Transcript for Ben Davies Podcast
Transcript for the podcast: Ben Davies: Greece is Just a Preview of What's Coming For the Rest of Us
Chris Martenson: Hello. Welcome to another PeakProsperity.com podcast. I am your host, of course, Chris Martenson. And today we are speaking with Ben Davies, experienced money manager and CEO of Hinde Capital, a fund primarily focused on the precious metals and commodity sectors. Given his vantage point from Europe, I have invited Ben on the program to speak with him about Europe’s worsening debt crisis, the recent efforts to bail out Greece, of course, and what it all means for the world economy and for individual investors. We will also address his outlook for gold and silver, of course. Ben, it is a pleasure to have you as our guest today.
Ben Davies: Hey, Chris, I am very flattered to be invited on and I am looking forward to a bit of a to and fro. That would be great.
Chris Martenson: I am, as well. We have had a very interesting pre-conversation here. I am hoping we can surface some of that. But here we are with the recent developments in Greece, and I have just been absolutely astonished at what I have seen going on there with the ECB now crowing about how they are going to make a substantial profit on the bonds that they had purchased at a steep discount in the open market. And those bonds magically are going to be repaid in full because, of course, the ECB spared itself from taking any losses on those bonds and pushing those losses off onto private investors. This is just a very interesting dynamic that is going on. What are you seeing from your vantage point? How is this playing in your corner of Europe? And what is your view of where we are going to go with all this?
Ben Davies: Well, I mean, that is an interesting segue to introduce there. I mean, I think it is fair to say that State intervention is the key word here, and the concepts of self determination and the rights of the individual have been thrown out the window. Clearly, the interesting dynamics of the ECB is that all bondholders and all equity holders, in many respects, should have equitability or they should have equities, so to speak – equality, sorry, that is the word I am looking for. And clearly in this case, they have given themselves seniority. The private sector is subordinate, and I mean, quite frankly, it is disgraceful. Clearly, there is a political expediency going on here. They do not want to denigrate that balance sheet. They, bizarrely, are trying to keep credibility of [the] ECB balance sheet, which has been ballooning monstrously and now stands at some almost thirty, thirty-five percent of the GDP of Europe. And that is an exponential growth, something that you talk about extensively in your book and something we focus on, as well. And I would go so far as to say that this exponential growth in the balance sheet is actually going to a rate of exponential of the exponential. And that sounds like a mouthful, but that gets very frightening because it becomes unsustainable. And politicians and the ECB, they totally understand that in the case of Europe.
But if we just circle back to specifics, actually the ECB, they bought a lot of these bonds around eighty cents to par. So I think they bought around fifty billion, so the value they paid was, call it forty billion. Now, they have – as you say – they started to… I would not say they are crowing about it, but what happened is – because a lot of these bonds are short-term maturity – that actually, you get a pull to par. So as you come into the maturity period, which is March 20th when the redemption and roll over of the two-year bond, actually you are getting that pull to par. So in many respects, with the interest payment that they have received on it, they have made this and amortized this return. Now, they have foregone that as is they want to try and help Greece reduce that debt to GDP to a hundred and twenty percent by 2020. But they have done it at the expense of the – as you say – the private sector bondholders, which, obviously, it rips up the legal framework by which we really exist within financial markets and within the rule of law. And this is really going to be an ongoing process. And a word I would really use, it is financial repression, to refer to this.
At the end of the day, capital is scarce. So governments who need to keep funding themselves in order to keep a welfare state going need to find capital. And they will move at nothing to achieve that. And in this case, they have written off the rulebook.
Chris Martenson: Let’s extrapolate, then. If the situation, if I am now a holder of Portuguese bonds, say, or Italian bonds, I am looking at this rule change that is happening in the context of the Greek bonds. Potentially, it is specific to the situation in Greece. But if I am a private holder of Portuguese bonds now, I am wondering if the same rule change won't be coming down the pike. I am going to be slightly less willing to hold these bonds, meaning I am going to want to sell them, I am going to expect the price to go up. Would you expect this action where the collective action clause has been unilaterally and retroactively applied by the ECB to the Greek situation, doesn’t that extend potentially to other bonds? Will this not just make… Are they not solving the problem in Greece – I am putting air quotes up – "solving the problem in Greece" with this rule change? Are they not just then transferring a larger problem to much larger bond markets?
Ben Davies: Very good question. Not an easy answer. I am going to try to answer it – best efforts. But I would say it is very specific to each country and it is very specific to what positions are in the marketplace, not only by investors, but banks. In the case of Greece – so let’s use that as an example – a lot of people have been under the misinterpretation that ISDA has not wanted a credit event to take place there. That is not the case. The market has been pricing it on these two years, which are maturing, to your Greek bonds, which are maturing on March 20th. They have been pricing in with the package, which is your longer two-year Greek bond and your long, some credit default swap on Greece. That package is known as a basis. And the probability assigned of a credit event is ninety-three percent.
