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Galbraith’s The Great Crash as our grandchildren will read it…

THIS BOOK is a page turner, writes Toby Baxendale of the Cobden Centre.

It is a must for anybody who has an
interest in what has gone wrong with our financial system and thus the
economy, and what can be done to fix the problems created.

It is an unparalleled tour de force of the last 300 years of
modern finance with special focus on the last 30 years and microscopic
focus on the last 30 months. In years to come this will be a book that
our children and our grandchildren refer to when studying The Great
Crash of the last years of the last decade. Sensible lesson are learnt
from the Japanese 20 year recession rather than the 30’s. The various
stimulus packages and failed deficit spending should be there in your
face for anyone with above room temperature IQ to learn what not to do,
but hey ho — every generation, like monkeys, we seem to have to re learn
everything in economics all over again. The short sharp shock of the
Savings and Loan crisis of the early 80’s could well show us a way
forward on the 00’s.

The alchemists in the title are 7 Nobel Prize winners, investment
bankers, the political class, other economists, and regulators.  They
exploit the frailty of the human condition — our impulse to believe that
“this time, things are different.”

Dowd and Hutchinson show beyond all reasonable doubt how the
financial centre of the economy has become one massive rent extraction
machine where gains are privatised and the losses are socialised — paid
by the likes of you and I, the hapless taxpayer. The bailouts are
unquestionably the biggest examples of this. No other industry on the
whole planet would get this treatment. Smaller examples of rent seeking
are the successes of the industry in achieving light touch regulation
and non-domiciled tax status for over 100,000 UK financial service
workers. Indeed, unbeknown to most, the UK is one of the biggest tax
havens in the world.

The authors also conclude, like I do, that excessive bails outs
funded by deficit spending leads to government debt crises, which is
“solved” by either monetisation of the debt (inflation), or straight
forward sovereign debt default.

We must remember that in 2008, one quarter losses of the financial system cost us taxpayers, one quarter of a century
of profits! Read that again.  It is so staggering a figure that anyone
who even believes these Alchemists should be allowed even near their own
money, let alone ours, occupies a different planet to me.

My in-depth review follows. I am inviting the authors to critique it.
There is much good debate to be had. I start with their conclusions
that will give you a flavour of the book and you may well stop at that.
If you want to delve deeper, I explore some of the issues more. However,
this is no substitute buying the book. I hope the compelling policy
recommendations will be taken up and the book itself will be a major
historical book that will last the test of time, and be read by
generations to come.

