I think the government and the people of the world share in the responsibility. But just because the dollar has lost 97% of its purchasing power doesn’t mean that any individual lost that much. How many people do you think are still holding onto dollars today that they earned a hundred years ago? How long would you hold dollars today? As long as the prices of things you want to buy don’t change during the time you are holding the currency, what have you lost? So imagine that you simply use currency for earning, borrowing and spending, but not for saving. Will it matter how much it falls over a hundred years? Your earning and spending will happen within a month or so, and prices won’t change much in a month. Also, your borrowing will be made easier on you as your currency depreciates. And your gold savings will rise. So with the proper use of money, there is no need for alarm if the currency is slowly falling at, say, 2% or 3% per year. Do you see America repaying all the debt that they have taken from the rest of the world? Or will they just inflate it away by printing more and more dollars? The debts that exist today can never be repaid in real terms. And as I mentioned before, they are all denominated in symbolic words like dollars, euro, yen, yuan and rupees. The debt of the U.S. Treasury, most of all, will of course be inflated away. What are your views about the crisis in Europe? Will the euro hold? Contrary to most of what we read in the Anglo-American press, I don’t think the euro currency is at risk from the sovereign debt crisis in Europe. They are two different things, the debt crisis and the euro. The euro currency faces none of the usual devaluation risks. Trade between the Eurozone and the rest of the world is balanced and the ECB has plenty of reserves. So aside from devaluation risk, which the euro doesn’t face, the only other risk is if the people decide to abandon the euro. Procedurally this would be so difficult for any country to do on a whim that I can confidently say it is virtually impossible aside from the most extreme situations like a revolutionary war or something like that. And I don’t see that happening. I think the euro survives come what may. What does FOFOA stand for? I remain anonymous because my blog is not about me. It is a tribute to “Another” and “Friend of Another” or “FOA” who wrote about this subject from 1997 through 2001. So FOFOA could stand for Friend of FOA or Follower of FOA or Fan of FOA. I never really stated what it stands for, so you can decide for yourself. 😉 Sincerely, FOFOA. (The interview was originally published in the Daily News and Analysis(DNA) on July 2,2012) (Interviewer Kaul is a writer and can be reached at [email protected])