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Some years ago
Gordon Brown, then UK
Minister of Finance, was asked at a dinner party why he had allowed the UK to sell
60% of the country's gold reserves from 1999 to 2002. According to someone
who was present, the reply was along the following lines: "We stared
into the abyss and were concerned that a sharply rising gold price would
alert the world to the crisis that the world was facing. That is why we sold
our gold".
Whether this is
fact, myth or urban legend is not important. What is fact is that a sharply
rising gold price does alert people to a major crisis. With gold pushing to
new all time highs above $850, we can conclude that the world is facing a
crisis of major proportions and that we have been catapulted into the abyss
that Gordon Brown feared.
The world is
dealing with a Sub-Prime crisis, an Evaporation of Credit crisis, a Banking
Solvency crisis, a US Dollar crisis and an International Monetary crisis. These
roll into one to produce the "Mother of All Crises", the
"Perfect Storm" crisis.
This crisis will
not go away. It is destined to escalate. Investors and businessmen need to
have a clear understanding of the constituent causes of this crisis and
ensure that they develop strategies for the financial survival of their
investments and businesses.
It is important
to differentiate between the symptoms (which are the items that catch the
media headlines) and the underlying disease that needs to be diagnosed and
cured.
In this article
four sections are covered:
- THE SYMPTOMS;
- THE DISEASE;
- THE CURE;
- INVESTMENT
STRATEGY.
THE SYMPTOMS
These are some
of the symptoms. The list is not exhaustive but it is not necessary to delve
too deeply as the various symptoms are well covered by the news media.
- Sub-prime problems: The sub-prime problems in
the USA, Europe and elsewhere stem from excessive liquidity
creation; leading to demand for investment vehicles exceeding supply;
leading to creation of new, esoteric products and fraudulent acquisition
of business. Losses from the sub-prime area started a chain reaction.
- Credit Default Swaps (Stop Loss Insurance on
credit/financial instruments): CDS's have
grown from $10 Trillion to $46 Trillion (notional value) in the 2 years
to June 2007, having mushroomed from $22 Trillion in December 2006, a gain of $24
Trillion in just 6 months. Purveyors and acquirers of suspect AAA paper
were attempting to cover their backs by purchasing loss insurance. Major
losses will emerge from the CDS area, related to both direct losses and
losses occurring as counter-parties in derivative transactions fail to
meet their obligations.
- Government Sponsored Enterprises (GSE's) such as Fannie Mae and Freddie Mac face
potential bankruptcy as they carry over $4 Trillion of Credit Default
derivatives on their books with a capital base of only 1.5% of the
liability. The GSE capital base is being eroded by mortgage losses that
are escalating daily.
- The Commercial Paper market has dried up. Banks
face solvency problems as their capital and reserves are reduced by
losses and they attempt to fund ongoing activities.
- FASB 157 accounting standards regulation: This
came into force on 15 November 2007 and requires financial institutions
to disclose their assets as either Level 1 (valuations determined
conclusively from quoted market prices); Level 2 (valuations determined
indirectly from market prices or other verifiable sources); Level 3
(valuations basically thumb sucks by the banks - with no verifiable
methodology to substantiate the valuations).
- The importance of these new accounting
standards is that auditors will have to certify whether assets are Level
1, 2 or 3. This puts an onerous obligation on the auditors who must be
aware that they may be sued by shareholders if assets are incorrectly
categorised. The shadow of Enron looms large. From the end of December
2007, bank and financial company reports will carry this designation of
assets. Level 3 assets will be highly suspect.
- If a bank reveals $150 Billion in Level 3
assets after already writing off, say, $10 billion in sub-prime losses,
there will be an expectation that a large portion of the $150 billion
will also end up as losses. If the bank's capital and reserves amount to
say $30 billion, the situation becomes perilous for the bank's solvency.
Banks may be relying on Credit Default Swaps to cover losses in Level 3
assets but it is becoming increasingly unlikely that insurers will be
able to meet their CDS obligations in full, if at all.
- Derivative contracts outstanding world-wide
recently exceeded $600 Trillion in notional value. Interest Rate Swaps
account for the largest proportion of outstanding derivative
instruments, approaching $500 Trillion in notional value. Counter party
failure is a major risk in this area. Counter parties who fail for other
reasons (e.g. sub-prime or credit default problems) may bring down this
shaky house of cards.
