Japan's Finest Hour

St.John's, Newfoundland, January 16, 2002.

Dear Sir,

May I assure you that I deeply sympathize with the felt bitterness of many of your compatriots who still remember the deprivations during and after the war, and who think that postwar Japan has set a proud example to the world of working hard and saving hard, phoenix-like to rise from her ashes, while constructing the world's second largest economy, creating a most reliable currency second to none in the postwar period, and helping the rest of the world lead a better life through her exports of consumer goods - only to see her prosperity give way to deprivation once more through deflation and depression.

Open the Mint of Japan to Gold!

Sir, I respectfully submit that you could make Japan once again the Land of the Rising Sun and, at the same time, you could prevent the Sun from setting on Western Civilization. Do not let Japan's stellar postwar record of currency management be smeared by engaging in 'reflation' as urged upon you by American economists. Follow the path of honest money. The choice is in your hands: open the Mint of Japan to gold.

Presently the United States government charges 100% seigniorage for supplying the world with international currency. It is usurping a privilege without shouldering the countervailing responsibilities. Another way of putting this is that the marginal cost for the United States of buying the export of other countries is nearly zero, as it is equal to the cost of printing Federal Reserve notes. This levy or, to use an older but more accurate word, tribute is bankrupting other countries. Evidently, it was this tribute that was responsible for breaking the back of the Argentine economy, the second largest in the South American hemisphere. This tribute has also been a very onerous burden on the Japanese economy, even though it is the second largest in the world. A case can be made that this tribute is responsible for plunging the Japanese economy into deflation. In the hour of her need, Japan's substantial foreign exchange reserves held in dollars proved unavailable or inaccessible. The sudden disappearance of a pile of currency of that magnitude cannot help but spell deflation.

As is well-known, the European Community has got tired of paying the tribute and started issuing its own euro, designed to compete with the dollar as an international currency. Unfortunately for the world, the Europeans missed a great opportunity. Rather than providing the world with a real alternative to the dollar, they chose to ape the Americans in charging 100% seigniorage themselves.

If Japan opened her Mint to gold, she would in fact become the provider of and international currency, the gold yen, at zero seigniorage. Anyone could take gold to the Mint and, free of charge, have it converted into gold yen coinage. The world would be a different place after Japan has resurrected free coinage. Zero seigniorage would guarantee the success of the operation. The trading nations of the world would now have a real choice: they could finance their trade with others either through an international currency available at 100% seigniorage, or through one at 0% seigniorage. Countries would send their gold to Japan to be converted into gold yen coinage, or credits denominated in gold yens, with which they could pay for the imbalances between their imports and exports. Free coinage would make Tokyo the center of financing world trade, a role once played by London after England opened her Mint to gold at the suggestion of the Master of the Mint, one Isaac Newton. Japan could charter the world's first Gold Bank in this new century and millennium. In acting as a clearing house for gold yen credits, the Bank would finance world trade. It could also help developing countries raise capital by underwriting gold bond issues. By its Charter, the Bank could only accept collateral security for its loans in the form of gold bonds with a sinking fund protection. It would also be prohibited from borrowing short in order to lend long.

The importance of opening the Mint of Japan to gold becomes clear if we contemplate that the default by the United States on its international gold obligations in August, 1971 has, in retrospect, done a great disservice not only to the creditors of the United States, but also to world trade. It immobilized the most reliable, most potent, and most flexible source of credit with which to finance world trade: gold. All the other countries and peoples of the world were made to suffer so that the loss of face of America connected with the default may be covered up. In consequence, world trade has been crisis-prone ever since, and the international payments system has been in a state of near-paralysis. Japan could end this stalemate by mobilizing the world's gold reserves, making world trade prosper once more. There is no need to 'fix' the 'official' price of gold in terms of the paper yen which, along with paper dollars, may be allowed to circulate side-by-side with the gold yen. Let the free market decide the ultimate fate of irredeemable paper currencies, as it always has.