How to Exit this Mess

• No more bailouts just bankruptcy and a realignment of capital to those who are more prudent.
• Make debt for equity swaps if need be with over leveraged banks.
  Ironically, this is the policy the banks themselves are forcing on
  companies that they deem to be too highly leveraged. What is good for
  the goose is good for the gander.
• Abolish deposit insurance.
• Remove failed management in the banks and in the regulators.
• Abolish the regulators and put the individual back in change of his/her risks.
• Move to historical cost accounting and not mark to market.
• Move back to partnership banks with open-ended liability. Like
  doctors who have an open-ended liability to you in the advice they give
  and medicine they administer, they are professional experts and you are
  not. They have a fiduciary duty to you. So too should the bankers go
  back to having this fiduciary duty to you.
• If mathematical models are to be used at all in risk management,
  they suggest the “Expected Shortfall” or the “Probable Maximum Loss”
  model. I personally have reservations about any mathematical models as I
  favour sound entrepreneurial judgment.  If you do not have this, you
  should not be playing, thinking you are investing, with savers’ money.
• My view on Maths in banking is that Bayesian or non Bayesian, Cauchy
  not Gaussian, fuzzy logic or good old fashioned Aristotelian logic is
  all by the by — if you don’t have a talent for matching the needs of
  savers and borrowers, you should not do banking. No mathematical system
  will aid you in this.  This alternative model outlined by Dowd and
  Hutchinson is new as far as I am aware, and needs to be debated. It is
  certainly better than our Alchemists of Loss failure model. Personally, I
  favour entrepreneurial judgement by bankers with open-ended liability.
• Scenario planning should become a major factor in banks’ internal
  risk assessments. I agree, predictions are binary and assumption-laden.
  Scenario planning, especially if it is ongoing, is like musical chairs
  — you always have an eye on a seat should the music suddenly stop!
• Rating agencies should be compelled to remove conflicts of interest
  by not being paid to assess a security by the issuer of the security!
• CDS instruments should only be allowed to be sold to you if you have
  an “insurable interest” in the underlying asset. See more in the
  article about this very interesting proposal.
• Use the language of investment and not speculation. If you use the
  latter, you are a gambler, if you use the former, you are a banker.
• Let judgement rule over the mathematical models. Do not diversify for the for the sake of the model.
• If you do not understand it, do not buy it.
• The recommendation they make to set up Zombie banks, I take it to
  read as simple saving and lending, plain vanilla banks like Jimmy
  Stewart / George Bailey in “It’s a Wonderful Life” would have run, as
  opposed to the Zombiefied state owned banks that we see today that are
  very challenging to deal (as anyone in business will testify).
• Root money back into a commodity standard such as gold.  This would
  require no central bank support (i.e. the central bank could be
  abolished).
• If a central bank does exist, go for the hard money Volcker-style
  monetary control or hard currency control like the early Bundesbank.
• They suggest a tax on assets to make the very large banks shrink.
  Personally I would suggest that if that is the way they want to go, they
  can just lawfully enact legislation to break them up. If free
  competition in banking with no central bank and no legal privilege is
  allowed, then the Behemoth banks would wither on the vine anyway.
• Concerning the ad valorem tax, should we keep the existing
  banking system, it will only push up the prices for the products sold. I
  do not know how this will achieve their desired objective of limiting
  excessive trading.
• Equalisation of taxes on dividends and interest as a foil against
  excessive leverage sounds a plausible reform should we stay with the
  existing banking system.
• Abolition of the non dom tax breaks which allow 100,000 people in
  the City of London to work in the biggest tax haven in the world and
  pretend that most of their income comes from elsewhere should be
  abolished.
• Establish a monetary constitution via legislation like the 1994 New
  Zealand Fiscal Responsibility Act sounds like a very good move to
  prevent the governments from going back to their old ways of monetising
  debt.
• Abolish the IMF and the World Bank, as these just perpetuate the
  international bureaucrat class that feathers its own nest and gives bad
  advice for recipient countries they lend to.
• Stop crony capitalism where bankers become politicians with ease,
  then go back to banking again. Make a mandatory time separation required
  should anyone want to move between the two, as has become fashionable
  during this period.
• Abolish any estate duties / inheritance tax so families can once
  again be the primary owners of banks and long term shareholders
  encouraged, often on an intergenerational level which is lacking today.
  Wealth confiscation by these taxes has created the big unaccountable
  beasts we have today. Let us go back to shareholder capitalism and not
  institutional crony capitalism.
• Above all bin Modern Financial Theory – it has utterly failed us.

For me I say amen to pretty much all of the above.

Modern Financial Theory

The authors see the current mess we are in as a blend of two very
wrong belief systems. The first is what is called Modern Financial
Theory and its offspring of the Efficient Market Hypothesis, Capital
Asset Pricing Model, Black-Scholes equation for option valuation, Modern
Financial Risk Management. The intellectual edifice of the above was
spawned by 7 Nobel winners, the lead Alchemists of Loss. I find these
distinguished mathematicians to be great builders of elegant
mathematical models, but they are abstract and do little to help us
study and understand the human condition.

A good start point for Modern Financial Theory is the 1958 seminal
Modigliani-Miller Theorem. Believe it or not, this Theorem states the
following: the value of a company is invariant to its capital structure;
or simply put, the capital structure, the balance between debt and
equity, is irrelevant!

Gloriously the theorem assumes;

1. No taxes,
2. No difference between the rates at which corporations can borrow,
3. Zero transaction costs,
4. The complete absence of agency costs

This gave academic credence to equity light, heavily laden, debt
leveraged companies. With assumptions like the above, it is hard to
imagine what relevance this has in the real world that we live in. It
has always alarmed me that such mathematical economics with its
unrealistic, otherworldly assumptions should be taken seriously as tools
with which to govern our lives.