Now, that is an interesting dynamic, because clearly people get paid out. The private sector has been holding out in the voluntary debt restructuring because they actually want the credit event to take place. They want to get paid out on the credit default swap, and clearly they make more money in that scenario. And the market is pricing that. And also, I would say about ISDA – seeing as I bring it up – is that ISDA, there are five banks effectively in charge or a committee in charge of the credit default swap market and the derivatives market. They do not want to ruin that market; the CDS market and the derivatives market is a big market. It is a big earner for the banks, and it is what is part of keeping this whole casino credit going. So there is no way they want to endanger that.
So I think people who have been talking about ISDA not wanting a credit event in this occasion are barking up the wrong tree. So I digress slightly, but I think it is pertinent to this, because it then comes down to what are the positions at any time for participants in the private sector.
So actually, it kind of flies slightly in the face, I was saying, about the ECB in terms of the hedge funds. They have not lost out in this at all. They have positioned themselves smartly. But certainly, I think it is very unfair on the Greek banks that they have to experience such a debt restructuring. They get a haircut when the ECB does not. And certainly, that applies to any other banks who have had Greek bonds. But to be fair, this can go on for a long time, and positions have been pared down over that time.
So in some ways, I hope I am answering your question. I think it is very specific to each country and who the holders are, whether it be the private sector or the public sector, clearly a lot of peripheral debt is held, has been held with the public sector, i.e., the bank – sorry, the private sector, banking sector. And it has been paramount for the ECB to make sure that that system does not implode. And so they introduced the LTRO for three years as a mechanism by which they could effectively keep these banks afloat and so they would allow them to fund themselves on an ongoing basis.
Now we have had one LTRO, which is about five hundred billion. We are going to have another one, which I suspect will be bigger, because I think that with all the downgrades we have seen recently, we are going to see actually more collateral will have to be put up by the bank. So I think some of the people will take this free money with all the hands they can get on it. They will grab it and put it onto their balance sheet. It was a very clever piece of work by the ECB because ultimately it stabilized the system, just for the medium term. Because now they have an inordinate amount of liquidity. And as I say, it is for a three-year period. But unfortunately, it just kicks the can down the road. What happens in three years’ time? Does the ECB have to roll over, give back all the toxic assets it has taken on in return the cash? So all that is doing is paving over the cracks in the short term. I hope that answers your question.
Chris Martenson: It does. So I am interested in this kicking-the-can-down-the -road phenomenon. Because as I look at it very specifically again, what the IMF is projecting for Greece and how it gets down to a hundred and twenty percent debt to GDP by, I think, 2020 or somewhere around there. They have them returning back to reasonably nominal two, two-and-a-half percent growth, starting next year and carrying forward. What happens to all of these debt rescue plans if it turns out that the signals that I am reading in the world right now say recession is again stalking the global landscape and certainly visiting Japan, it is visiting parts of Europe at this point in time. How does recession and the debt rescue plans, how do those two come together?
Ben Davies: Look, as I think we are both agreeing here, they are trying to buy time. I think I may first step back here and paint a bigger picture, which is the fact is that we are going to have a cataclysmic end to this. The mathematics does not add up. You have talked about exponential debt trends just as we have and at this point, if the policy prescription is more of the same, you will see that from 2007 that actually we have not deleveraged at all. Actually, the total credit has increased as a percentage of global GDP. Part of that is the common denominator has gone down to over a little bit as the GDP has fallen. But actually, total credit has expanded quite dramatically.
So what does that mean? I have forgotten what you asked me.
Chris Martenson: You are going exactly where I was hoping we were going to go with this. Which is, we started by looking at Greece, and there are some nice specifics there, and we can talk about what is happening in the credit market, specifically, and specific policy tweaks that are being done or whatever the ECB is doing with the collective action clause. This is useful… In microcosm, Greece is a useful way to get at this larger issue, which is what I am really interested in. Which is that if we look at Greece and we try and pencil it out, it just does not add up. Mathematically, there is a problem in Greece. And the problem really centers on the idea that Greece, like much of the developed world – the United States, Japan, OECD in general – has been growing its debts far faster than it has been growing its income. And we have been enabled in this, I think, with the abandonment of the gold standard in 1971, and there has been really no tether. Just it was sort of convention, I guess, in an agreement as to how much we were going to allow ourselves to grow our debts. Well, eventually, that pops, right? A credit bubble always finds a pin at some point in time. Potentially that was in 2008 with rising oil prices. It does not matter; somehow it found its pin and started to collapse.
And so here we are today and looking at Greece. And for me as an outside observer, I cannot make the math work. Somebody is going to have to take extraordinary haircuts and losses on that. And again, Greece, just a microcosm for what I think is a larger systemic problem, which is that we are going to have to take some pretty extraordinary losses across the whole system.
