A Tale of Two Crises

For those awakening to the unpleasant reality that the global financial crisis which began in 2008 has never been resolved, we have some important news for you: There are, in fact, two crises unfolding in parallel. One is phoney and in the spotlight; the other is real yet lurks in the shadows. This is because the phoney crisis is the one that policymakers want you to see: the apparently insolvent banking system in need of a bailout. The real crisis they refuse even to talk about is that economic resources have been so massively misallocated in recent years that sustainable economic growth has become impossible. What is needed to solve the real crisis is not to bail out insolvent financial institutions, rather the opposite. It is through a general bankruptcy and restructuring of the financial system that economic resources can be properly reallocated to where they can be gainfully and efficiently employed, enabling a resumption of healthy, sustainable economic growth, to the benefit of all.

A Tale of Two Crises

The powers that be would have you believe that, had they not taken various arbitrary, extraordinary actions in 2008 and 2009, the global financial system would have imploded, tanking the economy and quite possibly threatening society and civilisation as we know it. QE1, QE2, TARP, TALF, the Fannie/Freddie nationalisation, etc, etc, were all therefore necessary, notwithstanding their dubious constitutionality.

We disagree. There is a fundamental principle of western civilisation, known as the rule of law, which could have been invoked instead. Contracts would have been honoured. Failing financial institutions would have been left to declare bankruptcy, their assets would have been seized by creditors and/or disposed of by administrators and eventually the financial system would have reformed into a deleveraged shadow of its former self.

But wouldn’t this have put depositors at risk? Isn’t that what they said when they were trying to get Congress to pass TARP? That depositors would be summarily wiped out and, in the ensuing economic chaos and social unrest, martial law would be invoked to restore order?

That is a complete, utter fabrication. There is no reason to believe that, had TARP not passed, there would have been a general breakdown in the economy and society generally. Yes, there would most certainly have been a great deal of disorder in financial markets. There would also, most probably, have been a severe recession, quite possibly worse than that experienced to date. But unlike the current situation, in which ‘too-big-to-fail’ financial institutions have continued to grow, threatening another crisis in the near-future, had these institutions been allowed to fail instead, they would no longer pose a systemic risk. Indeed, the financial sector would have shrunk and de-leveraged to a size more compatible with stable, sustainable economic growth.

What follows in the next section is what would happen were governments and central banks now to sit back and allow the rule of law, capitalism, free markets and Schumpeterian creative destruction to work their magic and solve the real crisis.

The Best of Times, The Worst of Times

This is not going to make for light reading. Arguably the most wonderful, magical thing that humans ever get to experience is the birth of a baby, the miracle of life. But boy, is it painful: in the moment for the mother and in the years of toil thereafter for the parents to earn an income, maintain a home and raise the child to adulthood.

Let’s be under no illusions. The birth of a new financial system is going to be painful for the economy. First off, with the removal of government and central bank support, numerous financial institutions are going to go bankrupt. Shareholders will get immediately, completely wiped out. The same is probably true in most cases for subordinated bondholders. At a minimum, senior bondholders will take large haircuts. In extreme cases they, too, will be wiped out.

As for depositors, they will be protected, to some extent, by deposit insurance. To the extent that governments print money to make good on deposit insurance, depositors lose too, through inflation. That said, they will lose proportionately much less, because the printing press will only be employed to make depositors whole, not bondholders and shareholders. And with bondholders and shareholders taking losses first, in most cases deposit insurance will not even be necessary. Some houses always survive the earthquake without damage, built as they are on particularly solid ground.

Naturally, a general financial system bankruptcy will be hugely deflationary for prices of all things, from food to clothing to shelter. A little deposit insurance might, in the aftermath, go a rather long way. Imagine that house prices fall by 80%. Homeowners walk away from underwater mortgages en masse. But imagine how much a deposit-guaranteed $100k in the bank will buy you following that 80% decline. Renters with insured bank deposits will rejoice and some will become the new landlords, snapping up properties on the cheap. And why shouldn’t they? After all, they made the right decision not to buy into an inflated housing market. They should be rewarded. That is how free market capitalism works. Laws apply equally to all, for better or worse.

But will there be enough liquidity and cash in the system to provide for at least a minimum level of food, clothing and shelter as the financial system crashes? Of course. Prices for food, clothing, shelter, etc, will fall by as much as required to match demand to the remaining money supply of insured deposits, cash in hand and other money equivalents.

Let’s not forget, the vast, real economic infrastructure will still be there. Farmers will still trade food for everything else; manufacturers will trade their wares for food; and everyone will trade some measure of their labour for shelter of some kind. Anyone willing to work will claim a small piece of the output of the capital stock on any given day. The world will not end. But let’s be clear, its residents will need to work for a living. Is that such a bad thing?

