AMPHORA REPORT-MAR

1. THE AMPHORA REPORT
John Butler jbutler@jb-cap.com Jon Boylan jboylan@jb-cap.com MARCH 2010
IN THIS EDITION
 IS MONEY A STORE OF VALUE?
 HOW MUCH FREE LUNCH WOULD YOU LIKE, SIR?
 THE REAL LESSON OF THE GREEK DEBT CRISIS
IS MONEY A STORE OF VALUE?
Perhaps it is a sign of the times we live in that we feel the need to ask ourselves this question. The answer
might appear simple, in that textbook definitions normally list the following three properties of money:
1) A medium of exchange
2) A unit of account
3) A store of value
Well that settles it then. Or does it? Let’s consider our definitions carefully. A store of value must be
something which retains its purchasing power over time with a good deal of certainty. But by that
definition, there are many currencies in the world today, including major ones, that don’t measure up.
Consumer price inflation in the US, Europe and Japan may have been fairly low, on average, in recent
years, but history has been less kind and, as we know, governments and central banks are fighting against
credit and asset price deflation with all manner of unconventional policies, including those that, it seems,
they aren’t too keen to disclose in detail, if at all.
Why the secrecy? Well, the Fed has claimed, among other things, that to detail its emergency lending
activities would damage confidence in those firms that received assistance. Perhaps. After all, confidence in
general has been undermined by the near failure of the entire financial system. But the damage doesn’t stop
there. In their rush to underwrite the risks of their financial systems and stimulate their economies,
governments and central banks have undermined confidence in their creditworthiness and their currencies.
It stands to reason that anything purporting to function as a store of value must be durable. If it just
disintegrates, it’s not of much use. But a store of value must also be limited in supply. Were the supply of
money to double (and be perfectly distributed) overnight, the prices of all goods would also double. There
would be no change in real wealth. But money would have failed to provide a stable store of value.
The US monetary base has more than doubled since 2008...
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2. In the present case, the global monetary base has grown rapidly—more than doubled in the US—although
for the most part it has not been distributed outside of the financial system. Banks are not lending, due to a
combination of weak new loan demand and stricter lending criteria. This implies that the so-called “excess
reserves” of the financial system are largely just a loan loss reserve on a different part of the balance sheet.
Indeed, in many countries there is an outright contraction of bank lending taking place. While this is
potentially deflationary, policy actions during the past two years imply strongly that governments and
central banks aren’t going to sit back and allow this to continue indefinitely.
...but the new money is not flowing outside the financial system
There is an active debate out there regarding whether investors should be primarily concerned about
inflation or deflation. We find it difficult to commit to one side or the other because there is just no way to
know exactly what is going to happen on what time horizon. There might be periods of sudden inflation
alternating with sudden deflation. But where we are certain is that, given the broad range of unconventional
(and, at times, secret) monetary policy actions, surging government deficits and potentially fickle foreign
creditors, fiat currencies cannot possibly be as reliable as stores of value as they once were.
If we look back at how fiat currencies have fared as stores of value in general since the US formally
abandoned the gold standard in 1971, we find little reason for optimism. 1 If most currencies didn’t function
well on average as stores of value from 1971-2007, when financial systems were stronger, monetary policy
was more conventional, and deficits and future entitlements were far lower, we seriously doubt that those
same currencies are going to fare any better during the next few years. The dollar, still holding pre-eminent
reserve currency status, may be most at risk as the US has gone from being the world’s largest creditor
nation to the largest debtor. But the euro-area, Japan and most other developed and also emerging
economies have serious issues of their own. And, in most cases, they have taken interest rates down to
unusually low levels to try and buy themselves time. Some investors may be optimistic that an
unprecedented level of government intervention in financial markets and economies is going to compensate
for the monumental misallocation of resources that has taken place via a series of progressively larger asset
price bubbles in recent years, but history suggests that this is going to end badly.
HOW MUCH FREE LUNCH WOULD YOU LIKE, SIR?
“Time is Money” is perhaps the simplest expression of the economic concept of opportunity cost: Forgoing
one thing for something else. Interest rates represent nothing more than the “opportunity cost” of money, or
of forgoing some amount of money today for the same at some future point in time. Assuming that cash in
1
According to US Bureau of Labor Statistics CPI calculations, the purchasing power of the dollar has declined by approximately 80%
since 1971. The declines in the purchasing power of the Japanese yen and German mark (now the euro) have been somewhat smaller
at approximately 40% and 50%, respectively, according to OECD purchasing power parity estimates.