Against that, all of our fiscal and monetary authorities doing everything they can apparently to just paper it over, patch it up, keep the system going, status quo sorts of solutions. But from your perspective – I know you have written about this to some extent – that really, we have to get right into the center of this and look at money itself. The fiat money system, the process of credit creation, the degree to which we, in essence, are fooling ourselves by borrowing from the future on a constant and increasing rate. Are we not, at heart, talking about the idea that we have a systemic problem that needs to be addressed that is really going to be immune to whatever sort of minor policy tweaks can be envisioned, which is really that, to me, is the story of Greece. It is an attempt in small ways and with whatever agreements and sorts of complexities can be dreamed up, it is really still avoiding the larger issue, which has to do with our money system itself.
Ben Davies: Wow. You answered the question for me, I think. But yes, I think it is systemic. I think the monetary regime that exists today which is – let’s face it – has been around for forty years. It is a paper currency system, which means by decree of government, and when we say paper that has no backing to any real assets such as gold or silver. So when we say by decree of government, we mean that you have to pay your taxes, so it is your money.
And I think that really when you talk about Greece, we get lost in the minutiae about tax and collective action clauses, etc., etc. But really, we need to go to the bigger picture and perhaps get – seemingly existential for some people – but actually, we have to understand what money is. And money is created through the debt system. It is created out of thin air. A central bank or the Federal Reserve Bank, for example, creates money on the liabilities side of the balance sheet by buying existing Treasurys off the US Treasury itself onto the asset side. And as an accounting procedure, it puts down some paper money, on the liabilities side against it. That is how you create money.
Now, money creation is one methodology. How does that get into the system through something called fractional reserve banking? Every pound we hold on deposit is lent out multiple times, maybe the base is ten times. Now, this is a very insidious situation, really, that unfortunately, human beings cannot be trusted to keep it at appropriate levels of lending or borrowing. And why is this? Well, if it goes all the way to government, whereby effectively, a democracy starts off with all the right intentions. But if it is predicated on a fair currency system, eventually – in order to get re-elected, welfare will be paid for, wars will be paid for, other Social Security and Medicare/Medicaid as you have in the US, healthcare – will all be provided for. And they will buy their way into election.
So obviously, each year the debts just keep going up and up and up and up. And obviously, there is a servicing to that debt. But eventually, the math does not add up, and doubling rates – as you talked about in your book – is exactly what goes on here. At some point, we actually create so much debt that we are not able to service them.
And today – although we talk about Greece at this particular point – the reality is we have actually hit a debt saturation for the entire world. Now, we have had other situations where, let’s say, Argentina or Russia have had similar situations, perhaps even far worse. But they have been in isolation, so there has not been a systemic fallout. But this time, we actually – I believe – we have got to a situation where rather like, if you take Zimbabwe, Zimbabwe is a microcosm of the world. We actually had hyperstagflation there. We had debt deflation, as we are seeing now. And in order to really try and offset that, they primed the printing presses and they specifically printed paper. The only difference today in the US, the UK, Japan is that they do something called quantitative easing, which is a euphemism for printing money electronically. And quantitative there and qualitative, they are expanding balance sheets at the central bank and also, in this case, I would argue they are denigrating the quality of the balance sheet because they are actually taking a lot of assets at par that are not worth par.
So this is the difference today is that it is a global phenomenon in which case, we actually have a situation where capital is scarce. So every nation is trying to get capital. So this is going to lead to a lot of friction – not only domestically, but internationally. You can see that not only is the private sector being crowded out, but actually, sovereign to sovereign is getting crowded out. And herein lies the problem, and herein is why each central bank is having to step in.
Why is the UK printing inordinate amounts of money? Why is the European Central Bank printing inordinate amounts of money? Why is now Japan started again printing so much money? And actually, I mention Japan and that is interesting. They printed constantly after their credit induced bubble that collapsed in 1989, 1990. And they have been in the mire for over twenty years now. And everyone said, oh, well, we never saw inflation in that country. Well, guess what? Because that was in isolation at that time, the rest of the world was doing just fine, thank you very much. This was a very specific credit-induced bubble. The problem there is they exported inflation to the rest of the world.
Now we have a situation where every country is effectively going down the same routes as Japan and most are following a similar policy prescription, as you can see. Well, Japan is a thirty-trillion size economy, and they definitely have hit the tipping point. They are twenty years down the line. So they are the one to watch, where they cannot service their debts anymore. And if you notice, the Bank of Japan is just back in announcing that they are going to have to ramp up the size of their balance sheet. They are buying JGB, they are buying REITs, they are buying everything but the kitchen sink. They are not trying to tacitly inflate that system. Well, if the whole system is trying to do the same thing, I have to say that once you have debt deflation on one side of the coin, on the other you have gross monetary inflation.
