The Impending Monetary Revolution, the Dollar and Gold

The

Impending Monetary Revolution,

the Dollar and Gold

by

Edmund Contoski

American Liberty Publishers

Minneapolis, Minnesota

Copyright © 2012 by Edmund Contoski

All rights reserved. No part of this book may be reproduced of transmitted in any form or by any means, electronic of mechanical, including photocopying, recording, or by information storage and retrieval systems, without permission in writing from the publisher except in the case of brief quotations in critical essays and reviews.

Cover design: Paul Kielb

American Liberty Publishers

P.O. Box 18296

Minneapolis MN 55418

ISBN: 9781623097127

Library of Congress registration information available on request.

Other books by the author:

The Manifesto of Individualism

The Trojan Project

MAKERS AND TAKERS: How Wealth and Progress Are Made

and How They Are Taken Away or Prevented.

Table of Contents

I. The Beginnings of the Crisis

II. The Development of Money

III. The Perversion of Money

IV. Another Failure of Easy Money: the Credit Bubble in Housing

V. The World Seeks an Alternative to the Dollar

VI. Here Comes China! India, too

VII. The Problems Worsen

VIII. Economic Woes Add to Monetary Ones

IX. The Greek Dilemma: Bailout or Default

X. New Threats to the Banks

XI. U.S. Government Acts Against the Economy, Dollar

XII. Natural Rights Versus Democracy

XIII. America’s Ominous Future

XIV. The States Must Step Up

XV. Loose Ends

NOTES

The Author

Reviews of Other Contoski Books

I

The Beginnings of the Crisis

It began in a small country—Greece has only 11 million people—but it led to revelations of international financial vulnerabilities that are overturning the monetary system of the world. For years the Greek government has been spending beyond its means and borrowing to make up the difference. Just like the U.S. government. There is, however, an important difference. The U.S. dollar is the world’s reserve currency, meaning the U.S. is the only country in the world that can pay back its borrowings by simply printing more of its own money.

Greece does not have that option. It can no longer manipulate (inflate) its own currency, as the U.S. does. Greece and other members of the euro zone now share a common currency whose supply is determined by the European Central Bank (ECB), which has a single mandate: to preserve the value of its currency, the euro (€). Membership in this monetary pact requires the individual countries to limit their budget deficits to 3 percent of gross domestic product and their government debt-to-GDP ratio to 60 percent.

Having a common standard of value has certainly benefited commerce among member countries. It eliminated the necessity and inefficiencies of constant exchanges of fluctuating currencies. It also was seen as promoting monetary stability by inhibiting profligate public spending by individual countries, financed by inflation, which historically led to great volatility among European currencies. In addition, it was seen as an alternative to the dollar, whose usefulness as a store of value was declining with a decades-long trend of increased U.S. government spending.

The Greek financial crisis arose when the government increased its initial estimated 2009 budget deficit of 3.7 percent of GDP to 12.7 percent, with the debt-to-GDP ratio going to 113.4 percent. Even the earlier 3.7 estimate failed the euro zone requirement, but this was ignored because Greece was above 3 percent every year except 2006, and several other countries had sometimes been above the 3 percent limit. But Greece’s latest figures were shocking, leaving bond investors worried the country couldn’t pay them off. The pact among the euro countries was supposed to prevent a single free-spending country from undermining the common currency, but that now seemed to be happening. Since Greece could not inflate its way out of debt, the alternative proposed was economic reform to significantly reduce the deficit by cutting spending, increasing taxes, and freeing up the economy. Many doubted that could or would be done under Prime Minister George Papandreou’s Socialist Party government. Argentina, in a similar predicament in 2000, tried a fiscal austerity program similar to that proposed for Greece but ultimately defaulted in 2001. As a result, holders of Argentine bonds lost 70 percent of their money.

Mr. Papandreou warned that his country risked bankruptcy if it could not find lenders to cover its massive €300 euro ($411 billion) debt. Every year, we have to borrow about half of what we spend, he said. And every year we spend more, and every year we collect less as a percentage of GDP.¹ In other words, the country has been piling more debt on top of debt by spending more than it is taking in. The interest rate it must pay to borrow is higher than the economy’s growth rate, and the interest rate rises as the likelihood of debt default increases. The government projected its total debt would rise from its current 113.4 percent of GDP to 123 percent by the end of the 2010 and reach 148 percent in 2013.

