The Investor January 2017

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Time to re-think the way we run our monetary system

by Richard Cluver

We humans are an odd lot who compartmentalise our lives into blocks of years and then measure each one as if they can be put away in a drawer and forgotten while we take out a shiny new one that is full of promise. We conveniently forget that the events of this year are simply a continuation of the events of previous ones.

So, we have lived too long now with a world economy that has been in a phase of stagnation that has been labelled The Great Recession and with weary hope we dream that the new year might bring better times, ignoring the fact that only fundamental change to the way we run the world economy can bring about that change. For over a century we have allowed politicians to set the economic agenda and at their behest central bankers have tinkered with the system to try and force it to deliver what the politicians want. Repeatedly they have achieved short-term gains at the price of long-term growth which is in keeping with the desires of politicians whose major preoccupation is to be re-elected a few years hence.

The consequence of it all, as we were forcibly reminded by Oxfam ahead of the World Economic Forum, is that despite a century of politicians’ efforts to uplift the poor, just eight men now own the same wealth as the 3.6 billion people who make up the poorest half of humanity. Seven out of 10 people live in a country that has seen a rise in inequality in the last 30 years.  Between 1988 and 2011 the incomes of the poorest 10 percent increased by just $65 per person, while the incomes of the richest one percent grew by $11,800 per person – 182 times as much.

And to bring it home to South Africa where the gap between rich and poor is the world’s widest, the wealth of three South African billionaires is equal to that of the bottom half of the country’s population. Oxfam’s head of South Africa research and policy, Ronald Wesso, said that the top three billionaires were retail tycoon Christo Wiese, Glencore CEO Ivan Glasenberg and Aspen Pharmacare chief executive Stephen Saad. The information is based on data made available by the JSE in December 2016, and is based on share holdings.

Much more sobering, however, is the fact that in order to be included in the group of 63 000 South Africans who make up the country’s richest one percent you need an annual income greater than R570 000 after tax; that is a take home sum of R47 500 a month. More to the point, over 51% – some 29,733,210 of South Africans – live on less than R1,036.07 per month

Even more sobering is the fact, according to South African economist, Mike Schussler, that someone making R8,500 per month (R102,000 p.a.) would likely be in the top 5% of the world’s wealthiest. Or put another way, if you own assets greater than R2.4-million you are in the world’s top five percent and if you own assets greater than R9.25-million you are in the world’s top one percent.

Summing it all up is Oxfam’s executive director Winnie Byanyima who was quoted last week at Davos as saying’ “It is obscene for so much wealth to be held in the hands of so few when 1 in 10 people survive on less than $2 a day.”

Well why have we got it so wrong and is there a way to fix it?  In my second article in this issue I have dealt in detail with the history of the global monetary system since the world went off the gold standard led by the United States in 2013 and, as has been repeatedly illustrated since then, successive governments have always found compelling political arguments to abandon their promise that their currency will always be backed by bullion or other acceptable reserves. It has been demonstrated over and over again that our political leaders are quite unable to resist the temptation to print more money than their reserves allow. And the result has always been the same, an economy initially on steroids which makes the leadership of the day very popular with its electorate.

But then, just as inevitably there has followed a share market crash and in its wake years of recession during which the poor have suffered excessive hardship which has usually led to social upheavals, war and the discrediting of the political party in power at the time. Now, while the massive disparities of wealth and poverty are clearly politically explosive, it is not the accumulation of wealth that is the problem. It is these stop-start economic issues that have kept so many of the world’s population in penury. In an ideal world, everyone would be gainfully employed throughout their effective working lives earning sufficient to meet their immediate living costs and a little more besides in order that they might accumulate sufficient to be able to retire in reasonable comfort when they are too old to work. But when world monetary gyrations slow the wheels of industry and workers are forced into short-time or the loss of employment, neither the economy nor the needs of the individual can be met.

We can end the boom/bust cycles by rooting out the fundamental cause of monetary indiscipline (i.e. by taking away the ability of governments to manipulate their currencies) by a return to the gold standard or its modern counterpart, the Bitcoin but allowing for an element of annual inflation which would satisfactorily answer the arguments that economists like John Maynard Keynes used against the gold standard. Where previous Gold Standard economists got it wrong was the decision to value gold in terms of a currency. Thus in the post Bretton Woods world gold was valued at 32 dollars an ounce when the reverse argument should have applied; rather than setting the dollar as the standard the unit should have been a fine ounce of gold at its current market value expressed in whatever currency you like. This week, for example, a ounce of gold was worth 1199 US Dollars or 16 353 Rands and were we to so use the metal as a standard it would easily accommodate our problems of currency sufficiency to meet global trade requirements. My graph composite below thus illustrates how the real value of the Rand has shrunk pretty constantly at 10.9 percent compound over the past 30 years. This then is the true rate of South African monetary inflation. And below it I have traced the real value of the US Dollar which has similarly inflated at 4 percent compound.


Meanwhile, it needs to be recognised that one of the biggest problems bedevilling modern governments has been the need to support the poor, the unemployed and the unemployable with social grants, medicare and the like. Though this exercise is couched in altruism, the reality is that it is a means to buy a modicum of social peace. But the ability to fund such aid is likely to come under ever increasing pressure as leading governments are forced into tax competition in order to retain their corporates in a globalised world where the existence of the Internet means that head offices can be located anywhere where tax rates are favourable. Following the initial popularity of the tax havens, major nations began getting in on the act. Ireland and Holland led the way and have been so successful that the Donald Trump administration has opted to join them. And then this month British Prime Minister Teresa May signalled that Britain might also join the corporate tax competition.

Like it or not, world governments are beginning to see the probability of this formerly major source of revenue dwindling away. And most are already taxing their working citizens close to their limits. Proposals to introduce punitive taxes upon the wealthy cannot work because the rich will always find a way to move their wealth beyond the reach of governments. And such taxation would be merely a public relations exercise anyway because the sum of the wealth of the top one percent once redistributed would barely uplift the poor while simultaneously destroying the entrepreneurs upon whose leadership the world depends for innovation and job-creation.

The simple solution here is to opt for a low universal tax rate that few would fight against. A flat rate of around 15 percent with no special concessions or allowances has been shown to work extremely well in the past and if governments universally agreed to such a rate it is likely the benefits to them, particularly in saving the massive costs of enforcement, would outweigh any short-term problems. Finally, there is one tax which is easy to collect and police; VAT. The argument that the poor are disproportionally afflicted by VAT can be simply addressed by removing the tax from items that are sensitive to the poor such as basic foodstuffs, education and transport.

Ministers of Finance have repeatedly argued against such a regime as being too difficult to implement but the probable truth is that the tax enforcement industry and its counterpart, the specialists who at very high cost assist the wealthy to avoid taxes, have between them a massive political lobby. But finance ministers are likely to have to bite on this bullet in the fast approaching future because, as I have explained, the tide of history is against them.

I hope Pravin Gordhan is listening!

Why the world’s monetary system has failed us!

by Richard Cluver

I apologise for the exceptional length of this article which represents the justification for the argument I have made in the story above. It is worth the effort of reading, however for anyone seriously concerned about the outlook for world finance!

The Great Recession that currently holds the world in its grip began with the collapse of Wall Street values in April 2007 following a major boom which might be likened to a drug high, in this instance induced by a massive increase in money. The increase was caused by a commercial bank credit  explosion caused by speculative loans advanced against the security of parcelled-up mortgages whose size and spread, it was believed, would insulate the lenders against the risk of borrower default.

Ironically, the ratings agencies were subsequently blamed for failing to alert everyone to the risk and Moodys was this month fined a massive $1.5-billion for its failure when the truth is that the ultimate authority in this case was the US Federal Reserve which admitted at the time that it did not have a means of evaluating the value of the sub-prime mortgage parcels that were the source of the problem.

Now the blame game is a useful means of confusing everyone about the realities of our monetary system and the hardship that messing with it brings to every one of us ordinary citizens and so let us start by recognising that there is only one monetary system that neither politicians nor bankers can mess with and that is gold bullion and its modern equivalent, the Bitcoin. If all contracts between men and businesses were written it these, we would no longer have to worry about exchange rates, exchange controls, inflation and all the hazards that afflict the modern investor. So it is difficult to appreciate that these things have only been with us for the past century.

Though wars and political ideologies like socialism, communism and nazism  are nothing new, we have only been fighting over them since politicians and bankers began fiddling with the monetary system barely more than a century ago. But if you would like to fully understand it all you need to come with me on a lengthy journey to the cause of the Great Depression that began in 1913 with the passage of the US Federal Reserve Act which, in a single sweep, changed both the scope and the magnitude of government intervention in the banking and monetary systems. It had the power to regulate the size and growth of the money supply, thereby causing inflation or deflation in the economy. Through manipulation of credit, the Federal Reserve System fuelled a credit expansion the likes of which was previously thought impossible. When the steadily-expanding credit bubble finally burst with the crash of the over-inflated stock market it had created, the consequent credit contraction was infiniteoly more severe than any before.

The Federal Reserve System enacted by the US Congress in 1913 was an attempt to smooth out the then little-understood business cycles that plagued the world economy and were especially troubling to the banking system. The “Fed” was charged with ensuring the appropriate reserves of its member banks, lending to shaky financial institutions to prevent their closure, selling government securities, and regulating the banking industry. Throughout its subsequent history the American currency and monetary system has undergone many changes, going from a relatively pure gold standard at its inception to an adulterated standard in the 1940s and finally a total elimination of any gilded ties in the 1970s.

The Fed has assumed many more responsibilities than the drafters of the original legislation envisioned. Even so, its operations have changed very little over time. The most important of its roles, for our purposes, are: as setter of reserve requirements, lender of last resort, and regulator of the money supply. It is through these three functions that the US Government manipulates the economy most fundamentally. Let’s examine each function in greater detail:

Individuals lend banks money in the form of deposits. The banks issue the depositors something conveying a promise to pay on demand. Since the bank now owns this money, it can lend it to others to earn a return. In case the depositor wants his money back, the bank needs to hold some money back from its lending activities. These deposits held back are called reserves. The higher the bank’s reserves, the less it has to fear a fluctuation in its daily needs. However, if the reserves are kept too high, the loan portfolio is not productive and profitable enough. Therefore, a balance must be struck.

