Vol 2, 22 August 2011


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 euroarea 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 am ount 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 hardcurrency 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.

While impossible to know with any certainty. however peripheral. At each step the liability on the remaining players grows exponentially. 2 Please see our previous report. the Nobel Seminar paper is an excellent and most accessible reference. Rather. Rescuing Europe. a strong possibility that we raised in a previous Amphora Report. Perhaps the most outspoken of these is Dr. he argues that not only have various euro-area countries taken advantage of low borrowing costs to artificially amplify growth by failing to deliver m eaningful cuts in fiscal spending. To bring this discussion up to date. meaner. a circular arrangement with no economic logic. In other words. such bailouts create a massive moral hazard problem which virtually ensures that Germ an capital will continue to flow to 1 inefficient. although one providing a political fig-leaf for the Finnish government. As it happens. potentially initiating a new euro-area storm as their demands spread to other countries and undermine an already unstable equilibrium. the German government drew what appears to be a clear line in the euro’s Club-Med sand. why the Finnish demand for collateral? But if the latter. again increasing the liability on the remaining actors. most probably some combination of Germany. healthier and significantly more competitive. The Real Lesson of the Greek Debt Crisis. Were that to occur. while Finland is a rather small player on the euro Several prominent German economists are now openly advocating that Germany reconsider participation in EUbailout arrangements which do not require a substantial debt restructuring. In a recent For those interested in an introduction to the work of John Nash and to game theory generally. presumably to the dismay of France. the Benelux and probably Austria and Finland. the Nobel Prize winning economist and mathematician whose life and work was featured in the book and film A Beautiful Mind. Consider the game theory concepts of John Nash.amphora-alpha. Naturally everyone is focused on what Germany is thinking. but also that the capital that flowed into housing and unsustainable governm ent spending in the "windfall" economies was German capital that should in fact have stayed in Germany. as it generally did from 2002 to 2007. 22 August 2011 www. their actions have the potential to 1 In the specific case of the euro-area bailout debate.nobelprize. It is one thing for Germany. such thinking was not lost on other euroarea ash-lecture. which has been leading the bailout effort in the face of growing German opposition. just last week. colloquially known as the "Five Wise Men". The link can be found here: http://www. what this request would amount to in practice is for Greece to guarantee the Finnish guarantee of Greek debt. President of the prominent IFO Institute and member of the German Council of Economic Advisers. This presents an opportunity to explore why certain economic and political equilibria can be destabilised by the actions of apparently peripheral actors. asking for collateral arrangements of their own. What would remain of the euro-area would be leaner. As described by Professor John Harsanyi. why should the Finns be on the hook at all? Indeed. Is the German Eagle a Grey Swan? Vol1. In the Report cited above we also speculated that other euro-area members with relatively sound finances might withdraw support for the bailouts. 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. This will make such equilibria potentially 2 unstable. But if the Greeks had collateral. But in the latter case. where investments would have been less speculative and ultimately more sustainable. withdraws from the current agreement due to sufficient concerns about their implied future liability for guaranteeing Greek debt. the euro would likely begin to trade as a strong currency again. 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. While unclear what will happen to the euro-area in the event that Greece or another country ends up defaulting. last week. This unexpected increase in liability might be just enough to cause another peripheral actor to decide to withdraw.amphora-alpha. France. eventually a tipping-point is reached and the equilibrium collapses entirely. Hans-Werner Sinn. if just one small player. is that defaulting countries will redenominate their existing debts into a new.THE AMPHORA REPORT Vol 2. 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. devalued national currency. to have concerns about the bailout arrangements. this increases the implied future liability of the remaining participants. But the Finnish demand for collateral is akin to a butterfly flapping its wings. 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. While on the surface this might sound reasonable. including Austria and the Netherlands. September 2010. April 2010. besides his mixed equilibrium strategy. This of course is true also for Nash equilibria in mixed strategies. each player will also have infinitely many alternative strategies that are his best replies to the other players’ strategies. who promptly lined up behind the Finns. engine and anchor of the euro-area economy. This and other archived reports can be accessed at www.pdf. 02 . GAME THEORY AND NASH EQUILIBRIA Notice that. Finland demanded collateral from the Greeks in return for guaranteeing their debt. dysfunctional governments. cause quite a stir.

