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.
OF BUTTERFLIES AND SWANS
Some readers might be familiar with the use of the “butterfly causing a storm” analogy mentioned above, the point of which is to demonstrate the concept that, the more complex a given system, the more difficult it becomes to identify the ultimate causes of changes in the system. In this respect, the “Butterflies of Complex Systems Theory” can be compared to the “Black Swans” of author Nassim Nicholas Taleb, which represent the unforecastable uncertainties inherent in financial markets. In his opinion, financial markets are notoriously bad at pricing in Black Swans and that this inability is a source of opportunity for those who understand otherwise. In a previous Amphora Report, we adapted Taleb’s idea slightly, by introducing the idea of a “Grey Swan”, an event that is ignored or dismissed by the mainstream economic and financial opinion as a material risk, yet proves to be exactly that in time.
The collapse of the US housing market from 2007 and the broad impact that it had on global financial markets is a case in point. While the mainstream first denied that the US had a major housing bubble; then later believed that the initial de-bubbling in subprime would be “contained”; then subsequently denied that, even as the collapse spread to Alt-A and even prime mortgages, that this would not threaten the financial system generally; there were those who warned about precisely each of these risks at each step along the way. As these observers were outside the financial mainstream, however, when their predictions finally came true, the events in question were labelled as Black Swans when, in our opinion, they were rather Grey instead.
Another example of a Grey Swan is the developing, intensifying euro-area sovereign debt crisis. Last September, in a previous Amphora Report, Is the German Eagle a Grey Swan?, we identified the risk that, at some point in future, Germany would lose patience with profligate euro-area governments and would withdraw support, in whole or in part, from the bailout mechanisms agreed to date or would refuse to expand them if so requested. As we put things at the time:
For decades [the Germans] have provided vast subsidies and support to other European countries, both via the EU and bilaterally. They spent a huge amount of their savings to help rebuild East Germany following reunification. They thought they were doing Europe a great favour through their willingness to enter into EMU, thereby sharing the fruits of their successful hard-currency policy with their neighbours. Yet how have several of these neighbours returned the favour? By encouraging and subsidising real estate speculation; by standing by while public and private sector unions demanded ever higher wages, eroding competitiveness; by using accounting tricks to hide the true size of their public sector deficits; and then, when it all blew up in their faces, they had the audacity to BLAME THE GERMANS for being wary of more hazard and thus slow to acquiesce to ECB emergency lending facilities and a massive, open-ended EU bailout commitment.
Many Germans are, in a word, furious. However, what should be of greater concern to financial markets is that Germans are now openly debating, in academic and policy circles and well as in the press, just what is in Germany’s best interest. Few believe that the current bailout arrangements are. And in this debate there is little if any sympathy for the club of euro-area countries that have in their view betrayed German good-will and perhaps permanently compromised the hard-earned, hard-currency legacy of the Bundesbank.
Several prominent German economists are now openly advocating that Germany reconsider participation in EU-bailout arrangements which do not require a substantial debt restructuring. Perhaps the most outspoken of these is Dr. Hans-Werner Sinn, President of the prominent IFO Institute and member of the German Council of Economic Advisers, colloquially known as the "Five Wise Men". In a recent paper, Rescuing Europe, he argues that not only have various euro-area countries taken advantage of low borrowing costs to artificially amplify growth by failing to deliver meaningful cuts in fiscal spending; but also that the capital that flowed into housing and unsustainable government spending in the "windfall" economies was German capital that should in fact have stayed in Germany, where investments would have been less speculative and ultimately more sustainable. In other words, German capital has been misallocated and is now at risk of being outright squandered by German participation in ill-conceived bailouts which do nothing to remedy the underlying malaise of the bail-out recipients. Rather, such bailouts create a massive moral hazard problem which virtually ensures that German capital will continue to flow to inefficient, dysfunctional governments.¹
To bring this discussion up to date, just last week, the German government drew what appears to be a clear line in the euro’s Club-Med sand, ruling out the use of jointly issued and guaranteed “euro-bonds” to finance the bailout of Greece and other euro members at risk of default.
In the Report cited above we also speculated that other euro-area members with relatively sound finances might withdraw support for the bailouts. As it happens, last week, Finland demanded collateral from the Greeks in return for guaranteeing their debt. While on the surface this might sound reasonable, what this request would amount to in practice is for Greece to guarantee the Finnish guarantee of Greek debt, a circular arrangement with no economic logic, although one providing a political fig-leaf for the Finnish government. But if the Greeks had collateral, why would they need a long-term bailout arrangement in the first place? Is short-term liquidity or long-term solvency at issue here? If the former, why the Finnish demand for collateral? But if the latter, why should the Finns be on the hook at all?