Prior to the Federal Reserve Act each bank had to be responsible for the maintenance of its own reserves although there was an established legal floor. If a bank misjudged its needs, it either had to call in its loans or cease transacting business. Poor judgment led to what is known as a “run” — which occurs when depositors lose confidence in the bank’s ability to meet its obligations and seek to withdraw their money before the bank goes under. If this happens with any prevalence, this can shake the stability of the banking system.

The central bank theorists presume that the bankers, if left to their own judgment, will stay fully loaned up to the legal reserve requirement floor rather than maintaining a equalising balance between loans and reserves. For this reason, the Federal Reserve system was granted the authority to centrally alter the reserve requirements of every bank but, far more important than this is its power to determine what constitutes reserves. Previously, individual banks kept reserves in their vaults and, depending on the era the reserves were simply gold or silver specie. With the advent of the Federal Reserve System, banks were compelled to maintain their reserves at the regional Federal Reserve Bank.

In so doing, the Fed also altered the nature of such reserves. Previously, reserves had taken the form of specie deposits withheld from lending operations. Shortly after its inception, the Fed allowed reserves to be kept in either gold or Federal Reserve Notes (ostensibly representing a corresponding amount of gold) as well as government securities at a ratio fixed by the Board of Governors of the Federal Reserve. After the banks had accepted the use of Federal Reserve Notes, the Fed compelled the acceptance of these Notes as legal tender. This alteration accomplished two objectives: banks could purchase various vehicles for use as reserves and still be able to lend their deposits and the government had a ready buyer for any new issues of securities.

The abandonment of the gold standard made it possible for the welfare statists to use the banking system as a means to an unlimited expansion of credit. They created paper reserves in the form of government bonds which through a complex series of steps the banks accept in place of tangible assets and treat as if they were an actual deposit, i.e., as the equivalent of what was formerly a deposit of gold. The holder of a government bond or of a bank deposit created by paper reserves believes that he has a valid claim on a real asset. But the fact is that there are now more claims outstanding than real assets.

One cannot understate the importance of this fundamental change in the American system. Government expenditures could soar high above revenues and the Federal Reserve would aggressively market the deficit spending to an avaricious banking system eager to expand its ability to extend credit. Or, put another way, the government could create fiat money out of thin air: effectively an edict by expenditure. Previously, the only means by which government expenditures could increase were by a politically-inexpedient tax hike. Now, it had the Federal Reserve as its overdraft protection and the Fed could draw from the productivity and wealth of the entire American banking system.

By manipulating the nature of bank reserves, however, the Federal Reserve also contributed to a lack of soundness in the banking system. The last thing a bank needs is an aura of insolvency, yet that is precisely what the Federal Reserve System engenders. The Fed issues its Notes at an arbitrary ratio to its gold holdings; the banks then use these Federal Reserve Notes as reserves in another arbitrary ratio to their deposit base. Or, the banks use government securities–created out of thin air–as reserves and lend against them at a large multiple.

The problem in this activity is that the underlying value of the reserves has gone from significant (in the case of actual money stored in a bank’s vault) to insignificant (in the case of gold-based Notes) to none (in the case of fiat government securities). In the banking industry, this is called lower quality of liquidity. Not only that, but the Fed also sets the reserve requirements in a vacuum of information. Bankers, by virtue of their daily contact and intimate knowledge of the local business community, are better able to assess the bank’s balance sheet and respond accordingly. That is the way it attracts depositors and customers, by a reputation for fiscal soundness.

When a bank is free to fail, it has an interest in maintaining liquidity. Its management must balance the assets and liabilities carefully and prudently. But the Fed acts in the aggregate in setting reserve requirements, thereby punishing the most able bankers (by setting their reserve requirement above what they would have) and rewarding the incompetent (by allowing them to keep lower reserves than necessary).

The Fed, in its original legislation, was charged with operating as “the lender of last resort.” This meant that, if a bank found itself in an illiquid position, it could borrow from the Fed to see it through the situation. Initially, the bank had to pledge some valuable asset — such as commercial paper — as collateral to the Fed, but that requirement was soon dropped and now anything is eligible. Under this guise, the Federal Reserve sought to prevent the bank runs and systemic bank failures of past times. In effect, the Fed would prop up the banking system using its monopoly on money creation.

This, again, ties in with the above discussion on reserve requirements, since the lender of last resort function kicks in when a bank is in a jam. Each of these seeks to correct a supposed “failure” of the nineteenth century’s free-banking system; the former to forestall bank insolvency and the latter to avert bank panics. As with reserve requirements, there are considerable unforeseen consequences to the lender of last resort function. The first–and most obvious–problem is that it makes no distinction between illiquid banks and insolvent banks. The former are in a bind; the latter are in dire straits. The Federal Reserve qua lender of last resort would come to the rescue of each equally. The effect, then, is to further destabilise an already problematic situation.

The enactment of the Federal Reserve brought almost immediate changes to the American banking system. Prior to the Federal Reserve Act when banks kept their own reserves in their own vaults, the reserve ratio hovered around 21.1 percent. By 1917, the Act had legislated the reserve requirement to a mere 10 percent. Furthermore, the gold standard was devalued, since the Federal Reserve was only required to keep gold reserves of 40 percent against the Federal Reserve Notes and 35 percent against its members’ deposits. This all occurred within five years of the System’s inception. These two actions enabled a tremendous credit expansion.

The expansion amounted to $5.8 billion in deposits and $7 billion in loans and investments. This accommodated the financing of World War I in lieu of increased taxation and, at least, had some justification due to the war effort. What happened next is best summarized by US economist Dr. Benjamin Anderson: “We watched bank credit with fear and trembling as it expanded during World War I, because we knew then what we seem since to have forgotten, the dangers of over-expanded bank credit. We held it down all we could. But a great expansion was needed and we made it. It was enough. An expansion of $5.8 billion in deposits, with $7 billion in loans and investments, was enough.

“But between the middle of 1922 and April 1928, without need, without justification, lightheartedly, irresponsibly, we expanded bank credit by more than twice as much, and in the years which followed we paid a terrible price for this.”

The episode he spoke of — the 1922-28 credit expansion — began in 1922 with the first large open-market purchase of government securities, increasing the holdings of government securities by the Federal Reserve from $250 million to approximately $650 million–an increase of 260 percent! This first large-scale operation was instigated, not for credit expansion or interest rate suppression — since rediscounting had slackened after the war and Federal Reserve reserves were faltering — but simply because it could be done. The heady, unintended credit expansion was too profitable to make it a one-time deal. Consequently, two more major open-market purchases of government securities occurred in 1924 and 1927, each amounting to hundreds of millions of dollars–a scale unprecedented in the history of the United States. Plus, due to the multiplying effect of securities qua reserves, billions of dollars became available for lending–again, out of thin air. These purchases were motivated solely by credit expansion, without any thought to the “dangers of over-expanded bank credit.”

By these open-market operations and reserve fiddling, bank credit had expanded $11.5 billion in only five years. If it had reflected a genuine need by businesses, it would have been welcome and salutary. Since, however, commerce had no use for the available credit, banks sought other venues in which to channel the funds. The three primary vehicles were mortgages, financial instruments, and foreign loans. Each of these represented a deviation from traditional banking practices, viz., the financing of short-term commercial requests; short-term, because it helped to maintain the liquid position of the bank; commercial, because these tended to be the borrowers best able to repay. Mortgages and financial instruments–like bonds and securities–are particularly susceptible to fluctuations in value. Loans made to foreign governments–predominantly Latin American ones– were risky, since revolution and instability were prevalent.

Moreover, each of these types of loans is ineligible for rediscounting. Since rediscounting was the secondary reserve of the whole system, this meant that a significant portion of the bank’s assets were constrained. As of June 30, 1926, the Federal Reserve released the following statement, “Of the total loans and investments of all member banks on June 30, 1926, sixteen percent was eligible for rediscount at the reserve banks….”

With increased long-term holdings and decreased potential for rediscounting, the banks were in a pretty precarious position by the end of the twenties. All that was needed was a scaling-down of the expansion–maybe even a contraction–thereby allowing banks to liquidate imprudent investments gradually. This could be accomplished by setting the rediscount rate above the market rate and strictly limiting the use of open-market operations. However the Federal Reserve Board did precisely the opposite. In 1927, the Federal Reserve Board, under the Chairmanship of Benjamin Strong, inaugurated a new policy of cheap money to help the farmer. The Fed lowered the buying rate on acceptances–essentially future loan drafts–in the summer of 1927; sharply increased–by $320 million–its purchase of government securities through November; and lowered its system-wide rediscount rate to 3.5 percent by September of that year. This time, the credit expansion was funnelled almost exclusively into stocks. While further comment will be reserved for later, it bears mention that this growth in stock market investment that started in 1927 continued right up until the Crash.

Towards the end the Federal Reserve authorities desperately tried to reverse their mistake, increasing the rediscount rate to five percent by July 1928 and selling over $400 million worth of government securities by June 1928. This divestiture reduced bank reserves, necessitating over $600 million in rediscounting–though not enough to fully account for the reduction in reserves. In the week following the stock market crash, the Fed doubled its holdings of government securities. The Fed was trying desperately to increase its reserve situation but could barely keep its head above water due to the counteracting influence of a continuous outflow of gold to other nations. Throughout the crisis period–1929 to 1933–the Federal Reserve continued its inflationary policies in a futile attempt to initiate another boom akin to that of the twenties.

By the end of 1930, however, the fundamental instability of the Federal Reserve System became apparent. The number of commercial banks in the United States stood at 29,087 on June 30, 1920 and at 15,353 on June 30, 1934. In the period 1930-33 alone, a total of 9,106 banks failed. Bank failures had always been endemic to the Federal Reserve System, though, averaging 166 per year between 1913-1922 and 692 per year between 1923-1929. The reason for this should by now be clear. In creating money from nothing for banks to lend, the government distorts the market processes that regulate the economy. Credit arises from production. It cannot be overextended by private institutions, since they do not possess the power to counterfeit and debase. The creation of credit by banks is a productive enterprise in which all participating parties hope to benefit, and in which non-participating parties are not directly affected. Banks, in selecting where to extend credit, must necessarily be choosy. They must maintain liquidity at all costs, while maximizing the return on their investments.

