[This is an excerpt from a commentary posted at TSI about three weeks ago]

In an article titled “China’s monetary policy must change” Alasdair Macleod discusses a path that China’s government could take to make the Yuan gold-backed and thus bring about greater economic stability in China. Keith Weiner pointed out some flaws in the Macleod article, including the fact that the sort of Gold Standard that involves pegging a national currency to gold is just another government price-fixing scheme and therefore doomed to fail. We will single out an error in the article that Keith didn’t address and then briefly explain why a gold-backed Yuan is a pipe dream.

This excerpt from the article contains the error we want to focus on:

“China’s manufacturing economy will be particularly hard hit by the rise in interest rates that normally triggers a credit crisis. Higher interest rates turn previous capital investments in the production of goods into malinvestments, because the profit calculations based on lower interest rates and lower input prices become invalid.”

No, higher interest rates do not turn previous capital investments in the production of goods into malinvestments. A rise in interest rates can help reveal malinvestments for what they are, but it doesn’t create them.

Malinvestment occurs on a grand scale when the banking system creates a large amount of money out of nothing, generating false interest-rate signals and making it seem as if the amount of real savings in the economy is much greater than is actually the case. In response to the misleading (artificially low) interest rates and the increased future demand that these interest rates imply (more saving in the present implies more consumption in the future), investments are made in productive capacity. Many of these investments will prove to be ill-conceived, because future demand will turn out to be lower than expected. The investments only appeared to make sense due to the false impressions created by banks loaning copious quantities of new money into existence.

Another way to look at the situation is that a build-up of real savings requires a temporary reduction in consumption. Think of it as a savings-consumption trade-off. People abstain from consumption in the short term so that they will be able to consume more in the long term. When that happens on an economy-wide basis, interest rates move lower.

The falling interest rate indicates that savings are being increased and, by extension, that consumption will be higher in the future. In other words, the falling interest rate is a message that long-term investments in productive capacity are likely to pay off. The problem is that when money is created in large amounts out of nothing, interest rates tend to fall at the same time as consumption is increasing. So, entrepreneurs are being told (by the falling interest rate) that consumption will be greater in the future and to invest accordingly, but at the same time consumers are spending aggressively and ‘tapping themselves out’. Naturally, this doesn’t end well.

The crux of the matter is that malinvestment stems from artificially low interest rates. Also, once it has happened, it has happened. Rising interest rates can be part of the process via which the mistakes are revealed, but the mistakes won’t disappear if interest rates are prevented from rising. Putting it another way, it is not possible to avoid the painful consequences (economic recession or depression) that follow a period during which malinvestment was rife. This is relevant, because the Macleod article argues that interest rates could be kept low in China by linking the Yuan to gold and that by doing this the amount of existing investment that falls into the ‘mal’ category could be greatly reduced.

The reality is that regardless of what happens to interest rates in the future, the extent of the previous malinvestment is such that China’s economy will experience either a collapse or a very long period (probably at least a decade) of virtual stagnation. Given the control that the government has over the banking industry, we guess the latter.

The point is that linking the Yuan to gold wouldn’t be a way around the massive problems that are already baked into the cake. In any case this is a side issue, because there are two simpler reasons that the idea of a gold-backed Yuan is a non-starter.

The first reason is that in a world in which most international trades are US$-denominated, tying any currency apart from the US$ to gold would result in that currency’s exchange rate becoming as volatile as the US$ gold price. In fact, the exchange rate of the gold-backed currency would be totally determined by the performance of the US$ gold price. For example, if the US$ gold price were to rise by 20% in quick time then so would the exchange rate (against the US$) of the gold-backed currency.

The second and more important reason is that any government that implemented a Gold Standard would be relinquishing control of its currency. There would be no further scope for the manipulation of interest rates and currency exchange rates. Also, there no longer would be any scope for debt monetisation in particular and monetary stimulus in general. If we were to make an ordered list of the governments that are LEAST likely to give up these powers, China’s government would be at the top.

Summing up, linking the Yuan to gold would not prevent China’s economy from suffering the consequences of the widespread malinvestment of the past decade and probably would lead to much greater volatility in the prices of imports and exports. Most importantly, there is no way that the control freaks who lead the Communist Party of China are going to implement a monetary system that severely restricts their ability to intervene.

Most warnings about large increases in government indebtedness revolve around future repayment obligations. For example, there is the concern that greatly increasing the government debt in the present will necessitate much higher taxes in the future. For another example, there is the concern that if the debt load is cumbersome at a time of very low interest rates, then as interest rates rise the interest expense will come to dominate the budget and lead to an upward debt spiral as more money is borrowed to pay the interest on earlier debt. Although these concerns are valid they miss two critical points, including the main problem with government borrowing.

The first of the missed points is that there is no intention to repay the debt or even to reduce the total amount of debt. This is one way that government debt is very different to private debt. Nobody would ever lend money to a private organisation unless there was a good reason to believe that the debt eventually would be repaid, but when it comes to the government the plan is for the total debt to grow indefinitely. It will grow faster during some periods than other periods, but it will always grow. Therefore, it makes no sense to agonise over how the debt will be repaid. It simply won’t be repaid or even reduced.

