Multilateral Economics 101
October 20, 2014 By JC Collins
Deflation and Congressional Elections By JC Collins
Over the last 9 1/2 months many readers have asked me to explain what I think will happen during the transition to the multilateral system and what they should do about it.
I’ve been very reluctant to give financial advice in this regard and have deferred answers to the instincts of those asking the questions.
In this post I will attempt to be more straight forward and open about what I think will happen and how. What you choose to do about it will have to be inferred by your interpretation of what is written.
In previous posts I have mentioned that Quantitative Easing, or QE, the seemingly unrestricted money printing of the US dollar system, was designed and implemented for the purpose of building and semi-structuring the SDR multilateral system which is now emerging.
To more fully understand what this means we must also include the QE, or expansion of the money supply, by not just the US, but also China, Japan, and other central banks and treasuries around the world.
But first we must broaden our understanding of QE and what a reduction in QE, or all stop, will mean for the macroeconomics of the international financial system.
No discussion of QE can be thorough without a deeper awareness of the relationship between inflation and deflation. For this purpose let’s use the analogy of an ice cube tray as we delve into the contrived complexity of inflation and deflation.
Imagine an ice cube tray which is filled halfway with water. The tray is sitting on the counter and everything is at rest on the baseline.
Now let’s pick the tray up and slowly dip and twist, allowing the water to move and slosh from one cube to another, and consider these movements as the simultaneous actions of inflation and deflation.
Depending on how much, and to what extreme we dip and twist, the water can stay near baseline proportions or it can move from one end of the tray to the other, one side to the other, with some cubes overflowing while others contain little water.
This visualization can be applied to our understanding of how we have seen deflation in some markets, like commodities and mining, while we have seen inflation in other markets.
Inflation of course is the expansion of the money supply while deflation is the contraction of the money supply. It is assumed that both exist independently and separate, but connected through an action similar to a seesaw, one ends goes down and another end goes up.
This simple method of visualizing the relationship between inflation and deflation is made irrelevant when we consider the more abstract visualization of the ice cube tray used above.
Proponents of the palpable fear surrounding an all out financial collapse focus on the intensity of the money supply expansion as evidence that the end is near.
This interpretation is understandable from a straight forward analysis of economic fundamentals. But QE is designed to be unconventional and as such the economic fundamentals do not apply. At least not as we understand them.
Economic fundamentals would suggest that the water in the ice cube tray would eventual overflow all cubes, or components, and nothing would be able to structure or shape the money supply, leading to hyperinflation and economic collapse.
What QE was designed to do is restructure the system in preparation for the implementation of the multilateral financial system. This is best understood as the cubes within the tray expanding for the purpose of holding and shaping an increase of liquidity.
How each individual cube within the tray is connected to the others is what has been built and negotiated over the last few years. Where deflation and inflation settles within the whole of the tray has not been left to chance.
The volume of liquidity within each individual micro cube is determined by the volume of liquidity allowed to pour into the whole macro tray.
What the new multilateral system has achieved is an enlargement, or expansion of the whole tray, and as such, an enlargement or increased capacity of each individual cube to hold and shape more liquidity.
This liquidity, somewhat hidden at the moment, is obvious to see in the lack of hyperinflation.
The above explanation takes into account what at first appears to be discrepancies in the current system and the actions by the worlds financial institutions, including central banks and treasuries.
One of these discrepancies is the continued purchasing of US dollar denominated assets in the face of what one would assume is a reckless and destructive policy by America.
Why would China and other countries continue adding Treasury bonds to their foreign reserve accounts if the collapse of the dollar was so obvious and imminent?
Other discrepancies include a continued drop in the price of gold and silver. Supporters of $10,000 gold have been unable to explain why the precious metal is going down in price in the face of QE.
But lets look at QE in two segments. One segment is when QE was increasing and another when it was decreasing. With some lag time built in to the system, we saw gold reach the $2000 range at the height of QE and as QE has been reduced we have saw gold drop in price.
Gold and silver are likely to further decrease in price in the coming months as QE comes to its inevitable end. This end has been designed and planned with some flex allowed in the system.
With the end of QE will come the next phase in the transition of the financial system from the old dollar based structure to the new SDR based structure.
The SDR, Special Drawing Right of the International Monetary Fund, has been used twice before as a tool to shore up liquidity and help the global financial system, being the dollar based system, through a turbulent period.
In both cases it was the dollar system which was secured. This time the SDR will be used to secure and create liquidity for a multilateral system.
As we’ve discussed in many previous posts, the Chinese currency will be added to the SDR basket composition sometime between now and next summer.
The renminbi has been going through an extensive process where it is becoming internationalized. The renminbi denominated bonds which have been issued through the Canadian province of British Columbia and the country of Great Britain is only the start.
