the seven d´s of the developing disaster - alf field

8/2/2019 The Seven Ds of the developing disaster - Alf Field

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THE SEVEN "D's" OF THE DEVELOPING DISASTER

Alf Field

"The objective of investing is to increase the purchasing power of capital."

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 individualinvestor business of Morgan Stanley. "The Art of Asset Allocation" is possibly thedefinitive 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 hasgenerously donated the entire royalties from this book through the Morgan StanleyFoundation 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 thatmost of the major problems facing the USA (and thus the world) commenced with theletter "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. DEBT5. DEMOGRAPHICS

6. DERIVATIVES7. 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 likelyGovernment responses, will probably lead to a situation where one single investmentcriterion will become so important that it will transcend all other factors in investmentdecisions. 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 noneed to regurgitate them in detail here. These problems generally involve huge mind-

numbing, incomprehensible numbers of dollars. Those numbers continue to grow sorapidly that they tend to be out of date shortly after they are published.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 chroniclevels where each deficit now exceeds 6% of the country's GDP. How will thesecontinuing deficits be financed? The answer, by creating increasing quantities ofelectronic US Dollar credits.

The US DOLLAR will be under downward pressure while these deficits continue. Thelower the US Dollar declines, the greater the pressure on those countries that export to theUSA. These countries will protect their markets by invoking competitiveDEVALUATIONS. This cannot happen in a freely floating exchange rate system, but is


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effectively done by foreign countries creating massive quantities of their own currencies.These new foreign currency electronic credits are then dumped on the foreign exchangemarkets, thus weakening their currencies. In this way the American problem is exportedto the rest of the world.

DEBT of all kinds in the USA has been reaching record high levels for decades andcontinues 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 thoseother unmentionable "D" words, DEFLATION and DEPRESSION. This will not beallowed to happen. New electronic US Dollar credits will be created to whatever quantityis required to avoid this outcome.

DEMOGRAPHICS refers to the imminent retirement of the Baby Boomers generationand the huge unfunded liabilities that exist in Social Security, Medicare, Pension Fundsand other US programs that need to be funded. Several books have been written on thissubject. 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 Dollarcredits 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 instrumentsin existence are Exchange traded items such as futures and options. The other 75% areOver-the-Counter instruments, privately created and traded between major financialinstitutions. These tend to be extremely complicated transactions that are often difficult tovalue. They rely heavily on their counter parties in these transactions actually meetingtheir obligations when they fall due.

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

If this risk is readily discernible to outsiders, then bankers and others involved in the OTCderivatives must be acutely aware of the problem. Bankers are not stupid. They areextremely clever, cautious people. So how could they allow the OTC derivative situationto 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 markethave 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 beenunthinkable. Alternatively, they must have deliberately built up the derivative marketwithout considering the size or risks involved on the assumption that, as with past similarcases, the Federal Reserve and Federal Government would combine and to come to therescue of a failed major counter party.

The OTC derivative market looks like an accident waiting to happen. Already some lesserplayers 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 toprevent a catastrophe.


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The common thread that runs through this brief summary is that when problems emergein 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 towhatever extent necessary. This is not just a personal opinion. We have been told by nolesser 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 electronicprinting press, which will be utilised when disasters threaten.

When the supply of something is increased sharply relative to demand, the value of thatcommodity will decline. If the supply continues to increase rapidly and indefinitely, thenthat item will become worth less and less, with the potential to finally become nearlyworthless. This is the Developing Disaster facing the US Dollar and the world. This is thefactor that could become the single most important criterion in investment allocationdecisions 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. Dictionarydefinitions of the word DEVOLUTION include the following:

1. A passing down or descent through successive stages of time or a process. 2. Transference, as of rights or qualities, to a successor.3. Delegation of authority or duties to a subordinate or substitute.4. A transfer of powers from a central government to local units.

It is the first definition that is applicable here. Imagine an inverted pyramid of variousinvestment type assets where the least secure (and most prolific assets) are in the verywide top layers. The inverted pyramid then narrows down through layers of increasinglymore 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 todevolve downwards (hence DEVOLUTION) through the different asset class layers in theinverted 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 whatcan 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 andsilver bullion, assets that have performed the function of protecting wealth throughout theages. In the layer above the precious metals lie the companies that mine and hold largedeposits of gold and silver. The least secure assets in the envisioned environment, whichform the broad layers at the top of the inverted investment pyramid, will be the electronicUS 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 beengradually moving the assets of his investment company, Berkshire Hathaway, into


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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 ofprecious 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 andprecious metal mining company shares, a move that seems logical and inevitable in thecircumstances envisioned above.

A move into precious metals and their associated mining companies by a person likeBuffett 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 toinvestors. Then the devolution of investments down through the asset classes of theinverted pyramid will truly gather momentum. The quantity of precious metals and theirassociated mining company shares is very limited while the quantity of electronic USDollar credits is infinite. It will be a question of "first come, first served".

Cartoon from the London "Daily Telegraph"

Alf Field28 April 2005

the seven d´s of the developing disaster - alf field

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