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How Precious Metals Will Replace Fiat Money

March 17

It is only a matter of time before the global banking system unravels. For those of us planning for life after such an event, it is time to think what might replace fractional reserve banks and the paper money that is their stock in trade, but first we must understand why modern banking is certain to fail.

The seeds of the banks’ destruction lie in the fractional reserve system, whereby banks lend out many times their capital. The problem with fractional reserve banking is that if a number of a bank’s depositors decide to withdraw their money at the same time, the bank might only be able to satisfy a fraction of the demands. This is the permanent state of modern banking.

In our hearts we know this, but we have confidence that bank runs will not happen. In the current financial climate this view is dangerously complacent. The five to ten per cent of core capital in each of the large international banks is badly impaired, with these impairments swept under the carpet by accounting standards designed to conceal the true position instead of inform creditors. Again, we all know this.

However, it is increasingly clear there will be a global slump in business activity, as higher inflation kicks in and interest rates inevitably rise. Banks will face an escalation of bad debts as a result of higher interest rates that will eliminate much, if not all, of their remaining capital. Unfortunately, the abilities of governments to back-stop the banks are now very limited, because of the unprecedented deterioration in government finances since the first banking crisis.

The international nature of modern banking exposes even relatively sound banks to risks from bad debt contagion, if not at first hand, then through interbank relationships that were previously sound. The collapse of Irish, Portuguese or Spanish banks has the potential to undermine British, French or German banks, and therefore all their counterparties elsewhere. There are many chains of risk like this, respecting no borders. While there is much that can be done out of the public’s sight, it will be very difficult for governments to foist a second banking rescue on their electorates, because they have unwisely encouraged everyone to believe banks and bankers are evil and do not deserve public support. For this reason the only option central banks have is to continue to flood the financial system with new money to compensate for the deflationary effects of contracting bank credit. This new money in the central banker’s mind can be directed to supporting the weaker members of the banking system, and in the Keynesian mind, provide vital economic stimulus. But since successive tranches of new money are having less effect, the amount required continues to escalate.

This is why central banks are unable to stop issuing paper money, because to turn off or even to restrict the flow of the money-tap would fatally undermine the commercial banking sector. For this reason central banks have no option but to deny that inflation is a growing problem, otherwise they have to stop printing money and let interest rates rise.

So put simply, the future we face is that the entire banking system will sink, along with the purchasing power of paper money. Fractional reserve banking has been with us too long, so we have to consider what will replace it, having no working knowledge of any alternative. In doing so, we also have to consider what we want the bank of the future to do.

The original function of a bank was to hold deposits safely, and facilitate customers’ payments. If a bank lent money to a borrower, it had to be the bank’s own money and not taken from deposits entrusted to them by depositors for safe-keeping. It was clearly set out in Roman law that to take a deposit and then use it for your own purposes is theft, and that is still true for all of us today, unless you have a banking licence. However, a loan to a bank is an entirely different thing, because the relationship between the parties is clearly established. Like any business, a bank can use a loan for its own benefit, and in the event of the borrower’s bankruptcy the lender is simply a creditor. It is these two basic relationships, depositor and lender, that get rolled up into one by fractional reserve banking.

There have been many instances of governments exempting banks from Roman legal principals over deposits, usually because it has allowed governments to borrow money in greater quantities. This is as true today as it was in ancient Greece and Rome, for the Florentine and the Catalonian banks in the fourteenth century, the Medici Bank in the fifteenth, the banks of Salamanca in the sixteenth, John Law in France in the eighteenth, and finally the fractional reserve system supervised and guaranteed by central banks since Peel’s Banking Act of 1844.

These are just some examples of banking systems which start off respecting the custodianship of deposits and then sequester them for their own use. The fact that all this has happened before with predictable outcomes nails the lie that this time is different, or that we are now more sophisticated in our financial knowledge. The co-mingling of deposits, loans and bank capital almost always ends with bank failures, which is the true precedent for today’s banking outcome. Our banks have highly-geared balance sheets in uncertain times: these are precisely the conditions that end with a run on deposits, and because the global banking system is already under great financial strain, it is hard to see how they will avoid the mass failure predicted by the history of human behaviour.

The failure of the banking system does not deny the usefulness of an institution whose function is to look after customer deposits, but the business model will have to be entirely different. Since these deposits cannot in future be loaned out, they gain no interest; so paper currencies that lose purchasing power are unsuitable as a store of value. The only secure bank deposit system that truly works has to be based on gold and silver.

