Speech to senior representatives of the UK pension fund industry
Last week I spoke at the Open Forum Seminar organized by the European Pension Fund Investment Forum (EPFIF). The event was held at The Magic Circle, an organization for magicians that runs a theatre and a museum in London, both dedicated to the art of magic. Hence, the title of the seminar “Watching your money disappear.” Below is a transcript of my speech. Needless to say – but I say it anyway – the views expressed below are mine and not those of the EPFIF, any of the pension funds or any other speakers present at the event.
Ladies and gentlemen, ‘watching your money disappear’ – I could not think of a more fitting motto for an investment conference at this time. I believe disappearing money will be the major event of the present decade, and it will not just have major implications for your business, it will have grave consequences for society at large.
The money itself may not in fact disappear (although some of it probably will) but money’s value will disappear, moneys purchasing power. This will not be the result of an act of magic but will simply be the consequence of our monetary arrangements and the established course of policy. Future historians will be surprised that anybody could have seriously contemplated a different and much happier outcome for today’s system of unconstrained fiat money production.
Can the path of policy be changed and can our money still be saved? – Theoretically, yes, but practically – I doubt it. The system has check-mated itself. Large sections of society, first and foremost the financial sector and the government, are by now incurably addicted to cheap credit, and no central banker will have the guts to cut off society from an ever more generous flow of paper and electronic money to keep the illusion of widespread prosperity and solvency alive. The destruction of money is all but inevitable.
I am not talking here about some elevated levels of consumer price inflation for a number of years. I am not referring to the childish hope that a somewhat higher inflation rate could help us painlessly ‘inflate our debt away’, and would thus constitute more of a solution than a problem. I am talking about a proper currency crisis. Hyperinflation. Monetary breakdown. Money disappearing.
For most people this seems to be an extreme scenario. It doesn’t happen in prosperous, stable societies that are not in the grips of war or revolution. It cannot happen in the UK, or the US, or Germany? Or Japan? – Or can it?
… it happened more often than we think.
In fact, throughout history, every experiment with complete paper money systems – systems in which the money supply is not restricted by the available stock of a scarce commodity such as gold or silver but in which it is entirely unconstrained –, every experiment with totally elastic money ended in failure.
Paper money had already been tried – and it failed – in ancient China but most of the experiments with unconstrained money were conducted over the past 300 years, when modern banking became a big business.
Banking has, from its start, been more than just lending out what has been saved and deposited with the bank. Banking has from its inception involved the banker issuing new forms of money, money substitutes or money derivatives, when money proper was still gold or silver.
Such money-substitutes were banknotes and bank-deposits that the banker promised to convert back into gold or silver at any time, and this promise made these money derivatives as fungible as gold or silver. But, crucially, the banker issued more of these derivatives than he had physical gold or silver in his vault. Issuing such substitute forms of money made banking particularly profitable but equally risky. When depositors demanded to be paid in money proper – gold or silver –, bank runs and panics ensued, leading to economic contractions.
For obvious reasons, the state frequently felt compelled over the past 300 years to bail out the banks – that is, to lift the requirement of banks to repay in gold and silver and still allow banks to continue as going concerns – and to thus convert the system from hard commodity money (gold or silver) to soft paper money. This allowed more bank credit expansion from which the state itself benefited.
So, over the past 300 years, we had numerous experiments with paper money. All these experiments ended in failure – after inflation rose and other problems invariably materialized, the authorities either returned to some hard money voluntarily, usually by again linking their money to the precious metals, or they missed the point when this was still possible, and confidence in paper money evaporated completely, and the system ended in total currency collapse and economic chaos.
The beauty of gold and silver as monetary assets is precisely that they provide a straitjacket for banks and governments. Gold standards have not collapsed – as we are frequently told – they were abolished because states and banks detested the straightjacket.
It is not surprising that the pinnacle of gold money – a global gold standard that encompassed the entire industrialized world – lasted from 1879 to 1914, a period when the reigning ideology globally was Classical Liberalism, largely a British and French invention: laissez-faire, limited government and free trade. This was a period of unsurpassed gains in prosperity, of strong growth and largely harmonious economic relations between nations. It was also the first period of real globalization.
It is also not surprising that the 20th century – marked by the dominance of big state ideologies, such as socialism, communism, fascism, Nazism, and more recently social democracy- , was most hostile to gold money and to any limitations on the government’s meddling in monetary affairs. The Bolsheviks confiscated gold, the Nazis confiscated gold, Roosevelt, when he introduced the New Deal, confiscated gold. Almost all hyperinflations that were ever recorded in history occurred in the 20th century – usually that number is put at around 30, although some argue now that it should be closer to 50.