The bankruptcy of the financial system will transfer a huge amount of wealth from shareholders and bondholders to depositors. In other words, it will transfer wealth from the previously wealthy to the middle class. This should come as no surprise. Just as inflation and financial bail outs transfer wealth from the middle class to the wealthy, so deflation, left unchecked by government intervention and bail outs, effects the opposite.

But as we said above, this wealth transfer will not be pretty to watch. It will be temporarily destructive of wealth in general. Pensioners and others living on savings will be particularly hard hit, flush as they are with bonds and shares. While the population will not suffer inflation, they will suffer default. Those earning wages, by contrast, will find that their relative standard of living has improved enormously. What benefits the middle class generally, benefits the young, at the start of their working lives, lacking accumulated wealth, most of all.

Imagine that. The young people, who pay all the future taxes to support the current, excessive borrowing of their profligate governments and excessively leveraged financial systems find that, in fact, they won’t be left with the bill after all. No, those who ran up the tab will pay instead. This is capitalistic justice, pure and simple.
With harsh lessons learned first-hand, the young are highly unlikely to repeat the financial mistakes of their parents and grandparents. They will rebuild the economy and financial system accordingly, on more solid foundations, to the benefit of all.

This is how Schumpeterian ‘creative destruction’ works. As an old Irish saw goes, a man asks another for directions to Dublin, to which he responds: “Well I wouldn’t start from here.” Translated into economics, just because we inherit the capital stock we have today from that which we had yesterday, doesn’t mean it is the best of all possible capital stocks. The problem is that, while breaking it up, reorganising it, infusing it with new technologies, and ultimately making it more productive and efficient, it will produce proportionately less. So it is with any capital asset: To improve it materially requires taking it off-line, making the improvements and then switching it back on.

As such, those benefiting most from the capital stock as presently structured are going to resist a general reorganisation in which their wealth will be at risk. Yet when calamity does strike, for whatever reason, the creative destruction gets underway, works its magic, and a few years later the economy re-emerges all the stronger, with the most innovative, hard-working and also risk-taking entrepreneurs reaping the greatest rewards, as befits a healthy capitalistic system. Needless to say, the system we inhabit today bears little resemblance.

Bringing things up to date, as we know, there is now a coordinated global effort to bail out the insolvent euro-area banking system before it brings down those of other regions with it. Unlike other major central banks, the ECB lacks the power to outright monetise government debt. But just because the ECB is hamstrung hasn’t stopped other central banks from taking emergency action.

Last week, six major central banks announced what amounts to a coordinated global rate cut. It is possible that this is just the beginning of something larger, potentially involving the International Monetary Fund (IMF). One possibility is that the IMF will be given powers not only to lend to insolvent entities but to create new money on its own, independent of national central banks. As such, the IMF would not only become a lender of last resort but also a money printer of last resort.
We don’t know whether or not that will happen, but we do know that policymakers are gradually running out of rabbits to pull out of their hats to distract the public from the real crisis, yet to be addressed, or even properly acknowledged.

Are you a Capitalist, or a Socialist?

In recent years, the financial world has undergone an Orwellian transformation. Those that receive the biggest bail-outs regard themselves as the greatest capitalists. This is complete nonsense. They are the greatest socialists. They have appropriated the wealth of society not by adding value but by successfully seeking rents from governments and central banks. Those abhorring capitalism should admire Wall Street, not disparage it. They set the standard for how socialism is done. Occupy Wall Street really should occupy Wall Street. They should take those jobs! Then they will become the true beneficiaries of the anti-capitalist policies many of them appear to support. So what of the real capitalists that don’t believe in bailouts? Are there any left on Wall Street? Were there any to start with?

Back in 2008, as the TARP programme was being debated in Congress, we were seriously tempted to purchase an ad in the Wall Street Journal. It would have looked something like the following:








Needless to say, many major financial institutions would have declared bankruptcy in 2008 or 2009 had the TARP not passed and placed the taxpayer on the hook to cover Wall Street’s colossal gamble gone wrong. But as described above, while this would have been traumatic for the financial system and economy generally, it would also have been fundamentally cathartic, enabling a vast wave of creative destruction which could have completely transformed and re-energised the economy. Naturally, it would have also transferred wealth from the failed gamblers on Wall Street to their relatively more prudent sources of funding on Main Street.
Probably by 2010 or 2011, there would have been a general, palpable sense that a major turning point had been reached. A severe recession would have given way to a Schumpeterian boom. Yet this boom would not be the product of excessive debt and leverage, rather the opposite: Through the extinguishing of debt and leverage, a far leaner, dynamic, efficient reorganisation of the capital stock would be growing the economy at a rapid yet sustainable rate. There would be more than hope for the future, there would be a sense of real achievement for society as a whole, including a clear sense that capitalism works, that bankruptcy is salutary, and that justice was done.