The Blackhole of Zero Interest

American economists in and out of government have a patronizing attitude as they pontificate on the mistakes made by Japan while covering up greater mistakes by the United States in running an iniquitous, even predatory international monetary system in contemptuous disregard of the monetary clauses of the American Constitution. Thus John H. Makin of the American Enterprise Institute in his column Economic Outlook dated January, 2002, entitled Japan in Depression (www.aei.org) concludes that Japan has succumbed to depression. She could no longer escape from the pull of the Blackhole of Zero Interest, a concept I introduced in my essay The Economic Consequences of Mr. Greenspan ( www.gold-eagle.com ). Makin suggests that Japan can only blame herself as she failed to heed the warnings of the American money-doctors to reflate (a euphemism for 'inflate away' the increasing debt-burden through working the money-presses overtime). I take the liberty of drawing your attention to two errors, one of omission and the other of commission, in Makin's arguments.

In discussing the problem how to raise cash needed to bail out insolvent banks (or to compensate depositors for their losses after the banks have folded) Makin dismisses the idea of selling assets such as shares the government owns in Japanese Tobacco or Nippon Telephone as this would further depress an already battered stock market. Here he makes his error of omission: he 'forgets' to discuss that Japan could also draw on her huge dollar balances she has accumulated over the past four or so decades in the belief that the money will be at her disposal at any time. The omission is all the more curious since the purpose of having foreign exchange reserves in the first place is to use them in such a contingency Japan now faces. Maybe Makin has inside information to the effect that Japan's dollar balances are unavailable or inaccessible. Even so, it is disingenuous to talk about Japan's 'inescapable debt-death spiral' without pointing out that it is inextricably intertwined with America's own inescapable debt-death spiral. Still more glaring is the error of commission in Makin's argument. He blatantly states:

"Time and again, the Japanese government and the bank of Japan have demonstrated a preference for passivity with respect to the need to reflate. The inevitable outcome will be the failure of one of the several large banks that ultimately precipitates the failure of the banking system. By failure I mean simply that the depositors, convinced that the liabilities of Japan's banks far exceed their assets, will continue to withdraw funds. There will be a full-scale 'run' on the banks."

Japan is to be commended rather than castigated for not going the reflation route that would mean robbing the savers through deliberate debasement of their currency - the easy way out of her present plight recommended by American economists. Furthermore, Makin's statement is in error. It does not follow that there has to be a run on the banks. The banks know how to take care of themselves. They can mend the enormous holes in their balance sheet. The big American money-center banks worked out the applicable strategy back in the 1980's when they, too, were in danger of going under because of their non-performing loans. The strategy consists of bidding up the price of bonds or, what is the same, drive down the rate of interest if need be as low as one-tenth its previous level. Then say "abracadabra" and, lo and behold, the negative net worth of the banks disappeared through the capital gains in the bond portfolio. In the case of Japan, if the magnitude of the hole in the banks' balance sheet is of the order of $1 trillion as Makin conjectures, and the size of the bond portfolio is of the order of $ 100 billion, then the banks will keep buying bonds until the long-term rate of interest will have fallen from 1 percent to 0.1 percent. The continuing decline in the rate of interest strongly suggests that the banks in Japan are snapping up (or otherwise take control through derivatives of) all new bond issues as well as any old issue that may find its way to the market. That was the very purpose why the banks, American and Japanese, have created a $100 trillion derivatives market on bonds. As a consequence there is a downwards pressure on interest rates in countries with a bond market. This, then, is the banks' strategy to save their own skin: keep the primrose path to the Blackhole of Zero Interest wide open.

Destruction of the Twin Towers of the World Economy

But when looked at from the point of view of society, this is a kamikaze strategy. As a rule of thumb, every time the rate of interest gets halved, the debt burden doubles. Productive enterprise comes under pressure to liquidate debt and inventory, so excruciating does the debt burden become. The banks' speculation in derivatives is responsible for the deflation and depression now experienced by Japan. Worse still, the deflation metastasizes from Japan to the world economy. Should interest rates keep falling, as indeed appears likely, the world would experience an economic collapse far worse than the Great Depression of the 1930's, if for no other reason than the greater amount of debt now outstanding, further magnified by the zero-bound interest-rate structure.