Under the Federal Reserve, however, the banks found themselves awash in credit, regardless of the financial needs of their customers. They felt pressure to lend, without the assistance of a customer seeking a loan. Thus, they sought out anyone willing to take the credit off their hands. In the competitive world of banking, quality and creditworthiness were luxuries they could not afford to consider. As one banking historian put it, “numerous examiner reports cited bank failures as due to `generosity to borrowers’…with insufficient attention paid to discipline, the result of which is detrimental to both borrowers and lenders in the long run.” The banks ended up carrying a portfolio of speculative stock and real estate loans, long-term mortgages, and loans to impoverished countries. When the public loses confidence in the financial establishment, the banking industry bleeds to death until wholesale liquidation ensues. That is, unless the government frees the banking industry from meeting its obligations–through a banking holiday–or unless the government sets the money supply adrift–through the abandonment of the gold standard. Both of these things happened in 1933. These two events, then, were the culmination and the pinnacle of intervention in the banking system.

Another part of the economy that is deeply affected by Federal Reserve policies, albeit indirectly, is the private business sector. When we think of businesses in the Great Depression, we think of joblessness and overproduction. Not unemployment or large inventories on an individual, localized level, but on a nationwide scale. One must ask the question: how is it that problems can occur so? How can so many individual businessmen make erroneous judgments at the same time? This points to a more fundamental reason, one that can uniformly lead to miscalculation.

Once again, we find that the source of dislocation is expansion of bank credit divorced from any real source of expansion. In the boom–or inflationary–period, the businessman engages in a process of predicting the future return or value of present projects. One of the factors entering into his calculations is the interest rate–a measure of the cost of future goods versus present consumption. The drop in interest rates inherent in an inflationary environment interferes with the businessman’s planning. It implies an increase in the rate of thrift–traditionally the source of available capital–by individuals and corporations. This causes a shift by the businessman from investment in consumer goods to investment in higher-order capital goods, in expectation of soaring future demand. “An expansion in the production facilities and the production of the heavy industries, and in the production of durable producers’ goods, is the most conspicuous mark of the boom.”

As the bubble fills, productive capacity is expanded. Capital goods are acquired and implemented. Money flows into the capital goods industry. This money, remember, is not the result of increased savings, but money artificially created by the government in the form of credit expansion. So this boom is illusory. For, once workers in the higher-order industries receive income in the form of wages and salaries, `they would immediately attempt to expand consumption to the usual proportions.’ This sudden surge in consumption demand undercuts the demand for the still incomplete projects involving higher-order producer goods far removed from consumption, resulting in a slump in the capital-goods industries.

In other words, because the savings qua capital is not genuine, the money sunk into higher-order goods is spent according to existing consumption/thrift ratios. Or: the money spent by the misinformed entrepreneur is ultimately transferred to the consumer goods industries, shifting demand for the capital good. That is, unless the borrowing firm returns to the bank for more credit and temporary salvation. The greater the credit expansion, the longer it will last. When the expansion ceases, the boom complies. As Rothbard puts it, “the longer the boom goes on the more wasteful the errors committed, the longer and more severe will be the necessary depression readjustment.”

If we look to the historical record, we see that the facts bear this analysis out. Productivity per person-hour increased 63 percent from 1920 to 1929. Stock prices quadrupled during the twenties–stock being the primary source of capital. Durable goods, as well as steel production, increased approximately 160 percent. Non-durables, largely consumer goods, increased only 60 percent. Moreover, wages in the capital goods industries were higher than wages in the consumer goods industries. According to the Conference Board Index, hourly wages in manufacturing industries–such as meat packing, hardware, and clothing–increased an average of 12 percent while those in the capital goods industries rose even higher–12 percent in machine tools, 19 percent in lumber, 22 percent in chemicals, and 25 percent in steel.

The period after the boom also corroborates Mises’ and Rothbard’s cycle theory. Industrial production was 114 in August 1929 and 54 in March 1933. Business construction totalled $8.7 billion in 1929 and $1.4 billion in 1933. There also occurred a 77 percent decline in durable goods manufacturing in the same four-year period. Unemployment rose from 3.2 percent in 1929 to 24.9 percent in 1933. Furthermore, from 1929 to 1932, the money supply was contracting, “and since wages are less elastic than prices, real wages were rising (unbeknown to most workers), making it extremely difficult for business to employ people.”

Our last sector of concern is the investment sector, the stock market, its brokerage houses, and individual investors. The image that comes to mind immediately is the Crash of 1929. It occurred because the general price-to-earnings ratios–a common estimate of value in a security–had soared far above any representation in reality. The reason for this inordinate rise was due to speculative fever within the general public. Everyone wanted a piece of the action and were largely able to buy into it. Further probing finds the spectre of the Fed artificially propping the market.

The Fed’s purchase of government securities in 1924 was the first instance when the additional bank credit was almost exclusively channelled into securities–partly into direct bond purchases by banks and partly into stock/bond collateral loans. “This immense expansion of bank credit, added to the ordinary sources of capital, created the illusion of unlimited capital and made it easy for markets to absorb gigantic quantities of foreign securities as well as a greatly increased volume of American security issues.” Although the 1924 issue was the first instance of influence in the stock market, it was most definitely not the last.

The 1927 cheap money policy of the Fed was the final turn that opened the floodgates of giddy speculation. By lowering the rediscount rates, the Fed allowed the member banks to lower their own interest rates on stock and bond collateral loans as well as brokers’ loans. When the Fed reversed its policy late in 1927, it was too late. The psychological intoxication of the boom had taken hold of the American public. Eager speculators ignored increasing interest rates and took greater volumes of brokers’ loans. Even as member banks dried up the speculative security loans, new sources were utilized, viz., brokers’ loans `for account of others.’ Previously, brokers’ loans would be made for the bank’s account or an out-of-town bank’s account, with an occasional brokers’ loan for other customers. At the beginning of 1926, such loans accounted for $564 million of a total of $3.141 billion in brokers’ loans. By the summer of 1929, these loans totalled $3.372 billion of the total $6.085 billion in brokers’ loans. Furthermore, call loan rates rarely exceeded 10 percent, except just prior to the Crash, when they finally were raised to 20 percent. This also served as a fresh source of speculation money.

The effects of such ubiquitous investment were astounding. On November 15, 1922, the Dow-Jones Industrial Average closed at $95.11. By August 29, 1929, the Average had risen to $376.18. The Standard & Poor’s Common Stocks Indices showed similar fantastic gains: industrials, rails, and public utilities indices had risen from 44.4, 156.0, and 66.6, respectively, in 1921 to 172.5, 384.1, and 272.2 just six years later.

When the bubble finally burst–in October of 1929–it shattered confidence in the economy. The intoxication of seven years of giddy inflationary credit expansion had resulted in an economic hangover of heretofore unseen proportions. The following year, 1930, marked a watershed. The government’s response to the failings of the Federal Reserve would determine the severity of the necessary liquidation and recession. If the government allowed the market to correct itself, through interest rate hikes and bankruptcy, the consequent recession would be severe but brief. If, however, the government interfered with the market, the country would be in for a slow, arduous bloodletting and, ultimately, a future littered with cyclical depressions.

These three areas of the economy are the most important sectors and the ones most influenced by the arbitrary credit expansion of the Federal Reserve. In each one, government monetary intervention led to dislocations, distortions, and disequilibria. However, it would be foolish to imply that the Federal Reserve System was the sole factor in the playing out of the Great Depression. For our purposes, though, I will specifically omit the sometimes drastic effects of the Hawley-Smoot Tariff of 1930, Britain’s abandonment of the gold standard, reparations from defeated Germany, and other international elements that contributed to the extent and severity of the Depression of 1929-1940.

As I stated in the Introduction, if we can understand the ideas and underlying philosophy of the Great Depression, we can seek to eradicate those ideas from our midst and stave off a repetition of their actualization. The fundamental idea behind the Federal Reserve System is statism. It is the subjugation of individual freedoms and choices to the will and interests of the state, as representative of the “public good.”

In the case of the Federal Reserve, we can see that the Federal Reserve essentially dictates to the banking system what it can and cannot do. Consequently, individual depositors experience a reduction in choice among financial institutions, since they all are treated uniformly and it becomes impossible to determine the reserve quality and sufficiency of an individual bank. Furthermore, bankers are denied the possibility of issuing banknotes against real reserves and the element of control this encompasses. Businessmen are given mixed–and sometimes false–signals regarding the future cost of activities, leading to malinvestment and wasted capital. Finally, individuals are unable to assess the underlying value of the stock market, due to the dislocations produced by credit expansion on the part of the Fed. And volatility is officially sanctioned through the inflationary mechanism.

The lesson of the Great Depression is that statism leads to unintended consequences and undesirable effects and that this is inherent in the system. It illustrates the fact that the government has no business interfering in the private dealings of individuals. If the government had adopted the laissez-faire program it is alleged to have adopted, the economy would have certainly contracted, but its result would have been a strengthened and sounder economy. By the correction’s end, banks would have found appropriate reserve ratios and liquidated imprudent loans; businesses would have converted misguided endeavours into productive uses and shaken off inefficiencies; and investors would be left with more accurately valued stockholdings and a renewed confidence in the financial status of the nation. In short, the economy would have righted itself.

This, then, is the proper policy to follow in adjusting to a depression. It should be similarly obvious the method by which depressions may be averted; it is time for a separation of bank and state, akin to the separation of church and state and for the same reasons. An examination of free banking is beyond the scope of this essay, but suffice it to say that “depositors lost more money in the early phase of central banking (1913-1933) than earlier depositors had lost in the entire 75-year free banking period (1838-1913).” To paraphrase Ronald Reagan: in that time of crisis, government was not the solution to our problems–government was the problem.

What relevance have the events of the 1920s to do with modern economics and global investment? Well the overwhelming evidence is that the cause of the Great Depression was, firstly, the fact that in the years leading up to the 1928 share market crash the US monetary authorities allowed an approximately four-fold increase in the total American money supply and the direct consequence was a nearly mirror image gain in the average prices of shares on the New York Stock Exchange. The Dow Jones Industrial Index rose from 9 511 in November 1922 to 37 618 in August 1929. The money supply increase led inevitably to soaring inflation, but the actual cause of the share market crash and the subsequent economic depression was the fact that the Fed raised interest rates in order to soak up excess money and so the actual cause of the crash was this tightening of credit.


Now let us turn to current events and note in the graph above that on October 11 2002 the Dow Industrial reached a low point of 71975 and subsequently doubled reaching a peak value of 141980 on October 12 2007. That increase happened, however, against a background of a steadily declining value of the dollar which was the result of a massively adverse US balance of trade that understandably led investors to seek safer havens for their money.

A major beneficiary of these world investment flows during the same period was South Africa where the JSE All Share Index quadrupled from a low point of 77 062 on March 11 2002 to a peak value of 317 282 on October 11 2007.


