Cyprus Targets Its Savers in Bailout Agreement: Part II

There is nothing like the pain of real losses to impress a principle deeply into people’s psyches. In Cyprus (and likely in other similarly situated countries) a lesson is now clearer to more people and businesses than it has yet been.

The Euro-banking system cannot be trusted.

Below are our analysis and predictions.

We expect that many people and businesses in Cyprus will entrust only a minimum amount, for cash flow needs, to domestic banks. They will withdraw the rest once the government allows the banks to reopen.

This will further weaken banks that are probably already close to toppling. Further rumors will grow in fertile ground. It should not take very long for Cyprus to be drained of most of the Euros presently kept there. The banking system will be reduced to a living-dead zombie, assuming the government acts to prop it up (which would be par for the post-2008 crisis world). Without government-provided infusions, the banks will collapse sooner rather than later. Either way, they will be incapable of performing their function of intermediating savings and lending to productive enterprise.

The spiral will become vicious as Cyprus government bonds sell off, causing further losses to the Cyprus banks (who own those bonds). This will be happening as the banks are being drained of their liquid cash. This process will likely play out in other distressed Euro area periphery countries. We see no reason it should not also play out in non-Euro countries such as Hungary, which will face the additional problem of the collapse in the value of its currency. Cypriots will suffer as the Euro declines, but problems in Cyprus by themselves cannot cause the currency to collapse.

The question on everyone’s mind is what will these people buy when they sell Cyprus bank deposits? Clearly, much of it will go into other Euro area banks such as Germany. Those with small bank account balances will not be able to justify going into other currencies nor typically have the sophistication or knowledge to do it. We expect they will hold paper notes more than they had and if that is not sufficient then they can open an account at Deutsche Bank or another bank in a domicile they trust.

The “inflation = rising money supply” crowd may sell gold, thinking that Cyprus is causing the money supply to shrink, thus prices to fall, thus people won’t need an “inflation hedge”. That would be a big mistake.

While the dollar price of gold could go up or down in the short term (the initial response of the gold price to this news is to rise), the real and sustained response will be to rise.

Gold metal has no counterparty.

The real meaning of deflation is a forcible contraction of credit. The Quantity Theory of Money holds that as the quantity of money (credit, really) decreases, the remaining units should increase in value. The reality is that those who hold credit in a time of sudden defaults are risking total losses. Prior to now, depositors in Cyprus may not have realized this (or maybe they had plenty of evidence), but now they know. And so do depositors, bond holders, etc. in other countries. Why should they not hold some portion of their wealth in gold? Aside from the lack of default risk, there is also the lack of debasement.

Perhaps even more interesting than seeing what happens to the gold price will be seeing what happens to the gold basis. While this is not a prediction, we would expect to see a falling basis and rising cobasis. Readers can follow the basis weekly in the Last Contango Basis Report. This is a perfect opportunity for leveraged traders of futures to be out of sync with the reality on the ground in peripheral countries.

People trying to protect themselves from sudden death will not behave the way that the Quantity Theory of Money says they ought.

We think two other currencies will see inflows: the US dollar and gold, in that order. We would not expect silver to be bought as much as gold in this transition. For larger amounts, gold is the monetary metal of choice. Those with only small amounts may not be in a position to do much, as they need their balance for daily living expenses. We have been expecting the gold:silver ratio to rise, and this event will likely add fuel to this trend.

There could be a good blip in other non-Euro currencies. It certainly seems plausible that every multinational corporation doing business in Cyprus (or Hungary, etc.) would consider reallocating some of their cash balances out of the euro and into their domestic currencies. If CHF weren’t pegged to the euro at 1.20, it could go up on this news. As it is, GBP, NOK, RUB, and maybe CNY could go up against the euro as a direct result of Cyprus.

The biggest gains of all paper currencies will be in USD. The US dollar, for those Europeans who want to get to a “safe haven”, will be the least unsafe. This will likely have the consequence of rising US Treasury bond prices / falling yields.

The question of the impact on the US stock market is more complex. In general, the question of why US stocks have been rising in a deteriorating real economy is a topic I intend to address in a separate paper (no, it’s not due to rising “money supply”!)