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3. hand is normally used for consumption rather than savings, another way to look at interest rates is that they
represent the opportunity cost of consumption today rather than at some point in the future: The higher the
rate of interest, the higher the opportunity cost of consuming today, rather than tomorrow.
However, as interest rates approach zero, the opportunity cost of cash in hand, or consuming today, rather
than in the future, also approaches zero. Why then, given that rates are currently so close to zero, don’t we
all just go to the bank, take out a huge, low-rate loan, and throw a big party? The answer should be
obvious: Human beings, irrational as they may be, tend to have the sense that they should hold something
in reserve for the future. After all, no matter how much you eat today, you are not going to be able to store
these calories efficiently and slowly burn them off for the remainder of your life (which, indeed, might be
cut rather short if you were to try). Nor is it practical or realistic to try and sort out your wardrobe or even
shelter arrangements for the remainder of your life all in one big shopping spree. (For those with children
or other responsibilities that will outlive them, there is also the desire to plan for what might be consumed
by others, after we have gone off to happier places absent such inconveniences as the fundamental laws of
economics.)
There is, therefore, a natural constraint on how much consumption will be brought forward in response to
zero interest rates, even in the case of those considered rather profligate. For those who are relatively
conservative financially, zero rates are not going to prevent them from continuing to save a significant
portion of their income and, in response to a sharp economic downturn and loss of job security, many
indebted individuals might decide to pay down some debt, notwithstanding the zero cost of rolling it over.
Some might choose to walk away from their homes rather than service a mortgage greater than the market
value of the property. Others might return a leased car to the dealer. A few might declare bankruptcy and
start over. There is just no way to know exactly how individuals are going to respond to an economic crisis.
These sorts of decisions are naturally unpredictable and unquantifiable, yet naturally arise in response to
changing economic circumstances. Characterised by Keynes as “animal spirits”, they continue to be
regarded as essentially irrational by neo-Keynesians today. But it is important to beware when an
economist begins to talk about behaviour being “irrational”, because what this implies, in practice, is that
their models cannot account for it.
Now in the same way that economists struggle to come to terms with supposedly “irrational” consumer
behaviour, they also find it troublesome that investors sometimes lose confidence in the sustainability of
fiscal and monetary policies and, therefore, engage in “irrational” and supposedly damaging behaviours
disparagingly referred to as “speculation” or “hoarding”.
Rather than respond to zero-rates by doing supposedly sensible things like ploughing their capital right
back into an economy that just collapsed, notwithstanding soaring government deficits and central bank
balance sheet deterioration, “irrational” investors might instead seek to reduce and diversify the risk of their
investments. They might “hoard” cash. They might “speculate” in assets that are relatively unaffected by
radical, unsustainable fiscal and monetary policy. In the present instance, as aggressively expansionary US
fiscal and monetary policies undermine the dollar’s role as the pre-eminent global reserve currency,
investors might want to consider ways to diversify out of dollars.
With the dollar not offering a positive interest rate differential versus other currencies for the first time in
many years, such diversification must appear unusually cheap. But what if other economies are facing their
own economic problems and implementing policies similar to those in the US? How much diversification
are investors really getting by moving into foreign currencies?
To make matters worse, what if central banks around the world do what they can to prevent their own
currencies strengthening by intervening aggressively to slow the dollar’s decline or stop it falling
altogether? The benefits of foreign currency diversification will decline dramatically. In the extreme and
highly unlikely scenario that all major countries peg their currencies to the dollar, the benefits of currency
diversification will approach zero. In this situation, what is an investor to do?
If the store of value function of all major currencies is substantially undermined, either through
unsustainable fiscal and monetary policies around the globe or through a general unwillingness to allow
meaningful relative currency appreciation, then investors are going to have to look for alternatives.
Historically, gold and silver have most frequently served as reliable, stable international stores of value,
protecting against devaluations and default generally. But there have been many cases of other
commodities serving as stores of value at certain times and places. There is no reason why, in an age of
globalisation, that any commodity that is liquid and widely traded cannot offer some useful diversification.
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4. Which brings us to an important point: If currencies in general are offering essentially zero rates of interest,
then what, exactly, is the opportunity cost of diversifying into traditionally zero yielding assets, such as
commodities? Essentially zero! And if such assets offer greater diversification benefits than a broad basket
of currencies, which should you overweight in a low-risk, defensive portfolio designed primarily to
function as a store of value?