So were there parallels between the money supply data of the 1920s and the first decade of the new millennium? Surprisingly at this stage of mankind’s development when we have access to data on practically everything, official global money supply statistics are extremely hard to come by. However a group of amateur US investors who, as they explain themselves “… got fed up with the lack of straight and relatively simple data on investing and economics, and put up a web site to address our various concerns….”

( ) have been collecting data from every available source in order to, among other conclusions observe that the total global money supply rose nearly five-fold between July 2004 and July 2007. Their graph overleaf tracks the annual percentage rate of change of the US “Monetary Base” together with the total change rate of reserves of the main Central Banks of the world. It basically measures how fast the central banks were adding liquidity by measuring the growth rate of their own reserves at the International Monetary Fund, then adding the Monetary Base to overweight the US Federal Reserve fund data. It is overlain with a graph tracking the annual rate of change in the dollar price of gold and what is important about this contrast is how accurately the gold price responds to increases in global money supplies albeit with an approximately two-year time lag.


So let us note in the graph below that the gold price more than trebled from a low of $252.60 on August 25 1999 to a peak of $842 on November 8 2007 ( and to $1851 in 2011). This tidal wave of new money had been engorging the world’s markets seeking a home wherever it could be found. So it should be no surprise that reports abounded at the time everywhere on the planet of credit cards arriving unsolicited in the post and of unemployed people being offered tens of thousands in shopping credits. But the process reached its pinnacle of irresponsibility with the advent of the sub-prime mortgage lending industry which had its roots in the US and whose ultimate collapse during 2007 shook the world’s financial system to its core. Here again it was a case of when the conventional lending market had become saturated, the money surplus inevitably began trickling down to would-be borrowers whose past credit record was so poor that in normal circumstances they would never have qualified for a loan. Suddenly, as if by magic, it was argued that this risk had gone away because someone had the bright idea of packaging hundreds of these mortgages together and selling them on to investment banks and pension funds who bought them on the understanding that by this process of aggregation only a moderate percentage of the loans might be expected to default and that this risk was covered by the relatively higher interest yield that the packages were offering.


Perhaps these institutions would not normally have been persuaded to take on the additional risk, but they had been under increasing pressure to obtain higher-yielding investments in order to fund the pension requirements of a society of “Baby Boomers” who had been living far longer than was anticipated by the actuaries who originally devised their pension plans. Frighteningly, however, in the aftermath of the sub-prime crisis when one after another the world’s biggest financial institutions were writing off billions in unrecoverable debts and CEOs were falling on their swords, it emerged that few had ever fully understood the risk potential of what they had been buying let alone grasped the extent of the non-performing portion of these bundled-together mortgages. The reality, of course, is that when you lend money to people who have very little ability to repay you, no amount of fancy financial engineering can cover up that fact.

Nevertheless, the whole card castle of debt might have remained hidden for far longer and assumed even more disastrous proportions had that inevitable consequence of a surging money supply, inflation, not come back to haunt the world and had central banks not, as they did in 1929, invoked their standard defence of raising their lending rates. People, who up till then had been just able to get bye meeting their mortgage repayments, could suddenly no longer do so and the process of mortgage repossessions began. In a chilling re-run of the events of the Great Depression, by the end of 2007 some two-million US citizens had lost their homes and the process was accelerating.

The graph below, courtesy again of traces US money supply over the past century (green lines) and inflation (black line) which emphasises the mirror image link between the two and, more pertinently at present, that money supply growth was at the time of writing showing no sign of abating and with it the inexorable upward march of inflation seemed endless.


Here a brief tour through a century of economic history is appropriate to an understanding of the graph. We have already documented the events of the 1920s and the Great depression which resulted from the increased money supply of that period. Then followed the huge contraction in money of the depression itself. However, as we have noted, right up to the 1940s the Fed was once again cranking up the money supply in a vain attempt to re-stimulate the US economy and resurrect the “good times” of the 1920s. The steep recession that followed the ending of World War 2 lasted until the middle 1960s although the corner was turned in the late 1950s accompanied by another expansion of the money supply and the first really significant post-war share market boom which was to end so spectacularly in South Africa with the crash of 1969 which in a matter of weeks in May 1969 knocked R5,6-billion off the value of ordinary shares listed on the Johannesburg Stock Exchange. Again it was the result of an interest rate hike following a warning in Parliament by the then Minister of Finance Nico Diederichs that excessive levels of speculation were being reached.

By the 1970s, it was a widely accepted economic doctrine by followers of British economist John Maynard Keynes that manipulating the money supply in order to create modest amounts of inflation was an acceptable price to pay as a consequence of government efforts to keep unemployment low. Keynes’ view was that runaway inflation could only occur at times of full employment, a proposition that was resoundingly discredited when the cumulative consequence of this approach by central banks led to an explosive surge of inflation which peaked at 13.5% in the United States in 1980 accompanied by a long period of high unemployment; the dreadful phenomenon which was to became known as “stagflation.”

US economist Milton Friedman provided an explanation for the onset of stagflation by arguing that once they were used to inflation as a daily fact of life, people would take it into account in their financial planning and so the long-term effect of reducing unemployment by increasing the money supply was a mirage. Eventually, ever-higher rates of inflation would be needed to stimulate hiring in order to keep unemployment low…. and the economy would collapse! This “monetarist” theory was put to the test by Paul Volker when he was Chairman of the Board of Governors of the Federal Reserve System in the late 1970s and early 1980s. He raised interest rates and reduced the money supply. The US entered a recession, unemployment went up, but inflation came down very fast. From 13.5% in 1980, it fell to a low of 1.9% in 1986. Then unemployment slowly came down and the recession ended, but high inflation did not return and had not returned by 2000 at which stage US inflation stood at 2.2%.

In the aftermath of the Milton Friedman/Paul Volcker cure, however, monetary policy was again relaxed but inflation remained low, seemingly giving the lie to the theory. We now know, however, that the reason inflation remained low during that period, notwithstanding a continued build-up of the world’s money supply, was economic globalisation: the sleeping giants of China and India were awakening their teeming millions of workers: armies who were prepared to slave long hours for less money than Western workers were accustomed to spending on lunch. The resultant flood of extremely low-priced consumer goods exerted a dampening effect upon global inflation that masked a rapidly increasing global money supply resulting in a new era of apparent prosperity in which the world’s central bankers (led by US Federal Reserve chairman Allan Greenspan as chief guru) basked in world adulation as geniuses who had finally cracked the secret of global economic fiscal management. Of course it was merely another illusion – as affirmed by Greenspan himself in his book ‘The Age of Turbulence: Adventures in a New World’ – which began unravelling, quietly at first from as early as December 1998 when a languishing oil price began creeping upwards and then quite dramatically 12 months later when Brent crude prices started an upward price acceleration rising at a compound annual rate of 37.6% until mid-2006. Then, after a brief five-month respite it returned with a vengent compound annual rate of 112.3% during 2007. Soon the oil price gains began to be matched by rises in most minerals, next by food prices and finally by wages in the beginning of another era of stagflation which promised to be even worse than that endured in the 1970s because the monetary authorities had clearly not learned the lessons of the past and were cranking up the money supply in order to stave off the pain of the sub-prime crisis.

In retrospect, other than the Great Depression, the 1970s had arguably been the worst phase of the 20th Century world economy as reflected by share markets that wallowed for over a decade after the stock market crash of 1973. And again it was clear that past lessons had not been learned for the world’s central banks had continued creating new money and inevitably inflation had soared on a global scale. With the buying power of money being steadily eroded, oil-producing nations of the Middle East had as a consequence been prompted to form the OPEC oil cartel in attempt to restore the real value of their exports. For a brief period OPEC held the world to ransom and, amid fuel shortages and soaring prices, the financial world had to adapt to a tidal wave of petrodollars seeking investment homes.

Simultaneously France, which had long been uneasy about the world’s dependency in terms of the Bretton Woods Agreement on the US Dollar as its ultimate reserve currency, had as a consequence been accumulating huge reserves of gold. Finally in 1971 French president Charles De Gaulle directly challenged America to honour its foreign debt with payments in bullion, grabbing headlines by demanding that the US prove that it did indeed hold gold bullion in the vaults of Fort Knox equal, at $35 an ounce, to the sum of its issued paper dollars. US President Richard Nixon responded by initially moving the official price of gold to $42 an ounce and finally, in a tacit admission that De Gaulle’s allegations were true, officially ended the link which thereafter allowed for a free float of the Gold price.

With the world’s monetary system again bloated, this time by petro-dollars, central banks again raised interest rates to rein in the inevitable wave of inflation and In the two years from 1972 to 1974, the American economy slowed from 7.2 percent real GDP growth to a minus 2.1 percent contraction, while inflation jumped from 3.4 percent in 1972 to 12.3 percent in 1974. The petrodollar surge had inevitably created a speculative bubble in the world’s share markets and the market crash of January 1973 was the aftermath of these events. In the 694 days between 11 January 1973 and 6 December 1974, the New York Stock Exchange’s Dow Jones Industrial Average lost over 45 percent of its value, making it the seventh-worst bear market in the history of the index.

Worse was the effect in Britain where the London Stock Exchange’s Footsie Index lost 73% of its value. From a position of 5.1 percent real GDP growth in 1972, the UK went into recession in 1974, with GDP falling by 1.1 percent. At the time, the UK’s property market was going through a major crisis, and a secondary banking crisis forced the Bank of England to bail out a number of lenders. In Britain the market slide only ended after the rent freeze was lifted on 19 December 1974, allowing a readjustment of property prices. Over the following year share prices rose by 150%. However, still reeling under the impact of an excessive build up of money, inflation continued to rise to a British peak of 25% in 1975 before the Paul Volcker solution ushered in a world-wide era of stagflation.

All the main share indices of the future G7 bottomed out between September and December 1974, having lost at least 34% of their value in nominal terms, and 43% in real terms. In all cases, the recovery was a slow and painful process. Although West Germany’s market was fastest to recover, returning to the original nominal level within eighteen months. However even it did not return to the same real level until June 1985. The London Stock Exchange did not return to the same market level until May 1987 when the notorious Black Monday crash happened. The United States did not see the same level in real terms until August 1993: over twenty years after the 1973 crash began.