So all those factors that have a finite supply – whether it be oil at the margin, whether it be gold at the margin – and I say at the margin because demographics are rising globally. As you wrote in your book, we have gone from three billion by 1961, and from 1961 to 2012, we have gone to six billion. That is an exponential rate. So there is a strain on resources. And it is not that we are running out of resources, perhaps, in the next millennia. That is not the point. It is the cost, in my mind, of extracting it and making that timely.
So in an era of just-in-time inventory, this is going to put pressure on the price of goods and force them to go up, especially when you are increasing more of the numéraire against a dwindling or not-so-readily available supply. And that is when you get hyperinflation. So people who are calling for debt deflation or hyperinflation, I think both can happen simultaneously.
Chris Martenson: Well, it did happen, as you mentioned, in Zimbabwe, where I have heard people say inflation is really in check because look at capacity utilization. You know, until capacity utilization, the factory really ramps up. We are not going to experience inflation. But in Zimbabwe, I believe, their cap utilization was down to ten percent, even as inflation was in the millions of percent. So you clearly can have a disconnect between those. And this means that, in my mind to widen that out, very interesting time in history right here – anything that we might have formed as opinions or ideas or beliefs around how the world works over the last twenty years, we might have to crack that open or even chuck it out the window. Because here, what we are facing now is –widen it all the way up – we have to ask the question, well, really, what is wealth? Ultimately, money is a marker for wealth, it is not wealth itself. And what it is making markers for? Well, it is the stuff we need, the stuff we want. And as you noted, global supplies of critical resources are strained at the moment in time – China now consuming half of the world’s coal, I believe, last year, and shooting upwards from there.
With other critical resources, maybe we can find ways to adjust and to produce more of these resources for a period of time – maybe decades even – but not in all cases and not in all circumstances, with, for me, the standout story being oil. Very mysteriously, we have not managed to increase production of regular oil – I will call it conventional crude oil – since 2005, despite some very nice hefty market pressures and pricing that it would really encourage, you would think, quite a bit of production.
And it is not just oil itself. We have to look at the different grades. It is light sweet is what the world wants. We seem to be in short supply of that. Plenty of sour crude kicking around. And this is what the data is suggesting to us at this point. And so from my perspective, I see a world where real wealth represented in real resources with the absolute cornerstone of that story being oil – particularly the grades of oil we want – sitting right there in plain sight. And all the central banks just blissfully unaware of that, apparently, and cranking the printing presses because their model says if we can just create enough liquidity, the economy will grow again. It seems like a colossal set of forces that are lining up on two sides of the field here. I am going with reality and oil as the potential winner of this match. How do you see it?
Ben Davies: Well, you know, I think you bring up some pretty pertinent points. I think we are on the same page here. I do think that people will say that obviously productivity will improve, and as a consequence, some of these energy sources will be made more readily available more quickly. And I think that is the pertinent point. But you are up against a very challenging demographic. Obviously in the developed world, we have collapsing demographics in terms of aging demographics in parts of Europe. You have got this monstrous growth happening in the Asian economies, particularly. And as we have already highlighted in just talking now, we just talked about the exponential growth, worldwide growth. Clearly, that rate comes into conflict with the rate of productivity. And for me, that is really the big issue.
Now, I think we are hitting a perfect storm, unfortunately, where you are having inordinate amounts of money created electronically around the world in order to maintain a monetary regime that is clearly beginning to fail. I am under no illusion that this is the start of this particular regime failure. I have seen in history that it is amazing how governments can often band together ultimately to keep the illusion. But I think as people are now really beginning to assess that validity of credit on what – as you have talked about – what is wealth? And, what is the value of my daily labor? Well, guess what? You know, it is really under threat when I see that it is being debased every day. So how do I impute what a value of oil is? How do I impute an ear of corn? What is the value of that when you are constantly changing the yardstick or the currency or that numéraire? That has become the very difficult aspect to ascertain.
And so clearly, we have got this very interesting dynamic where you have got positive demographics and you have just an inordinate amount of money being primed into the system. And they are at odds with each other.
Now, the feedback mechanism there, clearly, for oil, is actually, works as a tax on us in terms of traditional economics as the oil price rises, because we are still so heavily dependent on it worldwide. That actually has an impact on our disposable income.
Now, even if we start talking about replacement energy – natural gas is obviously the… clearly, shale gas, etc. – these are alternatives and I can see that there is a major disconnect between what the price of European gas is and US gas, natural gas. And I am sure that as they realize, find more sophisticated or clever ways to transport liquified gas around the globe that price will move up. So again, all the time, I just see that there is a constant strain.
Now, I know you are rightly fascinated with energy dynamics and I think what they have are hugely pertinent, even in our lifetime. But for me right now, as a fund manager, I am just concerned with trying to preserve wealth for my clients and for myself and for my family. And markets are so distorted today that I really throw my hands up in despair. I cannot with any conscience put people into bond markets, because they are effectively – and wholeheartedly – run by the financial system, which is now run by the government, the US government buys US bonds. The UK government buys government bonds, they buy MBS.