The renminbi denominated gold contracts as issued through the Shanghai Gold Exchange is another point of interception where the new multilateral system is emerging from the ruins of the old.
With these gold contracts can be found another discrepancy.
It was assumed by many analysts that the Shanghai Gold Exchange would adjust the price of gold to reflect what was considered to be the metals more accurate and higher value. All have been unable to explain why the price of gold has been maintained in line with the western exchanges.
With the end of QE approaching we are likely to see China announce an adjustment to their official gold reserves. This will be timed to correspond with a decrease of confidence in the US dollar system.
This decrease in confidence will be directly related to the end of QE, which is a contraction of the money supply.
The early signs of a broader deflation are already visible and growing by the day. Between now and next summer we will, at some point, see a fast contraction of the money supply, leading to a deflationary period which is unlikely to be sustained past the summer or fall of 2015.
This deflation is best visualized using our ice cube tray analogy above. The tray will be expanding in anticipation of an increase in liquidity.
As the individual cubes become larger the amount of water in them gets smaller in proportion. This deflation will hit harder in some areas as opposed to others.
Gold and silver will see further reductions in price and the stock markets will take some drastic drops.
The increasing lack of confidence in the dollar based system will lead to a major liquidation of assets as the masses seek to hold onto cash in the face of an ever decreasing supply of money.
By the summer of 2015 SDR denominated bonds will begin being used to re-liquidate the system.
Between then and 2018 the whole multilateral financial system will see massive increases in liquidity as everyone from central banks and global corporations issue SDR denominated bonds.
The level of assets held in foreign reserve accounts will transition into SDR assets through a process which utilizes substitution accounts. These SDR bonds will increase the liquidity in the system.
The deadline of 2018 for the transition to complete corresponds with the deadline for the full implementation of the Basel 3 Regulations on Liquidity.
These regulations are mandated by the Bank for International Settlements and trickle down to central banks and chartered banks around the world.
The deflationary period, which hopefully will only last a few months, will be devastating to the savings and pensions of many Americans and citizens of other countries. The full losses should be contained within the range of 30% to 50%.
Those who are able to liquidate as many depreciating assets as possible and reinvest in assets which will eventually appreciate again leading up to 2018 will be the ones to weather the storm.
Some of these appreciating assets will be gold and silver, as well as real estate and rare art, along with other physical assets.
The method of deflation has been engineered to perfection.
The wealth transfer which will take place, though destructive to many, will bring a semblance of balance back to the system in preparation for an increase of SDR liquidity. That is the path out of this contrived financial crisis, as cold and calculating as it appears to be.
It is important to remember an economic fundamental which the majority have forgotten over the last 3 to 4 decades, and that is one where an individuals consumption cannot increase out of proportion to their production.
The masses have willingly partaken in a consumption the likes of which the world has never seen. While this consumption was increasing there was a severe drop in production.
We can debate the engineering behind this, and I believe there was some, but that does not excuse each of us individually for our ignorance and role in the largest distortion between consumption and production in history.
We have all suckled at the tit of mammon and went back for more. The adjustments that we will see in the coming months will be on par with this distortion in wealth due to the disconnect between consumption and production.
In America the elections to determine control over the House of Representatives is approaching. On November 4th it will be decided who controls the House, the Republicans or the Democrats.
No matter who wins the 2010 IMF Reforms will be passed and the required legislation to support the modifications to the quotas and executive board of the IMF will be implemented.
The only thing that will vary is the other content and desired items included in the bill. Each party will attach beneficial items.
The republicans have denied passage of any bills which the Democrats have put forward on the IMF Reforms for the simple reason that they have also contained proposed legislation which they did not support, like changes to IRS rules regarding the tax exempt status of political organizations.
Both parties are very well aware of the reality being dictated to them by the outside international world.
The G20, IMF, World Bank, BRICS, and UN, have all demanded that the IMF Reforms be passed by the end of this year. If the democrats win control of the House they can pass the bill as they see fit.
If the Republicans retain control over the House then the Democrats will have to bend and put forward a bill which the Republicans will pass.
Either way, the long awaited 2010 IMF Quota and Governance Reforms will be passed by the end of this year which will open up the process of having the Chinese renminbi added to the SDR basket composition along with the dollar, pound, yen, and euro.
Gold, for its part, could also be added to the basket, though I’m beginning to suspect that gold may be added after another 5 years have passed, sometime around 2020.
This year has seen many truly incredible events and there is more to come.
The early months of 2015 and leading into the summer will be just as dramatic, if not more so. The multilateral system is beginning to emerge and its becoming harder to ignore the methodology which we have been discussing here. – JC