The 1970s were also an extremely painful time for Latin America. In the 1960s and 1970s Brazil, Argentina, and Mexico had borrowed huge sums of money from international creditors to fund industrialisation and infrastructure development and as a result their economies were booming. Creditors were thus happy to continue to providing loans with a result that between 1975 and 1982, Latin American debt to commercial banks increased at a cumulative annual rate of 20.4 percent. This heightened borrowing led Latin America to quadruple its external debt from $75 billion in 1975 to more than $315 billion in 1983, or 50 percent of the region’s gross domestic product (GDP). Debt service (interest payments and the repayment of principal) grew even faster, reaching $66 billion in 1982, up from $12 billion in 1975.

Then came the oil crisis when OPEC quadrupled oil prices in 1973. While the developed world met the challenge by printing money, the developing countries found themselves in a desperate liquidity crunch. The petroleum exporting countries were flush with cash after the oil price increases and invested their money with international banks which ‘recycled’ a major portion of it as loans to Latin American and African governments. Later, as interest rates increased in the USA and Europe in 1979, debt payments also increased making it harder for borrowing countries to pay back their debts.

Gradually the international capital markets became aware that Latin America would not be able to pay back its loans and the crunch came in August 1982 when Mexico’s Finance Minister, Jesus Silva-Herzog declared that his country would no longer be able to service its debt. In the wake of this default, most commercial banks significantly reduced or halted new lending to Latin America. Since most of Latin America’s loans had been short-term, a crisis ensued when their refinancing was refused. Billions of dollars of loans that previously would have been refinanced, were now due immediately.

As a result of the Latin America loan crisis, international banks were also growing wary of their loans to South Africa where a similar situation of constantly rolled on short-term loans was the order of the day. Thus in August 1985, US banks led by Chase Manhattan, suspended their South African lending operations. The credit crunch sent the rand into a nose dive, which was soon followed by the imposition of exchange controls and a debt “standstill.” was declared by South Africa which froze some $10 billion in payments to foreign creditors.

In both the Latin American and South African cases, repayment moratoria were put in place and the debts were gradually repaid at the expense of general recessions in all these countries and a considerable degree of sacrifice by their citizens. Not so the Asian Tigers when they got into a similar crisis a decade later. There, surprisingly, monetary authorities again forgot the lessons of the past and turned to the printing press to rescue them, thereby sowing the seeds of the next monetary crisis that would reach its conclusion in the Crash of 2008. What a pity they had so rapidly forgotten the lessons of the 1970s and 80s when such largess was untenable and austerity was the order of the day everywhere.

The market crash of 1987 was a little unusual although as ever it was again triggered by interest rate increases. A chain reaction had begun with Germany raising its interest rates which prompted the then Secretary of the US Treasury James Baker to comment that the increase was “…not a trend which we favour…” There was an immediate international panic among investors who for some months had been fearful that the market had been rising to excessive heights. At the time both Germany and Japan were running huge trade surpluses while the US was in deficit. James Baker’s remarks exacerbated fears that foreign investors might dump US investments and, to counter these, the Fed was rapidly forced to do what Baker had indicated it would not do: interest rates were increased and, as money supply shrank and recession again loomed, the inevitable happened: the market crashed.

Here in South Africa the JSE fell 40 percent between October 19 and November 4. In Britain where dividend yields had fallen to a record average low of 3%, the market fell less spectacularly but again the authorities over-reacted. Fearing that the crash would lead to a recession Chancellor Nigel Lawson cut base lending rates from 10% to 7.5% and slashed taxes. The result fuelled inflation and the Bank of England was later forced to raise rates to 15% which, inevitably, triggered Britain’s worst post-war recession.

So severe was this period of economic stagnation in the developed world that when the East Asian Financial Crisis gripped much of Asia, beginning in July 1997 raising fears of a worldwide economic meltdown, only the United States was economically strong enough to shoulder the burden of throwing money at the problem. US financial authorities at that time argued that the US economy was the sole engine of world growth and as such they were obligated to crank up money supply once more for the good of everyone on the planet.

At the time, and as a consequence of the stagnation in most western nations, Asia had been attracting as much as half of the total capital inflow to developing countries. The economies of South-east Asia in particular were maintaining high interest rates that were more attractive to foreign investors than the returns they were getting at home. As a result of this large inflow of money the Pacific “Rim of Fire” nations experienced a dramatic run-up in asset prices. The economies of Thailand, Malaysia, Indonesia, the Philippines, Singapore, and South Korea experienced GDP growth rates of 8 to 12% throughout the late 1980s and early 1990s and were at the time acclaimed by the IMF as the “Asian economic miracle”.

Then came the Asian Crisis that started in Thailand with the collapse of the Thai baht which in turn resulted from a decision by the Thai government to float the baht by cutting its peg to the US Dollar. Thailand had acquired a burden of foreign debt that made the country effectively bankrupt even before the collapse of its currency and the drastically-reduced import earnings that resulted from the forced revaluation rendered a quick recovery impossible without strenuous international intervention. As the crisis spread, most of Southeast Asia and Japan saw slumping currencies, devalued stock markets and asset prices, and a precipitous rise in private debt.

Although most of the governments of Asia had no national debt and seemingly sound fiscal policies, the International Monetary Fund (IMF) was forced to initiate a $40-billion aid program aimed at stabilising the currencies of South Korea, Thailand, and Indonesia, whose economies were hit particularly hard by the crisis.

Japan had already been in a state of profound recession due to a highly inefficient banking system weighed down under mountains of bad debt, much of which up to that point had been relatively invisible because of the established Japanese banking practice of hiding the losses of major customers. As part of the IMF-engineered life raft, the United States intervened to stop a precipitous slide in the value of the yen by agreeing to buy some $2 billion worth of the Japanese currency. In doing so, the United States hoped to increase the value of the yen, which had fallen to its lowest point in some eight years. In Indonesia, after 30 years in power, President Suharto was forced to step down in May 1998 in the wake of widespread rioting that followed sharp price increases caused by a drastic devaluation of the rupiah.

The seeds of the monetary crisis of 2007/8 were sown then for not only were the printing presses resorted to in an effort to re-float these Pacific economies, but Japan’s recovery plan included dramatically lowering its interest rate structure which led in turn to the development of what became known as the “Carry Trade”. Taking advantage of Japan’s low interest rates, speculators were able to borrow money at rates of less than half a percent and invest this initially in US Bonds that were then yielding as high as 6.75%. Then these certificates were round-tripped in order to be pledged as security for even more Japanese loans. Trillions of dollars of fiat money were thus created, seemingly out of thin air. Then, as US bond rates fell steadily to a low of 4.2% in June 2003, this carry trade money began searching for new investment markets which inevitably led to the worldwide share market boom of April 2003 to October 2007.

At this point I need to remind readers of the conclusion reached on the analysis of the Great Depression. “If the government (had) allowed the market to correct itself through interest rate hikes and bankruptcy, the consequent recession would have been severe but brief. If, however, the government interfered with the market, the country would be in for a slow, arduous bloodletting and, ultimately, a future littered with cyclical depressions.”

Which brings me to the actions of the Bank of England and the US Federal Reserve around the sub-prime crisis. In members question time in the British parliament on November 14 2007 Prime Minister Gordon Brown was asked to confirm that the Bank of England had loaned in excess of 25-billion pounds to the sub-prime troubled Northern Rock bank in order to stave off a run by customers: more than Britain had spent that whole year on education. And multiple billions were to follow in the bail outs of 2008.


The graph above, courtesy of Wikipedia, illustrates the ebb and flow of US inflation over the past century offering us an historic perspective of a problem that refuses to be tamed by the modern central banking system. Note particularly the sharp decline in 1920 which arguably allowed the US Federal Reserve the opportunity to massively inflate money supply and accordingly lay the foundations for the market crash of 1929. Note also the relatively low rates from 2000 onwards which laid the foundations for the events of 2007/8.

Weeks before that both the Bank of England and the US Federal Reserve had lowered interest rates successively and both had indicated that they were prepared to do so again if necessary in the future to ensure the continued stability of their respective economies. Meanwhile, in the United States, President George Bush was assuring home owners that action would be taken to save their homes from repossession.

Of course a primary function of central banks is to ensure financial stability and the Bank of England, the US Federal Reserve and the European Central Bank were acting responsibly when they created extra money at that time. Clearly, however, they had been less than responsible in previous years when they allowed such a mass of extra money to be created. The real question though is whether the central banks are any longer in control of the money supply? Former Fed chairman Alan Greenspan has, in his book The Age of Turbulence: Adventures in a New World’ effectively admitted that they are not.

To understand this point of view it is important to recognise that while the central banks create the monetary base, base money is only a minor part of the money supply. Most of the money we use is credit issued by private banks in the form of deposits. Bank deposits are accepted as money because of the promise that they can be converted into base money on demand. Thus, for example, when carry trade speculators borrow money in Japan to invest elsewhere and in turn recycle these investments as security against further loans in a virtually endless cycle, almost infinite sums are created which the modern central banking system is virtually powerless to regulate.

Next we have the phenomenon of the velocity of money. In the bygone era of the Gold Standard when the basic unit of most currencies was a fine ounce of gold and pounds, dollars, roubles and yen were thus all interchangeable throughout the marketplaces of the world, a merchant in Johannesburg ordering a consignment of fine linen from Manchester would ship the necessary coins as payment in advance of delivery in an extended journey by rail and ship which could take weeks or even months to reach its destination. Today the same value in electronic bank transfers can circle the globe in seconds. In relative terms then, the effective buying power of money has expanded in direct proportion to the rate in which individual transactions can be completed. So the world’s money supply money is growing exponentially as a consequence of both bank credit and the speed with which transactions can now be completed because of the development of the internet.

Finally, one needs to recognise that for the carry trade to prosper, it is necessary that interest rate differentials exist and so when central banks act in concert to raise rates, it understandably becomes increasingly unattractive to maintain the carry transactions and as each loan is repaid, the money supply again shrinks.


Thus, in theory, the central banks are still in control. In practice, however, each nation has its own political and monetary agenda and so consensus is seldom a practical reality. When it does occur it is usually in response to a crisis as illustrated by central bank action in the aftermath of the sub-prime crisis. And the consequent reality is that the world’s money supply has expanded at an alarmingly unhealthy rate. Worse, it logically follows that when private banks and market speculators lose their appetite for risk, close out their speculative positions and refund their loans, the world’s money supply can contract even faster: which is what happens when speculators fear that a bank rate increase or series of increases might be in the offing or when investment markets are perceived to have become dangerously expensive. Volatility has increased exponentially and with it the risk facing investors.