Indeed, such thinking was not lost on other euro-area members, including Austria and the Netherlands, who promptly lined up behind the Finns, asking for collateral arrangements of their own, presumably to the dismay of France, which has been leading the bailout effort in the face of growing German opposition.
GAME THEORY AND NASH EQUILIBRIA
Notice that, while Finland is a rather small player on the euro stage, their actions have the potential to cause quite a stir. It is one thing for Germany, engine and anchor of the euro-area economy, to have concerns about the bailout arrangements. Naturally everyone is focused on what Germany is thinking. But the Finnish demand for collateral is akin to a butterfly flapping its wings, potentially initiating a new euro-area storm as their demands spread to other countries and undermine an already unstable equilibrium.
This presents an opportunity to explore why certain economic and political equilibria can be destabilised by the actions of apparently peripheral actors. Consider the game theory concepts of John Nash, the Nobel Prize winning economist and mathematician whose life and work was featured in the book and film A Beautiful Mind.
As described by Professor John Harsanyi, at the 1994 Nobel seminar celebrating Nash’s work:
A Nash equilibrium is defined as a strategy combination with the property that every player’s strategy is a best reply to the other players’ strategies. This of course is true also for Nash equilibria in mixed strategies. But in the latter case, besides his mixed equilibrium strategy, each player will also have infinitely many alternative strategies that are his best replies to the other players’ strategies. This will make such equilibria potentially unstable.²
In the specific case of the euro-area bailout debate, if just one small player, however peripheral, withdraws from the current agreement due to sufficient concerns about their implied future liability for guaranteeing Greek debt, this increases the implied future liability of the remaining participants. This unexpected increase in liability might be just enough to cause another peripheral actor to decide to withdraw, again increasing the liability on the remaining actors. At each step the liability on the remaining players grows exponentially. While impossible to know with any certainty, eventually a tipping-point is reached and the equilibrium collapses entirely.
While unclear what will happen to the euro-area in the event that Greece or another country end up defaulting, a strong possibility that we raised in a previous Amphora Report, The Real Lesson of the Greek Debt Crisis, April 2010, is that defaulting countries will redenominate their existing debts into a new, devalued currency. What would remain of the euro-area would be a leaner, meaner, healthier and significantly more competitive, most probably some combination of Germany, France, the Benelux and probably Austria and Finland. Were that to occur, the euro would likely begin to trade as a strong currency again, as it generally did from 2002 to 2007.
A SAFE HAVEN REMOVED
Surrounded by growing euro-area instability, Switzerland’s currency has strengthened dramatically of late, making the domestic price level highly uncompetitive vis-à-vis not only the euro-area but most economies around the world. As such, the Swiss economy is importing a growing degree of deflationary pressure from the recent correction in global financial markets.
While the strength of the safe-haven Swiss franc is legendary, it would appear that things have now gone too far for even the currency-proud Swiss. Recently, the Swiss National Bank opined that, in order to relieve deflationary pressure on the economy, it might be sensible to peg the franc to the euro, thereby preventing a further appreciation and halting the decline in relative economic competitiveness.
Although perhaps understandable given the circumstances, consider what a Swiss peg to the euro would imply from the perspective of global investors searching for a safe-haven. Those that, up to now, have bought Swiss francs as a hard-money alternative to euros, or dollars, or other currencies, would suddenly discover that one of their safe-havens is no longer safe. As such, they are going to have to look elsewhere. But what currency can possibly offer a better alternative? The yen has also been strong of late but the Bank of Japan is already intervening in the currency markets to slow or prevent any further appreciation. Moreover, the Japanese economy faces severe challenges, both short- and long-term. Is the yen really an alternative safe-haven currency? It might provide some diversification, to be sure, and, in this newsletter, we have been generally positive on the yen as an alternative to the dollar, but we would not regard the yen as a perfect substitute for the franc.³
If even the Swiss franc is not going to provide investors with a safe-haven store of value and the yen not offering a proper alternative, there really aren’t any safe-haven currencies left. As such, investors have no choice but to increase their allocations to that which cannot be printed, or pegged, or otherwise distorted by policymakers seeking to reflate their economies or, at a minimum, prevent further deflation.
Consider for a moment the recent spike in the price of gold. Gold has retained its function as an alternative money and store of value ever since President Nixon “closed the gold window” 40 years ago last week. We find it no surprise that, as the Swiss contemplate a euro peg, gold has exploded higher in price versus all currencies. Yes, a rise in general risk aversion might better explain the recent surge in gold, but consider: Back in late 2008, when things were also looking rather grim in global financial markets, the gold price moved in only a narrow range vs the franc. More recently, the gold price in francs has soared.