8 tonnes of Venezuela’s official reserves. each member country was provided a designated vault in the basement beneath the NY Federal Reserve building in Liberty Street. Recently. or dollars. comprising apparently the bulk of the total 365. In many cases. have bought Swiss francs as a hard-money alternative to euros. and. For a thorough discussion of why we have been generally constructive on the yen this year. We find it no surprise that. with potentially large significance for gold and. More recently. As such.atomcapital. 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. but we would not regard the yen as a perfect substitute 3 for the franc. Those that. by extension. gold is held on a custodial basis elsewhere. for example. making the domestic price level highly uncompetitive vis-à-vis not only the euro-area but most economies around the world. Mr Mizuno Retires. Of with potentially large consequences for the euro-area and. One aspect of the gold market that sets it aside from financial markets is that. or pegged. prevent further deflation. investors have no choice but to increase their allocations to that which cannot be printed. for example. VENEZUELA TAKES DELIVERY The next butterfly (or swan) up for discussion has to do with gold directly. . at any one time. Venezuela announced that it was taking delivery of its allocated gold held in custody abroad in the US. Much as the Finnish butterfly has just flapped its wings. other precious and semi-precious metals. Manhattan. gold is a physical metal that can. to a lesser extent. as the Swiss contemplate a euro peg. As part of the Bretton Woods arrangements. is the normal and preferred way in which larger entities. Switzerland’ s currency has strengthened dramatically of late. In this regard. paper or coin money can be used for (generally quite small) transactions but. in order to relieve deflationary pressure on the economy. when things were also looking rather grim in global financial we have been generally positive on the yen as an alternative to the dollar. Yes. whereas most currencies exist primarily as bank accounts or other electronic entities representing ownership. which can be found here: http://www. the Swiss National Bank opined that. in particular that used for savings—cash in the mattress. Not so with gold. the gold price in francs has soared. at the NY Federal Reserve Bank. this represents only a tiny portion of the overall money supply.and long-term. the Japanese economy faces severe challenges. thereby preventing a further appreciation and halting the decline in relative economic competitiveness. consider what a Swiss peg to the euro would imply from the perspective of global investors searching for a safe-haven.THE AMPHORA REPORT Vol 2. Gold has retained its function as an alternative money and store of value ever since 3 President Nixon “closed the gold window” 40 years ago last week. in this newsletter. 22 August 2011 www. As such. Moreover.amphora-alpha. It is a popular misconception that most countries’ gold reserves are primarily held domestically. or otherwise distorted by policymakers seeking to reflate their economies or. both short. in a modern economy. Access to actual physical gold. it would appear that things have now gone too far for even the currency-proud Swiss. As such. New York City. the Swiss butterfly has also taken flight. 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. Consider for a moment the recent spike in the price of gold. so to speak. the Swiss economy is importing a growing degree of deflationary pressure from the recent correction in global financial markets. such as central banks or sovereign wealth funds. in physical form. or other currencies.pdf. Is the yen really an alternative safe-haven currency? It might provide some A SAFE HAVEN REMOVED Surrounded by growing euro-area instability. gold has exploded higher in price versus all currencies. As required periodically for balance of payments adjustments not settled in dollars. Although perhaps understandable given the circumstances. a rise in general risk aversion might better explain the recent surge in gold. the gold price moved in only a narrow range vs the franc. would suddenly discover that one of their safehavens is no longer safe. While the strength of the safe-haven Swiss franc is legendary. please see the previous Amphora Report. at a minimum. nevertheless. be traded electronically in a variety of ways. global financial markets. up to now. they are going to have to look elsewhere. there really aren’ t any safe-haven currencies left. it is notable that last week. Canada. own the metal. but consider: Back in late 2008. UK and Switzerland. gold bars were simply moved from one vault to another. it might be sensible to peg the franc to the euro. rather than merely an electronic claim thereon. to be sure.

