Lessons from history and art...
On ALL SAINTS DAY, 1st November 1755, an earthquake measuring roughly 9 on the Richter scale struck the Portuguese capital, Lisbon, writes Tim Price at Price Value Partners.
At least 30,000 people are estimated to have perished. A little over half an hour after the original quake, a tsunami engulfed the lower half of the city. Those not affected by the quake or the tsunami were then beset by a succession of fires, which burned for five days. 85% of Lisbon's buildings were destroyed. Ripples from the earthquake were felt far afield. Finland and North Africa felt aftershocks; a smaller tsunami made landfall in Cornwall.
Such destruction had a follow-on impact, in both philosophical and theological terms. In June 1756, the Inquisition responded with an auto-da-fé – a witch-hunt, effectively, for heretics.
One, much-loved, novel happens to cover both of these events, along with a third, from March 1757, when the British Admiral John Byng was executed for cowardice in the face of the French enemy at the battle of Minorca. This inspired the famous line, "Dans ce pays-ci, il est bon de tuer de temps en temps un amiral pour encourager les autres": "In this country, it is wise to kill an admiral from time to time to encourage the others."
That novel was written by a Frenchman, François-Marie Arouet, in 1758. We know him better today by his nom de plume: Voltaire. And his satirical magnum opus that catalogued these various disasters was called 'Candide'.
'Candide' is a triumph of the style of novel best described as 'picaresque'. It's crammed with eminently quotable lines – the 'Pulp Fiction' of its day, if you will. Candide himself is a naïf who wanders with wide-eyed innocence through a savage and corrupt world. But in its Professor Pangloss it offers us the perfect encapsulation of today's rogue economist, the unworldly academic whose misguided practice of a false science has dreadful implications for the rest of us.
As investors we are all now the subjects of a grotesque monetary experiment. This experiment has never been tried before, and its outcome remains uncertain. The unproven thesis, however, runs something like this: years into what will probably be regarded by historians in the future as a second Great Depression, the only way out is for central banks to print ever greater amounts of money. Somehow, gifting free money to the banks that helped precipitate the crisis will lead to a 'trickle down' wealth effect. Instead of impoverishing those with savings, inflation will be some kind of miraculous curative, and it must be encouraged at all costs.
It bears repeating: we are in an utterly extraordinary financial environment. Like Candide's, our journey is difficult to take even remotely seriously. As the fund managers at Incrementum AG have observed,
"We are currently on a journey to the outer reaches of the monetary universe."
There are two uncomfortable truths that investors today must recognise. One is that the global debt problem that first erupted in the form of the Global Financial Crisis of 2007/8 has now become a predicament that cannot realistically be resolved. It requires some form of monetary reset – one that ideally will not involve the implementation of CBDCs, central bank digital currencies. Why should the monetary terrorists behind the controlled demolition of the first tower of global finance be allowed to construct the second?
The second uncomfortable truth – from a year that has already given us several large bank failures and a not uncontroversial bank rescue – is that fractional reserve banking is always and at all times a colossal fraud.
From our 2016 book 'Investing through the Looking Glass':
"The modern banking system operates on what is called a fractional reserve basis: only a fraction of a bank's deposits are kept as liquid reserves. The vast majority of deposits are lent out, re-deposited, and re-lent elsewhere. This mechanism normally works tolerably well, though in the event of a systemic loss of confidence, it has the unfortunate side-effect of bank runs.
"There is one further huge side-effect of fiat money and fractional reserve banking: inflation. Monetary purists point out that inflation is not just defined as a generalised rise in the prices of goods and services – rather, it is the rise in the money supply that tends to ignite the rising prices that follow in its wake. To generate inflation, in other words, merely let politicians and central bankers print money and let their banker friends create more.
"As the investment managers Lee Quaintance and Paul Brodsky describe it, money, per se, is base money (a measure known by economists as M0), which may only be created by central banks. It is comprised of physical currencies in circulation and bank reserves held on deposit at central banks. Presently, there are nowhere near enough bank reserves to cover bank deposits.. There is no need to fear bank runs, however [from the perspective of central banks, at least]. Were every bank depositor in the world to suddenly demand his or her money, central banks could easily create it with a few keystrokes. Herein lies a critical problem: central banks can easily create base money ex nihilo. It requires no form of discipline or labour whatsoever. Central banks, in other words, have developed precisely the tools that will cause them to destabilise the global monetary system while they claim to be its saviours.