Modern Portfolio Theory came along around this time as well.  You
have a steady income if you diversify your risks.  Ideally you want to
have an investment portfolio with negatively correlated companies so if
one is tanking seasonally, there is another over performing etc. The
volatilities are labelled as a sigma and the higher the sigma the more
volatility. A portfolio manager should not worry about individual sigmas
but about the sigma of the whole portfolio.  I would add a further
point: if a portfolio manager is so dull that he can’t look for
companies with at least some of the following traits, then perhaps he is
in the wrong business:

1. Strong balance sheet with good equity and retained profits for a rainy day,
2. Ongoing investment,
3. Inspiring entrepreneurial leadership,
4. Good executive management,
5. Sensational, functional product,
6. High or strong barriers to entry

Modern Portfolio Theory

In enters Harry Markowitz, another Alchemist of Loss, he claimed to
be able to fix this problem of capital allocation in an investment
portfolio by using statistical methods. Assume a Gaussian distribution
of return from all investments — i.e. a Bell Curve and know the sigma
and plot the correlations between them — and there you have it: capital
allocation choices are no longer subjective, but objective and
quantifiable. Now you could just take your pick of your preferred
tradeoff between risk and reward.

Furthermore, you could now mathematically determine if a new share
was added, its riskiness (beta) or its potential for reward (alpha). So
the search was on for low beta and high alpha. My points one to six
mentioned above never seem to get a mention.

The Gaussian curve (think Bell Curve) clusters most sigmas in the
bell of the curve with the lip tailing off to the most improbable sigma
events.  To give you a flavour, 5 sigma loss is a 14,000 year event. A
23 sigma event is measured in many millions of years. In 1987 we had one
when the stock market crashed, and we had one again in 2008. The
authors quite rightly question the sanity of anyone who can believe in
this nonsense:

So when Goldman Sachs Chief Financial Officer David
Viniar famously admitted to being puzzled by a sequence of “25-standard
deviation moves” in August 2007, it might have occurred to him and
others that Wall Street’s risk management methods even at the best-run
institutions where hopelessly inadequate.

Efficient Market Hypothesis

This was the claim that market prices were efficient, i.e. they fully
reflected all available price data . This fitted in nicely with the homo oeconomicus of the Neoclassical School: that perfect all-seeing, all-knowing, rationally acting man.

The Blend with Keynes

The Keynesian system of state intervention and deficit spending, via
gigantic monetary pumping is the other trend line that has rollercoasted
us into a brick wall. Even though they all accept that credit is the
creator of the boom and the bust, they see more credit as its cure. I
call these economic practitioners witch doctors and mystics; the
politeness of Dowd and Hutchinson does not allow them to use this
language, but I am sure they agree with my sentiment.

The Emergency of Crony & Managerial Capitalism

With the advent of Modern Financial Theory, we have seen the
explosive growth in institutional ownership of shares and the demise of
the private share owner. There has also been a shift in the investment
horizon from the long term to the short term. In the 1950’s
institutional ownership was some 15% of shares in the USA.  Death duties
and other measures such as a pro inflationary policy had extracted
wealth from the long terms savers and by the 1980’s , over 50% of shares
were held by institutions, where it remains today.  The family owners
who controlled their shares have been usurped by the middle manager, a
salaried man commonly incentivised by a short term bonus and not the
underlying shareholder gains.

Modern Financial Theory also has suggested that the management are
perfectly aligned with their shareholders if they are given options to
effectively make them mini owners, the reality is most hold options for
the shortest time period and sell for gain as soon as they can. If there
is no gain, they lobby their senior manager to have their sunken
options re-valued again so they can have another go until they hit the
cash-in jack pot.

CEO salaries from the 1980’s in the USA have grown from 42 x average
worker earnings to 520 times. The Theory would work if shareholder value
had risen accordingly. Sadly, this annual growth of over 8.5% in CEO
salary corresponded with a 2.9% annual growth in profits. Management
somehow managed to get rewarded when shares went up, but never had to
return their bonuses when the share value went down. The dice now seem
to be loaded in favour of the manager rather than the owner.