This true depository service already exists in bullion dealing and depository facilities, the model for which is provided by GoldMoney, based in Jersey. They store customers’ bullion in secure storage facilities with no bank involvement. And they offer the further advantage of storage in a choice of different jurisdictions. With little or no modification to their businesses, bullion-dealing depositories can provide this facility to a wider public, allowing customers to access their deposits and make payments without going through a fractional reserve bank.

For example, assume you employ a local tradesman. To pay his bill, you get him to open an account with your bullion-dealing depository, and transfer to him the gold or silver equivalent of what you owe him. His bill is settled without the involvement of the banking system, and he has the wherewithal to pay his bills in the same way. It is also possible to envisage a network of these bullion-dealing depositories settling transactions for each others’ depositors. This network could grow rapidly as the payment system spreads.

The advantages of such a system include self-regulation, because bullion-dealing depositories are not required to be licenced to misappropriate customers’ deposits. And in the event of a banking wipe-out, customers of these bullion-dealing depositories will be in a powerful position, because at the outset they will be the only people able to settle transactions without resorting to barter, physical metal or Weimar-style cash.

It seems ironic that the greatest danger posed to personal wealth, apart from inflation, is from respected, regulated banks. With their demise, and the end of fractional reserve banking, the need for bank regulation will entirely disappear. Since bank regulation is one of the two primary responsibilities of central banks, the collapse of paper currencies will leave them wholly redundant, and finished as institutions.

While advocates of sound money will welcome the end of central banks, it will nevertheless be important to protect oneself from the event. A store of value in precious metals held and accessed independently from the banking system appears to be the logical conclusion.

FinanceAndEconomics.Org was established by Alasdair Macleod to educate decision-makers and other interested people in finance and economics.To find out more of their work, please visit www.financeandeconomics.org.

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Japan Crisis Prompts First Joint Currency Intervention Since 2000 Amid Threat to Global Recovery

By Richard Blackden and Louise Armitstead, March 18

The US, Europe, Japan and the UK are jointly intervening in currency markets for the first time since 2000, on fears a crippled Japanese economy, on top of the political upheaval in the Middle East, could combine to derail the global recovery.

The news of the intervention came very early this morning after a hastily assembled telephone conference of finance ministers and central bankers from the Group of Seven Industralised nations. Currency traders in Tokyo and Singapore immediately began selling yen, which had surged to a record high against the dollar in the days after the earthquake. Given the importance of major exporters such as Sony, Honda and Toyota to the Japanese economy, there’s concern that a stronger currency will inflict yet more damage on the country.

The Nikkei 225 took comfort from the decision, climbing almost 3pc, in a moved mirrored across Asian stock markets.

The surprise move – most in financial markets expected Japan to act alone – underlines the threat that authorities now see from Japan, which has faced a record earthquake, a tsunami and a nuclear crisis in the space of little over a week. The decision came just hours after the United Nations authorised military action against Libya, a move that will further complicate what’s likely to be a frantic day across financial markets.

“They felt the necessity to do something collectively,” said Masafumi Yamamoto, a currency analyst at Barclays Capital in Tokyo. “The disaster itself clearly had a very negative impact on the economy but the movement of the yen was making it worse.”

The finance minsisters will also be hoping both to arrest a wave of risk aversion that’s gripped the markets since the earthquake struck, as well as to temper the sharp moves in both currency and, ultimately, equity markets. “In response to recent movements in the exchange rate of the yen associated with the tragic events in Japan, and at the request of Japanese authorities,” we will intervene, the G7 countries said in a statement.

By 11am in Tokyo, the yen had tumbled to 81.18 against the dollar after surging to a record high of 76.25 on Thursday. Yoshihoko Noda, Japan’s finance minister, told reporters that the size of the intervention will be revealed in two months. The Bank of England, the European Central Bank, the Federal Reserve and the Bank of Canada have all agreed to sell yen as their respective markets open today. Analysts estimated that the intervention could be as high as 750bn yen.

The strength of the yen since the earthquake struck a week ago appears counter-intuitive, but Mr Yamamoto of Barclays said that the Japanese currency has historically served as a safe haven for investors during a crisis, even one in the country. He added that some speculators will have been buying yen in the hope that Japanese insurance companies would have to liquidate foreign investments in order to bring yen home to help pay for repairing the country.