Diversification is held, rightly, to be the only “free lunch” in economics. Not Keynesian pump-priming; not
central bank interest rate manipulation; not holding an asset for the long-term just because history has been
kind (equities, housing anyone?). No, diversification is the only exception to the rule. And in a world of
zero rates, where cash and low-risk asset rates of return are far lower than normal, and are likely to remain
there for some time, the benefits of diversification are available for far less cost. If you want as much free
lunch as you can get, make sure you ask for a generous helping of assets that are not only uncorrelated
normally but also remain so in a zero-rate world. We might be here for some time.
THE REAL LESSON OF THE GREEK DEBT CRISIS
Following years of budget deficits and generally unsustainable economic policies, the global financial crisis
has dealt the Greek economy and government finances a devastating blow from which it will be difficult to
recover. The crisis has also given rise to a general debate about the sustainability of European monetary
union (EMU) and, by implication, the value of the euro. If there is a mainstream opinion about the
implications of the Greek debt crisis for EMU and the euro generally, it is that it threatens the viability of
EMU and should, therefore, weigh on the euro. We disagree. Why?
Let’s start by considering the possible final outcomes of the Greek crisis. There are three possibilities:
1) Greece is summarily bailed out by some coalition of EU governments and goes merrily about its
profligate ways, most probably encountering another funding crisis at some point in the future
2) Greece is bailed out but only in return for dramatic fiscal consolidation resulting, in time, in a
fundamentally more competitive economy
3) Greece either voluntarily withdraws or is somehow forced out of EMU
The first possibility was, at first, widely held to be the likely outcome. Given the intense opposition to this
now on display in Germany and France, we heavily discount this scenario, although we would not rule it
out entirely.2 Much more likely in our opinion is either scenario 2) or 3).
In considering scenario 2), it becomes important to assess how likely it is that the Greek government could
actually deliver on an economic austerity programme. Although the government may try, we don’t think it
is realistic for Greece to significantly increase tax revenue amidst not just local but also global economic
weakness. Any serious progress in deficit reduction in the near-term will have to come from cuts on the
expenditure side.3 It is well-known that public-sector unions are immensely powerful in Greece and yet it is
precisely public sector jobs, wages and pensions that will need to be cut if Greece is going to be able to
demonstrate to financial markets that it can place government finances on a sustainable path. Once the
economy picks up, tax revenue should rise, also contributing to a decline in the real debt burden.4
So how likely is it that the Greek government can stare down the public sector unions? We don’t know. We
would suppose that no one really knows. Certainly the past is not encouraging, but recent opinion polls
show that a majority of the public support both increasing the retirement age and freezing the salaries and
pensions of government workers. Rather than estimate a probability, for purposes of this discussion, let’s
just define success as doing what is necessary for the financial markets to respond by dramatically lowering
the incremental yield required to hold Greek government debt.
If the government does not succeed in implementing draconian budget cuts and is not subsequently bailed
out by Germany and France, there is going to be either a default, as Greece limits or suspends debt
2
Those familiar with the history and politics of the EU understand that it is only when Germany and France agree that the EU can
take decisive action, for example to expand membership or powers. When Germany and France disagree, the status quo prevails. In
the present case, we consider it unlikely that both Germany and France would agree to hand Greece a blank cheque.
3
At time of writing, the deficit-reducing measures that have been enacted by the Greek parliament are split roughly evenly between
the revenue and the expenditure side. In our view, the revenue estimates are based on unrealistic GDP growth assumptions. There is
also the strong possibility that Greek taxpayers will find ways to avoid the new measures in part.
4
The emphasis here on the “real” debt burden is important. Within a currency union, the real debt burden cannot simply be reduced
via currency devaluation. The only real debt reduction options available are either a) running budget surpluses instead of deficits; or b)
defaulting. Consider by contrast the situation in the UK, also a member of the EU, but one which has seen its trade-weighted exchange
rate fall by some 30% during the past two years. This de facto devaluation of sterling-denominated debt reduces the real debt burden,
making it less likely that the UK will default. Were the UK to have joined EMU and thus been unable to devalue, it is not hard to
imagine that the UK would currently find itself in a position similar to Greece.
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5. payments; or Greece is going to withdraw from EMU, devalue and service its huge debt burden in devalued
neo-drachmas. In either instance, Greek sovereign borrowing costs for any new debt issued, whether
denominated in euros or neo-drachmas, will remain elevated as long as financial markets consider Greece
to be an unreliable creditor. Most probably, this would be for a period of at least several years.