Governments and
central bankers will not stand by idly while the financial markets burn. Interest
rates will be rapidly reduced and any major institution that threatens to
collapse the financial system will be bailed out. It is unthinkable that
Fannie Mae and Freddie Mac will be allowed to go under. Nor will any major
bank be allowed to go belly-up. There is discussion about nationalising Northern
Rock in the UK,
thus shifting the burden directly onto the tax payers.
Governments have
the ability to create as much new liquidity as is required to avoid a
systemic melt-down and they will use this ability to attempt to avert, or at
best, delay or ameliorate the major systemic crisis that the world is facing.
The outlook is for a flood of new world wide money creation as far as the eye
can see.
THE
DISEASE
The disease
stems from a malfunctioning and dysfunctional international monetary system
in which governments can create new local money at will without restriction. This
has been the case since 1971 when the Bretton Woods
system collapsed and all currencies floated against one another. August 1971
was when President Nixon decreed that the USA would cease exchanging gold
at $35 per ounce for gold tendered by foreign central banks.
Since 1971 the
world has embarked upon a binge of undisciplined credit and debt creation. It
is the first time that this has happened on a world-wide scale and the unpalatable
consequences of this orgy are revealed in the symptoms section above.
It is a boring
subject, but it is worth spending some time trying to understand the sequence
of events that has brought the world to this massive crisis.
Once gold was
removed as the disciplining factor in the monetary system, a new reserve
asset had to emerge. The US Dollar, presumably because of the size of the US economy,
became the de facto international reserve asset. What evolved became
known as the US Dollar Standard.
The principal
flaw in the US Dollar Standard is that it has no mechanism to prevent or
correct large and persistent trade imbalances between countries. Consequently,
the deterioration in the US
current account deficit has gone unchecked. It recently reached the level of
$2 Billion per day. This excess of imports over exports is settled by
exporting newly created US Dollars.
When foreign
companies sell goods in the USA
they take their dollar earnings home. When these proceeds are converted into
their own currencies it puts upward pressure on those currencies. The central
banks of those countries intervene to prevent their currencies from
appreciating so as to preserve their trade advantage. They intervene by
creating local money and using this to buy the dollars entering their
countries. In this way, the exporters are able to keep their export earnings
in their domestic currency while the central banks accumulate large foreign
exchange reserves.
Countries with
trade surpluses with the USA
experienced economic bubbles, Japan
in the 1980s, the Asian countries in the 1990s, and China today. As the central banks
of the United States' trading partners reinvested their dollar surpluses back
into US dollar assets, the USA itself (aided and abetted by lax credit and
monetary conditions in the USA), experienced a series of bubbles, such as the
stock market bubble in 1999/2000 and the real estate bubble from 2002/2005.
The US
current account deficit has destabilized the global economy. It has also
brought the US Dollar to the point where other countries recognise that the
US Dollar is grossly over-valued and that the US Dollar Standard as the basis
of the international monetary system has passed its "Use By" date.
Before the
breakdown of the Bretton Woods international
monetary system, international trade balanced. Under the Gold Standard, or
the quasi gold standard Bretton Woods
system, large and persistent trade deficits could not be sustained. The US
would have had to pay for its deficits out of its limited supply of gold
reserves.
The willingness
of the USA's trading
partners to accept payment in dollars instead of gold meant there was
effectively no limit to how large the US trade deficits could become. This
vendor financing arrangement allowed much more rapid economic growth around
the world than would have been possible otherwise. The greater the US current account deficit became, the more
the US
trading partners benefited.
The magic of the
Fractional Reserve Banking System and the fertile imagination of hedge funds,
investment bankers and other speculators in creating new derivative
investment products with levels of leverage unimaginable even a decade ago,
have created a most unstable world-wide financial and economic structure that
is in the process of collapse.
The disease can
be diagnosed as unsound money, plus an unsound international monetary system,
combined with undisciplined politicians and central bankers who have spawned
a system that is awash with vast quantities of newly created liquidity and
lax morals.
THE
CURE
The cure must be
the creation of a new international monetary system based on the principles
of sound money. Sound money requires the removal of the ability of
politicians and central bankers to create new money at will.
This is
obviously easier said than done.
It is
unthinkable that politicians and central bankers will give up their existing
sovereign situations without a major fight. That unfortunately means that the
world's economic and financial condition must deteriorate to such dire depths
that a point will eventually be reached where a consensus will emerge that
something radical must be done about it. One shudders at the thought of the
awful economic, financial and social consequences that must occur in order to
reach that stage.
