Gold News

August 2007: When the Central Bank Con-Trick Failed

"Whatever it takes" has so far equaled $15 trillion of QE...
WEDNESDAY this week marks the 10th anniversary of what pundits, analysts and most investors now agree was the start of the global financial crisis, writes Adrian Ash at BullionVault.
If they had been paying attention when the interbank credit markets first froze in fear – back on 9 August 2007 – most people would now recall that the real trouble began long before. 
The banking crash was a symptom – an outcome – of the crisis, not the thing itself.
The true "crisis" had in fact been the global credit bubble preceding it.
Lots of people saw that bubble and thought it looked, well, risky. You could hardly miss it in fact. One or two central bankers even said it could cause trouble. 
Yet very few people did anything about it, even after the crash had clearly begun. World stock markets in fact kept rising in summer 2007...setting new all-time highs one month after the global credit markets froze on 9 August. 
But by then the bubble had clearly found its pin and was gushing air. Over the next 18 months the MSCI World index would lose almost 60% of its value. It took another 5 years to get back to that top, even with $10 trillion of QE cash pumped into the financial sector. The extra $5trn since then has coincided with world equities hitting a run of new all-time record highs.
What might end this post-crisis bull market? The 2007 pin doesn't much matter today. It could have been emerging-market shares, pumped up by the BRICS marketing spin of Goldman Sachs.
Or the mining sector, bloated like oil and gas by the 'commodity supercycle' story... 
...or perhaps retailers, swollen by consumer credit growing at the fastest pace since the '70s... 
...or any number of other investment sectors super-charged by what had been the cheapest money in history between 2001 and 2005. 
The resulting credit bubble came thanks to central bankers rushing to avoid a Japan-style deflation and 'lost decade' after the Tech Stock Bubble went bang at the turn of the century. 
In its place they flirted instead with a 1930s-style crash and depression, plunging us all into an uncontrolled crisis when the Western world's entire banking system imploded in autumn 2008. 
As it happened, the role of sharp pointy object was played by US home-buyers. Specifically those US home-buyers with no job or prospects, but with huge mortgages on bright shiny new McMansions. 
I'll leave today's after-the-fact experts to rehearse that sad tale of greed, stupidity and history's roaring belly laugh for you. ( Or you could track the 2006 start of the crash in real time with Aaron Krowne's Mortgage Lender Implode-O-Meter. Or refresh your memory of government's role in the bubble here. Or see how Fed boss Ben Bernanke said subprime was no threat to the wider US homes market, let alone the entire global economy, in May 2007. Or read what we discovered and wrote about subprime debt derivatives in July 2007 here.)
Instead, let's use Wednesday's anniversary to note simply that:
a) 2007 was another missed opportunity to avoid moral hazard, and to find out what happens if capitalism is allowed to work. Let bankrupt banks go bust? The world chose tax-funded bail-outs instead, leaving the traders and bankers to keep their liberty and keep the bonuses they'd earned by booking profits on deals with years and decades still to mature;
b) Zero risk means zero return, and rightly so. If the world doesn't owe you a living, it certainly doesn't owe you a rate of interest on your government-insured bank savings. Nobody needs to borrow your cash anyway, not at what you might feel to be a decent rate of return. The world is drowning in money, all of it looking for a home. How else to explain Bitcoin?
c) When crisis becomes crash, gold tends to do well as share prices sink with interest rates. But it does best when people lose faith in central bankers. Hence gold's out-sized gains of 2007-2012, balancing the losses investors made elsewhere. Hence the retreat and now tepid recovery as shares and real estate have recovered since then.
The Fed, Bank of England, Bank of Japan and ECB in Frankfurt all failed to see the crash coming of course. Indeed, the UK and Eurozone had just raised rates to 6-year highs. The Fed confirmed its rate of 5.25% just 2 days before the 9th August panic.
Way behind the curve they had done so much to create, the central bankers then began cutting rates and throwing cash directly at the banking sector. Because that's the only crisis reponse they know.
Yes, Mervyn King at the Bank of England played tough for a week or two. But his resolve withered at its first test – the "banana republic" banking run on Northern Rock of mid-September. And yes, real shock and awe had to wait until after the Lehmans' collapse of 12 months later. Because tweaking the levers and twiddling the dials seemed to work at first. The Financial Times was so reassured, it made ECB chief Jean-Claude Trichet its 2007 Man of the Year!