Management while in control can push down dividends (now yielding 1%
on average in the USA), load up debt, and thus push the share price but
not the net value of the company up, forcing more events to run through
the extraordinary line and not the income statement.  Practices like
this are more prevalent now than ever.

The authors conclude that our system of capitalism is little better
than the corrupt crony capitalism of the new Russia, where only a
handful of people gouge the majority.

One statistic that shocked me is that fees to financial management
account for $620bn in the USA or a full 4.5%of their GDP. Once you take
into account the need to pay these fees before you even earn a dime, it
is little wonder that it is hard to get a return while the “croupier” is
always winning!

Hedge funds regularly charge “2 and 20” i.e. 2% management fee each
year and 20% of the upside. They never give 20% of the downside back
when the shareholders suffer loss, it is almost a one way bet for the
fund manager.

Derivatives

Outstanding trades are 10 times larger than global GDP at $512
trillion. With global GDP at $50 trillion, they estimate that only $2
trillion is actually used for some genuine hedge purpose.  The liquidity
that we actually need to facilitate transactions is only a fraction of
the hedge value, so why the need for all of these trades? To me they are
just bets, mere gambling. The authors do not spell this out, but I
suspect they would agree. They label these trades as just plain rent
seeking, another way for Wall St et al to extract more and more wealth from the system.

If it is gambling, I say let them gamble, but like a gambling
contract, give it no enforceability in law. Make them do it in casino
companies and not banks that should have a fiduciary duty to its
stakeholders!

The Ticking Time Bomb Securitization

If you can package up your mortgage book and sell the income stream
to some third party for a profit on the income stream, even though you
have not had to wait for the full 30 years of the mortgage income to
come through to you, you can a) hold less capital in place to cover
defaults on these loans and b) book all the income into the income
statement in one year. This means big bonuses being paid on profits that
have not even materialised! I personally would love to book 30 years
hypothetical profits of my business into one year and take and mother of
all bonuses. Also, being a simple seller of fish and meat, this
opportunity does not offer itself up. Being a banker however and
way-hey, you are in the money big time! No wonder there has been a rush
to securitize assets in banks like this. With the backing of Modern
Financial Theory giving you the academic basis to stretch your capital
as far as possible, and leverage, leverage, leverage, in the knowledge
that high numbered sigma events are a 1 in 10 thousand or million year
events, you are off to the races with sure fire certainty that this is
the right thing to do.

Needless to say, you can see the moral hazard in being able to sell
mortgages in the knowledge that you will never have to see them through
to the end of their life. Unless you are really unlucky and have some
very early month defaults, you will never see a default as it is not
your problem.

The rating agencies that are complicit in this process are paid by
the bank that is selling the security – no conflict of interest here
then!

The Community Reinvestment Act 1977

This act was a push to force lending to minorities and poorer
families, well intentioned I do not doubt, but the sad fact was, for the
sake of box ticking with regulators and with the sure fire knowledge
that you could lend to sub optimal borrows and remove it from your
balance sheet AND book profits for the whole duration of the loan to
your current year P&L via securitisation, and the time bomb of
subprime was set. The only wonder is how long it took to explode!

The Unbalanced Economy

At the start of the 80’s in both the UK and the USA, the finance
industry was around 5% of GDP, now it is close to 30%. The authors point
out that whilst the croupier can feed on us for a while, what indeed
are we going to feed ourselves on in the future? The authors are correct
to point out the dire straits that both economies (USA/UK) are in and
rightly question what the long term survival of both is going to be
predicated on.

Credit Default Swaps

These were created in the 1997 and from nothing reached $62 trillion
by 2007. They allow the owners of the swap to manage their risk exposure
to a particular credit default (“going bust”) event. Consider this as
an insurance policy against an underlying asset going bust on you. You
could now own a bond in a company and hedge your bets by taking out a
CDS and now bet that the company could fail. This was a perverse
incentive when the CDS became more valuable that the bond itself. The
authors liken this to a spectator shouting “jump, jump” when some poor
desperate soul is contemplating suicide. You did not even have to have
any relation with the company insured against as we saw with Lehman as
CDS positions were compelling the quick death of this company.

