Revolting PIIGs, A Golden Hope?

Almost a year to the day on June 27th, 2011 I wrote a blog for the popular alternative news broadcaster King World News. It was titled ‘Revolting PIIGs’. I made no apologies for my lack of sensibilities in a follow-up broadcast and still do not now. PIIGS is the appropriate acronym not GIIPS, as so many commentators now use having acquiesced to political correctness. If someone calls me ‘chubby’ I tend to do something about it. Get called a PIIG enough times you might hope EU member countries might do something about it. But that’s the problem try as they might to solve the problem they can’t because policymakers either do not want to understand the problem or actually just don’t understand the problem in the first place.

The problem runs much deeper than 500 years of European history, the problem lies at the heart of the construction of our banking and hence monetary system. The circular relationship between banks and sovereigns has always been the issue. Today, banks capitalise themselves to a large extent by purchasing sovereign debt. The outcome of this is two-fold. First, because under Basel capital adequacy regulations sovereign debt is afforded a zero risk weighting, no reserves need be set aside. They are essentially considered a risk free asset. Under fractional reserve methodology high powered money can be created by now lending multiple times off of these assets. Secondly it affords the sovereigns a steady home by which to fund the fiscal coffers. The central planners of banking can ably control the monopolistic issuances of fiat money and ‘moneyness’ in general; restraining any free market price discovery that provides appropriate signals for conversion of savings into much needed production.

I will re-hash in its entirety my original blog in a moment, where I discuss the relationship between sovereigns and banks; but I wanted to highlight a perhaps significant development in the treatment of gold in risk provision by the regulators. When I originally wrote the Revolting PIIGS piece I was tempted, but in the end neglected to mention that perhaps gold could be afforded the same subsidy that sovereign debt is afforded in bank risk weightings.

Gold has had a risk weighting of 50%, meaning an institution had to adjust its capital by 50% and then based on capital adequacy ratios mentioned below make appropriate reserve provisions. So if you had £4bn gold the institution has to provide capital as a proportion of only £2bn. Recent developments in the US suggest that gold may actually be offered the luxury of this very same subsidy given to sovereign debt. I originally didn’t mention it because I genuinely believed it was an unlikely event that gold could be considered a risk free asset and likewise eligible as collateral, as it flies in the face of financial repression tactics; sorry surely I mean macro-prudential regulation. Financial repression in this case refers to the coercion of the private sector to take on more sovereign debt. For example in 2009 the FSA enforced higher capital charges and take up of over £90bn of UK debt onto bank and UK based foreign bank branches. This recent gold risk weighing development has garnered very little attention, yet it could affect a significant change in understanding and application of gold within our current money system.

The Office of the Comptroller of the Currency (OCC), Federal Deposit Insurance Corporation (FDIC), in conjunction with the Federal Reserve Board of Governors, US Treasury have drawn up provisional plans to include gold in risk weighted assets (RWA) at zero percent in line with sovereign debt as part of a comprehensive review of regulatory capital rules, as well as standardizing the approach for RWAs, and enhancing market discipline and disclosure requirements. FDIC itself has released a ‘rulemaking notice’ (NPR) on this issue of proposed changes to capital requirements for banks under their supervision. FDIC’s proposal would only apply to financial institutions with less than $1bn in assets, but it is significant that it lists gold at par with sovereign as a zero risk weighted asset.

This is in contrast to the current interpretation of gold according to the Basel Committee on Banking Supervision report (2006)*- International Convergence of Capital Measurement and Capital Standards which footnotes’ state on pp.26 and pp.326 that the current stipulation on gold holds that gold may be held as zero risk weighted asset only to the extent that it matches gold liabilities:

“However, at national discretion, gold bullion held in own vaults or on an allocated basis to the extent backed by bullion liabilities can be treated as cash and therefore risk-weighted at 0%. In addition, cash items in the process of collection can be risk-weighted at 20%”.

*Basel III builds upon and enhances the regulatory framework adopted by Basel II and 2.5 provided in this June 2006 document, but as far as we understand will include the rule above in unchanged fashion from Basel 2 and Basel 2.5.

The FDIC proposal could be a game-changing event for gold if it found its way into the Basel framework, as should such rules be implemented gold will become a mainstay asset in our current monetary system, thus underpinning prices. This would be quite a deviation from previous financial regulations applied under Basel I and II. It is conceivable that in time this is as big an event for gold as the advent of central banks turning from net sellers of bullion to net buyers in 2009. For over the long run if this is employed it will add substantial demand for the metal.