If Greece were to fail, that might well spell the end of the euro. Germany’s Finance Minister Wolfgang Schauble stated: We cannot allow the bankruptcy of a euro member state like Greece to turn into a second Lehman Brothers.² French president Sarkozy said: We cannot let a country fall that is in the euro zone. Otherwise, there was no point in creating the euro.³

But there was great fear that a Greek bailout would lead to other countries demanding similar rescue from similar monetary sins, which would further undermine the value of the euro. On May 3, 2010, a week after Standard & Poor’s cut the Greek bond rating to junk status, European Central Bank president Jean-Claude Trichet said the bank would accept as collateral any current or future Greek government bonds regardless of how much the rating companies downgraded them. Trichet had explicitly stated only a few days earlier that this would not be done; the ECB’s rule had been to accept only bonds above a certain minimum rating. The new looser policy was widely interpreted as evidence of inflationary danger, detrimental to ECB’s credibility and its mandate to preserve the value of the euro. In recent years the euro had strengthened against the dollar because of U.S. deficit spending, but the Greek crisis from the very start undermined confidence in the euro, whose value began to decline significantly.

The problem was that there was no enforcement mechanism to ensure compliance with euro limits on budget deficits and debt-to-GDP ratio. When Helmut Kohl was the German chancellor, he wanted stiff fines for violators. That idea was rejected because it would have made the euro treaty a tough sell to European nations whose membership was regarded as essential for success of the new currency.

To save the euro now, it was deemed necessary to prevent Greek bankruptcy. German Chancellor Angela Merkel and French President Nicolas Sarkozy took the lead in arranging a bailout to save Greece from defaulting on its bonds, thus buying time for Greece to achieve the reforms necessary for economic recovery.

Governments, banks, hedge funds, and other investors use credit-default swaps to protect themselves against the risks of default on sovereign bonds such as Greece’s. These insurance-like contracts pay out if the bond issuer defaults. Their prices rise when credit worthiness deteriorates. These markets work because other investors and speculators are willing to assume the risks involved, in return for possible gains, by taking the opposite position in the swaps from those seeking protection. The market in swaps and related financial derivatives is due largely to the monetary instability created by irresponsible government policies. As a result, vast sums of money are diverted to betting on future monetary policy or exchange-rate movements.

France’s giant 116-year old bank Credit Agricole SA bought swap insurance against bond defaults by Greece, Italy and Germany. Spain’s Banco Santander protected itself against British, German and French government bonds. Barclays bank hedged its exposure to Italy, France, Greece, Germany and Portugal. Goldman Sachs was also a credit default swaps buyer.

As of June 2008, the notional amounts (face value) of financial derivatives, according to the Bank for International Settlements, totaled $673 trillion—over 12 times the world’s nominal gross domestic product! These derivatives included credit default swaps, options, forward-rate agreements, and foreign exchange contracts. All of these make it possible to bet on future monetary policy and exchange rates. And three-quarters of this massive derivatives market, which has wreaked the most havoc across global financial markets…derives from the capricious monetary policies of central banks and the chaotic movement of currencies,⁴ writes Judy Sheldon, economist and author of Money Meltdown.

On April 8, 2010 the Wall Street Journal noted, Several years ago, when few ever imagined a European Union member could face a default risk, insurance on Greek bonds was dirt cheap—a mere $7,000 a year to insure $10 million of Greek debt for five years. The cost reached $124,000 at the start of October 2009. Four months later it reached $425,000, compared to just $13,405 to insure $10 million of German bonds for the same period. In April 2010 the cost to insure $10 million of Greek debt was $711,000 per year, and the interest rate Greece had to pay to sell its bonds was 6.1 percentage points higher than those from Germany, a nation whose bonds were much less risky. The cost in May 2010 to insure debt of 10 million euros for five years was 163,789 euros compared to just 90,715 only two months earlier.

In the same way that governments, banks and other investors employ credit default swaps to protect themselves from default on Greek or other sovereign bonds, companies doing business internationally also find it necessary to protect themselves from monetary instability. They employ derivatives as insurance against currency and interest rate fluctuations in the countries in which they do business. Coca-Cola, for example, generates euro income equal to about $3 billion annually, and derivatives provide a way to protect against the loss of value when this revenue is converted into dollars. McDonalds hedges its euro exposure in the same way. So does Dole Food and countless other corporations.