For those, like us, who are disappointed that history has worked out rather differently, we need only be patient. By avoiding the necessary if painful adjustments in 2009-10, policymakers have created the conditions for an even larger bust in future. Hardworking, entrepreneurial young folks need only be patient. Your time will come soon enough.

2011 Themes In Review

As we did around this time last year, in this edition we take a look back at the various topics we have covered in the previous twelve months and consider how these have subsequently developed.

The Year of the Silver Hare (January)

Whereas much of the world follows a solar calendar, with the year beginning and ending around the time of the winter solstice, there are those that follow a lunar calendar instead, including of course the world’s most populous country, China. Their new year is still one month away and, this time round, will be that of the hare–in the 12-year cycle of their zodiac–and also that of yin metal, or silver–in the cycle of the five elements. While we are not astrologers, we nevertheless appreciate the meaning of these cycles for the Chinese, who currently face unprecedented, potentially destabilising economic circumstances. According to tradition, the hare is not comfortable in such situations, in which its behaviour becomes unpredictable and potentially dangerous.

At the start of the year we were convinced that developments in China would prove surprising in some way, perhaps in the area of currency policy. As it turns out, there have indeed been some surprises, including government moves to provide financial support to regions and banks. Currency policy, however, has remained essentially unchanged, at least until recently. Amidst a poorly performing stock market and growing evidence that a material economic slowdown is now underway, the currency has stopped appreciating. These developments suggest that all is not well in China and that a rather hard economic landing may have commenced.

Mr. Mizuno Retires (January)

We have read much in the financial press of late regarding Japan’s poor demographics, chronic government budget deficits and declining household savings rate. Several of these analyses conclude that these factors are negative for the yen. True, all is not well in Japan, but it is important to keep things in perspective. What options does Japan have to deal with an ageing population? Actually, they have several, and theirs are somewhat more palatable than those of the US, UK or even the euro-area. Yes, the Japanese may be gradually retiring, but at least they have saved prudently, and this legacy of savings is negative for US assets and positive for the yen.

Japan is a country beset with fundamental economic challenges. It lacks raw materials, has an ageing workforce and has accumulated a vast public sector debt. That said, we wrote this piece to remind readers that, for all its problems, Japan actually compares rather favourably with the Western economies in some key respects. Indeed, notwithstanding the Sendai earthquake, tsunami and nuclear disaster still unfolding, the Japanese economy has performed respectably this year and the currency has been strong. Based on our analysis, we would expect yen strength to continue into 2012.

The Inflation Tipping Point (February)

Ever since the global financial crisis struck in 2008, there has been a lively debate between those who have been expecting a prolonged deflation and those who have been predicting a rapid transition to inflation. In certain respects, both sides of this debate have been correct in their arguments, if not entirely consistent. Recent data indicate, however, that the terms of debate are now shifting decisively in favour of those anticipating inflation. Within a period of months, financial markets will begin to adjust accordingly, indicating that an important inflation “tipping point” has been reached. Once this occurs, there is a risk that economic behaviour changes in ways that can damage economies. Investors need to prepare accordingly.

With the global economy slowing again, inflation is no longer the topic du jour. Prices in many countries are no longer rising as fast as they were in 2010. But while that is an entirely natural cyclical phenomenon, the structural phenomenon of changing inflation psychology remains very much intact. Taking the US in the 1970s as an example, while inflation slowed in each downturn, it came roaring back in each upturn, the net result being a decade of ‘stagflation’. As long as policymakers continue to print money and avoid economic restructuring, this experience is likely to be repeated again, only on a greater, global scale.

Defensive Notes on the Margin (March)

Investors sharing our view that financial assets in general are fundamentally overvalued in real, purchasing-power terms naturally seek to preserve wealth in alternative assets, including commodities. However, while commodities may indeed be more fairly valued, that does not mean that they can decouple entirely from developments in financial markets. Should equity markets suffer a major correction, commodity prices are also likely to fall, in particular those for industrial commodities. But even non-industrial commodities can be subject to speculation from time to time and there is some evidence that this is the case at present. Defensive investors should take note.