The proposed effective date for the provisions of the FDIC NPR is January 1st 2015, and for BIS proposed changes come into effect also after 2015. Of equal significance is the application of gold as collateral. Observing both the FDIC NPR on pp.15 and that which exist already following BIS publication pp.35 they propose gold can be used as collateral in financial transactions by customers. I would note a passing concern that the FDIC proposal begs the question that financial institutions in the US are short of collateral. This is also a danger in Europe as the LTRO has sucked up a lot of impaired assets so maybe in time gold will also become more attractive as a zero risk weighted asset. A question to be answered another day, but I lay it out there anyway.

For a more in depth albeit brief look at this capital provisioning, which is the sickness that lies at the heart of our financial and monetary system here is the original and full ‘Revolting PIIGS’ blog text:

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Swine Influenza or what is commonly known as PIG Flu muddied our doors not long after the bout of Avian Flu. A suitable amount of press hysteria and a few years later and we humans are for now all still very much alive and kicking.

PIG Flu is quite common in pigs (unsurprisingly), with about half of breeding pigs in the US alone having been exposed to the virus. The main route of transmission is through direct contact between infected and uninfected animals. The direct transfer of the virus probably occurs either by pigs touching noses, or through dried mucus.

The hysteria that accompanied Swine Flu was in reaction to the news that avian flu virus H5N1 was endemic in pigs in China and had transmitted itself into humans. The pigs seem to be the pathogen carrier, the host to the hibernation of potentially lethal viruses. Of over 1400 pathogens known to infect humans over 60% are “zoonotic”. Zoonosis refers to any infectious disease that can be transmitted from animals (domestic or wild) to humans. The reverse, where humans infect animals is known as “anthroposis”.

I have read that airborne transmission through the aerosols produced by pigs coughing or sneezing could be an important means of infection from pigs to humans. There appears to me to be remarkable parallels with our very own man-made PIIG(S) Flu. This may not seem immediately obvious, but bear with me.

Our fractional reserve and credit based monetary system has mutated from the banking sector to the sovereign sector and back again. Socialisation of private losses, namely banking, by the public sector has been funded by the new issuance of vast amounts of sovereign debt. These are paper IOUs and worth arguably only what we believe them to be worth. A faith based system in other words.

The ‘Great Bailout’ of 2008 has exposed the fragility of our financial system. The banks and government are one and the same now. They are synonymous with each other in terms of their risk.

What we have witnessed is our very own form of zoonosis – a ‘banconosis’ if you will, where the bank’s have infected the sovereigns. But here is the kicker; all along the PIIGS’ pathogens have been sitting on the balance sheets of the banks. A form of anthroposis – ‘sovereignosis’ let’s say. Still not with me…read on.

Banks have to be appropriately capitalised, and capital was clearly something not in vast abundance when many managed to leverage themselves over 50 times. Capital was found sorely wanting when wholesale bank funding dried up.

A bank’s capital is equal to its assets minus its liabilities. It is the margin by which its creditors would be covered if assets were liquidated and its liabilities paid off. A measure of a bank’s financial health is its capital/asset ratio, which is required to be above a prescribed minimum.

In 1989 the US adopted the capital requirements established by the Bank for International Settlements (BIS) in Basel, Switzerland. The minimum capital is specified as a percentage of the risk-weighted assets of the bank. The following table shows the weight assigned to each type of asset, as an example:

Asset Risk Weight

Cash and equivalents 0

Government securities 0

Interbank loans 0.2

Mortgage loans 0.5

Ordinary loans 1.0

Standby letters of credit 1.0

The BIS rules set requirements on two categories of capital, Tier 1 capital and Total capital:

Tier 1 capital is the book value of its stock plus retained earnings. Tier 2 capital is loan-loss reserves plus subordinated debt. Total capital is the sum of Tier 1 and Tier 2 capital.

Tier 1 capital must be at least 4% of total risk-weighted assets. Total capital must be at least 8% of total risk-weighted assets.

One can see from one of the categories above that ‘Government securities’ – government bonds to you and I – carry zero risk provision which means banks buy this sovereign debt to capitalise themselves knowing they can lend out at least 10 times on this without breaching capital adequacy ratios. Today some 1.7 to 2.5 trillion euros worth of PIIGS/peripheral sovereign debt sits on the balance sheets of northern European banks.

PIIGS debt received AAA rated status on inception of the euro, piggy-backing on the inflation-busting, high credit status of the northern European countries, Germany in particular. This made them highly eligible for bank capital. So the banks lent prodigiously on the back of this ‘cheap’ PIIGS debt. As we all know a housing and consumer boom ensued, creating the illusion of prosperity and growth.