So what we are seeing here in reality is interest rate premiums are being squeezed lower. So interest rates are being set at face value that is really not reflective of the true marketplace. Interest rates are based on human preference of where people want to lend or borrow. And the reality is, when they are so artificially low, it distorts the whole term structure of financial systems.
So to just extrapolate that all and extend that thought process, look at equity markets at the moment. It is just incredulous. They seem to be rallying – I call it the Reluctant Rally, because most people are not invested at this point because there is just a huge disconnect between the credibility of what is actually happening in the real economy, which is effectively events in Greece and people are losing their jobs. Aggregate demand is falling. And globally, there are issues in China. It is not just even that economy is really starting to – I would say – starting to slow down, grinding to a halt, and its terms moving from ten percent GDP down to seven percent GDP. It is a material shift. So things are slowing down considerably around the world.
So I think that you have this dynamic where for equity markets, they are rallying, because the discount rate – which has been set by bond rates, which has been set by government – is artificially low. And so that discount mechanism is driving equities higher, that debasement of the currencies are underpinning these equity markets.
Now at times, you get this risk-on-risk-off. And the reason why we are seeing such high correlation between asset classes is that very reason. The term structure is being shriveled to a very low yield, which effects all markets converge to a return or a yield or a productive asset. And really, when you go to the zero bound, every asset class ultimately moves towards that. So axises [sic] are rallying to such a point in which there will be a zero yield return for you. Likewise, bond assets have gone to actually, they have now gone to a negative yield. So it is absolutely just, for me, there is absolutely, I know I am going to lose not only capital but after inflation I am losing three, four percent. Or whichever bond market in the developed world that I want to invest in.
This is the insidious part of the financial system for me right now, which is what do I turn to? How do I grow my business for my investors? Well, unfortunately, I just keep coming back to gold, which protects me in an inflationary environment and it protects me in a deflationary environment – probably more so because it has zero risk of default. And that is a really important point for me.
Chris Martenson: Absolutely. And so in gold, I assume we are talking not ETFs but physical gold or something where… I guess where I am going with this is MF Global, that debacle really sort of changed my perspective on the safety of assets and whatnot. So a bird in the hand is worth two in the bush, I guess. How do you invest in gold in this particular landscape?
Ben Davies: Well, you bring up a very interesting point, MF Global, and I just want to address that before I talk about ways of investing in gold. But something that we have not talked about but is at the root cause of the problem with our financial system today – fractional reserve banking and excessive credit spending beyond just central bank money creation is the concept of rehypothecation. And clearly, what has happened with – and well, I should probably define what rehypothecation is or I should say what hypothecation is. Hypothecation is where a borrower pledges collateral to secure some debt. So i.e., the borrower retains ownership of that collateral. But obviously, hypothetically, this is controlled by the credit group. A good example would be, I guess, consumers enter into a mortgage agreement, for example, in which the consumers house becomes the collateral until the mortgage loan is paid off. So that is hypothecation.
Rehypothecation is the practice that occurs in financial markets and I think, to some extent, first came to everyone’s attention with the Lehman debacle and the repo 101s. This is where the banks or a broker dealer can reuse that collateral that has been pledged by a client. And they can reuse that collateral as collateral for more borrowing. So this is what’s happened in the case of MF Global.
And interestingly, talking about, we just talked about income and yield. What were they trying to do? Corzine was an ex-Goldman Sachs individual. He was trying to create an income statement just like Goldman Sachs does, which is borrow in the short-term, lend long-term, you get the yield curve pickup. Now that yield curve has been narrowed. So he had an opportunity to purchase high yield and peripheral debt on the belief that he could… that the ECB or governments would step in and save the day, as we have to some extent. You know, they bought them that significant discount, they get a yield so that the likelihood of a default is already priced in to some extent. So they have got some cushion there. But all the time, there are earning that yield and that pull to par, except they were using collateral that had already been placed by clients and placing that as collateral to borrow more. And so you can see the insidious circle here.
MF Global is, again, it is a microcosm but it just exemplifies everything that is wrong with a credit-based system, the whole rehypothecation process. But what scares me most is how much collateral has been pledged and where it has been pledged. It is almost impossible for us to ascertain that – very, very, very difficult.
And that brings you on to the whole layer of – I think you called it part of your tertiary wealth. Well, I would not call this wealth, but all the credit derivatives are out there. Everyone talks about netting. And sure, you have banks that have now, if they have got shorter swap and longer swap, they have made sure that it is with the same counterpart to try and reduce some of that risk and they do not have to put up as much collateral. Well to me, it is the growth risk is really the most frightening element of it. That exponential growth in derivatives which, by the way, has just ballooned since 2007 because it has really been the only way to try and keep the deleveraging from taking place, and the consequence of which would be a collapse in aggregate demand. Clearly, it would just be default process right across the board – corporate, at the retail level, etc., etc.