Much as the Finnish butterfly has just flapped its wings, with potentially large consequences for the euro-area and, by extention, global financial markets, the Swiss butterfly has also taken flight, with potentially large significance for gold price and, to a lesser extent, that for other precious and semi-precious metals.
VENEZUELA TAKES DELIVERY
The next butterfly (or swan) up for discussion has to do with gold directly. One aspect of the gold market that sets it aside from financial markets is that, whereas most currencies exist primarily as bank accounts or other electronic entities representing ownership, gold is a physical metal that can, nevertheless, be traded electronically in a variety of ways. Of course, in a modern economy, paper or coin money can be used for (generally quite small) transactions but, at any one time, this represents only a tiny portion of the overall money supply, in particular that used for savings—cash in the mattress, so to speak.
Not so with gold. Access to actual physical gold, rather than merely an electronic claim thereon, is the normal and preferred way in which larger entities, such as central banks or sovereign wealth funds, for example, own the metal. In this regard, it is notable that last week, Venezuela announced that it was taking delivery of its allocated gold held in custody abroad in the US, Canada, UK and Switzerland, comprising apparently the bulk of the total 365.8 tonnes of Venezuela’s official reserves.
It is a popular misconception that most countries’ gold reserves are primarily held domestically, in physical form. In many cases, gold is held on a custodial basis elsewhere, for example, at the NY Federal Reserve Bank. As part of the Bretton Woods arrangements, each member country was provided a designated vault in the basement beneath the NY Federal Reserve building in Liberty Street, Manhattan, New York City. As required periodically for balance of payments adjustments not settled in dollars, gold bars were simply moved from one vault to another.
In theory at least, Bretton Woods participating countries were free to take delivery of their gold at any time, but that was generally considered an unnecessary inconvenience: Transporting large amounts of gold can be expensive and potentially risky. What happens if a ship transporting gold should sink, for example? It was of course far easier to move gold from NY Fed vault A to vault B, or back again, as required from time to time. (In August 1971, Charles De Gaulle famously sent a French warship to Manahttan to receive and transport France’s accumulated NY Fed custodial gold back to France, where it resides to this day.)
With the end of the Bretton Woods system, however, there is no longer any need to transfer gold between countries on a regular basis. This is because, with the US having suspended convertibility, balance of payments accounts are no longer settled in gold but rather in dollars or in some other currency. The international gold held in custody at the Fed to this day is thus a legacy of the gold-backed dollar. Were the gold not already there, there would be no point in shipping it to New York and placing it in the Fed’s custody.
There arises therefore the question post Bretton Woods as to whether having one’s gold held abroad sacrifices custodial security for convenience, as the convenience is, in fact, no longer of much if any value.
While countries friendly with the US presumably trust that the US would not, for some reason, refuse to hand over their gold if so requested, we now see that there is at least one country not on particularly good terms with the US, Venezuela, which has decided not to take any chances. There are, of course, a good handful of other countries that are not on particularly good terms with the US and, by our count, this list has grown in recent years. (China and Russia might come to mind but we do not believe that they have any custodial gold with the NY Fed.)
It will be interesting to see how the 60-odd countries with gold held in custody at the NY Fed react to Venezuela’s decision to take physical delivery or, potentially far more interesting, how the US responds to the request. Will the US arrange for a speedy handover? Will it be generally cooperative? After all, the US and Venezuela have not had good relations for years. Indeed, several years ago, an attempted coup against Venezuela’s President Hugo Chavez took days to put down and, while underway, the US refused to confirm whether or not it still supported Chavez’s rule, a huge diplomatic snub.
Of course, in the event that the US does make it difficult for Venezuela to take physical delivery, this will not go unnoticed elsewhere. Even countries on good terms with the US might be concerned if they see that the US resists delivering gold reserves to their sovereign owners. As with the other unstable equilibria discussed so far in this report, might a handful of other countries follow Venezuela’s lead? If so, might the US resist one or more of these requests? And if so, would this frighten a growing number of countries into also requesting delivery sooner rather than later? After all, just because a country is on good terms with the US today does not necessarily mean that they will be so tomorrow. In this regard, it is instructive to look around the world and see the large number of rather unstable regimes at present. In some cases, the potential new leaders might not be on as friendly terms with the US as those that they depose.
Regardless, Venezuela’s decision to take delivery of its gold places additional focus on the unique role that physical gold plays in the global economy. In recent months, the central banks of Mexico, South Korea, Bangladesh and Kazakhstan have bought gold on the open market. Others no doubt continue to accumulate gold less overtly. Why? If there was growing faith in the dollar-centric global financial system, would central banks be accumulataing gold reserves at the fastest pace since the 1970s?