The short answer is that the inrush of capital being transferred out of Europe could drive up all dollar-denominated assets. There are two massive opposing forces. First, business conditions in Europe will turn down harder as a result of Cyprus. US based multinationals will earn fewer euros in Europe, and each of those euros will be worth less in terms of dollars. The combination could be a significant hit to S&P earnings.

Second, the credit contraction in Cyprus will impact credit in many other areas. Facing additional stress on their balance sheets, a variety of players from banks to hedge funds to insurers may decide to sell assets to pay off liabilities. An environment of contracting credit could be the perfect storm that begins a selloff period in equities.

One thing seems likely. The trading pattern that has persisted for a seeming eternity now may end, to be replaced with a different one. This new pattern will likely contain at least some of the elements presented above: rising dollar, rising Treasury bond, rising gold, rising gold:silver ratio, credit crisis contagion, deteriorating economies, falling corporate profits, and maybe falling stock prices.

We live in interesting times, of that there is no doubt.

23 replies
  1. ex nihilo says:

    re your: “We would not expect silver to be bought as much as gold in this transition.”.
    why? would 1oz of silver bullion not be more feasible for barter, exchange and purchase of essentials during long bank holidays in piigs?

      • mossmoon says:

        “Why would they not use paper notes to buy groceries?”

        From which these questions follow:

        If this counterfeit credit deflation can occur without a collapse of the system (which is debatable), then the remaining dollars (physical notes) would be more valuable. Therefore if you can get access to your dollars, why buy gold?

        So: do you think a net credit contraction can occur in the dollar system that is so critically interconnected?

  2. mike n says:

    I have a question. Suppose I have a 401k with $50,000 in it. (I don’t). One adviser says I should pull it out and put it in gold because the dollar is ready to become worthless. Another adviser says hold on to and add to it because the best time to buy or invest in an asset like the dollar is when its value is falling. Which way do I go? Or do I do a bit of each?

    • Keith Weiner says:

      mike: I am surprised an investment advisor would recommend that.

      While I can’t give investment advice, I can point out that the dollar has been falling for 100 years. To anyone who says the trend is bound to reverse, I would ask what makes him think that?

      One of the key themes of Monetary Metals is that gold is the objective measure of value, against which everything including dollars, must be measured.

      I am comfortable saying that everyone should own some gold though NOT with borrowed money, not with leverage. How much depends on individual circumstances.

  3. samiam says:

    Keith: some columnists predict that the fall of the eurozone, which seems to be happening, will result in a very strong dollar, and lead to much, much lower gold price in dollar terms. You seem to think gold will rise in dollar terms in this scenario. For those of us with minimal dollars to convert to gold, timing and dollar price is critical. Every time I buy a little, next week the price is lower. I realize the window of opportunity will eventually shut, but I expect we have several months yet. Looking forward several months or maybe even a few years, what conditions, if any, would have to develop in the US that would make you expect a low gold price?

    • Keith Weiner says:

      samiam: I don’t expect a really low gold price looking forward, though this is not a prediction of timing nor a guarantee that the price could not dip further a bit. I do not share the same assumptions and economic theory as the folks who call for a $250 or $1000 gold or whatever price they name.

      The dollar is moving inexorably closer to its collapse under the weight of the exponentially-rising debt. The Fed is forced to issue unimaginable amounts of “liquidity” to keep things together. Just because the crisis in the euro (or yen or probably yuan) is much more immediate does not mean that the dollar is gaining value against an objective measure.

      While we do not recommend trading gold against the dollar based on our analysis of the gold basis, the graphs and discussions there may help give you a little perspective to make more informed trades or buy-ins.

  4. cbarton says:

    Hi Keith,
    I noticed your mentioning Hungary as one of your examples. I have family back there. Have been telling them for a while to put their savings into gold, instead of term deposits that keep them falling behind with inflation. Not sure what else to tell them, and they seem far less worried than I am for them going forward.

    Would you care to make some observations or comments on the subject?

    Also, now that the politicians in Cyprus have voted down the proposal that put the cat amongst the pigeons, so to speak, would you expect people being lulled into another period of false sense of security regarding the safety of their savings in the banks? Or do you think that the genie cannot be put back into the bottle, and people will try to get their savings out just as fast as they can? Thanks.