So you have had this constant buildup of the credit market, and we have now probably got over a trillion worth of derivatives, I am sure. That, to me, is a great example of a complex system. And from what I can see in nature, complex systems, you sow the seeds of their demise within the buildup of that structure.
You know, for example, there is a great book by chap called Sornette, a physicist, and he talked about stock markets crashing and how we could predict them. Now, he actually predicated some of his predictions on behaviors that happen in nature. For example, Ariane 4 and 5 rocket ships that they have these… they kept rupturing. And it was actually the Kevlar bonding matrix that they used. Actually, the way it bonded together, it almost bonded in an imitative behavior like we get imitative behavior in markets. And that ruptured and just very minor fissures and then under severe stress, they would blow up.
And that is really very analogous to what we are seeing today except you can see the imitative behavior that we are all following the same, we are all herding in the same way in terms of how we are being forced to borrow at lower and lower rates. Because that is the only way we can service our own mortgages, etc., etc.
So we are constantly reinforcing the system until such time as, let’s say, the main buyer has to stop – i.e., government – and then what happens? Who is the buyer in the bond market then? What happens when people go to sell? There is no buyer. The system collapses. Rates will go through the roof, people not being able to service their mortgages. Does that articulate the cataclysmic element of markets today?
Chris Martenson: You know, a couple of very important concepts in here. One, that our system obviously is a complex system – the economy, the financial system – is a complex system, which is interesting to hear that Sornette believes that you can predict these things. Something we do know about complex systems is it is not that they are fully unpredictable, so waves crashing on the shore, we know that these are a complex system. But you can be pretty reasonably certain if there are three-foot waves coming in, you will not see a twelve-footer in the mix. But within that boundary, it is impossible to predict how each wave will individually break.
So we have a complex system. I think that to even a very, very close observers such as yourself or anybody who is in the system, you just peer into it and you go oh, nobody really understands how the whole derivative market is fully put together. And certainly, if that escapes the architects of it, it has got to escape, say – I do not know – your average ECB bureaucrat who is trying to manage within that system.
So I believe that there is a general feeling of angst that we have got this large, exponentially growing complex system. Nobody quite has their arms around it. We do not exactly know what it going to happen – when it might break or what the trigger would be. But we have a sense that it cannot keep just growing forever. And you have articulated, thought, there are these risks, there are these strains, there are these pressures that are being placed upon it that the derivative market is now larger than when the crisis started. That I think we are looking at overall debt levels are actually now, in aggregate, larger than when this crisis started. The complexity, if anything, seems to be greater – not lesser – than when we started. So these are all just sort of risks.
And in the context of that, how do you do your job? How do you preserve or even grow capital during this tumultuous period? And specifically, how do you invest in gold given what we just talked about with the hypothecation/rehypothecation scandals?
Ben Davies: Well, I am going to answer that second, and remind me to answer that second. But I want to address the… We actually wrote a piece called Silver Criticality. And we were able to ascertain actually using Sornette’s work and some of our own work on fractals, actually quite basic concepts of you have something called self-similarity. An example would be when you magnify on a snowflake, at every level they look the same. We call this scale invariance or self-similar. Now, it was very clear that you could see imitative herding-like behavior occurring within the silver market. And the point about just before a crash is actually the preceding months, years leading up to a critical change in the state of the market, for instance, its endogenous. You can see it building and you can mathematically predict it. Now that is an example of a complex system where we can predict it.
I think the difference today is that not one person on the planet, in my opinion, can really ascertain every asset or derivative out there so that they can make a mathematical probability of when it will happen. And that is the difference.
So I could say that overnight we could have a trigger that would catch us and we would think it would come out of nowhere. But clearly in hindsight, we will be able to say well, we saw the endogenous effects of buildup of credit, etc., etc., etc. It was clearly going to happen. An example would be something that just happened recently, the downgrade of all banks. Now, it was not news to market participants. In many ways, it was already priced in the market. The market is reasonably efficient.
But actually, you have unintended consequences often arise within complex systems. An example in this case would be you have provisions within derivative contracts from one counterparty to another – not bank-to-bank – I am talking about a bank to a pension fund. Where the pension fund now can come back and say hang on, you have been downgraded. I need more collateral or I am going to reassign or just tear up this swap agreement. So it is an immediate loss for that bank.
Now, that is the kind of behavior that I have started to hear about recently, only in recent weeks. And before you know it, that snowball effect… And a good example is that [grain] of sand on the larger slope of sand that suddenly – inconsequentially, but very catastrophically – sends the slide down the mountain, you know, an avalanche. And you do not understand why it is that particular grain. So there is this whole buildup.