the potential new leaders might not be on as friendly terms with the US as those that they depose. this will not go unnoticed elsewhere.) 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. on the contrary. but that was generally considered an unnecessary inconvenience: Transporting large amounts of gold can be expensive and potentially risky. however. in fact. there would be no point in shipping it to New York and placing it in the Fed’ s custody. a good handful of other countries that are not on particularly good terms with the US and. uncertainty is a bolt from the blue. 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. First. where it resides to this day. undesirable outcomes. as the convenience is. how the US responds to the request. as a safe and reliable jurisdiction for global commerce. The international gold held in custody at the Fed to this day is thus a legacy of the goldbacked dollar. Why? If there was growing faith in the dollar-centric global financial system. Will the US arrange for a speedy handover? Will it be generally cooperative? After all. Venezuela. balance of payments accounts are no longer settled in gold but rather in dollars or in some other currency. South Korea. it can be “ priced” into a financial asset which can then be traded. There are. Risk is something that is known and that can be modelled and quantified with some degree of confidence. While countries friendly with the US presumably trust that the US would not. the central banks of Mexico. In some cases. there is no longer any need to transfer gold between countries on a regular basis. Bangladesh and Kazakhstan have bought gold on the open market. with the US having suspended convertibility. the US and Venezuela have not had good relations for years. Should more countries line up to take physical delivery of their gold. (In August 1971. in the event that the US does make it difficult for Venezuela to take physical delivery. Bretton Woods participating countries were free to take delivery of their gold at any time. it is important to distinguish between risk and uncertainty. as required from time to time. no longer of much if any value. In theory at least. Regardless. might the US resist one or more of these requests? And if so. 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. 22 August 2011 www. would this frighten a growing number of countries into also requesting delivery sooner rather than later? After all. (China and Russia might come to mind but we do not believe that they have any custodial gold with the NY Fed. or back again. Of course. it is pertinent to consider how investors can protect themselves from the uncertainty associated with unstable equilibria generally. affecting a larger number of equilibria. Were the gold not already there. while underway. by our count.) With the end of the Bretton Woods system. we now see that there is at least one country not on particularly good terms with the US. however. unforecastable Black Swans. This is because. 04 . several years ago.THE AMPHORA REPORT Vol 2. the US refused to confirm whether or not it still supported Chavez’s rule. for example.amphora-alpha. it would be a sign that confidence in the US itself. the price fluctuating as the assessment of a given risk changes over time. this list has grown in recent years. a huge diplomatic snub. In recent months. might a handful of other countries follow Venezuela’ s lead? If so. including those that qualify as unknowable. At the extreme. as a previously unknown force of nature. Venezuela’s decision to take delivery of its gold places additional focus on the unique role that physical gold plays in the global economy. As such. which has decided not to take any chances. No doubt there have been probably more such events of late than the few we note here. Regardless. an event with huge impact that arises spontaneously. insurance is the concept more commonly applied when dealing with uncertainty. Uncertainty. 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. this trend is a clear indication that global confidence in the dollar continues to erode. As such. is also beginning to erode. There arises therefore the question post Bretton Woods as to whether having one’ s gold held abroad sacrifices custodial security for convenience. for example? It was of course far easier to move gold from NY Fed vault A to vault B. While financial modelling and strategy built thereon is applied to risks of all kinds. would central banks be accumulataing gold reserves at the fastest pace since the 1970s? No. Others no doubt continue to accumulate gold less overtly. What happens if a ship transporting gold should sink. Charles De Gaulle famously sent a French warship to Manahttan to receive and transport France’s accumulated NY Fed custodial gold back to France. for some reason. it is instructive to look around the world and see the large number of rather unstable regimes at present. the right response to financial uncertainty is some kind of financial insurance against extreme or simply unknowable. an attempted coup against Venezuela’s President Hugo Chavez took days to put down and. potentially far more interesting. is that which cannot be clearly identified or modelled. As with the other unstable equilibria discussed so far in this report. refuse to hand over their gold if so requested. of course. rather than leave it in US custody.