In an effort to calm investors, Japan’s biggest insurance companies, which are big owners of America debt, yesterday issued strong denials that they were preparing a sell-off of US Treasury bonds.


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Japan’s Economic Crisis Could be Ours, too

By Jeremy Warner, March 17

Major countries all face the triple blow of debt, an ageing population and energy insecurity, writes Jeremy Warner.

Japan was already trying to overcome the world’s biggest deficit before the tsunami devastated the north of the country on Friday

Thirty years ago, people used to talk and write about Japan in much the same awestruck tones as they now do of China. It was seen as an unstoppable growth machine, with all the right responses to the ever onwards and upwards march of economic progress. It was only a matter of time, it was widely said, before Japan overtook the mighty US as the world’s largest economy.

Ten years later, the Japanese economic miracle ground to an ignominious halt, and the country has struggled to show significant growth ever since. With economic malaise has come a growing perception, both internally and externally, of irrelevance. Japan was becoming a forgotten country.

In an attempt to find anything positive in the catastrophic events of the past week, it is becoming fashionable to argue that they might just prove the shock that the country needs to rid itself of the political inertia and economic paralysis into which it has fallen.

Well, possibly – but the truth is that, regardless of the disaster’s potential to galvanise change, Japan’s future may already be largely pre-ordained, and with it, much of the rest of the developed world.

Japan is in the front line when it comes to the three big challenges which, to varying degrees, afflict all the major advanced economies: excessive public debt, the demographic costs of an ageing population, and increasingly acute energy insecurity.

What is more, the banking crisis that 20 years ago killed off the Japanese growth story has been replicated across Western economies, many of which are now threatened with much the same deflationary, low-growth future.

This isn’t altogether an unappetising prospect. My brother has lived in Tokyo throughout this period of relative national decline, and, from his perspective, it doesn’t seem so bad. If what we’ve had over the past 20 years is economic crisis, he’s prone to say, then we should have them more often.

For all the loss of national self-esteem, the reality is that Japan has coped with the aftermath of its banking crash reasonably well. Output has stagnated, but in per capita terms it remains one of the highest income countries in the world. Furthermore, it has managed to maintain a degree of social cohesion that higher growth economies struggle to replicate.

As for the events of the past week, the situation is still too fluid to be able to make lasting economic judgments. Yet the history of such disasters is both that the blow to activity is temporary, and that the biggest economic impact is not so much the damage to property and life as the hit to confidence.

The economic effects will be felt much more widely than just in Japan. Coming on top of a resurgent oil price, they threaten to derail an already all-too-fragile recovery across advanced economies. Monetary policy will, as a consequence, remain accommodative for longer than otherwise, and in some countries there could be a temporary suspension of fiscal consolidation plans.

Sentiment is hardly helped by the nonsense of 24-hour rolling news coverage, whose frequently alarmist, conflicting and apocalyptic reporting has turbo-charged the panic. We saw this phenomenon in all its glory two years ago during the financial crisis, the first such implosion to occur under the spotlight of instant, modern-day global communications.

Banks become technically insolvent in all big downturns, but in the past we’ve tended not to know about it until after the event, thereby limiting the immediate blow to confidence and consequent systemic damage.

As it happens, the media has tended to be rather closer to the truth of Japan’s fast-deteriorating nuclear situation than the authorities, but though I won’t excuse their fibs, and it runs counter to every journalistic instinct in my body to say so, it’s sometimes understandable that governments are economical with the actualité. The overall impact of a crisis is nearly always made worse by every-man-for-himself, blind panic.

If the nuclear debacle leads to more than just a temporary moratorium on new nuclear build elsewhere in the world, it’s certainly got the potential very seriously to upset the delicate balance in global energy supply. Never mind the advanced economies, China and India alone have plans for more than 200 new nuclear reactors, adding around 50 per cent to worldwide nuclear capacity.

A lack of viable alternatives to these programmes ensures that, in all probability, they will eventually go ahead, regardless of the outcome of the Fukushima disaster. There’s just not enough oil, gas and coal around to feed likely future energy demand.

Back in Japan, it’s just possible that far from prompting positive change, the earthquake could blow confidence away to such a degree that it tips the country, with its already mountainous public debts, into a full-blown fiscal and financial crisis on top of the natural one.

