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Delusions A Minskian roadmap to the next gold mania

(44) 20 7762 5872dylan.grice@sgcib.com

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Q In 1965, concerned at the inflationary policies of the US and the attendant threat to theirdollar reserves, the French central bank started converting their dollars into gold. This set inmotion events which saw the central banks of Belgium, the Netherlands, Germany, andeventually Britain doing the same in 1970. By 1971, the Bretton-Woods system, by which allcurrencies were pegged to the dollar and the dollar effectively pegged to gold, had broken.The French had fired the starting gun for the great 1970s bull market in gold and silver.

Q It s worth pointing this out because central banks aren t known for their investmentacumen. Some commentators have mockingly suggested that the Reserve Bank of India srecent decision to buy 200m tonnes of IMF gold signals the top of the market in the waythat heavy selling by the UK signalled the bottom in 1999.

Q This is cute. But I think it s wrong. Like today, central banks weren t buying gold in thelate 1960s to prop it up, they were abandoning attempts to prop up the dollar. Gold feelsfrothy today, but the Indian purchase of IMF gold eerily parallels the French purchases ofthe late 1960s. And ill policy winds are blowing in its favour. With the precious metalsconsultancy GFMS estimating that central banks will be net buyers of gold for the first timesince 1988, have the Indians just sounded the same starting gun the French did in 1965?

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1968 1970 1972 1974 1976 1978 1980

Central Banksstart hoar ding gold

First oil shock

Second oil shock

Gold mania

Source: SG Cross Asset Research

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Gold has rallied considerably in recent years, but the monetary base has grown even faster.So a better response to Mr. Buffet might be that you should buy gold because it s cheap

If my valuation of gold strikes you as a desperate attempt to value something which can t bevalued, it s no different from metrics such as the market cap to clicks or ARPU ratioswhich were used in the late 1990s during the technology bubble when demand for bullishvaluation analysis mushroomed. They seem crazy now but speculators bought into them

during the tech craze. And there may well be a bubbly parallel ... Charles Kindleberger,drawing heavily on the work of Minsky, outlined the following anatomy of a bubble .

Stage 1 sees displacement . Frequently, this comes about through the introduction of a newdisruptive technology (e.g. canals, railways, or the internet) although Kindleberger says itdoesn t necessarily have to come from such an innovation. It can arise on the back of greatermarket liquidity through, for example, financial deregulation.

Stage 2 is the boom. A convincing narrative gains traction (e.g. Asian economies aremiracle Tiger economies; the Internet will change the world; sub-prime mortgages help

financial institutions diversify risk). Price movements which seem to confirm the narrative arestoked by credit creation.

Crisis Euphoria

Revulsion Boom

Displacement

Source: Kindleberger, SG Cross A sset Research

Stage 3 is euphoria. In the words of Kindleberger, there is nothing so disturbing to one swell-being and judgement as to see a friend get rich. This greed sucks people who wouldn tnormally involve themselves in such practice into the mania. More and more people seek tobecome rich without understanding the process involved. Rationality becomes stretched andincreasingly fanciful notions excuse what would ordinarily be considered irrational behaviour.

Stage 4 sees the crisis. The insiders originally involved start to sell. Prices level off and beginto fall. Those who bought at the top find themselves pushed out first and their sellingeventually cascades down through the remaining believers. Speculators realise prices can nolonger rise and the rush to exit is on. To the extent that leverage was used to finance any

purchases at irrationally overvalued prices, savage price declines put banks in trouble too.Stage 5 sees revulsion where prices likely overshoot fundamental values on the downside.Scams and frauds are uncovered. Scapegoats are found for the financial distress caused. The

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object so richly desired as the bubble inflated becomes an object of ridicule and disgust,along with anyone or anything associated with it.

With this in mind, consider the parallels between the 1 st and 2 nd phase of the 1970s goldmania with the situation unfolding today. Then, the displacement was the collapse of theBretton Woods system, precipitated by central banks, distrustful of inflationary US policiesbuying of gold. This is very similar to what we are seeing today. Then, the liquidity turningdisplacement to boom came from central bank accommodation of the oil shocks. Today,

central banks are monetising government deficits to accommodate the recessionary effect ofthe credit crisis.

Then the convincing narrative was that with the Middle East controlling our energy fromabroad and aggressive trade unions rampant at home, policymakers were no longer in control.Today, the perception of central bank infallibility has been permanently ruptured by theircollective failure to see the 2008 crash coming. Nagging concern at their over-willingness toinflate, at the blurring of monetary and fiscal policy and over long-term government solvency(see chart below) gives traction to a similar narrative today.

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Germany Spain France Italy UK EU US

Official Net Debt, % GDP* Tot al net liabilities (on and of f balance sheet), % GDP**

* 2010 OECD pro jectio ns** 2005 estimates of to tal Fiscal Imbalance

Source: SG Cross Asset Research, OECD, Gokhale (2009)

On the Kindleberg-Minsky map as I ve drawn it, therefore, we ve had the displacement and

are only now entering into the boom phase. The mania phase lies well ahead. Who knowswhat unknown unknowns might parallel the two oil shocks of the 1970s?

The top of the gold bubble occurred when politicians won a mandate in the late 1970s/early1980s to take painful decisions, to take on the trade unions, and to raise interest rates totackle inflation. Only then, during the crisis phase did scams such as the Hunt brothers attempted corner of the silver market come to light. The parallel today would be governmentswinning a mandate to take the difficult decisions ahead on health care and pensionentitlement, or even climate change. And who knows what yet-to-be-conceived frauds await?

But that is a long way off. Governments only won such mandates because by the late 1970s,the inflation fatigued electorate was tired of lurching from one crisis to another. We reseveral crises away from governments winning similar mandates. In the meantime,displacement has happened, liquidity is plentiful, and the compelling narrative is gainingtraction. Oh, and gold is cheap ...

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