Life Assurance Act 1774

The authors make a very important point. The above act introduced the
concept of “insurable interest.” Before this a life policy could be
taken out by anybody over anybody. There was presumably a high incidence
of death for no apparent reason and the concept that you must have an
insurable interest to have the policy came into existence. A move to
establish the insurable interest equivalent for the CDS is certainly a
way forward worth investigating.

The reality is, with Modern Financial Theory and its faulty
mathematics predicting very remote possibilities of loss, the selling of
CDS to support securitisation, that biggest of all money spinners was
easy money for all in the finance sector. The horn of plenty continued
to gush forth money for all involved in these operations. AIG was one of
the biggest counterparties. They loved the fee income and with Modern
Financial Theory saw the risks to be negligible.

Mark to Market Accounting

The move from “historical cost” or “lowest realizable value” is
lamented by the authors as the finance sector has moved to “mark to
market”. This allowed the ever rising valuations in the balance sheet,
from which income that was not earned could be extracted in the form of
bonuses. Naturally if the valuation went the other way, nobody was ever
asked to put their bonuses back.

Deposit Insurance

Because banks lend more than they have in the vaults (i.e. they
maintain a fractional reserve, unlike every other kind of commercial
entity, which needs to keep its creditors whole), the USA introduced
deposit insurance in the early 30’s to assuage the rational fear that
people have of a bank run. The Alchemists, Diamond and Dybvig show in
their abstract model of 1983 that if you include this policy in your
banking systems, you stabilise the system so it can on lend as much as
it likes. There is no surprise to anyone that more risk is thus taken
and capital driven to its lowest possible number so all capital is
working efficiently!

Investor Protection

Dowd and Hutchinson show how this moves the onus of protection from
the individual to a whole array of government bodies that end up not
protecting you. Never has there been a bigger system wide banking
failure with tens of thousands of regulators.  In my industry with have
fish quotas and controls set on scientific measures undertaken by the
EU. No one believes their data on sustainability so new organisations in
the private sector have been created to fill this gap giving
sustainability information such as the MSC and the British Soil
Association. If we all have a stake in our industry we manage to provide
for the long term. Shift the responsibility to a third party to look
after us (or be forced to be looked after via the government) and it is
no surprise that the whole house of cards has toppled down.

The Regulators

The story of the incompetence of the FSA and the SEC is told, and it
would be funny if it were not such a telling bit of real financial
history with us as the victim.

Bankruptcies

Bankruptcies have been made easier to undertake, and to recover from. We should go back to the old bankruptcy laws.

Basel  I, II & III

If you wish know in detail how the Alchemists’ VaR (Value at Risk)
modelling has made this juicy bit of regulation positively dangerous
then I believe Dowd and Hutchinson make a compelling case indeed.  The
banks working under their partnership model with open ended liability
would not have historically countenanced such mathematical abstractness
to justify massive risk taking.

Some History

All historic recessions are shown to have been caused by either just one of these five causes or a combination of them:

1. Rampant speculation,
2. Government involvement,
3. Misguided monetary policy,
4. Misguided regulation or legislation,
5. New financial technology

All five were present in the 2007/08 Crash!

Values Lost

Partnership and open ended liability was the way forward for most of
the great names in banking historically. Limited liability was something
that you had to apply to parliament for. The knowledge that you could
lose your entire wealth as a bank partner historically kept you from
undertaking risky acts. You were prudent, your reputation was
everything. This ethical and commercial stance was no hinderance on the
creation of wealth in society as Modern Financial Theory will tell you;
indeed we must remember that the whole industrial revolution was built
on very solid financial foundations. The authors give ample evidence for
this.

Although Dowd and Hutchinson do not explicitly mention it, the
language of banking was of the fiduciary and now it is that of gambling.

The authors mention that the during the period of partnership-led
banking there was also the establishment of such organisations as the
Accepting Houses Committee in 1914, which you would not be allowed to
join if not of a certain reputation, and you would not be allowed to
have your trade bills “accepted” by the Bank of England.

