An Imminent Collision

ON DEC. 19, WE LEARNED THAT THE BRITISH GOVERNMENT’S guarantee to bail out Northern Rock’s creditors is worth a staggering £100 billion. That’s £5,000 [$10,000] per British household. This week, the European Central Bank made $500 billion available through money market operations. And only last week, $110 billion of new money was created by central bank loans with artificially low rates and reduced-quality security. This is money creation on an epic scale.

Why is this happening now? Here’s my theory: Dec. 31 is a major day on the financial calendar. If you take a sample of bonds, you’ll find that a disproportionate number of them are due for interest and/or redemption on Dec. 31. Redeeming bonds is very cash intensive, and cash is not freely available in the banking system right now.

So it seems likely that some frantic finance directors will be working long hours to find the cash that will enable them to avoid a default next week.

If that’s right, the festive season could see the announcement of some nasty shocks. June 30 won’t be much fun, either, for the same reasons. The credit crunch is deepening, and will continue doing so until at least next summer.

For those of us who like to take responsibility for ourselves (it’s called freedom, by the way), it’s getting just a little tiresome that money creation is diluting our savings and making us pay — again — for the excesses of the buy-now-think-later generation. Some of us would prefer to see the government react with a shrug and a sympathetic “bad luck” to the losers in the next financial train wreck. But it’s not the mood of the nation. Politicians have begun one of their competitive caring phases, and they’re rescuing victims everywhere. Every clapped-out bank, every busted pension scheme, every industrial zombie, and absolutely every government department will be nurtured in the warm embrace of the public purse.

This causes a natural backlash. Issuing new money reduces depositors’ returns, prompting savers to switch to better stores of wealth. This capital flight should be easy to spot, but modern economic statistics can obscure it. You see, the main way economists measure economic health is by counting the money spent in the economy, and now that savers are dumping currency (and buying better wealth stores), the effect is tough to distinguish from the economist’s beloved GDP growth. Our healthy GDP figures are a distortion, and the economy is not making a steady booming noise, but an ominous hissing — the noise of savers abandoning the currency.

You can see this at the key entry points to the real economy:

  1. Oil is multiplying in price.
  2. All the grains are multiplying in price.
  3. All the base metals are multiplying in price.
  4. Gold is multiplying in price.
  5. Producer prices are through the roof.

In spite of this, the monetary authorities are racing to issue more money, and economists are clamouring for cuts in interest rates. They’re caught ‘twixt the devil and the deep blue sea, because although they could address these serious inflationary indicators, doing so risks the revenge of a giant economic threat — a rout in the housing market. And that would mean depression.

So it looks increasingly likely that low rates are staying, and the hot global investment money, sucked in by Britain’s recent and comparatively high interest rates, is about to quit Britain and send the currency into a tailspin. This produces higher prices for imported goods. At the same time, our public finances are in a serious mess, and the biggest contributor to our service-based economy — London — is the main victim of current turbulence. And please don’t ask about the trade figures, because they’re just ugly.

It is becoming genuinely possible that people will refuse to hold sterling for more than a fleeting moment. Inflation could turn so severe that the “hyper” prefix is justified.

I know — it’s too far-fetched to be believable. Or is it? For 150 years, the values of Western currencies have stayed way above purchasing power parity levels with Asia. Being a developed country is what drove this premium, as money flowed down a one-way street to our advanced economies. These were the only places where sophisticated products could be built or bought.

Today, things are different. You could measure circuit board production in two factories in Indonesia and in Britain and get the output per worker priced in local currency. Multiply both by their conversion rate into U.S. dollars and the British factory seems to have produced five-seven times more U.S. dollar-denominated output. So our GDP looks good, but only through the distorting lens of a Western currency conversion. There’s another way to measure that same output: Simply count the circuit boards. Do that and you’ll see there’s no material difference in productivity between a British and an Indonesian worker. Perhaps the root cause of Western currency premium has evaporated, and the anomaly is now that sterling really is five-seven times overvalued against Asian money.

You could switch to euros. But looking at the EU’s policy, it’s creating as much money as the Bank of England. And the U.S. Federal Reserve is doing it too, while all of Asia is battling to hold down its currencies so that its exports can continue apace. It’s a bizarre race to the bottom for the world’s currencies.

It’s time to sidestep the financial consequences of this largesse. What can we savers do?

If you’re as bothered as I am, currency should be struck off your Christmas list and replaced with something more reliably rare. I think gold could soon look so highly priced in sterling that many of us will be too frightened to buy it. But it isn’t there yet, so perhaps buy just a little now, and if it makes you a small profit, it will be easier to buy a little more next month. If that makes you a profit too, allow yourself to build a proper stash. I’m not sure we’ll ever again be able to buy it for much under £400 per ounce.

I have just instructed my bank to transfer all my remaining cash deposits to BullionVault to buy gold, and I look forward to spending 2008 long gold and completely sterling free.

Paul Tustain

December 27, 2007