It’s certainly a risk, but to me that doesn’t look the way to bet either. More likely is that Japan in time merely returns to where it was. There must come a point where economies simply outgrow their capacity to grow. For years now, Japan has been blazing that trail. In the West, we may not be far behind. Japan is our future: we’ll be lucky if we handle it as well as they have.


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China’s Urbanization Driving Housing Demand and Car Sales

By Frank Holmes, March 17

Boom or Bust for Chinese Residential Construction?

It’s been an eventful week in Asia. The world turned its attention and concern to Japan as it copes with the most powerful earthquake in the country’s history. The markets reacted, with Asian shares declining and uranium sentiment negative as investors rethink nuclear power.

We are optimistic that a resilient Japan will turn from tragedy to opportunity by stimulating itseconomy through a reconstruction of the nation. Our thoughts are with the Japanese families searching for loved ones and facing the task of rebuilding their country.

This week, China was recognized for an achievement of its own. The country has resumed the leadership it lost to Britain and then the U.S. more than 165 years ago as the world’s top manufacturing country by output. In 2010, China’s manufacturing output accounted for 19.8 percent of the world’s total—surpassing the U.S. by 0.4 percent.

This growth does not surprise Michael Ding, portfolio manager of the China Region Fund (USCOX), who attended the ROTH Capital Partners conference earlier this week in California. There he met with and listened to numerous CEOs and CFOs from businesses in China across several industries, including materials, energy and industrials. The leaders indicated that their revenue growth rate is in the double digits, access to bond markets and bank lending continues, and business remains robust.

The most important take-away from the conference was that consumer demand remains strong. This is important to China as the country transforms from an export-driven economy to one based on domestic consumption.

Michael’s hands-on report mirrors what BCA Research has to say on the expected continuation of a residential construction boom. BCA says that strong consumer demand mixed with a lack of housing and land supply is supportive for the market.

What’s driving this growth? A portion comes from increased car ownership, which has grown from less than 1 percent to 13 percent over the past 10 years. In major cities, such as Beijing, more than 30 out of 100 households own a car.

Total sales rose from just over 2 million units per year in 2001 to roughly 10 million units by 2008. Since then, while much of the global economy has battled recession, automobile sales have risen another 60 to 75 percent.

Compare this growth to the rise of the American suburban family in the 1950s. As automobiles became more common, they transported American families from cities to newly built houses on the outskirts and a suburban boom ensued. The explosion in car ownership means people become more mobile. Chinese families living in urban areas can decide to move farther away from the city in search of newly-built houses with space for parking.

Likewise, people in rural areas can move to the cities. At a rate of nearly 15 million people per year, rural Chinese have been relocating to an urban area. Approximately 15 to 20 percent of the total urban population—or a stunning 35 to 46 million potential families—plan to buy homes within the next three months.

Many of these potential homebuyers have more disposable income to afford an upgrade in their housing situation. Chinese workers have been rewarded with considerable raises in income over the past few years. In 2010, urban incomes rose nearly 8 percent and rural income grew even faster at 11 percent. Their increased wealth has created a demanding consumer who desires the American dream of car ownership and better housing.

To accommodate this demand in the residential market, a tremendous amount of land and construction projects are needed. Currently urban residents make up only 50 percent of the population. If China follows the same urbanization pattern followed by economies such as the U.S., Japan and Korea, this number will climb to 80 percent by 2030, or about 570 million people. That growth implies the development of 10 million residential units every year.

For years to come, we expect China’s urbanization should continue to drive housing growth—and with it, demand for materials and resources needed for these projects.

Foreign and emerging market investing involves special risks such as currency fluctuation and less public disclosure, as well as economic and political risk. By investing in a specific geographic region, a regional fund’s returns and share price may be more volatile than those of a less concentrated portfolio.

This article is written by Frank Holmes and with his kind permission, O B Research has been privileged to publish his work on our website. All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor. To find out more about Frank Holmes’ work, please visit:

Japan Risks Credit Crunch as Yen Thunders

By Ambrose Evans-Pritchard, March 17

Japan is in imminent danger of a credit-crunch with global implications unless the authorities stabilise Tokyo’s stockmarket and take overwhelming action to stop the yen exploding to record levels.

The yen’s violent move late Wednesday to a record ¥76 against the dollar – smashing historic lines of resistance – has gone far beyond levels that automatically set off secondary effects through derivative contracts.

