Financial warfare

Apr 29, 2014

War is the continuation of Politik by other means.

– Carl von Clausewitz (1780-1831)

 

Regrettable though it maybe, but politics hasn’t died. Which means war hasn’t died either; though the tools of warfare are constantly evolving.

 

Clausewitz’s quote came to mind recently, when I read snippets from a recent interview the BBC’s Robert Peston did with Hank Paulson, US Treasury Secretary during the 2008 financial crisis. Paulson recalls how desperate he was that the Chinese – owners of some $1.7 trillion of mortgage-backed bonds issued by Fannie Mae and Freddie Mac – not start dumping these securities, so potentially leading to an even bigger crisis.

 

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Much has been said about how developed governments have been deficit spending as if they’re at war since 2007-2009. And you might expect the story to be similar on the monetary side. After all, the central bank balance sheet expansions that we’ve seen over the past few years look unprecedented. The reality may surprise you. We’ve charted the change in notes in circulation over WWI below and included a chart of central balance sheet expansions over the past 5 years. As you’ll see, it’s clear that wartime monetary easing was way in excess of what we’re seeing today. The central banks that have expanded their balance sheets the most recently are at worst comparable to neutral countries in WWI. See for yourself below. It could be much worse…

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If you measure the laxness of a central bank by the magnitude of its balance sheet expansion then there’s been a clear winner in recent years: the Bank of England (which has quadrupled its balance sheet since mid-2008). This leaves the UK at risk of a huge expansion in the broad money supply if the fractional reserve banking machine were to get going again. This, however, could be some time away and is not the only mechanism in play. Here we’ll look at central bank balance sheet expansions in relation to government accounts. By the end of this piece you’ll have a good understanding of how addicted various governments are to the printing press.

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In the 1930s and 1940s the default of a developed country sovereign was not uncommon. This is really difficult for us to grasp (we would have to be 80 years old to have experienced it). So just to remind you of how possible sovereign defaults are, here we present a list of (external currency) soveriegn bonds that defaulted during the 1930s:

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Recently we looked at the critical chart in sovereign debt analysis which painted a broad picture of how vulnerable sovereigns are to rises in interest rates. Well, today we thought we’d show you a couple of charts that should be paired with it. By the end of this piece you’ll have a good idea of the average debt costs that would detonate the accounts of major governments around the world.

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When looking at central bank balance sheets lately it’s easy to conclude that your portfolio should anticipate imminent cost-push inflation. After all, if you chart the major central banks’ balance sheets they’re all up and to the right like never before. Well, although this is a remarkable period in history (that may well see relentless inflation and/or sovereign default), it is not without precedent. If you go back far enough you’ll find that the world has experienced this type of environment before… and that the inflationary consequences of monetized fiscal deficits occur only over time. In order to give you a broad view of this subject, here we chart the history of the Bank of England’s balance sheet from 1844 to the present day.

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As some of you may know, I’m a big fan of Gustave Le Bon’s books; in particular I like The Crowd: A Study of the Popular Mind. I reread it (again) last week and was delighted to uncover some insights that I had not recognized fully before. So I thought I’d share some of them with you because I think that a sound understanding of crowd psychology is really useful for constructing or refining your investment process.

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