The countries that experienced proper hyperinflations, now defined by economic historians as inflations with documented rises in CPI of more than 50% in a single month, in the 20th century, include Austria, Germany (2x), Hungary (2x), Poland (2x), Russia (2x), China, Greece, the Philippines, Taiwan, Yugoslavia, Armenia, Azerbaijan, Belarus, Bosnia & Herzegovina, Bulgaria, Estonia, Georgia, Latvia, Lithuania, Moldova, Ukraine, Uzbekistan, Peru (2x), Argentina, Brazil, Chile, Nicaragua, Angola, Zimbabwe, Zaire, and the Democratic Republic of Congo.
A lot of paper currencies disappeared in a ball of fire in the 20th century but the pound sterling is still here, and I am sure you are taking comfort from this.
The pound is indeed the oldest currency still in use today. Yet, please remember that through most of its very long history the pound was linked to silver and then to gold, which put tight restrictions on its issuance. After World War 2, the pound was not linked to gold directly but indirectly via the dollar. Under Bretton Woods, the dollar had become the global reserve currency, and central banks received a promise from the US government that they could exchange their dollar holdings at any time for physical gold at the fixed price of an ounce. (Sounds a bit like those promises from the bankers, remember?) This meant the global reserve currency was tied to gold and its supply thus inherently restricted.
This lasted until August 15, 1971, when Richard Nixon defaulted on the United States’ promise to redeem dollars in gold, and since 1971, for the first time in human history, the entire world is on fully flexible, entirely unconstrained fiat money. The inflation that sterling experienced since 1971 is the highest over any 40-year span in British history, including previous periods during which the currency was off silver or gold.
It took the Roman emperors, who also had a penchant for monetary debasement, 200 years to debase their silver coins by 90 percent, as they had to clip coins, a rather arduous process. It took the Bank of England only 41 years to devalue the purchasing power of the pound by 90 percent. This says something about the higher productivity of modern central banking, and it may be one of the reasons why Britain awarded Mervin King an OBE.
By comparison, the dollar lost, since 1971, about 80 percent of its purchasing power, also the largest devaluation in its long history.
The reason for these inflations is obvious: fiat money creation on an unprecedented scale. We are still in the middle of an unsurpassed global orgy of money printing. What are the consequences? – We are often told that since the 1980s, inflation is roughly under control – not to worry. But money expansion has continued, and a lot of the inflation has been concentrated – for the past 20 to 30 years – in asset markets.
Around the world we have experienced spectacular asset price inflations: in equities, bonds and real estate – I do not have to remind this audience. Owners of financial assets and real estate, and those working in the financial industry, were among the largest beneficiaries of this massive inflation.
In the ten years prior to the start of the present financial crisis, US home prices rose 3 times faster than in the preceding 100 years, and total mortgage debt outstanding almost tripled from .8 trillion to .5 trillion.
The constant cheapening of credit through money expansion has led to an astonishing accumulation of debt. In 1971, overall debt to GDP stood roughly at 170 percent in the US, now it is close to 400 percent and thus about twice as large as at the start of the Great Depression.
With the even more aggressive debasement policy of the Bank of England, the UK has now overall debt that is about 5 times annual GDP, which makes Britain next to Japan the most highly levered society on the planet.
Is it any wonder that large parts of society have now become utterly dependent on cheap money? Is it a surprise that the savings rate is low and that the UK has become a nation of real estate punters? Is it any wonder that banks have become ‘too big to fail’ and that the size of banker’s bonuses has become a topic of public debate?
40 years of unconstrained and persistent fiat money creation, of artificially cheap credit and relentless bank credit expansion, have created a monster.
The dislocations at the heart of the global financial crisis are the same around the world: overextended banks, inflated asset markets and excessive levels of debt, now mainly public sector debt.
These imbalances would be inconceivable – certainly in their present magnitude – in a system of hard money. They require constant monetary expansion on the scale that only our fully elastic fiat money system allows.
Credit expansions and corrections did, of course, occur under the gold standard but they were on a much smaller scale. Gold (or silver) were inelastic, they could not be produced at will and injected into the financial system by the central bank When credit booms ended, they did end, and recessions were allowed to unfold and to cleanse the economy of the excesses from the previous boom.
But for the last 40 years, central banks have ‘managed’ recessions. Whenever deleveraging and credit contraction threatened to set in, central bankers lowered interest rates, printed some extra bank reserves, and bought the credit super-cycle another round.