Akito Fukanaga from RBS warned of a “financial shock” as banks and insurers comes under strain, and investors focus on the nexus of structured products linked to the yen.

“Preventive measures on the financial front are urgently needed. Sentiment has declined severely and there are concerns over capital erosion at financial institutions. Lower stock prices and yen appreciation are on the verge of triggering a credit crunch,” he said.

The yen’s violent move late Wednesday to a record ¥76 against the dollar – smashing historic lines of resistance – has gone far beyond levels that automatically set off secondary effects through derivative contracts.

The Topix index has regained some ground after crashing to 782 but is still at levels that leave Japan’s top three banks barely above water on $1 trillion of equity holdings. The risk is that they will curtail lending as a precaution.

The Bank of Japan has already injected ¥15 trillion (£117bn) in liquidity and pledge to boost quantitative easing to ¥40 if necessary, but even this may not be enough.

The G7 finance ministers were to hold a conference call last night to discuss possible intervention to stabilize the yen, perhaps at bearable levels of ¥80 to the dollar. But there seems little consensus yet on the scale of action needed. Dow Jones cited a Japanese official pledging “battle” to cap yen strength.

The channel of contagion from Japan to the rest of the world is finance, not trade, just as it was during the US sub-prime crisis. The trigger mechanism is the rising yen, which eats into profits and hits share prices.

It is the bitter-sweet fate of Japan to have a currency that strengthens furiously in a crisis, even if the crisis is in Japan itself. This is the flip-side of Japan’s envied role as top creditor with $3 trillion (£1.86 trillion) of net overseas assets, or 52pc of GPD. Switzerland has the same problem. “With the yen it is always up the stairs slowly, and down the elevator fast,” said David Bloom, currency chief at HSBC.

The casualties are legendary. It was the 1995 Kobe earthquake that caught Britain’s Nick Leeson on the wrong side of the yen, the Nikkei, and Japan’s bond market. The venerable Barings was ruined in short order.

Such yen moves are known as the “repatriation effect”, a hotly disputed theme. Citigroup said the effect would be “negligible”. Nomura also played down the risk. Yet the somebody is buying yen.

The repatriation argument is that Japanese companies and households sell foreign assets to cover needs at home. These holdings are mostly bonds of countries such as Brazil, South Africa, Australia, or New Zealand with temptingly high interest rates. They hold $50bn of bonds issued in Brazilian real for example, and $27bn of “Uridashi” bonds in Australia. The reversal of funds can be swift.

Japan’s authorities said there was no sign yet of a scramble by insurers or corporations to bring money home. “Rather, some institutional investors say this is a good opportunity to purchase foreign bonds,” said Rintaro Tamaki, Japan’s currency chief.

This raises the nasty possibility that the full force of repatriation has yet to begin. The currency moves we have seen so far may be “short covering” and foreign funds anticipating a yen surge, not the real thing.

The Bank of Japan can offset any inflows by stepping up purchases of foreign bonds. It launched a blitz in 2003, buying a quarter trillion dollars of US debt to weaken the yen and stave off a deflationary spiral. “They can print, and print, and never get tired,” said Mr Bloom.

There is no danger whatsoever that the Bank of Japan will run down its $886bn holdings of US Treasuries to cover reconstruction costs at home. That would be suicidal at this juncture, strengthening the yen even further. The risk lies elsewhere: with the über-charged commodity and emerging market currencies.

Fiona Lake at Goldman Sachs said the repatriation effect is largely myth. The yen rise after the Kobe earthquake was really a dollar slide. The Deutchmark soared pari passu the yen.

She said most of the foreign bond holdings of Japanese funds and savers – equal to 35pc of GDP – are hedged with foreign exchange derivatives. The insurers are also hedged. “If firms do choose to sell foreign assets to finance insurance payments, the impact of repatriation is likely to be limited.”

However, Goldman Sachs has other warnings. While the earthquake and tsunami have not “materially damaged” the manufacturing base, prolonged power cuts are another matter. “If the electricity shortage were to continue until the end of the year, we estimate that GDP would contract throughout 2011,” said Ms Lake.

The danger of relapse of into deep deflation is all too clear. So is the danger that this will cause the budget deficit to balloon once again, and push Japan’s public debt beyond the point of no return. At 225pc of GDP, the safety buffer is almost exhausted.


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