I have described the phenomenon of a relentlessly falling interest rates structure as the Blackhole of Zero Interest. Like blackholes in the physical universe, this one also pulls in with irresistible force everything that strays into its proximity, never to let go of it. Not even a ray of light or a radio signal can escape as gravitation inside tends to go to infinity. Likewise, we may presume that once the point of no return is reached, the Blackhole of Zero Interest could destroy the world economy through competitive currency devaluations, trade wars and, ultimately, through another world war.

Banks that are insolvent but have not been given the coup de grâce by bank inspectors will, of necessity, become desperadoes. They have not the slightest compunction to hijack the bond market as well as the derivatives markets and, in a kamikaze attack, crash them into the Twin Towers of the World Economy: the beehive of the savers and the beehive of the producers. The insolvent banks hold the world economy at gunpoint. It is incredible that governments are helpless to prevent the attack for fear of a banking panic. There was great wisdom in the practice of an earlier age not to allow a bank to continue in business once it has become insolvent. You cannot entrust the economic fate of the savers and producers to outlaws and desperadoes. It was a most serious blunder to compromise accounting standards in order to save banks "too big to fail".

Polarization of the World Economy

The present deflationary episode is characterized by a polarization of the world economy into a productive and a destructive sector. The former consists of the saving public and the producers of real goods and real services; the latter of the participants of the derivatives markets. The destructive sector, by virtue of being bigger and growing faster will, like a cuckoo chick, push the productive one out of the nest. The participants of the derivatives market are the big banks and their cohorts. In more details, they are the insolvent banks of Japan, fighting for survival, and the big American money-center banks such as J.P.Morgan-Chase and Citibank that dominate the derivatives markets. In the late 1970's and early 1980's, these colossi were also insolvent fighting for survival, just as the big Japanese banks are now. They diagnosed their problem as the rising interest-rate environment that had punctured their balance sheets almost beyond repair through the proliferation of non-performing loans. At that time they vowed that, if they can help it, they will never again face the prospect of rising interest rates. Instead, they decided to engineer a falling interest-rate structure that was expected to put them in an ultra-strong financial position on the strength of their bond portfolio. This is why they created the derivatives market in the first place. The risks of this plan are largely neutralized by Keynesian contra-cyclical monetary policy which, as the banks expected, would provide a pleasant tail-wind for their pirate ship. With this conviction the banks embarked upon their voyage on the uncharted waters of derivatives trading.

The most important thing to remember about the derivatives markets is that while they create no new wealth, they can be used by unscrupulous people and institutions to siphon off existing wealth from the producers. Contrary to what American economists say, the derivatives markets are not addressing risks inherent in or created by nature. They are addressing artificial risks created by man. In this respect they are like a gambling den. Derivatives markets include futures and options markets on bonds and foreign exchange, interest rate swaps, repos, knockout puts, etc., ad libitum. During the past decade there has been a phenomenal increase in trading derivatives which has by now reached the $100 trillion mark. The increase is continuing at an exponential rate. While the capital requirements of the productive economy are a small fraction of that figure, capital engaged by the destructive economy is even greater as it also includes the bond and foreign exchange markets of the world which are incapable of producing new wealth yet are fully capable of surreptitiously siphoning off the existing wealth of the producing public no less than the derivatives markets.

To expose the mechanism whereby wealth is being siphoned off we need only to contemplate that bond speculation drives down the rate of interest to near zero pari passu with increasing the market value of long-term bonds beyond any limit. As bond values rise, so does the present value of debt and the cost of servicing productive capital already deployed. The profits of the producers are squeezed and turned into losses. Firms are forced to liquidate debt and inventory. Many of them are ruined taking others down with them as receivables become impossible to collect. The point is that the wealth of the ruined producers does not disappear: it is transferred to the banks. It shows up in the form of capital gains in the banks' bond portfolio. The banks and bond speculators prosper while everybody else is being reduced to penury.

