"I cannot think of anything which would more surely lead to a danger of all-round deflation than the collapse of international monetary confidence."
~ Roy Jenkins, then British chancellor, debate on the London Gold Pool, 18 March 1968
This Summer's first U.S. debt downgrade came after Washington failed to fix the debt ceiling one way or the other. Three months later, and Washington just failed again.
Yet that first downgrade also saw 10-year Treasury yields fall to 3.0% as US debt prices rose. And today, with a second downgrade nailed on, that yield is already down below 2.0%.
What gives? Why is the financial world piling into US debt - driving its price higher - even as the security of that very debt risks being de-rated further below the magic risk-free AAA mark?
"Most risk and return models in finance start off with an asset that is defined as risk free," explains an NYU professor. "The expected returns on risky investments are then measured relative to the risk-free rate." The loss of "risk free" as a concept thus plays hell with Wall Street's investment confidence, let alone its models.
Pricing stock-market options using the Black Scholes equation, for instance, starts by assuming that "it is possible to borrow and lend cash at a known constant risk-free interest rate." Remove the "risk free rate", and things fall apart faster than Long Term Capital Management, the hedge fund built on Black-Scholes' model, which collapsed when the world changed but the equation didn't.
More urgently, messing with the concept of "risk free rate" also plays havoc with the insurance and banking businesses. "A reduction in the risk-free rate increases lending profitability by reducing funding costs and increasing the surplus the monopolistic bank extracts from borrowers," the IMF explains. "Insurance contract cash flows...are discounted using a locked-in discount rate determined at inception date," say consultants PwC, "[calculated as] the risk-free rate plus liquidity premium."
So no risk-free rate, no baseline for banks or insurers, those multi-trillion-dollar industries pervading pretty much every deal, order and purchase you can think of today outside the black economy. But even cash-only gangsters aren't free of the crisis hitting the financial world's only other competitor for the role of "risk-free" reference point. Because in Eurozone bonds, the very denomination itself is now in question.
"Reintroducing the national currency would require essentially all contracts - including those governing wages, bank deposits, bonds, mortgages, taxes, and most everything else - to be redenominated in the domestic currency," warned economics professor Barry Eichengreen of Eurozone break-up in 2010. The currency historian thought this hurdle was "insurmountable"; no member state would quit the Euro because the procedural obstacles were too great.
"Exit is effectively impossible." But in reality? It will be a real mess - a big, ugly, deflationary mess in which lending collapses and trading grinds to a halt.
Irony guarantees that we get the word "crisis" from the Greek, of course, via the Romans. Transliterated with a "k", it means "decision, judgement, event, issue, turning-point of a disease" according to the Shorter Oxford Dictionary - and that monetary madness which is the Euro has certainly reached one fork in the road or another.
The Esperanto Experiment clearly can't go on, won't go on, as it is. Whatever replaces or mutates it, one immediate horror is not knowing whose contracts with whom might be about to lose a surer foundation than the very ink in which they're written. Not just inside the Eurozone; around one-third of UK banks' lending is owed across the Channel. London-based asset managers are also "reducing their Eurozone exposures," says eFinancialNews, "for fear of capital controls freezing Euros and other assets held" inside the fissuring union.
"When the wall is lifted, the Euros might be new Drachma or new Pesetas or new Lira - you don't know what they'll be," the website quotes Alan Brown, chief investment officer at Schroders. But no matter the flood of non-Eurozone money getting (and staying) out of the Eurozone, there's more money pouring in, as Eurozone institutions pull back their money from outside. Over the 12 months to September, says ECB data, net portfolio inflows to the 17 member states hit €335 billion - more than 10 times the volume over the previous year, and "all the more significant" says Reuters "[because of] ample evidence that overseas investors have been exiting Eurozone securities."
"As Eurozone banks and other Eurozone entities lose access to funding markets abroad, they are forced, at least partly, to sell foreign assets," the newswire quotes Morgan Stanley. "This creates the rather counterintuitive result that stress in funding markets abroad induce repatriation flows that support rather than hurt the Euro."
Witness peripheral Europe outside the Eurozone, for example. What used to be called the "New EU" states risk being drained of capital as banks in core-member countries liquidate assets to hoard money closer to home or are told to stop new lending by their domestic regulators. That means the local currency falls (see the Polish Zloty for instance). Hence the crisis-defying strength of the Euro on the currency market. Less bothered by 2011's money crisis than Lehman's collapse in 2008 or the first Greek deficit crisis of early 2010, the Euro's strength is no less bizarre than US Treasury debt rising in value as Washington's credit rating is cut. But that's deflation for you - a dash for cash that sells first, asks questions later, and holds currency...the very stuff called into crisis...above everything else.
Thus Roy Jenkins' unwitting paradox of 43 years ago, quoted up top, still holds true. It is hard to imagine a more deflationary event than the collapse of confidence in the monetary system. "Feelings are reasons too," as Glyn Davies wrote in his History of Money, and short term, currency and near-cash Treasury debt look the only refuge from the system beneath them. As the US and Eurozone crises roll on, however, crushing Dollar-dependent and Euro-denominated asset prices worldwide, it's unsurprising to find demand to own physical gold and silver bullion surging worldwide, not least as the precious metals join the indiscriminate price fall.
Gold and silver's zero-yield is plainly risk free. Their value isn't denominated in any one currency or system. If this first blush of crisis turns red with anger, escaping all currency risk-free could become very much more popular still. Three-thousand years of monetary use will likely stand out as the 10-year Euro experiment and 40 years of Dollar dependency unwind together.