"Government-sponsored paper money, in conjunction with fractional reserve banking, is inherently inflationary. Former US Federal Reserve chairman Alan Greenspan admitted as much when he acknowledged in 2005 that 'We can guarantee cash benefits as far out and at whatever size you like, but we cannot guarantee their purchasing power.' In other words, central bankers can print as much money as you want – just don't expect it, over time, to retain its purchasing power. 'Modern money is satisfying the requirements as units of account and media of exchange, but not the requirement as a store of future purchasing power. So, it is foolhardy to save money.' as Lee Quaintance and Paul Brodsky wrote in 'Macro Polo', January 2013."
Harold James, writing for the Financial Times this April ('Mega-banks in small states spell danger'), made the following historical analogy:
"The operation to rescue Credit Suisse by pushing it into the arms of UBS was flawed and rashly concocted. It did not follow the cumbersomely negotiated model for the resolution of large systemically important financial institutions. It gave an uncanny echo of one of the reddest of red flags in international financial history, the story of the interwar failure of the Vienna Creditanstalt.
"In 1929, at the outset of the Great Depression, the Austrian government pushed the Creditanstalt, by far the country's largest bank, to take over the failing second-largest bank, the Bodencreditanstalt. Less than two years later, the Creditanstalt itself failed, and the rippling contagion brought down the German banking system. Ensuing panic then spread to major financial centres, London and New York, and ensured that the Great Depression would be a permanently scarring economic memory. In the Lehman weekend of September 2008, then Fed Chair Ben Bernanke thought immediately of the grim warning provided by the failure of the Creditanstalt.
"The Creditanstalt teaches two lessons. First, it is dangerous for any financial institution to take over a problematic bank. Nobody can tell for sure what worms are in the rotten apple. It is easy for nervous depositors and creditors and shareholders to think that the rot may spread further. That is why, in the German crisis of July 1931, following the Creditanstalt collapse, Deutsche Bank refused the government's plea to take over, or to give a guarantee to, the bankrupt Darmstädter Bank. A merged megabank would have been very vulnerable to a banking run.
"The second lesson is that very big banks become an impossible threat if they are in small host countries. The 1931 Creditanstalt rescue required large-scale government funds in the bailout, and the consequent fiscal hole generated a currency crisis. In 2008, small and even medium-sized countries were severely challenged by the cost of banking support. Crises in over-sized banks effectively blew up Ireland and Iceland, and required painful IMF involvement. Even in a larger economy, the HBOS saga cost the British taxpayer dear."
In 'Candide', after all their travails and at the close of the novel, Professor Pangloss and Candide assess their situation. Despite all the suffering they have seen and borne first-hand, all has been for the best in this best of all possible worlds, suggests the Professor. All that is very well, replies Candide, "mais il faut cultiver notre jardin": "but we need to work our fields".
In other words, the world may be imperfect, but we have to play the hand we're dealt, and simply get on with it.
There are other quotations from Voltaire that have a particular resonance for us as investors today. "Doubt may be uncomfortable, but certainty is absurd." In other words, we must prepare for as many different investment outcomes as we can; only a fool would believe he can see the future clearly. And we should not overlook "It is dangerous to be right when the government is wrong."
And perhaps most pertinently, "Paper money eventually returns to its intrinsic value – zero."
So it is certainly uncomfortable to consider keeping meaningful sums of (fiat) money on deposit within imperfect banks, even and especially as QE programmes have become more and more outrageous as the years fly by.
We seek solace in the tangible and the permanent. In the fullness of time, gold's price in money terms will be dictated not by leveraged sellers of paper gold, but by unlevered buyers of the physical asset seeking safety from ongoing monetary debauchery. This tide has indeed already turned, in favour of the tangible, and away from the illusory and the impermanent.
For fellow believers in the primacy of real assets versus unbacked paper ones, we close with advice that Voltaire, given his frequent critiques of the (Catholic) Church, would probably not have uttered himself, or at least with any great conviction:
"Keep the faith."