It should be clear that this stealthy wealth-transfer from the producers to the banks and other bond speculators is only possible because of the creation of artificial risks in the foreign exchange and bond markets. Of course, the public is told a different tale, which makes the fluctuations in foreign exchange and interest rates appear as a natural phenomenon, similar to the fickleness of the weather. However, this tale is only designed to cover up the surreptitious wealth transfer. The truth is that these fluctuations are caused by the iniquitous international monetary system that had been foisted upon the world in 1971. Once foreign exchange and interest rates were destabilized, their fluctuation could be and have been manipulated to the detriment of the savers and producers. There is no public benefit from bond and foreign exchange trading. It is simply not true that speculation in these markets has a smoothing effect, by analogy with the commodity markets. This non sequitur is still being taught as dogma in courses on economics at American universities. The difference, namely the fact that risks in the commodity markets are nature-given but, by contrast, they are artificially created in the bond and foreign exchange markets, explains why speculation has a stabilizing effect in the former and a destabilizing one in the latter. Bond and foreign exchange speculation exposes the general public to immense economic dangers and suffering as it escalates and starts spinning out of control. Bond and foreign exchange speculation victimizes the general public for the benefit of the banks. By contrast, in trading agricultural commodities where the risks have been created by nature and are beyond man's control, the speculators' activity has great social value and public benefit in alleviating gluts and shortages whenever they occur.

Bond Speculation is no Zero-Sum Game

In another respect, the destructive sector of the world economy is unlike a gambling den where compulsive gamblers can only put their own capital at risk in hope of a large payoff, but they will be out of action as soon as they lose their capital. At this point other gamblers who have been more successful take over. This is expressed by saying that gambling is a zero-sum game: one gambler's loss is another's gain. The same is certainly not true for the bond market. Bond speculation is not a zero-sum game. The gain of one bond speculator is hardly ever the loss of another. Bond speculators march in lockstep. They are almost always on the same side of the market, whether long or short. They want to induce trends which they can then ride. They are almost always on the winning side. The well-advertised failure of hedge funds such as that of Long Term Capital Management, or other firms active in derivatives such as Enron, is red herring. Occasionally the bond speculators would toss one fellow-traveller or two to the wolves, just to make it appear that there are also losers in trading derivatives. The fact remains that the obscene profits of the global bond speculators did not come out of the hide of LTCM or Enron. They came out of the hide of savers and producers.

Bond speculation is especially vicious in a deflation such as Japan now experiences. Speculators in bonds are typically long, as they want to drive interest rates further down. They are cocksure about their bets as they expect the central bank to make the sails of their pirate ship to bulge. They are aware that the central bank is trying to combat deflation through open market operations. So firmly do they feel in the saddle that they buy up all available bonds just before the central bank is ready to enter the market with its own shopping list, as it must, in order to put new currency into circulation through open market purchases of bonds. Thereupon the speculators feed the bonds to the central bank at a price of their own choosing. Thus, then, the central bank has been reduced to the position of a sitting duck. It is no longer effective in fighting deflation. Just as central banks mostly come out as losers in foreign exchange, for the stronger reason that their moves are more predictable in the bond market, they are also the perennial losers in bonds, too. Winners are the nimble speculators.

There is no reason for bond speculators to worry about the supply of bonds. If the government failed to supply them, the yen-carry trade will certainly oblige. The essence of this trade is the sale of Japanese bonds against the purchase of US bonds in order to pocket the difference between the higher interest rates in the United States and the lower ones in Japan. No sooner had the bond speculators driven down the rate of interest in Japan than the yen-carry trade started offering Japanese bonds for sale. The game could go on as long as US bonds were available. There is, of course, no danger that the supply of US bonds would run out.

