Great Depression II

So the gold standard was partly to blame for the Great Depression that began in August 1929.

It was a world wide depression that proceeded World War II, emenating in the US with the stock market crash of 1929 and then spread around the globe. The gold standard back then contributed to spreading the monetary shocks from one country to another because they were all connected.

With a monetary system based on gold, the amount of gold controlled the amount of money issued by central banks. So the amount of gold that the FED held in US vaults limited the amount of money that the central bank could issue to commercial banks, thereby influencing consumption and investment in the economy. The result was a monetary structure tied to the amount of gold in US vaults, But in 1930, FED failed to carry out one of its main functions of fostering financial stability in the economy. When commercial retail banks failed, the central bank stood idly by, in other words it didn't act as the lender of last resort. It let the banks fail and that resulted in a fall in the money supply. Even back then the world economies were interconnected, albeit to a much lesser extent compared to now. With feeble demand in the US economy, due to a contraction in the money supply, Britain was selling less goods (exporting) less to the US, whilst still continuing to buy goods from the US (imports). It paid for the difference with its gold reserves. So UK gold bars were physically shipped out of Britain and ferried across the Atlantic to the US. The resulting outcome was that the money supply decreased and the depression got even worse in Britain. What happened to all the gold flooding into the US? The Fed was hoarding the gold, it was locked up in US vaults.

Ironically, despite the fact that the gold standard has been abolished a long time ago the financial system is in a similar liquidity crisis today. But this time, economies are even more interdependent, there are no firewalls to stop the contagion, moreover leveraging is much higher, which could make the Great Depression II even more severe than the last one.

To understand the severity of the problem we need to zero in on the role that collateral plays in a modern economy. The word “collateral” is loosely used. The financial definition of collateral follows; “Property or other assets that a borrower offers a lender to secure a loan. If the borrower stops making the promised loan payments, the lender can seize the collateral to recoup its losses. Because collateral offers some security to the lender in case the borrower fails to pay back the loan, loans that are secured by collateral typically have lower interest rates than unsecured loans.”

For those of us with mortgages we are already familiar with this concept. When you take out a bank loan for a car or a home, the bank wants something pledged as collateral in the event that, for whatever reason, you fail to pay the money back.

Collateral for the bank then is like an insurance policy, should the deal not workout and the loan goes bad the bank can grab the asset pledged against the loan.

The modern global financial system, is like a fine tuned machine, it is based on leveraging, or in other words, it’s based on borrowed money. Collateral is the high performance oil that keeps the pistons in the engine lubricated, without it the engine seizes up. Similarly,without collateral there is no trust between financial institutions and if there is no trust, there is no borrowed money. If money doesn't enter the system the economy grinds ever closer to a stand still, which can lead to a depression.

On a consumer level, our homes and cars are used as collateral against loans. On a commercial level companies pledge various assets as collateral for a loan.

But how does it work for the financial firm at the top of the corporate food chain?

These carnivores pledge sovereign-debt as collateral, which is viewed as the most risk free assets in the financial system. Equity, municipal bonds and corporate bonds are all below sovereign bonds in terms of risk profile. Put simply, in most cases a country is less likely to go bankrupt than say a corporation.

Today the western financial system has sovereign bonds as collateral for hundreds of trillions of US dollars in trades. The global derivatives market is worth approximately 700 trillion US dollars in size This figure is so enormous that it is difficult to comprehend, but to give you an idea it is over ten times the world’s GDP. The prime collateral for underlying these trades include bankrupt sovereign debt from the peripheral EU bloc countries.

However, that is not the only big problem. The pool of high grade collateral has shrunk. High grade collateral is US, UK, German and Japanese sovereign-debt.

Why?

Through years of quantitative easing, the central banks have soaked up a vast pool of this high grade debt. By actively buying Treasuries, Japanese bonds, etc. central banks have soaked up over 10 trillion dollars worth of high grade collateral from the system.

So if there is no collateral, there is no trust and no liquidity. 

In this coming depression it is not gold that has been removed but high grade paper collateral. We are in a bigger credit squeeze this time around and the shock waves will be global.