THE SEVEN "D's" OF THE DEVELOPING DISASTER

By Alf Field              April 28, 2005

- From the Foreword to "The Art of Asset Allocation" by David M Darst. (Published in 2003 by McGraw-Hill).

David Darst is Managing Director and Chief Investment Strategist for the individual investor business of Morgan Stanley. "The Art of Asset Allocation" is possibly the definitive work on the principles of asset allocation in investment portfolios.

David's book deserves a plug firstly because it is good, but also because David has generously donated the entire royalties from this book through the Morgan Stanley Foundation to the families of the 13 Morgan Stanley employees who died in the World Trade Center on Sept 11, 2001.

It was David who planted the seeds of the idea for this article when he suggested that most of the major problems facing the USA (and thus the world) commenced with the letter "D". I have refined his idea to produce the following list:

1. DEFICITS (US CURRENT ACCOUNT AND BUDGET)
2. DOLLAR (US)
3. DEVALUATIONS (COMPETITIVE)
4. DEBT
5. DEMOGRAPHICS
6. DERIVATIVES
7. DEVOLUTION

Most readers will be familiar with the first 6 but will be puzzled by the last one, DEVOLUTION. It is included because the first 6 problems, combined with the likely Government responses, will probably lead to a situation where one single investment criterion will become so important that it will transcend all other factors in investment decisions. That situation will lead to DEVOLUTION. We will return to this later.

The first 6 problems have received a great deal of coverage elsewhere and there is no need to regurgitate them in detail here. These problems generally involve huge mind-numbing, incomprehensible numbers of dollars. Those numbers continue to grow so rapidly that they tend to be out of date shortly after they are published. The following brief notes on the first 6 "D's" deliberately ignore these gigantic numbers.

The US Current account and Federal Government DEFICITS have grown to chronic levels where each deficit now exceeds 6% of the country's GDP. How will these continuing deficits be financed? The answer, by creating increasing quantities of electronic US Dollar credits.

The US DOLLAR will be under downward pressure while these deficits continue. The lower the US Dollar declines, the greater the pressure on those countries that export to the USA. These countries will protect their markets by invoking competitive DEVALUATIONS. This cannot happen in a freely floating exchange rate system, but is effectively done by foreign countries creating massive quantities of their own currencies. These new foreign currency electronic credits are then dumped on the foreign exchange markets, thus weakening their currencies. In this way the American problem is exported to the rest of the world.

DEBT of all kinds in the USA has been reaching record high levels for decades and continues to do so. This is the way the economy is stimulated in a fractional reserve banking system. DEBT must continue to grow. A contraction in DEBT will lead to those other unmentionable "D" words, DEFLATION and DEPRESSION. This will not be allowed to happen. New electronic US Dollar credits will be created to whatever quantity is required to avoid this outcome.

DEMOGRAPHICS refers to the imminent retirement of the Baby Boomers generation and the huge unfunded liabilities that exist in Social Security, Medicare, Pension Funds and other US programs that need to be funded. Several books have been written on this subject. One of which is "Running on Empty" by Peter Petersen. Those unfunded liabilities will be funded, probably once again by the creation of new electronic US Dollar credits to the extent necessary to meet the unfunded liabilities.

DERIVATIVES have been the fastest growing area in US finance over the past 15 years. The numbers involved are truly mind boggling. About 25% of the Derivative instruments in existence are Exchange traded items such as futures and options. The other 75% are Over-the-Counter instruments, privately created and traded between major financial institutions. These tend to be extremely complicated transactions that are often difficult to value. They rely heavily on their counter parties in these transactions actually meeting their obligations when they fall due.

There is a grave risk of counter party failure in the Over-the-Counter derivative area. If one major counter party goes bankrupt and fails to meet its commitments, it could trigger a domino like collapse of major institutions in the financial markets. The numbers involved are so vast that there is potential to bring down the entire financial system in the event of a major counter party default.

If this risk is readily discernible to outsiders, then bankers and others involved in the OTC derivatives must be acutely aware of the problem. Bankers are not stupid. They are extremely clever, cautious people. So how could they allow the OTC derivative situation to grow to such a massive extent with all the concomitant risks involved?