In summary then, when the global money supply expands the twin consequences are that commodity and investment market prices rise in like proportion. Central banks, whose primary role is to keep inflation in check, were in the past able to directly control the quantity of money that was in circulation by manipulating the rate of interest that they charged when they lent money to private banks. Now, because of a huge overhang of bank credit which acts like a shock absorber dampening down the effects, it is accepted that it can take upwards of 18 months for a change in base lending rates to percolate through the system and affect the inflation rate.

Share market price levels, while a consequence of both long-term changes in money supply and changes in the profitability of their constituent companies, are as much driven in the short-term by human emotions and the herd instinct as they are by corporate profit growth. Thus, while changes in interest rates are nearly always intended to control monetary inflation and usually result in eventual changes in the profitability of exchange-listed companies many months in the future, the investing public will often indulge in immediate opportunistic buying or panic selling which usually results in the prices of securities grossly exaggerating the probable profitability changes and either rising far above or falling far below their long-term price means. The intelligent investor will accordingly adopt an investment strategy which can effectively exploit this.

Naspers  – how to add additional value for its shareholders

By Brian Kantor, chief economist and strategist at Investec Wealth & Investment

When the financial history of South Africa in the first two decades of the 21st century comes to be written, the role played by Naspers (NPN) will surely be a prominent one. Its achievements reflect many of the important themes of our financial times- not only that of outstanding returns to share-holders that made NPN by far the most important contributor to the JSE – with a weight in the JSE market Indexes of about 17% and a market value that rose from R7b in 2003 to nearly R85b by the end of 2016.

But as important and interesting is that the value added for shareholders came from participating in the new digital economy and by taking excellent advantage of South Africa’s newly acquired democratic credentials and consequent access to global markets in goods services and capital.

Fig.1; Naspers (NPN) Market Value and share of the JSE Swix Index


Source; Bloomberg, Investec Wealth and Investment

The most important decision made by NPN management was the decision taken in 2001 to purchase 46.5% of Tencent (a Chinese internet business listed in HongKong for USD34m.[1] This stake has since been reduced to a 34.33 per cent holding. As we show below the rand value of Tencent itself, when converted to ZAR at the current rates of exchange, is now over R3000b and the theoretical or potential worth of the NPN stake in Tencent to over R1000b.

Fig 2. Market Value R millions of Hong Kong listed Tencent and the theoretical value 34.33% NPN stake in it. 2007-2016. Month end data


Source; Bloomberg, Investec Wealth and Investment

The theoretical not actual value of the stake in Tencent

The theoretical nature of this estimate deserves emphasis. Firstly because its holding in Tencent is worth more than the value of NPN itself as we show in figure 3- some 22% or R216b less than its holding in Tencent.  This implies that all the other assets of NPN in which it has made very large investments have a large negative value for shareholders of as much as R216b.

Fig 3; The market value of NPN and its stake in Tencent (Rm) (Month end data 2014-2016)


Source; Bloomberg, Investec Wealth and Investment

The link nevertheless between the share value of NPN and Tencent Holdings is very close – notwithstanding the fact that NPN now seems to be worth significantly less than its holding in Tencent. The correlation of the daily level of two share prices measured in ZAR is 0.99 indicating that almost all of the price level of NPN in ZAR can be attributed to its holding in Tencent and the current value of a Tencent share.

NPN is much more than a holding company for Tencent shares- but what is its other business worth?

NPN, as a business enterprise, however is much more than a holding company for its investment in Tencent, as its cash flow statement for the latest financial year to March 2016, demonstrates very fully. NPN reports dividend income in 2016 (mostly from Tencent) of USD146m compared to net cash utilised in investment activity by NPN in FY 2016 of USD1,384m. This investment activity in 2016 was facilitated by additional equity and debt raised in 2016 of USD4470m of which USD2270m was applied to repaying existing debts.

The implication often drawn by investment analysts when comparing the value of NPN to its sum of parts- including the Tencent holding – is that all this investment activity undertaken by NPN management destroys rather than adds significant value for its shareholders. But such a conclusion, or rather the scale of this presumed value destruction, is perhaps not nearly as obvious as it may seem on the surface.

It is firstly not at all clear that NPN would ever be willing or indeed able to dispose of its holding in Tencent.  Even if NPN were willing sellers, such a disposal might well be subject to the approval of the Chinese authorities. These authorities would be concerned about who might acquire these rights to the revenue and income from NPN- for example US internet companies that have a dominant share of the global internet business that might not be welcome in China.

Thus valuing the NPN holding in Tencent, as if it could be easily disposed of a current market prices – or even unbundled to its NPN shareholders- may well be an invalid assumption. In reality the NPN stake in Tencent may well be more conservatively valued in the market place as an illiquid asset and so worth less than it appears on the surface- that is valued at less than the prevailing market value of Tencent- but exactly how much less would be a matter of judgment.

Moreover if there is no NPN intention or ability to dispose of its Tencent stake then its value to NPN shareholders will depend on the uses to which NPN puts the dividend income it receives from Tencent, and perhaps more important the borrowing capacity its stake in Tencent may give NPN and the debt capital it raises to fund investment expenditure.

The NPN cash flow statement for financial year indicates significant investment and financial activity as discussed above. The cash flow statement also refers to NPN dividend payments of USD254m in 2016. That is dividends paid to NPN shareholders in 2016 exceeded the dividends received from Tencent and other investments. Clearly these dividend payments are not valued as highly as dividends paid by Tencent a point to which we return below.

Tencent listed in Hong Kong is no ordinary company

The full nature of the holdings of NPN and other shareholders in Tencent Holdings in Hong Kong deserves full recognition. These holdings do not represent an ownership stake in the usual sense. Tencent Holdings in Hong Kong provide its shareholders with contractual rather than ownership rights. They only have rights to the revenues, earnings and dividends generated by the Chinese owned operating company provided by Tencent Holdings- not to the assets of the company in China that have to be owned by Chinese citizens. Accordingly these right holders have no claim on the assets of the company should they have to be liquidated, unless they are Chinese owners. The contractual right is only to a share of revenues earnings and most obviously to dividends- not to the assets of the company operating in China that is limited by law to Chinese citizens.

Foreign ownership of internet and media companies in China including Tencent is prohibited. These ownership restrictions were however overcome and access to foreign capital achieved by Chinese entrepreneurs, including those who founded and developed Tencent, through contractual arrangements known as Variable Interest Entities (VIE’s) of which Ten Cent Holdings listed in Hong Kong is but one of many such entities listed outside of China. The note from Reuters on Alibaba written in September 2016 – a large rival to Tencent Chinese owned internet company –more recently listed in New York –explains the nature of a VIE.

Report from Reuters on VIE’s September 2016

Sept 9 (Reuters) – When Alibaba Group Holding Ltd sells more than $20 billion in shares on the New York Stock Exchange next week, investors won’t be buying equity in China’s biggest e-commerce company. Instead, they will buy into a firm that owns the rights to participate in the revenue created by a handful of Alibaba’s e-commerce and advertising businesses.

* Alibaba Group is set up as a traditional variable interest entity (VIE) structure – an elaborate legal arrangement designed 14 years ago to help Chinese tech and financial companies that hold restricted government-issued domestic licenses raise money overseas.

* VIE structures allow offshore-listed companies to consolidate domestic Chinese firms in their financial statements by creating the appearance of ownership.

* Of the more than 200 Chinese companies listed on the New York Stock Exchange and the NASDAQ, 95 use a VIE structure and have audited financial filings for 2013, according to ChinaRAI, a Beijing-based business consultancy. They include China’s biggest internet companies, such as Baidu Inc and Inc.

* VIE structures typically involve offshore holding companies in the Cayman Islands and British Virgin Islands; Hong Kong subsidiary enterprises; Chinese wholly foreign-owned enterprises (WFOEs); and local operating companies. The Chinese operating companies that anchor the arrangement are called the VIEs and hold the Chinese licenses that are restricted to domestic companies – in Alibaba’s case, primarily internet content provider licenses.

* Alibaba’s VIE structure comprises five local operating companies, each of which is 80 percent-held by co-founder and executive chairman Jack Ma, and 20 percent by long-term executive Simon Xie – except for Zhejiang Taobao Network Co, which is 90 percent-held by Ma.

* A series of technical services, loan, exclusive call option, proxy, and equity pledge agreements bind the domestic firms to the WFOEs and create the “variable interest” – allowing offshore Alibaba Group shareholders the appearance of control of the local companies.

* The contracts also are meant to provide a legal framework of checks and balances to guarantee that the ultimate stakeholders of the local operating companies act in accordance with the wishes of the offshore listed company’s shareholders. On occasion, such contracts have been broken. In 2010, for example, Ma unwound the contracts for Alibaba’s Alipay unit, triggering a dispute with major shareholders, including Yahoo Inc.

* The VIE structure has never been tested by courts in China.

* In its pre-IPO filings, Alibaba cautions investors that it can’t guarantee its VIE shareholders “will always act in the best interests of our company”, and that if the Alibaba VIE shareholders breach their contracts, “we may have to incur substantial costs and expend additional resources to enforce such arrangements.” (Compiled by Matthew Miller; Editing by Ian Geoghegan)

Thus the value of these contractual right to the revenue, earnings and dividend streams generated by these VIE’s is subject to significant uncertainty that is surely recognised in the prices of their shares listed outside of China. Thus any negative impact on the value to the beneficiaries of these VIE’s arrangements will however also apply to the rights enjoyed by all owners in Tencent Holdings listed in Hong Kong- including those held by NPN. Any VIE discount attached to the rights in Tencent traded in Hong Kong would already be reflected in the Tencent share price.

The value of the dividends paid by Tencent- valuing dividends to recognise value destruction- and the value add opportunity.

The direct benefits to NPN shareholders have come in the form of dividends received from Tencent. These as may be seen have grown spectacularly both in USD and even more so in ZAR. By year end 2016 the .3433 per cent of the dividends flowing to NPN would have been of the order of USD200m or R2700m at current exchange rates. These dividends have grown spectacularly- at an average annual compound rate of about 42% p.a. in USD and 51% p.a when measured in ZAR since 2017. (See below)

Fig 4. Tencent dividend and earnings flows to shareholders. (2007-2016)


Source; Bloomberg, Investec Wealth and Investment

These growth rates and the expectation they would be sustained, have been reflected in the values attached to shares in Tencent Holdings. As we show below the Tencent shares as at December 31st 2016 traded at 42.1 times reported earnings and an even more spectacular 403.6 times reported dividends. (see figure 5 and 6 below where we show the trailing Tencent earnings and dividend yields and multiples.) The dividend yield (D/P) as at end December 2016 was 0.247 and the earnings yield (E/P) 2.37.