Derivatives for insuring against the loss of value—due to unreliable currency—impose gigantic costs on the world’s economy. What would happen if there were no derivatives? Coca-Cola would have to charge more for Coke, McDonalds more for its hamburgers, and Dole Food more for its products, in order to offset possible losses from currency fluctuations in countries where their products are sold. And Greece and other countries selling bonds would have to pay even higher interest rates to bond buyers if the latter were unable to offset the risk by purchasing derivatives.

Just like national governments and international businesses employ derivatives to protect themselves against currencies that are losing value, states and local governments have turned to derivatives for the same reason. But protective efforts that served well against inflation proved costly when the bubble burst. Aaron Lucchetti wrote:

Hundreds of U.S. municipalities are losing money on interest-rate bets they made during the bull market in hopes of protecting themselves from higher rates. The deals backfired when rates fell, shriveling the sums paid to municipalities….

The Los Angeles city council approved a measure…to try to renegotiate an interest-rate deal with Bank of New York Mellon Corp. and Belgian-French bank Dexia SA. The pact, reached in 2006 to help fund the city’s wastewater system, currently is costing the city about $20 million a year….

In Pennsylvania, 107 school districts entered into interest-rate swap agreements from October 2003 to last June [2009]. At least three have terminated them. Under one deal, the Bethlehem, Pa., school district had to pay $12.3 million to terminate a swap… ⁵

As of June 10, 2010 the Illinois Teachers Retirement System’s list of derivatives it owned ran seven pages. Its pension fund was the fourth-riskiest investment portfolio for a pension fund in the U.S., with 81.5 percent of its investments considered risky. It lost $88 million on derivatives in 2009. For 2010, it lost an estimated $515 million on them as of March 31. That left its $33.72 billion pension fund underfunded by $44.5 billion, or 60.1 percent, according to the Commission on Government Forecasting and Accountability.

The Service Employees International Union reported locals in Chicago, Denver, Kansas City, Mo., Philadelphia, Massachusetts, New Jersey, New York and Oregon have all lost money on swaps, ranging from a few million to over $100 million dollars a year.

And that is by no means the end of the string of losses from government policies that have been destroying the value of money. Remember how the collapse of residential mortgages in the U.S. triggered massive losses for governments, banks and other financial institutions around the world, particularly in Europe? They held huge investments in securities tied to U.S. home mortgages and suffered losses of hundreds of billions of dollars from the ensuing defaults. Well, foreign banks now faced a similar threat from a Greek default because they owned large quantities of Greek bonds.

Because countries in the euro zone share a common currency, there was no risk of currency fluctuations among countries in the zone. As a result, banks, insurance companies and pension funds in every euro-zone country became the biggest investors in bonds issued by other euro-zone countries. In the case of Greece, 90 percent of its public debt was held by foreigners, who could be expropriated by a default. French and German banks had by far the largest exposure to Greek debt. (Is it a coincidence that those were the two countries which led the effort to bail out Greece?)

The recession made things worse. By 2010, there were other euro-zone countries besides Greece with debt burdens well above the euro-zone limit of 60 percent of GDP. Scornfully known as PIGS (or PIIGS, if Italy is included), these countries had the following 2010 debt-to-GDP ratios, according to the International Monetary Fund: Portugal 83.1 percent; Ireland, 93.6 percent; Greece, 130 percent; Spain, 64 percent, and Italy 118.6 percent. In May 2010, Fitch Ratings lowered Spain’s AAA credit rating to AA, putting it in line with a similar rate cut by Standard & Poor’s the previous month. Fitch stated that government’s debt was likely to reach 78 percent of GDP by 2013, compared to less than 40 percent before the 2007 financial crisis and the subsequent recession. Collectively, internationally active banks in the 17 countries in the euro zone held $1.58 trillion, or 62 percent of the debt of the PIGS, according to the Bank for International Settlements. That left 38 percent spread around the rest of world, further exporting the problems.