The present crisis is not a business cycle phenomenon, it is not an accident, or the unfortunate result of policy errors – it is the inevitable outcome of 40 years of persistent fiat money expansion, monetary debasement, cheap credit and easy money.
Can this go on forever? No, it certainly cannot. This will end, it will end badly and probably soon.
Why soon? – Because around the world we have pretty much reached the endgame: Policy rates everywhere are now at zero and central banks around the world are using their own balance sheets to prop up banks and select asset markets. Again, the Bank of England is among the most eager money-printers and can rightfully claim the title ‘Queen of QE’. The BoE has already monetized about a third of Britain’s public debt. But forget the little differences between central banks that keep the editors of the FT busy: Fact is, ALL central banks use their own balance sheets to keep the financial system from contracting.
The major centrals banks have now a combined balance sheet in excess of trillion dollars, which is up from trillion only 10 years ago. Global central banks’ assets now comprise a quarter of all global GDP – up from only 10 percent in 2002. It is self-evident that these assets would trade at very different prices if they had to be placed in the free market.
Without these massive interventions the market would do what it always does when a credit boom has gone too far – it would liquidate what it considers unsustainable.
What is the endgame?
Only two outcomes are logically possible: Either monetary authorities stop their interventions at some point, stop the money printing and the manipulation of interest rates and asset prices, and allow the market to set prices and risk premiums freely. We would certainly go through a period of correction, of deleveraging, default and most certainly deflation, but at the end of this process the economy would be back to something that resembles balance and that is sustainable. However, this is today considered politically unacceptable, and no politician wants to have this happen on his watch.
The second alternative is to keep intervening in markets, but it is the law of intervention that once you fix some prices you have to fix others. Intervention begets more intervention. We already see this in monetary policy everywhere: There is no exit strategy. There is no end to quantitative easing. This policy will continue ad infenitum.
This policy will undermine money’s purchasing power without ever solving the underlying problems of the economy. Eventually, inflation concerns will materialize, money will become a hot potato and confidence in the system will evaporate. We then face an inflationary meltdown and economic chaos.
As the great Austrian economist Ludwig von Mises wrote in 1949:
“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”
Against this bleak backdrop, what is my advice to you? Well, sadly, I have no advice, other than ‘Don’t start here!’
If the forces of liquidation and correction get the upper hand, many asset prices will decline steeply. Real and nominal returns will suffer. If, on the other hand, the forces of policy maintain the upper hand, the policy of quantitative easing and easy money, then you face an inflationary endgame, in which real income on your assets will get decimated. The latter is the more likely outcome in my view.
The part of your portfolio that looks most vulnerable is bonds, in particular government bonds. I think government bonds are an ideal investment in this environment if you have a financial death wish.
I know that these bonds have delivered good returns in recent years on a marked-to market- basis. Of course, they have. These are uncertain times and all portfolio managers have learned in portfolio manager school that government bonds are ‘safe assets’, so everybody is presently piling into safety. But this safety is a myth.
If the central banks stop the printing press (and if paper money gets another lease on life) most governments – including Her Majesty’s – are bust. Their bonds will be defaulted on – as indeed they should be, in my view but that is a different topic. They will have to be “restructured”.
If the central banks keep printing money – and remember: NO EXIT STRATEGY! – it will end in an inflationary disaster.
For the bond investor it is either death by drowning or death by hanging. These bonds will not be repaid with anything valuable, that much is certain.
Yet, the pension industry has almost consistently increased its allocations to bonds. Ten years ago, UK pension funds had only about 18 percent of their assets allocated to bonds, now it is about 40 percent. I am aware that state regulation played a major role in this. The state scrapped tax relief on dividends in 1997 and introduced minimum funding requirements; in 2004 it introduced statutory funding requirements, a Pension Protection Fund and a Pension Regulator. In aggregate, the changing regulatory landscape has helped shift DB pension funds from equities to bonds. I believe that this is now a dangerous position to be in.
Since 2006 the volume of outstanding gilts has almost tripled and the Bank of England now plays an essential role in supporting the gilt market. Today, the Bank of England holds more gilts than all insurance and pension funds in the country combined.
This is a rigged market. The bubble in government bonds may not pop this year or next but it will pop eventually. This bubble sits at the heart of the present overstretched fiat money system. The implications will be much more meaningful than with any other previous bubbles. As Canadian fund manager Eric Sprott put it: “When they stop buying bonds, the game is up.” Then you will see a lot of money disappear.
Source: Paper Money Collapse