Fig 5; Tencent Holdings; Earnings and Dividend Yields Daily (Data 2007-2016)


Source; Bloomberg, Investec Wealth and Investment

Fig 6; Tencent Holdings; Price/Dividends and Price/Earnings Ratios (Daily data 2007-2016)


Source; Bloomberg, Investec Wealth and Investment

Were the dividends received from Tencent by NPN shareholders accorded the same price multiples as those accorded to Tencent shareholders themselves this .3433 share of the dividends paid by Tencent would command a value of about USD79b or ZAR1,085b, at prevailing exchange rates, that is well ahead of the ZAR850b of NPN market value recorded at year end 2016. Another way of putting this would be to say that the dividend stream paid by Tencent to its shareholders would now be worth R200b more if NPN shareholders could receive these dividends directly rather than via NPN. As indicated earlier unbundling these shares is not a choice NPN is likely to make- nor may it be a feasible option given Chinese sensitivities. What however might well be possible would be for NPN to create a Tracking Stock to track its Tencent Holding[2]. It could in other words further contract with its shareholders to pay out all the dividends it receives from Tencent directly to them and that these rights to the Tencent dividends could be traded separately in the market place. NPN would continue to own its Tencent rights so no change in control would have occurred and such ownership rights as before would be reflected on its balance sheet. The NPN, Tencent tracking stock would then presumably be a pure clone of Tencent itself and so command the same value- that is 400 times the dividends paid out. NPN shareholders would then be about ZAR200b better off.

Furthermore the shareholders and NPN managers would then know very precisely the value added or lost by the investment activity undertaken by NPN. The rump of NPN- net of the explicit value of its Tracking Stock – would very objectively measure how much the other assets of NPN – in which it has invested so heavily – are actually worth to shareholders. The case for adding to such assets- including raising debt to the purpose – would then presumably have to be a good one. In addition, with dividends flowing through the tracking stock, NPN could make the case for reducing its own dividend payments- and investing the cash. That is if NPN could realistically expect returns that would exceed its cost of capital, above required risk adjusted returns, and so add value for shareholders.

In line with much market commentary, is it unfair to suggest, that the complications inherent in valuing the Tencent stake in NPN has encouraged poor capital management by NPN? The large difference, approximately R200b between the value of the Tencent dividends received by NPN and the value of NPN itself strongly suggests that NPN is not expected to add value for its shareholders through its investment activity.

Recognising objectively the value of the Tencent stake through the market value of its tracking stock will help expose the significant other business of NPN to the essential disciplines that should govern the use of shareholder capital. This surely would be good for NPN shareholders.


For all its past success the management and directors of NPN have a very large problem with investors. The market reveals that NPN would be worth much more to its shareholders if it sold off all its assets and paid off its debts. The assets it has invested so heavily in (in addition to its investment in Tencent) would have significant positive value in other hands- surely many hundred of billions of rands. But such sales or unbundling of assets is regarded as a very unlikely event hence the lower sum of parts value attached to NPN.

What the market is telling NPN management is that its impressive investment programme is expected to destroy many billions of shareholder value. That is the cash to be invested, by NPN, is thought to be worth many billions more than the value of the extra assets the company will come to own and manage. This investment programme is a very ambitious one. In FY 2016 the company reported development expenditure of USD961m and M&A activity of USD1495m.

Clearly the NPN directors and management must believe differently, that the cash it intends to invest on such a large scale will add value for shareholders- that is return more than the cost of this capital- that is achieve an internal return of at least 8% p.a when measured in USD or 14% p.a in rands. If it achieves such returns it will add rather than destroy value for shareholders.

But there is room for an important compromise between sceptical investors and confident managers. And that is to separate the Tencent investment from the rest of the business. If NPN established a tracking stock that passed on the dividends directly to its shareholders this tracking stock would be valued at approximately 400*R2.7b, or approximately R1080b – about 200b rand more than the current market value of NPN itself. This tracking stock would be a pure clone of Tencent- perhaps also listed in Hong Kong and can be expected to trade on the same dividend generating basis as Tencent itself.

Shareholders would surely greatly appreciate an immediate  R200b plus value add – and the growing dividend flows from Tencent- via NPN. And the quality of NPN management could then be measured much more clearly without the complications and comfort of its Tencent stake.

[1] The listing in HK on the Hang Seng exchange is abbreviated as 700HK

[2] For a full analysis of Tracking Stocks and their feasibility see

J Castle and B Kantor,  Tracking stocks – an alternative to unbundling for the South African group, The Investment Analysts Journal, 2001 51(4), also to be found on the website, Research Archive.

       Trump vs. Big Pharma Welfare

By Patrick Watson

“They’re getting away with murder,” said President-elect Donald Trump..No, he didn’t mean Russian hackers. He was talking about red-blooded American drug companies.Trump went on: “Pharma has a lot of lobbyists and a lot of power, and there is very little bidding. We’re the largest buyer of drugs in the world, and yet we don’t bid properly, and we’re going to save billions of dollars.”

That last part isn’t quite correct, though. Trump said there’s “very little bidding” when the government buys drugs. In fact, there’s no bidding at all when Medicare buys prescription drugs. The Bush-era legislation that created Medicare Part D bars the government from negotiating lower prices, despite it being the drug industry’s biggest customer by far.

That’s one reason pharmaceutical and biotechnology stocks performed so well in the last decade. And it’s why the prospect of losing that advantage pushed those sectors lower. However, the Trump-inspired loss is actually minor compared to what another president once did to drug stocks. The dot-com bubble has some lessons we best not forget.

Party Like It’s 1999

Remember Y2K Eve? We all partied that December 31 because a) Prince had given us the perfect song for it, and b) we thought civilization might collapse when midnight struck.

Fortunately, the electric grid stayed online, everyone survived, and the stock market continued its steady climb. The Nasdaq Composite Index had risen 86% in 1999, and folks expected more of the same in 2000.

They got it… for a few weeks.

At one point intraday on March 10, 2000, the Nasdaq showed a 26% year-to-date gain. Another double-your-money year seemed possible. Then this happened.


March 2000 turned out to be the Nasdaq’s all-time high and remained so for another 15 years. That bear market had many causes, but Bill Clinton and the UK’s then-Prime Minister Tony Blair gave it the first push. The Human Genome Project was a big deal in the 1980s and 1990s. Scientists were trying to “sequence” our DNA, i.e., map which genes go where. It was a laborious process, even with that period’s best technology, but it promised to create medical miracles.

There was actually kind of a race underway:

· Universities and research institutions all over the world cooperated in a government-backed initiative.

· Meanwhile, Celera, a private company led by biotech pioneer Craig Venter, was trying to do the same. Celera focused on genes it thought would lead to profitable drug breakthroughs.

Celera needed patent protection for its genome data in order to develop its business. No one was quite sure that was possible, but they invested like it was a sure thing.

Bad idea. On March 14, 2000, President Clinton and British PM Blair popped the biotech bubble when they said genome data should be free to everyone.

You can see how much investors liked this idea in the Nasdaq Biotechnology Index. It had peaked a few days earlier but collapsed with the Clinton-Blair statement. In just a few weeks, sellers chopped the biotech index almost in half.


The March 15, 2000 New York Times recorded the carnage for posterity:

President Clinton and Prime Minister Tony Blair of Britain said yesterday that the sequence of the human genome should be made freely available to all researchers. The statement led to a sharp sell-off in the stocks of biotechnology companies, which hope to profit by creating drugs based on genetic data.

The White House quickly said it did not intend to hurt the fledgling biotechnology industry, but investors who have made biotechnology stocks the darlings of the market were unconvinced. In frantic selling, they wiped away tens of billions of dollars in market value from the industry. Genomics companies, which are racing to produce a database of human DNA, were hit hardest, with some off more than 20 percent.

The drop was not confined to the biotechnology sector. After briefly passing 5,000 in morning trading, the Nasdaq composite index, which is heavily weighted in technology stocks, fell steadily. The index closed at 4,706.63, down 200.61 points, its second-largest point loss ever.

For investors, the drop is noteworthy, because biotechnology and Internet companies have led the stock market so far this year, while most other stocks have languished. Despite falling almost 13 percent yesterday, the Nasdaq biotech index remains up almost 30 percent this year, thanks to investors’ belief that a new wave of drug discovery and gene therapy is imminent.

Biotech traders heard that “freely available” line and hit the sell button. That was smart, but even they didn’t know how bad it was going to get. The NYT writers didn’t realize they had just documented a generational stock market peak, either.

Did Trump just do the same thing again? We don’t know yet. As they say, history rarely repeats itself, but it often rhymes.

Back in that 2000 crash, biotech industry leaders made a key mistake. They thought getting the government to protect their genetic data would be easy. Pay some lawyers, make some campaign contributions, and voilà, you have a legal monopoly. Ka-ching. It turned out not to be so easy. Today’s drug companies are making a similar mistake. Because they greased the right palms when Medicare drug coverage passed back in 2003, they think they have a permanent right to set their own prices – which taxpayers must pay.

In both cases, private companies assumed they were permanently entitled to certain government benefits.Yes, I used that word: entitled. The “entitlement mentality” you hear about isn’t just for food stamp recipients. It exists within large corporations too, and the amounts are often much greater. But even if Washington grants you a benefit, today’s Congress can’t tie the hands of a future Congress.

Senators and Representatives can change their minds anytime they want—and they should change their minds, or at least consider it, when voters demand change through the electoral process. That’s a risk factor investors forget at their peril. If a business depends on some kind of government favor, don’t assume it will be there forever. Biotech investors found out in 2000 that political privileges are never a sure thing. The Trump era may teach Big Pharma shareholders the same hard lesson.

Will the rest of the market collapse, too, as it did in 2000? Ask me next year.

Trump’s long and winding road

by Cees Bruggemans

It started simple. We will give you tax cuts, better infrastructure, less regulation. For those craving it, there will be more trade protection &

fewer Mexicans. Geopolitically, we will demand fairer treatment, as much from our European and Asian allies as from China.

But it never stays simple. Daily tweets ensure that the (growing) assault from special interests, questioning media and of course surviving Democrats

offers ever more intensity. And the President-elect ever so willing to respond. I experience different sensations about Trump policy talk, depending on when taking a medium term view, the long view, or the short term noise.