John was Managing Director and Head of Interest Rate Strategy at Lehman Brothers in London. however. Many commodities do have negative roll yields. All express or implied warranties or representations are excluded to the fullest extent permissible by law. Another problem is that cash does not protect investors from devaluations of the currency. with central banks in much of the world holding interest rates lower. the best way to enhance portfolio liquidity without taking devaluation risk is to hold liquid commodities. But as with all forms of insurance. In the potentially long and certainly uncertain meantime. At John Butler has 18 years' experience in the global financial industry. were interest rates at a more normal. equities and debt. Yet while the nominal interest rate on cash is Acquiring such insurance is. however. The problem with this approach. investors need to take out insurance accordingly. easier said than done. yet the commodities in question can protect investors from the uncertainties surrounding highly expansionary monetary policies around the world. there would not seem much interest to forgo. is demonstrated by the recent debate in Switzerland. Cash insurance. Even the US. Liquidity is indeed a form of insurance. credible action to place its finances on a sustainable path. Beyond a certain point. Nothing in this report shall be deemed to constitute financial or other professional advice in any way. for example. AMPHORA: A lateral-handled. Whether initiated by governments or not. DISCLAIMER: The information. © Amphora Capital 2011 Amphora is a registered trading name of Atom Capital Ltd which is authorised and regulated by the Financial Services Authority 05 . has yet to properly begin on a meaningful scale. JOHN BUTLER john. ceramic vase used for the storage and intermodal transport of various liquid and dry commodities in the ancient Mediterranean. having worked for European and US investment banks in London. which would be more likely to hold their real values in the event of a large currency depreciation. New York and Germany. 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. As a first step toward accumulating insurance. Prior to founding Amphora Capital he was Managing Director and Head of the Index Strategies Group at Deutsche Bank in London. however. What investors need. 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. We have much sympathy with this. These terms are governed by the laws of England and W ales and you agree that the English courts shall have exclusive jurisdiction in any dispute. for example. tools and material presented herein are provided for informational purposes only and are not to be used or considered as an offer or a solicitation to sell or an offer or solicitation to buy or subscribe for securities. when adjusted for measures of inflation. Prior to joining DB in 2007. the forgone interest of holding higheryielding assets. however. Investors can naturally diversify the risk of holding cash by diversifying into a number of different currencies. in the form of exchange-traded futures. With even the Swiss having reached the point where there is serious talk of pegging the currency. 22 August 2011 www. has yet to take serious. but certain commodities have positive roll yields. costs or expenses nor for any loss of profit that results from the content of this report or any material in it or website links or references embedded within it. the issuer of the global reserve currency. We believe it is also the case today. and under no circumstances shall we be liable for any direct or indirect losses. investment products or other financial instruments. This was the case in the 1970s. In our view. where he was responsible for the development and marketing of proprietary. where he and his team were voted #1 in the Institutional Investor research survey. investors should recognise the limits of currency diversification. therefore. for example equities or property. countries do not welcome strong currencies.amphora-alpha. there is a time value opportunity cost of holding cash. This report is produced by us in the United Kingdom and we make no representation that any material contained in this report is appropriate for any other jurisdiction. That process. as commodity prices consistently rose in cash terms and also outperformed most financial assets. A balanced commodities portfolio need not have a net negative roll yield.THE AMPHORA REPORT Vol 2. positive level at or above the rate of price inflation. of much greater concern is that the interest rate on cash in most currencies is deeply negative in real terms. quantitative strategies. costs more to hold than would normally be the case. most investors would probably think that they should hold additional cash. therefore. namely. which contribute to sharply higher rates of price inflation down the road. He is a regular contributor to various financial publications and websites and also an occasional speaker at major investment conferences. implying a negative real interest rate associated with holding them. that is.butler@amphora-alpha. devaluations can negate much if not all the benefit of holding cash instead of other assets.

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