So to me, the system is very free-for-fall and at any point, it can collapse. So this comes back to what do we have to do as human being in terms of protecting wealth? And you did a great job in your book, and this is a book I wish I had written. I think it is a beautifully written book and you have managed to not only assimilate and disseminate a lot of information in a very concise manner, but I think you have addressed very eloquently some key aspects, which is, you know, how do you define wealth. And I am not going to label them off, but primary, secondary, and tertiary wealth.
But I have also… Wealth for me is not just how I value my day’s labor. Wealth is also connected to my relationships. I believe fundamentally – outside of being a fund manager – that I need to have the ability to be self sufficient, I need sustainability. In many ways, I need to make sure that I achieve the first stage of Maslow’s hierarchy so I have food, shelter, fire, etc., etc. And then I go up the levels and maybe the second one is, I think I believe it is safety, second stage. And part of safety for me – and this is where I see gold – physical allocated gold is, by definition, outside the constructs of the financial system. It comes from primary wealth, it is dug out of the ground. So it is a resource that cannot easily be created, and that is a very key thing in regard to why it is a great protection against inflation. You cannot produce inordinate amounts of it, and arguably, there is a finite amount.
But as importantly – and probably more importantly for me – is that it has no default risk – particularly in a credit environment where there clearly is debt deleveraging going on. Now I could lose my capital. I cannot lose my gold. And I will not lose my gold if I hold it within an allocated form, which means it is in the name of the holder.
Now, as a fund manager who hopefully believes that somehow we will get through this unholy mess and the system will survive, I am going to continue to ply my trade, because that is how I earn my living. And I want to protect my clients and myself; my family’s purchasing power.
Now, one thing I want to be positive. Despite looking at the math and despite the fact that I think the system is going to be a huge monetary regime, it is completely possible this can spin out over decades. It is amazing how government can obfuscate the situation. And perhaps we can come back to talking about financial repression and how I think they can do that. It is completely possible we can spin this out much longer, but then, that is not my best case.
But in the interim, I want to be positive. So I want do what I think is right by investors which is – for me – running a gold fund. And we store our gold in allocated form, and we try and create a return in excess of the gold price. We do not need to go into how or why we do that, but we have managed to create a return of, I think it is fifteen percent annualized above the gold price, which we are very proud of. And I definitely feel that I am doing a more worthwhile job than sitting there as a bond trader as I was once, perhaps, a decade ago.
Chris Martenson: Well, fantastic. I would be interested to hear more about that. And of course, I think people could go to your website at Hinde Capital and explore that more if they are interested, and I am interested.
And you also focus on commodities in general, and I was intrigued noting here that some of the earnings reports I was just sort of checking out – Kraft, for instance. So Kraft sells a lot of food items. Their sales rose because prices went up 7.6% and volume actually fell one and a half percent. Go figure. You know, rising prices ended up having a softening on volume impact. And they had price increases in all kinds of categories. By lunchmeats, they actually ended up offering smaller sizes to address the sticker shock people were feeling. And in others like bacon, they nearly doubled the price because of cost spikes but then, of course, sales struggle. I mean, this is serious. We are talking about bacon now. And I am looking at all of this and I am seeing inflation coming through very clearly in a lot of the reports I am reading.
It is not coming through in the official statistics, of course. And you mentioned that gold will do well in an inflationary regime, and even probably better in a deflationary regime, because of how it will protect against that default risk, meaning it is an asset you can count on, which is a pretty dear asset indeed when the system itself is struggling.
So as you look across the landscape, are commodities and gold, are these a way to just sidestep what is going on as we wait for happier times? Or do these have another story in there, as well, which is related to, I guess, what we were talking about before with seven billion people on the planet and potentially limited and limiting supplies of critical items. How are you approaching commodities right now?
Ben Davies: Yes, it is very interesting. One, I agree with you that clearly, report statistics bear no relationship to the reality. I would say in the UK at my personal run rate — and I consider myself a pretty average middle-income individual, contrary to what people might think about hedge fund managers earning vast fortunes – we ply an honest trade. I have an above-average income perhaps but nonetheless, I have very similar outgoings to most people in this country and obviously, my inflation rate is nearer ten percent, absolutely. And obviously, the old games of reducing packaging have been going on for years and keeping the price the same, and you know, it is just scandalous. And I think people have caught onto it to some extent, but there is not a lot they can do about it.
I actually feel very strongly that my wealth really should be assigned with gold, because I believe that to be my true operational wealth. I personally do not hold commodities. We just wrote a report, actually – it is on our website – called the Myth of Commodity Diversification. And I think that in classic portfolio management that – particularly within a fiat currency system – that actually, commodities are not a very good way to diversify your portfolio. You know, this is we are strictly talking about portfolio management. I have to be clear here.