The medium term “strategic” view is devoid of chatter, and also doesn’t take into consideration longer term sustainability. It assumes the airplane holds together, and will take-off, but with no sense of what happens thereafter.

The short-term daily focus is a totally different experience, creating an uneasy sense that this thing is hurtling towards a brick wall.

Three levels, three sensations, three outcomes. Which is the real one?

The most comfortable one is the broad-brush strategic view, with not too much focus on detail. We are going to cut taxes, increase infrastructure

spending, change the welfare function, deregulate in line with common sense.

The equity markets have responded positively to the implied faster growth and higher earnings, the bond market notices the switch in emphasis from

monetary to fiscal, and has raised bond rates (and expectations for the entire yield curve), and the Dollar is stronger. The good ship America is

holding to a new course.

Strangely, nothing is as yet firm about these policy shifts. Not about how low corporate taxes will be cut (really 15%?), how global earnings will be

treated (will it really trigger a repatriation of capital tsunami?), how much new infrastructure will be committed, what will be deregulated (and how

much?). Markets haven’t got the luxury of waiting. Instead, this gigantic bet that it will all be very big and wonderful, and thus discountable positive

rather than fearful .But a longer view sees something quite different. A fiscal deficit ballooning, a monetary policy and bond market rate hiking, a Dollar spike as

capital favours the US, global capital flow disruption weighing heavily on fringe emerging markets.

All this before shifting to the favoured trade policy of America first, which also has geopolitical implications.

Trump appears successful in inducing some American companies to reconsider their foreign investments, particularly in Mexico. Especially the motor

manufacturers, but also other industrial companies originally located in the American rust belt are in focus. It allows Trump to claim trophies and

hold them high, for his voters to see. Doing just what he has promised.Meanwhile American foreign trade is more than a few foreign car factories. If import taxes are set to be imposed, there will be global ramifications,

especially in China and Mexico, but also beyond.

American consumers would have to pay more for their imported consumption, China may find its trade balance and Yuan pressure worsening, global trade

competitors might find it necessary to meet tit for tat, while currencies will do most of the reweighing. The net outcome may be American-negative.On a more deeper level, is the real challenge facing America macro in nature (give us more demand) or is it supply (give us more competitive ability,

not through protection and a disruptive stronger Dollar, but through better and affordable education)?

So far, the airwaves have been full of the pleasant medium-term broad strokes, and the happy consequences flowing from them. But this happy picture is

being eaten away from two sides, both the long view and the daily assault. The questions raised longer term make the equity boom to date out as a mere sugar rush, while the bond market may ultimately not crack just as yet.

The more fascinating spectacle is the short view. The new administration is a week from inauguration and the noise levels are already getting painful.This is quite normal for any incoming administration, but what is on show now seems to be on a level of its own.

On one level this is creating an enormous excitement that something big is happening, with positive outcomes for years to come. On another level it is

creating caution, even fear, that something truly disastrous is within striking distance. But then the unknown always creates such sensations. In a manner of speaking, it feels like going to war. For some creating a deep sense of wonderment

about what is going to change for the better. For others a deep dread as to where it may lead. It won’t be long now before reality will start to intrude with the first real battle scenes and their outcomes.

SA interest rate prospects

by Cees Bruggemans

With growth short of 1% and the SA economy far from full resource use, inflation likely to fade from a recent peak of 6.8% to nearer 5%, the Rand

remarkably benign in 13-14:$ territory, and near neutral in trade-weighted terms, and the short-term interest rate structure (from repo to prime)

increasingly real, one might expect to see interest rates easing.

And yet those odds are fading. SARB is stability oriented, and the biggest risk resides in foreign capital flows, given the size of the SA current

account deficit needing foreign funding. Anything major going wrong could shock the Rand weaker, and inflation higher, having further secondary

effects on wage rounds and company pricing. The risk analysis on this front is a thorough one. Aside of domestic risks, especially political, about which the less said the better from an

institutional point of view, the main additional focus is international.

Here the past decade has offered many demons, real and as yet to unfold. Very real was the Anglo-Saxon debt crisis from 2007 onward. Europe offered

various crisis scenarios from 2009, focused on Greece and other peripherals. From 2013 the attention shifted primarily to the Fed, imminently starting

with tapering of its bond purchases, followed by a regime of interest rate tightening.

With the Obama government shooting all its fiscal bolts during the 2008-2009 financial debt crisis, the weakly recuperating US economy since then

could only get further support from the Fed through an exceptionally accommodative monetary policy that took interest rates eventually to zero while

multiplying the size of the Fed balance sheet various times over. Throughout, this was experienced as an area of major risk for the SARB, in the event of disrupted global capital flows, a weaker Rand and an inflation

shock. Something like that in fact erupted in late 2015 for domestic SA and US reasons, warranting the cautious SARB stance and gradually tightening

rate increases. From early 2016, however, both these domestic and US risks resided somewhat, the Rand started a long clawback, and the SARB seemed to become slightly

more relaxed.

How ironic then that we all had to wake up to a Trump presidency in early November, promising to shake up the USA and the world, and overnight taking

back the lead locomotive role from the Fed which became relegated to a secondary role. That may sound abrupt and overstated, but then the Trump impact

was that forceful and the Fed response that meek & mild. Yes, the Fed will raise US rates this year and next, but its own role in setting the pace has greatly diminished. Instead, Trump action in terms of

tax reform, business deregulation and the start of infrastructure spending (and most potently the private American economic responses thereto,

amplified globally), will likely set the pace henceforth.

With as additional complication an avowed promise to intervene in establish trade patterns in an attempt to favour America and bring the jobs back

home, but in the process potentially starting trade wars and losing the economic benefit of the globalised trading system that is now in place.

It would be a mild understatement to say that this has created huge uncertainty about the way forward, in markets, in the US economy and globally.

In the process, we may expect the SARB to shift its crosshairs once more, away from the Fed as main crisis instigator (but still as a major channel),

and towards Trump and his many intended actions.

Which of these policy initiatives may bear positive fruit and which may have explosive negative potential? These risks are not easy to read. For the time being SARB can be expected to remain highly vigilant, to see how this will play, with what effects on

SA. I would not call that an environment in which to expect interest rate cuts. Perhaps another time. We will be so lucky not to encounter rate increases

in 2017, the Year of Trump’s biggest policy makeover and disruption globally.

The President’s Weak Position

by George Friedman

The American presidency is a paradox. It is the most noted position in the world, imbued by observers with all the power inherent to the world’s most powerful country. Everyone is now trying to understand what Trump intends to do.

At the same time, the American president is among the weakest institutional leaders in Euro-American civilization. He can do some things unilaterally, particularly in foreign policy, but Congress can block them. He can do some things by executive order, but the Supreme Court can overrule them. He can pass certain programs that require cooperation from states, but the states can refuse to cooperate. At every step, as the founders intended, his ability to act unilaterally is severely limited. The difference between how presidential power appears and how it is applied in reality is enormous.

So now, the most important question is not, what does Trump intend to do… but instead, what will Congress do? Both chambers have Republican majorities. Republican control of the House of Representatives is overwhelming. Republican control of the Senate, though, is not.

The Senate has 52 Republicans, 46 Democrats, and two independents who are likely to vote with the Democrats. This essentially gives the Republicans a four-vote majority. Because the vice president would be the deciding vote in a tie… and because he is a Republican, three Republicans would have to switch sides to defeat any legislation.

Under the Constitution, senators are not elected to rubber-stamp the president. They are elected to represent their sovereign states. So this battleground will not be between Republicans and Democrats. Nor will it be between both chambers. The real battle will be among Senate Republicans.

Three defections make it impossible to pass any proposed legislation. As such, any Republican senator who can position himself as a potential defector will be able to negotiate for the president’s support on any number of issues. The president will either be forced to compromise or risk having the legislation defeated.

Approval Ratings Are Key

Senators are not free actors. They need to be re-elected. Their calculation on whether to oppose a Republican president will depend heavily (if not entirely) on whether the president will help or hurt them in their re-election bids. That depends on the president’s approval ratings, particularly in the senators’ home states.

According to a Fox News poll taken just before Inauguration Day, 37% of those polled approved of Trump’s performance and 54% did not. And therein lies Trump’s problem and battleground.

President George W. Bush, President Richard Nixon, President Lyndon B. Johnson, and President Harry S. Truman all had approval ratings around 37% toward the end of their terms. This number is normal for a failed or worn-out presidency.

I know of no president in the 20th century who began his term this way. Each party historically commands about 40% support among voters. When a president falls below 40%, he is actually losing support from his own party. It is normally hard to come back from that… and it usually takes years to get to that low level.

This poses a problem for Trump’s administration. With these numbers, it is possible that more than three Republican senators could decide that rigid support for the president might cost them their political lives.

Trump’s approval ratings are unlikely to fall below 37%, but to be effective, he can’t stay at that level. Republican senators will look at the president’s negative ratings in their states and calculate whether supporting his programs might lock 50% of voters against them. It is important to recall that constitutionally, a senator is supposed to serve the people of his state, not the president.

Because public support wanes over the course of a presidency (though it sometimes blooms with nostalgia later in his term), it is essential to start a term with as much support as possible. Therefore, if Trump wants to get controversial bills passed, he must build his popularity quickly. His staff, particularly the vice president, will be examining every Republican senator who is up for re-election in 2018 to determine how to help sway their states’ voters. Trump’s fear will be that he will alienate his core while failing to make inroads with his enemies.

The Other Roadblock

The final point to consider is, of course, the use of filibusters. This is a deep tradition in the Senate, and it has served as another check on power that the founders would have been proud of. Any senator may filibuster a bill, and if a whole party does it, the filibuster can only be stopped by getting 60 votes in favor or by letting the senators go on until they drop.

If the latter happens, the Democrats in the Senate would effectively be able to block Trump’s entire agenda. Alternatively, Trump would need the support of eight Democrats to get 60 votes to end a filibuster. That isn’t likely to happen.

The president can achieve some things with an executive order, assuming the Supreme Court doesn’t step in. But broader policies like infrastructure development won’t get passed without congressional support.

That battleground will be within the Republican Party in the Senate. The result will depend on whether Trump’s approval ratings increase above 37%. Just holding there won’t do it, as that number has been “Death Valley” for other presidencies… although we have no way to benchmark a presidency that starts at this level.

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