Following a large rally in 2010, commodity prices, as measured by broad indices, peaked in April this year, soon after we published this topic warning of excessive speculation in both industrial and non-industrial commodities. Prices have remained highly volatile ever since, including a big drop in September, from which they have only partially recovered. The indicators we used at the time to identify speculative interest are no longer flashing warning signs as positioning appears more balanced. As such, in the event that policymakers continue to print money, as we expect, commodity prices are likely to resume their multi-year secular rally.

The Inflation Tsunami (April)

As the world reflects on the earthquake and tsunami tragedy still unfolding in Japan, investors are seeking to understand the economic and financial market implications. There are some general observations that one can make at this point, the most important of which is to recognise that, in much the same way that the Japanese authorities are responding to the disaster with monetary stimulus, other major governments around the world continue to implement stimulus of their own in a futile and counterproductive effort to restore high rates of economic growth following the global credit crisis of 2008. The inevitable result of these responses to disasters, natural and man-made, is a global inflation tsunami which is going to cause significant economic damage. Time is running out for investors to escape into alternative assets.

As is the case with THE INFLATION TIPPING POINT above, this topic is one that has faded out of the spotlight as the global economy has slowed. But Japan continues to stimulate the economy, most recently by weakening the yen through yet another round of intervention in the foreign exchange markets. The Bank of Japan has also participated in the recent, coordinated action by global central banks in response to the escalating euro-area debt crisis. At the margin, Japan’s actions reinforce an accelerating global monetary expansion, thereby contributing to ‘stagflationary’ conditions around the world.

It’s the End of the Dollar as we Know It (Do We Feel Fine?) May

With each passing month, the dollar moves closer to becoming what one might call a ‘normal’ currency, in that it is gradually losing the pre-eminent reserve currency status it has enjoyed since the 1920s. In certain months, including that just passed, the end approaches rather more swiftly. While we have always regarded the demise of the fiat dollar as both necessary and inevitable, it is important to understand that, using history as a guide, what lies ahead is highly likely to be some combination of unpredictable, disorderly and even dangerous. But rather than stand as deer in the headlights, investors need to take action to prepare. Most important, they need to diversify away from not only dollar assets, but from fiat currencies and financial assets generally.

The dollar has been somewhat stronger of late, due in large part to the euro-area crisis and Japan’s currency intervention to weaken the yen. But dollar strength amidst signs of a faltering global financial system is hardly a vote of confidence in the global monetary structure. On the contrary, shaky sovereign finances and banking systems are symptoms of the impending end of the dollar-centric, global fiat-currency reserve regime. It may take a few more years to unravel, but then it could happen at any time. We continue to admonish our readers to diversify out of dollars, out of fiat currencies generally and also out of financial assets, most of which are leveraged to fiat currency stability to some degree. Real assets, in particular liquid commodities, provide a safe haven from global monetary instability today, as they have in the past.

It’s Euro-Party (And You’ll Cry If You’re German) July

Champagne is popping in Brussels, Strasbourg and other EU-bureaucracy cities this weekend, following a major decision by euro-area governments to address the prolonged euro-area sovereign funding crises with a dramatic expansion in cross-border financial support, including both fiscal transfers and guarantees. While no doubt a short-term political success, does this qualify as an economic one? Does it in any way address the fundamental economic problems which brought about the crises in the first place? No. The euro-area periphery still lacks the productive capacity to service its vast accumulated debt. And it is unrealistic to believe that, over the coming year or two, Germany is going to be both able and willing to make up the difference. The can has been kicked down the road yet again. What politicians have missed, however, is that the road ahead is quickly becoming more treacherous to navigate. Another funding crisis probably lurks in the near future.

We were not the only ones to be rather underwhelmed by the euro-area band-aid policy of expanding the European Financial Stability Facility (EFSF). In the event, the half-life of the euro-phoria this time round was mere weeks. At time of writing, euro-area leaders are pushing for a new EU treaty, which they claim will restore financial stability to the euro-area. While it is typical for politicians to see their laws as trumping those of economics, history demonstrates time and again that this is not the case. There is just no such thing as a free lunch. The euro-area has simply accumulated too much debt that it can’t possibly service without resorting to devaluation. Yet the Germans are rightly reluctant to go down that road. A partial euro-area breakup remains a distinct possibility, although one that the Eurocrats are loth to countenance.

The Butterflies of August (August)

While the August financial headlines have been dominated by the sharp decline in global equity markets and risk assets generally, there are a few stories that have gone relatively unreported and, in our opinion, underappreciated in their potential significance. Economies and the financial markets that express the value of their various assets are highly complex systems. As with all such systems, a small shift in an obscure part might, in fact, be highly significant, in that it could trigger a chain reaction which disrupts an unstable equilibrium, perhaps bringing down the entire system. A classic example is how a butterfly flapping its wings in the South Pacific might be the trigger that eventually whips up a storm that grows into a typhoon, in time making landfall and causing widespread damage. In this report, we examine what we might call The Butterflies of August and the potential risks that these have exposed.