    • Keith Weiner says:

      cbarton: I picked Hungary as an example of a peripheral country which uses its own currency. The problem any such country has is its dependence on the bond market to allow it to sell new bonds to pay bonds as they mature. Once their bond market goes no bid, then they are in real trouble.

      I don’t know Hungary well, though I’ve been there several times. What struck me was the tragedy of Soviet communism from which they have not recovered. As I recall, the forint was around 200 to the dollar when I was there, and if that recollection is right then the forint has fallen since then.

      It really bothers me when economists say “well, to stimulate the economy/employment/exports/etc just devalue the currency”. This is a real loss of capital for people who worked hard their whole lives to save, and for businesses who are trying to accumulate capital to invest. The only way to increase real wages is to increase capital invested.

      As to people being lulled, I would expect some will be but some have now got the wake-up call. If they don’t end up imposing losses on depositors (which according to the current rumors seems to be the case) then there will probably be less capital flight once they reopen the banks than there would have been if depositors had 15% haircuts.

      The thing that is so hard for me to get my head around is that despite the many problems with it, the social welfare state remains popular and hence the means of financing it is popular or at least not too unpopular.

  5. cbarton says:

    Thanks, Keith. Yes, I guess the psychology of it would be rooted in the understandable need for security, so the appeal of a so-called “safety net,” should one fall on hard times, is powerful.

    Back to EU members like Hungary with their own currencies, kindly tell me, why could these countries simply print their own money for facilitating trade and put it into circulation through government spending, such as public service salaries, pensions, etc., and then taxing it back to check inflation becoming a problem?

    Why issue bonds, in other words, hoping and begging for someone to come up with, or create, the money with which to buy it, instead of the money needed being created directly by the Treasury? Someone has to print up the money in any case, so why not cost-free by the Treasury itself, instead of the parasitic bankstas?

    After all, it has been done before in more than one place in history, and worked just fine, and even much better, than the disaster we see looming with the banksters.

  6. cbarton says:

    Sorry, in the second paragraph “why could these countries simply print” should read “why could not these countries simply print.”

    But also, it seems that the social welfare state’s expenditures are dwarfed by the boondoogles and bailouts given to special interests at the top of the food chain. Crony capitalism seems to be a greater burden on society than the benefits provided to its most vulnerable members. Your thoughts on this?

  7. cbarton says:

    Keith, I am enjoying your writings. I found your site after seeing Professor Fekete on the Keiser Report, and started look for any information I could find on backwardation and the basis.

    I have a couple of questions regarding your paper “When Gold Backwardation Becomes Permanent.”

    The first one is this: Is there a practical and reliable way of telling whether a particular episode of backwardation is becoming permanent? For the theory to be useful, one must be able to recognise its permanence before it is too late, so to say.

    The second one is this: Your paper seems to assume that gold owners, who hold it as money, rather than as a speculative investment, will hold it totally unencumbered, without debt. Do you see this as part of the definition of what it means to hold gold as money?

    If not, then presumably there will have to be a period of time during which all gold will move from weak hands to strong hands, where holders of gold with debt are squeezed, perhaps, to give up their holdings to pay down debt. Something like this might have been happening five or so years ago when the gold price crashed in the middle of the debt crisis. Many analists were saying that people were being forced to liquidate their gold positions, which were still worth something, to come up with much needed cash.

    Anyhow, amongst the many other questions raised by these matters is the state of the play at the present, and how long it might take for this process of gold finding its way into strong hands that will not be shaken out by crises like we have seen five or so years ago?

    An equally important one would be whether owners of gold with strong hands could not simply be put up against the wall by the very same criminal cartels that are running amock as we speak, and see the gold that was forcefully confiscated from them being used to prop up the paper until things calm down and trust is restored?

    It has happened before, and one must wonder if the current assault on the Second Amendment in the US might not be motivated rather strongly by the increasing likelihood that a day is approaching when the scamsters and banksters will have to resort to something like this to get owners of gold to part with their metal.

  8. Keith Weiner says:

    cbarton: if there was ever an era where gold owners would exchange their gold for arbitrarily-printed paper which is not based in debt but just outright printed, that era is not today. In my paper When Gold Backwardation Becomes Permanent I give the explanation of why a currency collapses if gold refuses to bid on it.