No, on the contrary, this trend is a clear indication that global confidence in the dollar continues to erode. Should more countries line up to take physical delivery of their gold, rather than leave it in US custody, it would be a sign that confidence in the US itself, as a safe and reliable jurisdiction for global commerce, is also beginning to erode.
INVESTMENT STRATEGY FOR A WORLD OF UNSTABLE EQUILIBRIA
In this report we have listed several examples of recent events that have exposed or further destabilised several already unstable equilibria. No doubt there have been probably more such events of late than the few we note here, affecting a larger number of equilibria. Regardless, it is pertinent to consider how investors can protect themselves from the uncertainty associated with unstable equilibria generally, including those that qualify as unknowable, unforecastable Black Swans.
First, it is important to distinguish between risk and uncertainty. Risk is something that is known and that can be modelled and quantified with some degree of confidence. As such, it can be “priced” into a financial asset which can then be traded, the price fluctuating as the assessment of a given risk changes over time.
Uncertainty, however, is that which cannot be clearly identified or modelled. At the extreme, uncertainty is a bolt from the blue; an event with huge impact that arises spontaneously, as a previously unknown force of nature, for example.
While financial modelling and strategy built thereon is applied to risks of all kinds, insurance is the concept more commonly applied when dealing with uncertainty. As such, the right response to financial uncertainty is some kind of financial insurance against extreme or simply unknowable, undesirable outcomes.
Acquiring such insurance is, however, easier said than done. As a first step toward accumulating insurance, most investors would probably think that they should hold additional cash. We have much sympathy with this. Liquidity is indeed a form of insurance. But as with all forms of insurance, there is a time value opportunity cost of holding cash, namely, the forgone interest of holding higher-yielding assets. At present, however, with central banks in much of the world holding interest rates lower, there would not seem much interest to forgo.
Yet while the nominal interest rate on cash is low, of much greater concern is that the interest rate on cash in most currencies is deeply negative in real terms, that is, when adjusted for measures of inflation. Cash insurance, therefore, costs more to hold than would normally be the case, were interest rates at a more normal, positive level at or above the rate of price inflation.
Another problem is that cash does not protect investors from devaluations of the currency, which contribute to sharply higher rates of price inflation down the road. Whether initiated by governments or not, devaluations can negate much if not all the benefit of holding cash instead of other assets, for example equities or property, which would be more likely to hold their real values in the event of a large currency depreciation.
Investors can naturally diversify the risk of holding cash by diversifying into a number of different currencies. The problem with this approach, however, is demonstrated by the recent debate in Switzerland. Beyond a certain point, countries do not welcome strong currencies. With even the Swiss having reached the point where there is serious talk of pegging the currency, investors should recognise the limits of currency diversification.
What investors need, therefore, is a way to benefit from the liquidity advantages of cash without suffering a negative real rate of return and exposing themselves to the risk of devaluation. In our view, the best way to enhance portfolio liquidity without taking devaluation risk is to hold liquid commodities, in the form of exchange-traded futures, for example.
Many commodities do have negative roll yields, implying a negative real interest rate associated with holding them, but certain commodities have positive roll yields. A balanced commodities portfolio need not have a net negative roll yield; yet the commodities in question can protect investors from the uncertainties surrounding highly expansionary monetary policies around the world.
This was the case in the 1970s, for example, as commodity prices consistently rose in cash terms and also outperformed most financial assets, equities and debt. We believe it is also the case today. There will come a day when sovereign governments have sufficiently reduced their debt burdens such that the temptation to print and devalue their currencies will subside. That process, however, has yet to properly begin on a meaningful scale. Even the US, the issuer of the global reserve currency, has yet to take serious, credible action to place its finances on a sustainable path. In the potentially long and certainly undertain meantime, investors need to take out insurance accordingly.
¹Please see our previous report, Is the German Eagle a Grey Swan? Vol1, September 2010. This and other archived reports can be accessed at www.amphora-alpha.com
²For those interested in an introduction to the work of John Nash and to game theory generally, the Nobel Seminar paper is an excellent and most accessible reference. The link can be found here: https://www.nobelprize.org/nobel_prizes/economics/laureates/1994/nash-lecture.pdf.
³For a thorough discussion of why we have been generally constructive on the yen this year, please see the previous Amphora Report, Mr Mizuno Retires, which can be found here: https://www.atomcapital.co.uk/wp-content/files_mf/1313663288AMPH_Report0111b.pdf.
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