Little did we know in writing this piece that the various ‘butterflies’ we identified would all figure prominently in the subsequent weeks. First, several small euro-area governments indicated their objections to the bail-out framework agreed by Germany and France the prior month, thereby instigating yet another round of crisis. Second, the Swiss National Bank acted to put a floor on the EUR/CHF exchange rate, at 1.2, thereby doing its part to grow the global money supply. Finally, Venezuela’s announcement that it would repatriate its gold held in custody abroad contributed to a huge rally in the gold price, to over $1,800. As it stands now, the euro-area crisis is nowhere near resolved, the SNB’s balance sheet has exploded with euro reserves and gold futures market data indicate a growing preference for taking physical delivery rather than rolling over open contracts. While other events may figure more prominently in the headlines at present, all of these developments continue to bear watching.

Who Will Rescue the Rescuers? (September)

German President Christian Wulff posed this provocative question in a speech in late August, the first official German statement to the world that Germany can no longer be relied upon to save euro-area member countries from the consequences of fiscal profligacy. Serving as an apolitical head of state—not head of government, a role that belongs to the Chancellor—Mr Wulff’s statement should be interpreted as a clear signal that a large and growing majority of Germans do not support recent government initiatives to further extend existing bail-out arrangements. But it also has far broader applicability. Just as there is no free lunch in economics generally, there is no free rescue. Someone always has to pay. Politicians may obfuscate this fundamental economic law from time to time, but no act can repeal it. Investors should take note.

The debate in Germany about bail outs continues to rage. Polls continue to show that, while Germans support the EU and EMU in principle, they do not believe that these institutions are functioning as they should in practice. Most Germans recall that, back in 1998, on the eve of EMU, Finance Minister Theo Waigel reassured them that the recently negotiated ‘Stability and Growth Pact’ would ensure that euro member governments would follow prudent fiscal policies. History has turned out rather differently. Germans are now highly and rightly sceptical that a new set of fiscal rules will work where the previous set didn’t. While Chancellor Merkel may be the Head of the Government, the Head of State, Chief Justice of the Supreme Court and President of the Bundesbank have all indicated that any form of fiscal union, guarantees or jointly-issued euro-bonds would require a popular referendum. It is far from clear that such a referendum would pass. Yet without it, the euro-area will not survive in its current form.

Fighting Solvency Time Bombs with Liquidity Bazookas (October)

With the recent expansion of the European Financial Stability Facility (EFSF), European leaders have taken yet another step to try and contain the euro-area sovereign debt crisis. As part of the arrangement, banks and other private entities will reduce the value of their Greek debt holdings by 50%, thereby recognising what has been a material deterioration in European bank solvency. As a consequence, European banks need to be recapitalised. This should serve to remind investors that the underlying problem in over-indebted economies is one of solvency, not liquidity, and that you can’t fight solvency time-bombs with liquidity bazookas. Broadening scope to the global economy, we consider where there probably lie additional solvency ‘time-bombs’ that could explode in future.

With the financial market focus remaining on the euro-area, we thought it important to point out that there were other regions where trouble is brewing. Sure enough, the areas we identified, including the UK banking system and US state and local government finances, face growing funding challenges ahead. Both the UK and US economies have slowed somewhat of late. UK banks are issuing profit warnings. US state and local governments continue to announce deteriorating finances, including the biggest state of all, California. Finally, we noted in this edition that corporations, although generally liquid were not in a position to invest in the size required to prevent a global economic slowdown.

Season’s Greetings

As last year, we take this opportunity to wish all of our readers a pleasant and festive holiday season, free from the relentless doom and gloom of the Amphora Report. While we would like to strike a more optimistic tone in the New Year, we doubt that policymakers will experience an epiphany over the holidays and stop preventing the general financial system de-leveraging and restructuring which is long overdue.

Then again, perhaps they will take time out to read A Christmas Carol, Dickens’ classic seasonal tale of epiphany and redemption. If so, they should read carefully: While the protagonist, Old Ebeneezer Scrooge, is transformed from a stingy into a generous man, let us not forget that he became generous WITH HIS OWN MONEY, not that of taxpayers. When it comes to spending other people’s money, we would prefer for policymakers’ epiphanies to be precisely the opposite.

AMPHORA: A lateral-handled, ceramic vase used for the storage and intermodal transport of various liquid and dry commodities in the ancient Mediterranean.

About the Author

Vice President, Head of Wealth Services