The current debt-based monetary system has been designed to expand…and expand…until it collapses and is replaced by something else.

Of course, the idea of debt repayment gets plenty of lip service. It has to be that way to avoid a premature collapse. The old Russian joke “we pretend to work and they pretend to pay us” springs to mind, but in this case it’s “the government pretends to care about debt repayment and bond investors pretend to believe them”. It’s a game, and for bond investors one of the guidelines of the game is “you’ll be fine as long as there are still plenty of people pretending to believe the government’s promise to pay”.

A consequence is that the rate of increase in government debt only matters to the extent that it affects the timing of the monetary system’s collapse.

The second of the missed points, and the main problem with government borrowing, is that the costs of the borrowing are immediate as well as long-term. The reason is that with one exception, every dollar added to the government’s debt pile results in a dollar less invested in the private sector. In effect, government debt accumulation adds to government spending at the expense of private-sector investment. This is a negative for economic progress, although it can give a short-term boost to economic activity in the same way that activity gets boosted by hurricane damage.

The one exception mentioned above is when the government debt is monetised by the banking industry (the central bank or the commercial banks). In this case it appears that new savings are magically created to finance the government’s deficit spending, but what actually happens is that misleading price signals are generated. In particular, interest rates are artificially lowered. The ramifications are less negative in the short-term and more negative in the long-term.

Summing up, when the government goes further into debt the biggest problem isn’t that it places a burden on future generations, since the debt will never be repaid anyway. The biggest problem is the immediate dampening effect it has on economic progress.

Here are two long-term charts illustrating the annual rate at which gold is extracted from the ground. The second of these charts shows why mine production can be ignored when trying to understand what happened to the gold price over the preceding few years or figure out what’s likely to happen to the gold price over the next few years.

The first chart shows the amount of gold produced by the global mining industry during each year from 1900 through to 2017 (data sourced from the US Geological Survey). The second chart shows the percentage increase in the world’s above-ground gold supply during each year (1900-2017) resulting from that year’s new mine production. In effect, the second chart shows the gold inflation rate.

Notice that over the past 70 years the annual rate of gold inflation has almost always been between 1.5% and 2.0% and has never strayed far from the 1.5%-2.0% range. In other words, regardless of what’s happening in the world, the total supply of gold increases by approximately the same tiny amount each year.

Over the past 60 years, trend changes in the annual rate of gold inflation appear to be lagged reactions to major price changes, with the 7-10 year lag being due to the time it takes from a major price-related incentive to appear and new mines to be brought into production. For example, the upward trend in the gold inflation rate that began in the early-1980s was probably a reaction to the major price advance that began in the early-1970s.

It’s normal for the stock market to ignore a rising interest-rate trend for a long time. The reason is that while the interest rate is a major determinant of the value of most corporations, the interest rate that matters for equity valuation isn’t the current one. What matters is the level of interest rates for a great many years to come. Therefore, a rise in interest rates only affects the stock market to the extent that it affects the general perception of where interest rates will be over the next decade or longer.

To further explain, the value of a company is the sum of the present values of all its future cash flows, with the present value of each future cash flow determined via the application of a discount rate (interest rate). Nobody knows what these cash flows will be or what the appropriate discount rate should be, but guesses, also known as forecasts, are made. Clearly, when discounting a set of cash flows spanning, say, the next 30 years, it won’t make sense to simply use the current interest rate. Instead, the analyst doing the calculation will have to make a stab at what will happen to interest rates in the future.

The analyst’s ‘stab’ naturally will be influenced by what is happening in the present, but the future interest rate levels that are plugged into valuation models won’t be adjusted in response to what are considered to be normal fluctuations in the current interest rate. It’s only when the current interest rate breaks out of an established range that it affects expectations in a big way.

That, in a nutshell, is why it isn’t a fluke that the 3rd October downside breakout in the bond market (represented by TLT in the following chart) coincided with the start of a rapid downward re-pricing in the stock market.

In addition to stocks being influenced by big moves (breakouts from ranges) in bonds, bonds are influenced by big moves in stocks. That’s especially so when important stock-market support levels are breached with little warning. For example, within a few days of the 3rd October downside breakout in the bond market setting in motion a sharp decline in the stock market, the stock market’s weakness was helping to prop-up the bond market. Interestingly, though, the quick 10% decline in the S&P500 Index from its peak led to only a minor rebound in the bond market, despite there being a record-high speculative net-short position in bond futures. As illustrated above, TLT didn’t even manage to rebound by enough to test its 3rd October downside breakout and has dropped back to near its early-October low in response to this week’s recovery in the stock market.

The bond market’s lacklustre response to the recent equity weakness suggests that equities will have to weaken further before the interest-rate trend transforms from a stock-market head-wind to a stock-market tail-wind. Also, the fact that the bond market has already dropped back to near its October low suggests that the stock market will be unable to make significant additional gains without pushing interest rates to new multi-year highs. This, in turn, suggests that there is minimal scope for additional short-term strength in the stock market.