The Financial Services Act 1986 swept all of this away. I remember
being very supportive of this liberalisation as a child, but in
hindsight it was ill thought out legislation.  My personal view is that
instead of a banking system based on bankers holding fractions of
deposits in reserves against liability claims, we need 100% reserve free
banking to produce a robust system. No amount of good practice can
ensure the system stays solid when it is inherently illiquid by any
normal commercial accounting standard. The authors suggest that a
fractional reserve free banking system similar to the Scottish system in
the early 1800’s would be the model to follow with all of the
reputational and partnership ethic strengthening up the system.  This
however is a small quibble about their reform program and not with what
they have to say about what has got us into this mess.

Buy the book, it is a sensational read.

Afterthought

Dowd and Hutchinson on Economics

They hold the view espoused by Friedman and Schwartz that the problem
with the 1930’s was that the Fed did not keep the money supply at the
levels seen in the build up to the 1929 crash. They hold a conventional
monetarist position. They do not discuss or entertain the possibility
that the massive uplift in money supply from 1913 – 1929 may well have
been the direct cause of the asset inflation, i.e. excess credit created
the boom that led to the bust.

By advocating that during this bust stage we should not do what other
monetarist inspired economists have done (such as Bernanke, who flooded
the market with liquidity), they take what I would call a hard
monetarist view and suggest a route of keeping money supply growing only
at the rate that productivity and the needs of trade demand. They do
not discuss the Austrian Theory of the Business Cycle, which I think is
the most useful theory for explaining the boom and bust. This is
puzzling.

Buy Alchemist of Loss at Amazon here…

Source:Alchemists of Loss

Turning paper into Gold Bullion at the emerging-world’s central banks…

CENTRAL BANKS are becoming modern-day alchemists, says Christopher K. Potter, principal of Canadian-focused hedge fund Northern Border Capital Management Inc., which he founded in 2002.

India’s big gold purchase late last year was a game-changer, Potter here tells the Gold Report, and more and more central banks will follow suit – he believes – successfully managing to turn the paper money their countries accumulate into Gold Bullion…

The Gold Report: Just after the Reserve Bank of India (RBI) bought 200 tonnes of gold last November, you wrote an article entitled Game Changer, highlighting previous transactions such as China’s Central Bank 99-tonne purchase gold in ‘02 and Argentina’s 55 tonnes in ‘09. Since no other central bank has stepped forward in the months since India’s announcement, was that really a game changer?

Chris Potter: I think so. For as long as I can remember, gold bears have warned that central bank gold is a massive source of supply that is capable of overwhelming any conceivable demand scenario. They said that this would make it very difficult for the Gold Price to rise significantly. It’s been an easy argument to make because one fifth of all the gold ever mined is sitting in central banks’ vaults.

But what we’ve seen over the last nine years is that argument being steadily dismantled, piece by piece. Year after year, signatories to the Washington Agreement have sold less than their quota of gold. We’ve also seen various central banks add and talk about adding to their gold reserves. Then when the world became aware that the International Monetary Fund – which I think is the third largest holder of gold – was a potential seller of 400 tons, there was all kinds of speculation that this would have a very detrimental effect on the Gold Price.

Well guess what, the opposite happened when the Reserve Bank of India announced that it not only bought 50% of what was for sale but bought it at market prices! All of a sudden people realized that central banks might be net buyers rather than net sellers of gold. This was a big development. We still haven’t heard about who is going to buy the other 200 tonnes but the market no longer seems concerned that a buyer will be found. You mentioned that no other central bank has bought gold since the Reserve Bank of India announcement – well, we don’t know that that is the case. If you were a central bank interested in increasing your gold reserves, you would not likely telegraph to the market that you were doing that until you were finished buying.

TGR: Is the IMF actively trying to sell the other 200 tons?

Chris Potter: They reported that they planned to sell 400 tonnes so I see no reason to believe that they have changed their minds about the remaining 200 tons. It had been rumored that the central bank of China was going to buy the whole piece and that is why the Indian announcement was such a surprise. Perhaps China buys what’s left.

We’ve heard that the Chinese Central Bank has been a consistent buyer of gold over the last several years, but we haven’t heard anything officially. I suspect that they do not want to signal that they have a lot of gold to buy, because that would just drive the price up. If they are negotiating with the IMF for the remaining 200 tonnes, we won’t hear about it until the deal is done.