Given high borrowing costs, one would be tempted to conclude that the Greek economy would remain
weak until such costs declined. But the real economic impact might be less severe. Consider the two
possibilities, either default or devaluation, in turn. If default, then the euro remains the legal tender. Greek
companies continue to do business as usual with their EU/global suppliers and customers. Do their
borrowing costs rise? Not necessarily. Indeed, this is one of the key, if commonly unrecognised benefits of
a monetary union. Just because a member country defaults or for whatever reason faces rising debt costs,
large, profitable, geographically-diversified companies are unlikely to be directly affected and will in any
case continue to benefit from operating in a large currency area in which there is no FX risk to manage and
in which capital, if not labour, flows relatively freely from one place to another. 5
If, alternatively, Greece leaves EMU and issues its own (presumably devalued) currency in which to
service its debts, then Greece will enjoy more competitive terms of trade with the EU and other countries
generally, although it is also likely to face somewhat higher borrowing costs for a time. But at this point
what happens to the Greek economy is largely irrelevant for the remaining euro-area, which is no longer
burdened by a relatively uncompetitive region. What remains of the euro-area will be proportionately more
competitive as a result.
Extrapolate this now to the other weak euro-area members: Portugal, Italy and Spain. Were all of these
countries to leave EMU, re-denominate their debt into national currencies and devalue, the euro-area would
be comprised primarily of Germany, France and the Benelux. Taken together, these countries would
comprise an economy somewhat larger than Japan, with a comparatively high per-capita GDP and current
account surplus.6 Taken to its potential conclusion, the Greek debt crisis could eventually result in the
emergence of a “lean and mean” euro-area comprised of only the most competitive economies. Is this a
recipe for a weak, or a strong euro?
***
The free market does not work its magic on the private sector alone. In the case of EMU, because the
various sovereign member states are the primary issuers of debt, financial markets are able to impose a
substantial degree of fiscal discipline. This happened in Ireland in 2009 and it is happening in Greece
today. By contrast, in the US, the federal government raises and then distributes most of the tax revenue
and issues most of the debt. Whereas financial markets can demand higher borrowing costs for weak sub-
sovereign entities such as California, the automatic federal funding for sub-sovereign entities, in the form
of transfer payments, imply a huge subsidy. States and municipalities have an incentive to grab the greatest
possible portion of federal funding (and Congressmen devote a great deal of their time do doing so).
Indeed, this centralisation of fiscal policy appears to us a good example of what is called the “Tragedy of
the Commons”: If all farmers’ livestock are allowed to graze on common ground, each farmer has an
incentive to allow as much grazing as possible by his own livestock, such that there will be overgrazing in
aggregate and a potentially renewable source of quality grazing land will soon be depleted and rendered
unproductive, at a loss to all. If the US government begins to bail out profligate states and municipalities,
the incentive to overspend, over-borrow and crowd-out potentially more productive private-sector
investment will only increase.
While mainstream economists refer to the “Tragedy of the Commons” as a form of “market failure” we
prefer to call it “property rights failure”. Were the common divided up into private plots of land, each
would be managed by a single farmer to the benefit of his/her own livestock. Successful farmers would,
over time, have the savings to acquire land from their unprofitable counterparts. If successful farmers
wanted greater flexibility, they could enter into contracts allowing shared use of each others’ land, perhaps
allowing their collective livestock to graze one farmer’s plot one week and another farmer’s the next,
thereby preventing overgrazing and also most probably allowing for some division of labour: As one
farmer tended the livestock the other would be free to work on capital improvements or maintenance.
5
Economist Robert Mundell, among others, has done much work on the concept of optimal currency areas. In brief, the idea is that
the larger the better so long as economic shocks can be absorbed by flexible prices and wages, and movement in labour and capital.
Where prices and wages are sticky, or labour and capital immobile, it is better to have your own national currency which can rise or
fall as necessary. In the EU, prices are generally flexible although wages much less so. Capital is mobile, although due in part to
language issues but also school, health and pensions systems, labour is relatively immobile when compared to the United States.
6
Source: OECD Factbook 2009. http://oberon.sourceoecd.org/vl=783560/cl=31/nw=1/rpsv/factbook2009/index.htm
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6. Indeed, we consider the concept of “market failure” to be in most if not all cases a form of intellectual
laziness or lack of imagination. And we are not alone. 7
Let us return to the euro-area. As the responsibility for debt service resides primarily at the sovereign level,
it is easy for financial markets to impose discipline on those EMU members who are widely perceived to be
following unsustainable fiscal policies, or whose economies are becoming unproductive, or who are found
to have used various accounting frauds or gimmicks to hide the true state of affairs. As financing costs rise,
so does the incentive to move public finances onto a sustainable path. We are seeing this process in action
with Greece and several other euro-area members as well. Already in 2009, Ireland faced a similar situation
and took swift, dramatic action in response. Financial markets soon backed off, although it is too early to
say that Ireland is out of the woods. Is it a bad thing that financial markets are now forcing the issue in
Greece today? In Portugal or Spain tomorrow? In the absence of such forces, would euro-area politicians,
on their own initiative, seek to reduce deficits? In Germany, perhaps, there is a tradition of proactive fiscal
prudence. But elsewhere?