Why is bond speculation not a zero-sum game? Speculators don't buy the bond because they want to earn the interest income. They buy it because they want to ride the uptrend in bond prices (or, what is the same, ride the downtrend in the rate of interest). They don't sell the bond because they want to invest the proceeds in the real economy. They sell it because they want to straddle the yield curve (selling the short-dated issues and buying the long-dated ones), or they want to hitch a ride on the band-wagon of the carry trade (selling the bonds of a country with a lower, and buying that of a country with a higher interest-rate structure). Speculators always crowd on one side of the market, whether it is the long or the short side. In either case, they create a trend which they then ride for all its worth.

The bond speculators profit together at the expense of the productive segment of society. The public is losing whenever there is a protracted fall in interest rates, but it is also losing whenever there is a protracted rise. In the first instance, when interest rates fall, there is a relentless rise in the present value of debt which will force the producers into bankruptcy as the rise in the cost of servicing capital crowds out profits and turns them into losses. In the second, when interest rates rise, the value of bonds fall and with it falls the value of equity capital. Bond speculation is a parasitic activity in the body economic. There is circumstantial evidence that bond speculation is animated by a conspiracy of big banks world-wide that are controlling the derivatives markets. If it is true that bond speculators act in collusion with one another, then the majority of society is being victimized by the vampirism of a small minority, and the world is facing the destruction of its productive capacity. The present international monetary system is not only conducive to such conspiratorial activity, it actually invites speculators to combine against the public interest and makes it possible for them to hide behind the façade of a money-center bank, a hedge fund, or a gold mining concern with a hedge book. Such a conspiracy, if it exists, represents an enormous financial force which one can only ignore at one's peril. It controls financial resources that in all likelihood eclipse those of the governments. And, above all, the conspiracy has a superb strategy that makes the central-bank dinosaurs sitting ducks for the nimble bond speculators.

How to Stamp out the Latter-Day Piracy of Bond Speculation

In order to understand how the world has become hostage to latter-day pirates, the bond speculators, we have to go back to the regime of the gold standard before it was first sabotaged and then destroyed by the American President F.D.Roosevelt. Under that regime there was simply no bond speculation. Interest rates were stable and there was no profit in carrying an inventory of bonds for speculative purposes. Moreover, issuers of bonds felt morally obliged to provide sinking fund protection for the benefit of the bondholders, many of them widows and orphans. If the price of the bond fell, the sinking fund manager would step in and keep buying the outstanding bond until its price stabilized at face value. In fact, the merit of a gold standard is not to be seen in its power to stabilize prices, which is neither possible nor desirable. It is seen in its power to stabilize interest rates at the lowest level compatible with savings and economic development. The gold standard alone makes it possible for the users of credit to provide sinking fund protection for the benefit of the providers of credit. We may add that a gold standard also rules out the possibility that the bond market be hijacked and used in a kamikaze terrorists attack to destroy the Twin Towers of the World Economy.

There was no foreign exchange speculation either under the regime of the international gold standard, as the minor changes in foreign exchange rates between the gold points didn't justify speculative positions. That was also a great benefit to the economy as producers and exporters were able to concentrate on the task at which they were best, namely, producing and exporting, and they could forget about the complicated business of managing the foreign exchange risks involved in their enterprise. There were simply no such risks. And there were no trade wars arising out of competitive currency debasement.

It has been said that gold is the only conceivable competition to government bonds. The converse is also true, albeit not unconditionally. The government bond is the only conceivable competition to gold, provided that the government issuing it is honest. The present crisis is a great opportunity for Japan to introduce this type of competition for gold once again, thereby to save not only her but also the world's producers from the terrible consequences of an approaching disaster.

Sir, in the name of fair and upright dealings between creditors and debtors, banks and depositors, governments and citizens, and in the interest of a brighter future for mankind, I implore you to open the Mint of Japan to gold. If and when you do, it will be Japan's finest hour.

I remain,

Your most obedient servant,

 

Antal E. Fekete
Professor Emeritus
Memorial University of Newfoundland
St. John's, Canada A1C 5S7