TGR: Could China just be buying it in such small increments that it might take them a year to buy it but they wouldn’t have to report it?

Chris Potter: I’m pretty sure that the US Federal Reserve is required to report purchases and sales of gold and other assets. I’m not familiar with the reporting requirements in other countries, but I would take any lack of disclosure about Chinese purchases of gold with a large grain of salt. In other words, just because they have not announced that they have been Buying Gold does not mean that they have not been.

TGR: Jon Nadler, Kitco’s senior investment products analyst, suggests that central banks’ acquiring gold is no more than re-balancing their portfolios. It’s part of a natural course of events since their portfolios are growing, and in that case, it shouldn’t affect the price of gold one way or another. What do you think of that view?

Chris Potter: By purchasing 200 tonnes of gold, the Reserve Bank of India increased its gold holdings by 50% – I would hardly call that rebalancing. But what is even more important than the amount of gold that central banks are buying is the realization that they are buying and not selling. This is a brand new idea and completely alters market perception about supply and demand. This kind of change in perception can have a very meaningful impact on price. So no, I do not agree with Jon Nadler’s suggestion.

TGR: So how do you look at it?

Chris Potter: If I were running a central bank and I had the ability to create money at virtually no cost and I could then exchange that costless money for one of the earth’s scarcest resources, why wouldn’t I do that all day long? Why not exchange something that costs me nothing for something that is incredibly rare and incredibly valuable?

TGR: It’s not a central bank’s role to print money for the purpose of Buying Gold, though. Creating more money creates other negative trends in the economy.

Chris Potter: Sure, it’s inflationary. But take the example of India buying 200 tonnes of gold. That’s a very large amount of gold, but relative to the amount of money that they are creating for other purposes, it has a very minor inflationary effect.

TGR: I’ve always had the impression that central banks were held to a higher standard to do what’s best for the economy.

Chris Potter: Well, maybe what they’re doing is best for their economies. If you’re a central bank and you’re observing that around the world vast amounts, unprecedented amounts, of new money is being created, you have to realize that somewhere down the road every one of those currencies is going to take a big hit. So, how do you distinguish you currency and your economy from your neighbors’?

Well, one thing you can do is Buy Gold. So maybe the Reserve Bank of India is being proactive about their economy. They are saying, "Look, we can Buy Gold now for $1000 an ounce and five years from now, when we are all swimming in newly printed money, gold might be $5000 an ounce. We can increase our wealth without inflating our currency to the same extent as other nations." Essentially they are hedging against a decline in their currency and that is good for their economy.

TGR: A lot of financial advisors tell investors they should have assets that include 10% to 15% precious metals as "insurance." Are the central banks looking at this as an insurance policy, too, or in some other way?

Chris Potter: I suppose you could call it an insurance policy and that is the way a lot of people think about gold. But that is not the way I think about it. I view gold simply as a currency whose supply and demand characteristics are vastly superior to other currencies. Perhaps that is a more accurate explanation for why central banks are exchanging their paper for gold.

TGR: Gold’s been trading around $1100 for the past few weeks. There seems to be some resistance at that level. Some gold bugs say gold will be at $2000 before the end of the year. Where do you project as a trend for the physical Gold Price through 2010?

Chris Potter: I have a much stronger view of where the Gold Price will be in two or three years than I do over the next few months. It’s had a good run so I am not surprised that it is taking a breather here. If I had to guess I’d say we’ll see new highs before the end of the year. I just think that the path of least resistance is up because the amount of debt that continues to mount around the world is staggering – a lot of that has to be monetized.

Everyone talks about deleveraging but the US ran a budget deficit of $1.4 trillion or $1.5 trillion last year, and it looks like we’re going to do something similar this year. I think I just read we’re trying to increase the debt ceiling here by $1.5 trillion Dollars to $14 trillion. These numbers would have been unheard of a couple of years ago. I think back to a speech that Bernanke gave in January of 2007, in which he worried that the US budget deficit would approach 9% of GDP by the year 2030.

TGR: Oh, we’re way beyond that already, and 2030 is still 20 years away!