The FT was as easily gulled as central bankers had grown smug and self-satisfied. Bernanke, King and Trichet happily gave themselves the credit for the 'Great Moderation' of falling inflation and booming growth in a run of speeches as the credit bubble inflated towards its pin.
But events were already running far beyond what these Wizards of Oz could halt with just a flash of powder or a booming voice. Central banking really is a confidence trick. August 2007 tore down the curtain hiding the all-too ordinary talents and powers of the assorted governors, chairs and presidents.
The uncontrolled crisis flickered with the UK's Northern Rock fiasco of mid-September 2007. It ran through the collapse of Bear Stearns the following March...hit its first peak with the US Fed's absurd and arbitrary decision to let Lehman Brothers fail while saying everyone else was solvent in September 2008...and then saw the markets run wild again with the US and then Eurozone government debt crises of summer 2011 and 2012 respectively. 
Take note however: Both today and into the future, most people will look back at gold's starring role in the story of #GFC2007 and assume that bullion prices rose because of the zero-rate and QE money-printing done by central banks to try and stem the crisis. 
But on the contrary...
Chart of central-bank total assets at US Fed, Bank of Japan, European Central Bank. Source:
Compare this chart with Yen gold prices, and you'll see that Japanese central-bank chief Kuroda's ku-razy QE shows no relationship to the path of bullion. Eurozone QE only took the ECB's total assets in the same direction as Euro gold prices 6 years out of the last ten. And if there is, as so many assume and claim, any correlation between the US Fed's balance-sheet and the price of gold, it isn't positive.
Chart of Dollar gold price (red, right axis) versus US Federal Reserve total assets (blue, left axis). Source: St.Louis Fed
See gold vault higher as asset purchases paused in late 2010? See it peak when QE hit the debt ceiling debacle of summer 2011?
Then see it whip below and re-test that peak as the Fed paused again...only to slump as the 2013 surge in QE coincided with the Fed proclaiming that, with the economy now fixed by money printing, it would start tapering the monthly squillions of newly-created central-bank money pumped into the financial sector sometime soon?
Quantitative easing – the art of easing with quantity – did in fact stem the panic. That in turn stemmed the rapid ascent of gold prices. It also shows a much stronger connection to the asset class most targeted by Fed and other central-bank policies: the stock market.
Chart of US Fed total assets, 2007-2017. Source: St.Louis Fed
"We will do whatever it takes," said Trichet's follow-on act as ECB chief, Mario Draghi, in summer 2012. "And believe me, it will be enough."
By no coincidence, gold priced in Euros was then surging towards its current all-time record highs, but in clawing for credibility, Draghi had at last stumbled upon it.
Come the next spring, bullion fell hard against all major currencies, even as the Euro banking crisis saw Cyprus shut down and locked out of monetary union. Because the markets judged "whatever it takes" to be enough. Confidence is what counts.
Today these buffoons really have got things back under control, simply because the financial world wants to believe that they have. Right up until the next time the world realizes they haven't.
When might that next crisis arrive? A year after the credit crunch began, zero rates and QE began flooding the markets with central-bank money. Global and especially US equities now look richly-priced by pretty much any measure. The Fed, like the ECB, has begun muttering about maybe letting its QE assets start to unwind...keeping the cash from maturing bonds and so withdrawing liquidity from the financial sector rather than re-investing that money in new debt.
But see the chart above. Equities look way more grateful than gold to QE. And below here on interest rates, the central-bank trick of slashing borrowing costs to support asset prices has nowhere to go.

Adrian Ash

Adrian Ash, BullionVault Gold News

Adrian Ash is director of research at BullionVault, the world-leading physical gold, silver and platinum market for private investors online. Formerly head of editorial at London's top publisher of private-investment advice, he was City correspondent for The Daily Reckoning from 2003 to 2008, and he has now been researching and writing daily analysis of precious metals and the wider financial markets for over 20 years. A frequent guest on BBC radio and television, Adrian is regularly quoted by the Financial Times, MarketWatch and many other respected news outlets, and his views from inside the bullion market have been sought by the Economist magazine, CNBC, Bloomberg, Germany's Handelsblatt and FAZ, plus Italy's Il Sole 24 Ore.

See the full archive of Adrian Ash articles on GoldNews.

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