    While payola to cronies is big, in the US at least the liability with the highest Net Present Value (by far) is Social Security + Medicare. I’ve seen many numbers for this, but I believe it is north of $100T.

    I will be writing more on permanent backwardation and how to recognize it. I’ve already said publicly that we’ll see backwardation in all futures months, and as the price is rising (probably exponentially) there will be rising backwardation. I have much more to say on this topic. :)

    Think of permanent gold backwardation as the withdrawal of the gold bid on the dollar. The government could take gold from by force (I don’t know what they will do, but I don’t think they will do this) but this will not bring back the good ol’ days; it’s just cargo-cult thinking.

  9. cbarton says:

    Keith, I was not thinking that gold confiscation would result in any sort of economic or general welfare boom, far from it, but merely that the scoundrels are likely to try saving the currency by backing it with confiscated gold, instead of allowing it to simply fall into a heap, unless this latter outcome suited them at the time.

    A dying currency could presumably be stabilised by its owners, if they have, or can put their hands on, the necessary gold with which to back it, and making that currency convertible upon demand with no transaction cost attached in either direction.

    Anyhow, the long and short of it is that, if the demise of a currency is preventable by making it convertible to gold, then gold going no bid in the free market is unlikely to be the end of the matter.

    For, even if the defenders of the currency lack the gold with which to back the currency, as long as they are in a position to put a gun to the head of those who have it, they can save the currency if they want to.

    Another, perhaps analogous and pertinent enough, example would be where the workers in society refused to continue feeding the parasitic classes above them. The assumption one would make is that in a situation like that the parasites would simply starve, unless they decided to become workers themselves. However, there is another possibility for them to try: turning the previously free workers into slaves, and continue living off them as before.

    Same with a sick currency: gold owners go no bid, and the response from the owners of paper and debt may well be to put a gun to the heads of these gold owners and say: “Your life or your gold, and either way, I will have your gold.”

    Indeed, I would expect them to do something like this, if that is what it should take, going forward. Unless, that is, gold owners are also gun owners, or find some other way of resisting a tyrannical move like that.

    Not sure anymore if I am still engaging with your thesis or arguments, but it seems relevant to cnsider the possibilities outside the standard assumption that owners of gold can forever and in all circumstances stay in control of their metal, and contemplate the possible and likely outcomes in circumstances where refusal is overcome with force.

  10. cbarton says:

    Ah, yes, I have read or heard you saying about permanent backwardation, that this would be manifested against all future delivery dates, which is compelling and what one would expect.

    Look forward to reading more from you on the topic. It is a very important one, indeed. But equally, perhaps, as I have just suggested, the available options and the likely responses of those in charge of a currency like the USD at the point of imminent collapse.

    Incidentally, would love to read your PhD thesis. Any chance of getting hold of a copy of it, or of finished chapters from it? Thanks.

  11. cbarton says:

    One more thought on the possibility of saving the USD with gold backing. There are some who suggest that this is unlikely to happen, because the aim of the money cartel is to dethrone it and replace it with a new supra-national currency, most likely the IMF’s SDR, as the new reserve currency for international trade. What are your thoughts on this?

  12. Keith Weiner says:

    cbarton: I know what you mean by the “currency’s owner” but I think in this context it’s important to point out that they are the currency’s OWEr. It is their liability to pay.

    I plan to write more about gold “backing”, but the brief of it is that it would just be a fixed price–until they ran out of gold. If gold is in the process of withdrawing its bid on the dollar, then no one will deposit his gold in exchange for paper notes. Depending on how much gold they have (and are willing to sell) and depending on how rapidly the worldwide market wants to buy gold, that would determine how long their gold sales at the official price could keep things going.

    My dissertation is here:

  13. cbarton says:

    Thanks, Keith. That’s tremendous, and well done!!!

    Yes, I guess, gold backing at any nominal paper price would require discipline of not overprinting from that point on, or, as you say, there would come a point when they would run out of gold, at which point they would be holding all their worthless paper, which nobody would be willing to accept and hold in the absence of backing.

    It is hard to know, I guess, what, if anything, coercion by the State could or would accomplish from that point onwards. They could once again criminalise gold ownership and all forms of transactions in gold, and mandating that debts can only be settled in paper. Would people go along with it? Would they give up their gold? Would they give up their other goods and services again for paper?

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