Chris Potter: Absolutely. Last year at $1.5 trillion, our budget deficit was more than 10% of GDP. Bernanke’s great fear about what the budget deficit might do occurred 20 years early and it happened not because of our unfunded Social Security and Medicare liabilities that he worried about but because of the global financial meltdown. When we layer on the unfunded liability issues we have a really gigantic problem that will be extremely difficult to grow our way out of, despite what Washington tells us. That is why I say that the path of least resistance – the solution to this – is to inflate these liabilities away.

That requires printing money. It requires a lot of new Dollars, a lot of new Renminbi, a lot of new Yen, a lot of new Euros, a lot of new Roubles. I think you’re going to see all of those currencies depreciate against other assets, and probably most against gold. I imagine that will continue this year, but anyone who has been involved in the gold market over the last seven to nine years knows to expect some scary rides up and down.

TGR: You’ve laid out a compelling argument about all governments increasing their money supplies and we’ll have inflation worldwide. How much higher do you think gold can go?

Chris Potter: It’s always difficult to put a number on it, but the inflation-adjusted Gold Price, depending on your assumptions and in which year you start, is somewhere between $2200 and $3100 per ounce. I’ve run a number of different models to see where the Gold Price could go and have come up with anything from $1500 to $3500 an ounce. In the end it’s anyone’s guess as to what the ultimate high will be, but as I said, the path of least resistance seems to be up.

TGR: If you follow the gold patterns, the summer months have historically been relatively low, with prices picking up again for the holiday seasons, particularly in India. Given that more gold is being bought as an investment or as insurance now, do you see that seasonality coming into play over the next two to three years?

Chris Potter: As you point out, more often than not we’ve seen a rise in the Gold Price in October and November, which coincides with the Indian wedding season. I have no particular expertise here, but I’ll guess that that seasonal pattern will continue. Ultimately though it is not a primary driver of the Gold Price If you look at a nine-year price chart, those seasonal moves are just blips.

TGR: Should investors be looking at physical gold, the majors, the juniors? How should they play what you see as upward trends in Gold Prices over the next several years?

Chris Potter: My strategy is to own both physical gold and mining stocks. I focus on the smaller capitalization gold companies, the exploration companies, the early-stage producers just because if you get those right, they have a lot more leverage to a rising price for the metal.

The problem with owning only Gold Mining equities, and no bullion, is that in a market sell-off, they can go down with everything else. I know people who were managing gold funds who had a very difficult time in 2008 despite the fact that the Gold Price was up. As we saw, gold mining companies were decimated. Many of those equities were down by 50% to 90% in 2008, and the Gold Price was actually up.

TGR: So is the combination of physical and equities a kind of a hedge against each other?

Chris Potter: I wouldn’t characterize it as a hedge. I would just say that it gives you a greater chance of participating in a rising gold market under various market scenarios.

TGR: As I understand it, you consider the Canadian market somewhat less efficient than the US market, thus making it easier to uncover attractively valued companies. What do you think accounts for the discrepancy, and is it specific to small caps or also true of large caps?

Chris Potter: It’s really true of both large caps and small but it’s not a permanent discrepancy. It’s more of a lag. What I mean is that US investors take a lot longer to recognize and buy high quality Canadian companies than US listed ones. I used to be concerned that this lag would somehow be arbitraged away, but I’ve been doing this now for 12 or 13 years, and it has not.

There are a lot of reasons behind that. For one thing, there seems to be an apathy or ignorance on the part of US investors about almost everything Canadian. There’s also a perception that the Canadian securities laws are lax, that its investment community is run by mining promoters, and that US investors won’t get a fair shake up there. While there are certainly landmines to look out for when investing in Canada, they are no more dangerous than those in the US

To characterize the entire Canadian investment scene as corrupt because of the Vancouver mining community and the Bre-X Scandal in the late ’90s ignores the fact that the US has had plenty of its own investment scandals such as Enron and a banking system that perpetrated the greatest financial fraud in history this past decade.

But I can’t tell you all of the reasons for the valuation lag that I continue to see between US and Canadian companies.

TGR: Thanks so much for your time, Chris. This has been great.

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Source:21st Century Alchemy