So I feel that I have to have a large holding relative to if I have equities and bonds portfolio, which actually, I do not. I have a large proportion of my wealth – I would say eighty five percent – in physical gold because I believe that is true money. And I believe that despite people like Buffett, who is an incredibly erudite and smart individual, I – unlike Buffett – just because gold has no seeming yield, I actually think it keeps up with the rates of money supply. In fact, it is actually undervalued relative to the monetary base because it is only backed at fifteen percent. To give you a clue, in 1981, that backing was a hundred and forty percent, which is when we knew gold was overvalued.
So today, gold looks extremely undervalued relative to the monetary base and, effectively, the leverage that has been created in the system. So it seems like a very cheap way if you just want to participate just from a capital appreciation perspective. But for me, I do not look at that. I just look at it as a means of protecting my operational wealth. I also can use it much more readily. If I go and buy a basket of commodities at a firm, to be honest, I have got counterparty risks right now I do not want to be putting myself at risk because I believe that we are ensuing debt deflation and we have not even begun to seeing the deleveraging yet. So I do not want to take on that added risk. At least I feel that I have a physical ownership. And I am – with my partner – one of the largest shareholders in our fund. So I am heavily aligned. So I feel that the structure that we have, it is very sound because we have physical gold held in a Swiss vault in a private bank. So it is outside the investment banking system and that is very important to me.
And some people say to me, well, don’t you need to own it in your house or in safety deposit boxes? And I do not feel that, because at my core, I believe the system will ultimately continue to exist, although in a bastardized form, and hopefully, it will have a new beginning whenever that will be. But I think you will be amazed at how society continues – even under the extreme duress. You just have to look at Latin America. You know, I just talked to a lot of the businessmen there and how they coped with hyperinflation. They continue to run their businesses. They just manage their billing system and their receipts and they made it work for them. So it is amazing how ingenuous we can become.
So I think the system in… I don’t think that banks are going to be falling whole-scale, partly because, actually, transactional banking will continue. It is just that what you are transacting will not be worth anything.
Chris Martenson: Well, fantastic. This is all the time we have for today. I want to give people an opportunity, though, to find some very nice writings you have on your website. How do they get there, and are there any pieces you would direct them to?
Ben Davies: Well, if you want to understand gold, I would read a piece called Gold: The Currency of First Resort. If you want to understand the relationship of the State and how they are trying to conscript capital and the solution that we propose for the monetary system, I would look at something called Monetary Singularity. Actually, I think it is called Singularity Transcendent Money on the website. It sounds a bit pretentious and it is not meant to be. And I gave a speech on this and I was thankful that afterwards everyone said oh, you know, I thought that was going to be really pretentious, but it was not, it was spot on and I felt very relieved about that. Because I think very easy for us to overcomplicate and be over-verbose, as often I can be. But this is actually a very simple subject matter.
But you can find that at our website and it is called www.HindeCapital.com and Hinde is H-I-N-D-E Capital dot com. And thank you for that plug, I appreciate that.
Chris Martenson: And thank you so much for kind words about my book. Obviously, this conversation could go on a lot longer, and I hope to do that at some point; particularly there are a number of subsectors that we opened up that we did not really get to address. There is so much to discuss here. The system itself needs to be understood, and then within that, how do we operate and maneuver given what we know? And by the way, what we know changes – for me, at least – almost every week now, as rules get changed, as new things are revealed, as data becomes into sharper focus, and as we learn more, and as the various players are maneuvering around. It is a very interesting time. And I think for me, the lesson is, I am both hunkered down and extremely alert. And I am like – I am hunkered down, and my gold holdings are about seventy five percent of my core holdings right now. And at the same time, I am just remaining as alert as possible to all the things that are just changing daily, it seems at this point.
Ben Davies: You know, I would echo those words. I think being alert is key. I mean, one thing I would say as we sound off – or sorry, round off – is that really unfortunately, a credit-based system or a fiat currency system where the welfare looks after so much of your needs, what tends to happen is that we have effectively had responsibility for ourselves expropriated from us. So I would say the most important thing for myself and my family and hopefully, people will echo this who are beginning to understand something is that you have to take responsibility for yourself. And that involves providing sustainable resources for yourself. And when I say sustainable resources or wealth, I mean by that, that can be social wealth, that can be gold holdings that protects your day’s labor, and obviously, being self-sufficient because we have just-in-time inventories and that really is an issue; we need to be able to fend fully for ourselves in terms of food and shelter. And that is not to be doom and gloom at all. I just think that is very sensible insurance.
Chris Martenson: Absolutely. Prudent, prudent, adult-sized responses to what is a very uncertain time. And the cost of doing these things is not high. The social cost might be for some people; it feels weird and awkward. But the physical and financial cost is not typically all that large. To me, it is like an incredibly cheap insurance policy, you know? You pay a dollar or a pound to get ten thousand of coverage. It just seems very reasonable.
So that is all the time we have today. Ben, thank you so much for your time. And it has been just fascinating and I look forward to doing it again.
Ben Davies: Thanks very much for having me on. Cheers.