Certainly not in the UK. The government threw itself into the crisis early on, taking various measures to
stimulate demand and support the banking system. The Bank of England cooperated with an aggressive
quantitative easing programme. These actions probably contributed to the dramatic, approximately 30%
decline in the trade-weighted exchange rate. Although a more severe downturn was probably avoided, the
UK now faces huge deficits as far as the eye can see even through taxes are going up. Consumer price
inflation is already back in positive territory but the Bank of England is considering extending its
quantitative easing programme. Neither Labour nor the Tory opposition are serious about tackling the
deficit and the risk of a hung parliament increases the probability that the UK will be unable to respond
effectively to a funding crisis. So now we ask: Can sterling be considered a reliable store of value? Not in
our opinion.
Are things much different in the US, where Fed Chairman Bernanke just told Congress that interest rates
are going to remain low for an extended period? Where nearly 90% of federal spending, including for
defence and for the various wars, is exempt from a proposed spending freeze? Where a growing number of
states and municipalities are either already facing or at risk of funding crises? Where nominees to President
Obama’s special commission to reduce the deficit are primarily neo-Keynesian economists who support
deficit spending as a matter of principle? Do we really believe that these people are going to support the
dramatic spending cuts that are going to be required to get US finances back on a sustainable path? And
even if they do, is the Congress going to implement their recommendations? In this context, should the
dollar be considered a reliable store of value?
***
In the drama of the Greek debt crisis we are seeing a classic example of financial markets doing precisely
what they are supposed to do. To mix our metaphors, on the gun pointed at Greece—and previously at
Ireland—we see not only the fingerprints of bond market vigilantes but also those of Adam Smith’s
invisible hand. And when we gaze into the future, we see either reformed, sustainable euro-area fiscal
policies across the board or a smaller but more competitive euro-area economy. The real lesson of the
Greek debt crisis is that it illustrates that, for all its flaws, the euro-area is structured in a way that imposes a
greater degree of market-based fiscal discipline on sovereign members than is the case in the US, the UK,
Japan, and probably most other countries. By implication, the euro should provide a superior store of value
than either the dollar or sterling in the coming years, as indeed it has done for the better part of a decade.
7
Those who seek to illustrate that “market failure” occurs frequently give the example of a lighthouse as a good from which all would
clearly benefit but which none would be prepared to provide privately, as it would be impossible to charge a fee for its common use.
While nice in theory, Nobel Prize winning economist Ronald Coase has shown in practice that, historically, many lighthouses were
privately and profitably owned and operated. An excellent collection including Coase’s work and other examples of the fallacy of
“market failure” is available in Daniel Spulber, ed, Myths of Market Failure, 2002.
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7. The Amphora Liquid Value Index (through Feb 2010)
AMPHORA: A tall, lateral-handled, ceramic vase used for the storage and intermodal transport of
various liquid and dry commodities in the ancient Mediterranean.
JB CAPITAL PARTNERS is dedicated to helping clients preserve wealth in a highly uncertain
global environment by developing products protecting against both inflation and deflation
John Butler jbutler@jb-cap.com
John Butler has over 16 years experience in the global financial industry, having worked for European and US investment banks
in London, New York and Germany. Most recently he was Managing Director and Head of the Index Strategies Group at
Deutsche Bank in London, where he was responsible for the development and marketing of proprietary, index-based quantitative
strategies. Prior to joining DB in 2007, John was Managing Director and Head of European Interest Rate Strategy at Lehman
Brothers in London, where he and his team were voted #1 in the Institutional Investor research survey.
Jon Boylan jboylan@jb-cap.com
Jon Boylan is a global capital markets professional with a 16-year record of trading and selling fixed income securities and
interest rate derivatives for US and European investment banks. He specialises in all facets of the G-10 interest rate markets.
Most recently he was a Director in the Macro Sales group for Dresdner Kleinwort based in London. Prior to that he spent 10
years in charge of USD trading and risk management for Dresdner Kleinwort and Societe Generale in London. Jon began his
career working as a market-maker on the US Treasury desk for Credit Suisse First Boston in New York.
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