Only then will
the causes of the problem be assessed objectively.
Once such a
consensus is reached and it is finally accepted that monetary discipline must
return, then an international gathering of experts might have a chance of
thrashing out a new monetary system based on the principles of sound money. What
seems likely is that a new world-wide currency will have to be created, a
currency that all nations will use. It must be a currency that cannot be
created at will by anyone. It will have to be managed and policed by a
totally independent and international body. It will also have to be based on
something of real value and be freely exchangeable.
It is futile for
over 150 countries to each have their own local currency. Globalisation
suggests that a single currency used world-wide is now possible. The template
is the Euro which replaced a whole raft of different European currencies. Be
prepared for the eventual arrival of the "GLOBAL".
INVESTMENT
STRATEGY
How does one
plan an investment strategy for such an awful outcome?
The first thing
is to accept that this is a real crisis of truly major proportions that will
require past investment yardsticks to be jettisoned. For example, the present
unit of measurement, the US Dollar, will become increasingly less suitable
for performing that function as the new money creation and bail-out bandwagon
gathers momentum. It is possible that gold may become the de facto new
unit of measurement.
In the
investment and business areas, anyone who is not aware of the causes and consequences
of this major crisis is likely to be crushed by it. It is the single most
important investment issue at this time and it transcends all other
considerations.
It seems
unlikely that the world will enjoy a miracle and be able to avoid the crisis
by virtue of some special person appearing on the world stage with the
ability to solve the problem. It is more likely that each country will do
whatever is perceived to be in its own best interests, and will do whatever
is required to prevent a financial or economic collapse in their own
countries.
Historically
this type of situation has resulted in politicians and central banker's
throwing newly created money at the problem areas. There is little reason to
think that the current crisis will be any different, except that the
quantities of new money that will need to be created to attempt to bail-out
all problem situations as they occur will be so huge that people will finally
realise that the money has become valueless.
The odds
strongly suggest that the world is facing the largest ever transfer of wealth
from financial (paper) assets to tangible assets, otherwise known as
"store of value" assets. This is the most likely strategy that
investors will adopt to cushion themselves in the attempt to survive the disaster
that seems certain to lie dead ahead.
Each person will
have a different view of what constitutes a suitable tangible "store of
value" asset. Different assets will have different propensities for the
protection of real wealth, which is why gold may emerge as the de facto unit
of measurement.
For example, a
blue chip centre city property may cost $850 million today, which means that
it has the same value as 1.0million ounces of gold at the current gold price
of around $850. The test of how well that property protects real wealth is
whether it can be sold some time in the future for more or less than the
equivalent of 1.0m ounces of gold at that time.
In previous
articles ("The Seven D's of the Developing Disaster" and "Gear
Today, Gone Tomorrow") mention was made of John Exter's
inverted asset pyramid.
Imagine an
inverted pyramid consisting of layers of various investment asset classes
where the least secure (and most prolific assets) are in the very wide top
layers. The inverted pyramid then narrows down through layers of increasingly
more secure assets to the small point at the base which consists of the most
secure (and least prolific) assets. The theory is that in times of financial
crisis investors will cause their investments to devolve downwards through
the different asset layers in the inverted pyramid as they search for greater
security. This move to assets representing greater security is already
happening in the current crisis.
The asset in the
most secure category at the tip of the inverted pyramid is gold. Platinum and
silver bullion lie directly above gold. Precious metals have performed the
function of protecting wealth throughout the ages. In the layer above the
precious metals are base metals, uranium and the minor metals. Above them are
the companies that mine and hold large deposits of metals. The least secure
assets in the envisioned environment, which form the broad layers at the top
of the inverted investment pyramid, will be financial and paper money assets.
Alf Field
Disclosure and Disclaimer
Statement: The author is not a disinterested party in that he has personal investments
gold and silver bullion, gold and silver mining shares as well as in base
metal and uranium mining companies. The author’s objective in writing
this article is to interest potential investors in this subject to the point
where they are encouraged to conduct their own further diligent research.
Neither the information nor the opinions expressed should be construed as a
solicitation to buy or sell any stock, currency or commodity. Investors are
recommended to obtain the advice of a qualified investment advisor before
entering into any transactions. The author has neither been paid nor received
any other inducement to write this article
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