We are now into a second week of a partial Federal Government shut-down, which is causing considerable concern, centred on the Government’s ability to finance its debt and pay interest without a budget agreed for the new fiscal year. Should this continue into next week and beyond, the Fed will have to enter damage-limitation mode if the Treasury cannot issue any more bonds because of the separate problem of the debt ceiling.
Most likely, QE will have to be
switched from financing the government to buying Treasuries already owned by
the private sector. Any attempt to reduce the monthly addition of raw money
will simply result in bond yields and then interest rates rising. And indeed, already
this week we have seen yields on short-term T-bills rise in anticipation of a
possible default. The market is naturally beginning to discount the possibility
that the Fed may not be able to control the situation.
The T-bill issue is very serious,
because they are the most liquid collateral for the $70 trillion shadow banking
system. And without the liquidity they provide securities and derivative
markets, we can say that Round Two of the banking crisis could make Lehman look
like a picnic in the park.
This is the sort of event
deflationists have long been expecting. According to their analysis there comes
a point where debt liquidation is triggered and there is a dash for cash as
assets collapse. But they reckon without allowing for the fact that deposits
can only be encashed at the margin; otherwise they are merely transferred, and
only destroyed when banks go under. This is the risk the Fed anticipates, and
we can be certain it will move heaven and earth to avoid bank insolvencies.
Furthermore the deflationists do
not have a satisfactory argument for the effect on currency exchange rates.
Iceland went through a similar deflationary event to that risked in the US
today when its banking system collapsed and the currency halved overnight.
Today a dollar collapse on the back of a banking crisis would also disrupt all
other fiat currencies, forcing central banks to coordinate intervention to
conceal the currency effect. This leaves gold as the only true reflector of
loss of confidence in the dollar and therefore all other fiat currencies.
Those worrying about deflation
ignore the fact that it is the fiat currency that takes it on the chin while
gold rises – every time without exception. This was even the experience of the
1930s, when Roosevelt suspended convertibility, increased the price of gold by
40% to $35 per ounce, and the banking crisis was contained.
Of course there is likely to be
some short-term uncertainty; but against the Fiat
Money Quantity (FMQ) gold is down 30% compared with the price pre-Lehman
crisis. This is shown in the chart below.
With gold at an extreme low in valuation terms,
current events, whichever way they go, seem unlikely to drive it much lower. A
wise man perhaps should copy the Asians, who know a thing or two about paper
currencies, and are buying gold in ever-increasing quantities.