Greece accounts for only 2 percent of euro-zone GDP, and Greece, Ireland and Portugal together account for only about 6 percent. But Spain accounts for 11 percent. It has a $1.6 trillion economy, the fourth largest of the 17 nations in the euro zone, and the ninth largest in the world. It also had 21 percent unemployment and a million vacant homes from that nation’s housing bubble. According to Morgan Stanley, 32 percent of Spain’s $748 billion debt was held by German banks and 25 percent by French banks. And 51% of Portugal’s $165 billion debt was owned by Spanish banks. And U.S. banks held more than $1 trillion in European debt. So you can see how intertwined the banks had become and how easy it would be for problems to spread worldwide, just like the housing bubble did.

The global interconnectedness of banks is also shown by an example from Ireland. Patrick Honohan, governor of the Central Bank of Ireland, who was also on the ECB governing council, said the real estate bubble fueled by Irish banks was financed to a large extent from abroad. He said between 2003 and 2008, net indebtedness of the banks to the rest of the world jumped from 10 percent of GDP to over 60 percent.⁶ He noted that many big loans to property developers were unlikely to be repaid.

In 2010, Peter Johnson, M.I.T. professor and former chief economist of the International Monetary Fund, and Peter Boone, of the London School of Economics, wrote:

Ireland’s banks are today probably insolvent. Who can afford to repay their mortgages when wages are falling and unemployment is rising? Irish house prices continue to speed downward. This [Ireland’s austerity program] is not an example of a ‘careful’ solution—it is a nation in a financial death spiral….

If one country must make a substantial and painful fiscal adjustment, eventually the rest will follow. The implication for bondholders is obvious: Edge toward the door. Bond yields will stay high or creep up, until the next crisis and contagion. The problems could easily jump beyond Europe.⁷

The United Kingdom is not a member of the euro zone, but it, too, had debt problems. The ratings agencies warned it could lose its AAA rating unless it came up with a tough, credible program to cut its deficit. In 2010, its deficit was 10.4 percent of GDP, which was larger than those of Portugal (9.1 percent) and Spain (9.2percent). The public debt was 80 percent of GDP. A disturbing indication of concern about U.K. finances was the rapid rise in investor purchases of credit default swaps to protect against a U.K. default. The size of this protection roughly doubled in the first four months of 2010, a far sharper run-up than Greek CDS in the autumn of 2009.

In a speech on April 15, 2010 Jurgen Stark of the ECB told a Washington audience that the euro zone wasn’t the only region facing major fiscal challenges. He said, Outside the euro area, bringing the public debt ratio back to safer regions appears even harder for the United Kingdom, the United States and Japan.⁸

What if the world had stable money? Then there wouldn’t be these troublesome monetary imbalances. And the huge losses cited earlier from employing derivatives wouldn’t occur, because there would be no need for derivatives to protect against money itself losing value. The trillions of dollars spent on them could instead be used more productively to produce prosperity. In fact, this is what happened when the dollar was as good as gold. For much of our history, the dollar was exchangeable for gold or silver at fixed rates, and derivatives against monetary instability were unheard of. And before the dollar emerged as the world’s currency, the British pound occupied that position because it was fully convertible into gold long before the U.S. dollar emerged as a formidable rival. The Bank of England, founded in 1694 as a private company (nationalized in 1946) issued banknotes that were indeed as good as gold and led to Great Britain adopting the gold standard in 1816. Gold-backed currencies controlled inflation, led to strong employment, fostered rising living standards, and kept national currencies from getting far out of whack, as they are today. Stable money made economic calculation simpler and more accurate, thereby creating efficiencies and optimizing investments. It also preserved the value of people’s savings, thereby encouraging them to save, which, in turn, increased investment capital to further enrich the people and the country. It all happened without any need to buy insurance against monetary defaults, fluctuating exchange ratios or variable interest rates.

From: http://demonocracy.info/infographics/eu/debt_greek/debt_greek.html Figure 1

Two billion euros (€) in €100 bills. (€100 equals about $130.)

The manikin is next to €100 million in €100 bills.

Source: Athens: Hellenic Statistical Authority October 17, 2011.

Greece needs to borrow twelve of these truckloads in 2012 in order avoid bankruptcy.

II

The Development of Money

Money is a measure of value. It must have a standard by which to gauge that which it measures. Length, weight, sound, time and temperature all have units that make it possible for people to communicate easily with each other about them. If some people used a foot that