One suspects that they know something we don't. Do the major players in the market have some assurance that there will be no counter party failure? Without that assurance, the gigantic build up of OTC derivatives over the past decade would surely have been unthinkable. Alternatively, they must have deliberately built up the derivative market without considering the size or risks involved on the assumption that, as with past similar cases, the Federal Reserve and Federal Government would combine and to come to the rescue of a failed major counter party.

The OTC derivative market looks like an accident waiting to happen. Already some lesser players are showing signs of strain. How do the authorities rescue a problem situation when it occurs? Again by creating electronic US Dollar credits to the extent necessary to prevent a catastrophe.

The common thread that runs through this brief summary is that when problems emerge in the US financial system, the authorities will solve them by throwing money at the problem, by creating new electronic US Dollar credits whenever necessary and to whatever extent necessary. This is not just a personal opinion. We have been told by no lesser personage than Dr Ben S Bernanke, who is a member of the Board of Governors of the Federal Reserve Board, that the authorities now have a new tool, the electronic printing press, which will be utilised when disasters threaten.

When the supply of something is increased sharply relative to demand, the value of that commodity will decline. If the supply continues to increase rapidly and indefinitely, then that item will become worth less and less, with the potential to finally become nearly worthless. This is the Developing Disaster facing the US Dollar and the world. This is the factor that could become the single most important criterion in investment allocation decisions and possibly even for individual financial survival.

When that point is reached, the headline to this article: "The objective of investing is to increase the purchasing power of capital," will become ever more pertinent.

We can now return to the final factor, the 7th "D", which is DEVOLUTION. Dictionary definitions of the word DEVOLUTION include the following:

It is the first definition that is applicable here. Imagine an inverted pyramid of various investment type assets 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 asset classes to the small point at the base which consists of the most secure (and least prolific) assets. This is an idea propagated years ago by John Exter.

The theory is that in times of financial crisis investors will cause their investments to devolve downwards (hence DEVOLUTION) through the different asset class layers in the inverted pyramid as they search for greater security. DEVOLUTION is thus a movement by investors out of riskier, speculative asset classes into more secure ones. This is what can be expected in the months and years ahead as the creation of electronic US Dollar credits gathers momentum and faith is lost in the US Dollar.

The assets in the most secure category at the tip of the inverted pyramid are gold and silver bullion, assets that have performed the function of protecting wealth throughout the ages. In the layer above the precious metals lie the companies that mine and hold large deposits of gold and silver. The least secure assets in the envisioned environment, which form the broad layers at the top of the inverted investment pyramid, will be the electronic US Dollar credits and assets or loans that are repayable in US dollars.

The DEVOLUTION of assets into more secure investments is not just an esoteric theory. It is already happening and can be observed in the actions of thinking investors such as Warren Buffett, possibly the greatest investor of the past century. Buffett has been gradually moving the assets of his investment company, Berkshire Hathaway, into increasingly more secure asset classes. He made headlines last year when he moved over $20 billion out of US Dollar cash assets into foreign currencies.

Buffett already has a stash of silver bullion, so is clearly aware of the protective power of precious metals. It is only one short further step for Buffett to move out of foreign currencies (which will eventually follow the path of the US Dollar) into gold bullion and precious metal mining company shares, a move that seems logical and inevitable in the circumstances envisioned above.

A move into precious metals and their associated mining companies by a person like Buffett would instantly change the public perception of this asset class. If it is not Buffett, it will be someone else, as the logic of doing this will become increasingly apparent to investors. Then the devolution of investments down through the asset classes of the inverted pyramid will truly gather momentum. The quantity of precious metals and their associated mining company shares is very limited while the quantity of electronic US Dollar credits is infinite. It will be a question of "first come, first served".

Cartoon from the London "Daily Telegraph"

Alf Field
28 April 2005

******

Disclosure Statement: To ensure full disclosure, the author advises that he is not a disinterested party. He has personal investments in gold and silver bullion as well as in gold and silver mining companies. The author’s objective in writing this article is to interest potential investors in this subject to the point that they are encouraged to conduct their own further diligent research. Neither the information provided nor the opinions expressed should be construed as a solicitation to buy or sell any stock, bond, 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.