What most also knew, but dared not to address, is that most countries have spent their future earnings today, as over-indulgent social safety-nets of state employment, medical care and social security have seen governments misallocate savings. Savings dwindled as these very same government provisions reduced the incentive for private enterprise and hence the conversion of investment into savings vis-à-vis tax revenue. There is no amount of growth available to the Western world to replace the growing fiscal gap.

The European periphery is guilty as sin of such a state of indulgence, and their populace have accepted it. This is not some Orwellian, dystopian nightmare, where the state was oppressive. Far from it. It’s a utopian dream where all have been funded handsomely, but the dream has evaporated as fast as the rising dawn.

Policymakers have been rendered impotent. Angela Merkel has had no choice but to back down on involuntary rollover, the banks cannot withstand the reprofiling of debt with a lower coupon and extended maturity exposure. The rollover is in effect this. A PIIGS default in true legal name is likely, as opposed to what is now – a default but by another name. The private sector will not participate much in the rescue package for Greece and it will be the European state that continues to meet the bill, but with what?

The European Stability Mechanism (ESM) due in 2013 is in effect a means of creating unlimited liability for all. A true fiscal transfer mechanism between EU members. Fiscal transference will not fly with all member countries as it comes at the loss of sovereignty. The Germans will foot more of the bill – not popular – and the PIIGS will not want to sell off their private assets. The bill is too big to meet and no amount of time will reduce the NPV of all these liabilities. Be prepared for a euro exit provision for the ailing PIIGS, which are infecting not only the banks but the rest of the world.

The stakes are high globally. The US Money Market Funds are exposed to nearly 40% of European bank debt. No wonder the IMF (US influenced) have been hammering on the table for a swift ‘solution’. Recall, the US MMFs nearly brought the whole financial system crashing down by investing in ABCP. Constantly chasing yield in a low bank rate environment they sought superior yield but these yields were based on debt ratings that were a fraud. They have learnt nothing and exposed innocent savers to unacceptable risk.

If the EU/IMF/ECB troika can delay default, come 2013 who will bailout the ESM when this ponzi scheme is also exposed – a supranational agency? And when that fails what then? The hand of God? Well almost. Western countries will continue to deficit finance (print money), a form of deity worshipped by the central banks. This can only continue for so long as Western creditors (mostly China) will tire of funding their largesse. They have their own issues.

China has been restraining creditor money creation by sterilising the unwanted QE2 monies via a combination of raising their bank required reserve rates, macro-prudential regulation and rate hikes. This is has tempered Chinese inflation for now, as demand for commodities has momentarily been quelled. But China has sneezed, its first signs of flu. Maybe it’s just a cold. But if China sneezes the rest of the world gets a severe bout of flu. The only growth today is courtesy of emergent countries such as China. However, one thing China has in abundance is currency reserves.

Financial conditions may have tightened of late which is why commodities have fallen quite dramatically. However gold has held up. It does what it should always do – maintain one’s purchasing power. One reason gold is holding up is not only as European’s flee their ailing banks fearing an Argentinean-style bank nationalisation (2001), but the Chinese, for all their monetary tightening, are still growing their reserves at 50 to 150bn dollars a month. (Some of this, recently, is down to increased trade settlement for exports in RMB but, nonetheless, it still exacerbates the imbalances.) It is our belief that come August to September, or at lower prices in commodities (including gold), this capital will be employed. To understand more about the dynamics of China and the path for gold, please see our Mines and Money conference presentation that Hinde gave in Beijing this month.

Individuals are revolting en masse in southern Europe. If we in the UK or the US think we are different, one need think again. We have been just as irresponsible – all of us. The infected financial system is mutating everywhere, which is why you need to own a store of value outside the investment banking sphere. Lest we forget, gold has no liabilities.

In re-reading this piece myself today, I could have easily resubmitted this post, full in the knowledge that sadly not much has changed other than we have had a European default and the Chinese have caught a dose of flu. As this circular charade of financing continues today we must re-invigorate the discussion on monetary and political reform, otherwise the domino cascade of default will continue. The only aspect I would possibly change today is that the socialist ideal that arose at the heart of Europe and indeed the developed world this past decade is dying. It is not capitalism that is failing but socialism and the State is desperately fighting to maintain its political position, by using the monopolistic application of money production; which is a symbiotic relationship between national Treasuries and central banks. This action merely serves to store up even worse outcomes than those which exist today, which are already bad.

In my next post I will highlight from the second part of our Eyes Wide Shut – UK Economic Repression and an End Solution how this monopoly is being defended, as well as some constructive ideas from ourselves and some think-tank groups such as The Cobden Centre. You need the correct diagnosis before you can begin to offer real solutions.